A few weeks ago, I had the opportunity to both attend and participate in the LendIt Conference -- the premier show dedicated to discussing important topics in the online lending (or alternative lending) space. While the topics of the show were solid, the most interesting discussion happened one of the nights at a private, small-group dinner. Jason Jones, one of the founders of LendIt, invited a select group of execs from the small business lending industry to join Karen Mills, former Director of the SBA, for dinner.
During the dinner, many topics came up, but one of the comments that triggered some healthy debate was the statement that many of today's lenders were really not creating any innovation, but were just taking advantage of the current regulatory environment (or lack thereof).
If you've followed the industry at all, you are certainly aware of the tremendous amount of growth that has happened in the industry and the excitement that currently abounds. New lenders are popping up on a regular basis and established lenders are regularly launching new loan products. What took a bank 30, 60, or 90 days to underwrite a decade ago, now happens in a matter of minutes through an online technology process.
But, perhaps none of that really matters? Maybe these lenders are just taking advantage of a regulatory loophole!
I disagree.
Previous to the surge in online (e.g. innovative or alternative) lending, business owners that were looking for $150,o00 or less had one source of debt capital: banks. The underwriting algorithms for these banks was elementary (at best) and consisted of checking the personal credit score of the business owner. If the score was good (680+), you were approved. If not, you were denied. Very few banks actually looked at any other factors related to the performance of the business.
Two of the most active banks in the space were Advanta and Wells Fargo. How do I know? I received a "business loan" from both of before I actually had any revenue with the businesses for which I was applying. My personal credit score was solid (over 700). I completed the application. And, I was approved. It was that simple.
'Giving away money is easy, it's the 'getting it back' that's the problem'
For those that know the story of Advanta, the FDIC-bank that specialized in providing capital to small business owners. In fact, they had a sincere desire to provide low-cost capital (2-10% APRs) to the masses. Within a few short years, Advanta's defaults piled up with more than 40% of their loans defaulting before they filed bankruptcy.
Fortunately for Wells Fargo, they were large enough and appropriately well-diversified to handle the huge amount of losses that they suffered with their small business loan product. However, being that large didn't mean that they'd continue to fund the loans... they also quickly departed the space.
Enter Alternative Lenders
By 2009, banks were quickly fleeing from the small business loan market, leaving a huge void for main street business owners. Unless you were looking for $1m or more (or if you had wealthy friends and family), you were out of luck. A restaurant owner looking to get $25,000 in working capital? Good luck.
Fortunately for the millions of small business owners, we are a country of innovators and entrepreneurs; when challenges occur for some, it creates new opportunity for others. LendingClub, OnDeck, and CAN Capital start looking at different ways to underwrite and price these loans. They started to consider new data sources (primarily bank statements and credit card statements) to price risk and ensure pay-back.
Pricing the risk and getting paid back was (and is) much more difficult that most give them credit for. While their bank counterparts depended on 50-90% SBA guarantees and almost a 0% cost of capital, these lenders had to figure out how to:
- Attract capital that they could use to fund the loans. Most of those that were crazy enough to get into the space demanded a high return (5-10% +) on their investment dollars.
- Use technology to efficiently underwrite the business (unlike the bank that used a full loan committee of 2-3 individuals to look at each deal).
- Price risk in a way that would allow them to cover their cost of capital and provide a return.
- Service the loan and handle collections without an enormously high rate of defaults.
But rates are incredibly high!
The argument against the innovation is the fact that the rates were / are much higher than their bank-counterpart (which is true). These loans are definitely not the solution for every business. If the business owner does not have a solid ROI case for the loan that they are getting, they can certainly get themselves into trouble. But, just because the rates are high, does not take away from the innovation that has occurred to create a whole new class of small business loans for the market.
Fortunately for the small business owner, the energy and momentum in the space is attracting new entrants on a weekly basis. New lenders are constantly putting pressure on the incumbents by identifying new data sources and risk pricing for underwriting. The new competition is forcing lenders to lower their pricing and improve the overall borrower experience.
Finally, a word about regulation...
There has been much discussion lately on whether or not the small business lending industry should be regulated. In my opinion, the major lenders are not the cause of any problems that are present in the space. Unfortunately, the small business loan market is still very inefficient and filled with unscrupulous loan brokers that are taking advantage of the business owner. Most of these organizations are shady, fly-by-night organizations that hide in the shadows of the market. They don't really have a brand (or it changes month to month), they don't publish an address or any mention of their principals on their website, and you can't find any information on LinkedIn. In addition to taking advantage of the borrower, those groups are also taking advantage of the current regulatory environment.
As an industry, I hope that we self-regulate by weeding out those that are using these practices. If we don't, regulation will surely come and significantly slow down (or ruin) the innovation that currently exists.
