I had a front row seat for the birth of peer-to-peer lending. In 2005 Omidyar Network invested in Prosper, arguably the first peer-to-peer lending platform. I didn’t work on the deal myself, so I don’t have any scuttlebutt on those early days, but I liked the founding team, I liked the concept and I’ve followed the field with interest ever since. In honor of the upcoming tenth anniversary of peer to peer lending companies (well, actually ninth, Prosper itself launched in early 2006, but that doesn't have the same ring to it.) I thought I would offer a few thoughts on what happened and why it might be time for those of us in impact investing to take another look at peer-to-peer lending.
I apologize ahead of time for the length of this ahead of time. It promises to be a rambler.
The pioneers of peer-to-peer lending were trying to completely disrupt the business of personal and small business credit. The (mostly correct) perception was that banks were incredibly conservative and rules-bound for whom they would extend credit to. Credit card companies and payday lenders would extend credit to almost anyone, but with high interest rates and confusing fee structures, it was rarely a good deal for borrowers. Finally, individual investors still smarting from the first dot com crash were looking for a reasonable, human-scale place to park their money. Enter peer to peer lending platforms like prosper. A borrower - a small business owner looking to expand, or a person with less than perfect credit starting to chip away at their credit card debt - would submit their request to the site. This would include not just standard financial information, but also their personal story. Why did they need the money? How would this change their current situation? They’d even upload a photo. This extra detail was important because on the other side of the platform would be an army of individual lenders, reading stories and contributing to loans a few hundred dollars at a time, not just because they were making a return on the investment but also because they felt a human connection to the people to whom they were lending.
This extra detail was important because the final piece of the model was a reverse dutch auction - lenders chose who they wanted to lend to and the rate at which they wanted to lend, so if a borrower had enough interested lenders (or a few who were happy to take a smaller return) there was a chance they would receive the loan at a very reasonable, if not surprisingly low, interest rate. In the same way, someone who couldn’t traditionally access credit might find that there were a group of people ready to lend to them because of some shared interest or piece of background. Prosper and platforms like it were trying to revolutionize finance. I know this because they would go on popular tech websites and say things like , “We’re going to revolutionize finance.” It’s been ten years. They have not yet revolutionized finance. They’re not even really peer to peer any more.
So What the Hell Happened?
Well, a few things happened:
Regulation - Much like companies in the new sharing economy, peer to peer lending platforms ran headlong into a thicket of regulation that had no interest in being disrupted. Lending, especially lending to individuals, is highly regulated, with federally and on a state by state basis. There’s good reason in theory for all this regulation - given the historic precedents of racial discrimination and good old fashioned fraud. Unfortunately, it means that a company trying to build a process that is genuinely unlike business as usual is going to face huge costs to negotiate state by state approvals. Additionally, they will have to abandon parts of their model to satisfy the sometimes valid concerns of regulator. Remember the photo of the borrower that helped you make a personal connection? What is that photo shows that she’s Latina? What if the borrower’s story includes that he is starting a business with his husband? Including this information in a lending process, even if the bulk of lenders would likely use it as an affirmative piece of information, is a pretty clear violation of fair lending practices. Even if in the long term everyone sees the value, a conscientious regulator’s first reaction is going to be “STOP!”
So that’s what happened. Peer to peer lending platforms spent years negotiating with regulators (and occasionally being shut down entirely) as they tried to negotiate this new paradigm. And when they came out the other side, the good news was they received the licenses they needed to stay in business making loans. In addition, they had built the infrastructure necessary to underwrite, process and service loans at scale. The bad news is, they unsurprisingly looked a lot more like standard lending practice. Gone were many of the personal details, replaced by credit scores and self reported income. Gone was the potentially revolutionary, potentially racist and definitely good for attractive people reverse auction, replaced by standardized rates based on credit quality. Not necessarily bad, but not revolutionary.
They dropped one of the two peers - It’s hard to overstate how difficult (and expensive) it is to attract and manage investors who are lending a few thousand dollars at a time. Once these platforms came back from their vision quest the regulatory wilderness and were ready to start scaling in earnest, the math was pretty simple. If you are ready to grow like crazy, it is a hell of a lot easier to raise $100 or $200 million in lending capital you’ll need from a single hedge fund than from a hundred thousand individuals. They kept calling themselves peer to peer lenders, but in actuality they became hedge fund to peer platforms. And hedge fund investors are, rationally, not interested in lowering your rate or taking a flier on you because you had some medical issues last year and are piecing your credit back together. Prosper still has a peer-to-peer lender window, but the vast majority of their loans are funded by hedge funds.
