Ever since the marketplace lending industry emerged as a force in the wake of the financial crisis, investors have marvelled at the growth rates that these technology-based businesses have been able to achieve. While lending growth at banks has only slowly recovered since 2008, online lenders such as Lending Club, Prosper and OnDeck Capital have been doubling the amount of loans they handle – or sometimes more – with each passing year. It is a feat that has forced the industry to rethink the way it does business. Marketplace lenders may have started out as anti-Wall Street revolutionaries seeking to reshape banking, bringing individual borrowers and lenders together using peer-to-peer technology.
In recent years though, loan demand has simply outpaced the ability of marketplace platforms to enrol enough retail lenders to finance it. Impatient venture capital backers have demanded faster expansion. The operators have therefore turned – guess where? Yes, to Wall Street, to hedge funds and private offices, to keep the money rolling in.
The numbers speak for themselves. Pure retail lenders going online accounted for just a fifth of the personal loans issued by Lending Club, the largest quoted marketplace lender last year. And while the retail channel has grown at a respectable 61 per cent over the past three years, institutional lenders (including managed funds and family offices) have gone up at more than twice that rate.
Now, however, some industry leaders are talking as if they want to wrench the model away from its growing dependence on market funding. Renaud Laplanche, chief executive of Lending Club, says he wants to cap at its present level the firm’s dependence on institutional money (although he is only talking about a subset – hedge fund, bank and insurance company cash – that accounted for about 45 per cent of its funding last year). Mike Cagney, the boss of SoFi, a big online lender specialising in university graduates, plans to set up a captive fund to invest in the company’s own loans, as well as those of its competitors.
They are right to worry about the industry becoming addicted to Wall Street lucre. Institutional capital might have helped the industry seize more of the lending market than it would have done otherwise. It has allowed two large operators – Lending Club and OnDeck – to float on the stock market, and given some private operators, such as SoFi, unicorn-sized valuations. But it is also a weakness.
Hedge funds and banks have proved a relatively easy sell when average rates on a Lending Club loan are between 7.5 and 25 per cent and the average bond fund yields a miserly 2 per cent. But their Wall Street dependence makes online lenders bear more than a passing resemblance to traditional finance companies such as Household and Countrywide Financial. And as those firms discovered in the run-up to the 2007 crisis, market funding can quickly dry up when sentiment turns.
Granted, we haven’t yet seen the sort of regulatory shock or tick-up in defaults that would trigger such a pullback. But the wobble that followed the US Federal Reserve’s rate increase last December is a clear reminder of the flightiness of sentiment. Not only did it force marketplace lenders to hoist their rates swiftly in response; it has also set off a hangover among buyers of securitisation deals. An issue by San Francisco-based Prosper last week had to offer investors in the riskier tranches a full five percentage points more than the firm had in similar deals just last autumn.
There is a clear argument for reducing the dependence on institutional money. Not only would it make these businesses more resilient from a funding perspective; slower growth rates would also reduce the risk of adverse selection to which youthful lending businesses must inevitably be prone. But the journey doesn’t come without pain for investors. Online lenders’ revenues are highly geared to the level of new business, mainly because they don’t own the loans they originate. Take Lending Club, for instance. Nearly 90 per cent of its $427m of revenue last year came from transactions. Strip away much of that and the company would fall deep into loss.
It is not a comfortable choice but marketplace lenders do at least have one: they can embrace the volatility of their existing model and keep on running to grow ever bigger. Alternatively they can redesign it to insulate themselves better from Mr Market’s stops and starts. There is, however, no free lunch to be had here. Slower growth rates and more permanent capital would reduce the risk of sudden finance company-like shocks. But only at the cost of making online lenders look more like the lowly rated financial institutions they were supposed to supplant.