Marketplace lenders are having a tough time getting a combination of consistent volume and good loan portfolio performance from business lending. Why is small business lending so difficult to master? Is it tougher to understand than consumer lending? Most people say yes.
When I was at Lend360 in Dallas last fall, I heard a presentation from the Jefferies Investment Bank. If that name sounds familiar, that's because they are the same investment bank who was defrauded in the 2016 loan sale scandal at Lending Club that led to the ouster of founder Renaud Laplanche. At their presentation, they said that marketplace lenders have 'cracked the code' on prime credit consumer lending meaning they do as well or better than conventional banks and lenders at targeting and underwriting this particular group of borrowers. However, not so with other borrowers......
Let's look at why small business lending is so tough.
On the surface, it looks like Consumer lending is almost entirely personal credit score (FICO, VantageScore) driven, especially for prime lending for the best credits. Most of the other successful platforms are Income (showing W-2 salary or tax returns) driven. These are Lending Club and Prosper's primary underwriting tools despite using proprietary underwriting that catches over 40 data points. They mostly capture the creditworthy market with a term loan product that had not been available to these qualified borrowers in years.
Even alternative marketplace platforms like Upstart and SoFi that use 'alternative' data points like social media or where you went to school or what your major was still incorporate credit scores into their approval decision.
The tremendous amounts of consumer data these platforms get from borrowers give them an edge over conventional lenders. The combination of better credits, more information, faster approval decisions and solid data analysis to improve underwriting means that marketplace lenders have more info and utilize that info better than a bank.
The real test of underwriting for consumer loans will come when the next recession hits, whenever that is, but the platforms are blending conventional tools with new data in some smart ways.
With small business lending, the owner IS the business so credit scores and other creditworthiness of the owners through FICO etc is important. But that's not the only thing. There is a business and the business needs money so we have to look at the business too. This means financial statements and tax returns and other items to show a lender the business can pay.
Let's look at 2 established forms of small business lending to see why it's so challenging.
Accounts Receivable Financing/Factoring
A/R (accounts receivable) financing or Factoring, loan products that are very similar but not exactly the same, are based on the premise of a business selling goods or services to clients on credit. Common terms you may have heard are Net 30 or Net 60 meaning payment due in 30 or 60 days.
The problem, which you probably figured out already, is that the business has put time, effort and money to generate those services or goods. Those goods have been delivered and now they need to get paid to do payroll or buy more inventory or whatever they need to run their business. So what do they do?
With a bank, private lender or marketplace lender like P2Bi or Bluevine, those receivables due from clients are an asset that can be borrowed against until the payments come in. Both of these marketplace lenders are doing well, however, receivables is a specialized market and many businesses needing money don't have receivables to borrow against or sell. And per numerous anonymous sources in this field, there is too much money competing for too few deals so originations are a struggle and bank rates for those that offer lines of credit on receivables are getting more aggressive.
The other major market for business lending is equipment leasing. In 2015, this was a $1 trillion market when including software purchases/leases, per the Lease Foundation annual study. Yet, this market flies mostly under the radar and in the background of business. Many of you know this is the field I was in before coming over to fintech and I love it.
The premise is that the business either leases or finances the equipment they need to run their business. That could mean anything from printers and phone systems to a company car or van like my friends at Smbizautolease do. Leasing is a great business, and you know how many marketplace lenders are in equipment leasing? ZERO. Zero lenders in a $1 trillion market.
No one has figured out how to merge the marketplace model with equipment leasing.......yet.
The 2 largest and most established business lending markets of A/R Financing and Equipment leasing are seeing some success with a couple platforms and zero attempts, let alone successes, respectfully. Business operational lending, known in the finance world as C&I (commercial and industrial) lending is lending money to operating companies. No equipment, no receivables, just cash on creditworthiness and ability to pay.
Why is Operational lending so tough? We explore this aspect of lending in more detail in Part 2.