FinTech Lending — Balance Sheet vs Intermediary?
Here’s a key topic that gets little airtime (including at the recent excellent Lendit[i]). Most marketplace lenders are intermediaries, not principals. They originate loans for investors, not for their own balance sheets — i.e., they retain no credit risk. Intermediaries, it is said, lack ‘skin in the game’ full alignment with the providers of capital. Al Goldstein, Avant Credit’s CEO, strikingly labeled this alignment as the ‘moral clarity’ that balance sheet lenders, by contrast, do provide. The lack of alignment creates significant potential problems for the providers of debt and equity capital.
But this is far from the only issue. A more pressing outcome of this funding choice is the impact on profitability. Assuming equivalent underwriting capability, balance sheet lenders will be much more profitable than intermediaries. Naturally — since they are rewarded for the credit risk they bear. That risk is real so that their earnings may be more cyclical and/or volatile. They may even face insolvency — if their underwriting process fails. They will also need to keep raising capital. But sound underwriting delivers higher profits and those profits can be re-invested into the business, with positive impacts on pricing, marketing, IT systems, customer experience and retention etc. The long-term challenge to pure intermediaries is clear. The implications for equity valuations — another under-emphasized theme — are also clear.
These are not just academic concerns. In 2005 Zopa was a path-breaking firm when it launched as an online lender and pure intermediary. The last accounts filed at Companies House are for the year to 31 December 2014 and show the firm making losses. Perhaps this is the acceptable price for growth in a new market, but what is striking are the shockingly low revenues. Revenues totaled just £11.5mn. Once again — this is for 2014 after starting to operate in 2005. No wonder Giles Andrews replaced himself as CEO with Jaidev Janardana (ex-Capital One) to become Chairman himself. This was followed by an equity investment from QED and the presence on the Board of Nigel Morris, QED’s Managing Partner, as a non-exec. (QED is a cutting edge FinTech venture shop and staffed exclusively by Capital One alumni.) Well done to Zopa — one could hardly have a better advisor. Zopa can also be proud of its consumer ratings and its growing volumes. Still, it’s instructive and it’s worth insisting on the challenges pure intermediaries face.
Contrast iwoca, a provider of working capital finance and a balance sheet lender, which operates in a much riskier and higher margin sector. I expect iwoca to reach profitability in around a third to a half the time of a Zopa and to deliver much higher returns on equity thereafter. Not all of this is due to the balance sheet / intermediary distinction but it is an important factor.
I am not advocating here for fractional reserve lending; FinTech platforms need not mimic the Banks. Nor am I suggesting every platform converts to a balance sheet lender. The intermediary model is viable but it throws up challenges that are existential — and that are significantly under-recognized within the industry today.
[i] Lendit (San Francisco April 11th-12th) was the largest-ever forum for marketplace lenders, its debt and equity providers (investors) and other system participants to learn, exchange and connect. Unsurprisingly, the mood this year was self-congratulatory (though the abrupt slowdown of VC investment and public exits cast a shadow). Marketplace lending is now an established feature of the financial landscape — though not yet mainstream. In the last three years the conference has grown from a few hundred pioneers to several thousand participants coming from startups and major institutions. A number of posts on this blog pick up on some key themes.