On December 1st, JPMorgan Chase announced a partnership agreement with OnDeck Capital, a publicly traded commercial Fintech lending enterprise. This may well be a watershed event in the emerging Fintech commercial finance segment as it represents the highest profile big bank entry into the space. Jamie Dimon, CEO of JPMorgan Chase, famously warned the bank’s shareholders in April that “Silicon Valley is Coming.” Noah Breslow, CEO of OnDeck, said in a press release, “OnDeck is working with Chase to build a new Chase lending product that will provide online loans to their small business clients. By combining Chase's relationships and lending experience with OnDeck's technology platform, Chase will be able to offer almost real-time approvals and same or next-day funding."
Most notably, American Express, Bank of America, Citibank, Goldman Sachs and Wells Fargo are active investors, sponsors and facilitators of the Fintech wave. Every day brings more Fintech news: new ventures, partnerships and a host of related business development activities. Not counting the Consumer Fintech segment (which is quite large in its own right and not included in this blog; strictly talking B2B here), there are more than 25 notable private Fintech enterprises up and running. By 2018, it is estimated that the amount of investment capital going into the Fintech segment will exceed $8 billion per year.
What is commercial or B2B Fintech (‘Fintech’ for this blog)? Broadly speaking, Fintech is an emerging commercial finance segment that seeks to automate the entire commercial finance process enabling businesses to access capital quickly and easily. The Fintech enterprise theory is that advances in the collection and processing of data ("Big Data”) from the internet (including social networking sites, 3rd party credit reports and other internet based sources) combined with sophisticated computer modeling (algorithms) will lead to less expensive, more accurate and more rapid credit decisions than traditional manual underwriting. Using such advanced forecasting techniques with access to more data points from social and business media platforms, the Fintech enterprise model is seeking to underwrite and manage financing risk, pricing and operations on a highly automated basis. Recent advances in on-line encryption technology, web security, documentation preparation, e-signing, electronic funding/payments, etc. has created a fertile environment for this new financing segment. The funding structures for Fintech enterprises vary widely. However, early funding models were primarily based upon peer-to-peer funding, where interested investors could selectively fund opportunities on a one-off basis. As the business has matured and grown rapidly, funding structures have become more sophisticated and may include bank warehouse credit facilities, private placements and securitization of asset pools.
Who are Fintech’s customers? Thus far, targeted commercial customers have been largely small businesses that run the gamut including retail, distribution, healthcare, commercial and industrial. No start-up companies (at least one year in business) are typically eligible, the company must have minimum monthly revenue and the owner an established personal credit score.
What do Fintech products look like? Fintech’s early focus was on merchant lending structures (working capital) given the opportunity to control and collect cash flows through point-of-sale (‘POS’) systems. This focus on working capital financing has continued, but now more Fintech’s are expanding into term loan financing. For example, OnDeck offers business loans from $5K-$500K and LendingClub from $15K-$300K. Repayment terms can be based on a percentage of cash receipts (working capital) or monthly installment plans (generally from 24 to 36 months). Almost all facilities are unsecured with a personal guaranty required from the owner(s) of the business. Pricing varies substantially depending on risk rating, structure and term. Posted pricing runs from 8% to 50%, but it is worth noting that typical yields on portfolios from the publically traded Fintech’s run from the mid 20’s to mid 30’s.
How are Fintechs performing? Since the segment is primarily privately held, it is difficult to draw too many conclusions. However, OnDeck and LendingClub are publically traded and the financials reflect start-up companies that have yet to reach a sustainable level of profitability. LendingClub’s enterprise model remains primarily Peer-to-Peer (provides underwriting advice and portfolio servicing) and is mostly consumer lending focused, while OnDeck’s is more of a hybrid model and strictly B2B (see www.lendingclub.com or www.ondeck.com). This segment is way too young to judge on the merits of financial performance. Clearly, the industry is attracting large numbers of investors, significant amounts of capital and plenty of attention!
