Articles by Paul Sweeney
Gold Rush: Merchant Cash Advances Are Still Hot
August 18, 2019
Last year, when Kevin Frederick struck out on his own to form his own catering company in Annapolis, the veteran caterer knew that he’d need a food trailer for his business to succeed.
He reckoned that he had a good case for a $50,000 small-business loan. The Annapolis-based entrepreneur boasted stellar personal credit, $30,000 in the bank, and a track record that included 35 years of experience in his chosen profession. More impressively, his newly minted company—Chesapeake Celebrations Catering—was on a trajectory to haul in $350,000 in revenues over just eight months of operations in 2018. And, after paying himself a salary, he cleared $60,000 in pre-tax profit.
But Frederick’s business-credit profile was so thin that no bank or business funder would talk to him. So woeful was his lack of business credit, Frederick reports, that his only financing option was paying a broker a $2,000 finder’s fee for a high-interest loan.
Luckily, he says, everything changed when he discovered Nav, an online, credit-data aggregator and financial matchmaker.
Based in Utah, Nav had him spiff up his business credit with Dun & Bradstreet, a top rating agency and a Nav business partner. This was accomplished with a bankcard issued to Frederick’s business by megabank J.P. Morgan Chase. Soon afterward, he says, Nav steered him to Kapitus (formerly Strategic Funding Source), a New York-based lender and merchant cash advance firm that provided some $23,000 in funding.
“They led me in the right direction,” Frederick says of Nav. “A lady there (at Nav) helped me with my credit, warning me that the credit card I’d been using had an effect on my personal credit. Then she led me to Kapitus, all probably within a week.”
Now, Frederick has his food trailer. He reports that its total cost—$14,000 for the trailer, which came “with a concession window, mill-finished walls, and flooring” plus $43,000 in renovations—amounted to $57,000. Equipped with a full kitchen—including refrigeration, sinks, ovens, and a stove—the food trailer can be towed to weddings, reunions, and the myriad parties he caters in the Delmarva Peninsula. In addition, Frederick can also park the trailer at fairgrounds and serve seafood, barbeque, and other viands to the lucrative festival market.
Meanwhile, the caterer’s funders are happy to have him as their new customer. The people at Kapitus, to whom he is making daily payments (not counting weekends and holidays), are especially grateful. “Nav provides a valuable service,” says Seth Broman, vice-president of business development at Kapitus. “They know how to turn coal into diamonds,”
Nav does not charge small businesses for its services. As it gathers data from credit reporting services with which it has partnerships—Experian, TransUnion, Dun and Bradstreet, Equifax—and employs additional metrics, such as cashflow gleaned from an entrepreneur’s bank accounts, Nav earns fees from credit card issuers, lenders and MCA firms.
The company has close ties to financial technology companies that include Kabbage and OnDeck, and also collaborates with MCA funders such as National Funding, Rapid Finance, FundBox, and Kapitus. “We give lenders and funders better-qualified merchants at a lower cost of client acquisition,” says Caton Hanson, Nav’s general counsel and co-founder, adding: “They don’t have to spend as much money on leads.”
As banks have increasingly shunned small-business lending in the decade since the financial crisis, and as the economy has snapped back with a prolonged recovery, alternative funders—particularly unlicensed companies offering lightly regulated, high-cost merchant cash advances (MCAs)—have been piling into the business.
And service companies like Nav—which is funded by nearly $100 million in venture capital and which reports aiding more than 500,000 small businesses since it was founded in 2012—are thriving alongside the booming alternative-funding industry.
Over the past five years, the MCA industry’s financings have been growing by 20% annually, according to 2016 projections by Bryant Park Capital, a Manhattan-based, boutique investment bank. BPC’s specialty finance division handles mergers and acquisitions as well as debt-and-equity capital raising across multiple industries and is one of the few Wall Street firms with an MCA-industry practice. By BPC’s estimates, the MCA industry will have more than doubled its small business funding to $19.2 billion by year- end 2019, up from $8.6 billion in 2014.
Bankrolled by a broad assortment of hedge funds, private equity firms, family offices, and assorted multimillionaire and billionaire investors on the qui vive for outsized returns on their liquid assets, the MCA industry promises a 20%-80% profit rate, reports David Roitblat, president of Better Accounting Solutions, a New York accountancy specializing in the MCA industry. Based on doing the books for some 30 MCA firms, Roitblat reports that the range in profit margins depends on the terms of contracts and a funder’s underwriting skills.
The numerical size and growth of the MCA industry is hard to ascertain, reports Sean Murray, editor of deBanked (this publication), which tracks trends in the industry and sponsors several major conferences. “So much is anecdotal,” Murray says.
Even so, the evidence that MCA companies are proliferating—and prospering—is undeniable. Over the past two years, deBanked’s events, which experience substantial attendance from the MCA industry, have consistently sold out, requiring the events to be moved to larger venues. In Miami, attendance in January this year topped 400-plus attendees, Murray reports, roughly double the crowd that packed the Gale Hotel in 2018.
Similarly, the May, 2019, Broker Fair in New York at the Roosevelt Hotel drew more than 700 participants compared with the sellout crowd of roughly 400 last year in Brooklyn. (Despite ample notice that this year’s Broker Fair at the Roosevelt was sold out and advance tickets were required, as many as 40-50 latecomers sought entry and, unfortunately, had to be turned away.)
The upsurge of capital and the swelling number of entrants into the MCA business has all the earmarks of a gold rush. “Everybody and his brother is trying to get a piece of the action,” asserts Roitblat, the New York accountant.
And there are two ways to hit paydirt in a gold rush. One way is to prospect for gold. But another way is to sell picks and shovels, tents, food, and supplies to the prospectors. “If you can find a way to service the gold rush, you can make a lot of money,” says Kathryn Rudie Harrigan, a management professor and business-strategy expert at the Columbia University Graduate School of Business. “It’s like profiteering in wartime.”
As Professor Harrigan suggests, cashing in on the gold rush by servicing it has parallels across multiple industries. Consider the case of Charles River Laboratories, which has capitalized on the rapid development of the biotechnology industry over the past few decades.
As scientists searched for biologics to battle diseases like cancer and AIDS, the Boston-area company began producing experimental animals known as “transgenic mice.” Informally known as “smart mice,” Charles River’s test animals are specially designed to carry human genes, aiding investigators in their understanding of gene function and genetic responses to diseases and therapeutic interventions. (The smart mouse’s antibodies can also be harvested. “Seven out of the eleven monoclonal antibody drugs approved by the Food and Drug Administration between 2006 and 2011,” according to biotechnology.com, “were derived from transgenic mice.”)
In the MCA version of the gold rush, a bevy of law and accounting firms, debt-collection agencies and credit-approval firms, among other service providers, have either sprung to life to undergird the new breed of alternative funder or added expertise to suit the industry’s wants and needs. (This cohort has been joined, moreover, by a superstructure of Washington, D.C.-based trade associations and lobbyists that have been growing like expansion teams in a professional sports league. But their story will have to wait for another day.)
Rather than being exploitative, supporting companies serve as a vital mainstay in an industry’s ecosystem, notes Alfred Watkins, a former World Bank economist and Washington, D.C.-based consultant: “A gold miner can’t mine,” he says, “unless he has a tent and a pickaxe.”
And in the high-risk, high-reward MCA industry, which can have significant default rates depending on the risk model, many funders can’t fund if they don’t have reliable debt collection. Many of the bigger companies, says Paul Boxer, who works on the funding side of the industry, have the capability of collecting on their own. But for many others—particularly the smaller players in the industry—it’s necessary to hire an outside firm.
One of the more widely known collectors for the MCA industry is Kearns, Brinen & Monaghan where Mark LeFevre is president and chief executive. The Dover (Del.)- based firm, LeFevre says, first added MCA funders to its client roster in 2012; but it has only been since 2014 that “business really took off.”
LeFevre won’t say just how many MCA firms have contracted with him, but he estimates that his firm has scaled up its staff 35%-40% over the past five years to meet the additional MCA workload. The industry, LeFevre adds, “is one of the top-growth industries I’ve seen in the 36 years that I’ve been in business.”
He also says, “People in the MCA industry know a lot about where to put money, but collections are not one of their strong points. They need to get a professional. It gives them the free time to make more money while we go in behind them and collect.”
If repeated dunning fails to elicit a satisfactory response, KBM has several collection strategies that strengthen its hand. The big three, LeFevre says, are “negotiation, identifying assets, and litigation.” He adds: “We have a huge database of attorneys who do nothing but file suit on commercial debt internationally. Then we can enforce a judgment. You don’t want someone who just makes a few phone calls.”
Because business has become so competitive, LeFevre says, he won’t discuss his fee schedule. As to KBM’s success rate, he says no tidy figure is available either, but asserts: “Our checks sent to our clients are more than most agencies because of our proprietary collection process.”
Jordan Fein, chief executive at Greenbox Capital in Miami and a KBM client told deBanked: “We work with them. They’re organized and communicate well and they know to collect. They’re on the expensive side, though. I’ve got other agencies that I use that are cheaper.”
Debt-collection firm Merel Corp, a spinoff from the Tamir Law Group in New York, might be a lower-cost alternative. Formed in just the past 18 months to service the growing MCA industry, Merel typically takes 15%-25% of whatever “obligation” it can collect, says Levi Ainsworth, co-chief operating officer.
A successful collection, Ainsworth asserts, really begins with the underwriting process and attention to detail by the funders. “Instead of coming in at the end,” he says, “we try to prevent problems at the start of the process.”
For an MCA firm dealing with an excessive number of defaults, Merel sometimes places one of its employees with the funder to handle “pre-defaults,” for which it charges a lower fee. The collections firm has also built a reputation for not relying on a “confession of judgment.” Now that COJs have been outlawed for out-of-state collections in New York State, Merel’s skills could be more in demand.
Better Accounting Solutions, which has its offices on Wall Street, is another service-provider promising to lighten the workload of MCA firms by providing back-office support. The company is headed by Roitblat, a 36-year- old former rabbinical student turned tax-and-accounting entrepreneur. Since he founded the company with two part-time employees in 2011, it’s ballooned to some 70 employees.
Roitblat does not have all of his firm’s eggs in one MCA basket. His firm handles tax, accounting and bookkeeping work for law firms, the fashion industry, restaurants and architectural firms. Even so, he says, thirty MCA clients— or more than half his clientele—rely on the firm’s expertise, three of whom were just added in June. His best month was January, 2018, when six funders contracted for his services. “Growth in the MCA industry has been explosive,” he says.
MCA accounting work has its own vagaries and oddities. For example, because of the industry’s high default rate, Roitblat notes, a 10%-slice of every merchant’s payment is funneled into a “default reserve account.” And when an actual default occurs, credits are moved from the receivables account to the default reserve account.
Roitblat takes pride that his firm’s MCA work has passed audits from respected accounting firms like Friedman, Cohen, Taubman and Marcum LLP. Moreover, he has helped clients uncover internal fraud and, in one instance, spotted costly flaws in a business model. An early MCA client, Roitblat says, had no idea that “he was losing close to $100,000 a month by spending on Google ads.”
Better Accounting also keeps its rates low. The firm typically assigns a junior accountant to handle clients’ accounts while a senior manager oversees his or her work. “He (Roitblat) does a fantastic job,” says David Lax, managing partner of Orange Advance, a Lakewood (N.J.)-based MCA firm. “They understand the MCA business. And even if your business is small, they can set up the infrastructure and do the work more economically and efficiently than you can. You’d have to create the position of comptroller or senior-level accountant,” Lax adds, “to equal their work.”
Top-notch competence and low rates, Lax says, are not the only reasons he often refers Roitblat’s firm to fellow MCA companies. “The only thing better than their work,” he says, “is the people themselves.”
Whether it’s oil and gas, banking and real estate, construction, health care or high-technology—you name it—lawyers have an important role across nearly every industry. So too with the MCA industry where, as has been shown, there is an especially high demand for attorneys skilled at winning debt-collection cases.
To hear Greenbox’s Fein tell it, a skilled lawyer handling debt collection can write his or her own ticket. A talented attorney, he says, not only retrieves lost money and prevents losses, but enables the funder to “offer the product cheaper than the competition.
“We use a ton of attorneys in 35 states in the U.S. and in Canada,” Fein adds, “and you have no idea how many attorneys we go through until we find a good one.”
Until recently, much of the MCA industry’s success has resulted from a hands-off, laissez faire legal and regulatory environment—particularly the legal interpretation that a merchant cash advance is not a loan. The industry has also benefited from the fact that most credit regulation focused on consumer credit and not on business and commercial financings.
But now, as the MCA industry is maturing and showing up on the radar screens of state legislatures, Congress, regulatory agencies, and the courts, there is heightening demand for legal counsel. In just the past 12 months, California passed a truth-in-lending statute requiring MCA firms not only to clearly state their terms, but to translate the short-term funding costs of MCAs into an annual percentage rate. The state of New York, as has been noted, passed legislation restricting the use of COJs.
Moreover, notes Mark Dabertin, special counsel at Pepper Hamilton, a top national law firm based in Philadelphia, the state of New Jersey is contemplating licensing MCA practitioners. The Minnesota Court of Appeals recently determined in Anderson v. Koch that, because of a “call provision” in a funding contract, a merchant cash advance was actually a loan.
And, Dabertin warns, the Federal Trade Commission, which has the authority to treat a merchant cash advance as a consumer transaction—replete with the full panoply of consumer disclosures and protections—is training its gunsights on the industry. “On May 23,” Dabertin reports in a memo to clients, “the FTC launched an investigation into potentially unfair or deceptive practices in the small business financing industry, including by merchant cash advance providers.”
These pressures from government and the courts will only make doing business more costly and drive up the industry’s barriers to entry. Failing to stay legal, moreover, could not only result in punitive court judgments, but render an MCA firm vulnerable to legal action by their investors.
