In this article, I will talk about two main points. The first is whether the Lending Club issue is an isolated event or if it reflects upon the lending industry largely. Can it really be generalized? And the second point is the responsibility that growing (maturing) startups have to realize. After all, the regulatory and compliance rigor that banks indulge in is not that wrong—it’s a necessary evil. Online lenders need to build protection for all the stakeholders that traditional lenders maintain.
Let me start with a minor third point which I wanted to make in this context. The other two points are far more important (IMO)—after this paragraph, the rest of the article will be about them. In the famous TV series Silicon Valley, the newly hired CEO of the hypothetical startup (Pied Piper) is an industry veteran. He was hired after the founder was downplayed and outvoted by the VC with a majority stake (now). So against the founder’s will, this new CEO says that the product of the company is not the tech platform, or the founder himself—it’s the stock. If the stock performs well, everything else is secondary. The founder does not agree but can’t do much against the CEO and the VC. After Lending Club’s stock price nose-dived, the other FinTech startups that have IPOed may be having a second look at the ways of dealing with the Wall Street.
Anyways, let me get to the other points. Does the recent downtrend suggest that marketplace/online loans model is flawed? Before we completely write-off online lenders, let us take a brief analysis of the major players, the recent issues and how long term the impact is. Lending Club was one of the pioneers of online/marketplace loans. This is how I understand things went for them:
- Founded in 2007
- Surpassed $10 Mn monthly loan volume in 2010
- Expanded from personal loans into business loans in 2014
- Filed IPO in 2014 after several rounds of funding (last pre-IPO valuation of close to $2.3 Bn)
- Raised ~$870 Mn from its IPO, pricing its shares at $15 in December 2014
- Partnered with Alibaba to expand business loans portfolio in February 2015
- In May 2015, the now famous Madden v. Midland Funding was out in the air (the case which is being still debated and worked upon, as to whether marketplace lenders could make loans above the state's usury limits/max legal interest rate)
- The downfall of the stock price continued from $14 in June 2015 to its lowest of $3.51 as of May 16, 2016
- The steep downfall to its current prize could be largely related to two major events: the case results putting tighter requirements on the marketplace lending platforms, followed by the recent revelations that led to the ouster of its founder and CEO.
A brief analysis of Lending Club’s financials provides us with some useful insights on its business model. A look at its net profit margin shows that it has increased from -15.57 in 2014 to -1.16 in 2015. While this indicates that it is still recording a net loss, it is a massive reduction in this profitability ratio and is a very good sign for the young company that is starting to generate large amounts of revenue. There could also be some uneasiness with the firm’s relatively high debt-to-asset ratios in the last two years of 2.89 and 4.39, but for a relatively new company, this is not abnormal. Lending Club is looking to expand its operations but doesn’t have enough retained earnings to finance it internally, so the next option is debt. They also surpassed industry expectations and posted $152.3 million in revenues in the first quarter of 2016, an 87% year over year increase. So things are not that bad as we are made to believe by the equity analysts.
Another major publicly listed marketplace lending company is OnDeck:
- Founded in 2007
- Raised $77 Mn in its latest funding round prior to IPO in March 2014
- Went for IPO in December 2014. Raised ~$200 Mn, valuing the company at $1.3 Bn
- In April 2015, they partnered with another Prosper, a major lending marketplace
- Expanded into Canada and Australia in April 2015
- Missed revenue estimates and reduced its growth guidance for 2016. This was largely due to lower originations (which is believed to be due to an overall low borrower demand), and higher provisions that led to the slump of its EBITDA. Also, the management believes that the hybrid funding model that the company adopted would provide stability over the long term while it would lower their revenues and increase the provisions over the short-term.
What we can also see is that the major reason behind the downgrade and slump in Lending Club’s stocks are more due to the human error than with the platform overall. The company was not only able to meet but also surpass the industry/Wall Street estimates for its latest earnings. While OnDeck had missed its revenue estimates and its guidance for the current year was cut, the credit quality and the successful launch of OnDeck as a Service platform with JPM are seen as key business growth drivers over the long-term. Coming to Lending Club, the error of changing the dates in order to sell loan packages to Jefferies and the probe which led to the revelations that their CEO had misrepresented facts regarding Cirrix has been a major reason for its downfall. Renaud Laplanche (now the ousted CEO of Lending Club) was considered as the face of online lending and his ouster is a major blow for the company and the industry. However, the expulsion of the CEO from the company and remodeling a technically/fundamentally strong company is not something new for Wall Street.
While the major concerns for these companies have been over their ability to meet the high growth rate that they have set up, the valuations (both while raising funds as private players and while setting their IPOs) were based on the growth rate they have seen in the past and have promised to the investors. There is also a fundamental difference between how banks and online lenders operate. Banks have deposits that they use to fund the loans while marketplace lenders rely majorly on institutional investors to fund their loan books. While some of these concerns are true, we believe that the overall industry need not be seen with a negative light. The tech platforms have shown a way as to how loan originations (previously only with banks) can be improvised – improvement in the time to evaluate the business/person, better lending terms, speed and ease of lending. All these are some of the major factors that have made online loans an attractive field for investments and growth. These factors are still valid in the market and the business is looking at expanding their business model to accommodate and strictly adhere to the different compliance requirements.
With the increased interest in getting the lending marketplace under the regulatory purview, businesses are taking strict action on reducing the human errors and making their process more efficient, the online marketplace still has huge potential to take off. Especially with banks considering to partner with the tech startups, the lending industry as a whole would benefit from the ease of use, lower interest rates and speed of delivery. However, for the short term, a major challenge that the industry needs to overcome is the perception of its investors as well as the questions on credibility from institutional buyers of their loans.
What happened with Lending Club is unfortunate and perhaps could be avoided to some extent. Online lending has lots of merits, but they will need to take into account regulatory requirements and compliance. These short-term challenges can be seen as largely good for the industry in the long term. Whether government-imposed or not, as the new standards kick in, investors will be able to more reliably understand the credit performance and risk of their investments and it will similarly help the borrowers as well.