Lots and lots of venture capital and hedge fund investors got interested in these platforms - With the regulatory questions more or less solved, the business model and operational questions more or less answered by early companies, and a ready source of capital available, this has become a hot space for venture investors and hedge funds. There are now tens (probably soon to be hundreds) of online direct lending platforms (many of whom are incorrectly identified as peer to peer). Some are broad based, like Prosper or Lending Club, others are going after specific borrower niches
A lot of the impact investor interest moved away from peer to peer lending - Where’d they go? There’s a revolution happening in crowdfunded donations/patronage and another one brewing in equity crowdfunding. There’s a whole other blog post, but for now let’s say that most impact minded folks spend more time in the past couple years thinking about Kicstarter than Prosper.
So where does that leave us after eight years?
We have an established regulatory and operational model for how direct lending should happen online. We have more and more platforms coming online with real infrastructure for lending at scale. If you have good credit and are generally the sort of person who could get a loan in the past, you can now get that loan much more conveniently on line. Your interest rate looks generally the same, maybe a little lower. Hedge funds are making money hand over fist and have effectively “captured” individual lending platforms, making them inaccessible to individual lenders. And everything else is kind of same as it ever was.
So this was all for nothing?
Maybe not. I’m actually pretty hopeful. There are a bunch of people who now understand how to navigate the regulation, and there are regulators who have had almost ten years to wrap their head around the concept of peer to peer lending. The infrastructure now exists to do massive direct lending at scale and, at least for now, there is a ton of spare capacity in that system. Finally, there is tremendous innovation in adjacent fields, both in alternative financial services for unbanked and underbanked people and in crowdsourcing different types of funds. I think right now is a perfect time to think about ways we could recombine these more mature elements to build lending platforms that have all of the impact we wanted in the first place, only we can go to scale really, really fast.
And that will be the next post.
I was asked to give a talk a while back on funding strategies to a group of aspiring social entrepreneurs going through Portland State’s Impact Entrepreneurs course. (It’s a great program run by awesome people - you should check it out) Like any good guest lecturer I immediately googled around looking for a presentation I could steal. I found some useful ones, but I was struck by how many otherwise sane people were telling social entrepreneurs that their main source of funding would be venture capital - either commercial VCs or that elusive (mostly imaginary) beast, the impact VC. The presentations focused on how to construct a pitch - to communicate the business to VCs in terms they understand - without stopping to consider one basic fact.
95% of social entrepreneurs will never receive venture capital.
What do you need to be venture fundable?
If you can do all of these things, then venture capitalists will, in theory, will provide you with millions of risk-loving dollars to rapidly scale your venture. There are a few social ventures that fit the bill and for those (or this one), venture capital is a great tool. It’s actually where I have spent much of my career, but it’s a tiny tiny sliver of the entrepreneurial landscape.For most ventures, even a lot of great ones, it’s a non starter for any number of reasons, including:
By now, you are probably asking “What’s the harm in all of this VC talk?” After all, a few ventures do get VC funded and the rest were probably crap anyway, right? Well, I think there are a few reason’s it’s dangerous.
So, as Chernyshevsky once said, What is to be done? Well, first off, I want the companies that are appropriate for venture capital and for the impact focused venture funds to keep kicking ass. Nothing in the above screed is an indictment of those for whom the VC model actually works, For the rest, though, I have a few incomplete ideas that I’ll be kicking (and I appreciate any feedback) I think we need:
Well, I definitely went over my time limit today. Hence the proposed solutions being less fleshed out than the problem statement. I guess I’ll work on this more another day and in the meantime, feel free to let me know what you think.
