Scott Sanborn, chief executive of Lending Club, describes his company’s core business in appealingly simple terms.
“We go after the nearly half of Americans that have credit card debt and tell them, you have a loan, and not a very good one,” he says. Lending Club loans generally carry a lower interest rate than cards, making repayment more likely. “These are high-quality loans that community and regional banks would have if they had the technical and operational capacity to originate them,” he says.
The summary captures the promise of marketplace lending, which took root on both sides of the Atlantic almost 15 years ago with the founding of Prosper and Lending Club in the US, and Zopa in the UK. Since then, investors have put millions behind the likes of SoFi, Greensky and Kabbage in the US and Funding Circle in the UK.
The pitch is seductive: there are good borrowers that banks cannot serve well because of high overheads, clunky technology and rigid regulation. But a tech platform can connect those borrowers with investors starved of yield in a world of low interest rates. Personal loans (Prosper, Lending Club, and Greensky), small business (Funding Circle and Kabbage) and even real estate (the UK’s Assetz Capital) could all be upended. And the platforms themselves are capital-light business, charging fees for originating and servicing the loans while taking no direct credit risk — a formula for high returns.
Yet the industry has not delivered. Only a few marketplaces have achieved profitability, and only just. Of the biggest publicly traded marketplaces, Lending Club and Funding Circle are lossmaking and at OnDeck and Greensky margins are thin. Shares in all four are down over 70 per cent since they listed over the past few years. In July, Funding Circle shares lost half their value as the company cut its revenue growth outlook in half.
The industry took a hard shot to its reputation in 2016 when the founder and chief executive of Lending Club, Renaud Laplanche, was pushed out over loan sales that violated company policies. He and a subsidiary of Lending Club were ultimately charged with fraud by the SEC and fined, and he was banned from the securities industry. (He did not admit or deny the charges and has since founded another marketplace lender, Upgrade). Another blow came when Mike Cagney, chief executive of SoFi, left the company in 2017 following lawsuits alleging sexual harassment and other unfair work practices at the company.
An industry turnround will require overcoming three tricky hurdles, insiders say. Borrowers are too expensive to acquire; the platforms serve investors that have a significantly higher cost of capital than banks; and the stock market is sceptical about whether the companies can weather an economic downturn.
“When [the industry] started out they all said they were better [underwriters] than traditional lenders,” says Jennifer Thomas of the asset manager Loomis Sayles. The platforms thought that using technology to analyse new data, they could beat the banks at their own game. “Then the loans had tremendous losses.”
With experience, however, the platforms’ underwriting skills are improving, Ms Thomas notes. Loan losses in marketplace asset backed securities (ABS) issued in 2015 hit 13 per cent, according to Bank of America; losses on the 2017 and 18 vintages are trending towards roughly 10 per cent.
Investor demand is improving too. The industry has largely moved away from the “peer-to-peer” structure, where loans were sold to individuals; not enough individuals were interested. Now the bulk of the loans are sold to banks, asset managers and hedge funds, directly or in the form of ABS representing bundles of loans divided into risk tranches.
In the second quarter of this year, a record $6.4bn in asset-backed securities based on marketplace loans were issued, up from $3.8bn the year before, according to Morgan Stanley.
Finding borrowers is harder. Many platforms spend 40 per cent or more of their revenues on acquiring borrowers. Much of this goes to “aggregator” sites such as Credit Karma and Lending Tree in the US, where consumers check their credit scores and shop for loans.
“Everyone is chasing the same borrowers with 700-plus [prime] credit score, that usually come from the same marketing channels” says Gal Krubiner, chief executive of Pagaya, an asset manager that invests exclusively in marketplace loans. So the companies running those marketing channels — the aggregators — take a lot of the profits.
Relying on asset managers seeking high yields has a downside, too. “The cost of capital of the hedge funds is high and that pushes you into risky lending,” says Rhydian Lewis, chief executive of RateSetter, a UK marketplace that, unlike most competitors, still sells its loans to retail investors.
“In the short term, that can work,” Mr Lewis says, “but in the long term, you have to figure out figure out how to compete with the banks.”
Not only do banks have low-cost deposit funding, but they amplify their returns because their balance sheets are leveraged. “If the banks could get out of their own way” — developing efficient small-loan origination technology — their economic advantages would crush the platforms, one fintech investor says.
Investors, meanwhile, worry that the improvement in underwriting could prove illusory if the economy slows. Andrew Sleeman, a portfolio manager at Franklin Templeton, says: “Our biggest concern is that from a system-wide basis [total] lending is not being captured” — that people who have reached their borrowing limits at banks may be using marketplace platforms to add additional debt. “It’s a bit of a black hole,” he says.
For investors who own shares in the platforms themselves, the key worry is that loan buyers will disappear in a downturn. James Faucette, an analyst at Morgan Stanley, points out that when markets seized up in 2016, demand for marketplace loans all but disappeared — even though existing loans continued to perform well.
Which of the platforms will manage to solve these problems? Almost everyone in the industry agrees on one point: in an industry where costs are a problem, size matters.
That should give and edge to big platforms like Lending Club and privately held San Francisco Sofi. Indeed, losses at Lending Club fell by two-thirds in the first half of 2019, compared to the year before, to $31m on revenues $365m.
“Lending Club in particular is on the verge of profitability . . . now it becomes a story about scale,” says Mr Faucette. “As an alternative path of customer acquisition, I think there is value there . . . but are [marketplace lenders] ultimately standalone entities or part of larger institutions? That remains to be seen.”
Mr Krubiner of Pagaya thinks the key is further improvement in underwriting, to widen the pool of borrowers. His company uses AI to help the platforms find the best borrowers who fall below the standard credit thresholds — and then buys the resulting loans.
“As we go through a cycle,” Mr Sleeman says philosophically, “one or two will have a business, and others will provide a good idea that somebody else can use. It’s like any technology, isn’t it?”