In the fickle world of startups and venture capital, no market segment has been hotter than FinTech. Billions of dollars have flowed into the space, supporting every kind of non-traditional lending you can imagine. Over the past few years, the influx of capital has supported the growth of companies including Lending Club, OnDeck and countless others.
Each promised to disrupt the status quo of lending, particularly in the small business space. However, I believe that the sector has failed to deliver on this promise. Instead, plentiful capital and sky-high valuations created a bubble that only a handful of the most forward-thinking players will survive. Many think that the bubble has already popped, but I believe that there are more challenges yet to come.
Stuck in an unbreakable debt cycle
The core message of most alternative lenders is that they can help individuals and small businesses alike consolidate their debts and pay them down at a more manageable interest rate. It’s the debt consolidation story we’ve all heard a thousand times, and it’s a good one. Businesses that are trapped in the painful cycle of credit card debt saw these organizations as pathways to become debt-free, which is an admirable goal. Much of the growth in the alternative lending industry was predicated on this notion.
Unfortunately, human behavior often deviates from the righteous path, leading to untenable situations. The dirty secret of the industry is that while customers of these types of loans often use their funds to pay off their credit cards, they don’t close out the accounts. Over time, they run their credit card balances back up, effectively increasing their overall debt burden.
To make matters even worse, the data reporting functions of alternative lenders tend to lag, allowing customers to take out loans with a number of providers around the same time. In a matter of weeks, people can increase their debt balances by tens of thousands of dollars, increasing their default risk right under the noses of the unknowing lenders. This process is known as “stacking,” and it is a huge problem.
Consider the case of market leader Lending Club. Over the past year, Lending Club’s non-performing loans (NPLs) have been picking up fairly aggressively. Although Lending Club claims that these NPLs represent just the lowest-graded loans, it is important to remember that every default cascade starts in that segment. Since its inception in 2006, Lending Club has not been tested in a deteriorating economic environment with a mature book of loans.
If the covert debt increase cycle I outlined above is correct, and I suspect it is, we should see an acceleration of defaults if the economy stumbles at all. This is an adverse selection problem in which the worst debt offenders are most attracted to the industry’s refinancing options, which puts the entire model severely at risk when we go into a typical economic downswing.
Data is the solution, but it takes time
So how do we fix this situation? The answer is as simple to understand as it is difficult to implement. Alternative lenders (and traditional lenders for that matter) need to monitor what is happening inside of their portfolio companies in real-time. I know the technology exists; in fact, it’s a huge part of what we do at my company, BodeTree. With real-time monitoring, lenders can ensure that their borrowers aren’t simply running up their debt balances and significantly de-risk the loans they make. While I wont speak for the entire industry, the clients that I have worked with in this space are much more concerned with the borrower’s personal finances than the business’ finances since they often obtain a personal guarantee.
It sounds easy, but the very same exuberance that has driven the FinTech sector over the past few years also discourages good behavior. With sky-high valuations and significant overhead, most alternative lenders find themselves in the position of having to pursue growth at all costs. More importantly, they have to show fast growth and unfortunately, that leads to a land-grab mentality that creates long-term problems.
Customer acquisition costs are out of control
While specific statistics are hard to pin down, we estimate that there are approximately 1,300 companies operating in the alternative lending space today. These 1,300 organizations are competing for about 1% of the overall market, compared to about 6,500 traditional banks competing for the remaining 99%. This perspective of the market may seem shocking at first, but in our discussions with hundreds of banks nationwide we’ve heard time and time again that the alternative lenders are having no impact on their market share. Instead, it’s the view of the banks that alternative lenders are pursuing the 1% of the market that has long been considered “unbankable.”
It should come as no surprise that this market segment, the 1% that the alternative lenders are all fighting for, represent the very people who are most likely to run up their debts. This is the core problem facing the industry.
Lenders are paying anywhere between $2,500 and $4,000 per loan to acquire the customer. At BodeTree, we work with a number of lenders who tap into our considerable user base to find customers. Historically, they’ve paid us about 100 basis points (1%) for each loan we source. Over the past 18 months, however, we’ve seen that number skyrocket to anywhere between 3% and 5%.
Think about that for a moment. The competition for these sub-prime borrowers is so strong right now that companies are willing to pay up to 10% for a successfully closed lead. This is very problematic.
The path forward
The only path forward for the alternative lenders at this point is to slow the growth engine and reevaluate their approach to the market. They have to work to grow the market, by using real-time data to develop deeper relationships with their small business companies and help nurture them down the pipeline to ensure that they use their debt products responsibly. This data-driven approach will not only de-risk their portfolios; it will also drive down the cost of capital, enabling alternative lenders to work with traditional banks.
Everyone in the space is desperate to work with banks and take the loans that traditional lenders don’t want to make. The problem is that banks have an allergic reaction to anyone offering to lend at interest rates above 15%. However, if the alternative players were to drive their cost of capital down through rigorous data analysis, I suspect this dynamic would change. Banks would open up the floodgates and alternative lenders would be able to stop fighting for the bottom 1% of the market.
I’d be willing to wager that this perfect scenario won’t come to pass as I hope. I think that the desire for quick growth and a culture of short-term thinking will prevail. When this happens, we’ll see a bloodbath in the sector as default rates spike and customer acquisition costs balloon even further out of hand. I hope I’m wrong, but there is little question in my mind that when it comes to whether or not we’re in an alternative lending bubble. The only real question is whether or not the industry will have the wherewithal to do the right thing.
Chris Myers is the Cofounder and CEO of BodeTree a web application designed to help financial institutions better interact with their small business clients.
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