With a market capitalisation of around US$9 billion, what does the Lending Club’s success mean for the peer-to-peer lending industry?
From the perspective of Lending Club’s shareholders and employees the company’s recent initial public offering (IPO) has been a resounding success. The danger though now is Lending Club’s success may carry seeds of peril for the nascent peer-to-peer (P2P) lending industry. Why? Greed.
That Lending Club’s IPO was a spectacular success is self-evident. The company’s shares priced 50 per cent above the bottom end of the initial price range formulated at the start of its IPO road show. Those shares then rose a further 56 per cent on its first day of trading as a public company. Lending Club currently has a market capitalisation of a little over US$9 billion. Not bad for a company that in mid-2012 had an implied valuation of $570 million and as recently as May 2013, when Google Ventures bought in, was valued at $1.55 billion.
Given that Lending Club is both the world’s largest, in originated loan volume terms, online P2P marketplace lender and the first of its ilk to achieve a public listing, it is little wonder people in the P2P industry are now in highly celebratory mood. While some air-punching and back-slapping should be enjoyed by those who have toiled hard to build a new industry that has now had its first major stamp of public approval, it is also a time for all involved, including their customers, to become even more vigilant about industry practices and standards. Particularly, underwriting standards.
Charlie Munger, the long time investment partner of Warren Buffett, famously opined ‘Show me the incentive structure and I’ll show you the outcome’. Post Lending Club’s IPO success the danger is that the core incentive structure at the heart of the P2P industry may have taken a turn for the worse. Specifically, the riches prospectively on offer in the public market for those P2P companies that can demonstrate ‘strong growth’ in what is now a ‘hot industry’ have become, all of a sudden, very large. Given this the temptation to take a short cut to success has never been higher in the industry. The real danger is P2P lenders aspiring to be ‘the next Lending Club’, probably egged on by VC backers who have ticking fund clocks, will prioritise asset growth over asset quality. If this is the case it will be a tragic mistake. A strategy of ‘Damn the torpedoes. Full steam ahead’ may have worked for the American Civil War admiral David Farragut at the battle of Mobile Bay in 1864, but it is, I suggest, highly unlikely to produce an outcome of glorious victory in consumer and SME lending markets today.
I say ‘a tragic mistake’ because a collective dropping of industry underwriting standards is the surest way the P2P industry can destroy the genuine value it has brought to the High Street. The beauty at the centre of the P2P industry today is that it offers its borrower and lender customers alike an evidently better value proposition than the incumbents (banks, credit card companies etc) of financial services do. The High Street customer value creation currently supplied by the P2P industry is one of the principal reasons the industry has enjoyed, and deserves to enjoy, a supportive regulatory regime as well as strong government backing.
P2P lenders are classic disrupters bringing radically lower cost structures to an industry. The foundation of the new lower cost structure P2P lenders have brought to the finance industry is part tech-enabled business model innovation, part regulatory arbitrage and part underwriting competence. Take anyone of those factors away and the cost structure advantage enjoyed by P2P lenders evaporates and with it so does a very significant part of the superior customer value proposition they offer. Of those three factors, underwriting quality is the factor most in the hands of P2P lenders to self-control. It is also the factor that can be most easily manipulated to improve near term loan origination volumes.
Just because a risk is at large does not mean it will become manifest. But the probability of it occurring does rise. How might the P2P industry protect itself from the risk of a possible deleterious drop in underwriting practices by those chasing growth and riches at all cost? There is no infallible answer but I suggest three things could and should be done.
What should the customers of the P2P industry do? In particular, what should the lender customers of the P2P industry do? Two things. First, be aware of the underwriting dangers that lurk. These dangers lurk not because P2P lenders are generally incompetent at underwriting. Indeed the reverse is often the case. There is a growing body of evidence to suggest certain P2P lenders do and/or will better assess credit risk in a given loan category than the incumbent loan providers in those categories do. Rather the dangers lurk because there is now a strong temptation at large for P2P lenders to adopt a ‘damn the torpedoes’ growth strategy. That is not to say they will. But the chances that they might have risen thanks to Lending Club’s success. Second, place more value on the product offerings of the more tried and tested among today’s P2P lenders. In the US that might mean Lending Club or SoFi. In the UK it is likely to mean the likes of Zopa and LendInvest which, along with attractive yields, have industry leading net charge-off rates.
The big truth in any industry and in any area of life is that very good is very rare. Underwriting is no different. It only becomes yet rarer still if incentive structures are not fully supportive of it. To protect against the risk of an erosion in the collective underwriting standards of the industry, and so to keep the P2P lending industry’s superior value proposition alive on the High Street, online marketplace providers and their customers alike should become even more vigilant and demanding in the wake of the Lending Club IPO. Their future depends on it.
Paul Jeffery (email@example.com) is a partner at LendInvest, the world's leading online P2P loan platform for real estate related loans. Paul, who has an extensive background both as a business builder and financial investor, is Chief Financial Officer and Head of Strategy at LendInvest. He is a Sloan Fellow (2013) of London Business School.
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