IFA Tells Merchant Cash Advance Companies to Get Lost
August 22, 2014On June 27, 2014, the International Factoring Association (IFA) and the American Factoring Association (AMA) publicly announced their decision to ban merchant cash advance companies from obtaining memberships. The nature of just how public that announcement was is questionable since nobody in the industry seemed to be aware of it, including a dozen plus merchant cash advance companies who have been longtime members of the IFA.
The timing of the ban is leaving a few companies unsettled since it was announced immediately following the IFA’s annual factoring conference in which merchant cash advance companies not only exhibited but were also amongst some of the event’s featured speakers.
To illustrate just how awkward the timing was, the IFA had just begun to thank everyone for attending the conference in the May/June issue of their magazine and in practically the same breath revealed that all merchant cash advance companies were banned going forward:
The IFA annual conference has grown to become the number one industry event for the factoring and receivable finance industry. The IFA convention is now the largest and most relevant event of the year, and as the attendees of San Francisco conference can attest to, it has become the must attend event of the year. Thank you to everyone that attended and helped the IFA achieve this unprecedented growth.
… … …
Due to the number of complaints that have been received, both the IFA and the AFA have voted to bar Merchant Cash Advance companies from membership in each organization. The boards of both associations felt that the model for this type of financing has changed and that there are a number of MCA companies that are not operating in an upfront manner. Given that the goal of both organizations is to assist the factoring community, we found it best to dissociate ourselves from this type of financing.
It is unclear if the IFA’s current merchant cash advance members were immediately terminated or if the rule only applies to new applications going forward. This is especially confusing since the feedback we’ve gotten from their members so far is that nobody knew this had even taken place.
Hopes for a peaceful breakup between the two industries has possibly weakened after a story was spotted in the July/August issue of the IFA’s Commercial Factor magazine aimed at attacking and discrediting merchant cash advance companies.
The article by factoring attorney Steven N. Kurtz alleged that tortious interference, regulatory scrutiny, and rampant disorder were reasons to steer clear of merchant cash advance companies. A more detailed breakdown of his arguments can be found on dailyfunder, but it fails to mention the way he concludes the story:
At the moment, there seems to be too many new players in the merchant cash advance industry, with no experience and loose underwriting standards. There is likely going to be a shakeout because the industry segment has a high default rate and investors who lose money will lose their appetite for the deals. Before the market corrects itself, the factoring industry will have to ride out the storm by adjusting their business practices to effectively compete.
Did you catch his last sentence about riding out the storm? He’s saying to adjust, hold on, wait for a shakeout, and hopefully business for factoring companies will go back to normal. The reason it’s not normal now is because merchant cash advance companies are killing them competitively.
I guess if you can’t beat ’em, ban ’em? They should’ve just said that was the reason from the beginning…
On Deck Capital IPO, An Insider’s Perspective
August 16, 2014It was August 23, 2011, the day the Virginia Earthquake could be felt all the way up in New York City. The four of us were enjoying outdoor seating at a restaurant on the Upper East Side. The ground shook, my drink spilled and Ace looked at each one of us and said, “Okay so I’m putting you down for five deals this month.” OnDeck Capital’s relationship managers were aggressive. If you were a small Independent Sales Organization (ISO), they didn’t expect to get all of your dealflow so they roped you in little by little. It was hard to say no. If five deals was too much, Ace would say three and if three was too much, then he’d put you down for three anyway. Zero was not in the cards. OnDeck owned a specific niche and if you didn’t send your premium credit clients to them, then any ISOs you were competing against would. That was a death knell in those days. Just a few years earlier I would’ve shrugged them off, but public sentiment was changing. Merchants were embracing the fixed daily payment methodology and the merchant cash advance industry would never be the same.
OnDeck Capital is now going public. Will you buy stock?
I’m in a unique position to discuss OnDeck. I started my career in this industry before they even existed. I’ve competed against them as an underwriter at a rival firm, worked with them as a referral partner when I was in sales, and covered them in my capacity as Chief Editor of an industry trade publication.
