A year ago, privately held online lenders like Prosper, SoFi and Avant looked all but certain to go public at the same unicorn valuations their venture investors had assigned them — if not higher. They were seemingly reshaping the student, consumer and small business lending business. The market they’re chasing is enormous: The U.S. consumer lending market is a $3.5 trillion business, and 22 of the largest online marketplace platforms originated just more than $5 billion of unsecured consumer credit in 2014 and more than $10 billion in 2015.
They also talked a big game. When SoFi raised a whopping $1 billion from Softbank last year, CEO Michael Cagney told Bloomberg: “I’m looking at over $1 trillion of market cap from the banks, and I think it’s all vulnerable.”
Fast forward to today, and it’s online lenders that suddenly look like sitting ducks.
In an SEC filing yesterday, Lending Club, which announced the surprise departure of its founder and CEO last Monday, revealed that investors who “contributed a significant amount of funding” for loans are now examining that performance “or are otherwise reluctant to invest.”
That’s a huge problem. Lending Club can’t originate a loan until it has sold it to another party.
It’s not just Lending Club that’s grown overly reliant on institutional sources of capital to keep its business afloat, though the problem is just becoming widely understood now.
For many casual observers in Silicon Valley, the first signs of trouble in the online lending category emerged in late April, when the WSJ reported that Avant made $514 million worth of new loans in the U.S. in the first quarter, a 27 percent drop from the fourth quarter of 2015. Then, two weeks ago, Prosper confirmed that it planned to cut roughly 28 percent of its staff in response to falling loan volume. And Prosper’s news came just a day after OnDeck Capital said its own first-quarter losses had more than doubled as demand for its loans began to nosedive.
Of course, the kicker came last week, when Lending Club CEO Renaud LaPlanche resigned following an internal audit that turned up $22 million in loans that were sold to Jefferies yet didn’t meet the investment bank’s criteria.
Fast growth, big risks
If the shift in the companies’ fortunes seemed abrupt to Silicon Valley, it wasn’t a surprise to many in the financial industry. They’ll tell you they’ve seen this movie before.
Online lending “grew incredibly quickly from loan volumes of almost nothing eight years ago to many billions of dollars a year,” says Max Wolff, chief economist at Manhattan Venture Partners, a merchant banking firm in New York. “But what started out as a disruptive movement known as peer-to-peer was far more novel than what it became, which, in many cases, is a front for whoever is providing [some of these startups with] capital to lend.”
Think banks like Goldman Sachs and Jefferies. Think hedge funds and insurance companies.
The obvious benefit of taking capital from larger institutions is that they allow online lending companies to grow, and quickly. While companies operating in this space come with inherent advantages — they use automated loan applications; they have no retail branches; they use electronic data sources and tech-enabled underwriting models that help them to quickly identify a borrower’s credit risk — having deep-pocketed friends has made other things easier. Among them is being able to provide funding decisions within 48 to 72 hours, and to offer small loans with short-term maturities.
Until recently, Wall Street has happily obliged. And why wouldn’t it? With interest rates so low for so long, these new lending products have been an attractive place to generate revenue. Some online lenders have charged more than 60 percent in annual interest on their loans, including origination fees.
In fact, the rates provided these institutions were sometimes so steep that the Consumer Financial Protection Bureau and the State of California began looking into these businesses last year out of concern over whether online lenders are treating consumers fairly.
Next steps
Judging by a lengthy white paper published by Treasury last week, slightly more regulation is coming, including additional safeguards to protect small borrowers, as well as standardized and clearer terms and disclosures to borrowers.
The government also seems interested in ensuring that online marketplace lenders expand beyond serving prime and near-prime consumer borrowers to those who are “creditworthy, but may not be scoreable under traditional credit scoring models.”
While online lenders might be relieved that Treasury doesn’t appear intent on aggressive changes (for now), a much bigger concern for them is a “market that now realizes how fragile online lenders’ business models really are,” notes Todd Baker of Broadmoor Consulting, a consulting firm to the financial services industry.
As he notes, it just took one “blip” in the capital markets last summer for this to become clear, when the banks, hedge funds and other institutions grew nervous about risk. Online lenders couldn’t give them better rates on loan sales while staying profitable, so these investors “started looking for greener pastures,” notes Baker — and they’re continuing to pull back.
“Wall Street walks when it gets nervous,” says Baker.
That’s not just bad news for publicly traded companies. So-called unicorn lenders — including Prosper, which has raised $355 million from investors and was valued at $1.9 billion as of April 2015; SoFi, which has raised roughly $1.4 billion altogether at an implied valuation of between $3 billion and $5 billion; and Avant, which has raised $654 million at a valuation north of $1 billion — suddenly look like long shots as upcoming IPO candidates.
In fact, consolidation in the industry, where other still-private players include Kabbage, Funding Circle, Earnest, Affirm and CommonBond (among dozens of others), now seems all but inevitable.
Smartly, some players are already looking to reimagine themselves as broader financial outfits. For example, SoFi, which began as a way for students from top universities to refinance their debt, has since branched into personal loans, wealth management and mortgages. It also said last month that it’s hoping to drum up more investor demand for the debt it originates by starting a hedge fund that will buy its own loans.
Baker expects that to survive and thrive, more online lenders may need to remodel themselves into the institutions they vowed to replace, either by becoming banks, buying or selling to banks, or else striking up partnerships with banks. OnDeck and JPMorgan made one such pact. Last month, JPMorgan quietly began offering online loans to its existing small-business customers using OnDeck’s technology.
Indeed, there is a silver lining, and it’s that huge market opportunity. The trick for online lenders will be finding new ways to pursue it while remaining viable businesses.
As notes Wolff, the economist, online lenders are “a part of the future. But the Web 2.0 model has been to ask for forgiveness, not permission, and the financial space is way too heavily regulated for that to a be a strategy.”
“Dangerous is cool when you’re in high school,” he says of online lenders’ dependence on fickle institutional investors.
When you’re in the money business? Not so much.
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