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Marketplace Lending in the U.S. - An industry overview March 2015

This is a study of the marketplace lending business in the U.S.

Marketplace lending (used to be called peer-to-peer or P2P lending earlier) is growing at a scorching pace in some lending segments, which traditional lenders might have all but abandoned. It represents technology-led disruption in the personal and small business lending space. What started life as 'borrowing from friends, family and peers' has turned into a broader 'marketplace' model, and might be on the cusp of becoming a mainstream lending channel in the next few years.

It is getting increasing attention (and investments) from established institutional financial players.

This study intends to provide an overview of what the marketplace lending business is all about. It takes a deep dive into the structurals - products, customers, regulations, platform models and who is investing in this space. It also lists the key success factors in this business, and tries to gaze into the future of what might be in store for this business in the coming few years.

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Marketplace Lending in the U.S. - An industry overview March 2015

  1. 1. Note: Study limited to the US market CONTENTS • TBD • ITEM 2 Marketplace Lending An overview of the marketplace lending business in the U.S. March 2015
  2. 2. Note: Study limited to the US market Contents • Different financing models – Traditional & alternative • The need for alternative financing • What sets alternative financing apart? RAJESH KAMATH © 2015 2 Introduction to alternative finance1 • The basic structure of alternative lending • A summary of the alternative lending business • Some alternative lending metrics Alternative lending – The basics2 • Participants in the alternative lending ecosystem • Typical borrower, lender (‘investor’) profiles and products • Common platform business models and revenue streams Alternative lending – Deep dive3 • Current and awaited regulations governing alternative lending • Some investments in alternative lending and related metrics • Active considerations, key success factors & the future… Alternative lending – The near term4
  3. 3. Note: Study limited to the US market Financing models – Traditional & alternative 3 Note: Similar alternative mechanisms are also being seen in the Investing & Wealth Management area Traditional Lending Access to debt finance via banks and lenders, mostly brick-n-mortar Traditional Investment Banking Access to equity and structured finance via investment banks Online Lending Established banks and new players lending via the online channel TRADITIONAL FINANCE ALTERNATIVE FINANCE Crowdfunding Crowd-sourced investments in the form on equity or end-product rewards Non-profit Finance Crowd-sourced investments with a social cause – under section 501(c)(3) Alternative Lending Peer and other investor sourced financing, in the form of debt The focus of this study RAJESH KAMATH © 2015
  4. 4. Note: Study limited to the US market The need for alternative financing 4 Seekers of funds Traditional financing mechanisms are not anticipating / meeting the funding needs of some customers / segments • Traditional lenders have eliminated some unsecured products completely • Reduction in home equity collateral mechanism as security for borrowing • Rigid underwriting standards eliminate potentially deserving prospects – insufficient credit / business history, irregular income, new graduates with jobs • High costs act against small ticket personal & business loans (<$100,000) • Equity funding via IPOs tends to be costly and requires robust business history Some potential customers might not even approach traditional finance channels for their funding needs • Small businesses do not consider bank lending as a viable funding channel • Millennials are less likely to approach traditional banks for loans • Borrowers are looking for finance costing lesser than credit card borrowing • Traditional investment banks are generally not accessible to these segments Providers of funds Providers might be looking for • Marketplace investments provide a product that is perceived to yield a higher return as compared to ‘traditional’ investment products (e.g., deposits, bonds) • Investors might want to participate in a ‘social’ cause that the funding is for • Some investors might want first-comer access to a path-breaking product / innovation that the borrower seeks to create with their investment Some Traditional Finance Metrics • More than 50% of small business applicants sought less than $100,000 in credit • A majority of small firms (under $1 million AR) and startups (under 5 years in business) were unable to secure any credit • 22% of millennials say they might never have a relationship with a bank • 76% of millennials said a mobile mechanism to access finance was very important to them • 73% of millennials said they are more excited about getting products from non-bank tech. companies Data sources: Federal Reserves - SBCS, ICBA, Microsoft, MDI, Peerform RAJESH KAMATH © 2015
