In the second of the series, we’ll be examining the segment from the non-bank lending platforms’ perspective. As we have been conducting these interviews, the overarching sentiment that all respondents have echoed is that the non-bank lending segment is not only here to stay, but is now a critical part of the financial infrastructure. The current pandemic has shone a light on credit markets, bringing into focus questions about these platform lenders’ robustness; this is the first significant shock the segment has had to overcome since its post-2008 expansion. Click Here to view the previous article.
As highlighted in part one, the platform lending segment has direct exposure to the real economy, especially given the growth in the consumer and SME sectors. This has resulted in platforms facing several specific challenges that we can group into three main categories. These categories are disruptions to origination channels, changes to borrower credit profiles/fundamental underwriting criteria, and cash flow. As we examine each class, it is essential to highlight a theme present throughout this article. Platforms are keen to convey that while you can broadly categorise the challenges they are facing, it is critical to look thoroughly and in detail at each platform as each will be affected in its own unique way. A question we posed to all respondents was whether they expected to see an increase in the cost of funding across the board. The overwhelming response from platforms was that investors should view this market disruption as a litmus test. This will allow the most robust businesses to separate themselves from the businesses that have benefited from the growth in the segment and did not necessarily have what it takes to weather challenging market conditions.
Looking at the first challenge platforms were faced with was a disruption to origination channels as the result of lockdowns and a slowdown in economic activity. Our respondents had a broad range of expectations for the impact of these disruptions. A consumer lender specialising in point of sale saw originations drop 99% as its distribution partner (high street) closed during lockdown. The same platform now reported 200% in originations compared to February as a result of new registrations and pent up demand. We also found a point of sale consumer lender involved in the buy now pay later segment that experienced a similar shock, however, with consumers who use credit for lower value purchases more likely to be affected by economic shocks, their demand outlook appeared less certain. On the other side of the coin, the lenders involved in distributing government support measures saw a surge in demand. However, it is worth noting not all of this increased demand would necessarily have an appropriate credit profile. It is these differences that platforms are keen to communicate to investors and are eager to have at the forefront of pricing discussions.
The other challenge platforms are facing are changes to borrower credit profiles and the effects on underwriting criteria, portfolio management and longer-term viability. This is having an impact on platforms in several ways, including affecting the value of existing loan books and the pool of potential borrowers. As we brace for what is likely to be a deep global recession, many businesses are facing questions about their viability, whether that be in the immediate term or post COVID and non-bank lenders are not immune from this. Platforms are keen to sit down with investors and help them understand how they plan to navigate the current disruption as well as position themselves for the future. The decision was made not to name the platforms interviewed as it would be challenging to ensure equal or even representation throughout this article. We would, however, be happy to provide introductions to any investors who are keen to have these conversations with our respondents. Similar to challenges to their fundamental businesses, a platform’s cash position and challenges surrounding that will be very dependent on each business. While some respondents expected something of a mini-credit crunch this side of Christmas, there was a lot of optimism that well-run businesses would be able to secure additional funding if needed and that competitive interest rates.
Digging deeper into views around funding, we ask whether platforms felt that investors truly understood the segment and whether funding costs accurately reflected this understanding. Respondents were overwhelmingly complimentary of their funding partners, while also highlighting several challenges that made securing the appropriate cost of funding for their businesses a sometimes time-consuming and frustrating endeavour. One of the biggest frustrations that platforms have expressed is the difficulty in getting investors to see where the real value of a business is in the non-bank lending space, especially with the shift towards fintech. Their view was that the landscape is changing and investors must be aware of these directional changes and start to evaluate platforms in a way that better assesses the value of those businesses and their future prospects. The segment is often referred to by several names including non-bank lending, specialty finance or fintech lending. These act as a catch-all for this segment; however, the platforms themselves are very keen to make it clear that the strength of the segment is in the ability of platforms to differentiate and specialise. This is how platforms can service areas of lending that traditional banks have been forced to withdraw from while still providing excellent returns for investors. Regardless of the sector in which they operate, be it consumer or SME, the geography or product offered, we noticed some themes amongst the respondents when it came to determining the value of a platform and how they feel investors should evaluate potential investments. We’ve created a simple diagram that aims to illustrate the points made by our platform respondents to provide a clearer picture of where the value is in the segment from the perspective of the platform.
Taking a bottom-up approach, a platform’s existing loan book is the first and most tangible indicator of their track record; it demonstrates the viability of the business and of course provides potential investors with the snapshot of the future prospects of an individual business. The loan book also represents a significant part of the value of a business. Several respondents did, however, caution that while this is undoubtedly the first area that any investor would reasonably assess, it is important to be mindful of the platforms which have been able to get their commercial offering spot on. These were able to demonstrate a large and growing loan book while not necessarily having the foundations that would underpin long-term viability. Examples of these foundations are real IP and an underwriting model that accurately assesses the risk in that specific area of lending not only in the short term but also through periods of economic uncertainty. We were given the example of a US-based consumer lender that had an IPO in May 2018 to much fanfare and has subsequently seen a significant fall in share price due to a lack of fundamental value beyond the loan book. At the time of publishing those shares were trading at c.18% of their IPO value. This equity value should certainly be something that even debt investors take into account as this ultimately provides a backstop in the event of trouble.
