Business Lending

Is That a Bird, a Plane or a Recession in the Wings?

The R-word has been rearing its ugly head with more frequency in recent months, propelled by falling stock prices, higher borrowing rates and the dollar’s ascent.

While a recession—typically defined as a fall in GDP in two consecutive quarters—is far from certain, it would most definitely be a double whammy for an industry that many believe is already ripe for a pullback due to multiple years of unfettered growth. Indeed, many funders have experienced great success riding on the coattails of the long-running favorable market. Some industry participants fear these funders are masking loss rates behind strong volume—a particularly problematic strategy if the volume were to taper off due to an economic downturn.

“It’s no different than what happened in the housing market in 2008,” says Andrew Reiser, chairman and chief executive of Strategic Funding Source Inc. in New York. If and when a recession occurs, several industry participants expect there will be a culling of the weakest firms. They say inexperienced and less-diverse funding companies are particularly at risk, as are MCA funders that don’t keep close tabs on their business dealings. They also believe that venture capital funding will be even harder to come by and regulation will rain down more heavily on the industry.

RISK FACTORS THAT SPELL TROUBLE IN RECESSIONARY ENVIRONMENT

For a variety of reasons, Glenn Goldman, chief executive of Credibly, a New York-based small business lending platform, believes that fewer than 50 percent of the funders today are prepared to weather a recession. Many don’t have strong data science and risk management, for example. Some newer platforms also don’t have the seasoned management to help guide them appropriately, he says.

Another red flag is when funders rely too heavily on a single source of funding. Goldman points back to 2008 when the commercial paper market disappeared. Companies that had on balance-sheet funding capacity were able to weather that storm because they weren’t exclusively relying on commercial paper or securitization, he says.

Goldman believes the prudent way to manage an alternative funding business is to utilize a combination of on-balance sheet financing, whole loan sales and securitization. “If the market moves sideways and you rely only on a single source of funding, you are at risk. It’s an incredibly obvious statement, but it becomes more acute when the economic environment comes under pressure,” he says.

Notably, there are very few sizable alternative funders who successfully survived the last big recession, meaning there are hundreds of companies now doing business in this space that don’t have years-worth of data to help them make more prudent underwriting decisions. Strategic Funding, for example, had the highest loss rate in its history in the third quarter of 2008 and has used its wealth of data to learn from past mistakes. “There’s no doubt that it is critical to be able to correlate events with history,” Reiser says.

Funders are also going to have to batten down the hatches when it comes to their underwriting standards. “Just because someone paid you back yesterday doesn’t mean he’s going to pay you back tomorrow,” Reiser says. “You have to be right more often in a recessionary environment.” Indeed, liquidity for originators and investors will become even more critical in a recession.

“Liquidity is king,” says David Snitkof, chief analytics officer and co-founder of Orchard Platform, a New York-based technology and data provider for marketplace lending. He points out the large number of companies that went belly-up in the last big recession for lack of liquidity. “The more that participants in this market are able to diversify their capital structure, diversify their funding sources and work with multiple providers, the better off they will be,” he says.

Another challenge will be for funders that haven’t had their servicing and collection capabilities adequately stress tested, Snitkof says. These firms should consider working with an outside provider to help them scale their collections as necessary. In this way, a company that needs additional resources can scale up pretty quickly without disrupting operations.

THE P2P OUTLOOK

To be sure, all types of companies fall under the alternative funding umbrella and each will have its own special challenges in a recession. In the P2P space, for example, having a diverse investor base and a sound credit model will become increasingly important. Peter Renton, an investor and founder of Lend Academy, an educational resource for the peer-to-peer lending industry, predicts that some of the newer P2P platforms will struggle more in a recession. That’s because they haven’t had as much time to accumulate and interpret borrower data and adapt their models accordingly.

Lending Club, for example, has gone through many iterations of its credit model over its multiple years in business, and it’s much better than it was even five years ago, says Renton, who had around $37,000 invested with Lending Club as of the third quarter of 2015. “The best data that anyone can get is payment history with your existing borrowing base,” he says.

Particularly in a recession, P2P players need to be extra careful about maintaining strict underwriting standards. Marketplaces may have to tighten their borrowing standards to lend to more solid companies, so the likelihood of defaults isn’t as great. So, for instance, if their standard was once borrowers with a FICO score of at least 640, they could up it to 660, Renton says.

Platforms also have to make sure they have enough investors to satisfy their borrowers, which is why having a diverse investor base is so important. In a recession if you have three hedge funds and that’s your entire investor base, they could all go away. By contrast, if a platform has five thousand individual investors, they aren’t all going away. You may lose 10 percent or 20 percent of them, but if you still have four thousand investors, you can still have your loans funded, Renton explains.

