Best of Both Worlds: The Composite Lending Business Model
By Sergey Vasin on 22nd February 2016
Alternative lending has become an important part of the financial landscape. Two major lending business models in this industry are marketplace and balance sheet lending, which differ mainly in the distribution of risk and the amount of return. Composite lending bridges those models and brings the benefits of marketplace lending to balance sheet loan originators.
In the world of alternative lending, two prominent lending business models are marketplace lending and balance sheet lending.
Marketplace lending for lower risk
In the marketplace lending model, lending companies sell loan portfolios to third party investors in exchange for collection of a service fee throughout the loan’s duration, and optionally an upfront origination fee. This transfers associated risk of loan default to investors, but it reduces the overall return by sacrificing interest rate spread of the portfolio. These sales bring in new capital, allowing the lending companies to originate more loans without being constrained by capital adequacy and leverage ratios.
Marketplace lending companies typically focus on long-duration loans, such as near prime unsecured consumer loans, small and medium enterprise (SME) loans, and real estate property financing. These are generally low-margin and long-duration deals, so these companies often require lengthy and substantial capital investments from VC firms to sustain operations.
Balance sheet lending for higher return
In the balance sheet lending business model, loan originators retain the portfolio and so collect the interest rate spread over the lifetime of the loans. This increases return and provides cash flow, but the lenders retain the risks of possible loan defaults.
Balance sheet lenders tend to focus on specialized lending, such as subprime short term loans, cash installments, POS loans, merchant cash advances, and factoring. Loans of this type are usually short in duration with a focus on current profitability.
Retaining the interest rate spread means the single-loan expected cash flow for these companies are generally greater than for marketplace lending firms, allowing them access to profit for business growth rather than relying on VC commitments. Nevertheless, balance sheet lenders have to meet certain covenants on capital adequacy and profitability when raising new capital to boost originations, since all risk is concentrated on their balance sheet.
Which model do investors prefer?
While balance sheet lenders may achieve a higher initial return, the marketplace lending model has proven to be more attractive for investors. Marketplace lending portfolios more readily attract mainstream investors for a variety of reasons:
Marketplace lending tends to be more transparent and the main risk investors must evaluate is that of the underlying, rather than the whole business as is the case for balance sheet lenders.
Direct loans to balance sheet lenders are risky for third-party investors and highly illiquid.
Investors are typically unfamiliar with the specialized assets in these portfolios, leading them to compare the lender with a bank and draw incorrect conclusions.
The short-term near-prime and subprime loans typically found in balance sheet lenders’ portfolios are difficult for investors to evaluate using a classical approach, while loans originated through the marketplace lending model are more easily evaluated using mainstream models.
However a bigger issue facing balance sheet lending companies is business scalability. The marketplace and balance sheet lending models both must generate capital to fund the ever-growing market demands for loans and to scale their businesses. Companies in each lending model need historical loan statistics to demonstrate proven results — a track record — to potential new institutional investors, but to create these statistics, they need initial investors. To reach this point, marketplace lenders must spend money from early investors, while balance sheet lenders may use their own equity for this purpose. Once a company collects enough statistics and attracts institutional money it will experience hockey-stick growth in originations.
Investors favour transparency and scale over high return with unknown risk. Therefore marketplace-lending firms were literally founded to acquire new investors to scale their growth. Balance sheet lenders retain their earnings, enabling the expansion into new segments and markets; however, few balance sheet lenders have scaled their operations sufficiently to raise debt through securitizations or off-balance sheets. This is mainly due to costly set-up and the lack of specialized investors.
Introducing the composite lending model
The composite lending model combines the benefits of balance sheet and marketplace lending. In this model, a portion of the portfolio is retained on the balance sheet funded by the company’s capital, while the other part is financed by outside investors on the principles of marketplace lending.
Transitioning from a balance sheet to a composite lending model is advantageous to the originator. The company enjoys the same high return on the current portfolio while collecting additional origination and servicing fees from the newly originated portfolio. Since newly originated loans are sold to the investors, the lender reduces the risk and leverage of the company as measured per origination volume. This allows for the virtually infinite scalability inherent to marketplace lending.
Composite lending gives businesses the flexibility to add new products and enter new markets using its own portfolio to expand the track record and subsequently open up this part of the portfolio for marketplace investors. By pointing to its existing balance sheet statistics as its track record of success, balance sheet lenders may present a solid case study for onboarding new investors for the marketplace lending part of the portfolio.
Another advantage of composite lending is the increased valuation multiples for the company. This is because marketplaces tend to have as much as 2.7x higher price to earnings ratios as compared to alternative balance sheet lenders, and 7.2x as compared with brick-and-mortar lenders.
However, developing a marketplace lending business requires substantial investments in IT, legal, and marketing, since it is not the core business of a balance sheet lender. Moreover investors could be concerned by the perceived conflict of interests for the originator splitting the originations between retained and for-sale potions of portfolios as well as setting the fees.
Brick-and-mortar banks use marketplace lending to set up their consumer-lending portfolio using a process called lending as a service (LaaS). Similarly, balance sheet lenders outsource the onboarding of institutional investors through the marketplace lending model to a third party using marketplace lending as a service (MPLaas).
Marketplace lending as a service
An example of such a third party is Blackmoon Financial Group, which offers a platform used by institutional investors to invest in loans originated by balance sheet lenders.
Balance sheet lenders partner with Blackmoon to scale their businesses and sell loans at the time of origination. The integration is executed via API (application programming interface) and is designed to be easy for lenders’ own IT personnel to deploy. By using the API, the entire data exchange between the originator and the investor takes less than a second, with no effect on customer experience.
To ensure the absence of conflicts of interest, each loan is priced independently and receives origination and servicing fees according to its risk and expected cash flow. This allows for the avoidance of cherry picking on behalf of investors and selection bias on behalf of originators.
Investors are provided with independent analytics of the originators, flexible loan selection criteria, and an opportunity to diversify over different geographies and currencies. All of this ensures the pure marketplace lending approach is executed based on full transparency and informed decisions.
The composite lending model brings the benefits of marketplace lending to companies operating under the balance sheet lending model. Those benefits include scalability, lower risk, and improved cash cycle while preserving high return and discretion over the retained portfolio. Balance sheet lenders are perceived as more advantageous by institutional investors, as they see not only a solid track record of originations in the portfolio, but also a transparent, skin-in-the-game approach.