“It’s inevitable that the industry will evolve,” Dabertin says, and firms in the industry will have to self-police. “They will need to hire counsel and a compliance staff,” he adds. “You can’t just do it by the seat of your pants.”
Are The Bankers Taking Over Fintech?
June 27, 2019
For Rochelle Gorey, the chief executive and co-founder of SpringFour, a “social impact” fintech company, mingling with industry movers and shakers at this year’s LendIt Fintech Conference was just what the doctor ordered. “I went mainly for the networking opportunities,” Gorey told deBanked.
SpringFour, which is headquartered in Chicago, works with banks and financial institutions in the 50 states to get distressed borrowers back on track with their debt payments. It does this by digitally linking debtors with governmental and nonprofit agencies that promote “financial wellness.
The indebted parties—more than a million of whom had referrals that were arranged by Gorey’s tech-savvy company last year—constitute not only household consumers but also commercial borrowers. “Small businesses face the same issues of cash flow as consumers, and their business and personal income are often combined,” she says. “If their financial situation is precarious, it’s super-hard to get credit, a line of credit, or a business loan.”
Although Gorey felt “overwhelmed” at first by the throng of 4,000 conference-goers at Moscone Center West in San Francisco—roughly the same number as attended last year, conference organizers assert— her trepidation was short-lived. It wasn’t too long before she was in circulation and having chance encounters and serendipitous interactions, she says, with “all the right people at the workshops and at the tables in the Expo Hall.”
Armed, moreover, with a “networking app” on her mobile phone, Gorey was able to arrange targeted meetings, scoring roughly a dozen, 15-minute tete-a-tetes during the two-day breakout sessions. These included audiences with community bankers, financial technology companies, and “small-dollar” lenders. “And it went both ways,” she says. “I had people reaching out to me”—just about everyone, it seemed, appeared receptive to “finding ways to boost their customers’ financial health.”
Gorey’s success at networking was precisely the experience that the event’s planners had envisioned, says Peter Renton, chairman and co-founder of the LendIt Fintech Conference. Organizers took pains to make schmoozing one of the key features of this year’s gathering. Not only did LendIt provide attendees with a bespoke networking app, but planners scheduled extra time for meet-ups. “We had around 10,000 meetings set up by the app,” Renton says, “about double the number of last year.”
deBanked did not attend the LendIt USA conference on the West Coast this year. But the publication sought out more than a half-dozen attendees—including several financial technology executives, a leading venture capitalist, a regulatory law expert, and the conference’s top administrators—to gather their impressions. While informal and manifestly unscientific, their responses nonetheless yielded up several salient themes.
The popularity—and effectiveness—of networking was a key takeaway. Most seized the opportunity to rub elbows with influential industry players, learn about the hottest startups, compare notes, and catch up on the state of the industry. Most importantly, the event presented a golden opportunity to make the introductions and connections that could generate dealmaking.
“My goal this year was to strike more partnerships with lenders and fintech companies,” says Levi King, chief executive and co-founder at Utah-based Nav, an online, credit-data aggregator and financial matchmaker for small businesses. “We had great meetings with Fiserv, Amazon, Clover Network (a division of First Data), and MasterCard,” he reports, rattling off the names of prominent financial services companies and fintech platforms.
James Garvey, co-founder and chief executive at Self Lender, an Austin-based fintech that builds creditworthiness for “thin file” consumers who have little or no credit history, said his goal at the conference was both to serve on a panel and “meet as many people as I could.”
Self Lender is in its growth stage following a $10 million, series B round of financing in late 2018 from Altos Ventures and Silverton Partners. Garvey reports having meetings with Bank of America and venture capitalist FTV Capital “over coffee” as well as F-Prime Capital, another venture capitalist. “It’s just about building a relationship,” he said of making connections, “so that at some point, if I’m raising money or want to partner, I can make a deal.”
There was a concerted effort to recognize women, as evidenced by a packed “Women in Fintech” (WIF) luncheon that drew roughly 250 persons, 95% of whom were women. (“Many men are big supporters of women in fintech and we didn’t want to exclude them,” Renton says). The luncheon was preceded by a novel event—a 30-minute, ladies-only “speed-networking” session—which attracted 160 participants, reports Joy Schwartz, president of LendIt Fintech and manager of the women’s programs.
At the luncheon, SpringFour’s Gorey says, “it was empowering just to see lot of women who are senior leaders working in financial services, banks and fintechs.” The keynote speech by Valerie Kay, chief capital officer at Lending Club, was another highlight. “She (Kay) talked about taking risks and going to a fintech startup after 23 years at Morgan Stanley,” Gorey reports, adding: “It was inspiring.”
The women’s luncheon also marked the launch of LendIt’s Women In Fintech mentor program, and presentation of a “Fintech Woman of the Year” award. The recipient was Luvleen Sidhu, president, co-founder and chief strategy officer at BankMobile, a digital division of Customers Bank, based near Philadelphia, which employs 250 persons and boasts two million checking account customers.
I am honored to be the 2019 Fintech Women of the Year and thrilled that @BankMobile won Most Innovative Bank. It’s very exciting to be recognized by @LendIt Fintech with this prestigious award and I congratulate the finalists in all the categories. https://t.co/qjADuKEMrB pic.twitter.com/hFJVFw1fLS
— Luvleen Sidhu (@LuvleenSidhu) April 11, 2019
BankMobile, which also won LendIt’s “Most Innovative Bank” award, has an alliance with Upstart to do consumer lending and a partnership with telecommunications company T-Mobile. Known as T-Mobile Money, the latter service provides T-Mobile customers with access to checking accounts with no minimum balance, no monthly or overdraft fees, and access to 55,000 automated teller machines, also with no fees. (At its website, T-Mobile Money describes itself as a bank and uses the slogan: “Not another bank, a better one.”)
The impressive salute to women notwithstanding, their ranks remained fairly thin: just 733 attendees identified themselves as “female” on their registration forms, LendIt’s Schwartz says, a little more than 18% of total participants. Seventy-five of the 350 total speakers and panelists—or 21%—were female. (Schwartz also reports that another 157 registrants selected “prefer not to say” as their sexual orientation, while 22 checked the box describing themselves as “non-conforming.”)
In LendIt’s defense, deBanked, who caters to a similar audience, regularly reviews its readership demographics using several tools. They have consistently indicated that women make up 18% – 23% of the total, in line with what LendIt experienced at its most recent event.
By all accounts, many panels were informative, jampacked and attendees were engaged. King, who moderated a panel on regulatory changes in small business lending, which dealt with such topics as California’s commercial “truth-in-lending” law and controversial “confessions of judgment” laws, says: “They didn’t have to lock the door but the room was pretty full and people seemed to be paying attention. I didn’t see people studying their cellphones.”
The Expo Hall was teeming with budding fintech entrepreneurs, financial services companies and multiple vendors hawking their wares. But as numerous fintechs were angling to forge lucrative symbiotic relationships with banks, some participants—even those who were hailing the conference for its networking and deal-making opportunities—lamented the heavy presence of the establishment.
The banks’ ubiquitousness especially vexed Matthew Burton, a partner at QED Investors, an Arlington, (Va.)-based, venture capital firm and a veteran fintech entrepreneur. Before signing on with QED last year, Burton had been the co-founder of Orchard Platform, an online technology and analytics vendor for fintech and financial services companies which was purchased by fintech lender Kabbage.
Not only did bankers seem to playing a more prominent role at the LendIt conference, Burton notes, but “big four” accounting firm Deloitte had signed on as a major sponsor. “The energy level seemed a bit lower than in past years,” Burton told deBanked. “It’s not like people were depressed but it wasn’t bubbling with excitement. A couple of years ago we thought all these new fintechs would replace the banks,” he explains. “Now the discussion is over how to partner and collaborate with banks. It’s not as exciting as when everyone thought banks were dinosaurs.
“I couldn’t really tell if there were more bankers attending this year,” Burton adds, “but it sure felt like it.”
King, the Nav executive, told deBanked: “It was a little bit subdued. I don’t know if it was nervousness about the economy or politics, but the subject of risk came up more often in side conversations with venture-backed businesses and banks and alternative fintech lenders. One large bank we deal with,” he adds, “told me it’s spending most of its time working on risk.”
Cornelius Hurley, a Boston University law professor and executive director of the Online Lending Policy Institute who participated in a standing-room-only session on state and federal fintech regulation, declares: “I’ve been to three of their conferences, including one in New York, and I would say that this one did not have as much pizzazz. It may be that the industry is maturing.”
For his part—when asked whether there was a palpable absence of passion this year—LendIt’s Renton told deBanked: “I would say that it felt more businesslike. Fintech has had a lot of hype and we have had conferences that were ridiculously over-hyped in 2015 and 2016. And in 2017 (the mood) was much more somber. This one felt optimistic and businesslike.”
There were 750 bankers in attendance, almost one in five participants. “The number of bankers was not up significantly” over last year, Renton says, “but the seniority of the bankers was higher. We worked very hard to get senior bankers to attend this year.”
Renton was bullish on the closer ties developing between nonbank online lenders and banks. That was reflected as well in the several panels exploring ways to develop partnerships between the two sides. He noted that a session called “How Banks are Matching Fintechs on Speed of Funding and User Experience” drew a heavy crowd. “It brought more bankers than we’ve ever had before,” Renton says.
Moderated by Brock Blake, founder and chief executive at the fintech Lendio, the panel was composed of three bankers: Ben Oltman, the Philadelphia-area head of digital lending and partnerships at Citizens Bank; Gina Taylor Cotter, a senior vice-president at American Express (the highest-ranking woman at the company); and Thomas Ferro, a senior marketing manager at Bank of America. “The banks came to LendIt not just to learn but to decide whom they’re going to partner with,” Renton says. “Fintechs need banks and banks need fintechs. That is the narrative you hear on both sides.”
(Asked whether any banks sponsored this year’s conference, Renton replied: “They are not sponsoring yet in any number but we are working on that.”)
OnDeck, a top-tier fintech lender to small-businesses in the U.S., which has been making forays abroad to Australian and Canadian markets, is an enthusiastic champion of the fintech-bank union. So much so that it claimed LendIt’s “Most Promising Partnership” award for the cooperative relationship it struck with Pittsburgh-based PNC Bank, which uses OnDeck’s platform to make small business loans. (Among the partnerships that OnDeck-PNC beat out: Gorey’s SpringFour, which was named a finalist in the competition for its association with BMO Harris Bank.)
“We were the first fintech lender to strike a true platform relationship with a bank,” Jim Larkin, head of corporate communications at OnDeck says, noting that the PNC deal follows on the New York-based fintech’s similar, innovative arrangement with J.P. Morgan Chase. “Others may do referrals,” he explains. “What we do is actually provide the underlying platform to accelerate a bank’s online lending capabilities. We deliver the software and expertise to construct the right type of online lending engine.”
Meanwhile, there was avid interest about the stock performance of publicly traded fintechs—for example, Square and GreenSky—both of which had seen their share prices tumble and then recover.
Burton noted that, among venture-backed firms, the most excitement seemed to be coming from Latin America. “Everyone was very bullish on a Mexican company, Credijusto, an alternative small business lender that was written up the in the Wall Street Journal,” he says. “It’s not going public yet but it had a large debt-and-equity raise of $100 million from Goldman Sachs. And SoftBank Group announced a $5 billion Latin American tech fund.
“There was a lot of talk,” he adds, “about how money was flowing into Mexico and Brazil.”
Online Loans You Can Take To The Bank
April 16, 2019
OnDeck, the reigning king of small business lending among U.S. financial technology companies, is sharpening its business strategies. Among its new initiatives: the company is launching an equipment-finance product this year, targeting loans of $5,000 to $100,000 with two-to-five year maturities secured by “essential-use equipment.”
In touting the program to Wall Street analysts in February, OnDeck’s chief executive, Noah Breslow, declared that the $35 billion, equipment-finance market is “cumbersome” and he pronounced the sector “ripe for disruption.”
While those performance expectations may prove true – the first results of OnDeck’s product launch won’t be seen until 2020 – Breslow’s message seemed to conflict with OnDeck’s image as a public company. Rather than casting itself as a disruptor these days, OnDeck emphasizes the ways that its business is melding with mainstream commerce and finance.
Consider that the New York-based company, which saw its year-over-year revenues rise 14% to $398.4 million in 2018, is collaborating with Visa and Ingo Money to launch an “Instant Funding” line-of-credit that funnels cash “in seconds” to business customers via their debit cards. With the acquisition of Evolocity Financial Group, it is also expanding its commercial lending business in Canada, a move that follows its foray into Australia where, the company reports, loan-origination grew by 80% in 2018.
Perhaps most significant was the 2018 deal that OnDeck inked with PNC Bank, the sixth-largest financial institution in the U.S. with $370.5 billion in assets. Under the agreement, the Pittsburgh-based bank will utilize OnDeck’s digital platform for its small business lending programs. Coming on top of a similar arrangement with megabank J.P. Morgan Chase, the country’s largest with $2.2 trillion in assets, the PNC deal “suggests a further validation of OnDeck’s underlying technology and innovation,” asserts Wall Street analyst Eric Wasserstrom, who follows specialty finance for investment bank UBS.
“It also reflects the fact that doing a partnership is a better business model for the big banks than building out their own platforms,” he says. “Both banks (PNC and J.P. Morgan) have chosen the middle ground: instead of building out their own technology or buying a fintech company, they’ll rent.
“J.P. Morgan has a loan portfolio of $1 trillion,” Wasserstrom explains. “It can’t earn any money making loans of $15,000 or $20,000. Even if it charged 1,000 percent interest for those loans,” he went on, “do you know how much that will influence their balance sheet? How many dollars do think they are going to earn? A giant zero!”
