3rd May 2017
Marketplace Lending Sector
Today, the traditional financial system is being put to the test: on the equities side, crowdfunding platforms are competing against the traditional investment industry; while from the credit standpoint, alternative finance models are attacking the traditional banking industry. Alternative financing has developed in different forms via innovative Online Direct Lending processes, such as Marketplace Lending (MPL), which is today’s evolution of Peer-to-Peer Lending (P2PL).
Crucial for MPL’s development has been large amount of venture capital devoted to the sector. According to TechCrunch, just in 2015, seven of the largest MPL players in the US had raised $2 billion in growth capital with valuations ranging from $1 billion to $3.5 billion. In 2014 two of the largest US lenders, Lending Club and OnDeck went public with valuations of $9 billion and $1.3 billion respectively. In January 2017, Funding Circle, one of UK’s major MPL players, raised $100 in growth capital from top-tier VC funds such as Accel Partners and Index Ventures, valuing the firm over $1 billion.
The success base of these alternative-financing models is their ability to provide capital to niche borrowers while presenting private investors with higher return rates than typical bank deposit schemes. Lately, P2PL start-ups have been attracting capital from institutional investors – including banks – due to their capability in serving niche borrowers and for providing higher rate of returns, transforming service operators from being peer-to-peer platforms to proper marketplaces, creating the broader sector defined as MPL. The success of MPL can be traced to the combination of a successful business model and the demand for an alternative to the traditional banking system.
Believe it or not, the disruptive P2PL business model was actually born many centuries ago. Social lending, which could be considered the ancestor of P2PL, was the most prominent form of capital circulation in Europe until the 20th century, when individuals and small shop owners would borrow capital through their private network of acquaintances. In the past century, however, as the banking system started to emerge, banking institutions started to centralize the credit market acting as intermediaries, giving birth to the financial system that is still the most prominent today. While it is not within the scope of this article to discuss the development of the banking sector, it is important to note that the consolidation of the sector led the banks to grow in size, increasing their bargaining power versus depositors and clients, which fuelled the desire for private investors of finding an alternative solution. Such solution came through in 2005, when a London-based start-up – Zopa – was founded with the intent of reducing the spread between the cost of funding and the interest rate charge to borrowers through a web based platform, converging private lenders and borrowers (Figure 1).
Figure 1: The peer to peer lending business model
As a matter of fact, MPL is commonly described as the loan making between borrowers and lenders, which are matched via the online marketplace. Lenders directly assume the risk of default on the loans in a model where there is no leveraging on behalf of the MPL platform. As a result, the platforms act only as loan originators, avoiding balance sheet risk and dis-intermediating the lending process by bypassing financial institutions. Furthermore, MPL platforms also differentiate themselves from traditional financial institutions through their lightweight online operating modules and innovative credit scoring techniques. The lean cost structure allows MPLs to serve small borrowers with loan requests typically ranging between $5,000 and 35,000 (personal) or $50,000 and 100,000 (SMEs). The interest rate quoted to the borrower is the combination of the real market-value interest rate (cost of capital) and platform fees. Therefore, unlike banks, MPL platforms charge commissions for their services rather than make money off a spread. Different platforms differentiate from each other in terms of product; personal credit, business loans, student loans etc.; and by fee structure, based on the volume of loans originated versus a fee combination on carry and the latter.
By reducing agency costs and eliminating intermediation, MPL platforms are more flexible both in terms of operating expenses and responsiveness compared to traditional financial institutions (figures 2 & 3). The ultimate objective is higher returns for lenders and lower interest rates for borrowers, improved quality and speed of service for both, and the ability to serve the small size loan and credit segment ignored by banks. Furthermore, lenders also perceive MPLs to be more responsible and socially sensitive, as compared to conventional banks.
Figure 2: MPL platforms vs. banks’ cost structure
Figure 3: The role of MPL platforms in disintermediation
In point of fact, the real turning point for P2PL has been the post-2008 credit crunch, when finally the new-born business model was able to overturn the initial scepticism and start growing exponentially. The 2008 aftermath had three major effects on the financial system that opened an opportunity for the P2PL platforms: it increased the banks’ risk adversity in providing capital to both business and individuals, due to new tougher regulations (Basel III); it caused central banks to relax monetary policy to pump liquidity in the financial system, therefore decreasing the cost of funding for financial institutions, which reflected in lower interest rates for depositors; and it unveiled principle-agent problem of the traditional banking system, pushing lenders and investor to demand transparency in their investments.
Avertedly, the P2PL platforms fulfilled the new wants of private investors and potential borrowers: they provided liquidity to borrowers overlooked by financial institutions; it benefited private investors with higher returns in a market where interest rates are at historical minimum; and allowed them to have a direct sight over their investment.
