Loan Growth Targets at Peer to Peer (P2P) Lenders Unsustainable
With additional headwinds expected for the broader tech start-up industry (and Fintech specifically) and an unknown regulatory environment ahead, we are comfortable watching LendingClub and the broader Fintech industry from the sidelines.
The securitization rate at P2P lenders has halved since the end of 2015 (Source: The Economist). This is important because P2P lenders, much like mortgage originating banks in the years leading up to the 2008 financial crisis, were able to increase the scale and rate of their loan origination business by off-loading risk to third parties through securitization. This slowdown suggests the market is sensitive to default risks in the P2P lending industry and such securitization practices will likely compound the effect of potential defaults/ losses.
Taking LendingClub (NYSE: LC) as an example, they increased their loan book by roughly 50% in 2015 and currently project an additional 70% increase to their 2016 loan book to the sum of US $14 billion. With the backdrop of macro tightness in credit markets, potential for Federal Reserve interest rate hikes (raising borrowing costs), and the aforementioned securitization market headwinds, projected growth rates at Lending Club and its peer P2P lenders seems dubious.
Seeking Funding to Meet Growth Targets
The significant slowdown in securitization rates puts into question where P2P lenders will find funding to originate new loans and continue achieving growth targets. To date, IPOs, institutional investors and individual investors have been the well spring of funding for the P2P lending industry. While some P2P lenders, such as LendingClub and OnDeck Capital (NYSE: ONDK), were able to tap the IPO market while still hot, the IPO market has been on a cooling downward trajectory since 2014 with the number of venture backed tech IPOs falling roughly 33% in 2015 (Source: Renaissance Capital). It is worth noting the shares of both OnDeck and LendingClub are down sharply from their IPO prices.
The IPO market in 2016 continues to flow like molasses, with only 8 IPOs to date, a 73% year on year decline (Source: Marketwatch). There have been no financial tech (Fin-tech) IPOs in 2016 and this trend is poised to continue thereby eliminating the potential for IPO derived capital to fuel loan growth. Notably, non-bank lending company LoanDepot Inc. was one Fintech casualty from the current IPO slowdown when it scraped IPO plans in November 2015.
Absent IPOs, P2P lenders will be forced to seek investment from institutional investors to fuel loan growth, the same institutional investors that have lost an appetite for IPOs and appear to be contributing to the drastic IPO slowdown. One class of institutional investor, hedge funds, had their worst year (in terms of total returns) since 2008 and witnessed more funds closing their doors (979) than new funds opening (968) (Source: Fortune). Further, with the hedge fund industry facing consolidation, it reasons there will be less competitive impetus for funds to fight each other "just to get a piece" of the tech start-up industry, Fin-tech included.
Given the macro-economic headwinds outlined above, institutional investors are practicing prudence and focusing on bottom line numbers (profits and earnings), as opposed to top line numbers (revenue, market share). Our assessment is that this bodes poorly for companies like LendingClub that require additional scale and capital to translate growth into profitability.
Sustainability of P2P Lending and Broader Fintech Sector
Prosper Marketplace, the second-largest P2P lender, reported that loan delinquencies are rising, but insisted that the amount was trivial. We firmly believe that rising loan delinquencies should not be dismissed as trivial, especially in the FinTech industry where, like much of the rest of the tech start-up economy, the companies have not proven their business model through business cycles (up and down).
Like many tech start-ups, LendingClub's annual income statements indicate average annual loses of approx. $12.1 million from 2011-2015, with the exception of a nominal gain ($191,000) in 2014. LendingClub lost $5 million in 2015. We do not fault LendingClub for their lack of longevity or for prioritizing growth over profit as the market rewarded this behavior. However, we believe a dose of skepticism is healthy when viewing the FinTech industry.
Fintech, as well as other non-bank lenders, has benefited from operating within an unregulated grey area of non-bank commercial financing. Generally, the advantage of not having to adhere to existing regulations lowers the cost of doing business. Uber is an ubiquitous example of this principle.
The argument goes that the classification as a non-bank entity allowed companies such as LendingClub to profitably capitalize on business that was either too small or too expensive (due to aforementioned regulation) for banks. This argument was logical and consistent with market activity up until 4Q 2015 when headwinds against tech startups, including Fintech, started to strengthen and easy financing (the driver of loan growth origination) vanished.
Our Take: Happy to Stay On The Sidelines And Watch Fintech From Afar
Easy financing, the lack of regulation and associated opacity in the Fintech industry may have enabled dubious loan origination strategies, such as origination for the purpose of winning market share and stoking top-line numbers without regard for long-term bottom line profitability. We believe top-line focus (and related positive results) was facilitated by easy start-up financing and liberal securitization practices that enabled aggressive loan origination and the off-loading of this risk to third parties, much as we saw happen in the sub-prime mortgage crises of 2008. We are now seeing a precipitous decline in willing third party buyers. A notable signal.
While we do not want to be alarmist, we believe it prudent to question whether a slowdown in securitization rates which indicate rising loan delinquency, as well as the subsequent downplaying of loan delinquency by Proper Marketplace, are in fact legitimate reasons to worry about the viability of this upstart industry.
Prosper Marketplace, along with LendingClub, have recently raised lending rates, indicating a potential recognition of the need for profitability (over marketshare) and the need to accurately price-in the risk of their loans. However, when the industry's riskiest loans carry rates upwards of 31% and LendingClub's average loan rate is 12.6%, we do question whether their original business model and associated risk analysis is in fact viable (Source: Marketwatch). With already elevated P2P consumer loan interest rates, how much room is there to raise rates further to achieve profitability and mitigate baked in risk from existing loans? At what rate does LendingClub and industry peers need to lend to achieve sustainable profitability?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.