What Happens to Alternative Lenders when the Market Tanks?
Lenders are likely to fare better than the rest of fintech
Today’s alternative lending companies — Avant, Earnest, Kabbage, Lending Club, LendUp, OnDeck Capital, Prosper, SoFi, among others — have had a spectacular run over the past few years, many earning “unicorn” status. However, none of these companies have experienced a market downturn with any meaningful volume in their portfolio, so I wanted to ask the question, how will alternative lenders fare when the market sours?
Full disclosure: we’ve invested in several lending companies, including Kabbage and Global Analytics out of Mohr Davidow Ventures and Earnest and Zebit out of Wildcat Venture Partners. As part of our diligence into those investments, we had to understand how a market downturn/economic contraction would affect them. I am now extending that analysis to other notable alternative lending companies and presenting the results below.
A Framework for Assessing Market Resilience
Alternative lenders are sliced in many ways — marketplace vs. balance sheet, super-prime vs. sub-prime vs. underbanked, consumers vs. small businesses, etc. — so we employed a more simplistic framework that captures what we believe are the most relevant factors in assessing a lender’s market resilience:
- Underwriting Sophistication — use of technology and non-traditional criteria to identify the lowest-risk borrowers within a risk band
- Borrower Credit Quality — relative proportion of higher credit quality borrowers who are less likely to default during a market contraction
- Shorter Loan Duration — relative proportion of short duration loans that are, in turn, less susceptible to sustained market contractions
- Higher LTV/CAC Ratio — higher ratios today leave more room for ratio compression that could occur during a contraction
- Ease of Customer Acquisition — a streamlined customer acquisition operation can better adapt to different credit environments (shift to higher quality borrowers, etc.)
For every company, each factor is qualitatively scored from 0–4 (0 is low and 4 is high; see appendix for scoring rationale) and the mean is computed. The lenders are then ranked by their average score and grouped into high, medium, and low buckets directionally reflecting their ability to endure a market contraction.
Most Alternative Lenders Will Be in the Clear
A company’s ability to weather unfavorable economic conditions will depend on the team, execution, capital efficiency, among other factors than the ones evaluated here. Nevertheless, from a core business perspective, we feel the companies evaluated above stratify into three distinct groups today:
High Resilience: Earnest, SoFi, and Kabbage — Earnest and SoFi have merited inclusion here due to their exclusive focus on high quality borrowers, use of advanced underwriting algorithms, and product mix (student loan refinancing is characterized by high LTV/CAC ratios); Kabbage similarly employs sophisticated underwriting algorithms, but compensates for lower credit quality small businesses with shorter-duration working capital loans
Medium Resilience: Lending Club, LendUp, and OnDeck Capital — Lending Club and LendUp, together, highlight the trade-offs between borrower credit quality and loan duration, though both have surprisingly similar profiles otherwise; OnDeck Capital fares middle-of-the-road overall, but is somewhat hampered by the challenges around acquiring small businesses
Low Resilience: Prosper and Avant — Prosper finds itself in this bucket primarily due to its limited underwriting sophistication and a product mix with low LTV/CAC ratios; Avant, on the other hand, may have more sophisticated underwriting, but remains sensitive to market winds due to its focus on lower credit quality borrowers
Closing Thoughts: Not All of Fintech Will Be So Lucky
On the whole, the lenders evaluated above are reasonably positioned to withstand a turn in the business cycle. Prosper and Avant appear most likely to struggle at first, but can respond by rolling out better underwriting technologies, shifting their product mix to higher margin loans, and focusing on higher credit quality borrowers. Of course, in a sustained downturn, all of these lenders — with the possible exception of Earnest — will have to throttle their growth, so valuations are likely to be affected, at least temporarily.
The rest of the fintech industry, however, may not be so lucky. Square’s S-1 filing, for example, shows a company with incredibly thin gross margins overall, high operating costs, and an insatiable need for capital to sustain the business. Whereas the alternative lenders have sound business models with healthy margins, many of the low margin fintech players — payment processors, online consumer banks, remittance companies, etc. — may have a reckoning on the horizon.
Appendix: Scoring Rationale
- Underwriting Sophistication — heavy reliance on traditional indicators (i.e., FICO, credit reports) score low here; higher scores are achieved through a combination of technology sophistication, volume/breadth of non-traditional data points, signal quality (e.g., predictive value, longitudinal vs. snapshot data), and long-term feedback loops
- Borrower Credit Quality — a high proportion of underbanked or subprime borrowers scores low, whereas a high proportion of super-prime borrowers scores high
- Shorter Loan Duration — loans with terms measured in years score low, whereas loans on the order of days or months score high
- Higher LTV/CAC Ratio — the ratio is largely dictated by the product mix, the target customer segments, and our experience working with Earnest, Global Analytics, and Kabbage: reoccurring payday loans of $100–250 score low, whereas $10–200K student loans score high
- Ease of Customer Acquisition — brick and mortar acquisition or traditionally difficult-to-reach segments (i.e., small businesses) score low, whereas unique acquisition channels score high