The COVID crisis and resulting economic disruption have certainly brought into focus the importance of origination channels for platforms. Our respondents were keen for investors to consider how well platforms were able to communicate their knowledge and understanding of their origination channels. They encouraged investors to challenge this knowledge from a growth and resilience perspective. Growth: would have an impact on the number of new loans they would be able to originate? Resilience: would existing origination continue to offer similar volumes with acquisition costs over time? And if not, how would these affect a platform’s immediate and long term prospects.
Platforms want investors to ask questions and challenge them to ensure that they can articulate that they fully understand the segment in which they operate. To demonstrate their sector expertise as this is where they are keen to differentiate themselves from other players and highlight their true value proposition to the investor community. Platforms want investors to look beyond the general categories such as asset class and geography, to allow them to demonstrate their deep expertise through their underwriting models or a keen understanding of the product that they are offering relative to their borrower community. All of our respondents were keen to make themselves available to have these conversations with investors, enabling them to differentiate between platforms and understand how best to assess the risk associated with their specific businesses to ensure any funding is priced appropriately for that platform.
The key to determining the long-term success and value of a platform lender would be whether that platform indeed possesses Intellectual Property. In a segment commonly referred to as fintech lending, the majority of respondents were at pains to highlight the fact that real IP was in short supply. They were keen to emphasise the feeling that this is where you would find the actual value of a business beyond its loan book. Respondents felt the recent pandemic would bring this into focus with some platforms not being able to survive in the short term as a result of not having the technology to adapt their businesses through this period of disruption. You could operate in a segment with high demand growth, low acquisition costs and high-quality borrowers, however, if you do not have the technology underpinning your business, you may struggle to adjust to changing credit conditions and that could ultimately spell the end of a business. The pandemic has led to an increase in the demand for credit across the board while simultaneously seeing a reduction in credit profiles as a result of the economic uncertainty. This had led to the need for platforms to reassess their entire business models and in some cases, make changes to those models to reflect market conditions better. Those platforms who have invested in their technology are likely to be best placed to make the necessary changes to their businesses to survive the short-term disruption and also position themselves to take the best advantage of any recovery. The importance of IP was further highlighted when we posed the question of whether respondents felt the current disruption would lead to a wave of consolidation within the non-bank lending space. The perceived lack of IP meant the majority of respondents did not see the value in acquiring other platforms as they could wait for those businesses to fold and acquire the loan book in distressed sales and usually at a discount. If this were to take place, it would likely only happen within specific sectors where a player would be looking to consolidate their position rather than across sectors where their specialisation that contributes to the value of that platform may not translate.
The consensus view from platforms is that this is an opportunity to separate the wheat from the chaff. The one thing in investors favour is that platforms are craving the chance to demonstrate they have what it takes to not only weather this storm but also to come out on the other side of this positioned to take full advantage of a recovery. There were calls to create a framework that would help facilitate the discussions between the platforms and investors. A framework would allow investors to spend time getting to understand their platform businesses while being able to have some benchmarking in what is quite a fragmented segment when you think about the differences from sectors to geographies.
Based on the conversations that we have had, the charts above aim to provide a simple framework that would help in the screening process for investors, help to drive conversations with platforms and support the decision making process. The chart on the left aims to tackle the challenge that is faced when assessing platforms that operate in various sectors and geographies, using the axis on the chart to determine a location for each platform, one can use this to create benchmarks. Understanding the relationship between demand growth and acquisition costs would enable investors to assess the commercial viability of a platform based on its area of operation and specialisation. The commercial challenges for a platform operating in a segment with high demand growth and low acquisition costs would be very different from those of platforms operating in a segment with low demand growth and high acquisition costs.
The chart on the right aims to help determine the resiliency of a platform based on its borrower base and specific product offering. The y-axis looks at the credit profile of the borrower base. The x-axis looks to assess whether the credit product offered would be repaid on schedule during periods of increased volatility. We have coined the term repayment elasticity in an attempt to illustrate this concept. Repayment elasticity aims to quantify or measure the likelihood of a borrower deviating from the regular repayment schedule in a period of stress/volatility. This can be affected by the type of credit product on offer, be it secured or unsecured, term or revolving and market segment within which the platform operates. If you took a credit card, for example, we would determine this credit product to have a high level of repayment elasticity. As a revolving credit product generally without a prescribed repayment schedule, in a period of stress you would expect individuals to increase their utilisation while reducing repayments. An example of a product with inelastic repayments would be a salary advance/payroll borrowing which would likely be deducted by their employer at every pay date. Looking at this relationship with a borrower’s credit profile if you offer a product that is very inelastic to high-quality borrowers, you are most likely to find repayments remaining largely on schedule despite increased uncertainty. On the other side of the coin, if you offer a credit product with a high level of repayment elasticity to lower-quality borrowers, you are likely to see a considerable divergence from the expected scheduled payments in your loan book. Our respondents were keen to highlight that they felt there was value to be found for investors across the spectrum. They encouraged investors to engage in conversations with them to help determine where each platform is located using the framework above and to then work together to price debt financing appropriately.
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