When? -- I think it is high time to bring “Silicon Valley” into commercial financing as a key constituent investor/principal rather than a departmental service. For too long established banks and leasing companies have tried to automate various parts of the financing business by growing IT departments and investing untold billions into technology software and hardware. While many of these investments have been successful on a narrow scale (and many a total bust!), few could claim to be revolutionary or transformative.
Competition and Opportunity -- I would suggest that the current enterprise model for Fintech financing is not materially different than business credit card financing. However, Fintech companies are not yet at scale to drive down operating expenses. This leads to a common commercial finance industry challenge of either pricing to a future estimated static pool of assets or pricing to current operating expenses. Pricing to current operating expenses to make an acceptable return typically requires pricing well out of market, and usually does not attract a sustainable spread of risk. So, unless Fintech can differentiate its value proposition (probably by increasing its deal size above commercial credit card products or offering different products), then it is hard to see how the Fintech model is superior to commercial credit cards.
Practical Limits of Computing Power – Computing power is only as useful as the data that can be reasonably collected, is accurate and efficiently input (the old computer programming truism of “garbage in garbage out” has never been more relevant). Bottlenecks in data input and the subjective and qualitative nature of making sense of complex financial statements, industry and macroeconomic risks creates substantial barriers to entry for Fintech enterprises into the tradition commercial banking and leasing segments.
Business Model Limitations – The current Fintech concept of automated commercial lending relies on minimizing the cost of underwriting, documentation and account management. As such, most Fintech enterprises place heavy emphasis on personal credit scores and personal guarantees rather than the additional cost/work of secured financing processes (let alone ownership of the assets as a lessor). This leads to a heavy reliance on credit decisions and aggressive collection practices since a default leads to a total loss in most cases. There is no opportunity to recover collateral since these are unsecured loans and it is generally viewed as too expensive to pursue guarantors except perhaps to sell or assign such accounts to third party collectors or investors. It is hard to imagine that automated credit scoring systems, no matter how sophisticated, can obviate the need for secured financing with larger non-investment grade credits.
Manpower Limitations – When banks were deregulated in the 1980’s, the Savings and Loan banks attempted to expand into commercial lending and leasing. Unfortunately, these institutions had no significant commercial underwriting or leasing expertise, policies or procedures to enable this expansion. These were real estate lending institutions (and mostly residential lenders)! Many of these institutions attempted to hire the necessary expertise from commercial banks and leasing companies, but there simply was not enough talent to go around. As you can imagine, the results of this expansion were pretty much an utter fiasco. The S&Ls lost hundreds of millions of dollars and contributed to the consolidation of the banking industry. I think it is quite possible that the Fintech industry will face similar talent acquisition challenges if it continues to grow at this pace.
Unsustainable Portfolio Performance Caused by Adverse Selection – Current Fintech pricing does not attract enough quality customers leading to adverse selection and a subprime portfolio. Adverse selection leads to a high probability of portfolio failure in a recessionary economy. Without pricing to attract more creditworthy customers, the economics simply do not work. I think most of us who have been involved in commercial lending since the 1980`s would have to admit that we’ve learned this painful lesson enough times to know better.
Regulation Coming – Non-traditional Fintech enterprises are not subject to the same level of scrutiny or regulatory compliance that traditional financing sources are. Thus, with enough scale, Fintech may enjoy a cost advantage, but this may only be temporary. Various government agencies and Congress are already looking at the potential need for regulatory controls. In the meantime, the lack of regulatory oversite may lead to serious exogenous risks (fraud, compliance problems, class action suits from collection abuses, funding source issues with poorly understood portfolio risks, etc.). We already have the high profile problem of Web Bank (www.webbank.com) funding a loan to one of the San Bernardino terrorists!
Conclusions -- The emergence of the Fintech enterprise segment is challenging the status quo. This forces positive change, brings new talent into the industry and disrupts conventional wisdom in a healthy way. If successful, it will open the door to a more efficient capital allocation system for commercial businesses. It may also finally help established financial services enterprises truly automate those processes that can efficiently and effectively be automated. On the other hand, the Fintech segment would do well to learn from the decades of experiences from the commercial finance professionals in the traditional commercial finance space. As the philosopher George Santayana said: "Those who cannot remember the past are condemned to repeat it."