I left my post as Merchant Cash & Capital’s Director of Underwriting in late 2008. I was 25, about a year or two older than the average employee in the industry. Several of MCC’s rivals got demolished in the financial crisis but OnDeck wasn’t one of them. They also weren’t much of a competitor either. Struggling to define themselves as the anti-merchant cash advance, their product ran counter to the spirit of the industry’s rise. The single biggest allure of a merchant cash advance wasn’t that it was easy to obtain but that there was no fixed repayment term. The funds came with a pre-determined net cost but no specific date on when the delivery of future sales would be due.
Outsiders like the news media aren’t exactly sure what separates merchant cash advance from OnDeck except for maybe the cost of funds. Cash advance just sounds expensive, doesn’t it?
Outsiders identify the company by three characteristics.
1. They’re a non-bank business lender
2. They’re more expensive than a bank
3. They’re a tech company
These bullet points gloss over the fact that OnDeck’s loans require payments to be made every day. Can you imagine a credit card company forcing you to send a payment every day of the month? Or your landlord asking for rent on the 1st of the month, the 2nd, the 3rd, 4th, 5th, and so on every day until your lease is up?
This is not to say that this system is necessarily bad for borrowers, but that it is quite possibly the most unique and important part of what makes OnDeck different. It’s their secret sauce. It is why OnDeck gets lumped in with merchant cash advance companies in many conversations. OnDeck and the legion of copycats they have spawned are part of a broader industry that includes merchant cash advance companies. I call them daily funders. Daily funders provide financing on the condition that payments are made daily. I don’t call them daily lenders because traditional merchant cash advance products are not made by lenders, but by a unique group of investors that purchase future revenue streams.
Transition
Under company founder Mitch Jacobs, OnDeck had established themselves as the de facto loan option.
The merchant’s not biting on merchant cash advance? Send it to OnDeck. The merchant doesn’t accept credit cards? Send it to OnDeck.
They were every merchant cash advance ISO’s frenemy. They’d solicit you for your deals and then throw you under the bus to journalists as evil purveyors of expensive financing. They needed us to source dealflow and we needed them to maximize closing ratios but neither was quite satisfied with the arrangement.
When the company’s first employee took over as CEO in June 2012, the rhetoric changed. While still happy to be portrayed as the anti-merchant cash advance, OnDeck transformed their image from a niche Wall Street lender to a Silicon Valley-esque tech company. Noah Breslow was a curious choice. He has a BS from MIT and an MBA from Harvard Business School. He’s tall, charismatic, and he introduced vocabulary words such as algorithm to an industry that relied entirely on manual human underwriting.
At a recent lending conference, the younger crowd characterized Breslow as the Steve Jobs of business loans. He commands a cult-like following inside and outside the company, and in 2013 was embraced by New York City’s Mayor Bloomberg.
Breslow fast tracked OnDeck. With only $43 million raised in the first 5 years, the company went on to raise more than $300 million in the first 24 months under Breslow’s leadership.
This was their plan all along
In November 2012, OnDeck entertained a buyout offer from UK-based payday lender Wonga in which they reportedly received a $250 million valuation. The deal fell apart in the late stages but at the time I believed the negotiations were all a ploy for OnDeck to get a true market valuation. With a solid offer on the table, they knew both where they stood and where they needed to go. Last week the WSJ reported that preliminary IPO discussions valued them at $1.5 billion, six times higher than where they were two years ago.
With stock options being offered to new employees at least as far back as 2012, the plan to go public should come as no surprise. Later this year, those employees may actually get to do something very few startup workers ever get to do, convert those options into real shares.
So will OnDeck ride off into the sunset of billion dollar bliss? Not so fast say several industry insiders, some of whom are itching to short the stock on the first day they can.
Smoke and mirrors?