  5. 5. Note: Study limited to the US market Alternative financing essentials 5 Data-driven: Use broader set of data sources in decision-making, and technology to leverage this data Channels: No branches – access and service almost exclusively over online & mobile channel and phone Efficiency: Focus on technology-driven speed in decision-making and funding; try to reduce human-in-loop aspect significantly Cost of funds: Lower establishment costs and higher efficiency = lower cost of funds for clients and better returns to investors Fund sources: Multiple sources - individuals, accredited & institutional investors, lenders Choice: Greater say (/flexibility) to the customers in the financial product Experience: Focus on overall customer experience before, during and after the funding Community: Expertise of community and investors made available to the fund-seeker, in some cases RAJESH KAMATH © 2015
  6. 6. Alternative Lending – The basics Financing provided in the form of debt Crowdfunding Not in scope of study Non-profit Finance Not in scope of study Alternative Lending Covered in detail in subsequent slides
  7. 7. Note: Study limited to the US market Alternative lending – The basics 7 Marketplace 1 2 3 4 5 6 Requests loan Grades borrower risk, posts loan & notes, provides loan data Funds loan by purchasing ‘notes’ Borrower Lender Processes loan funding payment Makes loan installment payment Processes loan inst. payment 7 Remits loan payment against ‘notes’ A borrower might have their loan request funded by one or more lenders (called ‘investors’) The lender (called ‘investor’) might decide to fund a loan request completely or partly The marketplace brings together the borrowers and investors, and charges fees for its services Product(s) Investment securities (‘notes’) Product(s): Loans, Refi, Lines of credit RAJESH KAMATH © 2015
  8. 8. Note: Study limited to the US market Alternative lending – Business summary 8 Targets the millennials segment of borrowers, both as individuals and small (& medium) businesses Is often benchmarked against credit cards in terms of highest cost of finance offered, rather than traditional personal or small business term loans Is growing at a significantly higher rate as compared to traditional lenders, in sub & near-prime personal, small business and some other lending Is focusing on access to institutional sources of funds & liquidity via lending commitments, securitization & secondary markets Targets mostly accredited and institutional investors (i.e., lenders), with final regulation on retail investor participation awaited Has increasingly specialized loan offerings, even for specific business scenarios in specific customer segments RAJESH KAMATH © 2015
  9. 9. Note: Study limited to the US market Alternative lending – Some metrics 9 alternative lending originated: ~$5.5b traditional finance new: ~$67b The alternative lending channel can be considered small as compared to the traditional channel, but… … alternative lending is growing at a scorching pace as traditional lending growth is declining 84 % credit cards o/s cons. fin. o/s alt. lend. orig. -2 % -0.7 % Note: Growth calculated in period Q2 2007 – Q2 2014Note: Figures as of Q4 2014 Alternative lenders have a significant advantage over traditional lenders in operating expenses Estimates for the future size of the alternative lending market vary, but all suggest significant impact on lending Data sources: Cleveland Fed, McKinsey, PwC Note: Operating expenses expressed as % of loan portfolio traditional lender alternate lender 5 % 7 % 2 % Part of 3-5% difference in ops costs passed on to borrowers and investors 2015 $6 b 2025 (e) $150 b PwC $1,000 b Some VCs $13,000 b Current rate RAJESH KAMATH © 2015
  10. 10. Alternative Lending – Deep dive
  11. 11. Note: Study limited to the US market The alternative lending ecosystem 11 Marketplace Secondary Market Provide mechanism for investors to trade marketplace securities (notes) e.g. FOLIOfn for LendingClub 3rd Party Loan Servicer Provide servicing for loans originated on marketplace e.g. Mohela & TruStudent for SoFi Investor Data Aids Provide loan data & analytics, for investment decision support mostly e.g. Crowdnetic, LendingRobot Marketplace Software Provide white-labeled software platforms for building marketplaces e.g. Cloud Lending Inc., Mirador Payment Processor Provide payment processing for borrower, investor, other payments e.g. Stripe, Braintree Collection Agency Provide collection services to lenders for past due /in default loans