Specialty Finance: Marketplace Lending
This specialty finance commentary is the first in a series of updates on origination, secondary market and regulatory trends in consumer and commercial finance. "Specialty finance" encompasses a broad spectrum of industries, asset origination channels and products across the lending landscape, including mortgages and consumer loans, as well as auto and equipment finance, among others.
Given the potential credit and regulatory risks associated with some of these industries, U.S. banks have generally avoided the sector, though a selective few have acquired or established specialty finance lending units. On the other hand, private equity, credit, and strategic buyers continue to show interest in the market owing to the potentially higher returns in off-the-run lending segments. For these "non-banks," cost-efficient financing, sales and securitizations of underlying assets are critical in freeing up capital and balance sheet capacity to provide credit for their consumer and commercial borrowers.
Investors in asset origination platforms, the assets themselves and/or related securities need to be mindful of trends in both the primary (loan origination) and secondary (financing/sale) markets, particularly as each underlying asset class has its own set of opportunities and challenges. Our goal is to help our clients and prospects better understand relevant market trends and be prepared to navigate issues as they arise.
Below we focus on one specialty finance sector that is garnering a significant amount of attention: marketplace lending.
Marketplace Lending – A Brief History in a New Era
"What makes the desert beautiful," the little prince said, "is that it hides a well somewhere…"
Antoine de Saint-Exupery, The Little Prince
In the wake of the 2007-2009 financial crisis, where credit availability in certain industries effectively evaporated (e.g., subprime mortgage lending in the U.S.), alternative asset managers are again focusing on consumer and small business credit. This view is increasingly shifting from the tangled, paper-laden web of traditional mortgage lending to a dynamic "web" of convenience: online, marketplace lending ("MPL"). This rapidly emerging asset class is a hybrid product borne of financial technology and old-fashioned consumer/commercial finance – and one that is quickly becoming a driving force in lending and investment opportunity.
MPL has its roots in peer-to-peer lending ("P2P"), which began in the United Kingdom in 2005, where individuals lend to other individuals or businesses through an online marketplace. While it has since expanded to include direct, alternative lending from institutions, the core features of MPL remain the same: online, internet-based loan application and technology-driven credit approval. Early MPL innovators in the U.S., such as Avant, Lending Club, OnDeck and Prosper, were amongst the first to provide individuals and small businesses an expedient bank alternative by offering loans through online, technology-driven platforms: the new convenience stores for loans that enhance the customer experience. The success of those platforms has spawned a multitude of new lenders that are refining the automated, "machine learning" approach to credit to deliver need-specific financing such as unsecured consumer, payday, auto, student, health care, equipment, commercial/residential solar and real estate loans, among others. The "fintech" aspect of the lending process has also helped expand the geographic reach of marketplace lending, particularly across the Americas, United Kingdom, Europe, China and Australia.
The opportunities for marketplace lending are significant and growing, as approximately $3.6 trillion of U.S. consumer credit is outstanding and is increasing at a rate of nearly 6% per year.1 Moreover, with over $2 trillion in commercial and industrial loans held among all U.S. commercial banks,2 even capturing a small percentage of small business loans within that category provides substantial growth prospects. Indeed, MPL lenders are charging ahead; a recent report indicates 700% growth over the past 4 years amongst the top U.S. MPL originators.3 Growth in this market continues in other jurisdictions as well; in 2015, the United Kingdom's alternative finance industry grew to £3.2 billion, an 84% increase over 2014 lending volumes.4
As marketplace lending has evolved, so too have options for alternative investment managers, among them:
- Venture capital and early stage investors in MPL and related platforms: Consolidation will be at the forefront, as some MPLs will make acquisitions to achieve scale while shakeouts are bound to occur as the market matures. In addition, start-up service providers to the industry are emerging, providing credit data, marketing, software, payment collection and related functions.
- Later stage private and public investors: As marketplace lenders grow in scale and size through organic development or acquisitions, opportunities will extend to institutional and retail investors, as evidenced by the recent IPOs of MPL firms such as OnDeck and Lending Club.
- Loan and securities investors: As marketplace loans make their way from origination to distribution, we expect the market to grow for whole loan portfolio sales and asset-backed securitizations ("ABS"), particularly in the U.S. The MPL ABS market will be of interest as it transitions to an established, liquid asset class. Importantly, as more lenders enter the market, data and reporting metrics will vary – normalization of loan-level attributes and credit performance will be keys to investor and rating agency acceptance of ABS supported by MPL loans.
Economic and Corporate Finance Considerations
Investors in the industry will need to question and research the business models of MPLs as their business functions vary.
- What roles are these MPLs playing and do they have a direct, economic interest in the subsequent credit performance of their loans? For example, is the MPL acting as a true, stand-alone marketplace (purchasing loans from other originators and selling those loans to investors) without retaining any economic interest?
