What is the best capital markets strategy for an online lending originator? Some companies argue that the balance sheet model is ideal because your business deploys its own money (aka, it has “skin in the game”) and therefore is less likely to originate borderline borrowers. Others argue that the marketplace model is ideal since you can build a lightweight and highly scalable technology company. I believe that the best capital markets strategy is the hybrid model and I recommend that all new startups follow this capital markets blueprint. The hybrid model combines the best of the balance sheet business with the best of the marketplace business. At the end of the day your goal should be to maximize the diversity of your funding sources so when the next liquidity crunch hits you will be somewhat insulated. The hybrid model helps you achieve that goal.
Start with the Balance Sheet Model
Balance Sheet: It is called the balance sheet model because the originator uses its own balance sheet to fund loans. This model has been around for many years, well before technology began influencing the category. These models operated under the name “specialty finance” companies or “non-bank lenders.” Since they apply their own balance sheet, their goal is to lend at a high rate and borrow at a low rate to capture the maximum spread. As a result, the spread drives revenue. OnDeck was the first “fintech” balance sheet lender. They embraced the use of technology to find efficiencies in their lending operations and they re-thought the underwriting process using big data and machine learning algorithms. While a traditional specialty finance company was viewed as a low margin, low growth, low multiple business, Wall Street priced this first fintech balance sheet lender at a much higher multiple. For instance, OnDeck’s current Enterprise Value-Revenues multiple for ‘17 is about 5x whereas American Express trades closer to 2.6x and Ally Financial is more like 1.8x. OnDeck is a good example of a company that started as a balance sheet lender and is transitioning to a hybrid model (more about that later).
Here is the process for rolling out a balance sheet model:
VC: Have you ever noticed that the VC rounds for online lending startups are some of the largest in all of VC? It is common to see $25, $50, $75, or even $100+ million equity rounds in Series A, B, and C. This is because these businesses have a capital markets strategy that starts by using VC money to fund loans. From the VC’s perspective, this sounds crazy since VCs are expected to take high risk in exchange for a high return. For an early stage company, the VC likely has an IRR return target of about 30%+ and they will never achieve their target if they have to invest in 12% yielding loans unlevered. However, they know that someone needs to lend the first money. They know that if they can get the fly wheel churning there will be new money (aka, Transitional Capital) that follows their money. They also know that their equity can eventually be levered if the company can manufacture new cash into the company. The VCs allow the management teams to use maybe 60% of their VC commitment to fund loans for a year or two but then the company needs to reinvest that VC lending capital in a more traditional way (hire new staff, invest in additional technology, acquire new borrowers, etc). As a result, the VC’s round is almost like two rounds combined into one, the original 40% not used for lending capital that was originally applied as working capital, and the follow-on 60% that is recycled into working capital after its use as lending capital. In order to convince a VC that this is a smart investment, your company better have a transitional capital provider warmed up before the the VC money is committed. [Read more…]