Some Online Lenders Unprepared for Credit Downturn, Investor Warns

Few people have spent as much time studying the marketplace lending business as Frank Rotman.

Rotman is a venture capitalist whose firm's investments include several leading names in the burgeoning sector, such as Social Finance, Prosper Marketplace, Orchard Platform and Avant.

He is also a blogger at fintechjunkie.com, and in 2015 he wrote two lengthy white papers on the rise of alternative lending. The second of those papers, published in October, focuses on the competition among online lenders and banks for small-business borrowers.

Rotman predicts that the swelling ranks of online small-business lenders will thin as a handful of firms establish dominance.

"You're starting to see a diaspora of 10 or 12 interesting players out there," Rotman said in a recent interview, "and I think time will tell which models end up emerging as superior models with superior management teams, and attract capital."

Rotman and the two other founding partners of his venture-capital firm, QED Investors, are all former executives at Capital One Financial.

He spoke to American Banker about the impact a turn in the credit environment would have on online lenders, the competition between banks and nonbanks for small-business loans, and whether the arrival of equity crowdfunding will influence loan demand. Here is an edited and condensed transcript:

Do you think that some of these online lending platforms are set up for a fall when the credit environment changes?

Credit policy for unsecured loan products is about certain fundamentals at the customer level — ability to pay, stability of income and willingness to pay. And in the case of online lending, it's also about proving the applicant is who they say they are. And I have to admit that some of the credit policies that I've seen that have been created by the more advanced and sophisticated next-gen platforms are quite good.

But I do have worries. I see hundreds of new platforms every year, and some of them are lacking individuals with credit expertise.

They say they want to hire credit policy experts into their companies, but some of them decide to hire data scientists instead of trained credit professionals. And some of the data scientists look at the data as data and don't understand that credit policy and data are not the same thing.

There is real danger if these data scientists optimize their credit policies using only the performance data that they have, which has been generated in a very benign credit environment. None of the performance in recent years reflects what will happen if the economy changes for the worse.

You indicated in the white paper that you see the opportunity for disrupters in small-business lending as being somewhat smaller than it's sometimes touted as being. Can you talk about why that is?

To be clear, the opportunity is large, but if you dig in and talk to small-business owners, you realize that many small businesses aren't just smaller versions of corporations. Their goals aren't to build themselves into the biggest businesses they can. So if a good number of the businesses are happy just being well-managed lifestyle businesses that throw off cash for their founders, there isn't as much need for financing as one would think, because financing needs correlate with growth.

And a lot of the innovators in this space look at the total number of small businesses that are out in the U.S. and use this as their basis for how big the market is. There's still a big opportunity, just not as big as what some of the players are stating.

Do you see the pullback in bank small-business lending over the last eight years or so as being likely to be a permanent shift, a temporary one, or partly cyclical but also partly structural?

Almost everything in the banking world comes in cycles. There are times when banks are interested in low-risk, low-yield assets. And then they wake up one day and say 'I need yield.'

They're pulling back on small business right now for a variety of reasons, but over time some of the banks are going to wake up and see small-business lending as a growth and yield opportunity.

What are some of the key advantages that banks have, and what are some of the key advantages that the online platforms have in small-business lending?

The banks' advantages are really clear. They have a cost of funds advantage that no one is ever going to beat. They basically have free money. 

The second thing they have is a data asset that's really, really valuable. They have near-complete information on money going in and money coming out of a small business's bank account, which is data that a lot of the other lenders would die to get their hands on. The third advantage is a large number of existing customers that they can tap into who are already onboarded into their systems.

The innovators in this space have very different advantages, which is important because they're highly disadvantaged on all of the advantages the banks have. 

The innovators are focused on making loans versus developing a broader banking relationship. They have speed. They have talent. They have energy. They have the ability to customize products. And it's very important to internalize that they have a significant user-experience advantage in terms of the application process and the servicing of their customers. They have more modern technology and can speak to the customer in ways and through channels that the banks can't. 

The banks have legacy architecture and are very slow to change, which makes it difficult to capitalize on all the advantages they have.

Do you think we're going to see banks becoming more interested in making smaller-dollar small-business loans than they have in the past? Presumably they can take advantage of some of the same technology that marketplace lenders and balance-sheet lenders online have pioneered.

There's definitely the potential for banks to take advantage of emerging technology, but it hasn't been actualized yet. 

I won't name names, but I was talking to the head of small-business lending at a top-10 bank and he said, 'We're lending more and more to small businesses than we ever have.' I asked, 'What's a small business?' They said, 'Oh, under 100 employees and under $150 million in revenue.' I asked, 'What about the small business that's doing $1-$2 million of revenue and has three to five employees?' They said, 'Oh, that's a microbusiness. We don't lend to them.'

In the banks, many of their small-business lending policies come from a commercial lending mind-set. In order to understand the health of a business from a commercial lending mind-set, it needs to be producing significant revenue. A loan officer will attempt to prove that the small business has zero risk, and if he can't do this, he can't approve the loan.

You probably saw that the Securities and Exchange Commission approved final regulations for equity crowdfunding. Do you think that is going to have any significant impact on the demand for small-business credit, as it becomes more established, or is it likely to be pretty small, or for different use cases?

Yeah, there are different use cases. Fundamentally there are certain businesses that need equity and other businesses that have strong enough profiles that they can support debt.

A lot of the businesses that are being rejected by their bank for a loan really need equity. If a business doesn't have a strategy for repaying the loan because it's for unproven growth or startup activities, the business typically needs equity. So I think what equity crowdfunding does is make equity more available to businesses that aren't ready for debt.