Similarly, Wasserstrom says, spending the tens of millions of dollars required to develop the state-of-the art technology and expertise that would enable a behemoth like J.P. Morgan or a super-regional like PNC to match a fintech’s capability “would still not be a big needle-mover. You’d never earn that money back. But by partnering with a fintech like OnDeck,” he adds, “banks like J.P Morgan and PNC get incremental dollars they wouldn’t otherwise have.”
The alliance between OnDeck and old-line financial institutions is one more sign, if one more sign were needed, that commercial fintech lenders are increasingly blending into the established financial ecosystem.
Not so long ago companies like OnDeck, Kabbage, PayPal, Square, Fundation, Lending Club, and Credibly were viewed by traditional commercial banks and Wall Street as upstart arrivistes. Some may still bear the reputation as disruptors as they continue using their technological prowess to carve out niche funding areas that banks often neglect or disdain.
Yet many fintechs are forming alliances with the same financial institutions they once challenged, helping revitalize them with new product offerings. Other financial technology companies have bulked up in size and are becoming indistinguishable from any major corporation.
Big Fintechs are securitizing their loans with global investment banks, accessing capital from mainline financial institutions like J.P. Morgan, Goldman Sachs and Wells Fargo, and finding additional ways — including becoming publicly listed on the stock exchanges – to tap into the equity and debt markets.
One example of the maturation process: through mid-2018, Atlanta-based Kabbage has securitized $1.5 billion in two bond issuances, 30% of its $5 billion in small business loan originations since 2008.
In addition, fintechs have been raising their industry’s profile with legislators and regulators in both state and federal government, as well as with customers and the public through such trade associations as the Internet Lending Platform Association and the U.S. Chamber of Commerce. Both individually and through the trade groups, these companies are building goodwill by supporting truth-in-lending laws in California and elsewhere, promoting best practices and codes of conduct, and engaging in corporate philanthropy.
Rather than challenging the established order, S&P Global Market Intelligence recently noted in a 2018 report, this cohort of Big Fintech is increasingly burrowing into it. This can especially be seen in the alliances between fintech commercial lenders and banks.
“Bank channel lenders arguably have the best of both worlds,” Nimayi Dixit, a research analyst at S&P Global Market Intelligence wrote approvingly in a 2018 report. “They can export credit risk to bank partners while avoiding the liquidity risks of most marketplace lending platforms. Instead of disrupting banks, bank channel lenders help (existing banks) compete with other digital lenders by providing a similar customer experience.”
It’s a trend that will only accelerate. “We expect more digital lenders to incorporate this funding model into their businesses via white-label or branded services to banking institutions,” the S&P report adds.
Forming partnerships with banks and diversifying into new product areas is not a luxury but a necessity for Fundation, says Sam Graziano, chief executive at the Reston (Va.)-based platform. “You can’t be a one-trick pony,” he says, promising more product launches this year.
Fundation has been steadily making a name for itself by collaborating with independent and regional banks that utilize its platform to make small business loans under $150,000. In January, the company announced formation of a partnership with Bank of California in which the West Coast bank will use Fundation’s platform to offer a digital line of credit for small businesses on its website.
Fundation lists as many as 20 banks as partners, including most prominently a pair of tech-savvy financial institutions — Citizens Bank in Providence, R.I. and Provident Bank in Iselin, N.J. — which have been featured in the trade press for their enthusiastic embrace of Fundation.
John Kamin, executive vice president at $9.8 billion Provident reports that the bank’s “competency” is making commercial loans in the “millions of dollars” and that it had generally shunned making loans as meager as $150,000, never mind smaller ones. But using Fundation’s platform, which automates and streamlines the loan-approval process, the bank can lend cheaply and quickly to entrepreneurs. “We’re able to do it in a matter of days, not weeks,” he marvels.
Not only can a prospective commercial borrower upload tax returns, bank statements and other paperwork, Kamin says, “but with the advanced technology that’s built in, customers can provide a link to their bank account and we can look at cash flows and do other innovative things so you don’t have to wait around for the mail.”
Provident reserves the right to be selective about which loans it wants to maintain on its books. “We can take the cream of the crop” and leave the remainder with Fundation, the banker explains. “We have the ability to turn that dial.”
The partnership offers additional side benefits. “A lot of folks who have signed up (for loans) are non-customers and now we have the ability to market to them,” he says. “After we get a small business to take out a loan, we hope that we can get deposits and even personal accounts. It gives us someone else to market to.”
As a digital lender, Provident can now contend mano a mano with another well-known competitor: J.P. Morgan Chase. “This is the perfect model for us,” says Kamin, “it gives us scale. You can’t build a program like this from scratch. Now we can compete with the big guys. We can compete with J.P. Morgan.”
For Fundation, which booked a half-billion dollars in small business loans last year, doing business with heavily regulated banks puts its stamp on the company. It means, for example, that Fundation must take pains to conform to the industry’s rigid norms governing compliance and information security. But that also builds trust and can result in client referrals for loans that don’t fit a bank’s profile. “For a bank to outsource operations to us,” Graziano says, “we have to operate like a bank.”
Bankrolled with a $100 million line of credit from Goldman Sachs, Fundation’s interest rate charges are not as steep as many competitors’. “The average cost of our loans is in the mid-to-high teens and that’s one reason why banks are willing to work with us,” Graziano says. “Our loans,” he adds, “are attractively structured with low fees and coupon rates that are not too dramatically different from where banks are. We also don’t take as much risk as many in the (alternative funding) industry.”
Despite its establishment ties, Graziano says, Fundation will not become a public company anytime soon. “Going public is not in our near-term plans,” he told deBanked. Doing business as a public company “provides liquidity to shareholders and the ability to use stock as an acquisition tool and for employees’ compensation,” he concedes. “But you’re subject to the relentlessly short-term focus of the market and you’re in the public eye, which can hurt long-term value creation.”
Graziano reports, however, that Fundation will be securitizing portions of its loan portfolio by yearend 2020.
PayPal Working Capital, a division of PayPal Holdings based in San Jose, and Square Inc. of San Francisco, are two Big Fintechs that branched into commercial lending from the payments side of fintech. PayPal began making small business loans in 2013 while Square got into the game in 2014. In just the last half-decade, both companies have leveraged their technological expertise, massive data collections, data-mining skills, and catbird-seat positions in the marketplace to burst on the scene as powerhouse small business lenders.
With somewhat similar business models, the pair have also surfaced as head-to-head competitors, their stock prices and rivalry drawing regular commentary from investors, analysts and journalists. Both have direct access to millions of potential customers. Both have the ability to use “machine learning” to reckon the creditworthiness of business borrowers. Both use algorithms to decide the size and terms of a loan.
Loan approval — or denials — are largely based on a customer’s sales and payments history. Money can appear, sometimes almost magically in minutes, in a borrower’s bank account, debit card or e-wallet. PayPal and Square Capital also deduct repayments directly from a borrower’s credit or debit card sales in “financing structures similar to merchant cash advances,” notes S&P.
At its website, here is how PayPal explains its loan-making process. “The lender reviews your PayPal account history to determine your loan amount. If approved, your maximum loan amount can be up to 35% of the sales your business processed through PayPal in the past 12 months, and no more than $125,000 for your first two loans. After you’ve completed your first two loans, the maximum loan amount increases to $200,000.”
PayPal, which reports having 267 million global accounts, was adroitly positioned when it commenced making small business loans in 2013. But what has really given the Big Fintech a boost, notes Levi King, chief executive and co-founder at Utah-based Nav — an online, credit-data aggregator and financial matchmaker for small businesses – was PayPal’s 2017 acquisition of Swift Financial. The deal not only added 20,000 new business borrowers to its 120,000, reported TechCrunch, but provided PayPal with more sophisticated tools to evaluate borrowers and refine the size and terms of its loans.
“PayPal had already been incredibly successful using transactional data obtained through PayPal accounts,” King told deBanked, “but they were limited by not having a broad view of risk.” It was upon the acquisition of Swift, however, that PayPal gained access to a “bigger financial envelope including personal credit, business credit, and checking account information,” King says, adding: “The additional data makes it way easier for PayPal to assess risk and offer not just bigger loans, but multiple types of loans with various payback terms.”
While PayPal used the Swift acquisition to spur growth and build market share, its rival Square — which is best known for its point-of-sale terminals, its smartphone “Cash App,” and its Square Card — has employed a different strategy.
OF A FREIGHT TRAIN
By selling off loans to third-party institutional investors, who snap them up on what Square calls a “forward-flow basis,” the Big Fintech barged into small business lending with the subtlety of a freight train. In just four years, Square originated 650,000 loans worth $4.0 billion, a stunning rise from the modest base of $13.6 million in 2014.
Square’s third-party funding model, moreover, demonstrates the benefits afforded from being deeply immersed in the financial ecosystem. Off-loading the loans “significantly increases the speed with which we can scale services and allows us to mitigate our balance sheet and liquidity risk,” the company reported in its most recent 10K filing.
Square does not publicly disclose the entire roster of its third-party investors. But Kim Sampson, a media relations manager at Square, told deBanked that the Canada Pension Plan Investment Board — “a global investment manager with more than CA$300 billion in assets under management and a focus on sustained, long term returns” – is one important loan-purchaser.
Square also offers loans on its “partnership platform” to businesses for whom it does not process payments. And late last year the company introduced an updated version of an old-fashioned department store loan. Known as “Square Installments,” the program allows a merchant to offer customers a monthly payment plan for big-ticket purchases costing between $250 and $10,000.
Which model is superior? PayPal’s — which retains small business loans on its balance sheet — or Square’s third-party investor program? “The short answer,” says UBS analyst Wasserstrom, “is that PayPal retains small business loans on its balance sheet, and therefore benefits from the interest income, but takes the associated credit and funding risk.”
Meanwhile, as PayPal and Square stake out territory in the marketplace, their rivalry poses a formidable challenge to other competitors.
Both are well capitalized and risk-averse. PayPal, which reported $4.23 billion in revenues in 2018, a 13% increase over the previous year, reports sitting on $3.8 billion in retained earnings. Square, whose 2018 revenues were up 51 percent to $3.3 billion, reported that — despite losses — it held cash and liquid investments of $1.638 billion at the end of December.
King, the Nav executive, observes that Able, Dealstruck, and Bond Street – three once-promising and innovative fintechs that focused on small business lending – were derailed when they could not overcome the double-whammy of high acquisition costs and pricey capital.
“None of them were able to scale up fast enough in the marketplace,” notes King. “The process of institutionalization is pushing out smaller players.”
Get The Affidavit or Waive It? Examining Confessions of Judgment
February 1, 2019
Caton Hanson, the chief legal officer and co-founder of the online credit-reporting and business-to-business matchmaker Nav, says that his Salt Lake City-based company would not associate with a small-business financier that included “confessions of judgment” in its credit contracts.
“If we understood that any of our merchant cash advance partners were using confessions of judgment as a means to enforce contracts,” Hanson told deBanked, “we would view that as abusive and distance ourselves from those partners. As a venture-backed company,” Hanson adds, “we have some significant investors, including Goldman Sachs, and I’m sure they would support us.”
Steve Denis, executive director of the Small Business Finance Association, which represents companies in the merchant cash advance (MCA) industry, says that, as an organization, “We’ve taken a strong stance against confessions of judgment.”
He reports that his Washington, D.C.-based trade group is prepared to work with legislators and policy-makers of any political party, regulators, business groups and the news media “to ban that type of practice.
“We’re fighting against the image that we’re payday lenders for business,” Denis says of the merchant cash advance industry. “We’re trying to figure out internally what we can do to stop that from happening and we have been speaking to members of Congress and their staff.”
“Confessions of judgment,” says Cornelius Hurley, a law professor at Boston University and executive director of the Online Lending Policy Institute, “are to the merchant cash advance industry what mandatory arbitration is to banks. Neither enforcement device reflects well on the firms that use them.”
These are just some of the reactions from members of the alternative lending and financial technology community to a blistering series of articles published by Bloomberg News on the use—and alleged misuse—of confessions of judgment (COJs) by merchant cash advance companies. The series charges the MCA industry with gulling unwary small businesses by not only charging high interest rates for quick cash but of using confession-laden contracts to seize their assets without due process.
The Bloomberg articles also reported that it doesn’t matter in which state the small business debtors reside. By bringing legal action in New York State courts, MCA companies have been able to use enforcement powers granted by the confessions to collect an estimated $1.5 billion from some 25,000 businesses since 2012.
“I don’t think anyone can read that series of articles and honestly say what went on were good practices and in the best interest of small business,” says SBFA’s Denis, noting that none of the companies cited in the Bloomberg series belonged to his trade group. “It’s shocking to see some companies in our space doing things we’d classify as predatory,” he adds. “As an industry we’re becoming more sophisticated, but there are still some bad actors out there.”
A confession of judgment is a hand-me-down to U.S. jurisprudence from old English law. The term’s quaint, almost religious phrasing evokes images of drafty buildings, bleak London fog, and dowdy barristers in powdered wigs and solemn black gowns. (And perhaps debtor prisons as well.)
Yet while the legal provision’s wings have been clipped—the Federal Trade Commission banned the use of confessions of judgment in consumer credit transactions in 1985 and many states prohibit their use outright or in such cases as residential real estate contracts—COJs remain alive and well in many U.S. jurisdictions for commercial credit transactions.
Even so, most states where COJs are in use, such as California and Pennsylvania, have adopted safeguards. Here’s how the San Francisco law firm Stimmel, Stimmel and Smith describes a COJ.
“A confession of judgment is a private admission by the defendant to liability for a debt without having a trial. It is essentially a contract—or a clause with such a provision—in which the defendant agrees to let the plaintiff enter a judgment against him or her. The courts have held that such a process constitutes the defendant’s waiving vital constitutional rights, such as the right to due process, thus (the courts) have imposed strict requirements in order to have the confession of judgment enforceable.”