The success of MPL can be easily measured by its exponential growth rate around the world in the last five years. The most common indicator for credit demand is the annual amount of loans originated. By 2015 the total Online Direct Lending demand amounted to $180 billion (Liberium), where China accounted for the largest share of $157 billion. In particular, according to Deloitte, in 2015 the MPL market demand in the US amounted to $22.7 billion, growing at a 163% CAGR from 2011; in the UK – the largest MPL market in Europe – it amounted to £2.7 billion, growing at a 134% CAGR; and in Europe – excluding the UK – it amounted to €670 million, growing at a 114% CAGR (figure 4).
Figure 4: MPL Market Overview (2011-2015)
The high growth rates are explained by the rapid expansion in terms of MPL platforms and loans originated per platform. According to KPMG, by the end of 2015, the UK alone counted more than 90 different platforms, while the rest of EU more than 200. As the market expanded, different platforms developed exploiting different vertical channels, and today MPL platforms target both retail and business borrowers and attract both private and institutional lenders. KPMG calculated that in 2015 circa 25% of funding in P2PL platforms in Europe (excluding the UK) derives from institutional investors.
Business Model & Competitive Advantage of MPL
Also banks have apprehended the potential of MPL: JP Morgan has developed a strategic partnership with OnDeck, while BBVA, Credit Suisse and again JP Morgan have also participated in one of Prosper’s funding rounds. Bilaterally, MPL platforms are also starting to engage in bank-like functions such as asset securitization. In 2013, SoFi, a US based MPL platform, sold the first A-rated securitized product of P2P loans, with a $152 million offering. Also, in 2017, the same platform has bought the California based Internet banking company Zenbanx.
As sound as the business model may seem there is a catch. MPL investors are subject to credit risk just as the banks, on top of that some platforms do not provide investors with the discretion of selecting individual loans, but instead offer “sets” of many pre-selected loan pieces according to risk tolerance and other criteria outlined by the investor. In 2016, Lending Club, sold loans that failed to comply with investors criteria, the result was not only the platform’s share price dive on the US stock market (Reuters), but also the sudden realization of the need for regulation.
Today, lawmakers have addressed MPL in a variety of ways. The Financial Conduct Authority (FCA) in the UK has treated MPL as a new asset class: rather than extending existing regulation, the FCA interpreted MPL as an alternative to credit rather than a replacement for credit, therefore creating ad hoc registration licenses. In the EU, according to Deloitte, MPL is subject to regulation on a national level. Some countries, including France, have introduced specific regulation covering aspects such as disclosure, due diligence and the assessment of creditworthiness. At a pan-European level the European Commission’s Capital Markets Union led an initiative emphasizing the role that MPLs could play in helping SMEs diversify their sources of funding, therefore pushing members to embrace the FCA approach. In the US, at a national level, platforms have been required to register with the Securities and Exchange Commission in order to allow retail investors to employ their private capital. However platforms have to comply with state regulations, which in certain cases do not allow retail investors to lend money to SMEs.
The VC perspective
So, how does MPL stand in the eyes of a venture capitalist? While there is still a numerous amount of newly born MPL platforms across the EU and the US, which are still in the early-stage financing process, the future outlook on the sector from a VC perspective is not as attractive as it may seem.
Major sector experts and investors, including Sequoia Capital, expressed their view on the upcoming consolidation of the market. The experts, have discussed the future outlook of MPL on a panel organized by CB Insights and predicted fierce competition between players, fostering M&A activity to reach break-even volumes but also insolvencies for platforms lacking core competences of credit issuance. Also a great uncertainty in the future regulatory framework for MPL represents a huge risk for investors. Lawmakers across Europe and the US are threatening to introduce tighter regulations, which could result in the curtailing MPL platforms’ competitive advantage. In addition, the surprising convergence in terms of strategic integration between the traditional banking institutions and MPL players allows for the conjecture that, in the long-run, one of the two models will have to prevail, if not a hybrid of both, implicating also further future uncertain regulatory adjustments. Therefore, in-sector competition, external competition, and regulatory uncertainty, are not in the scope of the typical VC’s risk-return trade-off appetite, but rather for private equity investors. It seems that today the bandwagon has already passed for VC investors.
Future Developments for the MPL sector
Yet, MPL does offer some opportunity for VC investors. As for any tech development, adjacent service providers powering the very platforms competing will have room for growth due to the very convergence of the model. For instance, providers of big data analytics for credit scoring can support platforms in retaining a competitive advantage. Other adjacent services, such as indirect MPL via platform-to-platform partnerships or providers of data homogenisation algorithms might also represent an opportunity in the future, due to their potential disruptive nature in the jungle of the credit industry.
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