Innovation of the Year: Online Marketplace Lending

When gold was discovered on the remote Klondike River in northwest Canada in 1897, people got excited. "STACKS OF YELLOW METAL!" one newspaper headline screamed.

An estimated 70,000 prospectors headed to the Yukon territory. Along the way, tens of thousands of them stopped in Seattle, the nearest city of much note, to buy the gear they would need. The city's population surged, as merchants popped up to sell tents, warm clothing and stores of food.

Pardon the well-worn metaphor, but 2014 was a Gold Rush year for online marketplace lending.

The sector's undisputed leader, Lending Club, more than doubled its quarterly loan volume on its way to a lucrative initial public offering. A flood of new capital from hedge funds and other institutional investors entered the market. Bankers sat up and took notice. New asset classes — including small-business loans, real estate loans, and even loans for the purchase of solar panels — were pioneered. An ecosystem of ancillary firms matured. By December, roughly 100 different online platforms were operating in the U.S., according to one estimate.

As a result of the industry's rapid growth and evolution, American Banker has named marketplace lending its Innovation of the Year.

Here's one sign of dizzying change in this industry: American Banker's editorial staff recently had an internal debate over what moniker to use to describe it. Until recently, "peer-to-peer lending" was the preferred term for the business activity of companies like Lending Club and Prosper.

Then, after individual investors in the loans began to be elbowed out by hedge funds and other institutional investors, the industry rebranded under the "marketplace lending" name. There's also the "alternative lending" label, which is often used to describe nonbank balance-sheet lenders, such as OnDeck, that rely on Web-based loan origination platforms.

In the end, we decided that "marketplace lending" best describes the many fast-growing firms using technology to build online platforms that stand between borrowers and lenders. Fortunately, unlike the investing public, we're not required to make a judgment about how big marketplace lending will eventually become.

Today, there's certainly no shortage of excitement or hype.

Lending Club's share price shot up by 56% on the first day of trading in December, resulting in a market capitalization roughly equal to those of midsized banks like Huntington Bancshares and Comerica Inc.

The sheer variety of investors piling into marketplace lending speaks to the perceived size of the opportunity. An estimated 80% of the industry's loan originations are now going to institutional buyers.

The massive asset manager BlackRock may be the company that's currently most heavily invested in marketplace lending. But the spectrum of participants also includes hedge funds, business development companies, banks and, soon, life insurance companies, according to advisers. It's a far cry from the days when the online marketplaces were geared primarily toward individual investors.

Former Pimco CEO Mohamed El-Erian was the most recent high-profile investor to formally enter marketplace lending. He took a $12 million equity stake in online platform Payoff, which is setting up an infrastructure to originate its own loans. Another famous investor, the billionaire George Soros, is also preparing to back the industry, American Banker reported in November.

A recent report by a California venture capital firm predicted that marketplace lenders will originate $1 trillion of loans annually by 2025. That'd be more than a 100-fold increase from the estimated $8.8 billion in marketplace loans made this year.

"For the first time in banking, the online marketplace makes it possible for a third party to match idle supply and demand," argues the report, written by Foundation Capital, which has investments in both Lending Club and OnDeck. "As a result, lenders and borrowers can now find one another and agree to terms — all without the involvement of retail banks or credit card companies."

But there are reasons to be cautious, at least for now, about starry-eyed predictionsfrom the industry's boosters. Among the concerns are interest rate risks, the patience of investors, the ability of the loans to weather the next economic downturn and possible competitive threats from traditional banks as well as more established technology companies.

In this article, we profile some of the players — a mix of startups and more established firms — that are emblematic of the new industry and its underlying technological and social infrastructures. And we offer an outlook on the challenges ahead that could add up to marketplace lending's first wakeup call — or worse.

The Pacesetter

Lending Club, which launched its website in 2007 and started growing rapidly in the wake of the Great Recession, maintained its sharp upward trajectory this year.

In March, the San Francisco-based company extended past its roots in consumer lending and started originating small-business loans. In April, Lending Club paid $140 million in cash and stock to buy Springstone Financial, which offers private student loans and financing for elective medical procedures. In the second quarter, Lending Club topped $1 billion in quarterly loan originations for the first time.

In December, the company became the first marketplace lender to sell stock to the public. And on the first day of trading, its stock price popped.

"The Lending Club IPO, I think, was just a manifestation for so many people of the fact that marketplace lending's time has come," said David Klein, the CEO of CommonBond, a marketplace lender that specializes in student loans. He noted that the company is valued at more than $8 billion, and added: "I think what's behind all of that is the promise of making finance better."

That's a bold claim, but it fits with Lending Club's big ambitions. In a document filed with the Securities and Exchange Commission prior to its IPO, Lending Club fired a rhetorical shot across the bow of U.S. banks. "Due to its high fixed cost of underwriting and servicing," the document states, "the traditional banking system is ill-suited to meet personal and small business demand for small balance loans."