I was in a meeting the other day with a group of high powered people who are relatively new to impact investing, and the topic of Social Impact Bonds (more and more often being referred to as Pay for Success or Pay for Performance contracts) came up, as it often does with this type of folks. If you are reading this, you know what I'm talking about, but just in case, SIBs or PFP contracts are ones where a non-profit or for profit venture enters into a contract with government to provide a set of services that will save the government money later. The group bears the up front cost of providing the service and, based on how they perform against a predetermined metric, the government pays them a portion of the savings. The better they do against that metric, the more the government has saved and the more the organization is paid. The classic example is services for recent parolees. A group raises money from investors to provide counseling and job placement for recent parolees, and after a year (or two), the government pays the group based on how much lower their parolees’ recidivism rate is than a control group.
It's a powerful idea and one of those concepts that lead high powered people to ask "Why isn't this happening all over the place already." I'm bullish long term on the idea and I'll probably blog about it more in the future. It funds innovation and the sorts of preventative programs that are often the first to have their budgets cut. It takes the short term funding burden and risk of failure off government since they only pay for demonstrated savings. And, theoretically, it will make huge pools of capital available to service organization that can prove their efficacy, but the devil for now is in the details. For a successful program, you must have:
This brings us to Campbell’s Law, which states:
"The more any quantitative social indicator (or even some qualitative indicator) is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor."
Simply put, the higher the stakes are around a single measure of progress, the more likely that groups will try to game the system (or commit outright fraud) an the less useful that measure will be for determining whether or not you are actually accomplishing your goals. The most recent prominent example is outright fraud in Atlanta around high stakes testing, but more broadly you could argue that, as testing becomes the single measure of educational achievement, it crowds out all the other educational outcomes that we were hoping to use testing as a proxy for. Pay for test results, get a generation of optimized test takers (or worse yet, a bunch of cheaters).
Campbell’s Law doesn’t doom SIBs or Pay for Success to failure by any means, but it is something to keep in mind for those designing programs and those considering investing. As we are building these new systems, we need an evolving apparatus that helps us to reward what works without having the measurement tail wag the programmatic dog.
Peter Thiel is on the speaking circuit this month. He has a new book that I haven’t read yet, Zero to One, and so he’s showing up in a number of my feeds. He’s a smart guy who I disagree with on a number of fronts, including libertarianism and sea steading, so I really enjoy hearing him talk. Check him out here or here.
He said a couple of contrarian things that really stuck with me. The first was that he’s skeptical of the Lean Startup movement. Amazingly, he might be the first Silicon Valley type I have heard question the book that everyone quotes and no one has read (including me. I’m sure the book is great, it’s the people quoting it who annoy me.) His point is that great companies are built by people who are obsessed with solving one big problem, and that the Lean Startup movement, which encourages companies to be constantly ready to pivot is anathema to building companies that solve real problems. I couldn’t agree more. Many of the people I respect most have been working a problem for years and the challenge in my mind is figuring out when they are ready to accelerate and what they need to do so, not how to get them to pivot to an adjacent, easier problem.
The second point he made that really stuck with me was that friendships are more important than networks. The Paypal mafia work together again and again because they genuinely like each other, and he suggests that people should seek out opportunities to work with people you genuinely like on problems you believe in because the bonds you form are far more useful than more numerous weak links. I couldn’t agree more, and it’s why I work in impact investing.
OK, so Monday wasn’t very funny. I’m not sure today will be much funnier, but we’ll get there eventually.
Monday I stated that most of the things people expect out of a “real market” do not exist in adequate supply and diversity in most corners of impact investing. Today I am going to try to enumerate a few of the key pieces of infrastructure and why we don’t have much of any of them.
Let’s start with investment advisors. Building a portfolio of investments is hard work, one for which most investors have neither the time, expertise, requisite networks nor internal management infrastructure to do themselves. Doing it in impact investing, where you are trying to adhere to a specific set of impact parameters while picking through a small-ish and idiosyncratic set of opportunities? That’s even harder. So, almost everyone is going to need help. They need an investment advisory firm that has expertise in impact investments.
