Now, with Lending Club and OnDeck Capital’s shares getting pummeled by public market investors, news outlets are asking if this is the end for fintech lenders. The same pundits who once lauded the potential of newcomers to “transform credit evaluation and loan origination” are now declaring that those alternative lenders “will not be significant players.”
As we at Bessemer Venture Partners have evaluated these businesses as potential venture investments over the past several years, we struggled across a few key fronts when trying to justify the lofty valuations of these tech-enabled, non-bank lenders. Now, with regulators worried that fintech lenders may destabilize the financial system and journalists racing to point out the cracks appearing among fintech lenders, we wonder if the pendulum has swung too far in the opposite direction. Ultimately, we feel that many of these businesses were simply evaluated under the wrong valuation lens.
For more than a decade, the shifting environment in what we like to refer to as the tech-enabled lending space has driven much of the industry’s excitement and our own investment thesis for the category. We remain enthusiastic about many of the businesses created in this space, beginning with companies like our own portfolio company Zopa, a pioneer in the category that launched in the U.K. in 2005, and Lending Club and Prosper shortly thereafter in the U.S.
Since then, we have seen an explosion of startup activity by many talented entrepreneurs attacking every element of the lending markets, from student debt, to small business loans, residential mortgages, commercial real-estate, payday lending and more.
These businesses are similar to existing banks and specialty finance companies, albeit with certain benefits.
These markets, historically built upon legacy systems and stale underwriting practices, continue to be ripe for disruption, and we still firmly believe that software-enabled, data-driven companies will lead the way. While the favorable fixed income market conditions and historically low interest rates over the past several years certainly can and will change, there are a number of other market developments that are here to stay.
This group of alternative lending startups has seen phenomenal growth and has leveraged software and better data to disrupt large markets. But at the same time, these new originators shouldn’t continue to be valued off of the same metrics and lofty valuation multiples as SaaS businesses or online marketplaces. Instead, these new lenders are more appropriately evaluated within the context of the financial services companies they are trying to displace. When you approach alternative lending in this way, you can see that the former hype and current disillusionment with the category are both off base.
To better understand the true value these emerging lenders bring to the industry, here is a simple matrix we have used that can be applied across the non-bank, alternative-lending industry:
- Innovative underwriting: While many alternative lenders do have an innovative underwriting approach (big/new data, better signals, machine learning, etc.), the fixed income capital markets aren’t ready to rely on these untested models. Instead, debt ratings and securitizations for loans underwritten by new lenders are still primarily based on conventional metrics (e.g. FICO). We do believe this will happen, but it will take time and will need to be proven through various economic cycles.
- Low-cost, capital-lite loan factories: Most lending startups are at their core lower-cost originators taking over the lucrative and capital-lite aspects of banking, where software gives them an edge. The structural deficit of the incumbents makes it difficult for traditional financial institutions to compete with capital-lite startups in many ways.
- Sustainable growth: New originators have demonstrated some explosive growth relative to established financial institutions, but fast growth isn’t always attractive in this market, as it can result from, or often lead to, problematic underwriting practices and rising customer acquisition costs as fast followers enter these markets.
- Cost of capital: The cost of deposit funding for banks is significantly lower than it can ever be for emerging, non-bank marketplace lenders; the average cost of capital for a bank is typically < .5 percent, while even for the well-established tech-enabled lender OnDeck’s cost of capital was 5.5 percent in Q1 2016. On the positive side, these emerging lenders do save significant sums by avoiding the huge regulatory costs banks incur.
- Valuation, valuation, valuation: Alternative lenders have primarily been either fee-based market makers selling loans to investors or have been leveraging their balance sheets and earning interest income and securitization revenue, much like established specialty finance companies and banks. Simply put, these are not software businesses. Historically, banks have been valued on a price/book basis (typically ranging from ~1-2x P/B) with P/E as an additional guide for public equity investors. As alternative lenders have emerged, many venture investors focused on unit economics, but banks have long been valued on their book equity for a reason.
We remain excited about the transformation of the lending landscape. While we’re currently experiencing some soberness after years of froth in the space, this current negative sentiment may now lead to overly depressed valuations and overlooked opportunities. We are confident that many great companies will be built as entrepreneurs bring more software, data-driven underwriting practices and innovative origination models to improve the market for borrowers and enhance capital market efficiency in the years ahead, and we look forward to meeting you.wowomnom/Shutterstock (IMAGE HAS BEEN MODIFIED)