Is Bigger Better? Historically, big banks were the only lenders to consumers, small businesses and big business. However, over the years, big banks have re-focused their efforts on large loans. That’s created a gap, or perhaps a giant hole, in the lending markets for both consumers and small businesses seeking to access capital at acceptable rates and terms.
Curiously, investors are searching for acceptable yield or income with an acceptable risk. So, on one side, we have creditworthy borrowers seeking loans with acceptable terms. On the other side, we have investors seeking yield at acceptable risks. Today, getting borrowers and lenders together without a middleman has proven to be better for both sides. We’ve seen this direct matching occur in many industries in the past years. In fact, Bill Gates remarked decades ago, “Banking is essential, banks are not”.
Well, in the world of innovation and a quest for simply a better solution, a broad range of non-bank lenders have emerged over the past 10 years. Lending is a really an old practice, dating back to 2000 B.C., where the lending of grains was used in ancient Babylon. In more recent times, banks had a monopoly on lending, but with a brick and mortar business and intense human needs for small single loan underwriting, they gracefully exited. The lending hole left by banks with a demand from credit worthy consumers is now being filled. Loans to credit worthy consumers, small business operators and medium-size enterprises can provide investors with higher returns and surprisingly low risk. With no brick and mortar, using smart underwriting guidelines and scaled with technology, a new asset class has emerged right under most investors noses.
So lending is not new, it’s just new to most investors.
From Abnormal to Normal – Alternative Lending. “Aha”! There it is. Let me introduce you to the world of alternative lending. It has moved from obscurity to conventionality. In this new world of private lending, a mind bogglingly large asset class, bigger was not better, and lean businesses with remarkable technology have replaced brick and mortar banks with astounding advantages. How is alternative lending distinguished from traditional Banks? Here are a few of the characteristics:
- They do not accept deposits
- They act as intermediaries, pooling loans
- They provide a conduit between investors and borrowers
- They enjoy a substantial cost savings
- They usually specialize in a particular niche
The appeal to this asset class is not just one opinion, but the opinion of those large analyst firms that have either made investments in the space already or are now watching this space with frothing mouths. In reality, investors seek yield, but they have not been able to find it. Morgan Stanley recently corroborated this viewpoint in its research notes citing examples such as:
- Hard asset lending, whereby lock boxes, intense cash controls and tough covenants protect the lender yet can provide growth capital to smaller companies.
- Loans backed by government-sponsored programs can create a state or federal government receivable with small credit risk yet attractive returns.
- Lending to high-growth companies with lower nominal yields but with an added return “kicker” from equity participation (warrants, restricted stock, options, or convertible notes) is another venue.
- Marketplace lending platforms offer even smaller loans, almost on a self-serve basis, providing widespread geographic and industry diversification.
So, over the past 10 years, emerging non-bank lenders include Lending Club, Prosper, Funding Circle, SoFi and a hundred more are all getting a piece of this really big pie. For perspective, the Federal Reserve tracks consumer debt, and it is currently at roughly $3 trillion. Right now, the private lenders represent under 2% of that, and gaining market share exponentially. Who else believes in small loans? Goldman Sachs. In October 2016, they launched an online consumer finance division named “Marcus” to offer loans up to $30,000 to qualified borrowers. Yes, Goldman Sachs, but that’s for their own capital. SunTrust Bank has an online loan generation business named LightStream that allows individuals to apply for almost any type of loan you can imagine. That is also for their own capital. So how do you get in?
Investors go where banks are not
Consumer and small business loans had previously been monopolized by banks and institutions, but now, there are access points to let certain investors participate. There are both private and public investments for different types of investors. However, in each private lending investment opportunity, understanding the credit providers, undertaking due diligence, and managing any allocation to the asset classes takes time, energy and expertise. This challenge further enhances the opportunity. Excluding large investors of a billion dollars or more, participation in consumer, small business, merchant advance and other niche areas further diversifies the risks of nearly any lending investment portfolio. Right now, with unusually low excepted returns from so many asset classes, the risk adjusted return for private lending is compelling. You just need to know how to get there.
Slow and steady wins the race
So you know, I do have a prejudice; steady returns without large drawdowns. If you were an investor in 2008, excluding new contributions, most investors only broke even from their losses in 2015 or 2016. Ouch! That’s 7 or 8 years to recover from a single year loss, and devastating to compound investment returns. The various opportunities we have uncovered for investors in private lending continue to be very appealing. To capture the beauty of compounding returns, a primary focus needs to be on maintaining a healthy portfolio without those drawdowns, and the alternative lending space is an important component to achieve predictable results and achieve goals. Our Quixotic quest of a short term, high quality, high yielding investment with reasonable liquidity has resulted in a relentless pursuit of compelling alternative lending ideas. I welcome you to join us in this pursuit.
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