How marketplace lending is accelerating digital transformation in financial services
Jon Barlow is the founder and former CEO of Eaglewood Capital Management. He began his career in equity research at JP Morgan and was part of the first securitization of debt on an online platform. He’s also a leader in digital lending, and spoke with ESRA about the fundamentals of marketplace lending.
Looking back six years
Barlow began his discussion by noting: “It’s been six years since I’ve been involved in online marketplace lending, which makes me a veteran. I define peer-to-peer lending as marketplace lenders that originate consumer unsecured loans. I made my first investment in Lending Club loans in 2010 and founded Eaglewood a year later.
“We faced a number of obstacles. There was no ecosystem in place. Very few people were familiar with that asset class. Today, however, we have an environment where investors can achieve in weeks what it took us months to accomplish just five years ago.”
He continued: “In 2010, loan selection on marketplace lending platforms was manual. Today there are service providers that can build APIs and other technology that can automate the purchasing process.
“I remember vetting custodians for our first fund. They were uncomfortable providing custody for electronic loans. They wanted us to print off our list of thousands of micro loans so they could put them in a safe. That was their idea of custody. Today they can use technology that enables custody for electronic loans.
“Our auditors were uncomfortable with placing a ‘fair value’ on our portfolio. We spent 8 months going through the client acceptance process of a big four audit firm. When we started, I thought it would take two weeks. Today, all of the big four firms in this sector have clients.
“In 2010, there were no bankruptcy-remote vehicles. Today, you can set up your own or use one provided by one of the platforms.
“Loans were sold entirely through fractional interest in 2010. Today, you can buy whole loans or fractional interest loans.
“In 2010, institutional quality purchasing and service agreements didn’t exist. I remember negotiating 35 drafts of a purchasing agreement over several months. Today, that’s been standardized.
“There was also no industry conference. People in marketplace lending didn’t know they were connected to each other. I remember going to the first one and it was all t-shirts and jeans, and today it’s all suits and ties, which is emblematic of what’s happening in the industry.
“There was no leverage in 2010. We at Eaglewood spoke to at least 30 banks about giving us leverage on our assets. We got two term sheets. Today, there are at least a dozen banks providing leverage to this asset class, or they’re providing due diligence.
“Regulatory awareness in 2010 was limited to the SEC. Today, there are several regulators educated on this sector and the Treasury produced a white paper. They’re getting up to speed.”
The tipping point
Barlow continued: “As this ecosystem came together, the sector hit a tipping point with demand and volume. It saw volume increase to $12 billion 2015, up 80 times from 2010. There were a few key events that helped legitimize the sector and create the tipping point.”
Those events were:
1. In late 2010, Lending Club created first bankruptcy-remote trust. They also launched the first institutional fund in the sector, called LC Advisors, which raised over $1 billion of capital.
2. Eaglewood brought leverage to the market in 2012 and securitization in 2013.
3. In 2013, OnDeck became the first online small business lender to create a whole loan program.
4. In 2014, Eaglewood created the first publicly traded peer-to-peer fund. They also saw a large asset manager in New York, Gerson, do the first Prosper loans.
5. Lending Club and OnDeck went public at the end of 2014.
6. In early 2015, Blackrock was able to dot he first rated peer-to-peer securitization. It was widely syndicated to over 30 institutional investors. Some of those institutions were disappointed by their allocations and they had comversations with Lending Club and Prosper about buying their loans directly and bypassing the securitization market.
Barlow continued with his recap of history: “As these institutional structures became more prevalent, institutional capital became a larger percentage of the industry’s volume. In 2014, the industry issued more whole loans in tis history than fractional interest loans, and last year that was 62%.
“Early on, retail investors dominated the industry. The first institutional investors were hedge funds and others. There was a transition as the industry built a track record, and banks and others began to come in. There was a huge influx of institutional capital.
“An analogy can be drawn between marketplace lending and the hedge fund industry. We can learn some lessons from them. Hedge funds are almost entirely reliant on uncommitted external sources of capital, and in the early 90s, there was only a handful of hedge funds. But over time, an ecosystem formed and that asset class became mainstream.
“The estimated cost of starting a hedge fund also came down dramatically, so the number of them exploded. Over 11,000 of them now exist, managing over $2.5 trillion of assets.
“If you look at the cost of starting a marketplace lender, it’s around a few hundred thousand dollars today, versus several million dollars 5-6 years ago. When I look forward to the next decade, I see the formation of thousands of marketplace lenders. Regulation may slow that trend, but it won’t stop it.”
