White Paper | by Dalton Investments | 06.15.16
Crisis can create opportunity. The Financial Crisis of 2008 was such an occasion, upending the established financial system, while creating new industries now taking root in the broader economy. Among the most successful of these is Financial Technology, broadly known as FinTech, a line of business based on using software to provide financial services outside the traditional banking system.
Lending Club and Prosper Marketplace, Inc. were the first FinTech companies to offer “peer-to-peer” lending (“P2P”). P2P uses online lending platforms to connect borrowers looking to obtain unsecured personal loans with retail investors who directly fund their loans at an agreed interest rate. After the 2008 Financial Crisis hit and banks tightened their lending standards, these companies experienced extreme growth. Mainstream banks cut back on home equity lines of credit (HELOC) and subprime consumer lending in order to focus on the “prime” section of their consumer credit businesses. The result was a gap in the consumer lending market that was quickly filled by the new FinTech industry.
Lending Club, the largest market player in the FinTech space, saw loan origination rise from just $257 million in 2011 to almost $8.4 billion in 2015 and was estimated to reach $12 billion in 2016. In order to fund this rapidly increasing demand from their borrowers, Lending Club and their competitors shifted from traditional P2P lending to what is now called Marketplace Lending, which utilizes the capital markets to finance loan originations.
This same scenario has played out in the $450 billion small business lending market.1 In 2015, banks originated 43% of business loans of up to $1 million, down from 58% in 2009. OnDeck and Kabbage, the two largest FinTech small business lenders, have filled the gap, originating approximately $4 billion and $6 billion to date respectively. OnDeck introduced marketplace capabilities in early 2015 and believes this segment will help spur their growth going forward. The company believes it will help double their business within two years.
But now Lending Club, the industry pioneer that grew so rapidly in the wake of the Financial Crisis, is facing a crisis of its own. In May, founder and Chief Executive Officer Renaud Laplanche, along with three senior executives resigned or were fired after the Company’s Board of Directors said it found evidence of loan data integrity breaches along with undisclosed conflicts of interest surrounding a personal investment. The event has cast a shadow of doubt over the FinTech industry and prompted calls for better internal oversite over key compliance issues. For many investors, the bigger question remains, is this a viable business line going forward or is history repeating?
Dalton believes the industry will weather these storms and adjust as needed. Our big question is, how much of the industry will survive once the “music stops.” With over 100 companies competing in the space, price competition/refinancing alone has accounted for tremendous volume. While we believe that FinTech is an advancement in lending that is well suited to the times, the industry has yet to experience a full business and economic cycle. And as stated earlier, the regulatory environment is complex and uncertain.
For example, the industry was founded on consolidating credit card debt into a term loan at a much lower APR. But getting our hands around the amount of loan volume due to credit card consolidation vs refinancing existing term debt is extremely difficult. According to Lending Clubs website, in 2015 ~19% of its loans were credit card consolidation vs ~49% refinances. The designations are self-reported by the borrower so it is tough to know how much overlap occurs.
This is one reason we choose to invest in the structured securitizations. New securitization markets have historically provided opportunities for those with transferable expertise, nimble capital and the patience to wait for truly attractive opportunities. Choosing the right spot to invest in the capital structure can provide greater protection against defaults, thereby improving the odds of success. We will explain this in greater detail in our next paper which will examine the roller coaster ride for both FinTech bonds yields and equities since the end of 2015, and the emerging risks and opportunities for investors.