We have all been watching the proliferation of new lending businesses and originators over the last few years and wondering how there’s consumer demand for so many new entrants. While many of these businesses have built fantastic user interfaces and products that solve customers' needs better than those offered by the incumbents, there seems to be a universal belief that very few of the nonbank lenders and originators will survive the test of time. Some industry experts believe that a funding crisis will wipe out most of these players. Others believe that hyper growth paired with unproven underwriting technology will be the source of their extinctions. And most universally accepted is the belief that we've been living in magical times that won’t last forever.
Since the economy bounced back from the crisis, we've existed in a world of entrepreneurs getting low-cost and free-flowing capital as they vie to steal share from banks that have been distracted by dealing with serious regulatory matters. It was a bonus that the personal balance sheets of U.S. consumers improved dramatically over this same period with the benefit of low interest rates, falling unemployment and gas prices below $2 a gallon. Capital combined with talent and solvent consumers results in nirvana for entrepreneurial ventures.
While it’s a near certainty that tough times will eventually arrive, there is room for quite a few of the new entrants to carve out a profitable piece of the pie. The best companies will do more than just survive tumultuous times. They will thrive and put another check mark in the win column for innovation. Others, however, will flame out when winter arrives. Each company's fate depends on the answers to these four important questions.
1. Is the business generating a resilient book of business?
The concept of resilience is critical in lending but much neglected. At its core, a resilient loan book is one that can experience a significant increase in losses and still maintain a positive spread. Any originations machine needs to produce resilient loans because the economy is cyclical in nature and credit loss curves are highly correlated with macro-factors.
Well-managed businesses have trained credit professionals who understand core drivers of risk (i.e., ability to pay, willingness to pay, stability of income and value of collateral) and have policies in place that restrict access to highly volatile applicants. Their goal shouldn't be to eradicate risk completely. Rather, it should be to create a loan book that performs well in good times and adequately in lousy times. Why? There's nothing that can sink a debt investor's confidence faster than breached covenants and negative yields. And since it's impossible to manage a lending company or originator without a vehicle to fund new loans, maintaining the confidence of the debt community is equivalent in importance to the oxygen we all breathe.
2. Can the business recruit the right investors who like the economics of the loan production?
There are many sources of capital in the world. Contrary to what most traditional bankers believe, not all lending capital thinks alike. The key to managing a nonbank lending originator is to find the right partners who like the economics of the business. Some investors are looking for low risk, low volatility and collateral-backed loans. Others are looking for high-yield assets from which they can quickly exit if warning signs arise. Retail investors don't look anything like giant international insurance companies nor do the insurance companies look like hedge fund traders.
The key to survival is securing the right partners.
3. Is the business able and willing to switch its cost structure when faced with slowing or shrinking growth in originations?
Operational discipline is an important key to survival and the best companies are able to rein in spending and minimize burn when times are tough. Doing more with less without sacrificing the user experience is not a trivial task. Keeping morale high when employees see slower growth is a skill that only great leaders possess.
Having the conviction to reduce growth plans during uncertain times is characteristic of thoughtful management. Good cost containment gives a company extra fuel to generate revenue, albeit not now.
4. Is the company capitalized to weather a prolonged storm?
Even if an originator is able to reduce its burn rate during tough times, it might have to dip into its coffers if it isn't generating enough cash to support its operational infrastructure and contractual reserves. Some originators don't have to worry about maintaining risk reserves because they sell their loan production. But these same originators don't have an existing loan book producing cash flow either. Non-balance-sheet lenders shouldn’t hide behind not being directly affected by losses because they still need to support their semi-fixed cost structure. And not all lenders and originators score perfect marks with the first three questions so they will require time and investment to fill in their holes. As a result, all lenders and originators have to worry about how well-capitalized they are.
Any originator that will require an infusion of capital if and when a storm arises is operating on shaky ground. It's not game over, but they better have investors who are willing to pony up additional cash and ride out the storm with them. If not, there's a chance that capital can't be raised when it's needed, and only bad things will happen from there.
While some lending companies and originators have good answers to the above questions, some don't. Concentrating on fixing the fundamentals should be priority No. 1, because the key to survival will be determined by how prepared a company is when tough times arrive.