A crisis of confidence
However, the industry has not been without its turmoil, as Barlow recounted. “The largest US marketplace lender disclosed that it had altered certain loanddocuments, which it sold to a third party investor. That created a major crisis of confidence in the industry. Debt and equity investors pulled back.
“It was very negative in the short term, but there’s a silver lining. I think this will force the industry to further institutionalize. Investors are now requiring greater standards of controls and compliance before they’ll commit capital to these platforms. It will make the platforms stronger and the industry will come back.
“There’s a precedence in hedge funds. In the early 90s, the largest one in the world got into serious financial trouble because of risky bets they had made that went bad. Many thought the hedge fund industry was doomed, but the industry recovered because it institutionalized. That caused investor confidence to come back.
“I remain very positive on the fundamentals in marketplace lending. Long term trends still support it. Banks remain highly regulated and very inefficient with loans, especially small ones. Yields on bonds are at record lows – they’ve even turned negative in some countries.
“In addition, baby boomers will be retiring in record waves in the coming years. Many people when they retire shift their money out of equity and into fixed income. And they’re doing this as we have record low interest rates, so many of them will look for alternative sources of yield and will land in this industry,.
“Most institutional investors also still have no exposure to this asset class. Most of the capital came from a handful of very large institutional investors. Most investors have not invested here, but I think that will change. I’m amazed by how many institutional investors I meet who haven’t invested here and are doing due diligence for the first time. Many of them are seeking alternative sources of yield too.”
He concluded: “All of that leaves me bullish on this sector.”
At the center of compelling forces
Barlow said: “The growth of marketplace lending is at the center of some compelling forces that are forcing the adoption of technology in lending, including new compliance requirements, new risk management requirements, the increased use of securitization as a funding mechanism for digital loans, and greater mobile usage.
“And these forces are expected to result in significant growth. Digital transaction management is poised to grow from $5 billion last year to $30 billion-plus by 2020. Marketplace lenders have always been tech-savvy and forward-thinking, so the influx of capital into this sector has created strong growth for suppliers of technologies.
“Finally, the industry shift from retail to institutional capital is creating new opportunities for the digital management sector as institutional investors need higher standards of controls and risk management.”
Achieving break-out scale
Looking ahead, Barlow remarked: “In a few years, we’ll look back and realize that the opportunity was far larger than traditional peer-to-peer, where this industry started. That industry has dominated headlines, but that will change. Marketplace lenders will achieve break-out scale in some large sectors, like auto loans and commercial real estate. Lenders in those sectors are in their infancy and the combined size of those markets is quite significant.
“I see large opportunities globally too. Loan origination over the Internet is an efficient model that not only works in the US but in a lot of other countries too. So while today the largest marketplace lenders are in the US and UK, I expect to see lenders achieve significant scale in other countries too. Brazil, Canada, India, and Australia are among the countries that have high mobile banking usage (not so much in India) and high credit card penetration, which is a great combination for growth in this sector.
“Although institutional investors are the majority of the capital, their volumes are small compared to their investments in other asset classes. Last year, investors put $25 billion in marketplace lending – that’s 1% of the $2.5 trillion put into hedge fund investments. There’s a long way to go.
Barriers to investing
Barlow also listed what he sees as the barriers to investing. However, he thinks they will be overcome as the industry achieves what he calls “marketplace lending 2.0.”
He said: “The marketplace lending industry has made a lot of progress creating a seamless experience for borrowers, but not so much for investors. That will change, though, and the digital transaction management industry will play a role in that.
“Every institutional investor is also paying too much in legal fees. You have to go through 80-100 pages of legal documents to get set up on one of these platforms. I think marketplace lending 2.0 will standardize those documents. Lending Club and Prosper have already done it and others will too.
“This is a very back office intensive business. When you’re investing in thousands of micro loans and need to have accurate reporting on time, every month, that has to happen in a seamless manner, but it doesn’t always happen that way. After loans are originated, they’re sold, warehoused, and securitized, and at every step, multiple data points have to be verified, audited, and custodied.
“Some of those processes are automated, but in marketplace lending 2.0, they will need to be extended into other sectors too.”
In addition, he said, “the due diligence process can be standardized. There are many emails, with hundreds of documents. That can be standardized and centralized into a frictionless experience for institutional investors.
“On the tax side, offshore investors want to buy marketplace loans in the US, but they need to be seasoned to satisfy IRS requirements. That’s a major hurdle to capital coming into the sector, and there are some solutions on the way.