In California, those “strict requirements” include not only that a written statement be “signed and verified by the defendant under oath,” but that it must be accompanied by an independent attorney’s “declaration.” If no independent attorney signs the declaration or—worse still—the plaintiff’s attorney signs the document, the confession is invalid.
But if the confession is “properly executed,” the plaintiff is entitled to use the full panoply of tools for collection of the judgment, including “writs of execution” and “attachment of wages and assets.”
In Pennsylvania, confessions of judgment are nearly as commonplace as Philadelphia Eagles’ and Pittsburgh Steelers’ fans, particularly in commercial real estate transactions. Says attorney Michael G. Louis, a partner at Philadelphia-area law firm Macelree Harvey, “They may go back to old English law, but if you get a business loan or commercial lease in Pennsylvania, a confession of judgment will be in there. It’s illegal in Pennsylvania for a consumer loan or residential real estate. But unless it’s a national tenant with a ton of bargaining power—a big anchor store and the owner of the shopping center really wants them—95% of commercial leasing contracts have them.
“And any commercial bank in Pennsylvania worth its salt includes them in their commercial loan documents,” Louis adds.
Pennsylvania’s laws governing COJs contain a number of additional safeguards. For example, the confession of judgment is part of the note, guaranty or lease agreement—not a separate document—but must be written in capital letters and highlighted. One of the defenses that used to be raised against COJs, Louis says, was that a contractual document was written in fine print “but we haven’t seen fine print for years.”
Other reforms in Pennsylvania have come about, moreover, as a result of a 1994 case known as “Jordan v. Fox Rothschild.” Says Louis: “It used to be lot worse. You used to be able to file a confession of judgment and levy on a defendant’s bank account before he knew what happened. It was brutal. But after the Fox Rothschild case, they changed the law to prevent taking away a defendant’s right of notice and the opportunity to be heard.”
Because of that case, which takes its name from the Fox Rothschild law firm and involved a dispute between a Philadelphia landlord renting commercial space to Jordan, a tenant, the law governing COJs in Pennsylvania requires, among other things, a 30-day notice before a creditor or landlord can execute on the confession. During that period the defendant has the opportunity to stay the execution or re-open the case for trial.
Defenses against the execution of a COJ can entail arguments that creditors failed to comply with the proper language or procedures in drafting the document. But the most successful argument, Louis says, is a “factual defense.” Louis cites the case of a retail clothing store renting space in a shopping center that has a leaky roof. In the 30-day notice period after the landlord invoked the confession of judgment, the tenant was able to demonstrate to the court that he had asked the landlord “ten times” to fix the roof before spending the rent money on roof repairs. In such a case, the courts will grant the defendant a new trial but, Louis says, the parties typically reach a settlement. “Banks generally will waive a jury trial,” he notes, “because they don’t want to take a chance of getting hammered by a jury.”
A number of states, including Florida and Massachusetts ban the use of confessions of judgment. That’s one big reason that Miami attorney Roger Slade, a partner at Haber Law, advises clients that “there’s no place like home.” In other words: commercial contracts should specify that any legal disputes will be adjudicated in Florida. “It’s like having home field advantage in the NFL playoffs,” Slade remarked to deBanked. “You don’t want to play on someone else’s turf.”
He has also been warning Floridians for several years against the way that COJs were treated by New York courts. Writing in the blog, “The Florida Litigator,” Slade—a native New Yorker who is certified to practice law there as well as in Florida counseled in 2012: “If you live in New York, a creditor can have your client sign a confession of judgment and, in the event of a default on a loan, can march directly to the courthouse and have a final judgment entered by the clerk. That’s right—no complaint, no summons, no time to answer, no two-page motion to dismiss. The creditor gets to go right for the jugular.”
In addition, because of the “full faith and credit clause of the U.S. Constitution,” Slade notes in an interview, a contract that’s enforced by the New York courts must be honored in Florida. “Courts in Florida have no choice,” Slade says. “It’s a brutal system and it’s unfortunate.”
In December, two U.S. senators from opposing parties—Ohio Democrat Sherrod Brown and Florida Republican Marco Rubio—introduced bipartisan legislation to amend both the Federal Trade Commission Act and Truth in Lending Act to do away with COJs. Their legislative proposal reads:
“(N)o creditor may directly or indirectly take or receive from a borrower an obligation that constitutes or contains a congnovit or confession of judgment (for purposes other than executory process in the State of Louisiana), warrant of attorney, or other waiver of the right to notice and the opportunity to be heard in the event of suit or process theron.”
But with a dysfunctional and divided federal government, warring power factions in Washington, and an influential financial industry, there’s no telling how the legislation will fare. Meantime, the New York State attorney general’s office announced in December that it will investigate the use of COJs following the Bloomberg series. And New York Governor Andrew Cuomo has declared support for legislation that will, among other things, prohibit the use of confessions in judgment for small business credit contracts under $250,000 and restrict judgments by New York courts to in-state parties.
But if New York State or Congressional legislation are adopted it can have “unintended consequences” to merchant cash advance firms in the Empire State—and to their small business customers as well—asserts the general counsel for one MCA firm. “Losing the confession of judgment will be removing what little safety net there is in a risky industry,” the attorney says, noting that the industry has roughly a 15% default rate.
“It is not as powerful a tool as the Bloomberg news stories would have you believe,” this attorney, who spoke on the condition of anonymity, told deBanked. “The suggestion seems to be that the MCAs can use the confession of judgment to get back the total amount of money due—and then some—while leaving a trail of dead bodies behind. But that’s not the case.
“What is much more likely to be the case,” he adds, “is that MCA companies try to get the defaulting merchant back on track. And—probably more than we should and only after we’ve tried to reach out to them and failed—do we then reluctantly use the COJ as a last resort. At which point we hope we can recover some part of our exposure. The numbers vary, but the losses are always in the thousands of dollars. These are not micro-transactions.
“What’s going to happen,” he concludes, “is that It will not make sense for us to work with those merchants most in need of working capital. The unfortunate reality is that businesses who don’t have collateral and can’t get a Small Business Administration product will be left out in the cold.”
All of which prompts BU professor Hurley to argue that the “Swiss cheese” system of financial regulation among the 50 states continues to be a root cause of regulatory confusion. Echoing Miami attorney Slade’s concern about New York courts’ dictating to Florida citizens, Hurley likens the situation governing COJs with the disorderly array of state laws governing usury regulations.
In the 1978 “Marquette” decision, the U.S. Supreme Court ruled that a Nebraska bank, First of Omaha, could issue credit cards in Minnesota and charge interest rates that exceeded the usury rate ceiling in the Gopher State. Since then, usury rates enacted by state legislatures have become virtually unenforceable.
“The problem we’re seeing with confessions of judgment is a subset of the usury situation,” Hurley says. “One state’s disharmony becomes a cancer on the whole system. It’s a throwback to Colonial times with 50 states each having their own jurisdictions—and it doesn’t work.”
Hurley’s Online Lending Policy Institute has joined with the Electronic Transactions Association and recruited a phalanx of “academics, non-banks, law firms and other trade associations as members or affiliates” to form the Fintech Harmonization Task Force. It is monitoring the efforts by the 50 states to align their regulatory oversight of the booming financial technology industry which was recently recommended by a U.S. Treasury report.
Tom Ajamie, who practices law in New York and Houston and has won multimillion-dollar, blockbuster judgments against “dozens of financial institutions” including Wall Street investment firms, also argues for greater regulatory oversight. He urges greater funding and expansion of the powers of the Consumer Financial Protection Bureau to rein in “the anticipatory use” of confessions of judgment in commercial transactions.
However, notes Catherine Brennan, a partner at Hudson Cook in Baltimore, the job of protecting small businesses is outside the agency’s mandate. “The CFPB doesn’t have authority over commercial products as a general rule,” she explained in an interview. “Consumers are viewed as a vulnerable population in need of protections since the 1960’s.” As a society “we want protection for households because the consequences are high. A family could become homeless if they lose a house. Or (they) could lose employment if they lose a car and can’t drive. And there is also unequal bargaining power between lenders and consumers.
“Large institutions have lawyers to draft contracts and consumers have to agree on a take it or leave it basis. So there’s not a lot of negotiation and government has decided that consumers need protections, including a (Federal Trade Commission) ban on confessions of judgment.”
But Christopher Odinet, a law professor at the University of Oklahoma and a member of Hurley’s harmonization task force, sees the efforts of the federal government and the states to grapple with confessions of judgment as further recognition that small businesses have more in common with consumers than with big business. The COJ controversy follows on the recent passage of a commercial truth-in-lending bill by the State of California which, for the first time, stipulated that consumer-style disclosures should be included in business loans and financings under $500,000 made by non-bank financial organizations.
He cites the close-to-home example of an accomplished professional who got in over his head in financial dealings. “I recently observed a situation where a family member who is a very successful and affluent medical professional was relying on his own untrained business skills,” Odinet says. “He was about to enter into a sophisticated and complex business partnership relying on his intuition and general sense of confidence in the other party.”
Odinet says that he recommended that his relative hire a lawyer. Which, Odinet says, he did.
Less Than Perfect — New State Regulations
December 21, 2018
You could call California’s new disclosure law the “Son-in-Law Act.” It’s not what you’d hoped for—but it’ll have to do.
That’s pretty much the reaction of many in the alternative lending community to the recently enacted legislation, known as SB-1235, which Governor Jerry Brown signed into law in October. Aimed squarely at nonbank, commercial-finance companies, the law—which passed the California Legislature, 28-6 in the Senate and 72-3 in the Assembly, with bipartisan support—made the Golden State the first in the nation to adopt a consumer style, truth-in-lending act for commercial loans.
The law, which takes effect on Jan. 1, 2019, requires the providers of financial products to disclose fully the terms of small-business loans as well as other types of funding products, including equipment leasing, factoring, and merchant cash advances, or MCAs.
The financial disclosure law exempts depository institutions—such as banks and credit unions—as well as loans above $500,000. It also names the Department of Business Oversight (DBO) as the rulemaking and enforcement authority. Before a commercial financing can be concluded, the new law requires the following disclosures:
(1) An amount financed.
(2) The total dollar cost.
(3) The term or estimated term.
(4) The method, frequency, and amount of payments.
(5) A description of prepayment policies.
(6) The total cost of the financing expressed as an annualized rate.
The law is being hailed as a breakthrough by a broad range of interested parties in California—including nonprofits, consumer groups, and small-business organizations such as the National Federation of Independent Business. “SB-1235 takes our membership in the direction towards fairness, transparency, and predictability when making financial decisions,” says John Kabateck, state director for NFIB, which represents some 20,000 privately held California businesses.
“What our members want,” Kabateck adds, “is to create jobs, support their communities, and pursue entrepreneurial dreams without getting mired in a loan or financial structure they know nothing about.”
Backers of the law, reports Bloomberg Law, also included such financial technology companies as consumer lenders Funding Circle, LendingClub, Prosper, and SoFi.
But a significant segment of the nonbank commercial lending community has reservations about the California law, particularly the requirement that financings be expressed by an annualized interest rate (which is different from an annual percentage rate, or APR). “Taking consumer disclosure and annualized metrics and plopping them on top of commercial lending products is bad public policy,” argues P.J. Hoffman, director of regulatory affairs at the Electronic Transactions Association.
The ETA is a Washington, D.C.-based trade group representing nearly 500 payments technology companies worldwide, including such recognizable names as American Express, Visa and MasterCard, PayPal and Capital One. “If you took out the annualized rate,” says ETA’s Hoffman, “we think the bill could have been a real victory for transparency.”
California’s legislation is taking place against a backdrop of a balkanized and fragmented regulatory system governing alternative commercial lenders and the fintech industry. This was recognized recently by the U.S. Treasury Department in a recently issued report entitled, “A Financial System That Creates Economic Opportunities: Nonbank Financials, Fintech, and Innovation.” In a key recommendation, the Treasury report called on the states to harmonize their regulatory systems.
As laudable as California’s effort to ensure greater transparency in commercial lending might be, it’s adding to the patchwork quilt of regulation at the state level, says Cornelius Hurley, a Boston University law professor and executive director of the Online Lending Policy Institute. “Now it’s every regulator for himself or herself,” he says.
Hurley is collaborating with Jason Oxman, executive director of ETA, Oklahoma University law professor Christopher Odinet, and others from the online-lending industry, the legal profession, and academia to form a task force to monitor the progress of regulatory harmonization.
For now, though, all eyes are on California to see what finally emerges as that state’s new disclosure law undergoes a rulemaking process at the DBO. Hoffman and others from industry contend that short-term, commercial financings are a completely different animal from consumer loans and are hoping the DBO won’t squeeze both into the same box.
Steve Denis, executive director of the Small Business Finance Association, which represents such alternative financial firms as Rapid Advance, Strategic Funding and Fora Financial, is not a big fan of SB-1235 but gives kudos to California solons—especially state Sen. Steve Glazer, a Democrat representing the Bay Area who sponsored the disclosure bill—for listening to all sides in the controversy. “Now, the DBO will have a comment period and our industry will be able to weigh in,” he notes.
While an annualized rate is a good measuring tool for longer-term, fixed-rate borrowings such as mortgages, credit cards and auto loans, many in the small-business financing community say, it’s not a great fit for commercial products. Rather than being used for purchasing consumer goods, travel and entertainment, the major function of business loans are to generate revenue.
A September, 2017, study of 750 small-business owners by Edelman Intelligence, which was commissioned by several trade groups including ETA and SBFA, found that the top three reasons businesses sought out loans were “location expansion” (50%), “managing cash flow” (45%) and “equipment purchases” (43%).
