So in Part 1 I described what had happened to P2P lenders (who I am calling online lending platforms from here on given that many of them now raise money from institutions, not individuals) . Part 2 covered why we should care that these platforms, despite impressive growth, aren’t yet reaching new audiences or lending in any radically new way, especially given that, from an impact investor’s perspective, there is a far greater need for debt than venture capital.
Before I offer a few different options, I’d like to point out a few key traits of the new lending platforms:
The first P in P2P is essentially gone - Most lending capital is being sourced from hedge funds and other institutions. If you are lending on one of these as an individual, you are basically picking through the scraps that the institutions didn’t want.
Now that the model is ironed out and the infrastructure is in place, there is a huge lead conversion element to their business model - They have the machinery to underwrite, process, fund and service loans. Now they need to generate leads in large quantities and then convert some percentage of them into loans. Their success will hinge on a) how good their leads are and b) how good they are at getting a lead all the way through their process to actually take out a loan. This conversion rate is a result of a mix of lead quality, their own process quality and how competitive their loan is with other options
Their conversion rates are really, really low - Most of these platforms are way under 1%. That means there are several hundred people, each of which the platform has spent money to find, who start the application process for every one loan they end up making. Most people abandon the process before the ever get to underwriting. The platforms are spending a lot of time and money trying to figure out how to get that conversion rate up.
Their underwriting is algorithm-based, rather than rule based - Traditional bank underwriting is rule based. If you fail one criterion, credit score for example, there is no other place you can make it up. You’re rejected. The lending platforms, by and large, are algorithm based, which means they have more flexibility in setting underwriting standards. Low credit score? Maybe there is some recent income history you could show to make it up, or maybe you can pay a slightly higher interest rate. Whether or not they are yet using it, they have the capacity to deal with non-traditional credits than banks because they have this inherent flexibility. It also makes them easier to collaborate with, as long as you understand how they are building their own credit algorithms.
OK, so with all that said, I think it is time for impact investors to come back to these lending platforms. The regulation is more or less understood now. The business models are set. The lending infrastructure has been built. And there is a huge need for responsible loan products across a whole host of sectors, from broad based local economic development to support for specific industries to specialized retail loan products. There are at least three ways to attack the opportunity:
Build a New Platform - There is now a workable model for how you build a lending platform. With enough time and capital, you could build an impact-specific platform from scratch. There are many venture funded, non-impact focused companies that are following this path. However, I wouldn’t underestimate the time and money required to build one. The regulatory side of things, while well understood, is still not simple and varies from state to state. If you want to go this route, it helps if you have $10-50+ million in equity to burn and a couple of years to get to scale. And it’s not worth doing unless you think you can run a few billion dollars through that platform, which is a tall order for an impact-only lender. There are a couple of groups going down this path (Community Sourced Capital and Kiva Zip) on the impact side, but I get the impression they are taking a short cut around regulation by only doing interest free loans.
Buy an Existing Platform - With all of the VC funding going into building new platforms, it is only a matter of time before some of the also-rans are for sale. Of course, you have to wait for the right opportunity, but potentially it is a way to own the infrastructure without paying the full cost of developing it or waiting several years to build your own.
Rent Someone Else’s - Many of these platforms are more than happy to underwrite process and service other pools of loans as long as they are structured to fit within their existing processes (so, for example, you can have different underwriting standards, but the methodology by which you approach underwriting has to be similar) It’s a nice bit of extra revenue for use of there infrastructure without a lot of marginal cost. It’s even better of there is some expectation that the conversion rate is higher than 1% (which it should be given that many impact lending programs come with additional grant funded educational programming and/or a subsidized interest rate)
The trick with renting (and with the other two approaches for that matter) is that you need to guarantee a certain amount of volume for it to be worth doing. This means you need a large enough pool of qualified borrowers on one side and enough lending capital committed on the other to guarantee a certain minimal scale. I don’t know exactly how much, but it’s probably in the neighborhood of $10 million. This may sound like a lot but its well within the scope of many larger non-profits in terms of their outreach, and well within the scope of foundations or high net worth individuals to fund, especially if you consider that you could earn a reasonable rate of return on that capital. Here’s a graph of how it might work:
Once you did this with one type of loan/borrower, that infrastructure can be used again and again across a whole host of other programs, which gets you this
Once you did this with one type of loan/borrower, that infrastructure can be used again and again across a whole host of other programs. In theory, it feels like a win-win-win. The funder, a foundation, government or high net worth in this case, can deploy a large amount of capital relatively quickly with tight control over the mission scope and the interest rate with a relatively low amount of operational exposure. Non-profits get to extend new services to their clients without having to build the whole back end. The lending platforms get a guaranteed piece of revenue that requires little extra effort on their part.
The key question, in my mind, is, are there funders and non-profit partners that would be ready to use this tool if it existed? If there are, I think it may solve one of the big current road blocks in impact investing: how you preserve the mission lens that non-profit partners bring without being dependent on them to scale up and manage the actual nuts and bolts of lending programs.
OK, so my hour is up and I think I am going to move on from P2P next time. I’m not sure how well I am articulating the vision in this post, but I think the approach has real merit. The question now is whether it solves a real problem for anyone in the short term. If any of the four of you who read this blog have any ideas, call me. Or post a comment.
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.