BY SAM GRAZIANO
“Peer-to-Peer” lending, also known as “P2P,” is now nearly a decade old in the United States, yet it still needs a primer for those who have not been paying attention to its exponential growth for the last several years. For those of you that are not yet indoctrinated, P2P lenders are platforms that source, underwrite, sell and service consumer and small business loans through innovative online processes.
The two market leaders in P2P, Prosper and LendingClub, originated a combined $1.4 billion of loans in the 2nd quarter of 2014, principally fixed-rate consumer installment loans that are used to consolidate credit card and other personal debt. In the same quarter of 2012, these same two institutions originated only $175 million combined. Clearly, growth is high, and the hype on this market is even higher. Yet, at approximately $5.5 billion annually for the two market leaders, this market is still just a guppy in a sea of gigantic credit market participants.
When Prosper opened its doors for business in 2005, it brought a truly novel, online marketplace to the United States, where individuals were able to borrow money directly from groups of other individuals over the web – one “Peer” to another “Peer”. In a world captivated by all things “crowd,” P2P lending was just the latest example of a market being democratized by the crowd.
Fast forward to 2014, and P2P Lending has a new, although imperfect moniker, “Marketplace Lending.” To us traditional capitalists, a marketplace is a forum where there is price discovery through bids and asks for a given security or asset. Yet, Marketplace Lending, is a business model where the middleman (the platform) sets the price (interest rate) between the bid (the buyer of a loan) and the ask (the borrower). Think of it more like arbitration.
What prompted the need for the name change from P2P to Marketplace Lending was twofold: (1) people, the original suppliers of capital, are now only a small share of the buyers for these loans, and (2) new platforms have emerged, bringing a supply of borrowers in the form of small businesses, commercial real estate loans, student borrowers and any other small balance lending product that a platform is capable of sourcing, screening and administering on behalf of willing lenders.
Marketplace Lending is now a market dominated by hedge funds, family offices and other large institutional buyers of whole loans. These institutions are deploying capital in large amounts in product categories that were once prohibitively expensive to access in a cost-effective manner independently, which would have meant building their own specialty finance operations.
By virtue of buying loans from one of the Marketplace Lenders, all an investor needs is the capital, the risk tolerance and, as of recently, access to the supply of loans on these platforms. Demand from the institutional community (and yes, even some banks) has reached such a fevered pitch that an institution needs one of two things to get access to these loans, (1) the fastest algorithm to buy loans when they come available, or (2) a special deal with one of the platforms, guaranteeing an allocation of loan volume.
On the surface, it would appear that there is not much new about Marketplace Lending. Fundamentally, these institutions are a new play on an old business model. They source borrowers, underwrite and sell loans for a gain on sale (origination fee) and a servicing fee. Countless institutions have performed the very same set of services in the mortgage, home equity, student loan and auto finance markets.
What is different, and one might argue odd, is that these platforms insist on selling these loans at par value. The traditional originate-and-sell model was predicated on maximizing the premium they could garner in the secondary market. Why do they do that? These platforms are convinced that simply being the “dealer at the craps table” is the better business model. As the neutral party (the arbiter) between supply and demand for these loans, they are creating a marketplace for small loans where borrowers and lenders will come together in greater amounts and across market cycles. In short, they plan to create powerful brand recognition in each market they choose to participate in and take a smaller share of the revenue available on each loan that is originated for being the neutral party, the marketplace.
Whether or not this is a new paradigm for the delivery of credit is highly debatable. However, what many believe to be the more important innovation is the process of how capital is being delivered to the borrower. The marketplace dynamic of these business models is perhaps the secondary driving force of these business models. The Marketplace Lenders are just one manifestation of many variations of online lenders that are delivering capital through far more efficient, transparent and customer friendly processes than those that have traditionally been employed. Marketplace and Online Lenders are creating attractive user interfaces and mobile applications to create intuitive and convenient means of communicating with customers. More importantly, they are leveraging real-time data accessibility and cutting-edge data analytics to deliver lending decisions instantaneously, or within days as opposed to weeks. In short , they are delivering financial products through the same convenience that consumers have come to expect from products and service providers they interact with in the rest of their digital lives.
Say what you will about the business model of a Marketplace Lender, the Wall Street bulls are charging behind it. At a rumored $5 billion market valuation, LendingClub’s valuation is in the stratosphere, 26x Revenue and 312x EBITDA. To buy into this valuation, you have to accept the Silicon Valley narrative, which is that Marketplace Lenders are merely the latest example of technology enabled companies disrupting one of the last industries that still operates under the rules and structure of the old economy.
Unfettered by access to capital (they don’t require a balance sheet after all), investors believe that these platforms will grow at an exponential rate for years to come. A prominent venture capitalist from Foundation Capital recently authored a white paper predicting that Marketplace Lending will originate $1 trillion in loans by 2025.
Few bears deny that Marketplace Lenders are amongst a crop of innovators leveraging data, analytics and online methods to deliver capital in a more efficient and customer-friendly way than the banks. Further, few would argue that the regulatory environment is anything but helpful to these businesses that are not encumbered by bank regulators, reducing risk, taking and limiting their innovation agendas.
However, to the trained eye, this would appear to be a familiar business model wrapped in new clothing. The fundamentals of these business models are ultimately driven by their exposure to the inevitable, the brutal cyclicality of credit markets. Much damage has been wrought by the short-term memories of financial market participants.
So, what happens when the cycle turns again? Do these balance sheet-light business models have material credit risk at that point? Are their earnings streams cyclical? Are their capital supplies volatile? Those are the questions that some of the skeptics are asking.
Marketplace Lending is innovative, exciting and capturing substantial market share in enormous markets. No wonder investors are excited, as they should be. However, history has not been kind to investors that are unfamiliar with the volatility of the credit markets. Only time will tell if Version 2.0 of originate-and-sell has pioneered new ground and if these “Arbitration Lenders” are on to something.
Sam Graziano is the chief executive officer of Fundation, a New York City-based small business direct lender and solutions provider that utilizes a sophisticated software platform to streamline the lending process. Fundation launched its system to the public in May of 2013 and is now backed by a group of high-profile private equity firms and other investors. Graziano is a highly experienced financial services professional and entrepreneur. Prior to Fundation, he spent over a decade in investment banking and private equity where he developed an expertise on strategic, financial and operational issues for banks, specialty finance companies, asset managers, broker/dealers and other institutions throughout the financial services sector. At Centerview Partners, Graziano provided strategic and financial advisory services to some of the nation’s largest and most recognizable financial services companies. Prior to Centerview Partners, he spent six years with Keefe, Bruyette & Woods, the nation’s largest boutique investment bank focused on the financial services sector, where he executed dozens of mergers and corporate finance transactions and then co-founded the firm’s private equity practice. Graziano graduated from Bucknell University with honors with a degree in Computer Science & Engineering.
Fundation combines the benefits of a bank loan with the ease and efficiency of an online lender. We offer conventional loans with competitive rates to businesses with varying credit profiles. Our technology allows us to deliver capital in as few as 3 business days through streamlining the collection and evaluation of customer information and conducting the majority of the lending process electronically. As a direct lender, we use our own capital to originate and hold the loans we make, so that we can focus on building relationships with our customers. Our dedicated customer relationship model enables us to understand each unique borrower’s business. This level of service, coupled with our best-in-class products, is why many of our customers come back to us repeatedly for more capital.