By James Levy on 14th August 2014
In this third instalment of a six part survey of market lending from the investor’s perspective, I would like to address what I see as an important potential bottleneck for the growth of market lending in the future, and the ability of the alternative lending platforms to meet very ambitious growth projections for the coming years.
I want to make clear that I have enormous respect for each and every legitimate non-bank lender competing in this space, and what has been achieved already is very impressive in terms of rapid growth and fast rising total loan volumes. However, when compared to the incumbent banks, the entirety of the industry, even including the American giants of Lending Club and Prosper, reminds me of the small mammals that emerged at the end of the age of the dinosaurs. They were much more clever, agile and able to adapt to new circumstances, and indeed did inherit the earth eventually. However, this outcome was by no means pre-ordained and could have turned out very differently. The banking “dinosaurs” of today have at their disposal tremendous balance sheets, generous credit lines with central banks, as well as gigantic advertising budgets, not to mention many friends in government and regulatory agencies worldwide to help them maintain the primacy and market share in the coming years. Despite all that has occurred during and since the 2007-2008 financial crisis, for the most part the banks still enjoy enormous advantages over their market lending competitors in terms both of name recognition and of perception of credibility and safety of the savings they hold in deposit on the part of the investing public.
It has been my privilege to enjoy an unusual perspective on the market lending revolution over the past couple of years. Firstly, as an “early adopter” international investment advisor embracing this new field as a consequence of my need to secure consistent, attractive returns for my investing clients. More than two years ago I concluded that I could no longer accept the very high levels of systemic risk in the stock and bond markets, especially given the poor expected returns for bond holders in a time of historically low interest rates. Since then, in countless meetings with potential private clients, family office managers and institutional fund managers I have gained insights into how the emerging market lending asset class is viewed by investors, and how far it yet has to go to be accepted as a mainstream asset class. The fact is that an overwhelming majority of investors, both individual and professional, have never heard of market lending, and continue to be focused exclusively on the familiar territory of stocks, bonds, and mutual funds or unit trusts. Unfortunately, only a very small percentage of investors today are willing to make the leap to investing directly in consumer and small business loans, even in the face of a growing track record of attractive, consistent returns.
More recently, my advisory practice has given me the opportunity to work on the other side of the balance sheet as well, helping businesses to gain non-bank funding through a variety of platforms. This experience has led me to conclude that it is much easier to close a deal to provide a loan to a person or business that needs financing, than it is to close a market lending investment by an investor. The market lending financing transactions that I have originated during the past year have moved from initial contact to closing at a breakneck pace in comparison to the operations where I have presented the advantages of market lending as a new asset class to private banking investors or professional fund managers.
This imbalance between acceptance of market lending among borrowers as compared to investors might have very important implications for the future of the industry. These are my observations:
1) People in need of a loan for the most part do not care very much about the details of the company that is providing the financing. Their decision will be based almost exclusively on the loan parameters of interest rate, repayment terms and possible guarantees required. Other factors such as the name recognition of the lender, the lender´s own credit rating and the size of the lender´s balance sheet are of little or no concern to the borrower. This is in very sharp contrast to the opposite situation where an investor is considering placing their hard earned savings (or savings over which a professional investor has a fiduciary responsibility) into the market lending sector through one of the platforms, trusts or mutual funds currently available. Here the investor will be very concerned with the history and reputation of each platform, the default rates, and the procedure and consequences when any of their loans should default. When a potential investor tells me, “I never heard of them” (often stated even when presenting leading names such as Lending Club or Funding Circle) I have found that it is likely that this investment alternative will ultimately be rejected in favour of continuing with the familiar investment tools of stocks, bonds and traditional unit trusts and mutual funds.
2) Investors for the most part do not want to be “educated” or have to go through a learning process in order to become “seasoned investors” in the market lending space. Whenever I hear an investment advisor say, “we have to educate the investing public about (fill in the blank)”, I know that this is a person with no real experience on the sales side of the investment world.
In the specific case of market lending, other than early adopters unusally open to new tendencies, the vast majority of investors do not want to learn the ins and outs of loan selection criteria, default rates, seasoned vs. unseasoned loans, or other skills necessary to become well informed investors through the current platforms. Most investors simply want to place their savings with a company with a name that sounds familiar, in a simple process, where they have liquidity and security, that is, confidence that they earn an acceptable rate of return while still being able to recover their funds at any time without facing excessive penalties for withdrawing their funds before the stipulated time.
3. As a substitute for making the effort to actually learn about a new and unfamiliar investment, both individual and professional investors generally rely basically on reputation alone instead of real due diligence and investigation. If the particular investment is proposed by Goldman Sachs for example (even shares of Banco Espirito Santo, as they did last month) the natural response by investors is acceptance of the concept as a valid investment alternative for their consideration. This works very much to the disadvantage of the alternative lending platforms, as they are currently too small to have much name recognition or the backing of large investment firms. New ideas such as direct lending without powerful sponsors and name recognition are more likely to face initial rejection as an almost reflexive response rather than an open mind eager to learn about a new emerging asset class.
My point is that the optimistic projections for the growth of market lending in the coming years can surely be met given the demand on the borrower side, but I very much doubt that they can be met on the investor side without changes in how the market lending sector is structured. It takes two to tango, and every Pound, Euro or Dollar loaned to a small business or individual must be obtained through demand for loans from an investor who has accepted market lending as a worthwhile source of returns for their savings or professional investment funds. The borrowing side cannot grow without the investor side growing at the same pace.
Fortunately, changes are already taking place that will facilitate very large investment sums from both retail and professional investors, counted in the billions rather than the millions, eventually flowing towards market lending. These changes include the issuance of bonds by the platforms themselves (where Wellesley has been a pioneer for example), the issuance of public shares on the stock markets (where Lending Club is about to take the first step) and in general a process where the market lending firms will become known to investors as the company that they are investing in, rather than simply as an intermediary providing a service to allow them to invest directly in consumer or SME loans. Reputation is enormously important for investors, and ultimately the market lending platforms will have to put their own reputation as well as balance sheet on the line. In order to compete head to head with the traditional banks for investor funds, and bring the benefits of direct lending on a massive scale to both borrowers and investors, these firms will have to leave behind their “lean start-up” phase by building their own balance sheets through issuing bonds and shares to reach a much broader base of investors who invest in the platform itself, not necessarily just the individual loans. Along with lots of advertising, the platforms will have to assume the fiduciary responsibility of allocating funds on behalf of investors, as well as facilitating the entry of investment funds from individual and institutional investors through developing their own bonds, ETFs, Unit Trusts and mutual funds investing in the loans of their platform.
Does this mean that the platforms will ultimately become traditional banks? Most certainly not. No matter how large they grow, if the platforms maintain efficient operations with serious credit standards while holding their assets (loans) and debits (sources of financing) at approximately equal levels, they will avoid the dangers of the highly leveraged balance sheets of today´s banks. In this way both borrowers as well as savers and institutional investors will benefit from more attractive terms and greater stability of the financial system as market lending becomes the norm rather than the exception in coming years.
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