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Specialty Finance: Examining Fintechs’ New Approach to Growth

Date: Jun 20, 2017 @ 07:00 AM
Filed Under: Specialty Finance

Over a relatively short period of time, technology has significantly altered the lending landscape for both consumers and business owners. Bank loan applications can be completed online or via mobile phone, approvals (or rejections) arrive in mere hours versus days or even weeks, and for the institutions, new uses for and new types of data are allowing digital lenders to re-imagine the underwriting process to deliver both efficiencies and added insights. As a result, the market for tech-enabled lenders has grown rapidly, albeit not without a few bumps and scrapes that tend to typify any new business model.

In this year’s keynote address at the Lendit USA conference, held during the first week of March in New York City, OnDeck’s Noah Breslow highlighted the four phases that tend to characterize the evolution of any new market. He also observed that the marketplace lending industry has already progressed past the first three phases – growing awareness, initial skepticism, and the ensuing stampede among new customers and providers. Today, Breslow emphasized, lenders are now adjusting to the fourth phase, which he predicted will see the strongest players thrive amid a still-rationalizing peer set.

Alongside this transition, however, the definition of “strength” has also shifted quite dramatically. Eighteen months ago, for instance, an online lenders’ strength might reflect its scale or ascendant growth. Industry observers now recognize that strength is perhaps better characterized through a renewed appreciation for credit quality and a heightened discipline around tightening underwriting standards. Effectively, the future has replaced the present as a better lens through which to assess actual versus perceived strength.

To be sure, marketplace lending has grown rapidly over the past three years. To wit, originations of unsecured online loans jumped from $5.57 billion in 2014 to $11.99 billion in 2015, according to Orchard Market Data. After peaking in the fourth quarter of 2015, however, originations have since receded, pulling back roughly 18% last year. At the same time, Orchard documented that the 2014- and 2015-vintage loans experienced higher and faster charge-off rates than previous years, attributable at least in part to a higher proportion of subprime originations during those two years.

As a result, online lenders have transitioned from acquiring customers at any and all costs to focusing very intently on unit-level profitability. Gone are the days when a new, tech-enabled lender would look to prove out their business model by quickly accumulating customers with little or no regard to the bottom line. The assumption that new accounts will turn profitable upon renewal is no longer enough to justify lax standards in building out a book of business.

This is in part due to some of the challenges facing consumer lenders today, particularly those in the digital space. The further removed the market is from the credit crisis, the harder it can be to distinguish between attractive candidates. As credit scores rise across the board, it becomes harder to identify those who successfully managed their finances during past periods of economic stress. There has also been an increased tendency among consumers to “stack” loans, in which borrowers line up capital from multiple originators at the same time, before the updated data is captured by the automated underwriting systems. This is why – at a time of low unemployment, higher wage growth and a growing GDP – delinquencies continue to climb.

The underlying shift in mindset among the digital lending universe may also be the result of some notable struggles involving certain high-profile fintech names -- lenders who have either had to cut staff or shut down their origination efforts altogether. When LendingClub replaced Renaud Laplanche as CEO last May, for example, it seemed to catch the entire industry by surprise. And while the economy continues to grow, lenders are well aware that the current credit cycle is most probably entering the later innings. The renewed focus on underwriting likely reflects a growing recognition that the current cycle will at some point have to level off even as unemployment numbers continue to improve and manufacturing activity grows.

To be sure, these trends are also evident among the publicly held fintech names, such as OnDeck and Lending Club. The former, for instance, in its most recent earnings call in the first week of May, highlighted new efforts around credit management, noting that on average, customers in the first quarter took out smaller loans over shorter durations versus both the previous quarter and year over year. As a result, the lender is anticipating a cut in 2017 total volume, but also expects its unpaid principal balances to decline from current levels over the rest of the year.

Whatever the case, however, the renewed attention to underwriting among the fintechs should not be viewed in a negative light, as the market for tech-enabled lenders remains vibrant for both funding sources and for borrowers. Investors and specialty finance companies funding warehouse lines of credit also appear optimistic. While investments in the segment hit a peak in 2015, when there were 132 new investments in the space worth a combined $5.2 billion, according to PitchBook Data, new capital has continued to pour into the market.

If anything, the institutionalization of marketplace lending has helped reinforce this newfound discipline around underwriting, particularly as more and more digital lenders seek to partner with banking institutions. And the shift, while somewhat abrupt, will be critical for the still-fledgling industry to erect a sustainable model.

At Monroe, for instance, our specialty finance vertical will partner with tech-enabled lending platforms. Beyond the traditional warehouse lines of credit or securitization structures, we’ll also look to make selected equity investments. The common variable, however, is that the platforms we back all have a unique and differentiated sourcing function. Without this, the platform would be unable to compete with the hundreds of other online lenders or even the community banks or traditional mid-market business lenders.

Consider Monroe’s 2015 investment in Minnetonka, Minn.-based Channel Partners, which took the form of an equity investment and a three-year $50 million credit facility to expand the company’s lending capacity. Channel, formed in 2009, offers working capital loans to small businesses and differentiates itself through extensive and deep relationships with small-ticket equipment leasing companies.

A differentiated sourcing strategy is critical not just for driving new business, but also because high acquisition costs can influence other areas. Coupled with an unrelenting pursuit of scale, for instance, high acquisition costs will often translate into lower underwriting standards. Many startup lenders – if there is pressure to put capital to work – may relax their criteria to drive deal volume or try to undercut the competition either through providing more debt or coming in at a lower price.

This year at LendIt, for instance, we heard ongoing debate around whether the origination channel, itself, should be considered as part of the underwriting process. But we believe that argument is a red herring that seems to misinterpret the role of underwriting in the first place.

Whether it’s equity sponsors backing new platforms or more traditional lenders funding warehouse facilities, the focus from investors is now squarely trained on both acquisition costs and the quality of underwriting. Make no mistake, the scrutiny into these two areas will only become more intense. As Breslow identified in his keynote, this is merely the fourth and final stage of growth, whose summation will be marked through a bifurcation between the haves and the have nots. This is the phase that all lenders must confront at some point in their growth, when their underwriting standards are put to the test.

Aaron Peck
Managing Director, Co-Head of Specialty Finance | Monroe Capital
Aaron Peck is a managing director at Monroe Capital and serves as both the portfolio manager of the firm’s affiliated business development company, Monroe Capital Corp., and co-head of Monroe’s Specialty Finance vertical. Monroe’s Specialty Finance vertical has the resources to underwrite transactions of over $150 million and focuses on generating cash flow based on senior-secured debt investments.
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