I have friends who run what I truly believe is the best impact-focused investment advisor in the world. Last time I checked, they had over $400m under advisement for 35 clients, each one of whom has a specific set of issues they care about and expect to have a portfolio that matches that issue set. But it’s tough work. Investment advisory work is traditionally one where you collect a bunch of assets and provide all of your clients similar products (tailored to their needs, but drawn from the same pool). By comparison, these friends of mine are providing custom mission specific portfolios and diligencing new products all the time for clients who fall into at least 5 (and probably more like 10) different issue areas. It’s a tough business to manage, because investors have set expectations about what they will pay for advisory services, and it is generally based on a percentage of assets. And those expectations are based on the high assets, low customization approach of traditional asset management. The standard is somewhere between 35 and 75 basis points. Now, take an impact adviser, one who will manage a relatively small mandate with a high level of customization. They still get paid a standard fee on an assets under advisement basis. So that $1,000,000 in that cool fund in East Africa? The one they found, flew 2 staff to Nairobi to meet with for a week, did 2 months of due diligence calls on and for which they now do quarterly investment reviews? They make $7,500 a year managing that (and that doesn’t include the work they did on the 5 funds they decided to not recommend). There won’t be a gold rush into impact advisory services any time soon, not unless the mandates get much larger, the product set becomes much more standardized, or people are ready to actually pay full freight for the services they receive. (By the way, some institutions do pay, many of them have been my clients, and but they are in the small minority, so I am within my rights to complain about everyone else for rhetorical effect.)
Now, if you look past this one firm, into a market where there are allegedly trillions of dollars already being deployed, there aren’t really any other credible shops in the US, past single-person operations that focus on a particular sector or work for just one client. This is a huge problem since, as stated here and earlier, most people and institutions new to impact investing are not ready to navigate it on their own. And don’t get me started on traditional advisors ability to serve this market. That’s a different post. Maybe Friday.
Now let’s talk about fund managers. A lot of my favorites in the impact space, like Core Innovation Capital, were born out of insights from people with deep domain expertise, people who have been working in a certain community or a certain sector. They see an opportunity to deploy capital in their market in a new way that can drive positive change and make a return for investors, so they start a fund. The problem is, usually they don’t have a track record, or at least not enough to appeal to large scale investors. So, they raise the 5 million or 10 million they can from impact investors to prove out the strategy. Fund 1 is underway! Good news, right? Well, sort of. The problem, once again, is that there is an established rule of thumb for what investors will pay a fund manager, a 2% annual management fee and 20% carry. That leaves our new fund with $100,000 to $200,000 a year which seems like a lot of money, but when you realize they have to pay 2 or 3 people and cover operations, back office and legal fees, it’s not that much. Now add to that the fact that they are pioneering a new area – one where they are invariably going to hit some twists and turn and unforeseen bumps in the road? You now have an undercapitalized entity that’s trying to innovate along multiple axes simultaneously, and that is a recipe for an unnecessarily high failure rate. Some people make it, but it feels like we’re setting most of these guys up for failure. Then we investors complain because they’re “not really institutional quality.” I have talked with various impact investors about systematically investing into fund management companies (as opposed to funds) to solve this capacity issue, but to my knowledge no one has done it yet.
So one last piece of middle ware worth talking about. In a mature market, the lives of investors, their advisors and those who are raising capital are made easier by firms that help structure investment products that meet the needs of both owners of capital and seekers of capital. They take a variety of forms, but I’ll call them deal structurers (You can also call them investment banks but that term has some well deserved baggage at the moment) There is a tremendous need, specifically in impact investing, for firms that work with people and organizations with deep domain expertise to develop investment opportunities that meet the needs and interests of impact investors, especially given the structural limitations mentioned above. However, you don’t see a lot of people moving into this market yet. Why?
Well, unfortunately, we are back to our old friend, scale. It can take 2 or 3 years to take an investment opportunity to market, 50% - 90% of what you are working on never comes to fruition, and when you get there it’s usually not a big enough deal dollarwise to make enough money to justify the time investment and all those deals that didn’t work out. There are a few boutique firms, usually a couple of people at a time doing the work because they love it, but there is a tremendous undersupply of this service in the market and I can’t help but think it has to do with the fact that it is hard to see a real business model at the moment.
So, what’s the answer? I realize this post is already pretty long and I burned through my 1 hour per blog post writing limit, so I’ll be coming back to it. In short, we need to admit that much of what’s going on here is sub-scale. We need to find ways to properly capitalize the businesses that are the connective tissue of the market. There are a number of ways to do this – the simplest is to decouple for now the return of the underlying investments from the cost of finding, structuring and evaluating them. If you want to invest $1,000,000 in a Ugandan mobile money business, it might cost you $150,000 to do it right. If you want and need highly trained professionals to do things right, pay them! If you don’t, then don’t. This sounds simple, but it is unfortunately common for investors to nickel and dime vendors on what are still sub-scale, specialty deals. This leads to existing firms cutting corners to stay in business on anemic fees or great people staying out of the business entirely. We can’t build a real industry until we solve this problem.
