The Fitch ratings agency, who along with Standard & Poor's are the 2 largest US based ratings agencies just released their first report on Peer to Peer Lending. While the report is based on the lending platforms themselves, you can't have a report on the platforms without examining the industry in which they operate. This report does both. This report is so important that I think every peer lending investor should have it. A link to the report is right here:
Overall, their analysis is pretty solid but I wanted to focus on 8 things in particular including 5 things they got right that we as investors need to keep in mind and 3 things that I think they got wrong.
1) Limited Operating History
The undisputed leaders in the industry all over the world, when you look at loan volumes, are Prosper and Lending Club. They are the only 2 to originate at least $1 billion USD equivalent in loans. Zopa from the UK is the oldest having been in business since 2005, Prosper has been in business since 2006 and LC since 2007. While the bumpy and completely unpredictable nature of being in startup mode is gone, these are still young companies at 8 and 7 years respectively. This means that the companies have limited operating history to judge their performance by.
Furthermore, it's very important to understand the potential lack of value of historical data overall because the overwhelming percentage of loans originated by both have been in the last 2 years. The origination of loans in dollars in LC's first 4 years in business is equal to the the dollar origination of the last 12 months. Prosper has similar looking numbers meaning that the numbers are skewed towards a disproportionate number of newly originated loans, including the bulk of which have not termed out yet to see how full cycles of loans go from start to finish.
2) Unpredictable Cash Flows
According to Fitch, 'the vast majority of their revenues come from loan origination fees' (Fitch Report, p. 10) meaning that growth in loan volume is essential to growth in Revenues. In 2013, LC's revenues were 88% from origination (Fitch Report, p.3). Since both platforms are owned by multiple private equity investor groups, this is a fact they already know and understand.
Does this mean that the platforms will loosen credit requirements in order to approve more loans to generate more Revenue? I doubt that because trust in the platforms and their underwriting/due diligence/vetting abilities is part of what is making them successful now. That doesn't mean that this is not something we as investors need to be aware of and keep in mind.
3) Underwriting generally consistent with industry practices
Since I do credit analysis for small to mid sized businesses for a living, this is something I definitely agree with. This ties in with #2 above, especially the previously asked question about loosening credit. Right now, the underwriting is very solid and consistent with other lending programs that would or could be available to prime borrowers but today mostly are not available. Trust in these lending platforms has been earned due to this consistency in underwriting and why I am confident investing my own money.
4) Minimal Cash/Capital Requirements
The peer nature of the platforms and the private money invested both as investors like us and as shareholders like Sequoia, BlackRock and Google Ventures means that the platforms have minimal cash or capital requirements as compared to other lending institutions that lend as much money as Prosper and Lending club do. This could mean a potential liquidity crunch from time to time or if a big one time event happens like a lawsuit or new regulatory action that it could be detrimental to the operations of these companies. This is something we need to look out for despite the fact that we see the peer nature of the platforms as an advantage. Prosper alone generated more loans in the last quarter than they did in all of 2013 and they did it with our investor cash.
5) Key Man Issues
The report does a good job of outlining how the boards of both companies have gotten much deeper with financial and banking experience. However, there is still a 'key man' problem. Key man is just what you think it might be, that there is a key man (or woman or both) who is vital to the organization's success. There are no bigger advocates for our industry than LC CEO Renaud Laplanche and Prosper President Ron Suber. There is no question in my mind that if one or both of these guys were not at the helms of these platforms that their results could and would be drastically different than the high growth environment we see today.
As an investor in these platforms, you are kidding yourself if you don't think there would be a major effect here and this is something we need to be watching. ALL. THE. TIME.
While I think Fitch's analysis is pretty solid, I do think there are some areas where they may be mistaken.
1) The Impact of Rising Interest Rates
Fitch believes that a rising interest rate environment could be bad for business since 83% of borrowers (or 5 out of 6) state that they use peer loans to consolidate credit card debt. On the surface, this sounds like it would be right. After all, who wants to consolidate credit cards as rates are increasing?
What Fitch is missing here is that yes rising rates generally could be bad but what peer borrowers look at is the difference in rates, known as the spread, between their CC rate and their approved loan rate. As any peer loan investor will tell you, we see tons and tons of great credit on time payers who have had their CC interest rate increased by the card issuer just because they can or because the customer is starting to carry a balance when they didn't used to have one.
The actual rate environment is irrelevant to the CC issuer's mostly arbitrary choice of when to increase their rates and by how much. The actuality is that rising rates means that CC rates will increase their rates more and faster than they do now. All peer loan rates have to do is continue to grow at a slower rate than the CC rate. A borrower will still gladly pay us 12% instead of the CC issuer 22% just like now they would rather pay us 9% instead of 18% to the CC issuer. The only issue is the spread. If peer loan rates grow slower than CC rates, then it's still a big win and opportunity for the lending platforms. The spread staying the same or increasing is good for us and for the platforms. Only if the spread shrinks (peer loan rates grow faster than CC rates) is that a potential issue like Fitch outlines.
2) Lack of Diverse Funding Sources
The third party peer nature of funding for these loans is an issue for Fitch especially since third party investors have a 'risk appetite that can change rapidly based on underlying market conditions' (Fitch report p.11). While this is true, I think it's a little overly simplistic. Fitch does outline how the platforms are developing strategic relationships with mostly community banks but also larger ones like Santander's relationship with Funding Circle US.
The fact that institutional funds, RIAs, and other private money are prominent here is something I've written about on this blog numerous times including at least once where I have lamented about whether us little guys were getting crowded out of the market. Overall, the fact that these big guys with big money are here and us little guys are too is good and healthy for the market and gives the platforms a diversity in funding that I think Fitch is missing. Both institutions and little guy retail investors are well represented.
3) Online Platform Increases Potential for Fraud
Fitch states that while Prosper and LC's management of risk and potential fraud has been manageable so far that this is a risk that could increase over time (Fitch Report, p.10). My experience in seeing people I know apply for loans on these platforms is that the verification processes are even more than the banking KYC requirements are since lots of paperwork from tax returns to pay stubs are or can be required. It is certainly far more scrutiny and due diligence than their closest competitor, the credit card issuer. The fact that these docs are requested and then uploaded online is something that for most people is a non-factor.
One part of this that Fitch is right about is that things like security breaches or other things that create reputation risk are something that could very negatively impact these platforms since trust in them is at an all time high now. This is something we need to be watching out for in the future.
Fitch has issued a pretty thorough report on our beloved industry and it talks about many things including the significance of the market opportunity that still exists. It's a very good report and well worth your time to read it. After digging a little deeper, we went into 5 things that I think they really got right, especially the underwriting and key man points and 3 things that I think they may have missed on with the impact of rising rates being the biggest area of potential misunderstanding of the market.
Give the report a read and let me know what you thought of it below.