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Why Embedded Lending Made our Investment in Constrafor a Clear Choice
Lending has been largely a bad word within the VC community since the lackluster public market performance of LendingClub and OnDeck. Affirm, once the darling of the industry, has seen its public market valuation cut by 80%+ from market highs. Private markets house hot companies like Clearco, Capchase, and Pipe, but it becomes more challenging to raise at high growth multiples when the public market comparables are trading so low.
The reason lending businesses have historically struggled to trade at high multiples of revenue or profit is that they generally have low barriers to entry and therefore are subjected to margin compression over time, are impacted by defaults and therefore sensitive to market cycles, tend to have less consistent revenue streams than other venture-backed businesses (such as SaaS companies), and require significant human capital to underwrite risk and they are balance sheet intensive (require large quantities of debt and equity to scale).
Payments companies on the other hand are asset light, have recurring revenue based on consistent transactions on their payment rails, take minimal risk on capital transmitted, and can scale significantly without the same operational overhead of lending companies. Payments companies do have a different economic schema. Where lending companies make hundreds or thousands of basis points per transaction, payments companies earn tens and therefore, rely on substantial volume to make a big business. Payment processors who generate higher margins (think Visa and Mastercard) are facing regulatory scrutiny in the current inflationary environment as the transaction costs borne by merchants are ultimately passed through to the consumer.
What if you could have the same economics of lending, with the scaled infrastructure of payments? We view certain forms of embedded lending as striking this happy medium.
Embedded lending refers to loans that are distributed at the point of sale or within a piece of software that captures data related to the borrower or a transaction being financed. For example, CoVenture recently partnered with Constrafor, a company that provides B2B software to enable payments between general contractors (“GC”) and sub-contractors (“sub”) within the construction industry. With the software layer, Constrafor captures key data points that enable them to make smarter lending decisions. They will have historical transaction data between the GC and sub, the job history for each of those entities, the payment history of the GC, the payment history of the project owner, in addition to traditional credit metrics.
With this data, Constrafor can underwrite each party more precisely than a bank could and therefore make better credit decisions. Given their financing tool is embedded in the software, a customer can access capital faster and will be less likely to search for other financing sources or field offers.
Let’s revisit the original hesitations of investing in lending businesses and how offering an embedded lending product can change the calculus:
Barriers to Entry / Margin Compression: With the product embedded in the platform of use or at the point of sale, the customer or user is less likely to shop for a different rate due to the convenience of the offering, allowing the embedded lender to earn a premium to what others in market might be able to offer
Impact of Default Rate: Due to proprietary data points for underwriting, embedded lenders can mitigate the impact of defaults and keep them to significantly lower levels than traditional lenders who can only underwrite off of readily available data that might be less correlated to credit performance
Non-Recurring Nature of Revenues: A sub on Constrafor’s platform is likely working on a consistent stream of projects throughout the year and will continue to use the financing for each project they are working on to improve the working capital. This flips the paradigm from one-off financing revenues into a recurring stream of financing revenues. The same is true for a buyer on a marketplace who is consistently sourcing supplies to sell through to their end customers
Human Capital Required to Underwrite: There will likely always be some human touch when sending tens of thousands to millions of dollars around, but due to the data advantage and technology being built by the embedded lenders, the underwriting process can become highly automated, significantly scaling an individual underwriter’s time
Balance Sheet Intensity: This is a bit inevitable, but if an embedded lender is able to show higher quality data related to defaults, it could make their capital structure more equity efficient, therefore improving their return on equity
If managed correctly, embedded lenders can achieve lending economics, with the scalability and moats of payments businesses, all while adding value to the platform it is embedded in. We are bullish about our investment in Constrafor for the reasons above and remain excited about more companies being founded in the embedded lending space.
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