As OnDeck took advantage of the swing in public consensus (that fixed terms were better and lower costs increased the attactiveness ), insiders began to ask an important question. Why weren’t merchant cash advance companies collectively countering with lower prices to remain competitive? Greed was fingered by journalists especially in the wake of the financial crisis. But greed is a weak prerogative if you consider that merchant cash advance companies were filing for bankruptcy left and right in 2009.
And oddly or perhaps even ominously, an entire segment of merchant cash advance companies began to raise their prices just as OnDeck was lowering theirs. When I wrote The Fork in the Merchant Cash Advance Road in April 2011, I said:
While the margins earned on high credit accounts shrank, funding providers were dealing with another challenge simultaneously, defaults. Whether the business owner intentionally interfered with their credit card processing or the store went out of business altogether, bad debt in the MCA world was mounting…FAST!
Risk was and still is the number one reason that merchant cash advances cost so much. While it’s true that OnDeck serviced higher credit businesses, insiders speculated that the spreads were too thin. For years, OnDeck’s merchant cash advance competitors have doubted the soundness of their model.
It’s a debate that continues even to this day and yet OnDeck has secured hundreds of millions in investments from companies like Google Ventures, Goldman Sachs, Peter Thiel, and Fortress Investment Group. Their notes got an investment grade rating from DBRS. And as far as volume is concerned, they have likely eclipsed the industry’s all time reigning giant CAN Capital. If they had reached none of these milestones, OnDeck would have little credibility to convince critics of their sanity.
With a mountain of circumstantial evidence through big name backing in OnDeck’s favor, it seems to be indicative that the skeptics are wrong. But maybe they’re not. Could their model be both seriously flawed and superior at the same time?
It’s all about eyeballs
Going back to the 1990s, Internet companies have been judged, valued, and made famous by the price of eyeballs and the number of site visits. It’s a measure that’s never disappeared and according to USA Today is making a comeback. And while OnDeck Capital has always been based in New York City, true to their Silicon Valley form, their model has been to conquer market share first 
and take on profitability second. In their case, it’s not eyeballs or site visits, it’s loan origination volume.
Five months ago Breslow was quoted in the WSJ as saying OnDeck is “imminently profitable“. With seven years in business, it’s proof that their critics have been right all along, that their model doesn’t make money.
What scares their competitors though, is that this strategy has been intentional. Very few if any players in the industry have had the luxury, guts, or the purse to lose money for seven years as part of a coup to conquer the market. Disbelievers in this long term wildly risky strategy are salivating at the opportunity to inspect the company’s financial statements in the IPO.
In When Will the Bubble Burst?, RapidAdvance CEO Jeremy Brown, whose company became part of the Quicken Loans family last winter, fired shots at OnDeck, “To accomplish high growth rates, which may be driven by a desire or need for an IPO or to raise investment or to sell to private equity, assets are being overpaid for through higher than economically justified commissions (I’ve heard 12-15 points upfront from the more aggressive companies) and stretch the repayment term of the MCA or loan even further (On Deck24, I am talking about you).”
Insiders testify that OnDeck’s strategy has not so much been about lower costs but about growth at all costs. Among the evidence is the sudden removal of an industry-wide practice of verifying the business owner is current on their rent. Repayment terms are getting stretched out, commissions have shot up, and for a while they ran a program that allowed applicants to get funding with the submission of just a single bank statement.
Merchant cash advance companies look at their own default figures and scoff at the notion that OnDeck’s aggressive practices could produce low single digit defaults as they’ve publicly claimed.
Imminent
Through it all, there remains the fact that OnDeck has never claimed their methodologies to be profitable, at least not yet. Red ink at IPO time might reward their detractors with a certain delicious satisfaction, but what will they say if and when they become profitable?
I’m reminded of The 20 Smartest Things Amazon Founder Jeff Bezos ever said. Below is a few of them.
- “There are two kinds of companies: Those that work to try to charge more and those that work to charge less. We will be the second.”
- “Your margin is my opportunity.”
