The wrong 'culture' has often been blamed for credit market debacles in the past.
The breakout is complete. Private credit is no longer a side-show. It has become an asset class. Market leaders are predicting that it will ultimately be bigger than private equity. What is more, there is a chance that a new culture is evolving in the credit market which may make the debacles of the past less likely to occur.
The promise of direct lending 2.0
The fastest-growing and potentially huge segment of private credit is being brought about by tech and data powered lending platforms – Direct Lending 2.0. These groups have evolved from their P2P roots. Business models are being re-examined, which is healthy. Several, such as Auxmoney,Funding Circle and Lending Club are now large originators and servicers of SME and consumer credits direct for institutional investors. Just one UK-based platform lender originating SME credits of around 100,000 Euros per clip made more loans of that size to UK companies than the entire UK banking system managed in Q4. This potentially vast capital market has the potential to be a sustainable alternative to the banking system.
But unfortunately in the past when the demand for investments has outstripped their supply, the core principles of credit have been compromised. Now that private credit can stand on its own without the banks, will things be different?
To be virtuous, not vicious
An effective framework with which to look at credit markets is either as virtuous circles or as vicious circles. In the virtuous circle the most eligible borrowers come forward. Lenders then get clean, direct data about potential borrowers. They can build better models and ensure pricing is appropriate. Investments perform well. More capital is attracted. More borrowers can be reached and more data is accessed. Round it goes and everybody is happy.
But in the pre-2008 vicious circle, as more capital was committed of course underwriting processes deteriorated. Long chains of intermediaries introduced the borrowers. Data was often poor, sometimes fraudulent. Modelling worsened. Pricing was unattractive but was obscured by complex structuring to keep the capital coming. Ultimately the buyers, smelling a rat, went on strike. Investors redeemed, depositors ran and the system failed.
Scores of regulators' reports and Hollywood movies have since concluded that the culture of originate-to-distribute finance made crisis inevitable.
Credit is more science than art, but is there potentially a cultural shift inherent in Direct Lending 2.0 that means our descent into vicious circles is less likely?
The arrival of credit culture 2.0?
In this context it was interesting to see Patty McCord, world-beating Netflix’s ‘Chief Talent Officer’ (we don’t see many of those in the credit market) recently join Lending Club. At Netflix McCord had crafted what Facebook’s Sheryl Sandberg hailed as ‘the best thing ever to come out of Silicon Valley’ – the famous Netflix Culture Deck. When joining LC, McCord went as far as stating that the US-based online lender shows the kind of highly successful culture she had helped to shape in her 14 years at Netflix.
Does a finance firm’s culture really determine whether the virtuous or the vicious ultimately prevail? People certainly do make public efforts on culture. Lehman’s pre-2008 mission statement was centred on ‘commitments to partnership’ and ‘dedication to clients’. Enron, as quoted in the Netflix Deck, had ‘integrity’ and ‘excellence’ inscribed on its lobby wall as the firm collapsed. So did most of the investment banks in September 2008.
Compared to those high-minded concepts, the nine Netflix Values in McCord’s original Culture Deck distributed in 2009 do come across as strikingly personal. ‘Curiosity’, ‘courage’, ‘honesty’, ‘passion’ and ‘selflessness’ are expected of staff, as are ‘judgment’, ‘communication’, ‘innovation’ and ‘impact’. Netflix states that these ‘specific behaviours and skills’ are to be demonstrated if promotions are to be awarded and severance packages avoided.
But which of these traits and values, if carried through to a significant degree by frontline staff in investment banking or asset management, could have helped the credit market to avoid that fatal vicious circle? Curiosity, courage, innovation and impact were all there at the creation of the ghoulish subprime CDO-squared. Collective judgment was of course disastrous, but individuals used their judgment as best they could. ‘Passion’ – eg for helping to extend home ownership - might have blinded you to the flawed gaussian models that told you those subprime bonds rated out at AAA. It is unclear that testing for these behaviours and skills in performance appraisals could have prevented the run-away train that was the 2003-2008 credit market.
Radical change, steady focus
It is when you look at what is required to maintain a virtuous circle that the Silicon Valley mindset starts to make sense. What Netflix went through was one of the most effective pivots in the history of global business. Blockbuster is dead as a dodo and Netflix is one of the most admired and influential companies in the world. They had the foresight and courage to change their business model when the context was changing.
The lending platforms have already shown some of that NetFlix nimbleness. Funding Circle, for example, recently closed its whole Spanish business and ended all property loans to concentrate on its core, world-leading SME franchise. Several other platforms have pivoted their models from B2C to B2B or have teamed up with banks. The platforms are certainly able to attract the more ‘curious’, ‘courageous’ and ‘passionate’ finance talent that will be needed to keep their performance ahead of their peers. Funding Circle now has over 800 people worldwide, a quarter of whom are in risk or underwriting.
Discipline is different to processes
McCord's Culture Deck goes on to set up the problem that growth brings more complexity and that complexity requires the adherence to more and more processes. Firms become big - but vulnerable to changes in their market - and the talent leaves. The 2008 banks, caught in the vicious circle, famously just needed to ‘keep on dancing’. The Blockbuster board probably said something similar about distributing DVDs more effectively by mail.
The complexities available to the 2.0 platforms are indeed myriad. Do they retain a pure marketplace ‘uberised’ model? Do they take on some balance sheet of their own alongside their institutional lenders? How soon will a Direct Lending 3.0, perhaps the widespread adoption of blockchain, threaten to upend everything?
The winning strategies are likely to be those of the pure-play. Sticking either to a core SME or core consumer base has proved sensible for the firms that have done it. Unlike banks, which levered up equity to increase return for shareholders, the platforms’ game is to increase size and therefore profitability through operating leverage not financial leverage. Doing one big thing well is what is working best.
Above all the lending platforms, like banks, need to stay disciplined. Finding ‘alpha’ and outperforming benchmarks is not the name of the game. The alignment of interest for investors is in a platform running disciplined operations. It needs low default rates for a given return level to be able to attract more investors - the virtuous circle. To do this, the platforms will need to be extremely sensitive to change: changes in their markets, changes in borrowers’ financial status, changes in their own organisational behaviours.
Discipline will come through strategic foresight, flexibility, relentless risk management and a positive culture of ethics. You need talent for that.
Indeed, these are the requirements for our whole market, now that it is embarking on its own life as an asset class.