Despite that adversarial rhetoric, and the fact that Lending Club competes with certain banks for loans, the company also collaborates closely with numerous banks. Santander Consumer USA has an agreement to buy up to 25% of Lending Club's total originations. Union Bank also has an agreement that allows it to buy the firm's loans. And Lending Club's equity backers include a venture capital fund that counts Wells Fargo as its primary investor.

Lending Club's regulatory filing continues: "We are the world's largest online marketplace connecting borrowers and investors. Our technology platform supports this innovative marketplace model to efficiently connect the supply and demand of capital. Our marketplace also substantially reduces the need for physical infrastructure and improves convenience and automation, increasing efficiency, reducing manual processes and improving the overall borrower and investor experience."

Some of this is necessary bravado. The company's regulatory filing, while a legal necessity, functions as a sales document for potential investors. But the document also speaks to the fundamental promise of marketplace lending: no branches, computers that underwrite loans in a much more cost-effective way than human beings, and an efficient method of bringing borrowers and lenders together.

For now, Lending Club needs to sell itself based more on its future potential than on a history of proven performance. The company turned a $7.3 million profit in 2013, but fell back into the red in the first half of this year.

"From an outside perspective, it looks like the company got to break even last year and then decided this year that it was more important to grow rapidly than to make money today," Brian Foran, an analyst at Autonomous, wrote in a research note.

Before its recent IPO, Lending Club was expanding at literally an exponential rate. It will rely on the proceeds of its recent stock offering to continue that growth trend. Given the company's rich valuation, that's clearly what its investors are on counting on.

A Facilitator

The world of marketplace lending is still a small one. Most people know each other, or at least recognize faces that are familiar from the industry's regular conferences.

In this circle, the Orchard Platform team is the cool-yet-approachable group of kids that everyone wants to be friends with. They're younger than your average company co-founder, but they're seen as leaders within the industry. At a recent conference, when asked in private conversation of their opinion of Orchard, nearly everyone responded with glowing praise, but for one. Everyone seems to think they're great, the dissenter noted, before acknowledging that he's actually not sure what Orchard does.

That raises a good question. What exactly does Orchard do?

New York-based Orchard, which was founded last year, can best be described as a marketplace of marketplaces, a matchmaker for prospective investors and platforms, and a company that seeks to provide the tech infrastructure possible for such partnerships. Orchard has also become a lead evangelizer for the nascent industry, compiling alternative finance's first U.S. index, hosting near-monthly meetups in New York, and running a blog that profiles online marketplace lenders.

Orchard's business model comes from a confluence of perspectives that embody the synthesis of 21^st Century tech culture and centuries-old lending practices. Matt Burton, Orchard's chief executive and public face, worked for Internet startups prior to Orchard. Angela Ceresnie, the firm's chief financial officer, and fellow co-founder David Snitkof come from more traditional financial backgrounds; each previously worked as a credit risk analyst at both American Express and Citigroup.

Burton and Ceresnie were both investors in Lending Club loans when they met in 2012. "One thing was apparent: she was really good at building risk models," Burton said. "Her return levels with Lending Club were much higher than mine." As the two kept talking, they saw a chance to exploit what they saw as chronic underinvestment in technology by legacy financial institutions.

"It became clear that the systems banks use at the end of the day go back to mainframes and back to some really old programming languages," Burton said. "Over time you get to these systems where, it's a spaghetti system, where nothing talks to each other."

"That's why Lending Club was growing so fast. They were this new model that got to start from scratch and had none of this legacy technology, so they were reimagining how all of this should work."

Lenders have long relied on data, credit scores being one obvious example. But marketplace lenders are using data in novel ways — Burton gave the example of an online bike company providing UPS receipts so that a prospective lender could model the firm's earnings.

Like its founders, Orchard's investors represent a mix of folks from the tech sphere and the banking world. In the former camp are PayPal co-founder Max Levchin and Santo Politi, a partner at tech venture investor Spark Capital. In the latter group are former Citigroup CEO Vikram Pandit, former Morgan Stanley CEO John Mack and Hans Morris, a onetime president of Visa.

Orchard has ambitious expansion plans. The company plans to use part of a recent $12 million investment from early-stage venture investors to expand into Europe next year. Continental Europe is seen as a fertile area for growth, because marketplace lending has yet to take off there on the same scale that it has in the U.S. and the United Kingdom. By placing itself at the center of the marketplace lending sector, Orchard hopes to ride the wave of industrywide growth, no matter which platforms ultimately prevail.

Crossover Plays

It's not just new online marketplaces that are seeing an opportunity to elbow their way into the traditional role of banks. PayPal and Square, both of which began as payment companies, have begun to capitalize on the rich transaction data they collect from their customers in order to move into the lending business.

Square launched Square Capital in the spring of 2014. The program offers business financing to merchants who already use Square to process their transactions. About 15,000 sellers have accepted Square Capital offers, with aggregate volume of about $1 billion, according to the company.