The proper metric to be employed for such expenditures, Hoffman says, should be the “total cost of capital.” In a broadsheet, Hoffman’s trade group makes this comparison between the total cost of capital of two loans, both for $10,000.
Loan A for $10,000 is modeled on a typical consumer borrowing. It’s a five-year note carrying an annual percentage rate of 19%—about the same interest rate as many credit cards—with a fixed monthly payment of $259.41. At the end of five years, the debtor will have repaid the $10,000 loan plus $5,564 in borrowing costs. The latter figure is the total cost of capital.
Compare that with Loan B. Also for $10,000, it’s a six month loan paid down in monthly payments of $1,915.67. The APR is 59%, slightly more than three times the APR of Loan A. Yet the total cost of capital is $1,500, a total cost of capital which is $4,064.33 less than that of Loan A.
Meanwhile, Hoffman notes, the business opting for Loan B is putting the money to work. He proposes the example of an Irish pub in San Francisco where the owner is expecting outsized demand over the upcoming St. Patrick’s Day. In the run-up to the bibulous, March 17 holiday, the pub’s owner contracts for a $10,000 merchant cash advance, agreeing to a $1,000 fee.
Once secured, the money is spent stocking up on Guinness, Harp and Jameson’s Irish whiskey, among other potent potables. To handle the anticipated crush, the proprietor might also hire temporary bartenders.
When St. Patrick’s Day finally rolls around—thanks to the bulked-up inventory and extra help—the barkeep rakes in $100,000 and, soon afterwards, forwards the funding provider a grand total of $11,000 in receivables. The example of the pub-owner’s ability to parlay a short-term financing into a big payday illustrates that “commercial products—where the borrower is looking for a return on investment—are significantly different from consumer loans,” Hoffman says.
SBFA’s Denis observes that financial products like merchant cash advances are structured so that the provider of capital receives a percentage of the business’s daily or weekly receivables. Not only does that not lend itself easily to an annualized rate but, if the food truck, beautician, or apothecary has a bad day at the office, so does the funding provider. “It’s almost like the funding provider is taking a ride” with the customer, says Denis.
Consider a cash advance made to a restaurant, for instance, that needs to remodel in order to retain customers. “An MCA is the purchase of future receivables,” Denis remarks, “and if the restaurant goes out of business— and there are no receivables—you’re out of luck.”
Still, the alternative commercial-lending industry is not speaking with one voice. The Innovative Lending Platform Association—which counts commercial lenders OnDeck, Kabbage and Lendio, among other leading fintech lenders, as members—initially opposed the bill, but then turned “neutral,” reports Scott Stewart, chief executive of ILPA. “We felt there were some problems with the language but are in favor of disclosure,” Stewart says.
The organization would like to see DBO’s final rules resemble the company’s model disclosure initiative, a “capital comparison tool” known as “SMART Box.” SMART is an acronym for Straightforward Metrics Around Rate and Total Cost—which is explained in detail on the organization’s website, onlinelending.org.
But Kabbage, a member of ILPA, appears to have gone its own way. Sam Taussig, head of global policy at Atlanta-based financial technology company Kabbage told deBanked that the company “is happy with the result (of the California law) and is working with DBO on defining the specific terms.”
Others like National Funding, a San Diego-based alternative lender and the sixth-largest alternative-funding provider to small businesses in the U.S., sat out the legislative battle in Sacramento. David Gilbert, founder and president of the company, which boasted $94.5 million in revenues in 2017, says he had no real objection to the legislation. Like everyone else, he is waiting to see what DBO’s rules look like.
“It’s always good to give more rather than less information,” he told deBanked in a telephone interview. “We still don’t know all the details or the format that (DBO officials) want. All we can do is wait. But it doesn’t change this business. After the car business was required to disclose the full cost of motor vehicles,” Gilbert adds, “people still bought cars. There’s nothing here that will hinder us.”
With its panoply of disclosure requirements on business lenders and other providers of financial services, California has broken new legal ground, notes Odinet, the OU law professor, who’s an expert on alternative lending and financial technology. “Not many states or the federal government have gotten involved in the area of small business credit,” he says. “In the past, truth-in-lending laws addressing predatory activities were aimed primarily at consumers.”
The financial-disclosure legislation grew out of a confluence of events: Allegations in the press and from consumer activists of predatory lending, increasing contraction both in the ranks of independent and community banks as well as their growing reluctance to make small-business loans of less than $250,000, and the rise of alternative lenders doing business on the Internet.
In addition, there emerged a consensus that many small businesses have more in common with consumers than with Corporate America. Rather than being managed by savvy and sophisticated entrepreneurs in Silicon Valley with a Stanford pedigree, many small businesses consist of “a man or a woman working out of their van, at a Starbucks, or behind a little desk in their kitchen,” law professor Odinet says. “They may know their business really well, but they’re not really in a position to understand complicated financial terms.”
The average small-business owner belonging to NFIB in California, reports Kabateck, has $350,000 in annual sales and manages from five to nine employees. For this cohort—many of whom are subject to myriad marketing efforts by Internet-based lenders offering products with wildly different terms—the added transparency should prove beneficial. “Unlike big businesses, many of them don’t have the resources to fully understand their financial standing,” Kabateck says. “The last thing they want is to get steeped in more red ink or—even worse—have the wool pulled over their eyes.”
California’s disclosure law is also shaping up as a harbinger—and perhaps even a template—for more states to adopt truth-in-lending laws for small-business borrowers. “California is the 800-lb. gorilla and it could be a model for the rest of the country,” says law professor Hurley. “Just as it has taken the lead on the control of auto emissions and combating climate change, California is taking the lead for the better on financial regulation. Other states may or may not follow.”
Reflecting the Golden State’s influence, a truth-in-lending bill with similarities to California’s, known as SB-2262, recently cleared the state senate in the New Jersey Legislature and is on its way to the lower chamber. SBFA’s Denis says that the states of New York and Illinois are also considering versions of a commercial truth-in-lending act.
But the fact that these disclosure laws are emanating out of Democratic states like California, New Jersey, Illinois and New York has more to do with their size and the structure of the states’ Legislatures than whether they are politically liberal or conservative. “The bigger states have fulltime legislators,” Denis notes, “and they also have bigger staffs. That’s what makes them the breeding ground for these things.”
Buried in Appendix B of Treasury’s report on nonbank financials, fintechs and innovation is the recommendation that, to build a 21st century economy, the 50 states should harmonize and modernize their regulatory systems within three years. If the states fail to act, Treasury’s report calls on Congress to take action.
The triumvirate of Hurley, Oxman and Odinet report, meanwhile, that they are forming a task force and, with the tentative blessing of Treasury officials, are volunteering to monitor the states’ progress. “I think we have an opportunity as independent representatives to help state regulators and legislators understand what they can do to promote innovation in financial services,” ETA’s Oxman asserts.
The ETA is a lobbying organization, Oxman acknowledges, but he sees his role—and the task force’s role—as one of reporting and education. He expects to be meeting soon with representatives of the Conference of State Bank Supervisors (CSBS), the Washington, D.C.-based organization representing regulators of state chartered banks. It is also the No. 1 regulator of nonbanks and fintechs. “They are the voice of state financial regulators,” Oxman says, “and they would be an important partner in anything we do.”
Margaret Liu, general counsel at CSBS, had high praise for Treasury’s hard work and seriousness of purpose in compiling its 200-plus page report and lauded the quality of its research and analysis. But Liu noted that the conference was already deeply engaged in a program of its own, which predates Treasury’s report.
Known as “Vision 2020,” the program’s goals, as articulated by Texas Banking Commissioner Charles Cooper, are for state banking regulators to “transform the licensing process, harmonize supervision, engage fintech companies, assist state banking departments, make it easier for banks to provide services to non-banks, and make supervision more efficient for third parties.”
While CSBS has signaled its willingness to cooperate with Treasury, the conference nonetheless remains hostile to the agency’s recommendation, also found in the fintech report, that the Office of the Comptroller of the Currency issue a “special purpose national bank charter” for fintechs. So vehemently opposed are state bank regulators to the idea that in late October the conference joined the New York State Banking Department in re-filing a suit in federal court to enjoin the OCC, which is a division of Treasury, from issuing such a charter.
Among other things, CSBS’s lawsuit charges that “Congress has not granted the OCC authority to award bank charters to nonbanks.”
Previously, a similar lawsuit was tossed out of court because, a judge ruled, the case was not yet “ripe.” Since no special purpose charters had actually been issued, the judge ruled, the legal action was deemed premature. That the conference would again file suit when no fintech has yet applied for a special purpose national bank charter— much less had one approved—is baffling to many in the legal community.
“I suspect the lawsuit won’t go anywhere” because ripeness remains a sticking point, reckons law professor Odinet. “And there’s no charter pending,” he adds, in large part because of the lawsuit. “A lot of people are signing up to go second,” he adds, “but nobody wants to go first.”
Treasury’s recommendation that states harmonize their regulatory systems overseeing fintechs in three years or face Congressional action also seems less than jolting, says Ross K. Baker, a distinguished professor of political science at Rutgers University and an expert on Congress. He told deBanked that the language in Treasury’s document sounded aspirational but lacked any real force.
“Usually,” he says, such as a statement “would be accompanied by incentives to do something. This is a kind of a hopeful urging. But I don’t see any club behind the back,” he went on. “It seems to be a gentle nudging, which of course they (the states) are perfectly able to ignore. It’s desirable and probably good public policy that states should have a nationwide system, but it doesn’t say Congress should provide funds for states to harmonize their laws.
“When the Feds issue a mandate to the states,” Baker added, “they usually accompany it with some kind of sweetener or sanction. For example, in the first energy crisis back in 1973, Congress tied highway funds to the requirement (for states) to lower the speed limit to 55 miles per hour. But in this case, they don’t do either.”
GOING NATIONAL: How David Gilbert Built One of the Largest Small Business Lenders in the Country
October 17, 2018
When Ty Austin, who owns a florist shop in West Palm Beach, secured a $5,000 loan from National Funding last year, he was happy to have working capital and could build inventory for mini-gardens and landscaping,
The experience, moreover, was surprisingly pleasant. “The guy I worked with was really cool,” Austin says, referring to the sales representative at the San Diego-based financial technology firm. “It turned out that he was getting married and I ended up giving him and his fiancé advice on floral arrangements.”
The borrowing worked out so well that the Floridian, who is 46 and the sole proprietor of Austintatious Designs, re-upped for a second loan of $12,000 to help purchase a commercial van. The van will be used to transport flowers, plants and tools while doubling as a billboard-on-wheels. “It gives me more ‘street cred,’” he jokes.
To register his approval with National Funding, Austin went online to TrustPilot and posted a rave review of the sales rep: “James Johnson Rocks!”
Pam, a Texas wellness coach who provides clients with an array of holistic health therapies, needed extra money to buy an infrared sauna to add to her portfolio of services. But her credit rating was “poor,” she told deBanked in an e-mail interview, “from when I changed careers and lost my health and struggled to make my credit card and student loan payments on time.”
Like Austin, Pam — who asks to be identified by her first name —found National Funding through an online search. And she too secured $5,000, although her transaction was structured as a merchant cash advance, rather than a loan. The terms of the MCA require a daily debit from her bank account. She reckons that the total cost of the MCA to be roughly $1,500.
Pam pronounces herself satisfied with the deal and mightily impressed with the way National Funding treated her. The process took about three days — and would have gone even quicker if she’d located her professional licenses sooner. Best of all, she says, the agent at the company tailored the financing to suit her circumstances. “They were great as far as getting my questions answered, even listening to my past situation, which others may not have cared about,” she says.
“They really wanted to get me an option that they knew I’d be able to repay,” Pam adds. “They said they were in the business of helping small businesses grow rather than putting them in a hard financial situation.”
The positive experiences that Austin and Pam had with National Funding are not isolated instances. Rather, they are representative of clients’ dealings with the company. Witness its online reviews from business borrowers at TrustPilot which go back three years, run for 36 pages, and merit National Funding a 9.4 rating on a scale of 10. That’s a straight-A grade on any report card. Although there’s the occasional naysayer — four percent assert that their experience was “poor” or “bad” (and some negative comments can be blistering) — the weight of the reviews is almost embarrassingly positive.
Typical postings find that National Funding and its agents win kudos for, among other things, being “prompt and professional,” providing service that is “hassle free and about as friendly as you can be,” and even being “accommodating and gracious.” A man named Al McCullough spoke for many when he declared: “My experience was great. Professional and on time. Couldn’t ask for more.”
All of which helps account for why National Funding — its 230 employees working out of a sleek suburban office building guarded by a tall stand of palm trees in San Diego — is a rising star in the world of alternative business lending and financial technology. In 2017, the company raked in $94.5 million in revenues, a 24.8 percent bounce over the $75.7 million recorded a year earlier and nearly fourfold the $26.7 million posted in 2013.
In recognition of the company’s three-year growth rate of 142%, Inc. magazine included National Funding in its current list of the country’s 5,000 fastest-growing companies, the lender’s sixth straight appearance on the coveted roster. Since its inception in 1999, National Funding reports that it has originated more than $2 billion in loans to some 35,000 borrowers.
The company’s impressive performance has similarly merited accolades for David Gilbert, the 43-year-old chief executive who started the company on little more than a shoestring and whom employees regularly describe as “visionary.” Among Gilbert’s trophies: Accounting firm Ernst & Young recently presented him with its “Entrepreneur of the Year 2017 Award” for San Diego finance.
At first glance, the San Diego financier doesn’t look too much different from its cohorts. The company proffers unsecured loans of $5,000 to $500,000 to a mélange of small businesses in all 50 states and across multiple industries, including retail stores, auto repair shops, truckers, construction companies, heating-and plumbing contractors, spas and beauty salons, cafes and restaurants, waste management, medical and dental clinics, and insurance agencies.
