Old Hill Partners Commentary
Point-of-Sale Lending: A New Frontier for Alternative Credit?
It’s not every month a breaking news story aligns with a topic we’re considering for a commentary, but last week’s announcement that Square, the tech-enabled payments company founded by Twitter CEO Jack Dorsey, was expanding into point-of-sale lending is one of them.
Square’s new service, named Installments and run through its Square Capital division, will allow the end customers of merchants using Square’s POS technology to finance their purchases. The service will offer loans of up to $10,000 for periods of up to 12 months, the company said, at interest rates ranging from zero to 25% and repayable via fixed monthly payments. Square’s hardware will take a simple online form at the time of purchase and provide a decision right there at the counter. The merchant will be paid in full for the purchase immediately; Square will take the loan onto its balance sheet.
It’s certainly not a new concept – stores have been financing customer purchases since the invention of the layaway, and big banks have offered store-branded credit options for decades. These days, though, point-of-sale lending is booming thanks to a combination of different factors. First, technology has reached a point where low-balance, installment-focused loans can be approved on the spot, so a range of merchants that previously only took cash or credit cards can now offer quick and uncomplicated financing options. For firms like contractors, medical offices, retailers selling electronics and other higher-ticket merchants, these options have translated directly into higher sales.
Secondly, millennials are much more comfortable borrowing for specific things when they know the exact amount and timing of their payments in advance. In contrast to previous generations (and perhaps due to the financial crisis), they’re allergic to big banks in general and traditional credit card terms, revolving structures, and costs in particular. The growing crop of point-of-sale loan options, in comparison, are very easy to understand, don’t involve opening a new credit card account, and better illustrate the actual costs of financing a specific purchase. A $1,500 air conditioner financed for 12 months at 10%, for instance, will ultimately cost $1,582 by way of twelve payments of $132 – simple, uncluttered by subsequent purchases, and with a built-in expiration date.
Add the ease with which millennials interact with technology, and the growth in point-of-sale lending is easy to understand. A recent article inquoted a survey by fintech company Affirm in which a whopping 87% of consumers aged 22 to 44 said they were interested in paying for large purchases via monthly installments. Moreover, most of those respondents also said the knowledge – in advance – of how much they will owe, and when, were the most attractive aspects of such transactions.
From the lending side, the point-of-sale development is also interesting. Since they’re usually financing specific purchases, these types of loans provide granular insights into what borrowers are actually doing with the loan proceeds. Although they are generally unsecured and add exposure to the volatile balance sheets of consumers, the shorter loan terms and balances pose less risk to the financial firms underwriting them than, say, three- and five-year car loans or home equity lines. For many financial institutions, moreover, this is where loan growth is occurring, and point-of-sale credit formation diversifies loan books away from more traditional structures.
Old Hill Partners was an early backer of point-of-sale financing. Several of our oldest and best-performing transactions were with firms that work with merchants to lend at the point of sale. Similar to the work we do with sub-prime auto lenders (and Square’s approach), our borrowers generally take these loans onto their balance sheets, and our capital gives them the ability to expand. We’ve developed expertise in this sector and understand how crucial merchant partnerships are to the success of this type of borrower, so we work specifically with companies who can grow into a deep pool of consumer-facing merchants whose products lend themselves to point-of-sale financing.
Granted, our “lend to the lender” approach requires us to also ensure our borrowers have keen eyes for credit quality. A downturn in the economy can rapidly put pressure on the ability of consumer households to pay down debt, and in a pinch, they will quickly prioritize house and/or car payments over the aforementioned air conditioner loan. Plus, the due diligence associated with point-of-sale lending is necessarily less detailed than what’s typically seen in more traditional credit formation, so default risk is not immaterial. However, technology plays a mitigating role here, too – the ability to quickly access a wide range of debt-related information about a customer through the point-of-sale device itself makes the lend/don’t lend decision at the store counter much more informed than in years past.
Plus, Old Hill Partners has deep and successful experience with transactions that “lend to the lender.” We understand the unique credit requirements of such borrowers, and have structured our own due diligence processes to account for them. Underwriting and origination standards, proper diversification across multiple merchants, conservative loan-to-value ratios, third-party servicers and ample collateral protecting our capital are among the stringent requirements we have in order to enter such transactions.
Point-of-sale lending is one of the fastest growing areas of the alternative credit sector. We’re fortunate to have both a proven approach to this niche, as well as years of experience, notably through all phases of a credit cycle, doing it. When done properly, the new flavor of point-of-sale lending can be an attractive way to generate above-average, risk-adjusted fixed income yields, and we will be selectively participating in it going forward.
Illustrating Our Approach:
Periodically, we like to include an example of a transaction Old Hill is either considering or has rejected as a way of illustrating our overall approach. This time, we’d like to highlight a proposed deal which is tied into point-of-sale lending.
The proposed transaction is a $5.0 million senior secured revolving-to-term credit facility to a bankruptcy remote special purpose entity, which is wholly owned by a company well known to Old Hill due to an existing lending relationship. Due to on-going changes in the marketplace and the desire of the company to provide a full-scale financing solution to its merchant partners, the company approached Old Hill about a new financing facility to support its loan product expansion. The facility will be secured by a direct pledge of all closed end retail installment sales contracts originated by the borrower pursuant to their underwriting guidelines. The facility revolves for twenty-four months, after which time it amortizes over a fifteen-month period and carries a coupon of prime + 6.5%.
As we have discussed above, there has been a trend in recent years for consumers to prefer level payment installment loans rather than revolving lines of credit such as credit cards. The keys to remaining competitive in the general point-of-sale lending industry are merchant partnerships and speed of credit approvals. Old Hill believes the facility presents an attractive opportunity to finance a known asset class with underlying characteristics we are familiar with and with a company that is well known to us.