eSignature Provider Provide eSignature capabilities for contracts and other documents e.g. DocuSign Marketplace Aggregator Aggregate investment opportunities from multiple marketplaces e.g. Orchard Bank / Lender Fund loans qualified and referred by online broker / marketplace e.g. Cross River Bank for Peerform Forms & Services Provider Provide e-forms, filing & payment tracking services for P2P lending e.g. NFM, Lending Karma Asset Manager Buy marketplace loans to convert into saleable securities e.g. Blackrock for Prosper Broker / Referrer Channel borrowers to lending marketplaces (Can be small banks) e.g. Buynance Data Providers Provide credit, social and other data, for underwriting risk analysis e.g. Credit bureaus, ‘Social’ websites Rating Agency Provide risk ratings to securities originated by marketplaces e.g. S&P for SoFi’s securities RAJESH KAMATH © 2015
  12. 12. Note: Study limited to the US market Wants funds in form of bitcoins Typical borrowers – Segments, profile, needs 12 FICO > 660 Active ‘social’ profile Other additional requirements Individual Is looking for a student loan / refi Is looking for to payoff credit cards Is looking for a mortgage Small business Owner FICO > 600 1-2+ years in business Annual revenues $100,000 Other additional requirements Is looking for franchise finance Is looking for a term business loan Note: Above listing is illustrative, and is not intended to be comprehensive. Certain lenders listed above have products that fulfil more than one business requirement. Is looking for merchant cash advances Is looking for a line of credit Is looking for funds against invoices Real estate co. Is looking for a personal loan Is looking to provide clients with funds Is looking for debt / equity investment Is looking to finance commercial non-owner occupied residential RE for development, rehab etc. Complex, highly specific borrower eligibility requirements RAJESH KAMATH © 2015
  13. 13. Note: Study limited to the US market Typical borrower product structure 13 Individual Note: Above listing is illustrative, and is not intended to be comprehensive. Certain lenders might have different loan / finance terms from those listed above. Loan type Term (Months) Amount ($ 000s) Min APR (%) Other Notes Mortgage 60 36 84 250 450 5,000150 . .2.8% 5.7% Data shown for 5/1 & 7/1 ARM mortgages Min and max from any marketplace Typical range from across marketplaces Personal loan 12 36 606 3 35 501 Fixed APR, generally 4% .5% 7% 7.5% Student loan refi 12 36 606 3 35 501 Rates for fixed rate loan Min var. APR - 1.9%. .2.8% 3.5% 3.75% Notes: Rates vary frequently. Other loan terms might also change. Data meant to be representative, not comprehensive. Marketplaces typically do NOT charge any prepayment penalties or fees. Refer subsequent slide for revenue streams. Data snapshot taken on 3/21/2015. Small business Term loan 12 36 606 50 250 5,0005 Fixed APR, generally 8% .10% Line of credit 12 36 606 25 100 5005 Fees charged monthly . .12.7% 27% 30% RAJESH KAMATH © 2015
  14. 14. Note: Study limited to the US market Typical lenders (‘investors’) and products 14 Accredited Investor • The most common form of marketplace ‘investor’ • Consists of high net- worth persons & families, subject to certain income and networth criteria • Can invest after establishing accredited status Retail (‘Peer’) Investor Traditional Bank / Lender Marketplace / Online Lender IRA Account Holder Other Financial Institution • Found on very few alt. lending platforms, which are community or family & friends lending oriented • Can invest in ‘private’ offerings only • Need to meet additional state qualifications • Not all IRAs eligible to invest via platforms • Can invest through a ‘self- directed IRA’ account • Some platforms have started offering self- directed IRA accounts – e.g. Prospect IRA • Lend (rather than ‘invest’) their own funds • Funds available via capital infusions or lending commitments • Model close to traditional lending, but via the online / mobile channel • Traditional banks, lenders buying loans originated on marketplaces • Fund (and service) loans after platform approval • Platforms play the role of origination risk managers / referral channels • Specialist factors, merchant cash advance providers using platforms to fund borrower needs • Some FIs have also started securitizing loans originated by platforms, providing ‘indirect’ capital for lending The Investor Product • The most common investor product is Borrower Payment Dependent Notes, or “Notes” • The notes do not have a payment guarantee, even if underlying loans are secured • Marketplaces might allow both part and whole-loan investments via these notes • The notes do not have a secondary market (with few exceptions like FOLIOfn) • Some RE marketplaces also allow investments in equities or fund-like products Typical characteristics of notes - bear interest from issue date - have a fixed rate of return - are payable monthly - have a maturity of 1-3 years - typical APR 5-14%, v/s 1% CD RAJESH KAMATH © 2015