To qualify for financing, a prospective borrower should have been in business for a year, have at least $100,000 in revenues, and boast a personal credit score of at least 500. While there’s no collateral required for loans, National Funding insists on a personal guarantee. The website reviewer NerdWallet cautions borrowers that this “puts your personal assets and credit at risk if you fail to repay the loan.”
Along with unsecured loans, National Funding offers equipment leasing – usually for heavy trucks and construction equipment – as well as merchant cash advances. The equipment lease is secured by the machinery. As in the case of Pam, the wellness coach cited above, MCAs are debited daily, the money automatically withdrawn from bank accounts.
There are a number of businesses that National Funding disdains, no matter how stellar their credit. “We won’t finance casinos, strip bars, tobacco, or firearms,” Gilbert says. “We’re not going to support industries like that.”
For CEO Gilbert, doing business ethically is a signature feature of the company. Among other things, National Funding presses its salespeople to steer clear of putting people into dodgy loans that are likely to default. “We’re lending capital,” Gilbert says, “and one of our core values is the way we support our customers. Are we placing people with the right product to meet their needs or are we being selfish? The best way to be customer oriented is to get a better understanding of what capital will do for them.”
That corporate ethos, coupled with the company’s remarkable performance, has raised its profile while earning it a measure of esteem among industry peers. “What I do know about National Funding,” says Douglas Rovello, senior managing partner at Fund Simple, a lender and broker in the Tampa area, “is that they have five or six different programs and set their rates high but competitively. They’re known for fitting their products to a client’s needs,” he adds. “And in a business that has its share of bad actors, they have a reputation as a company with a conscience.”
A company with a conscience. Customers come first. And yet National Funding turns heads with its sales production of roughly 1,000 financings a month and triple-digit growth rate. So how do they it? A good place to start is with Gilbert, whose leadership skills, business acumen, and second-to-none work ethic “set the tone,” says Kevin Bryla, the company’s 52-year-old chief marketing officer.
For his part, Gilbert credits his family background and an upbringing in which education and academic achievement were strongly encouraged. The fifth of six children, he’s the only one who opted for a business career. “There are three doctors, two lawyers – and me,” Gilbert says.
The son of a prominent physician, his mother a homemaker and volunteer docent at the nearby Nixon Library for the past 25 years, Gilbert grew up in Yorba Linda. He attributes his keen interest in business to observing how his father, a pathologist, operated his own laboratory, which employed 60 people. “It was the business side of medicine that fascinated me,” he asserts.
Even so, his two closest friends at the University of Southern California — fraternity brothers Marc Newburger and Sean Swerdlow– tell a somewhat different story. They remember Gilbert as someone who found his true calling, his métier, during his college years. Enrolled initially in pre-med courses, he was a diligent student but, his friends assert, manifestly unsuited for a career in medicine.
“Formative,” says Swerdlow, the older of the two fraternity brothers and now a management consultant based in Southern California, “would be a very good word” to characterize that period during which Gilbert abandoned medicine in favor of the world of commerce. In 1997, he earned a bachelor’s degree in business administration “with an emphasis in entrepreneurship.”
But it was fraternity life just as much as the classroom, his friends agree, that shaped him and foreshadowed his future. “It wasn’t ‘Animal House,’” Swerdlow says of Alpha Epsilon Pi. “We boasted the highest GPA (grade point average) on fraternity row.”
Nonetheless, Gilbert took to the social life and camaraderie that the fraternity offered with gusto, and his friendship with the colorful Newburger was especially fateful. A freewheeling entrepreneur today, Newburger takes a measure of credit — Gilbert’s disapproving parents might have preferred the word “blame” — for contributing to his fraternity brother’s metamorphosis. “Dave hated all of his pre-med classes,” Newburger insists. “He had zero stomach for it. He was so much like I was: a natural people person and a born entrepreneur.”
Newburger is the quintessential soldier of fortune. After college, he tried his hand as an actor, supporting himself by playing poker and getting paid to be a contestant on TV game shows including “The Dating Game,” “Card Sharks,” and “3’s A Crowd.” He’s now the co-president and co-inventor of Drop Stop, a patented device that “minds the gap” between a car’s front seat and the console and prevents coins, keys, glasses, and mobile phones from disappearing down that rabbit hole. (Drop Stop really took off after Newburger and his business partner appeared on the television show “Shark Tank” and scored a $300,000 capital injection from celebrity-investor Lori Greiner who took a 30% stake in the company and slapped her name on the brand.)
Back at the frat house, Newburger and Gilbert collaborated on business ventures. The pair once sold T-shirts sporting an off-color message about USC’s archrival, the University of California at Los Angeles. “The (anti-UCLA) message was pure hatred,” Newburger recalls. “But it was just for the day of the football game and it was all in fun.”
At first, sales at the stadium were lackluster. USC students kept trying to bid down the price or importune them to throw in an extra tee. As for the game itself, USC’s chances for victory looked equally unpromising. As time ran out, however, the Trojan quarterback completed a Hail Mary pass and USC won. The two fraternity brothers grabbed the bundle of shirts and sprang into action. “We got to the exit just in time and sold out in a matter of seconds,” Newburger recalls.
Newburger takes credit too for introducing his friend to Las Vegas’ gaming tables. Gilbert, his friend says, immediately demonstrated a knack for counting cards, handling money, and taking risks. “It was typically blackjack,” recalls Swerdlow, who sometimes accompanied them. “We didn’t have much money then. But there were moments when Dave would bet a big pile of chips. He’s willing to make a bet and live with the consequences.”
Sports are another of Gilbert’s enthusiasms. His friends say that, whether he’s returning serve at ping pong or standing over a putt — he plays to an 11 handicap at golf – he wants to win. Remarks Newburger: “He’s competitive to the point that — when he beats you — he wants the Goodyear blimp flying overhead to announce his victory.”
Gilbert, who is married with two children, is legendarily loyal to friends and family. While most members of a college fraternity might keep up with old companions after graduation by exchanging greeting cards and attending college reunions, Gilbert goes the extra mile.
He once footed the bill for Swerdlow to travel with the USC football team to an away game, arranging it so that his fraternity brother could view the action from field-level. After Newburger had a recent health scare (no worries, he’s O.K.), Gilbert rounded up a couple of dozen fraternity brothers and their wives (or companions), and put together a four-day bash in his buddy’s honor. The event was held at Cabo, the Mexican beach resort in Baja California, and Gilbert underwrote a fair amount of the cost. “He shares his success with his friends,” Newburger says, adding: “I don’t know anybody who works harder on friendships.”
Many of the personality traits described by friends and colleagues — tenacity and competitiveness, self confidence and leadership — played a key role in the development and success of National Funding, which Gilbert founded just two years out of college with $10,000 borrowed from his uncle, Howard Kaiman, of Omaha.
He’d worked a couple of quick jobs right after college, including a stint at small-business lender Balboa Capital, but he was always destined to be his own boss. Gilbert’s start-up was called Five Point Capital and, at first, it was located in the affluent Chatsworth section of Los Angeles and concentrated on equipment leasing.
“The first two years we were a cold-calling company and then we got into direct mail and saw some success and then we moved to San Diego and started to scale up the company,” Gilbert says. The decampment, he explains, was “for the quality of life, but we also felt we could hire from a better talent pool than L.A. We wanted to set ourselves apart.”
By 2007, Five Point was cranking up operations, revenues shot to $28 million and its headcount totaled 210 employees. “Then the Great Recession hit” in 2008-2009, Gilbert says. The company was forced to furlough 140 employees, two-thirds of its workforce. Yet even as it retrenched, the company managed to branch out. It began making merchant cash advances, Gilbert says, and, also in 2007, it linked up with CAN Capital to do broker financings. “We were pretty well known and they were looking for partners for factoring and leasing,” Gilbert explains.
It took time to recover after the financial crisis. But by 2013 – the year that Gilbert re-branded his company “National Funding” – the company was able to hire back as many as 15% of its laid-off employees (most had found other jobs, in many cases relocating to Silicon Valley, Gilbert reports). By then, the company had secured a $25 million credit facility from Wells Fargo Bank, which allowed it to move up the food chain to “become a balance-sheet lender,” Gilbert says, and offer a wider selection of financing options.
Key to driving the company’s phenomenal growth has been its flood-the-zone marketing and sales strategies. The company spends $16 million annually on marketing using a full panoply of channels and media, both online and offline. These include direct mail and targeted marketing, paid advertising, search-engine optimization or SEO, and sports sponsorships. “We try to build a whole range of marketing mechanisms,” explains marketing chief Bryla, “and when you get the mix right, they all help each other.”
Gilbert is a big believer in the benefits of sports marketing, the company’s website featuring the logos of the San Diego Padres (baseball), and Anaheim Ducks and Los Angeles Kings (hockey). Ever the faithful alumnus, Gilbert and his company back USC football as well. During the 2015 2016 college football season, the company paid for naming rights for what became, for one night, the “National Funding Holiday Bowl” at Qualcomm Stadium.
Janet Fink, department chair at the McCormack School of Sports Management located at the University of Massachusetts-Amherst, told deBanked that sponsorship programs can easily cost a million dollars or more. “It’s not cheap,” she says. “When a company sponsors a team, they get a number of benefits. One is that they get to put the team’s logo on their website. The idea is that fans are passionate or have an affinity for the team and that it will rub off on a sponsor.
“Sports enthusiasts,” Fink adds, “often make good customers. When you have enough disposable income to go to these sporting events, you’re probably a good prospect for a loan.”
The sponsorships — which include civic involvement such as offering Holiday Bowl tickets to members of San Diego’s large military contingent as well as to company employees — also build good will in the community and team spirit among the workforce. (National Funding also makes an effort to hire veterans, says Bryla.)
Gilbert believes in the old adage that you have to spend money to make money. The company spends $14 million rewarding its network of outside brokers. Inside the company, high-performing salespeople are compensated with commissions, bonuses and an assortment of rewards, including resort trips.
But sales representatives’ must conform to company guidelines. Justin Thompson, National Funding’s sales chief, explains that the “customer comes first” philosophy is not just a slogan but a core value. “We’re not a factory spitting out widgets,” Thompson says. “We’re here to build relationships and sell a repeatable product. We want that customer to come back to us. Every loan is customized. Six of ten customers who pay off their loans come back for a second financing. Whether your business is dog grooming or you’re an asphalt company,” he adds, “people will do business with people they like and trust.”
Using the software program “customer relationship management” (CRM), National Funding expends a lot of effort gathering data on its business customers and extrapolating the information for use in credit evaluations. But the use of technology only goes so far.
Gilbert reckons that the art of the deal involves about “70 percent algorithm and 30 percent people.” He adds, “You still need the people component to look at credit profiles. The algorithm spits out a recommendation but we still need the human element.”
If there’s a fly in the National Funding ointment, it’s that the company’s fees can be more expensive than a bank loan.
But borrowers who have been denied loans at a bank or other lender are likely to overlook those costs. Austin, the florist in West Palm Beach, for example, came to National Funding when his bank, North Carolina-based BB&T Bank, gave him the cold shoulder despite the $15,000 in deposits that he averages each month. “I’ve been with them for six years,” he fretted, “and they treated me shabbily.”
Even more grateful was Jimmy Frisco, of Annapolis, who is co-owner with his wife of Lisa’s Luncheonette, a business that includes a food trailer and several cafeterias located in the city’s office buildings. They employ about a dozen people.
Frisco had taken a nasty spill and was laid up for seven months. Health insurance covered the $18,000 in medical costs but he and Lisa fell behind in their bills and needed working capital to pay for food purchases and other business expenses. By the time a flyer from National Funding popped up in his mailbox, he and his wife “had been turned down by several other lenders, including banks,” he says, adding: “Things happen in life and we don’t have the best of credit.”
Getting that loan for $25,000 from National Funding took just three days. Frisco’s health is much improved and business is back to normal. He won’t discuss the terms of the financing, other than to say “it was reasonable.”
He adds: “There were no problems with National Funding, no hassle with the paperwork. They’re great people to work with.”
The Seven-Minute Loan Shakes Up Washington And The 50 States
August 19, 2018
It takes seven minutes for Kabbage to approve a small-business loan. “The reason there’s so little lag time,” says Sam Taussig, head of global policy at the Atlanta-based financial technology firm, “is that it’s all automated. Our marginal cost for loans is very low,” he explains, “because everything involving the intake of information – your name and address, know-your-customer, anti-money-laundering and anti-terrorism checks, analyzing three years of income statements, cash-flow analysis – is one-hundred-percent automated. There are no people involved unless red flags go off.”
One salient testament to Kabbage’s automation: Fully $1 billion of the $5 billion in loans that it has made to 145,000 discrete borrowers since it opened its portals in 2011 were made between 6 p.m. and 6 a.m.
Now compare that hair-trigger response time and 24-hour service for a small business loan of $1,000-$250,000 with what occurs at a typical bank. “Corporate credit underwriting requires 28 separate tasks to arrive at a decision,” William Phelan, president, and co‐founder of PayNet—a top provider of small-business credit data and analysis – testified recently to a Congressional subcommittee. “These 28 tasks involve (among other things): collecting information for the credit application, reviewing the financial information, data entry and calculations, industry analysis, evaluation of borrower capability, capacity (to repay), and valuation of collateral.”
A “time-series analysis,” the Skokie (Ill.)-based executive went on, found that it takes two-to-three weeks – and often as many as eight weeks—to complete the loan approval process. For this “single credit decision,” Phelan added, the services of three bank departments – relationship manager, credit analyst, and credit committee – are required.
The cost of such a labor-intensive operation? PayNet analysts reckoned that banks incur $4,000-$6,000 in underwriting expenses for each credit application. Phelan said, moreover, that credit underwriting typically includes a subsequent loan review, which consumes two days of effort and costs the bank an additional $1,000. “With these costs,” Phelan told lawmakers, “banks are unable to turn a profit unless the loan size exceeds $500,000.”