One way to do well even in a recessionary environment is for P2P players to tweak their credit model to be more restrictive so their default rates are lower. “If your default rates are only 3 percent and your competitors are at 6 percent, you’re going to get more business,” Renton says.

Certainly, alternative funding companies can get into trouble if they don’t act early enough when they see a change in activity and economic performance, says Ron Suber, president of Prosper Marketplace, a P2P lender based in San Francisco. Funders need to be able to nimbly adjust their pricing, risk models and expected default rates as needed. “Every marketplace will see a change in borrower behavior as unemployment increases and there are economic declines. Therein lies the question: what does the marketplace do?” Prosper, for instance, recently raised rates on loans, telling investors it had increased its estimated loan loss rates and therefore was updating the price of loans to reflect increased risk. Understanding risk and pricing loans accordingly is always important, but even more so in a shaky economic environment. “You always have to stay on top of it,” Suber says.

MANY MCA FUNDERS AT HIGH-RISK IN RECESSION

If a recession strikes, some observers believe the risk to certain MCA funders will be particularly acute. That’s because new players have entered the MCA space over the past several years, and a sizable number of them don’t have a good handle on their business. Higher default rates could force many of them to shutter operations. Certainly merchants especially those with bad credit—will need more access to capital during a recession and MCA is a natural place for these businesses to turn. But MCA funders have to do a better job of adjusting for risk and keeping adequate records if they hope to weather an economic downturn, says Yoel Wagschal, a certified public accountant in Monroe, New York, who has worked with a number of struggling MCA funders. “A small recession could lead to big failures if you don’t take the right steps,” he says.

To avoid business-threatening issues, Wagschal recommends that MCA funders take steps now to develop stronger underwriting systems to vet merchants better. He believes it’s more prudent to do fewer deals with higher rated merchants than to continue taking on risky businesses as customers. If they see more defaults are coming in, funders should also consider raising their factor rates, he says. Another option is to halt new funding for three to four months to re-energize the business. “It’s much harder to make money than to lose money,” he notes.

If they don’t already have them—and many don’t—MCA funders also need to invest in a good accounting system that can flag their profits, losses and defaults on a real-time basis. This information allows funders to make swift decisions about the business so they can take necessary steps at the right time, he says. “You don’t wait for months, or year end, to analyze all the facts. You might have already lost your business and lost your money because money is just turning around so quickly.”

UNCERTAINTY ABOUNDS FOR VENTURE CAPITAL INVESTMENT

Existing funders won’t be the only ones to struggle in a recession; the well of venture capital funding for new entrants could easily dry up as well,like it did in the last big recession. That’s not to say VC firms will lose interest entirely, but new funders will have to work even harder to get noticed. “There are so many originators, for any new entrants, the bar gets higher and higher to prove that you have something truly unique,” says Snitkof of Orchard Platform. Reiser of Strategic Funding already sees this scenario playing out. “I don’t think the market [lately] has been very favorable to our space,” he says, noting the dearth of exit strategies that have made it riskier for VC firms to invest. “It’s always easy to get in; it’s hard to get out,” he says.

GET READY FOR MORE REGULATORY ACTION

Industry watchers also believe the alternative funding industry will become more heavily regulated in a recession and its aftermath.

Reiser points to all the additional restrictions placed on the mortgage industry in the wake of the housing market bust in 2008. At a time when the housing market was restricting, you had more compliance placed on it as well. “I think you’ll have more compliance in our industry too. That’s just another cost that will have to be absorbed,” Reiser says.

In a recession, there’s more likelihood that harm can come to customers and that will drive regulatory action as well, he adds.

THE ART OF MAKING TOUGH DECISIONS

If the economy turns south, many alternative funders will be forced to make tough underwriting decisions. It can be hard if your analysis of data tells you that things are going to turn downward and your competitors don’t take the same stance, says Stephen Sheinbaum, founder of Bizfi, a New York-based online marketplace.

In that case, funders have to decide whether they are willing “to tighten and pivot while the rest of the players in the space are going full steam ahead,” he says. “That’s where you have to have some conviction and trust your data and do the right thing.”

Of course, even as the rest of the economy is faltering, recessionary times can also be a boon for enterprising companies. For example, the 2008 recession turned out to be positive for Bizfi, which at the time was called Merchant Cash and Capital. Using housing starts, consumer spending and other data, the company correctly predicted the economy was going to take a severe turn downward. It therefore made tweaks to its underwriting guidelines, moving into certain industries and away from others it deemed riskier. “Change can be hard, but it can be for the better,” Sheinbaum says.

Indeed, alternative funders that embrace new opportunities can be successful even in a broad economic downturn. “It’s about having the foresight to be able to discern good from bad and just being really disciplined about it,” says Snitkof of Orchard Platform.