Lending Club, the world's largest online peer-to-peer lender in loan origination terms, has filed for an initial public offering likely to result in a day one public market valuation of more than $5 billion. Paul Jeffery examines the prospective importance of this for equity investors in public financial markets.
Lending Club may or may not be a good investment at IPO. Whichever the case, this IPO – planned for later this year -- potentially matters a great deal for all public market investors because it is likely to challenge their current thinking in a number of important ways. Perhaps the most important of these ways is how they think about the future of the current incumbents of the finance industry.
The 2004 IPO of Google changed the common understanding of the future of what a dollar of advertising and marketing spend would look like. There are good reasons to believe the prospective IPO of Lending Club, the world’s largest online peer-to-peer lender (P2P), may come to change how investors see the future of what a dollar of spend in financial services will look like.
Why is this the case? Because the public spotlight that comes with an IPO will show that through a combination of technological and business model innovation, Lending Club, and the aspirant disruptor cohorts of fin-tech, are prospectively commercial Davids with, over time, a real shot at humbling incumbent Goliaths. With the financial sector continuing to weigh-in at over 16 per cent of the S&P 500, the disruptive spectra that Lending Club represents is good reason to think investors should and will care about the company’s IPO irrespective of whether they regard it as being a good investment.
Google, currently the world’s third largest company by market capitalisation, was incorporated barely 16 years ago and in August celebrated its tenth anniversary as a publicly listed company. The point of this observational trip down memory lane is to remind ourselves that when genuine disruption comes it can come faster and on a much larger scale than conventional, particularly industry incumbent, wisdom imagines.
Primed for disruption
The hybrid fuel making disruption possible is one part colossal ambition and another part compelling value. The colossal ambition needs to be in the restless mind of the founding entrepreneur(s) of the industry disruptor and must be leavened with exceptional commercial ability. The compelling value must be located in the customer value proposition the disruptor brings relative to those of incumbents and that proposition must be scalable and defendable.
Lending Club is fuelled to disrupt. The epic scale of Lending Club’s ambitions is made plain in an open letter from Renaud LaPlanche, founder and CEO, contained in the company’s recently filed IPO prospectus. In the letter LaPlanche states he and his Lending Club co-workers are intent on ‘transforming the banking system’ and in so doing making ‘credit more affordable and investing more rewarding’ by ‘cutting out the middlemen and lowering intermediation costs’. As he and team do this they expect, as so many of their Bay Area predecessors in other industries have done, to build a ‘very big company’ with a global reach.
Can Lending Club ‘transform the banking industry’ and build ‘a very big company’? When you look at the quality of their customer value proposition there is good reason to believe they might, for their proposition appears to be compelling, scalable and defensible.
Back in 1994 Bill Gates observed: ‘Banking is necessary, banks are not.’ The primary function of a bank is to bring savers and users of capital together and to facilitate an agreed exchange between the two parties. For their role as intermediaries between savers and users of capital, banks, via their net yield, add substantially to the cost of both borrowing and lending. Hitherto this added cost has been accepted by the public at large due to the lack of a credible alternative, as well as the general oligopolistic structure of the banking industry itself. What Lending Club and many of its fin-tech ilk do is provide the previously missing credible alternative. Lending Club is the world’s largest online market-place connecting borrowers and lenders. It is, essentially, the eBay of loans.
Among other things what is revolutionary about the business model of online market-place lending is it results in fully reserved non-fractional lending, entails no balance sheet risk on the part of the service facilitator and the facilitator has a fee based revenue stream rather than a spread based revenue stream.
Today Lending Club primarily provides a market-place for unsecured consumer loans. In this market its proposition to borrower customers is essentially threefold. First, a speedy online loan-application-to-loan-decision process. Second, for successful borrower applicants who met its underwriting criteria, either access to capital they otherwise could not access or access to capital at materially lower rates of interest than available to them via traditional financial channels (bank debt/credit card debt). Third, the loan accessed, which ranges from US$1,000 to $35,000 in size, is based on a fixed rate for durations of either three or five years and has no ‘hidden’ fees attached, including no early repayment fees.
The number one reason given by successful applicant borrowers for taking a loan via Lending Club’s market-place is to pay off more expensive forms of other debt. Typically this means credit card debt and the average cost saving is reported to be in the range of 500-600bp.
Lending Club makes loans to 35 different grades of consumer borrower, ranging in its credit taxonomy from A1 to G5, at rates of interest ranging from eight to 25 per cent. In 2012, 2013 and during the first half of 2014 the total net charge-off rate on these loans in aggregate has been three to 3.5 per cent. Retail and institutional lenders can access these loans on a fractional or whole loan basis and can diversify their portfolios as much or as little as they wish. The value proposition to the lender is readily apparent. In a low yield world the lender gets yield pick-up for an acceptable level of risk and volatility. The essence of it is the lender is being offered an attractive relative and absolute risk reward proposition.