According to the National Bureau of Economic Research, the country’s very biggest banks — Bank of America, Citigroup, J.P. Morgan Chase, and Wells Fargo—have been the financial institutions most likely to shut down lending to small businesses. “While small business lending declined at all banks beginning in 2008,” NBER’s September, 2017 report announces, “the four largest banks” which the report dubs the ‘Top Four’—“cut back significantly relative to the rest of the banking sector.”
NBER reports further that by 2010—the “trough” of the financial crisis—the annual flow of loan originations from the Top Four stood at just 41% of its 2006 level, which compared with 66% of the pre-crisis level for all other banks. Moreover, small-business lending at the “Top Four” banks remained suppressed for several years afterward, “hovering” at roughly 50% of its pre crisis level through 2014. By contrast, such lending at the rest of the country’s banks eventually bounced back to nearly 80% of the pre-crisis level by 2014.
That pullback—by all banks—continues, says Kenneth Singleton, an economics professor at Stanford University’s Graduate School of Business. Echoing Phelan’s testimony, Singleton told deBanked in an interview: “Given the high underwriting costs, banks just chose not to make loans under $250,000,” which are the bread-and-butter of small-business loans. In so doing, he adds, banks “have created a vacuum for fintechs.”
All of which helps explain why Kabbage and other fintechs making small business loans are maintaining a strong growth trajectory. As a Federal Reserve report issued in June notes, the five most prominent fintech lenders to small businesses—OnDeck, Kabbage, Credibly, Square Capital, and PayPal—are on track to grow by an estimated 21.5 percent annually through 2021.
Their outsized growth is just one piece—albeit a major one—of fintech’s larger tapestry. Depending on how you define “financial technology,” there are anywhere from 1,400 to 2,000 fintechs operating in the U.S., experts say. Fintech companies are now engaged in online payments, consumer lending, savings and investment vehicles, insurance, and myriad other forms of financial services.
Fintechs’ advocates—a loose confederacy that includes not only industry practitioners but also investors, analysts, academics, and sympathetic government officials—assert that the U.S. fintech industry is nonetheless being blunted from realizing its full potential. If fintechs were allowed to “do their thing,” (as they said in the sixties) this cohort argues, a supercharged industry would bring “financial inclusion” to “unbanked” and “underbanked” populations in the U.S. By “democratizing access to capital,” as Kabbage’s Taussig puts it, harnessing technology would also re-energize the country’s small businesses, which creates the majority of net new jobs in the U.S., according to the U.S. Small Business Administration.
But standing in the way of both innovation and more robust economic growth, this cohort asserts, is a breathtakingly complex—and restrictive—regulatory system that dates back to the Civil War. “I do think we’re victims of our own success in that we’ve got a pretty good financial system and a pretty good regulatory structure where most people can make payments and the vast majority of people can get credit.” says Jo Ann Barefoot, chief executive at Barefoot Innovation Group in Washington, D.C. and a former senior fellow at Harvard’s Kennedy School. But because of that “there’s been more inertia and slower adoption of new technology,” she adds. “People in the U.S. are still going to bank branches more than people in the rest of the world.”
Barefoot adds: “There are five agencies directly overseeing financial services at the Federal level and another two dozen federal agencies” providing some measure of additional, if not duplicative oversight, over financial services. “But there’s no fintech licensing at the national level,” she says. And because each state also has a bank regulator, she notes, “if you’re a fintech innovator, you have to go state by state and spend millions of dollars and take years” to comply with a spool of red tape pertaining to nonbanks.
At the federal level, the current system— which includes the Federal Reserve, Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC)—developed over time in a piecemeal fashion, largely through legislative responses to economic panics, shocks and emergencies. “For historical reasons,” Barefoot remarks, “we have a lot of agencies” regulating financial services.
For exhibit A, look no further than the Consumer Financial Protection Bureau created amidst the shambles of the 2008-2009 financial crisis by the 2010 Dodd-Frank Act. Built ostensibly to preserve safety and soundness, the agencies have constructed a moat around the banking system.
Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington, D.C. consultancy, is a banking policy expert who frequently provides testimony to Congress and regulatory agencies. She wrote recently that the country’s banking sector has been protected from the kind of technological disruption that has upended a whole bevy of industries.
“The only reason Amazon and its ilk may not do to banking, brokers and insurers what they did to retailers—and are about to do to grocers and pharmacies,” she observed recently in a blog—“is the regulatory structure of each of these businesses. If and how it changes are the most critical strategic factors now facing finance.”
Cornelius Hurley, a Boston University law professor and executive director of the Online Lending Policy Institute, is especially critical of the 50-state, dual banking system. State bank regulators oversee 75 percent of the country’s banks and are the primary regulators of nonbank financial technology companies. “The U.S. is falling behind other countries that are much less balkanized,” Hurley says. “Our federal system of government has served us well in many areas in our becoming a leading civil society. It’s given us NOW (Negotiable Order of Withdrawal) accounts, money-market accounts, automatic teller machines, and interstate banking. But now it’s outlived its usefulness and has become an impediment.”
Take Kabbage, which actually avoids a lot of regulatory rigmarole by virtue of its partnership with Celtic Bank, a Utah-chartered industrial bank. The association with a regulated state bank essentially provides Kabbage with a passport to conduct business across state lines. Nonetheless, Kabbage has multiple, incessant, and confusing dealings with its bank overseers in the 50 states.
“Where the states get involved,” says Taussig, “is on brokering, solicitation, disclosure and privacy. We run into varying degrees of state legislative issues that make it hard to do business. Right now we’re plagued by what’s been happening with national technology actors on cybersecurity breaches and breach disclosures. We are required to notify customers. But some states require that we do it in as few as 36 hours, and in others it’s a couple of months. We’ve lobbied for a national breach law of four days,” he adds, which would “make it easier for everyone operating across the country.”
Then there’s the meaning of “What is a broker?’” says Taussig, who as a regulatory compliance expert at Kabbage sees his role as something of an emissary and educator to regulators and politicians, the news media, and the public. “The definitions haven’t been updated since the 1950s and now we have wildly different interpretations of brokering and solicitation,” he says. “The landscape has changed with e-commerce and each state has a different perspective of what’s kosher on the Internet.”
Washington State is a good example. It’s one of a handful of jurisdictions in which regulators confine nonbank fintechs to making consumer loans. In a kabuki dance, fintech companies apply for a consumer-lending license and then ask for a special dispensation to do small-business lending.
And let’s not forget New Mexico, Nevada and Vermont where a physical “brick-and-mortar” presence is required for a lender to do business. Digital companies, Taussig says, would have to seek a waiver from regulators in those states. “Many companies spend a lot of money on billable hours for local lawyers to comply with policies and procedures,” Taussig reports, “and it doesn’t serve to protect customers. It’s really just revenue extraction.”
All such restraints put fintechs at a disadvantage to traditional financial institutions, which by virtue of a bank charter, enjoy laws guaranteeing parity between state-chartered and federally chartered national banks. The banks are therefore able to traverse state lines seamlessly to take deposits, make loans, and engage in other lines of business. In addition, fintechs’ cost of funds is far higher than banks, which pay depositors a meager interest rate. And banks have access to the Fed discount window, while their depositors’ savings and checking accounts are insured up to $200,000.
The result is a higher cost of funds for fintechs, which principally depend on venture capital, private equity, securitization and debt financing as well as retained earnings. And that translates into steeper charges for small business borrowers. A fintech customer can easily pay an interest rate on a loan or line of credit that’s three to four times higher than, say, a bank loan backed by the U.S. Small Business Administration.
Kabbage, for example, reports that its average loan of roughly $10,000 typically carries an interest rate of 35%-36%. It’s credits are, of course, riskier than the banks’. The company does not report figures on loans denied, Taussig told deBanked, but Stanford’s Singleton says that the fintech industry’s denial rate is roughly 50 percent for small business loans. “Fintechs have higher costs of capital and they’re also facing moderate default rates,” notes Singleton. “They’re not enormous, but fintechs are dealing with a different segment. Small businesses have much more variability in cash flows, so lending could be riskier than larger, established companies.”
Even so, venture capitalists continue to pour money into fintech start-ups. “I’ve gone to several conferences,” Singleton says, “and everywhere I turn I’m meeting people from a new fintech company. One of the striking things about this space,” he adds, “is that there are lot of aspiring start-ups attacking very specific, very narrow issues. Not all will survive, but someone will probably acquire them.”
Contrast that to the world of banking. Many banks are wholeheartedly embracing technology by collaborating with fintechs, acquiring start-ups with promising technology, or developing in-house solutions. Among the most impressive are super-regionals Fifth Third Bank ($142.2 billion), Regions Financial Corp. ($123.5 billion), and BBVA Compass ($69.6 billion), notes Miami-based bank consultant Charles Wendel. But many banks are content to cater to familiar customers and remain complacent. One result is that there’s been a steady diminution in the number of U.S. banks.
Over the past ten years, fully one-third of the country’s banks were swallowed whole in an acquisition, disappeared in a merger, failed, or otherwise closed their doors. There were 5,670 federally insured banks at the end of 2017, according to the Federal Deposit Insurance Corp., a 2,863-bank, 33.5% decrease from the 8,533 commercial banks operating in the U.S. in 2007.
It does appear that, to paraphrase an old expression, many banks “are going out of style.” In recent years there have been more banking industry deaths than births. Sixty-three banks have failed since 2013 through June while only 14 de novo banks have been launched. In Texas, which is known for having the most banks of any state in the country, only one newly minted bank debuted since 2009. (The Bank of Austin is the new kid on the Texas block, opening in a city known as a hotbed of technology with its “Silicon Hills.”)
One reason there’s so little enthusiasm among venture capitalists and other financial backers for investing in de novo banks is that regulators are known to be austere. “If you’re a company in the U.S.,” says Matt Burton, a founder of data analytics firm Orchard Platform Markets (which was recently acquired by Kabbage), “and you tell regulators that you want to grow by 100 percent a year – which is the scale you must grow at to get venture-capital funding – regulators will freak out. Bank regulators are very, very strict. That’s why you never hear about new banks achieving any sort of scale.”
But while bank regulators “are moving sluggishly compared to the rest of the world” in adapting to the fintech revolution, says Singleton, there are numerous signs that the status quo may be in for a surprising jolt. The Treasury Department is about to issue (possibly by the time this story is published) a major report recommending an across-the-board overhaul in the regulatory stance toward all nonbank financials, including fintechs. According to a report in The American Banker, Craig Phillips, counselor to Treasury Secretary Steven Mnuchin, told a trade group that the report would address regulatory shortcomings and especially “regulatory asymmetries” between fintech firms and regulated financial institutions.
Christopher Cole, senior regulatory counsel at the Independent Community Bankers Association—a Washington, D.C. trade association representing the country’s Main Street bankers—told deBanked that, among other things, the Treasury report would likely recommend “regulatory sandboxes.” (A regulatory sandbox allows businesses to experiment with innovative products, services, and business models in the marketplace, usually for a specified period of time.)
That’s an idea that fintech proponents have been drumming enthusiastically since it was pioneered in the U.K. a few years ago, and it’s something that the independent bankers’ lobby, whose member banks are among the most threatened by fintech small-business lenders, says it too can support. Treasury’s Phillips “has said in the past that he’d like to see a level playing field,” the ICBA’s Cole says. “So if (regulators) are going to allow a sandbox, any company could be involved, including a community bank. We agree with him, of course, because we’d like to take advantage of that.”
In March, 2018, Arizona became the first state to establish a regulatory sandbox when the governor signed a law directing that state’s attorney general (and not the state’s banking regulator) to oversee the program. The agency will begin taking applications in August with approval in 90 days, says Paul Watkins, civil litigation chief in the AG’s office. Watkins told deBanked that he’s been most surprised so far by “the degree of enthusiasm” from overseas companies. With the advent of the sandbox, he adds, “Landlocked Arizona has become a port state.”
The OCC, which is part of the Treasury Department, may also revive its plan to issue a national bank charter to fintechs, sources say (EDITOR’S NOTE: This had not yet been implemented before this story went to print. The OCC is now accepting such applications) – a hugely controversial proposal that was put on ice last year (and some thought left for dead) when former Commissioner Thomas J. Curry’s tenure ended last spring. At his departure, the fintech bank charter faced a lawsuit filed by both the New York State Banking Department and the Conference of State Bank Supervisors. (Since then, the lawsuit was tossed out by the courts on the ground that the case was not “ripe” – that is, it was too soon for plaintiffs to show injury).
Taussig, the regulatory expert at Kabbage, reports that the Comptroller of the Currency, Robert J. Otting, has promised “a thumbs-up or thumbs-down” decision by the end of July or early August on issuing fintechs a national bank charter. He counts himself as “hopeful” that OCC’s decision will see both of the regulator’s thumbs pointing north.
The Conference of State Bank Supervisors, meanwhile, has extended an olive branch to the fintech community in the form of “Vision 2020.” CSBS touts the program as “an initiative to modernize state regulation of non-bank financial companies.” As part of Vision 2020, CSBS formed a 21-member “Fintech Industry Advisory Panel” with a recognizable roster of industry stalwarts: small business lenders Kabbage and OnDeck Capital are on board, as are consumer lenders like Funding Circle, LendUp and SoFi Lending Corp. The panel also boasts such heavyweights in payments as Amazon and Microsoft.
Working closely with the fintech industry is a “key component” of Vision 2020, Margaret Liu, deputy general counsel at CSBS, told deBanked in a recent telephone interview. CSBS and the fintech industry are “having a dialogue,” she says, “and we’re asking industry to work together (with us) and bring us a handful of top recommendations on what states can do to improve regulation of nonbanks in licensing, regulations, and examinations.