In another post I’ll suggest some ways to start getting after it.
So, this is my third post of the week. The deal with myself is that I’ll post on a regular basis for the rest of the year, even if I don’t have the time to refine the post down to a cogent point. So, . . . sorry. I’m resolving to be funnier starting today, so let’s see how that goes.
Yesterday’s topic was Oregon, a topic I’ll return to . Today, let’s talk impact investing. I assume if you are reading this, you know what impact investing is, but just in case: http://en.wikipedia.org/wiki/Impact_investing. I’ve been working in some capacity in impact investing since 2004. First as an investor at Omidyar Network, then as a consultant to google.org, as an investor and grantmaker at Lemelson Foundation, as an advisor to foundations and families at Imprint Capital and finally focusing on Oregon here at Occam Advisors.
Over the ten years I’ve been doing this, two things have remained constant. Every year there is more interesting stuff happening than the last - more diversity of deals, higher dollar value, better defined impact – and over the whole time, the hype has stayed way, way ahead of reality.
Impact investing has been a hot topic in philanthropy (and increasingly in finance as well) for as long as I have been around, and people’s introduction to the field has stayed depressingly similar the whole time. A person - be they an entrepreneur, an non-profit executive, an investment professional, a foundation staffer or a wealthy individual – reads an amazing story in the New York Times about this amazing new field of Impact investing. Maybe like this one? Armed with this glimpse into an exciting new field, our intrepid professional dives head first into this brave new world, ready to raise (or invest, or raise and then invest) big money. Doing well AND doing good!!! Isn’t this great? There is big stuff happening!!! I mean, for heaven’s sake, 11% of the capital market is already investing this way!!!
Only it isn’t.
They go to their conference. The speakers are inspirational! The vegan lunch is served by an at-risk youth making a living wage! They get a laptop bag made out of recycled waste! There’s only one problem – despite all of these charismatic entrepreneurs, despite the regular announcements that this old foundation or this newly minted billionaire is getting into impact investing, our friend slowly realizes, very little is actually being invested. Our panelist friends - the entrepreneurs and budding impact fund managers - are on the circuit for one, two, three years with very little to show for it. If they do raise money, it’s often from “regular investors.” Our foundation friends and the financial advisor to that billionaire secretly (or publicly) complain that they can’t find anything that meets their mandate, especially because impact investing is only part of their job.
There is almost no money changing hands.
Now, I am being slightly hyperbolic. Of course some deals are getting done. But in comparison to the hype, in comparison to the need, in comparison to what many people think the potential is for impact investing to fund a whole set of socially and environmentally beneficial initiatives, almost nothing is happening. So what is happening?
That 11% number that people love quoting – it includes every negatively screened public equity fund on earth, most of which are pension funds whose only screening criteria is to stay away from tobacco stocks. Most of that 11%, in fact, is comprised of these negatively screened funds. Now, I am not the word police. I know that screening public equity funds falls under some definitions of impact investing, and that’s fine. But quoting a number that is overwhelmingly comprised of one type of investment that is not what most people think of when they think “impact investing?” It’s either naïve or intentionally misleading.
So what’s the harm, you may ask? Why not spin that number as much as possible and get people excited, get them involved? Well, 11% implies that impact investing is a mature market. In a mature market, an investor with capital to invest can rightfully assume that there will be a full suite of investable options across asset class and sectors. It implies that there is a diverse set of advisors to help you navigate all of these options. If you are a fund manager or an entrepreneur, often someone who is taking a ton of career and financial risk to start a new venture, it implies that if you build something of value, there is 11% of the available capital pool ready to look at what you have built, more than enough to make a go of it. And that isn’t what either group finds.
