3 is a Magic Number in the Marketplace Lending Ecosystem
Orchard is excited to introduce The Marketplace Lending Thought Leadership Series on its blog. The inaugural post below is contributed by Glenn Goldman, CEO of Credibly. We encourage other thought leaders to share their industry insights with us and participate in the series. Please reach out if you’re interested.
Marketplace lending has made extraordinary progress in democratizing access to capital and delivering a solid and growing value proposition to borrowers. The next frontier, and arguably the most critical, is the allocation of capital and the development of a truly efficient and transparent marketplace for the loans marketplace lenders/Platforms originate. In an efficient and transparent marketplace, pricing will reflect the quality of underwriting (distinguishing amongst Platforms), and risk and capital will be truly aligned.
This article addresses four ecosystem participants:
- Lead Generation/Customer Generation Business Models
- Platforms – whose business models are built on either:
- P2P/i2P/Whole Loan Sale, and/or
- On-Balance Sheet funding, and/or
- Securitization – formal or informal, ie, first loss and reserve fund structures negotiated directly with a Whole Loan Buyer/Lender all the way up to full-on rated securitizations
- Whole Loan Buyers/Lenders/Investors
Other ecosystem participants include those who facilitate and/or provide services to these four participants: third party servicers, data providers, etc., particularly as they seek to price and value their services.
Best practices and prudent financial management would suggest that Platforms avail themselves of the trifecta of liquidity and access to capital: On-Balance Sheet funding, Whole Loan Sale, and Securitization. In addition to providing optionality and diversification, the pricing of each should keep the others “honest.”
With cost of acquisition a major pain point, this, the supply of and demand for capital, and the level of capital required to execute each of these three strategies should be what determines of the value of a Loan.
When matched up with an individual Loan’s Net Yield (APR % – servicing fee – assumed loss and volatility of loss) and an Investor’s targeted unlevered return or Investor Net Yield, the ecosystem should have a very clear and transparent view on the value of a Loan.
However, this is not currently the case. Loans with a 25% APR and Net Yield of 20% trade at par, as do Loans with a 12% APR and Net Yield of 9%. At the same time, two “identical” loans, 12% APR, 3 year term, same credit profile, originated on two very different Platforms, also trade at par, implying that there is no difference between these two Platforms, which of course we know is simply not the case.
While there are emerging exchanges/mini-markets where Loans are trading at Par+ premiums, they are nowhere near efficient, and thus cannot yet reflect value creation or capital allocation across the four participants.
It is the role of our transparent, data-rich, high-velocity ecosystem, and the marketplace overall, as encouraged and facilitated by the Orchard Marketplace, to accelerate the evolution to efficient market pricing for Loans. This will ultimately benefit all participants of the ecosystem and most of all, our borrowers. After all, it’s our borrowers’ APR (interest rate + fees) that feeds our entire ecosystem!
Three is a Magic Number
Over multiple market cycles, access to On-Balance Sheet financing, Whole Loan Sale, and formal/informal Securitization (rated or unrated) have ebbed and flowed – so much so, that for prolonged periods of time access to one or more of these strategies all but disappeared. Ensuring access to all 3 is paramount to prudent financial management, maximizing optionality, and ensuring Platform longevity
- On Balance Sheet (“Eat what you cook”). Platforms should be willing to assume the risk they create, and demonstrate that willingness by holding Loans on their own books, whether that be over the life of the Loan or for some period of time simply to age out a Loan beyond early stage risk.
- Whole Loan Sale. Consistent with Sunlight Banking, more so today than ever before, technology and data allow whole loans to be bought and sold individually or in pools custom built by investors (death pool CDOs/CLOs anyone?).
- Formal/Informal Securitization. Effectively a hybrid of On-Balance Sheet and Whole Loan Sale, where the Platform retains a portion of the risk in the form of first loss protection and/or supporting a guaranteed return.
In an efficient market, each of these 3 strategies, and their respective ecosystem participants, play a highly effective role in keeping the other honest from a pricing and capital allocation perspective.
Providers of On-Balance Sheet funding need to offer attractive and appropriately priced warehouse financing to incent Platforms to borrow and maintain outstandings. At the same time, the Securitization markets need to offer Platforms equal or better execution/pricing to grow into a vibrant alternative to retaining On-Balance Sheet or selling Whole Loans.
Platforms originating higher Net Yield Loans should and could demand Par+ pricing from Whole Loan Buyers, particularly if their Loans will find their way into Securitization, delivering highly attractive leveraged returns to the Securitizer, which, as noted, is not yet the case today. At the core of this analysis is the size and tenure of capital required by each Participant, and hence the level of risk retained.
This dynamic will drive a necessary and critical incentive. Appropriately, Platforms originating increasingly better performing loans (and at the same time increasingly happier Borrowers), will be rewarded with lower cost of capital and/or a greater premium on the sale of their loans.
What is the appropriate value creation and compensation to each of the 4 Participants and what is the role of the Marketplace in determining the price of a Loan? This will be determined over time, however movement down this path must be accelerated.
With the likelihood of a credit correction and/or shift in economic cycles ahead, there will be even greater pressure on margins. For pure play Platforms in particular, as well as Platforms with varying levels of On-Balance Sheet capacity, if not today then sometime in the very near future profits will matter.
Where Will the Profits Come From?
With competition for Borrowers growing every day (a very good thing for Borrowers!), cost of acquisition is at best static, and for many, increasing in certain channels. One could argue that pure originator/aggregators are garnering a disproportionately larger slice of the pie.
Some argue that profitability will come with scale, but that rarely arrives on time or at levels hoped for. This leaves two choices:
- Retaining On-Balance Sheet, either directly or indirectly, some component of the loans we originate (there is meaningful reward-to-risk benefit here), and/or
- Recognizing the true value of the loans we originate by accelerating the development of a transparent, data-rich, high-velocity whole loan trading marketplace with some loans trading at a discount and others at a premium – like every other well developed debt market. Its time to get busy!
Glenn Goldman is the CEO of Credibly, driving the company’s expansion by offering a comprehensive suite of financing products to a broad range of small businesses. Formerly the CEO of CAN Capital for 12 years, Glenn helped create the alternative lending market, building and growing a leading financial technology platform that revolutionized the availability of capital to small businesses.