In March 2014, The Economist published Banking without banks, declaring that peer-to-peer (P2P) lending platforms were set to disrupt banks and other traditional sources of capital by directly connecting borrowers to individual lenders.
In the past few years, the so-called P2P lending industry has certainly experienced tremendous growth, with origination volume doubling annually, reaching $24 billion globally in 2014.
Morgan Stanley forecasts that global originations will grow at a 51 percent CAGR and reach a staggering $290 billion by 2020. P2P lending startups also have attracted an enormous amount of attention from venture capitalists: According to Dow Jones VentureSource, U.S. lending startups raised $2.4 billion in the first three quarters of 2015 alone. Yet despite all this excitement, there are many things that are misunderstood about the industry.
“P2P” is a misnomer
While the earliest lending platforms (e.g., Prosper, LendingClub) began with true “peer-to-peer” models, the majority of lending capital is now provided by institutional investors, such as hedge funds, insurance companies and, yes, even banks. Institutional investors have been drawn to the asset class by strong unlevered yields and highly predictable credit performance across a large portfolio of loans. In 2014, 81 percent of LendingClub’s loan originations came from institutional and managed investors.
This shift explains why many participants now refer to the space as “marketplace lending,” reflecting the wider range of investors. As the capital supply is now more concentrated with institutional investors, the two-sided “network effects” boasted in the early years of P2P lending may not be as important today.
This phenomenon — the shift of suppliers from many small providers to fewer large ones — is not unique to P2P lending. The same trend can actually be seen on many other types of Internet marketplaces. For example, on eBay, power sellers control a disproportionate percentage of transaction volume, and a recent report found that on Airbnb in New York City , the 6 percent of hosts with more than three rooms (i.e., commercial users) accounted for almost 40 percent of transaction volume.
Technology-enabled lending, not “marketplace” funding, is the driving force
The term “marketplace lending” implies a meeting place where investors and borrowers can be freely matched. But new lending platforms actually employ two new business models: technology-enabled lending (a new distribution and underwriting model) and 100 percent off-balance-sheet financing through a “marketplace” (a new funding model).
These two models are often conflated, and many new lenders actually have traditional sources of capital, but use the Internet as a distribution channel to issue new loans. While platforms such as LendingClub, Prosper, Peerform and CircleBack are actual marketplaces, other platforms coined as marketplace lenders, such as SoFi, Earnest and Avant, are for the most part traditional lenders using their balance sheets or similar credit facilities.
The characteristics that enabled success for the first-movers in P2P lending are not the same as those which will determine the next generation of successful startups.
The success of those businesses using traditional funding models points to the fact that the explosive growth is due more to the strength of the new distribution and underwriting models. Originating installment loans (a much better product than credit cards for long-term, higher-balance lending) through an online channel (a much more convenient option that traditional lenders offer) has meant a much stronger value proposition to the consumer versus existing unsecured consumer finance products.
The marketplace funding model is also valuable, because it allows a single platform to serve more customers (wider range of risk tolerances among investors) and grow more quickly (less capital-intensive model), but, ultimately, the technology-enabled distribution and underwriting has been the predominant driving force.
Point-of-sale financing is the biggest opportunity
Most marketplace lending today, at least on the major platforms, is for refinancing old loans, not issuing new ones. For example, about 70 percent of origination volume on LendingClub is for refinancing or paying off credit card debt.
With most consumer lending platforms addressing refinancing, an enormous opportunity exists for emerging platforms to focus on the even larger market for purchase finance (i.e., directly helping consumers to finance new spending), where today, credit cards are the status quo.
Startups have begun to emerge to address this opportunity across many verticals of consumer spending: e-commerce (Affirm, Bread), elective medical procedures (PrimaHealth Credit), coding academy tuition (Climb, Earnest, LendLayer), automotive financing (AutoFi) and weddings (Promise Financial — in which I am an investor).
The point-of-sale opportunity is also specifically suited to marketplace lending in a way that refinancing is not; retailers need high approval rates, which the marketplace lending model is uniquely suited to offer because of its ability to find investors for a broad range of borrower credit profiles. “Purchase financing is a logical evolution of marketplace lending,” says Brad Vanderstarren, co-founder of Promise Financial.
“Marketplace lending allows a single platform to make financing offers to a wide variety of borrowers by operating a marketplace of credit investors with various risk/return preferences. This is critical for point-of-sale lending, where it’s important to have high approval rates to meet the needs of retailers.”
Lastly, point-of-sale borrower acquisition channels may also be more defensible in the long-term than the channels used in consumer refinancing, such as Google AdWords, Facebook ads and direct mail.
Looking forward
P2P startups have enjoyed enormous success over the last 10 years. Looking forward, the evolution of the market implies new opportunities and challenges. There are now deeply entrenched platforms, rising interest rates are putting pressure on refinancing activity and it is much more difficult for smaller players to attract borrowers.
The characteristics that enabled success for the first-movers in P2P lending are not the same as those which will determine the next generation of successful startups. Instead, look for companies with a differentiated borrower channel strategy addressing needs beyond refinancing.