“We want to know,” she added, ‘What the main friction points are so that we can find a path forward. We want to hear their concerns and talk about pain points. We want them to know the states are not deaf and blind to their concerns.”
Tech Changes Lending And Payments The World Over
June 25, 2018
On a business trip to China last summer, Matt Burton had plenty of money in his wallet but it was practically useless.
Case in point: He had a lengthy standoff with a Shanghai taxi driver who insisted on a mobile-phone payment. “I spent 20 minutes arguing with the cabbie,” says Burton, one of the founding partners at Orchard Platform, a leading provider of technology and software to the alternative lending industry. “You’d think that — out of all of the professions — a taxi driver would accept cash.”
The New Yorker finally convinced the cab driver to take the payment in renminbi, China’s paper currency. The incident, meanwhile, is illustrative of how deeply and widely mobile payments have penetrated the huge Chinese market. “No one in China carries wallets anymore,” Burton reports. “Everyone pays with their smart-phones. Even the elderly women selling vegetables on the side of the road accept mobile payments,” he adds. “Cash has become a hassle.”
Welcome to China’s financial technology revolution. Almost overnight, China’s population graduated from calculating with the 16th-century abacus to showcasing what is arguably the world’s most sophisticated system of mobile payments. Thanks to financial technology, China is fast becoming a cashless economy. China is just one place outside the U.S. where financial technology is catching on in a big way. As Americans remain, for the most part, wedded to suburban drive-in banks, walk-up automated teller machines, and plastic credit and debit cards, the rest of the world is rapidly embracing digital solutions. And nowhere is that happening more dramatically than in China.
According to the most recent figures released by China’s Internet Network Information Center, the country had 724 million mobile phone users at the end of June 2017. China’s Ministry of Industry and Information Technology reports, moreover, that consumers paying for everything from food and clothing to utility bills to movie tickets and – you guessed it, cab fare — engaged in 239 billion mobile payment transactions in 2017, a surge of 146 percent over the previous year.
Mobile payments have become a $16 trillion industry in China, the ministry adds, accounting for about half of all such transactions in the world.
And there’s ample room to grow. The World Bank discloses that there are now 772 million Internet users in China, more than double the entire population of the U.S. Yet that leaves 50% of China’s population – mostly in the countryside and rural areas – who are not yet plugged in to the Internet.
Two Chinese mobile-payment platforms dominate the industry. Ant Financial is the 800-pound-gorilla, its Alipay program boasting 520 million global users on its website. It’s an affiliate of publicly traded Alibaba Group Holding, an online merchandiser known as the “Amazon of China” which was founded by entrepreneur Jack Ma, reputedly the richest man in China.
Alipay not only has bragging rights to roughly 60 percent of China’s digital and online payments market but, in 2013, it overtook PayPal as the global leader in third-party payments. With deep roots in e-commerce, Alipay is the go-to payments option for online shoppers, who are steadily migrating from laptops to mobile devices.
WeChat Pay is the upstart in the duopolistic rivalry. Launched in 2013, nearly a decade later than its rival, it’s a unit of conglomerate Tencent Holdings, a social network and messaging platform often compared to Facebook. As WeChat continues to add subscribers, its Tenpay app has been growing accordingly, eroding Alipay’s market share as new users gravitate to the e-payments program. While WeChat records fewer payments than Alipay, Forbes magazine reports that it claims more users.
Whatever WeChat’s virtues, Ant Financial continues to chew up the scenery. It recently topped the charts as the world’s “most innovative” fintech in 2017, as reckoned by a research team formed by accounting giant KPMG and H2 Ventures. China scored a hat trick, moreover, as two additional homegrown fintechs — online property-and-casualty insurer ZhongAn and credit-provider Qudian Inc. — took second and third place, respectively, in KPMG/H2’s rankings. For good measure, China also claimed five of the top ten spots on the “most innovative” list, edging out the U.S., which had four.
Financial analysts recently surveyed by the Financial Times reckon Ant Financial’s market valuation at $150 billion, catapulting the company into the rarified status of not just a “unicorn,” but a “super-unicorn.” (Named after the rarely seen mythical one-horned horse, “unicorns” are start-ups valued at $1 billion). So robust is Ant Financial’s market valuation that the global investment community is salivating over its impending initial public offering.
(Ant’s progenitor, Alibaba, holds bragging rights as the largest IPO ever, according to the Financial Industry Regulatory Authority. It raised $21.8 billion in 2014; its NYSE-listed stock was trading at $194.36 in mid-May, essentially in the same league as Apple and Facebook, trading at $188.80 and 187.08, respectively, on Nasdaq.)
“Four of the largest fintech unicorns in the world are coming out of Asia,” notes Dorel Blitz, the Tel Aviv-based head of fintech at KPMG. “The companies are getting bigger and stronger,” he adds, “and you’re beginning to see more direct investment in public fintech companies as well.”
Adds Orchard’s Burton: “I think it shows you how massive the opportunities are outside the U.S.”
Ant Financial and WeChat are also serving as a world-class demonstration project on how fintechs can turn a tidy profit while opening up financial services to large populations who lack access to basic financial services, thereby providing entry to the middle class. The two platforms have provided “financial inclusion for tens of millions, if not hundreds of millions of people” who previously were on the periphery of the banking and financial system, says Kai Schmitz, a fintech lender at International Finance Corporation that lends to private businesses in the developing world.
Once people are making electronic payments on their mobile devices, Schmitz notes, it creates a “pathway” to a whole panoply of financial services, including personal and business loans, savings, insurance, and investments.
“You can create a user profile so that a large part of the population that could not be reached (by traditional financial institutions) are now making payments and can be followed on the data track,” he says.
The World Bank reports that two billion adults and 200 million businesses in the developing world are currently unable to access even basic financial services. Through IFC, the World Bank has invested $370 million in fintech companies operating throughout Asia, the Middle East, Africa and Latin America. The fintechs, an IFC communications manager told deBanked, offer “a range of products and services — from e-wallets, virtual banks, lending, and online payments to retail payment points and exchanges.” IFC, she adds, also invests in fintech funds.
Anju Patwardhan is the U.S.-based managing director at CreditEase Fintech Investment Fund, a $1 billion Chinese venture capital firm that invests in fintechs delivering financial services to “unbanked” and “underbanked” populations. “They are living in Africa, Bangladesh, China and elsewhere on less than two dollars a day and have no access to financial services,” she says.
“But there are also a very large number of people who may be technically included in the financial system but still don’t have access to a full range of financial services at reasonable prices,” she adds. “If someone is borrowing from a moneylender or pawnbroker, it doesn’t count (as financial inclusion). In that case, the number of people is very much more than two billion.”
Once phone towers are built and a payments infrastructure is in place, fintechs promising more sophisticated financial services can operate similarly to the settlers who followed pioneers in the U.S.’s westward expansion. That’s been the story in Kenya and other African countries where M-Pesa (“pesa” is Swahili for money) and other mobile-phone payments systems set up shop a decade ago.
Branch International, based in San Francisco but doing business exclusively in emerging and frontier markets for only three years, is one of the settlers. It boasts that it now has the “No. 1 finance app in Africa.” In March, Branch raised $70 million in a second-stage round of debt and equity financing from a group of venture capitalists led by Trinity Partners that included Patwardhan’s CreditEase and the IFC. Patwardhan will serve as an advisor to Branch’s board.
Branch’s principal business is making loans and micro-loans ranging from as little as $2 to $1,000 in Nigeria, Kenya, and Tanzania. Despite its name, Branch touts itself as a “branchless bank”, all of the credit transactions taking place on mobile devices, says Matt Flannery, Branch’s chief executive and founder. Its average loan amount is $25.
Many of Branch’s customers are individuals and businesses who often had trouble obtaining credit from established financial institutions or were ineligible for loans. But, according to Branch’s website, it’s possible for a prospective borrower to obtain a loan in just a matter of minutes. “Branch eliminates the challenges of getting a loan by using the data on your phone to create a credit score,” the website says. Branch promises privacy, fees that are “fair and transparent,” and terms that “allow for easy repayment” with no “late fees or rollover fees”. “As you pay back on time,” the website also says, “our fees decrease, and you unlock larger loans with more flexible terms.”
The platform, CEO Flannery says, has lent out $100 million dollars to roughly that same number of people. “The formal financial system in African countries is generally composed of old-fashioned banks that are risk-averse and fairly slow to make lending decisions,” he says. “People really appreciate us,” Flannery adds. “I’d say we’re like Uber and they’re the horse-and-buggy.”
The company is growing by 20 percent month-over-month and expects to disburse more than $250 million in 2018. Asked to describe Branch’s typical borrower, Flannery says: “We have some rural users (of Branch’s finance app). But in general we’re serving the commercial middle-class — shopkeepers and entrepreneurs – in urban capitals.” Want to know precisely who Branch’s customers are? “Just go to downtown Lagos (the capital of Nigeria and the largest city on the African continent) and you’ll see all different kinds of businesses and single-owner merchants on street corners,” Flannery says.
Jeff Stewart, the founder and chairman of Lenddo (which recently merged with competitor EFL) asserts that his firm’s machine learning technology and risk modeling techniques, which are being deployed in emerging countries from Costa Rica to The Philippines, have the capacity to assess the “creditworthiness of everyone on the planet.” In the absence of credit history in much of the developing world, he explains, this can done by constructing a risk profile combining both “psychometrics” and a “digital footprint.”
Psychometrics is a behavioral assessment tool based on a prospective borrower’s “Big Five” personality traits: openness to experience, conscientiousness, extraversion, agreeableness, and neuroticism (OCEAN for short). “What we’ve been able to show,” Stewart asserts, “is that certain personality types have a positive and negative correlation with repayment. It’s not 100 percent accurate. But you can predict the statistical recovery ratio on repayment. You can say that, for a person with a high score, something like 88 out of 1,000 people (with his or her profile) would not repay.”
The digital footprint, which is the second “critical component,” Stewart says, analyzes a prospective borrower’s reliability by reconnoitering their smartphone usage. “We’ll look at everything on your phone,” he says, “How you use the phone. Whom you interact with. When you use your phone. There are thousands of features that generate a digital footprint. Everything from meeting someone at a sports bar to the apps on your phone to things like e-mailed receipts that show your financial activity.”
Such methods help build credit for those lacking credit history while rehabilitating those whose credit history is blemished. And all that’s needed is a smartphone. “We’ve turned the smartphone into a credit bureau,” Stewart says.
The acquisition of smartphones is taking place at a blistering pace, Stewart notes, now that cell phone costs are “at the bottom of the cost pyramid” in many countries. For example, a “low-end Android” now fetches as little as $25 in Africa. “One credible study I’ve seen shows that every 10% percent rise in access to smartphones translates into a 1/2 percent rise in a country’s gross domestic product,” Stewart says.
While the private sector is driving the trend to financial inclusion in China and Africa, India’s government-driven model “is setting a new global standard in using financial technologies to support financial inclusion,” declares Patwardhan of CreditEase, who also lectures at Stanford. “The country has become a giant testing ground for financial inclusion and innovation,” she argues in a recent academic paper, “and may become a role model for other emerging economies.”
India’s state-run effort includes a $1.3 billion digital identity program known as Aadhaar. Under Aadhaar (which means “foundation”), the state issues residents a 12-digit identity number that’s based on their biometric data –such as fingerprints and iris scans — and personal information. The ID number covers more than 1.19 billion residents. In just the first two years after Aadhaar’s 2009 debut, Patwardhan says, more than 250 million Indians were able to open bank accounts.
Jo Ann Barefoot, chief executive at Barefoot Innovation Group in Washington, D.C. and a senior fellow emerita at Harvard’s Kennedy School of Government, agrees. She notes that Aadhaar opened up access to both fintech services and bank accounts to women who were long treated as second-class citizens by the social and economic system. “India’s digital ID program means that wives and daughters have identity now,” she says.
“In the past,” she adds, “only (male) heads of households would have family identity documents and a government card — which would be the equivalent of having a Social Security number in the U.S. But the wife wouldn’t have her own card. So this is a massive door-opener to fintech growth. And it’s also opening up (all areas of) finance to millions and millions of people.”
India’s “digitalization” program, moreover, has entailed development of a national payments network called “unified payments interface,” or UPI. The combination of UPI and Aadhaar as well as other digital initiatives have resulted in “a surge of online lending platforms,” says Patwardhan, citing Capital Float, NeoGrowth, Faircent, LendingKart, Quiklo, IndiaLends, CreditExchange, and Onemi.
The homegrown fintechs, however, will be up against tremendous external pressure as India, with 1.3 billion people and poised to overtake China in population growth, is generating enormous interest from global fintechs. Among outside platforms piling into the country are China’s Ant Financial and WeChat. The former took a $1 billion stake in Paytm, an Indian mobile payments and e-commerce company. Similarly, competitor WeChat’s parent, Tencent, has invested in Hike, a mobile wallet valued at $1.4 billion last June, according to CNBC, exciting investor interest as a unicorn.
U.S. companies are getting into the act too. Google launched digital payments app Tez last September, which “is taking advantage of India’s infrastructure and has already gotten 30 million downloads,” Patwardhan says. In February, Facebook rolled out a peer-to-peer payments feature on WhatsApp. Even Branch’s Flannery has announced that his “branchless bank” plans to earmark part of its $70 million war chest to offer $2-to-$1000 loans on the subcontinent.
Having banned high-denomination paper bills as a way to rein in corruption and aiming at a cashless economy, India has been innovating in ways that “have gone the Chinese one better,” marvels Patwardhan. “Their payment systems going through the UPI network are interoperable,” she notes, for example. “You don’t have to be on the same app or with the same bank. India is now on the cutting edge.”
