What Makes Some Lending Companies More Valuable Than Others?

The Venture Capital market has historically done a poor job of discerning which Lending Platforms will become valuable, and which ones won’t. And in many ways, it’s because “all lending companies sorta sound the same” unless you’ve looked at… well… hundreds.

The Bear Case Against Lending Businesses:

Historically, a lending business sells money to people. And money is a commodity, so the margins on the money are pretty low. If Wells Fargo offered you a loan, and JP Morgan offered you another at a worse price, you’d stick with Wells. And on top of that, Wells isn’t any easier to work with than JP Morgan is. Maybe the person you work with is nicer… or they’re down the street… or you have your bank account with them so it’s a bit less of a hassle. But it’s not a step function different.

In addition, the revenue is at risk, and if you ever sell your money to the wrong person, you might lose not only your expected revenue, but some of your operating cash as well. To make things worse, if you sell money to too many sub-par borrowers, your business goes into turbo-mode fast. Your investors will now require a higher return because you have shown that your loans are riskier, so your capital becomes more expensive, even though you’re selling the same USD that everyone else is selling. You get fewer customers as a result, making your LTV:CAC worse, and so on.

And THIS is why most lending businesses aren’t valuable. Because they sell a commodity, because their revenue is at risk and because their actual equity is at risk when they do business. Their margins are low, and when things go bad, they can go bad very quickly and publicly.

On top of all of that – these companies take a lot of equity. Normally, a lending business needs to put up first loss capital – so in thinking about how valuable the business can get, an investor thinks about how much of a capital outlay it’ll take to get there. And yeesh… it can be a lot. Especially when the money is being used to receive some ROE on invested capital, as opposed to being used for operations that result in future product, growth, and leverage.

But Some Lending Companies Exhibit the Traits of Software Businesses, and These Companies are Very Valuable

Let’s try to remember why software companies are valuable. SaaS companies trade at crazy multiples because they have a whole bunch of superpowers:

1. They have high margins: incremental revenue likely results in minimal variable cost

2. They have predictable revenue: SaaS businesses have somewhat predictable churn, and so predicting cash flows from existing customers in the future feels easier than normal, so the discount rate on those cash flows is lower

3. They have high barriers to entry: ripping out software kinda sucks, and so it’s hard for a competitor to just come into a space and take away customers. And this high barrier to entry allows for pricing power.

4. They are capital efficient: It doesn’t take a lot of equity to launch a company, hire salespeople, and grow to $100M+ in revenues so long as payback periods aren’t wacky.

There are a bunch of other reasons software companies are valuable… but this is a good enough summary for now.

So… How Can Lending Businesses Achieve Characteristics of a Software Company, So That They Can Become Valuable?

In lending, you can innovate in four places:

(1)   Origination:

Can you originate via some unique channel where you’re the only offer in the room? And where it would be a step function more annoying for a potential borrower to try and find some competing offer?

Affirm is a great example. Affirm integrates with online merchants. It then makes a loan at the point of sale. If I buy a Peloton bike and I’m offered an Affirm loan I’m likely to take it. Why? Because (i) my other option is to try and apply for a loan somewhere else, whereas on Affirm I’m pre-approved when I get the offer, and (ii) because Affirm distributes through large partners, Affirm has very low CAC, allowing it to offer lower rates than I’m likely to get elsewhere and (iii) because Affirm is able to negotiate deals with online merchants such that it receives a discount from the merchant, in exchange for allowing the merchant to offer installment payments, lowering the merchant’s CAC and (iv) because Affirm has data about the propensity to pay back loans for the purchase of certain items, augmented by other basic consumer lending data sets.

Often, software companies can build a relationship with a customer such that they gather unique information. This unique information might relate to the quality of the customer’s business (e.g. online review scores), future cash flows from new customers that have just been signed, etc.

This unique data augments traditional lending data, allowing the software company to extend a loan where others cannot.

By way of minimal competition, the software company can then offer a loan at a relatively high rate compared to the risk, creating high margins. If it’s the type of loan that needs to be offered on a repeat basis, it can also become predictable. Even better, these loans are very cheap to originate, because the customer is already within reach.

