Along with the explosion of investor interest in online marketplace lending has come some confusion, and as a result, this month we are devoting our commentary to this intriguing and fast-growing segment of the private credit market. We will also look at the similarities and differences between online marketplace lending and the segment of Old Hill’s asset-based lending strategy that “lends to the lenders,” i.e. works with specialty finance companies to lend to consumers and small businesses.
First, some background: As we’ve frequently described, the global financial crisis impacted bank lending in many ways, ranging from a reduction in activity to stricter regulations and higher credit standards. But it also occurred simultaneously with rapid technological innovation in cloud storage, machine learning algorithms and the advent of low-cost, high-bandwidth internet connections. Add in broad and deep-seated dissatisfaction with the traditional loan process, general unavailability of credit, and a dearth of fixed-income yields available to investors, and you had an opportunity ripe to disrupt the lending industry status quo.
Initially, online lending platforms were true peer-to-peer networks, connecting individual lenders with consumer borrowers for small-balance loans of $10-$20K. They were entirely web-based and offered consumers a simpler, faster and far more flexible underwriting process and were less expensive than alternatives like credit cards. For investors, the high risk-adjusted yields available from these transactions were very competitive against the rock-bottom returns available from traded credit markets.
Fast-forward a few years, and institutional money now drives loan volumes, often via competitive auctions whereby loan data is transmitted instantly from applications to prospective funders. Whoever bids the quickest and/or with the lowest rate wins, frequently within seconds or even milliseconds.
Furthermore, institutions are also buying fractional participation in a platform’s overall deal flow instead of directly underwriting a specific loan to a specific borrower. Small businesses have also begun seeking capital through this “marketplace lending” channel, for all the same reasons, and the kinds of loans offered have expanded into real estate and student debt. In some cases, these platforms function much more like brokers than lenders.
A cardinal distinction of online lending is automated underwriting; e.g., the heavy use of sophisticated technology like artificial intelligence, machine learning, big data analytics and crowd sentiment. These tools are used to facilitate application processing, make underwriting decisions and determine risk ratios. As the segment has matured, the arrival of large institutional participants has brought a rapid growth in securitizations, in which marketplace lenders utilize investment banks to bundle platform loans into asset-based securities that can be sold to investors.
However, there is a world of difference between what we do at Old Hill Partners and what marketplace lenders offer. First and foremost is the relationship with collateral. Marketplace lending transactions typically take the form of principal transactions whereby the purchaser of the loan owns 100% of the risk. In contrast, our assets are a well-diversified portfolio of consumer or small business loans or leases against which we lend at a significant discount to par that protects us against most of the default risk.
Secondly, default risk is where we generally part ways with the idea that marketplace lending can act as a substitute for traditional underwriting of properly structured asset-based lending transactions. Average default rates among loans made via marketplace lending platforms began trending higher than initially expected once the sector began gathering significant institutional capital. For LendingClub, the largest U.S.-based MPL platform, charged-off loans accounted for 6.95% of the $24.3 billion in loans issued since the first quarter of 2007. In comparison, the small business segment in which Old Hill typically operates has an annualized default rate of 1.86%, as measured by the September 2017 reading of PayNet’s Small Business Default Index. Granted, there are differences – lenders charging higher interest rates can also withstand higher default rates, and in a scenario when a large numbers of a MPL platform’s underlying loans default, both direct and indirect financing channels could suffer a loss. However, all else being equal, those losses would be less under Old Hill’s “lend-to-the-lender” structures.
Thirdly, an important distinction to make when considering investing into MPL platforms is that investors in platform-originated loans are not always actually lending anything to anyone. Instead of the original peer-to-peer promise of connecting lenders with borrowers, certain investment avenues offered by platforms are not loans at all, but rather credit-linked notes (similar to CDS of old) issued by the platform sponsor or affiliate. Furthermore, if the platform is merely a matchmaker, an incentive mismatch exists because it has no skin in the game and generates revenue from origination and servicing fees. This incentivizes the funding of as many loans as possible regardless of risk…and as with U.S. mortgage brokers before them, engenders reduction of credit quality in favor of volume.
Also, although the application of financial technology, artificial intelligence and big-data machine learning to the lending process has theoretically reduced the friction and cost associated with traditional approaches, the niche has yet to be tested through a full credit cycle. On the contrary, it has existed in what any veteran credit analyst will describe as a singularly unique environment marked by ultra-simulative monetary policies, central bank intervention, and an extraordinary hunt for yield at all costs by investors. In short, a cycle unlike any before it.
We believe the nuances involved with successful loan underwriting are far more complex, and more customized, than simple algorithmic scores can capture. It is highly likely this trait will become apparent once marketplace lenders have gone through a complete credit cycle, and doubt they will be able to outperform traditional underwriting methods in times of tighter credit and/or significant market stress.
In contrast, a portion of Old Hill Partners’ asset-based lending strategy has concentrated on wholesale transactions to specialty finance providers in which a traditional underwriting approach is applied involving deep due diligence, extensive loan-to-value analysis, and broad diversification of the underlying loans is created. Moreover, the specialty finance company always has skin in the game through subordinated capital, assuring an alignment of incentives that helps further mitigate risk.
The Bottom Line
The advent of private credit solutions, whether marketplace-based or asset-based, is a fundamentally good thing. Both disrupt a long-standing loan process that has become disjointed, expensive, time consuming and ultimately not very effective at providing credit where it is needed. But credit investors should recognize the risks inherent in direct participation in marketplace loans, securitized pools of them, or synthetic credit-linked notes: Unsecured status, relatively high defaults, and very questionable recovery potential.
On the other hand, the portion of Old Hill Partners’ lending strategy that provides wholesale lending to specialty finance loan originators combines the ability to invest in consumer and small business loans with a much more disciplined underwriting and risk mitigation while the variety of other asset classes against which we lend concurrently ensures a much more diversified portfolio. It is a compelling combination, and one that investors interested in engaging the marketplace lending niche should consider.