While marketplace lending has recently grabbed a formidable share of headlines, venture capital dollars, and “fin-tech” lustre, all that glitters is not gold, and much of the promise to date is no more than good packaging.
Granted, the marketplace approach has improved upon staid bank lending models through streamlining user experience and non-bank involvement, but the model is not ground-breaking. Marketplace lending is simply the next iteration in a long line of ever-evolving funding strategies for the otherwise traditional business model of lending to consumers and small businesses. In this way, marketplace lending is closer but also less-transformative, to the creation of the securitisation market than to the advent of Facebook.
For the purposes of our discussion, we consider not just “marketplace lending” but specialty finance in general. Specialty finance is a wide swath of non-bank and non-corporate lending ranging from equipment leases to consumer credit cards to niche small business lending. Specialty finance is also a rapidly growing opportunity that has many attractive sub-categories.
In short, our perspective is that the largest marketplace lenders are generating reasonable relative returns when compared with traditional (liquid) similar duration fixed income alternatives; however, the returns are underwhelming when compared with illiquid alternatives. To be clear, we do think that there are some attractive smaller operators within the marketplace landscape so want to avoid painting all originators with the same brush.
Atalaya has consistently found better return opportunities through either rediscount lending (“lending to the lenders”), or by targeting smaller, less volume-driven asset classes within the broader specialty finance category.
MARKETPLACE LENDING: GROWING, INTERESTING BUT STILL A DROP IN THE BUCKET
Like private (non-bank) credit in general, marketplace lending has flourished in the aftermath of 2008. The most significant factor has been a new, complex regulatory framework (Dodd Frank, Basel III, etc.) that has furthered bank retrenchment from consumer and small business lending.
In addition to bank retrenchment, factors driving the rise of marketplace lending have been: (1) robust investor demand given a thirst for yield in a low return world, and (2) a benign macro environment (ie, a deleveraging US consumer and falling unemployment) that hasn’t stressed delinquencies or underwriting.
The combination of these factors has propagated explosive marketplace growth in the post-crisis “goldilocks” environment. While volume has grown rapidly, the sum of all marketplace lending still constitutes just a fraction of the burgeoning specialty finance industry that is increasingly replacing diminished bank lending capacity for consumers and SMEs. While marketplace lending may grab more headlines, Atalaya has mined a far wider universe of emerging specialty finance lenders where the market is larger and the return on assets more plentiful.
MAINSTREAM MARKETPLACE RETURNS: EXPECT MEDIOCRITY… AND A LOT OF LEVERAGE
One prominent marketplace lender advertises blended unlevered net returns to its investors of circa 7-8 percent annually, Atalaya’s internal projections, for their 2015 originations, indicate that actual performance is in fact trending closer to mid-single digits. While arguably attractive in today’s low-return environment, we don’t find this outcome an overly compelling return for illiquid structures with limited performance history.
Subsequently, institutional investors have been required to embrace substantial leverage (ie, 4-9x debt:equity ratios) through securitisations in order to convert single-digit marketplace yields into a potential net double-digit return. This construct becomes quickly precarious should asset returns decrease or securitisation markets prove unreliable.
A key issue for sceptics of marketplace lending is the principal-agent problem. Marketplace lenders, while having their revenue almost entirely reliant on loan volume, are also the risk arbiters, deciding which loans should be made and at what interest rates. The fact that marketplace lenders have no “skin in the game” other than reputation, and are rewarded by volume, is often the type of story that ends in investor tears.
Beyond the primary principal-agent risk, other risks to loan buyers include macro, credit, regulatory, servicer and illiquidity concerns, all of which investors need to price into expected returns. While we continue to monitor this fascinating landscape for opportunities that meet our risk-return thresholds, we largely remain observers, and submit that marketplace is a flavour of non-bank lending that would need more seasoning for our taste.
Despite its glittering status as a headline-maker and VC darling, marketplace lending is certainly not alchemy, but rather just the next step in the evolution of funding strategies for lenders and specialty finance companies.
Relative to today’s mainstream fixed income alternatives, the biggest, best-known marketplace returns appear reasonable, despite asset performance which has lagged expectations. Investors, however, charged with generating double digit, risk-adjusted returns on illiquid capital, are likely to find better alternatives.
While Atalaya remains circumspect about the current state of marketplace returns, we do not sit idly. Instead, we focus on a different subset of the specialty finance universe which offers a more attractive ROA to investors by mining smaller companies that operate in more narrowly defined niches. Such businesses more often benefit from unique (or captive) origination channels, insulating them from competition.
We firmly believe in this “quality over quantity” approach, and the trade-off in scalability is one we’ve happily made in exchange for better risk-adjusted returns.
As previously mentioned, the specialty finance market is much broader than just the marketplace subset.
Other platforms filling the lending vacuum employ a traditional “balance sheet” approach or a hybrid approach, which involves keeping some assets on balance sheet and selling the remainder. For a number of reasons, we believe both of these models to be inherently more stable and attractive than the pure-play marketplace model.
These new lenders need debt capital themselves in order to finance the loans that they are originating, which has created an opportunity for investors to be a lender to the lender, or a “re-discount lender”. The “re-discount” nomenclature refers to the fact that Atalaya lends a discounted amount against loans already originated at a discount to the borrower’s collateral or repayment obligation.
In this structure, Atalaya provides debt capital at a discounted advance rate relative to the balance of the underlying assets, with the loan originator providing the remaining capital on a first-loss basis.
The advance rates are structured to withstand a dramatic increase in loss rates, such as the recurrence of a 2008-like recession, minimising the risk of asset under-performance to the investor. This structure mitigates a number of the issues associated with marketplace lending, most importantly by aligning economic incentives with the lending platforms that are acting as the arbiters of the underlying risk, largely eliminating the principal-agency issue.
Because of the complexity of the asset class, there are few providers of this type of capital, and Atalaya believes that unlevered double-digit returns are reasonably attainable.
Ivan Zinn is founding partner and chief investment officer at Atalaya Capital Management, the New York-based alternative investment advisory firm focused on investing in credit opportunities and special situations.
This article is sponsored by Atalaya Capital Management. It appeared in the November 2016 issue of Private Debt Investor.