- “We’ve done price elasticity studies, and the answer is always that we should raise prices. We don’t do that, because we believe — and we have to take this as an article of faith — that by keeping our prices very, very low, we earn trust with customers over time, and that that actually does maximize free cash flow over the long term.”
- “If you never want to be criticized, for goodness’ sake don’t do anything new.”
- “Invention requires a long-term willingness to be misunderstood. You do something that you genuinely believe in, that you have conviction about, but for a long period of time, well-meaning people may criticize that effort. When you receive criticism from well-meaning people, it pays to ask, ‘Are they right?’ And if they are, you need to adapt what they’re doing. If they’re not right, if you really have conviction that they’re not right, you need to have that long-term willingness to be misunderstood. It’s a key part of invention.”
I wonder if the executive team at OnDeck would share these philosophies.
They’ve always claimed themselves to be a tech company, much to the bewilderment of their competitors. Will technology come through for them?
The data available on businesses has changed. Bank statements and a credit report might’ve been all there was to go on when the company first started, but in Automated Intelligence Breslow said, “the fact is most businesses operating today, in 2014, are already technology focused to one degree or another. They have computers, they have online banking, they use credit card processors, their customers are reviewing them online, there are public records, etc. All this electronic data helps paint a deeper and more accurate picture of the health of a business.”
With such easy access to important data, it might be possible that through the use of 2,000 data points, OnDeck doesn’t need to do all the manual investigations that their competitors still place high values on. The available data might be able to predict loan repayment success just as well as a human analyst.
And if that’s true, then they can reduce the cost of overhead as they scale. As their predictive algorithms get fed more data, they might be able to eliminate humans altogether. At the May 2014 LendIt conference, Breslow admitted that 30% of their loans were still manually underwritten but said that “if customers want full automation, we are prepared to deliver it.”
By that charge, a sustainable model should not be that far out of reach. Through advanced data analysis and decreasing fixed costs, profitability may indeed be imminent.
Winner
If the story of the merchant cash advance industry has been a race to the top, then OnDeck might be declared the winner in a successful IPO. It would be an ironic achievement for the company that positioned itself as the anti-merchant cash advance. In their wake today are hundreds of daily funders offering fixed payment products.
OnDeck’s critics are in a paradoxical position because a successful IPO is good for them too. They want to believe OnDeck’s model never worked, can’t work, and have it be proven a failure. But if it goes the other way, the legitimacy of the daily funder universe will be solidified in the mainstream. What’s good for the goose is good for the gander.
As AmeriMerchant CEO David Goldin said to Inc, “the OnDeck IPO shows that Wall Street is now taking this industry seriously.”
So does that mean he’d buy stock? Somewhere out there at a restaurant in New York City, an OnDeck relationship manager is probably putting Goldin down for five shares.
Cue the earthquake, the industry will never be the same.
Curious how it will change it exactly? Read my magazine published prediction, The Retail Investor.
Should Licensing and Accreditation Come to MCA?
August 13, 2014
It’s not said often, but it has been suggested by some players in the merchant cash advance industry to introduce sales licensing requirements. Anybody can sell and broker MCAs or alternative business loans, even your mom.
That’s been a boon for growth but a bust for maintaining any kind of uniformity or standards. That’s a bad position to be in when influential political leaders are beginning to talk about oversight and regulation, even if it’s way too early to sound the alarm.
Earlier today, former SBA head Karen Mills published, Can Lending Technology Revive America’s Small Businesses? in which she states, “there is already concern that, if left unchecked, small business lending could become the next subprime lending crisis.”
One way to dispel future regulation is through self-licensing, much like the payments industry worked to pull off three years ago. For the first time ever, merchant account sales reps could take an official exam and become a CPP, a Certified Payment Professional. This originated when I was still directly selling merchant cash advances and along with it, merchant accounts.
Merchant accounts were the focus of my compensation strategy and I seriously considered taking the first ever CPP exam in 2011 even though it cost $350. I considered it solely on the basis of whether or not it would convince more people to change their merchant accounts. I finally decided to wait and see if it was helping others before jumping in myself. The question in my mind was, would merchants care? If not, then why busy myself with being accredited?
