That Could Mean a Lot of Different Things

As CFA’s recent Alternative & P2P Lending and Investing Forum in New York proved, “alternative lending/fintech” is a topic on many minds today. It’s also still somewhat shrouded in mystery. Sam Graziano, CEO of Fundation, sheds some light on the topic, particularly about those investing in the space.


“Alternative Lender” is a term now applied to just about any lending-oriented business model without the word “bank” in it. The term has been applied to businesses that source borrowers and refer borrowers to lenders (also known as an “Aggregator”), businesses that originate and sell loans or loan participations (also known as “Marketplace Lenders”), and businesses that originate and hold loans for their own balance sheet (also known as “Direct Lenders”). From an investor’s standpoint, there are dramatic differences in how you can participate in this market and your investment rationale for doing so.

The Old Alternative Lending and the New Alternative Lending

For many of you reading this article, “alternative lending” is not a new term. In fact, your business may have been called an alternative lender, a term that historically was applied to asset-based lenders, factors and other commercial finance companies that originated leveraged loans, equipment loans, and short-term and long-term secured receivables financing. Many of these product categories are now addressed by specialized business units within the banks themselves.

The new alternative lenders are something else entirely. The markets they address, the way they underwrite and how they acquire customers is different. The ecosystem of aggregators, marketplace lenders and direct lenders provides small-balance credit instruments predominantly through the Web to consumers and small businesses, uses business process automation to deliver cost and time efficiencies into the lending process, and uses real-time (seconds) data aggregation and analytics to predict and price risk. Fundamentally, these business models are leveraging technology to deliver small-balance credit in markets where the banks do not. I humbly suggest a different term for these companies: “Digitally Enabled Lenders,” or DELs.

Why Is There So Much Interest in DELs?

After about eight years, two IPOs and perhaps $20 billion originated, the level of investor excitement over DELs has not dissipated. LendingClub, the world’s largest marketplace lender, launched its initial public offering in December 2014, followed shortly thereafter by OnDeck Capital, the largest short-term working-capital financing provider to small businesses. LendingClub, a business without much of a balance sheet , trades at nearly 200x its annualized “adjusted” EBITDA and more than 100x forecasted 2016 earnings. OnDeck Capital, predominantly a balance sheet lender, trades at more than 4x book value and more than 35x forecasted 2016 earnings.

Unquestionably, these valuations indicate an expectation of a high rate of growth for years to come. Justifying these growth rates requires investors to assume that DELs are technology disrupters that will disintermediate the banking industry and capture meaningful market share in the process. The investment narrative is
that regulatory pressure, heightened regulatory capital requirements, and antiquated and entrenched technology put banks at a competitive disadvantage versus DELs. There is a lot of merit to this investment rationale, as the level of regulatory supervision is impeding bank innovation and consumers are embracing what the web and mobile applications deliver throughout their lives.

The Other Side of the Coin

The largest DELs address the unsecured consumer loan, nonconforming mortgage, graduate student loan and small business loan markets, where digitally enabled processes permit the delivery of small amounts of credit to individual borrowers through the Web. It is easy to understand why DELs do not exist in larger-ticket, higher-touch lending categories like ABL commercial real estate and commercial loans. However, there are also no substantial DEL franchises in some of the largest consumer markets, such as credit cards, auto finance, conforming mortgages and government-guaranteed student debt. The national banks and other national brands still dominate these product categories.

Despite an operating expense advantage enabled by technology, the banks have a potentially insurmountable advantage in terms of cost of capital. They also have a structural advantage to the customer’s mind share as a result of the deposit relationships they have with customers. So the question remains as to whether DELs can compete head-to-head with banks for a customer. DELs, thus far, thrive where the banks cannot or will not participate.

Banks will often shy away product categories where all, or many, of the following characteristics are present:

  • Regulatory pressure or a deliberate risk management decision on the part of the banks to reduce exposure to a given product category
  • A lack of (or material deficiency of) collateral or government guarantees
  • Heightened regulatory capital requirements
  • The need to employ a risk-based pricing framework to manage risk effectively, with which many banks are uncomfortable.

Even when these market characteristics are present, many of the consumer-oriented products are dominated on a national scale by virtual oligopolies among the national banks. Take credit cards, for example: this market is dominated by 7 companies—Bank of America, JPMorgan Chase, Capital One, Citigroup, AMEX, Discover and US Bank. These are business lines with massive scale and are highly profitable. These firms will protect their trophy franchises at all costs.

Investing in Digitally Enabled Lending

To be an investor in Digitally Enabled Lending, you have to pick your product category and pick your investment strategy. Marketplace lenders offer investors, for the first time, the ability to purchase consumer and small business loans at scale, a proposition that can deliver exceptional risk-adjusted returns with low volatility across market cycles.

As an equity investor, you need to pick the business model that you believe in. Aggregators and Marketplace Lenders are capital-light, low-profit-margin businesses (profit as a percentage of dollars originated) and, therefore, require substantial scale to generate profits. But scale is the name of the game, as many believe that these businesses can grow unconstrained by access to capital.

Direct lenders, on the other hand, are capital-intensive businesses, but capture the entire revenue stream on a given credit instrument rather than outsourcing most of that to the loan buyer. These are traditional commercial finance companies in the way they make money, but nontraditional in how and what they originate and retain.

In today’s landscape of Digitally Enabled Lending, we find an interesting mixture of traditional financial-services equity investors, credit investors and technology-minded investors that have different points of view.

Ultimately, every DEL is exposed directly or indirectly to the cyclicality of the demand for, and performance of, credit. Time will tell if this is a new story altogether, or the same story in digital form.

Sam Graziano is the chief executive officer of Fundation, a New York City-based small business direct lender and solutions provider that utilizes a sophisticated software platform to streamline the lending process. Fundation launched its system to the public in May of 2013 and is now backed by a group of high-profile private equity firms and other investors. Graziano is a highly experienced financial services professional and entrepreneur. Prior to Fundation, he spent over a decade in investment banking and private equity where he developed an expertise on strategic, financial and operational issues for banks, specialty finance companies, asset managers, broker/dealers and other institutions throughout the financial services sector. At Centerview Partners, Graziano provided strategic and financial advisory services to some of the nation’s largest and most recognizable financial services companies. Prior to Centerview Partners, he spent six years with Keefe, Bruyette & Woods, the nation’s largest boutique investment bank focused on the financial services sector, where he executed dozens of mergers and corporate finance transactions and then co-founded the firm’s private equity practice. Graziano graduated from Bucknell University with honors with a degree in Computer Science & Engineering.