Time to Align Incentives for Marketplace Lenders, Investors

After a period of rapid growth, the intense scrutiny now following marketplace lending was inevitable. But a path forward for this nascent industry to achieve long-term sustainability is clearer than you may think.

Some critics of the industry, who are almost jubilant that their initial skepticism about marketplace lending may be proven right, are questioning the sector's ability to mature and weather a sustained period of economic volatility. Others fear that potential regulatory risks threaten the industry's viability. Still others suggest that the recent dip in investor demand for marketplace loans is an indication that the model itself is broken.

Once the headlines and hysteria die down, investors will realize that Lending Club and other marketplace lenders have merely been doing what they were set up to do. They provide a market for loans. And the performance of that market is a reflection of loan supply and investor demand. Marketplace lenders don't resemble the risky lenders of the mortgage boom-and-bust period, as some commentators have suggested. The turmoil in marketplace lending is not necessarily the result of deteriorating quality in the underlying loans.

The culprit instead has been a misalignment of incentives. When a marketplace lender has more investors than borrowers, rates fall to entice more borrowers and investor returns suffer. Conversely, when a marketplace lender has too many borrowers and not enough investors, rates rise to attract more investors. This basic incentive to make a market has created yield uncertainty, something fixed-income investors inherently abhor.

Correcting this will require a realignment of the incentives between investors and lenders. High investor demand shouldn't hurt returns enough to upend the market, nor should low demand upend the loan pricing structure. Capital moving into nonbank loans is going to have to do so in a way that ensures lenders have no incentive to make bad loans and less need to move interest rates based on the supply of investor capital.

There are two primary mechanisms that investors can use to achieve incentive alignment with lenders. The first is by including a service fee rebate provision in loan purchase agreements. When investors purchase loans from nonbank lenders, they typically pay servicing fees to the lender. Including a rebate provision in these agreements ensures that if a lender's overall monthly return is below a set rate, the investor gets back some of this servicing fee. This would reduce the lender's incentive to make bad loans or artificially set a lower interest rate.

The second mechanism involves the investors providing a loan facility, such as a single-purpose vehicle, in which the lender still owns the loans. In this model, the underlying assets serve as collateral and the investor has no direct equity interest in the loan. The investor lends to the SPV at a fixed rate of return, and the lender guarantees the facility with equity and a corporate guarantee. This means the investor earns a fixed coupon. But with the lender retaining some of the credit risk, and standing in a "first loss" position, it further aligns the incentives between the two parties. This is similar to how some marketplace lending was financed early on, and is the traditional structure that banks use in asset-backed lending.

As the market moves forward, there will continue to be strong demand from borrowers for alternatives to traditional bank lending. Lenders meeting this demand will have to accept that they will be in "first risk" position on an increasingly large proportion of the loans they originate. Those that can efficiently separate bad borrowers from good borrowers, and more efficiently collect on good loans, will continue to reward with excess returns.

Whichever mechanism investors choose in order to align incentives, marketplace lenders will increasingly have to have more skin in the game, while investors should hold firm and accept that the online lending industry is changing and adapting, like any maturing industry. No matter how they are funded, they will have to accept that over the long term they will need to act less like brokers, and more like lenders.

Brendan Ross is the president and founder of Direct Lending Investments LLC, a private fund manager that invests in short-term small-business loans.