Now that three years have gone by, the Green Sheet is attempting to answer this question: Is the CPP Dead on Arrival? Members of their forum reported that accreditation had no teeth because the Electronic Transactions Association (ETA) which created it, lacks industry oversight authority. Others said it was a flawed idea from the beginning. And just as I expected to find, there is belief that merchants do not recognize it as meaningful, don’t know about it, or they don’t care.
The story concludes by saying there is hope since three years is too early to judge CPP adoption. Regardless of what will become of CPPs, today any person with access to a phone or the Internet can sell merchant accounts. If you don’t understand how interchange works or what it is, it doesn’t matter.
Ironically, in the very same Green Sheet issue there is a story that argues the secret to selling merchant accounts successfully is really just about having the right tone. Accreditation? What’s that? Interchange? Huh? Instead, ask the owner a few things about their business, “match your response as closely as possible to that of the merchant. Use similar words. Try to pause as the prospect paused.”
The advice touches upon an interesting aspect of sales, that your clients don’t necessarily care about how smart or knowledgeable you are about the subject matter. They’re buying YOU even if your product sucks. Compare that to say accounting where prepared financial statements need to be constructed in such a way to comply with IRS codes or law where a lawyer needs to be admitted to the Bar to practice. In those cases the clients can’t even receive the service unless the seller meets certain professional standards.
And that’s where accreditations become murky. As a business owner, you’re allowed to wildly overpay for printer ink and buy it from someone who doesn’t know anything about printers or ink. I’ve done it myself. I don’t care if they have a certificate in printing expertise or if they’re members of the National Ink Masters of America. Part of being a business owner means being automatically qualified to make transactional decisions.
The same can be applied to merchant accounts. Need to accept cards? Find a rep you like that can articulate what’s important to you. You can make a deal based on no intellectual substance or one completely dependent on it. If it’s not legally required to be a CPP, then the target audience needs a lot of convincing as to why it should be important to them.
Tom Waters and Ben Abel of Bank Associates Merchant Services are the writers behind the CPP DOA piece in Green Sheet and they admit that success in mainstreaming accreditation can and has taken up to 25 years in other industries. That of course brings me full circle to MCA and business lending. The enormity of self-licensing could take years or perhaps even decades to nail down. And even if they were instituted, would the merchants care? That’s the question I ask myself.
With virtually no outcry from merchants over best practices currently, I think the dream some have of becoming a CMCAP (Certified Merchant Cash Advance Professional) will have to be put on hold. Of course you could always be proactive and become a Certified Lender Business Banker, though I predict it would do nothing to help you in this business.
The reality is that we should expect to live with the status quo at least for now. My advice is to be honest, fair, and a good example for everyone else. Do that and we’ll never have to worry.
—-
Are We in a $300 Billion Market?
August 7, 2014
Earlier today on a large group conference call with Tom Green and Mozelle Romero of LendingClub, I learned a few more details about their business loan program. In the Q&A segment, one attendee came right out and asked if they believed their competition was merchant cash advance companies and online business lenders.
According to Green, it’s not so much other companies that they feel they are up against but more of the broad challenge of market awareness. Their struggle is about getting people to know that there are non-bank options available and to make people aware of their existence.
It’s the same challenge merchant cash advance (MCA) companies have been dealing with for more than a decade. Notably though, there are many in the MCA industry that feel the market is saturated and thus a lot of the industry’s growth has been fostered through a turf war for the same merchants. Stacking (the practice of funding merchants multiple advances or loans simultaneously) is partially spurred by a belief that there are no more untapped businesses left to fund. The acquisition costs of a brand new untouched business that is both interested and qualified is so high, that it is not a pursuit some funders and brokers can afford to take on.
Market Size
At present, daily funders, which are a combination of both MCA companies and lenders that require daily payments, are funding somewhere between $3-$5 billion a year. On the call Green said he believed the potential market was far larger than that, though he discredited the $200 billion figure that some independent research had predicted. That was only because LendingClub believes the potential market is substantially higher, more like $300 billion.
