As the market matures, the number of participants in most countries is shrinking. Phillip Toth of Oberon Securities explains why.
Online lending continues to expand. Yet, it doesn’t’ seem like a week goes by without hearing about layoffs or a firm closing. And it isn’t unique to one country or sector as the number of lenders across segments in China, the U.S. and the U.K. gets smaller. How can an industry with so much growth and promise have so many companies shutting down?
The most common explanation is a maturing market. Such is the case in other industries, where after a high level of growth slower growth occurs, the industry consolidates and then declines. But the industry life-cycle paradigm doesn’t apply well when the industry grows rapidly at the same time it consolidates. In the case of online lending consolidation, it is better explained at the micro-level and has more to do with financing than any industry growth pattern.
A flood of early-stage capital served companies well as venture capitalists and others provided capital to expand business and cover operating costs. Much of that capital went to good use improving the borrower experience, reconfiguring origination channels and cultivating a huge and wide-open market. Collectively, online lenders disrupted the lending industry by offering simplicity and an overall better customer experience.
The abundancy of early-stage capital was the focus of many companies. It all made sense as early-stage investors paid handsome valuations based on origination volumes rather than profitability. Business expanded as did operating expenses. The increased cash shortfalls financed in the same way technology entrepreneurs financed technology companies by successive rounds of equity financing. What the companies didn’t realize was that they had their capital structure upside down.
Financial firms have a different look to their balance sheets than other firms. For one, they are more highly leveraged. Finance companies also have access to an inordinate amount of cheap capital through their deposit base, central banks and the broader capital markets. In turn, they finance loans with this low-cost financing. A strategy dependent on more expensive equity-financing puts a firm at a distinct cost disadvantage to their counterparts as lending competitiveness and profitability are predicated on a low cost of funds.
A model based on volumes and customer acquisition rather than risk management is also difficult to sustain. Managing losses is essential to preserving the capital base and a key component to profitability and return on equity. The higher the risk, the higher interest charge to the borrower and the more capital set aside for losses. So, it is the right borrower at the right price that matters more than the number of loans. An ability to produce those types of loans represents the true value of a lender’s origination channel as borrowers themselves are ubiquitous.
Should an online lender pursue a strategy to finance loans, then they should resemble other balance sheet lenders accessing less expensive debt capital vis-à-vis the debt capital markets. That means working with banks rather than replacing them. Warehouse lines, senior credit facilities or other loans agreements are good examples of such cooperation. Securitisations also work well for balance sheet lenders. Thus, it is no surprise that many of the most successful companies have a securitisation program.
Companies with an originate-to-distribute model have a different look to their capital structure. So-called, “operators” come in many different forms but essentially all procure borrowers or borrower information for the party financing the loan. As the service or business strategy may differ from one firm to the next so should the financing. For example, a company with a high-technology component such as big data or artificial intelligence has a different business model than a firm based on operational efficiency. The higher-tech firm likely has higher development and customer acquisition costs requiring somewhat sticky equity capital to finance these upfront costs whereas the pure operator is best-suited with a capital light strategy often selling loans to finance operation costs.
In summary, there is no one-sized capital solution for internet lenders. Firms positioned to succeed in the online lending space have a capital structure that matches the firm’s business strategy. The recent consolidation of the online lending sector indicates that explosive growth alone cannot offset the mismatch of the two. That is especially true in the financial services sector as sustainability relies on low cost of capital. Those that get it right will reap the rewards of an industry with tremendous growth opportunity.