I think this let down has a real price. It repels investors who are initially excited. It especially damages the credibility of the board member or senior staffer who put their neck out in the first place to get their foundation or fund to look at the space. And most importantly, they show up unprepared to do (or to pay for) the hard work that is still necessary to build a portfolio in most areas. On the other side, entrepreneurs and impact fund managers waste months or even year chasing phantom “impact dollars” that are reported to exist in the billions but are only ever seen in the wild in the millions (or for an entrepreneur, often only in the thousands). Finally, I think the triumphalism of 11% leads people to blow past the need for core infrastructure and middleware that does not exist yet. Advisers, investment bankers, deal structurers, match makers, incubators, accelerators, standardized documents and structures – everything that people have a right to expect when they see that 11% number – they’re not all there yet. And not enough people want to pay for them.
Let me end on a positive note. Every year I have been in impact investing, including during the recession, we have grown. There have been more investors, more capital, more interesting deals, and more diversity every single year. But if we’re not honest about where we are, we’ll never build the stuff we need to get us where we want to go.
I grew up here. I left 20-some years ago to go to college and spent most of my career in San Francisco and Silicon Valley. I moved back with my family a few years ago, but even then my work kept me out of the state and out of the country most of the time. About two years ago, I was working on a project for a consortium of out of state foundations and discovered the Freshwater Trust’s StreamBank program. In a little less than a decade, TFT had developed a method for quantifying the impact of streambank restoration on water quality, built a software platform to manage the process of certifying water quality credits, received buy in from local regulators and signed contracts with a few pioneering utilities to fund large restoration projects instead of building gray infrastructure. A decade!! Depending on your frame of reference, ten years is either an insanely long time to bring a single product to market or an insanely short period of time to take a revolutionary model for environmental restoration from back of envelope to regulatory approval.
A decade. The more I poked around Oregon, the more I found projects that embodied this type of persistent, decade scale innovation; Farmers Conservation Alliance, who spent the first 6 years of their existence navigating the web of approvals necessary for their innovative irrigation equipment, a time frame that would have killed a normal technology start up twice over; or Ecotrust, who have carefully shepherded a whole host of projects related to forests, farms and fish out in to the world with this same type of patient innovation.
This patience has historically been a double-edged sword. You talk to any professional investor here, especially in technology, and the will curse a blue streak about Portland’s “lifestyle businesses” and entrepreneurs and employees who don’t work the crazy hours necessary to build a hugely successful business in the 3 or 4 years that investors require. I can only assume they know what they are talking about, but I would like to offer two counter arguments.
First, young, educated, driven people are moving here in droves. Any complaint about Portland or Oregon that is based on past experience is a complaint about a place that already doesn’t exist anymore, and will be even less relevant in the future. The opportunity now is to ask, “Who are all these new people and what do they want to do?” Sure, a lot of them want to grow mustaches and sling coffee, but a lot more of them are driven, creative people who moved here because they wanted something different than what New York or San Francisco offers. What is that something different? I would suggest we don’t know yet.
Second, it’s clear that people here want to work insanely long hours for the promise of big riches, and I don’t think there is any reason to think they ever will. New York and San Francisco are perfectly optimized systems for those types of people, and I don’t think Oregon has any chance of competing for those people or those businesses.
So, what can we be world class at? What do all these people want to do? We haven’t yet seen the full impact from the collision of the patient innovation that has been the hallmark of Oregon for years and the new wave of talent just arriving. I think something really, really cool is about to happen if we can get the right elements lined up to support it.
And that, I guess, is what this blog will be mostly about.
I set this blog up a year ago as I was starting a much-needed sabbatical, away from the world of impact investing where I have worked for a decade. My thought was that I would have the time to think and write about big issues facing the industry, and that would help me figure out what I would work on next. Well, instead I spent a year riding my bike and hanging out with my children. I don’t regret it in the slightest, but the blog, um, suffered. The two of you I told to bookmark this blog were surely disappointed.
A year later, and I’m really back. My firm, Occam Advisors, is working to get the capital markets working for impact in my home state of Oregon. That work is taking many different forms, from helping foundations set up investment programs to helping businesses that are committed to integrating impact into their products to helping innovative non-profits think about how to scale their work. The challenges and opportunities we see here in Oregon mirror what’s going on around the country. I hope that by writing about a few things I’m seeing, I can spur a dialog with people here and elsewhere about scalable solutions to big problems.
So, here goes.
Patrick Maloney lives in Portland, OR where he helps nice people working on cool stuff. He tries to limit his blogging to things about which he knows something.