Is this scalable and defensible? In 2012 Lending Club originated $871 million in loans on its platform; in 2013 it originated $2.1 billion in loans; and in 2014 it is on track to originate $4 billion+. What is the size of the pie being played for? According to Federal Reserve data annual total US consumer debt origination is currently around $3.2 trillion and the stock of US credit card debt is just shy of $900 billion. It should also be noted there is nothing stopping Lending Club entering the market for non-consumer loans as is evidenced by the fact it entered the market for SME loans in March of this year. So in the narrow sense there is a lot to play for, Lending Club’s business is scalable.
The business also appears scalable in the broader sense that its operations are robust and its model defendable. The robustness of Lending Club’s business is probably best demonstrated by the fact that, since it originated its first loan in 2006, over 92 per cent of lenders have achieved rates of return between six to 18 per cent. This suggests Lending Club is highly proficient at credit risk assessment.
How has it managed to do this? By harnessing technology. First, the advent of cloud computing and big data means Lending Club is able to access all the generic (see FICO, Experian etc) consumer credit data any of the banks can. Second, Lending Club has developed proprietary algorithms which leverage behavioural, social, transactional data and employment information to refine and improve upon the traditional tools of consumer credit assessment. As Charles Moldow, General Partner of venture capital firm Foundation Capital has put it: ‘They can out-FICO FICO.’
It would appear to be the case that in the world of consumer credit risk assessment entrepreneur-driven Lending Club is being more innovative and experimental, and with positive effect, than manager-led banks and credit card companies. Your inner economist is probably telling you this is yet another example of Schumpeter’s theories playing out in practice.
What makes Lending Club’s compelling customer value proposition defensible (as well as those of many of its fin-tech brethren) is its cost structure relative to those of banks. The consultancy firm McKinsey has estimated, even at current scale, Lending Club has a 400bp operating cost advantage versus large scale banks. What is driving this advantage is an absence of branch costs and, because it is neither a deposit taker nor a fractional lender, it can largely side step the extensive compliance and capital costs that a bank endures in a Dodd-Franks and Basel III determined financial era.
In addition to this, unlike banks, the majority of Lending Club’s costs are variable rather than fixed. An example of this is that sales and marketing costs currently eat up 45 per cent of Lending Club’s net revenues. In time this number will surely come down materially, which in turn will likely only boost further its relative cost edge versus banks. This relative latent cost of doing business advantage, married to its high quality credit risk assessment capability, suggests in all rate environments Lending Club will have a large yield-to-customer edge over banks. Due to powerful network effects in borrower and lender acquisition on the one hand and credit risk assessment capabilities on the other, the bigger the scale of Lending Club’s loan originations the better and better its competitive unit economics will likely become. As a consequence, its business model has the hallmark of being defensible as well as scalable.
Once public market investors become familiarised with the relative power of Lending Club’s customer value proposition, they are likely to start re-assessing some of their core assumptions about the future profitability of commercial banks and other incumbents in many areas of the finance industry. The loan origination volumes of Lending Club may look paltry today when stood against the size of the consumer loan books of major commercial banks. But at one point Google’s share of total advertising and marketing spend in the US also looked modest. Business history suggests incumbent size and power does not ultimately matter if the disruptor has a compelling, scalable and defensible relative customer value proposition. As the multi-industry studies of Clayton Christensen, the leading disruptive innovation theorist, show, ‘there is repeated evidence that the levels of resources committed (to the competitive fight) often bares little relationship to the outcome’. Google seems to recognise all of this which presumably explains why it bought an eight per cent stake in Lending Club in 2013.
The first of many
Lending Club represents the first wave of a rolling set of waves of fin-tech companies now crashing on to the shores of incumbent finance globally. Behind Lending Club, to name but a few, are the likes of its principal US peer, Prosper (in which Black Rock has a stake); OnDeck and Kabbage, seeking to change the face of SME lending; SOFI and CommonBond, looking to re-invent student finance; Upstart, addressing the market for thin-filed credits; and LendUp, seeking to overhaul pay-day lending.
This is not just a US phenomenon. In the UK, online P2P lenders such as Zopa, RateSetter and Funding Circle are growing rapidly and have explicit government support. In Sweden, Klarna is simplifying online payments as we know it and pushing its solution around the world. In China, where according to Credit Suisse the value of P2P transactions has been growing at a monthly CAGR of 16.9 per cent over the last 12 months, the likes of Credit Ease, Lufax and Dianrong may soon surpass the origination volumes of Lending Club.
What the companies in this disparate fin-tech group have in common is their businesses are addressing real customer needs, often exploiting anomalies which are a by-product of finance as we have known it, and are doing so while delivering superior customer value propositions to those of the incumbents. The Lending Club IPO brings the business models and competitive position of the ambitious cohorts of fin-tech centre stage. As it does so it is liable to alter, maybe significantly, investors tacit net present values for a wide range of financial sector incumbents.