$300 billion?! That’s about 100x larger than the current daily funder market combined and starkly contradicts any belief that there’s no merchants out there who haven’t already gotten funded.
LendingClub’s minimum gross sales requirement is $6,250 a month and they have an upper monthly gross threshold on applicants at $830,000 a month, though they’ve had businesses apply who do even more than that. Their sweet spot as Green put it, is the segment doing $16,000 to $416,000 gross per month.
I can’t help but notice that’s the same sweet spot that daily funders have. And we mustn’t forget, LendingClub’s target business owner has at least 660 FICO. If it’s a $300 billion market for good credit applicants, then it’s got to be even bigger for the ultra FICO-lenient companies in MCA.
What’s a business?
LendingClub only needs someone with at least 20% ownership to both apply for and guarantee the loan, an unheard of stipulation in the rest of alternative business lending. One cardinal rule in MCA has been that there needs to be at least 51% or 80% ownership signing the contract. That’s had a lot to do with the fact that most MCA agreements are not personally guaranteed and the signatory is required to have absolute authority to sell the business’s future proceeds.
Summer of Fraud
In 2013 the MCA industry experienced what many insiders dubbed the summer of fraud. Spurred by advances in technology, small businesses were applying for financing en masse while armed with pristinely produced fraudulent bank statements. Fake documents overwhelmed the industry so hard that today it is commonplace for underwriters to verify their legitimacy with the banks. This is done manually or with the help of tools such as Decision Logic or Yodlee.
Knowing this firsthand, I asked LendingClub if they also take the care to verify bank statements. In the majority of cases they do not. They rely greatly on an algorithm that detects fraudulent answers on the application but the statements themselves are not scrutinized except in very high risk situations. Considering they’re wildly less expensive than MCAs, I find it odd that they are exposed to this type of risk. Fraudulent documents are the norm and in these underwriting conditions, I would expect them to charge as much or more than MCA companies, not less.
At the same time it’s important to mention that at present, business loans on their platform are only funded by institutional investors. Retail investors can only invest in consumer loans. LendingClub has been very transparent about excluding retail investors here for the very purpose of shielding them from unevaluated and unforeseen risk. My guess is that as time goes on, they will do more to validate the bank statements which is the bread and butter of assessing the risk and health of a business.
$300 billion
In a FICO flexible environment, it’s possible the potential for daily funders is at least $300 billion. If true, that would mean that for the 16 years that MCA players have been around, they barely reached even 1% of their target audience. I’ve been saying it since I’ve started this blog 4 years ago, every business owner I’ve spoken to has never heard of a merchant cash advance… which means saturation is a myth.
Tom Green was right, the real competition is public awareness. 99% of the potential market is untapped. If you’re fighting with 5 other companies over the same merchant, you gotta:
You gotta keep on looking now
Keep on looking now
You’re looking for love
In all the wrong places
Suspicious Listing on LendingClub
August 4, 2014While perusing LendingClub’s loan platform today, I came across a highly suspicious borrower. It’s member loan #23954784 who is currently a lab assistant in Albuquerque, NM. The reason for the loan request? “Other”.
This is what I suspect behind the scenes:
Six Signs Alternative Lending is Rigged
August 3, 2014There’s a lot of players at the alternative lending table but there are two that have won a string of lucky hands to put them on top. Neither were the first to draw cards, nor do either of them offer something that everybody else does not. These two lenders have something in common of course, special favor with the Internet gods. Is the game rigged?
OnDeck Capital is the most celebrated alternative business lender of our time. Their daily repayment loans and fast approval times are a hit with customers. In fact, as told in their recent securitization prospectus, OnDeck has been eroding its reliance on brokers and third parties to accommodate growth through their direct channel. Direct has been good for OnDeck, very good.
