Independent Thinking^®

The Case for Alternative Lending

Banks have long been the primary source of credit, using their low-cost deposits to fund loans to consumers, small businesses, and students. Recently, however, advances in technology and the disintermediation of banks have opened up a new channel: alternative lending. This rapidly growing industry can be of significant interest to qualified private investors.
 
Alternative lenders provide credit directly to borrowers. Their ranks include direct lenders that raise capital from institutional investors to make loans to middle-market companies, and peer-to-peer lenders, also known as marketplace lenders, that make loans to consumers or small businesses. Marketplace lending has grown substantially, but still only accounts for 1% of the $3 trillion U.S. consumer credit market. Industry analysts estimate that it could grow fivefold to $150 billion by 2020.¹
 
At their core, alternative lending platforms and traditional banks have the same functions and are subject to many of the same regulations governing credit cards and banks. But alternative lenders are more nimble and efficient than banks, as they don’t need to maintain significant reserve requirements, an expensive branch infrastructure, or embedded practices such as manual data input. Instead they are able to tap into a different source of funding and use technology to gain operating efficiencies. (See the box below for a comparison of alternative lending companies and banks.)

The human capital-intensive process of banks doesn’t just slow down the lending process, it makes it uneconomic for banks to lend at all, even to borrowers with sound financials. Currently only 5% of small business loan applications are approved by traditional banks, leaving an increasing number of business owners with limited options for capital other than credit cards, despite fees that average 22%. With rates averaging 14%-15%, alternative lenders can be a much more attractive option for borrowers.²
 
In short, alternative lenders have a more streamlined and faster underwriting process at a lower cost – and are able to pass these savings along in the form of lower rates to borrowers and higher yields to investors. Investors in alternative loans generally expect to make about 8% through a full market cycle, net of fees and losses due to charged-off loans. That compares with the current yield of less than 0.25% on bank deposits.³
 
For investors, alternative lending is essentially a new asset class, providing direct access to consumer, student and small business loans, and expanding the investable credit universe beyond government and large corporate bonds. It has a low correlation to other asset classes, including global equities and traditional fixed income, as returns are impacted more by factors such as local unemployment rather than Federal Reserve fund rate changes or fiscal policies. It’s also important to note that these short duration, fully amortizing loans allow the platforms to respond dynamically to changes in interest rates and economic risks. When defaults increase, or are expected to increase, alternative lending platforms increase yields to compensate investors for the additional perceived risk.
 
Investing in alternative loans is not a low-risk strategy and is more appropriate for portfolios with a medium- to long-term investment horizon. The industry came under significant scrutiny in May 2016, when the CEO of Lending Club, an industry leader, resigned following an internal investigation. Some institutional investors backed off from buying loans from alternative lending platforms, but as demand from borrowers remained steady and default rates did not materially change, many have since returned.
 
We believe the loan underwriting and servicing processes remain robust at many alternative lenders. While increased regulation could increase costs or slow down the underwriting processes, it seems likely that it will have a greater impact on those lending platforms that target subprime or lower credit quality borrowers. Across fixed income investments, the borrower’s ability and willingness to pay drives the performance of the asset class. A turn in the credit cycle will affect all lenders, but should have less of an impact on the platforms that focus on higher quality borrowers.
 
In its current form, alternative lending has not experienced a significant down cycle. Losses have historically increased during times of economic stress, although charge-off rates have never risen to a level where lenders faced principal losses, even during the global financial crisis. In 2009-2010, charge-off rates for consumer and small business loans ranged between 6%-8%,⁴ well below the current yields of 12%-14% for these loans. Alternative lenders mitigate these risks through careful underwriting practices, targeting the borrowers that they believe will have the highest ability and willingness to repay the loans. Monthly payments on alternative loans are auto-debited from borrower bank accounts, significantly reducing the risk of non-payment. The high-touch servicing component of these platforms is critical too.
 
Investors can access the alternative lending market through a variety of sources, including funding individual loans directly through one of the alternative lending platforms. While this provides direct access to alternative loans, there is limited ability to diversify broadly.
 
Investors can also invest in a pool of funds, either managed directly by the alternative lending platforms or managed externally by hedge fund or mutual fund managers. We recommend the latter, as institutional managers who oversee large pools of capital have the flexibility to invest across multiple alternative lending platforms to ensure diversification across geographies and loan types. They also receive significant transparency into the underwriting process and can ascertain which platforms have the more rigorous underwriting and servicing processes. All else being equal, we also prefer fee-efficient funds with reasonable liquidity.
 
Stephanie Hackett is a Managing Director and Portfolio Manager at Evercore Wealth Management. She can be contacted at [email protected].

¹ U.S. Department of the Treasury, “Opportunities and Challenges in Online Marketplace Lending”, May 10, 2016.
² Lending Club Corp survey, 9/30/2015. Survey borrowers reported interest rate on outstanding debt or credit cards averaged 21.8%. Lending Club borrower rate is average rate paid by borrowers (FICO 699).
³ FDIC data as of September 26, 2016 for national average rates for savings, interest checking and money market accounts and for CDs 12 months and shorter.
⁴ Federal Reserve data.
⁴ Lending Club Corp survey, 9/30/2016. Median Adjusted Net Annualized return for investors with 100+ notes, note concentration of <2.5% of portfolio value, all loan grades, and a portfolio age of 12-18 months. EWM may recommend or has recommended Lending Club Corp. within its investment strategies.