"We're in a unique position because we have a holistic understanding of how a business works," said Faryl Ury, a Square spokesperson. "We understand how a business is growing and we see their payments in real time. As such we can reach out to businesses and offer them capital and they can get it the next business day."

Borrowers most often use the funds for inventory, marketing, equipment, remodeling, working capital and expansion, according to Square. The highest demand comes from food, retail, repair services and taxi companies.

Merchants pay back the money they have borrowed through the sales that Square is processing for them. Payback time varies, but is usually about 10 months. San Francisco-based Square says it is encouraged by the early results and plans to use an investment from Victory Park Capital to accelerate the program in the next year.

Square's program is similar to PayPal Working Capital, which came out of pilot in March, and also relies on the merchant's sales as a source of funds to pay back the credit.

As of July, the PayPal program had funded more than $200 million in loans to more than 20,000 businesses. The San Jose, Calif.-based firm has also increased the maximum loan amount to $60,000, from an earlier cap of $20,000. By November, about half of the borrowers were using the funds to prepare for holiday spikes, including bolstering inventory and hiring staff.

PayPal said the program appeals to merchants as an alternative to the "painstakingly slow" process of securing a bank loan, which typically involves providing personal tax information, bank statements, personal and business reports. PayPal underwrites its loans in a few minutes based on the transaction data it already has from sellers, the company said.

"Companies like Square and PayPal have more information about the trends for these businesses, and have access to that in real time," said Michael Misasi, an analyst with Mercator Advisory Group, adding a bank would have less of a view into the merchant's operational history. "A bank may be uncomfortable making these types of loans."

Downers for the Rush?

The industry's rapid development is unquestionably exciting for those inside marketplace lending, as well as consumer borrowers saddled with high-cost debt, small-business owners who feel cheated by the traditional system, and observers who just enjoy cheering disruptors of the establishment.

But memories of the financial crisis that began five years ago are fresh, and the cautionary tales of the tech bubble of the late '90s have not completely faded. Those experiences prompt skeptical questions about the durability of the institutional funding, the quality of the credits and the threat posed by the sleeping giants on Wall Street.

Fueling the phenomenal growth of marketplace lending are institutional investors, which have seized the opportunity to earn relatively high returns from the debt-consolidation loans that Lending Club and Prosper offer to U.S. consumers.

It is unclear whether those same investors will remain onboard when interest rates rise, and returns in other asset classes start to grow.

"Is it still as attractive a place to put your money as it is today? I think the jury's still out on that," said Michael Brown, a general partner at Battery Ventures, which invests in financial technology firms.

"Some of the investor base is not known for its long-term interest through interest-rate cycles," added Eric Rapp, a senior vice president at the rating firm DBRS.

What's more, marketplace lenders don't yet have a track record across an entire credit cycle, which has given some observers pause.

They note that large marketplace lenders like Lending Club and Prosper earn the vast majority of their revenue from what are essentially origination fees. So unless the companies diversify their sources of revenue, they'll need to continue to churn out new loans. That could put pressure on the platforms to move further down the credit spectrum.

Marketplace lenders also face a dilemma over whether to invest in the loans originated on their platforms. Lending Club and Prosper have chosen not to do so, opening themselves to the criticism that their platforms bear a resemblance to the originate-to-distribute model of the subprime mortgage era, when originators had no incentive to produce good-quality loans.

But when other firms, including the small-business loan marketplace Dealstruck, have retained some of the loans on their balance sheets, they've attracted scrutiny over whether they plan to cherry-pick the best loans.

And then there are pesky questions about when marketplace lenders will become profitable, and whether future scrutiny by regulators will eventually change the economics of the business.

At the same time, banks are increasingly visible participants in marketplace lending. Time will tell whether they prove to be friendlies or hostiles.

A handful of banks, including Capital One Financial, have taken second-lien positions to lever funding lines to prop up the industry. Other banks involved are also now said to include CapitalSource, Citigroup, Credit Suisse and Deutsche Bank. CapitalSource is offering lenders revolving and term note credit facilities from $5 million-$100 million, officials there are telling potential partners.

The largest banks are extracting special deals, even if they are not directly invested in marketplace-lending asset purchases. Morgan Stanley's wealth management business, for example, has worked out an agreement with Lending Club to offer those clients direct access to the firm's loans, a person with direct knowledge said.

For banks, the next step may be to buy entire origination platforms to reduce the competitive landscape.

"Banks are taking a very close look," said Sam Hodges, the U.S. managing director of the small-business lender Funding Circle. "I think they will partner or they will buy."

One of the industry's high-profile backers, the former Citi chief Pandit, acknowledges that marketplace lending faces big tests ahead.

"These platforms will have a role to play," says Pandit, whose investments include a stake in CommonBond, before adding: "As to how big or small will depend on the kind of trust they develop over time, through cycles and stresses and strains, and through learning."

In other words, it's probably too early to say how many stacks of yellow metal are up for grabs.

Matt Scully contributed to this article.