LendingClub on the other hand is the big dog in consumer lending, having funded more than $5 billion since inception. Every month they shatter the previous record for volume of loans funded and they’re expected to go public within the next year. LendingClub continues to pound their distant rival Prosper in monthly loan production. Are they just better at marketing?
Curiously I can’t help but notice they have something in common, they’re both owned by Google. Google Ventures led OnDeck Capital’s series D round and Google Ventures’ Karim Faris sits on OnDeck’s board of directors. Similarly, Google owns a minority stake in LendingClub.
While neither is outright owned or controlled, It’d be surprising if Google didn’t do something to foster the success of their investments. What could a billion dollar Internet giant possibly do to give them a little push?
Stop backlinking and SEO. The game is rigged
If you reproduce a search for the same keywords, you should know that results vary depending on what kind of device you’re using (mobile vs. desktop), what zip code you’re in, what time of the day it is, whether or not you’re logged into Gmail/Google+/Youtube, and whether you’ve searched for related topics before. I performed my searches with a fresh desktop browser on a Sunday evening in NYC with all cookies, cache, and Google account sessions wiped clean.
You might not get exactly what I get and I realize that obfuscates the conspiracy I’m trying to establish here. If you do witness peculiar keyword domination though, keep an open mind that there might be more going on than good SEO and strong natural backlinking brought on by mainstream media publicity. Plenty of big businesses that dominate offline fail to rank well in the top ten results online.
Search engines say that if you’re popular, you’ll rank well. But there are plenty of cases where ranking well has made businesses popular.
Maybe, just maybe the game is rigged…
Yield Baby Yield
July 30, 2014
Somebody once called business loans the Cadillac of Credit products and that person is Brendan Ross, the President of Direct Lending Investments (DLI). In a newsletter he put out in September 2013, he began by saying:
Business loans are the Cadillac of credit products, with the highest yields and lowest default rates. Portfolio returns of 13-17% are the norm for successful underwriters – generally private, non-bank institutions.
He goes on to share his firm’s own investment success in these asset classes, claiming to be earning approximately 1% a month. DLI currently manages $48 million, all of which is deployed in alternative lending.
In today’s newsletter Ross admitted the goal is to “maintain unlevered, double-digit, investment returns.” With savings accounts today paying only fractions of a percent, double digits sounds too good to be true. But do you need $48 million to partake in the action?
The truth is you don’t. If you’re an ISO in the merchant cash advance industry you likely have the option to syndicate on your deals and if you’re friends with the right people you can syndicate on deals you don’t even originate.
But even then for folks who don’t have tens of thousands or hundreds of thousands at their disposal to recycle into deals, you can still strive for double digit returns through peer-to-peer lenders like LendingClub or Prosper. Through investments as small as $25 a pop you can participate in 3-5 year consumer loans that pay out monthly.
I myself opened a LendingClub account early this year to understand the experience and grew comfortable enough to begin amassing a real portfolio there. You can craft a portfolio based on your yield goals but the higher paying loans have much higher levels of default.
Investing in G-rated loans with an average annual interest rate of 25% doesn’t mean you’ll get that number or that you can even comfortably expect double digit returns. But you can try… And most do.
In fact the higher yielding loans are bought up fast and furiously every time LendingClub uploads a fresh batch to the platform. They’re added at four precise times a day: 9am, 1pm, 5pm, and 9pm EST. Savvy investors call each interval feeding time and the early bird truly gets the worm. By 9:03 a.m., hundreds of newly added loans are already fully funded and off limits to late investors looking to get the good stuff.
That doesn’t mean there is nothing to invest in if you log on an hour later, but the loans with the most desirable characteristics are nowhere to be found.
The average interest rate of my own portfolio is currently 15.72% a year before taking into account defaults. Using LendingClub’s sophisticated tools, I can compare how my portfolio is likely to play out against very similar ones on their platform (Same yield range with a minimum of 500 loans). Over the course of 30 months, it suggests that defaults will probably drop my actual yield below 10%.
