November 19, 2013
Guest Post by Brendan Ross
[Editor's Note from Peter Renton: Today we have something a bit different. Rather than discussing p2p lending from an investor perspective this article is for the platform operators, specifically those entrepreneurs looking to enter the space with their own platform. This is a guest post from Brendan Ross who runs Direct Lending Investments which is the General Partner of the first and largest peer-to-peer fund with an exclusive focus on short-term, high-yield small business loans.]
I have at least two conversations a week with entrepreneurs who want to start a lending platform.
I have another one to two conversations with online lenders who are not currently P2P, but who are interested in earning working-capital-free servicing revenue by selling loans to hedge funds like mine.
This piece, which Peter was gracious enough to offer to publish on Lend Academy, captures my beliefs about what it takes to start and grow an online lending platform.
In November, the Direct Lending Income Fund that I founded over a year ago will buy $5 million in small business loans originated by online lenders. While that is bigger than many entire lending platforms, it is still a very, very small part of the financial services industry.
These are early days for P2P lending. Those of us in the tent feel enormously privileged to be a part of it, and we are generally welcoming of new entrants.
Two Phases To A Successful Exit
Along the path to a successful exit, online lending platforms must go through two phases:
- Phase 1: Need Lenders. You have borrowers but need capital to lend.
- Phase 2: Must Scale Borrowers. You have an oversupply of capital and must scale your borrower origination.
Phase 1: Have Borrowers, Need Lenders
If you start a lending platform, it is because you believe that you can find borrowers. Initially, you will certainly find more borrowers than lenders, which will probably lead to a phone call with someone like me.
During this period in which you have little underwriting history, it is your fate to struggle to find lenders. You will feel enormously loyal to those lenders who first believe in you, and you should.
If those lenders are like me, they believe that in exchange for their early trust they will get a big seat at the table when you enter the sunny uplands of Phase 2, and lenders are begging for you to feed them loans.
Three Models for Attracting Lenders
There are generally three models for attracting lenders:
- General Public – If you want to sell securities to the public, you will incur substantial SEC registration costs. LendingClub and Prosper did this out of necessity early on, and there are many European players still doing this. Now that P2P is on the radar screen of institutional investors, there are few new US platforms considering this route, no doubt to the disappointment of many Lend Academy readers.
- Accredited Investors – Many new companies plan to be a pure platform, meaning that they do not keep any loans on their own balance sheet and are entirely focused on servicing revenue. There is a perception that this is “more fair” than (3) below, but I do not agree. Being a platform has its own challenges, the largest of which is getting investors to trust your underwriting since you are not eating any of your own cooking. This is typically less of a problem with shorter duration loans.
- Balance Sheet Partners – The least “P2P” of three strategies, a lender looking for a balance sheet partner will have its own equity in loans. This equity may be levered with an asset-backed line at around 3-to-1, so that $10 million in equity would permit $40 million in loans. To get bigger, these lenders look to investors like my Fund to whom they will sell loans, retaining servicing rights and fees. Typically they are only looking for a minimal number of partners. I am a fan of this strategy because the lender is eating its own cooking, but of course it is only marginally P2P.
Endless variations are possible here, including doing a low-risk tranche with P2P accredited investors who will earn a fixed, preferred return, and then using balance sheet partners to share the exposed tranche at higher but variable returns.
The Work of Phase 1
During Phase 1 you will perform four important tasks:
- Sourcing Borrowers. Feels easy, doesn’t it? Just wait.
- Underwriting. Free money! Until your first delinquency…
- Building Tech. You are running a “bank,” so get this right.
- Finding lenders. Hard yards.
Smart money knows that (1) feels easy now, but will eventually become much harder than (2) and (3).
Look at LendingClub today: they have far more money lined up than they have borrowers. Turns out finding $200+ million in borrowers is A LOT harder than finding the lenders to sell them to. [Editor's note: Lending Club have told me that there is no shortage of borrowers, they are scaling as quickly as possible. But the point remains that investor money is flowing in much more easily than borrowers.]
Scaling borrowers is what big exits are all about
When I look at new platforms, I view the underwriting and technology as very hard tasks with significant execution risk, but very little creativity / business model risks. I am not suggesting that underwriting is easy, but I am saying that the next decade will see plenty of good underwriters struggle to find enough borrowers for a successful exit.
The most important part of the lending platform’s story for me is their plan to scale borrowers.
Of course everyone wants to build a brand and get a direct channel going that has zero origination costs. Here are the paths to get there, in order of what I like to hear:
- Unique Deal Flow: Fantasy example from small business lending: you ink a deal with Citibank to get their business loan rejects in exchange for a modest origination fee.
- Better Mousetrap: You design a unique direct mail balance transfer marketing campaign that is highly effective. As a result, you can get your share of balance transfers into 3 year amortizing loans and you may be able to scale. Not unique, but may be credible if you have the right staff.
- Brokers: This is a pretty common strategy that is harder to execute than you think, and is very time consuming to scale. This is not unique at all, and I would discourage you from going this route.
- Dreams: You have your first few borrowers ready to roll, and you will just figure this part out later…
You can get away with slightly weaker underwriting skills if you have unique deal flow. If you are going the broker route, you need to be careful not to be the dumb money that picks up the loan no one else wanted.
Customer acquisition costs are typically paid from a combination of origination fees and service fees as the loans are repaid. If your acquisition costs are higher than your origination fees, which is relatively normal, then you must use working capital while you wait for servicing revenue to flow in. This can make scaling expensive.
Phase 2: The Real Work Begins
For the industry leader LendingClub it took them about 5 or 6 years to get to Phase 2: oversupply of capital. The platforms I buy from are all borderline oversubscribed, but that is partly a function of my participation.
When Phase 2 happens, your large and rapidly growing senior leadership team can spend time focusing on scaling borrowers while maintaining your underwriting standards.
How fast can you responsibly scale? This is a rich man’s problem. If your underwriting starts to slip as you scale, you risk jeopardizing your entire business because your investors will lose faith in you.
Platforms that keep none of their own loans face a unique trust problem in Phase 2, because they have a strong incentive to grow quickly at the expense of good underwriting. Two factors mitigate against this sort of moral hazard: the short duration of the loans, so that investors would smell a rat before managers could achieve an exit; and second, the integrity that I have seen across all management teams in this space.
Aside from this moral hazard problem, there are the growing pains involved in achieving the 10% month-on-month growth that we have seen from LendingClub and others. My advice is to err on the side of caution.
If you have lenders queuing up and are printing money, it is worth exercising some discretion. Remember that financial services is not a winner takes all space. There is plenty of room for many large P2P lenders, just as there are many large credit card banks.
There is much about Phase 2 that is unknown. P2P lending is young, and the story of how these companies become mature parts of the world’s financial system has yet to be written.