The business of lending, the skill, the expertise and therefore the value, is not getting money out of the door, it is in getting money back through the door after a full repayment, or at the very least a decent recovery of a defaulted position. Contrast this with how an investor in the space currently views the industry, which is all about getting as much money as possible out of the door. If you stand at the top of a building throwing bank notes off the roof are you creating value? According to many investors in alternative finance you are.
On the equity side the problem manifests itself as a focus on origination volumes. No one has been able to explain to me why it is that a platform that writes twice the volume of loans should be automatically be worth twice as much as an identical platform writing half the volume. In any normal lending business that rapidly grows its book there is concern that the quality of the book is deteriorating, but in the alternative finance world no such caution is present. Go to an alternative finance conference and every platform will highlight origination volumes, whilst no one discusses the cost its cost of customer acquisition, or the lifetime value of the customer, since the former is often greater than the latter (unless some heroic assumptions are made on how long a customer can be retained on greater-than-bank-rate products). All will focus on current low default rates, with no attempt to normalise for the fact that we have been through the most benign lending conditions for a generation or more. They will talk about stress-testing the portfolio, but that is not the same thing, and the financial crisis showed the folly of believing in such analyses.
I recently sat down with a serial, successful financial entrepreneur in New York, who has a stake in a fairly early stage consumer lending platform. He was deeply frustrated that, in discussing potential equity investment with a whole series of venture capitalists, all said that they would be interested in investment if the origination levels were higher. No one was interested in the fact that the book of business had some tremendous characteristics and would be extremely resilient in a downturn, all the investors focused on was the size of the loan book. The implication was that a poorer run business, with less substance would be worth more than one that actually has sustainable competitive advantage.
On the lending side the situation is just as acute. Although an extreme generalisation, I would say that there are three broad categories of lending through the alternative platforms:
“Big Company Lending”, where weight of money has depressed returns;
“High Coupon Lending”, where investors chase yield; and
“Low Coupon Lending”, where returns are extremely secure.
The “Big Company Lending” through the larger platforms has seen returns whittled down by the high amount of interest from investors in the assets. I have always been bemused by the notion that, just because more people want to buy a loan it becomes less risky and therefore can be written for an acceptable risk/return at a lower interest rate. If one thing is certain about the current macro-economic environment, it is that the world is not getting less risky, and yet yields have come down as money chases returns. Money is chasing returns because the larger platforms are the only ones through which larger investors can allocate sizeable sums. However, that is no way to determine the pricing of risk.
With the “High Coupon Lending” the problem is also one of unevaluated risks, but for different reasons. In this market investors’ desire for high returns drives the lending criteria, rather than the other way round. There is a significant amount of lending that is being done in more risky areas that only exists because investors desire the sort of interest rates available. Investors appear to give little time and effort to doing true due diligence on the underwriting or (more importantly) some research on the likely default rate across the cycle. I suspect the risk adjusted return from many such platforms will prove disappointing.
Finally there is the “Low Coupon Lending”, where ironically the best risk adjusted returns are available, but unfortunately these areas are of little interest to most investors, since the headline rates are low and yet the risks are negligible. Examples of this would be extremely low loan to value property loans, or credit insured loans. These are the assets that investors should be buying, because the returns are significantly above where they should be for a very low risk asset. However, platforms that play in this space have continuously struggled to obtain funding, reflecting the relatively unsophisticated nature of much capital in the space at the current time. The answer that comes, time and again, is that the yield on the assets is not high enough.
The biggest problem with this misallocation of funding is that it provides a glass ceiling to the growth of the sector. As alternative finance companies grow they will need to access funding from traditional buyers of financial paper. Why? Because these are the multi-billion dollar pockets that will allow platforms to truly go mainstream. However, traditional finance buyers will want companies to be focused on making money and basing their model on conservative assumptions; they will want platforms to base their pricing on rigorous across the cycle modelling of the asset class that enables a proper evaluation of risk adjusted return.
Alternative finance companies need to evolve to access these greater pools of capital, and this will be the greatest challenge for many in the coming months and years.