“To attract more liquid forms of capital, a secondary market is needed. I think that legal frameworks and back office infrastructure are in place on some platforms for that. We’ve seen some activity in the past year, and a secondary market will develop out of structures that I’ve seen come about.
In conclusion, Barlow said, “offline lenders want what online lenders have: hihgly efficient platforms. And online lenders want access to cheap capital, like offline lenders have. Banks took a conservative approach in this sector, and they mostly loaned money to investors. But they’ve started buying whole loans and equity stakes, creating strategic partnerships, and you even have Goldman Sachs creating their own online marketplace lender, which just went live a few weeks ago.
“It’s only a matter of time before the difference between online and offline lending blurs and we’ll just talk about lending in the future.,
“There’s a decade of opportunity in this sector. It’s an important component of digital transaction management.”
Barlow then opened the floor to questions.
Q: I’d like to hear more about consumer dynamics of marketplace lending. Is tolerance going to be there? For example, maybe there are bubbles in the auto and student loan sectors.
A: Last year, the US consumer unsecured lenders did about $12 billion in volume. The credit card industry alone has about $900 billion of debt in the US alone. When you look at other installment lending sectors, people estimate there’s about $1.5-2 trillion of consumer unsecured debt in the US.
So the sector is still a very small fraction of consumer lending. That being said, consumer unsecured lending is the most advanced area of online marketplace lending. It started in 2005 in the UK. They’ve had roughly a decade to create this model.
Three or four years ago when those platforms started seeing growth, Silicon Valley started funding other business models. SoFi is the industry leader, given what’s happened to Lending Club, and they built it on student lending. Several copycats want to get into the student lending space.
This is a very large addressable market, one of the largest in the world, so we still have a very small fraction of the total potential market that’s been addressed at this point.
Q: Blockchain technologies are happening, and I’m expecting increase in the securitization of these loans. Will both happen together?
A: I’ve spent some time on blockchain. I think it’s exciting and I support it. I’m still trying to figure it out. I think the securitization market has a life of its own in marketplace lending, and it’s moving forward with or without blockchain. But hopefully blockchain will help it
Q: Wondering about your thoughts on two challenges: the perceived volatility of funding sources and whether the credit underwriting systems have been stress-tested.
A: That’s one of the major weaknesses: stability of funding sources. Earlier this year, when the Lending Club crisis broke out, a lot of investors disappeared. If you were reliant on uncommitted sources of capital showing up every day to buy your loans, you saw a big pullback this year.
In a crisis, investors all tend to pull back at once, so diversification of sources doesn’t necessarily buy you the benefits you wanted.
There are a couple exceptions to this. I think retail investors have proven to be far stickier than institutional sources of capital. Two or three years ago, everyone was racing to get institutional money because it’s like rocket fuel. Retail investors take a lot more time and patience to gather, but they tend to be stickier.
Lending Club has actually taken market share from Prosper this year because Lending Club the last few years has been pursuing retail investors while Prosper ignored them in favor of whole loan buyers.
A good retail program can give you some insulation. We’ve also seen the creation of permanent capital vehicles that are publicly traded. Those types of investors and structures can continue to buy.
A lot of platforms are part balance sheet and part marketplace, or they create their own funds. Rather than dilute their equity, they create partnerships. Funding Circle created a publicly traded fund that they used to buy their own loans.
There are a number of solutions that are already there but aren’t widely used,.
In terms of credit quality, it’s unlikely that the many marketplace lenders who have popped up will all survive the next credit crisis. The models are mostly untested. The ones who survived the last crisis did so on very small volumes. So it’s a risk.
Q: What’s your view on the strategy of retail investor going direct to platform? For an individual wanting to invest in this asset class, is it the best approach to go direct to platform?
A: There are some asset managers who have created funds and other vehicles for retail investors. You also have, in the UK, some publicly traded funds that investors can buy in their brokerage accounts. And I’m also seeing quite a bit of interest from what we’ve seen in wealth management industry, some peer-to-peer robo advisors that offer easy access to a large number of platforms at low fees and through a single account.
You’ll see a lot more innovation in this area of the business.
Q: A follow-up question on asset class. Has any work been done on how this asset class correlates to other consumer debt?
A: We did some work on that several years ago. It was difficult a few years back when the industry was so small. It was hard to draw firm conclusions. We did find in the case of consumer unsecured assets that it was highly correlated to the credit card industry. There’s a lot of data on credit cards that we used to do a lot of analysis and credit card losses were significant in predicting losses in the peer-to-peer industry. We’ll see if that continues to be an indicator in the future.
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