Social Finance Peer-to-Peer Lending: Bubble in the Making?

By Scott Tucker on 17th March 2015

P2P/Marketplace Lending

Encouraged by the huge success of the Lending Club IPO, another P2P lender SoFi, that started out in 2011 as a specialist student loan refinancer and has recently branched out into other consumer loan products, reportedly plans to file for an IPO in the coming months. In its most recent PE funding round, the company was valued at $1.3 billion, or about 4.0 times estimated book equity – a multiple that IPO investors might bid up in expectations for this tech-driven unsecured lending marketplace to grow at a rapid pace for many years. If so, such expectations are likely to prove fragile because SoFi faces certain key competitive and balance sheet risks that will slow down its growth, creating potential for sizeable losses to investors when those risks materialize.

Social Finance Peer-to-Peer Lending: Bubble in the Making?

To put things into perspective, even before the planned IPO, SoFi’s valuation of 4.0x book equity represents a significant premium to other traditional student loan refinancers such as Wells Fargo (NYSE: WFC, 1.7x book equity) despite the company’s limited operating history, small size and negative ROEs. In my view, this valuation premium, which will presumably expand in the run up to the IPO, is anchored in market expectation for SoFi to deliver very high loan origination and cash flow growth rates for many years, based on two “apparent” value propositions of its business:

  • First, lower student loan interest rates compared with those offered by the federal government and many conventional banks/specialty lenders. This value proposition is based mainly on the company’s focus on low risk borrowers (students with FICO scores of 700+ and free cash flows) to exploit inefficiencies of the $1.2 trillion market that tends to work on a “one-size-fits-all” pricing model and features a federal government that prohibits “government refinancing” of loans originated at high rates in the last decade.
  • Second, a scalable low-risk business that not only supports the company’s expansion into multiple product lines (personal loans, credit card debt, mortgage finance) but also the ability to do so without putting shareholder equity at risk, based on the “originate to distribute” model. More specifically, the model entails third party investors financing school-specific student loan “pools” in return for a “core” interest rate (currently about 4 percent p.a. on Fixed Rate Loans and Libor + 2.25 percent p.a. on Variable Rate Loans), adjusted for pool-specific loan losses. As such, the model supposedly allows SoFi to transfer “all” loan related risks to third party investors, allowing high-paced growth without risking own equity.

In my view, this positioning is somewhat removed from the truth as SoFi faces certain competitive and balance sheet risks that will likely slow down its growth trajectory in the coming years:

Concerning the first value proposition, while the industry’s “one-size-fits-all” pricing approach and the prohibition on government refinancing of high-cost FFELP and other eligible loans have underpinned SoFi’s rapid growth over the past few years, I believe those dynamics are already undergoing a change, creating prospects of growth headwinds for the company.

For starters, aside from the expected increase in competition from other P2P platforms such as CommonBond, large money centre banks such as Wells Fargo (NYSE: WFC) have already started defending their market share by reducing refinancing rates for students with strong credit. At the same time, in a signal of their willingness to respond vigorously to competitive threats, smaller banks such as DRB have started offering loan refinancing at rates that are even lower (by up to 100 bps on 20-year fixed rate loans, for instance) than those offered by SoFi. In my view, the intensity of these competitive pressures on SoFi’s growth prospects is only likely to increase in the coming years.

Separately, the U.S. Congress is debating a bill that could materially reduce the pool of loans available in the market for refinancing by players such as SoFi. In particular, the bill (titled “Bank on Students Emergency Loan Refinancing Act”) calls for allowing private and federal student loan borrowers to refinance their high-cost loans (originated in the last decade when interest rates were much higher than they are currently) with the federal government. If the Congress were to pass this bill, I suspect it would become very hard for players such as SoFi to sustain their rapid growth pace.

Concerning the low-risk business model, I note that while SoFi claims to be P2P lending platform, sometimes giving an impression that it is just a facilitator of transactions between lenders and borrowers, in fact it acts – much like a bank – as a “principal” on both sides of the transaction. More specifically, while third party investors on the company’s platform choose to finance specific loan “pools”, they do so by lending money to SoFi against “Credit Linked Community Notes” which the company issues typically for a “five-year” tenor. SoFi then uses the proceeds of the Notes to originate the loans, with borrowers owing money to SoFi, not to third party investors.

The trouble with this structure is that it is not low-risk. Although SoFi transfers the “credit risk” associated with the loans to Note subscribers, it retains “duration” and “refinancing” risks because it funds fixed rate assets that mature in 5-20 years with fixed rate liabilities that mature in five. While this asset-liability gap tends to inflate short-term profitability in a declining interest rate environment (owing to SoFi capturing a “term premium” associated with long-term loans), it exposes the company to considerable mark-to-market losses on loan portfolios and debt refinancing risks in a rising interest rate environment. As such, I believe SoFi is anything but a low-risk business.

Separately, concerning the scalability of SoFi’s business based on the “originate-to-distribute” model, while the company’s student loan portfolio would remain exempt from compliance with the five percent “risk retention requirements” proposed under the recently adopted SEC rules, such exemption might not hold for other loan products that the company has recently launched. As such, depending on when these rules go into effect, and that could take a few years, SoFi is likely to need equity capital infusion to fund growth, which would naturally put a limitation on its growth pace.

Overall, while I see SoFi as an interesting business that creates value and has potential to deliver reasonable returns, investors should be cautious in viewing the company as a very high growth technology play deserving stratospheric multiples. In my view, SoFi is essentially a specialty finance lender and should be valued as such, without regard to the usual euphoria that precedes IPOs.

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Companies in this Article:

SoFi
CommonBond

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