(2)   Underwriting:

A lot of 1.0 online lenders took loans that used to be made offline and just put them online. And the financial system was able to react quickly, and reach market efficiency. Why? Because if I’m building a business that provides home mortgages, the whole financial system knows how to assess the risk. Making those loans online doesn’t change the fact that they’re home mortgages. And so some big credit fund like GSO can offer credit, and then get levered up by some big bank like Goldman Sachs, and Goldman Sachs can explain to the regulators why they should be allowed to use Tier 1 capital to finance the assets. And some regulator will look at historical data and say “yeah… that kinda makes sense.”

So then as soon as one company is successful in the space, a bunch of others will pop up, they’ll all be able to borrow cheaply, and prices will become efficient.

BUT, if a startup invents a new form of credit, the rest of the financial system will find it very difficult to catch up. And so as the startup is able to prove to its lenders that it’s good at its job i.e. its cost of capital will come down, making it easier to offer cheaper advances to its customers, and making it impossible for new competitors to ever compete.

For example: ProducePay finances perishable produce. No one has ever done that before. So when ProducePay started, its cost of capital was high because it was a new, risky thing. But Produce Pay has spent 5+ years proving it’s good at it, which led to the company’s lenders giving them cheaper capital over time.  And when you invent a new form of credit, you are the only company with the dataset and track record required to borrow cheap capital.

GSO can’t just go to some great entrepreneur and convince them to go start a business doing the same thing. They have to finance ProducePay, because ProducePay is the only one with the track record. If GSO financed anyone else, they’d have to lend to them at a higher rate than ProducePay gets, meaning Produce Pay could continue to finance growers at a better price because it had cheaper capital, pushing out competition.

Financing a new form of credit, and proving you’re good at it, creates a lower COGS relative to the competition, which leads to very high barriers to entry, pushes others out of the market, and leads to sustainable high margins.

(3)   Sourcing Capital Differently:

Some lenders are able to source capital differently, which lends them borrow at cheaper rates, and pass those savings along to their customers – which creates an ability to provide a cheaper product at affordable margins.

YieldStreet is the first company I’ve ever found that has really tapped into retail in a significant way. Sadly, retail investors have less access to great financial products, so they are willing to accept a lower return than traditional hedge funds would.

On top of that, by accessing YieldStreet directly, they bypass the fees a fund manager would charge, making the cost of capital 2-4% lower. If a fund charges 2 & 20 on a 15% yielding asset, that ends up translating to 2% in fees + 20% of net after fees profit (13*.2=2.6%) so 4.6% in total savings by going direct. That makes the cost of capital 4.6/15 cheaper (30% cheaper!). Having a 30% cheaper cost of goods sold is a structural advantage.

(4)   Collections & Servicing

Some companies are better at getting paid back than anyone else. Payroll deduction is an example of this. It’s where you lend money to a consumer and get repaid by garnishing part of their wage. In this example, you enhance the credit profile of the borrower by getting in the flow of their cash and improving the chances of repayment compared to a scenario where they just had to pay back a normal consumer loan that’s not top-of-the-stack of their cash waterfall. This lets lenders see lower default rates – so they either offer cheaper loans or earn higher margins.

So How Does This Tie Together?

A great lending company can earn the attributes of a software company by innovating in one of these four areas.

Proprietary origination sources allow a lender to advance money to customers who will accept a non-competitive price, because there are few alternatives. And these companies have low CACs, high margins, and are difficult to rip out, so have high barriers to entry.

Companies offering new forms of credit are able to offer capital at high rates, and borrow at low rates, and develop local monopolies such that they have minimal competition and high barriers to entry.

Companies that have new forms of capital, have structurally cheaper COGS, offering savings to consumers or high margins, or both.

Companies that are good at servicing, can offer their loans at low rates knowing that their default rates will be low due to the repayment mechanism, or they can offer loans at normal rates and earn a higher margin. Alternatively, they can lend to customers that other lenders wouldn’t touch, because without the repayment mechanism the borrower wouldn’t be credit-worthy enough.

So while many lending businesses are sub-par because they have low margins, their revenue is at risk, they take lots of capital to build and they get competed with heavily — it’s not true for all of them.

Some can actually have:

• High barriers to entry

• High margins

• And be built cheaply by developing strong distribution channels

• Some can even build predictable revenue if they offer a repeat credit product like factoring or merchant cash advance

And so we are not excited about all lending companies. And we don’t hate all lending companies. Instead… we look for the nuance.

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