I have a say in how it will actually play out. For instance if loans in Nevada and Florida are likely to default substantially more than loans in other states, then perhaps I can expect different results between a D-rated loan in Florida and one in Vermont. Using both experience as a merchant cash advance underwriter and the controversial article, The Joys of Redlining as a basis, I never make loans to consumers in Florida, Nevada, or California.
Logging into the platform between feeding times, I often notice an abundance of seemingly attractive but very available loans in those specific states.
Whether that and other aspects of my strategy allow me to prevail with consistent double digit returns is to be determined but I can’t help but contrast even a substantially worse outcome against my savings account which legitimately only pays .01% a year. Not 1% and not .1%. It actually pays .01%.
My S&P mutual funds meanwhile are up more than 6.5% this year already but stocks are far more volatile. I’d also like to add that rather than compare the performances of both and decide to choose 1 over the other, consumer lending is a great way to diversify your overall investment capital. An index fund diversifies your stock holdings but there were very few options for everyday people to invest in outside of the stock market until alternative lending came along.
I still keep some cash in the savings account, but much like Brendan Ross announced in his newsletter today, I’m going full speed ahead with buying loans. In 2014, you don’t have to have $48 million in assets to make the returns that institutional investors can. There’s yield to chase out there and anyone can grab it.
The Missing Puzzle Pieces
July 24, 2014
About 1% of my LendingClub consumer loan portfolio bounces their very first payment. It’s discouraging stuff, especially considering these loans range between 3 and 5 years. Granted, most manage to get caught back up at least for a little while.
LendingClub, like the rest of the alternative lending industry relies on ACH debits to retrieve those monthly payments. I’ve published my feelings before on single monthly debit payment systems (they’re like roulette). Out of 30 days of the month, you’re betting on the balance being available on just 1 particular day. When I noticed that 1% of my borrowers were failing right out of the gate, it validated two practices that originated in the merchant cash advance industry, daily payments and the analysis of historical cash flow.
For all the underwriting data points that LendingClub offers its investors, I don’t get to see average daily bank balance, overdraft activity, NSF data, or anything at all related to the borrower’s bank account. Ironically, many merchant cash advance companies consider that data to be the single most important piece of assessing a deal.
The problem my 1%-ers have is not a credit problem or a stable income problem, it’s a cash flow problem. You can have 750 credit and be broke. You can have a good job with a hefty salary and be broke. You and I knew this already, which is why it’s odd that LendingClub and other p2p lenders like them still rely mainly on employment data and FICO score.
What I want to know is if the borrower is broke…
That’s something that LendingClub can’t tell me and doesn’t know. Hence a good looking borrower like the one mentioned below, missed the first payment. That led to a negotiation for a reduced monthly payment. They then failed to pay even the reduced amount.
This was a very low risk B1 note. The borrower is a nurse that has worked at their current job for 5 years. They had over 700 credit and very little revolving debt, only $5,500 (compared to some on the platform that have more than 50k!). It was a 3 year loan and it has blown up in my face.
The borrower is broke and nobody knew it.
The Missing Puzzle Pieces
This borrower may very well have done better with a change in how the deal was both underwritten and structured. With daily payments:
- The borrower will know exactly how much cash they can really spend on any given day. They don’t have to worry about trying to set aside for that one big day.
And
By examining their last 3 months bank transactions:
- Their payment plan will be based on more relevant data. There are 3rd party tools like yodlee that consumers could connect their bank accounts to, so at the very least LendingClub could see what’s really going on. Why business lenders consider this essential while consumer lenders completely ignore this, I don’t understand. Business lender Kabbage for example requires applicants to connect their bank accounts in the application process before they even type in their business address. It is the single most important part of their underwriting.
Picking loans on LendingClub is like trying to complete a puzzle without half the pieces. If you guessed the puzzle on the right was an ocean scene with dolphins playing because of the pretty blue border pieces, you were wrong. It’s actually a picture of a guy on a boat holding a bank statement that shows a negative $3,000 balance and 10 NSFs.
Oops…
