By Morgan Edwards, CommonBond CFO
Over the past several years, a transformation has taken place in marketplace lending. Although certain originators continue to match borrowers with investors in a peer-to-peer "marketplace," individual investors have seen their market share decline as the market grows and institutional investors take center stage.
Last year, marketplace lenders originated $8.8 billion in loans, according to American Banker. For 2015, Morgan Stanley forecasts volumes of $15 billion and Foundation Capital predicts the industry could reach $1 trillion in lending volume by 2025. While consumer demand is driving this juggernaut, investor capital is fueling it. Eighty-five percent of institutional investors have expressed an interest in making some form of marketplace lending investment, according to recent survey published by Wharton FinTech and law firm Richard Kibbe & Orbe.
So why has institutional demand for marketplace lending grown?
We've identified five reasons:
- A favorable interest rate and business climate has provided a benign default environment, giving confidence to an expanding investor set.
- Low return expectations for both the high yield and equity markets have forced fund managers to seek alternate investment opportunities.
- The quantity and quality of historical loan performance information coming out of rating agencies, the federal government, Lending Club and other sources have provided a wealth of data. Rating agencies and Wall Street underwriters have been at the forefront of harnessing this data, developing intricate models to stress marketplace portfolios ahead of the next downturn.
- Technology has enabled lenders and investors to carefully analyze data, overlay expected defaults, legally document their loans and make viable credit decisions.
- A host of very smart people have flocked to the sector, abandoning more traditional banking, finance and consulting jobs to build an exciting new industry.
Capital structures continue to evolve and multiply as marketplace lending continues to mature. Industry-leading platforms Lending Club and OnDeck are now public companies. Traditional financial firms, including Goldman Sachs, a firm that has been absent from the consumer-facing lending arena throughout its 146-year history, are mobilizing to enter the industry. KKR and Apollo, to name a few, struck sizable deals earlier this year with Lending Club and Avant respectively. A number of fund managers are expected to launch '40 Act funds as early as January 2016.
How underwriting has changed
As expected, equity and debt capital has flowed in to support the volume growth on the rising strength of a number of platforms. What is not as widely recognized is that more credit is generally available to just about every borrower across the full credit spectrum. Furthermore, just about all borrowers, prime and sub-prime, receive a lower interest rate than in days past.
Fifteen years ago, lending officers went through 6 months of credit training. They memorized the 5-C's of credit -- Character, Capacity, Capital, Collateral and Conditions -- and applied this training to vastly inferior quantitative and qualitative data than what we have today. The substantial time and effort required to evaluate each loan decision had to get passed along to the borrower, or "paid", through a higher interest rate. In addition, the probability for error was greater and therefore the risk premium charged on loans was necessarily higher. Although the human element is still critical, the speed and breadth of technology has the power to model vast quantities of data across multiple scenarios, reducing processing speed and some of the uncertainty around expected losses. Today's borrowers benefit from receiving lower rates, while investors benefit from having lower expected volatility in their return profile.
Clearly, underwriting models have yet to be tested by adverse market conditions. We know from experience that as unemployment rises and wages fall, consumer defaults rise. Although the timing of the next cycle is in doubt, history is known to repeat itself, and marketplace lending will be no exception. Platforms that operate at the lower end of the credit range will see much more dramatic shifts in adverse credit performance. At CommonBond, we expect that our credit performance will experience some deterioration through the cycle. But based on our current record of zero defaults and zero 30+ day delinquencies and the ultra-prime quality of our borrowers, the underlying stability of returns is what has attracted investors to our platform.
All said, it's still early days for marketplace lending. Only twenty-nine percent of the institutional investors surveyed by Wharton FinTech and Richard Kibbe & Orbe currently have capital allocated to marketplace lending, yet more than sixty percent of those investors expect returns from marketplace lending to outperform those for corporate credit of similar quality. This dichotomy suggests that there is plenty of capital to fund this expected trillion-dollar market.
For investors, marketplace lending is a risk-return decision. The beauty of this industry is that it now offers investment opportunities for just about every risk appetite. Investors can match the level of return they want with the level of risk they can tolerate. The marketplace model allows borrowers and investors to find each other rapidly and in significant size. At CommonBond, we have developed relationships with financing partners that value our predictable, low-risk return profile. We have obtained committed warehouse lines with staggered maturities from leading financial players, bolstered by committed forward flow agreements from alternate providers. This diversified funding base ensures that we have committed capital to fund our growth regardless of the condition of the capital markets. In June, CommonBond completed its first securitization of $100 million in student loans, receiving investment-grade ratings from Moody's and DBRS.
Regulation on the horizon
Despite the enormous growth, marketplace lending is not the Wild West. An impressive level of care, diligence and back-testing goes into developing each underwriting model. Senior-level executives at every marketplace lender are in active dialogue with regulators. All market participants want an orderly marketplace to develop as we embrace the oversight and accountability necessary to safeguard the consumer. Over the summer, the U.S. Department of Treasury requested information on marketplace lending, asking the community of marketplace lenders, borrowers and investors what the federal government could do to foster innovation. That's a sign of a maturing industry.
So what about retail investors?
With the surge in institutional capital flows, will the individual investor be left behind? Definitely not. A number of managers have plans to launch '40 Act funds in the first half of next year. These funds have expressed plans to purchase a foundation of very stable student loans mixed in with some higher risk business loans and a broad range of personal loans. The goal is to offer investors access to a diversified mix of marketplace loans that they could not replicate on their own. Targeted returns are in the high single digits unlevered; perhaps higher in good times with the idea that in the next downturn, diversification will ensure that yields remain positive despite rising defaults on the riskier end of the portfolio. Buy-ins will be in the $10,000-$25,000 range. Expect to see this and other retail products proliferate over the next 10 years.
Back to the future
In the late 80s, banks had an +80 percent market share of the commercial lending space. Transactions rated below BB+ could only be funded through equity or perhaps mezzanine debt from insurance companies. Back then, default data was not published or shared and therefore it was not well understood. Over the next decade, M&A activity took off. Banks, rating agencies and others collected and published data which showed that you could correctly price all risk, even low rated CCC risk, and capital flowed. Private equity flourished. The CLO was created. High yield bonds and leveraged loans became massive industries. Hedge funds and credit funds proliferated. Each of these sectors became trillion dollar industries, employing tens of thousands. Today, commercial banks have less than a 20 percent share of the sub-investment grade debt market. What is typically overlooked, however, is that actual dollars lent by banks is higher now than in 1990. The market has grown that much.
I cannot predict the exact size of marketplace lending loan balances in 2025. But I will guarantee that over the next 25 years, our industry will experience massive growth. Capital inflows will be sizable. We will witness the continued creation of new products, many of which are not yet on the drawing board. Securitization markets will deepen. Innovation will come from the need to satisfy retail demand and will also be driven by smart and clever underwriters and institutional investors seeking to grow the market. The end result of all of this growth and innovation will be that the individual consumer will have better access to credit than ever before and at the most favorable rates they have ever seen.
Morgan Edwards has more than 25 years of experience across financial services at companies including Morgan Stanley and Bank of America. Prior to CommonBond, he spent seven years as a managing director at Macquarie Capital, playing a key role in the firm's rise to becoming a leader in leveraged loan debt underwritings.