- Alternatively, is the MPL firm "all-in," whereby it originates loans, retains them on a balance sheet and services the collections of borrower payments? Even if it operates such an end-to-end platform, the short maturity of marketplace loans (3-5 years) demands that investors be comfortable with efficient, early-stage servicing, payment collection and operational capabilities to ensure returns on investment.
- How extensive is the lender's competitive reach into consumer and commercial borrowers? As the number of MPL lenders increases, some firms are seeking to deepen their pool of prospective borrowers by, ironically, aligning themselves with traditional banks with co-branded or "white-gloved" origination programs. In the United Kingdom, it is estimated that traditional banks account for 25% of the loans on P2P websites.5
- For marketplace lenders that fund their business via the ABS market, risk retention ("skin in the game") will likely be viewed more favorably by ABS investors and rating agencies given the alignment of economic interests.
Adequately Measuring Performance
A key differentiator between traditional financing and MPL loan origination is the technology deployed in the credit decision-making process. MPLs are increasingly using non-traditional metrics to measure a borrower's ability to pay, often using proprietary algorithms and data sources. The use of technology and integration of data on an automated basis (vs. manual underwriting of loan applications) speeds the credit review process, reducing origination costs. However, that "real-time" credit analysis varies from originator to originator and, given the relatively new construct of this market, only time will tell which MPL firms have best-in-class credit and performance models.
Regulation and Best Practices
Not all jurisdictions are progressing at the same rate in supervising MPL lending practices. For example, in the United Kingdom, the Financial Conduct Authority ("FCA") has already promulgated rules governing the authorization of these platforms to lend in the P2P market. In addition, the Peer-to-Peer Finance Association ("P2PFA"), a self-regulatory body, was established in 2011 to supplement the FCA's regulatory regime.
However, only recently have U.S. regulators, particularly the Consumer Financial Protection Bureau ("CFPB"), begun to examine MPL lending practices and their potential impact on consumers and small businesses.6 While U.S. MPLs originate under federal and state laws governing lending, banking and securities activities, many of these laws were enacted before the advent of MPL lending – consequently, developments in these areas require special attention. A recent case, Madden vs. Midland Funding, has raised significant concerns in the industry as to whether state usury or federal banking laws should apply in the origination and/or transfer of an MPL loan.
Industry and advocacy groups such as the recently founded Innovative Lending Platform Association, the Marketplace Lending Association and the Structured Finance Industry Group will hopefully develop lending, governance and/or reporting standards that deliver greater transparency to the origination and performance of MPL loans and related asset-backed securities.
As we go to publication, recent developments have materially affected the world of P2P/marketplace lending. In early May, Lending Club's founder, Chairman and CEO departed the firm over allegations regarding loan misrepresentations made to an investor in a portfolio sale as well as an undisclosed personal interest the executive may have had in a fund that Lending Club invested in. While circumstances are still coming to light, it appears that each issue is rooted in internal control failures.
Coincidentally, the U.S. Department of the Treasury published a white paper on May 10 surveying online marketplace lending in the U.S., underscoring the need for greater transparency for investors and borrowers alike. Importantly, the white paper recognizes the growing importance of marketplace lending for individuals and small businesses in accessing credit. However, in citing the industry's fast growth and its relatively untested credit models and operations, the white paper calls for greater transparency around loan terms (e.g., annual percentage rates) and other borrower protections. Given the CFPB's broad authority, it seems likely that regulatory oversight will soon follow. As our commentary notes, adequate governance and transparency standards are key elements of any investor's decision-making process, particularly in a fast-growing industry. We will keep our readers apprised of related developments and their impact on the marketplace lending industry… stay tuned.
While the financing needs of consumers and small businesses are omnipresent, we are witnessing the development of a new origination ecosystem for these loans. While formidable in its opportunity, the rapid development of the MPL industry bears watching, particularly in the nature of loan origination and servicing capabilities, asset credit performance and regulatory/judicial oversight.
1 Federal Reserve Consumer Credit Data as of February 2016 at http://www.federalreserve.gov/releases/G19/Current/.
2 St. Louis Federal Reserve Report (March 2016) at https://research.stlouisfed.org/fred2/series/BUSLOANS/.
3 American Banker "Marketplace Lending Grew by 700% in Four Years," (April 8, 2016) citing a report published by the California Office of Business Oversight (April 2016).
4 The University of Cambridge, Cambridge Centre for Alternative Finance: "Pushing Boundaries, The 2015 UK Alternative Finance Industry Report" (February 2016).
5 The Financial Times, "Banks Behind a Quarter of Loans on Peer-to-Peer Websites," (February 17, 2016), citing the University of Cambridge report, infra.
6 See Consumer Financial Protection Bureau March 7, 2016 press release. See also April 26, 2016 The Wall Street Journal"Consumer Finance Watchdog Plans to Supervise Marketplace Lenders".
Asset Management Intelligence - Q1 2016