The first half of May was challenging for the alternative lending industry. As a result, now there is a plenty of alarmists’ notes implying that recent developments are a canary in a coal mine. On the other hand, there is a decent number of posts by those who understand that alternative lending is here to stay and platforms with solid economics will survive in the long run.
As John Maynard Keynes coined: “In the long run, we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again”.
The question is what lies in between “now” and “the long run”. What we witness is the set of exogenous shocks amid solid performance of the underlying. Current environment can be outlined as follows:
- The valuations of public companies have fallen;
- VC funding has decreased;
- Investors have become more reluctant to buy new originations;
- The trust of the investors has been impaired;
- Still the performance of the underlying remains stable.
The last point suggests that no matter how painful in the short term, these events would enable the industry to address certain issues and build the foundation for a stronger growth.
Before we go into details of points 1-4 it is important to refer to the chart below (gathered by MonJa). The 30+ day delinquency is an early indicator of the portfolio performance. The blended metric of Lending Club and Prosper is below 2011-2012 levels. This is because the performance of the portfolios has nothing to do with the state of VC funding or the Wall Street sentiment; it is driven by the originators’ underwriting policies and the state of the economy.
So if the current downturn in alternative lending is exogenous what are the implications for the industry?
A decreased valuations of public companies will postpone IPOs of private companies. And there is a possibility that the exit for the investors would be at a lower valuation than expected if the company would be forced to do so (via IPO or a private sale) before the stock market rebounds.
It is said that you can always tell when the VC enters your house because he does so backward since he always thinks about the exit. Public valuations are used as guidance for the private companies’ valuations whether it is the new round, acquisition or revaluation of the portfolio. So decreased public valuations will impact the valuations at new rounds and will force VCs to mark down their portfolios. This, in turn, would impact VC funding.
Decreased VC funding means that fewer companies would close new rounds and the valuations would be lower. Companies with poor business models or copycats that didn’t scale enough would not raise new rounds and go out of business. Others would have to optimize their operations and prove that they have an edge over the competition to get funding. Some companies might merge. Larger players would have an opportunity to acquire teams and complementary businesses at a lower price. While this process might be painful for some teams and VCs this development is good for the industry. As a result, survivors will emerge leaner and more efficient while the landscape will be less crowded and therefore the economics of the projects will improve through lower customer acquisition costs.
Marketplace business model convergence
The biggest pain for the industry though is a decreased in the demand for new originations exaggerated by the case of Lending Club. Unlike balance sheet lenders that can rely on the proceeds of the portfolio, marketplace lenders depend on the willingness of the investors to buy new loans. And the question is whether the decreased origination now and servicing fees in future would cover OPEX or the companies would go into the red. While for the profitable Lending Club there is some room, it’s the tricky question for unprofitable companies. Still every company would have to adapt.
Prosper layoffs are exactly this type of adaptation. In addition to that, we might see some convergence between pure marketplace and balance sheet lenders. Probably we have already seen such a move when SoFi announced the establishment of a captive fund to buy new loans. More on the benefits composite lending you can find in this article.
Moderate increase in the interest rates could also help to bring the investors back. Even if the companies would loose some borrowers the overall effect on the origination volumes would be positive.
And as with decreased VC funding, this contraction in originations is good for the industry. Some investors have already raised their concerns that oversupply of capital might lure companies in less strict lending policies. So this exogenous decrease in demand, since the performance of the underlying is not the cause of the problem, might have helped the industry not to fall into a real crisis, caused by the loan portfolio performance.
Still the most difficult challenge for the alternative lending industry is building back the trust since it is the most important driver of the investors’ demand for loans, which in turn impacts all other metrics. And here alternative lending has a huge advantage over banks and other financial institutions. This advantage is transparency. Marketplaces cannot hide under-performing loans in reserves and fine print. US-based alternative lenders could adopt the best practices of UK-based Peer-to-peer finance association to standardize data and further enhance transparency.
3rd party service providers
In addition, service providers like Orchard for marketplace lenders and Blackmoon for balance sheet lenders, further enhance investors’ trust by providing independent insights in portfolio performance as well as enable investors to apply customized investment strategies, that screen each loan independently. One can expect that such companies that act as a gateway to the alternative lending for institutional investors could benefit from recent developments and help the industry to restore trust. New entrants like Global Debt Registry are willing to step in and earn their place in the sun by validating data as well .
To sum up the current downturn in alternative lending was caused by exogenous factors such as a limited supply of capital to fund growing origination volumes that in turn caused the reassessment of growth forecasts and singular failure of corporate governance in the largest player in the market. The good thing is that the underlying asset doesn’t show any erosion and therefore the downturn is not systematic. Throughout the recovery we might see that some businesses will fail and give way, some might consolidate or be acquired by largest players. At the end of the day, the most viable business models with the strongest team will adapt and emerge even stronger. Alternative lending has another chance to prove all the skeptics that the industry is here to stay since fundamentally it’s more efficient than traditional banking.
Author: Sergey Vasin
About the author: Sergey Vasin is an investment director and chief operations officer at Blackmoon FG, the platform that enables institutional investors to directly invest in newly-originated loans issued by balance-sheet lenders. Sergey is responsible for cooperation with loan originators and daily operations of the company.