  15. 15. Note: Study limited to the US market Common platform business models 15 P2P Lender • Very few of pure-play P2P lenders exist currently. A few have adopted ‘hybrid’ models (Peer + Self / Investor lending) • Some bit-coin based lending still shows P2PL characteristics Note: Accredited investors NOT considered ‘peers’. Offer investments by peers (i.e., retail investors) Online Lender • No concept of ‘investor’ marketplace – loan funds come from single source • Typically, own funds are lent to borrowers • Can also be alternate origination channel for a bank / lender Offer loans through online / mobile channel. No investor marketplace Lending Marketplace • The most common model of alternative lending currently • Funds lent might be own capital /debt funding or from accredited / institutional investors, single / multiple lenders • Some only originate for a single lender now, but with scope for future expansion or act as a loan broker Marketplace model for loans. Mix of traditional lenders & ‘investors’ RE Lending Marketplace • Variant of lending marketplace, focusing on real estate • Funds typically lent for development and rehab of commercial RE / non-owner occupied RE, including fix-n-flip • Many allow for both loan and equity-based funding Marketplace model for real estate loans Financing Marketplace • Offers non-term-loan business finance like lines of credit, cash advances and invoice factoring • Focused on working capital needs of small businesses • Can act as broker or online channel for existing financers Marketplace model for non-loan debt financing RAJESH KAMATH © 2015
  16. 16. Note: Study limited to the US market Platform revenue streams - Summary 16 Origination Fee Maintenance / Servicing Fee Failed Payment Fee Rate Spreads Listing / Platform Fee Most platforms make their revenues (and defray their costs) by charging fees Revenue from rate spreads do not accrue to marketplaces, only to online / lenders Borrowers are expected to pay a higher number (and amount) of fees as compared to investors Fees and charges can be one-time or periodic or event based; they can be charged as a percentage or as a flat amount Refer following slide for additional discussion… Borrower Fees & Charges Investor Fees & Charges Late Payment Fee Check Processing Fee Other Fees Other Fees Investor Servicing Fee RAJESH KAMATH © 2015
  17. 17. Note: Study limited to the US market Platform revenue streams 17 Borrower Fees & Charges Investor Fees & Charges • Most common fee on marketplace / lending platforms • Biggest contributor to marketplace revenue • Exact amount (as %age) based on borrower risk ‘grade’ determined by the platform algorithm, on funding success Origination Fee • One time • Between 1% – 5% of amount funded • Typically charged in non-term-loan financing scenarios • Represents fee against extended line of credit, calculated on actual credit availed / outstanding Maintenance / Servicing Fee • Monthly (or weekly) • Between 1% – 2% of credit line outstanding • Failed payment fee – For reprocessing failed payments • Check processing fee – For payments made via checks • Late payment fee – For payments not received by due date Payment- related Fees • Typ. flat fee per event • Late fees can be %age of payment due No pre-payment penalties are charged by alt. lending platforms • Charged by online lenders, but NOT by marketplaces • Difference between cost of funds, and borrower APRs Rate Spreads • %age of loan amount • Listing / Platform fee – For listing loan on marketplace • Rarely seen; typically charged by <5% of platforms • Others Other Fees • Varies • Most common fee on marketplace / lending investors; though NOT as common as Borrower Origination fees • Used mostly for processing periodic investor payments Servicing Fee • Payment based • Between 0.5% – 1% of every investor payment • Platform fee – For registration, charged as one-time flat fee • Rarely seen; typically charged by <2% of platforms • Others Other Fees • Varies RAJESH KAMATH © 2015
  18. 18. Alternative Lending – The near term
  19. 19. Note: Study limited to the US market Regulation - Summary 19 Note: In addition to the above, offerings have to consider state financial suitability requirements. Crowdfunding, and more specifically, alternative financing is sought to be finally regulated under the JOBS Act 2012. Title III rules of the Act, governing crowdfunding intermediary (i.e., marketplace) provisions, are expected to go into effect by Q4 2015. Current marketplace offerings mostly take advantage of Reg. D exemptions under the Securities Act 1933. Today, mostly institutional or accredited investors (‘lenders’) can invest in securities offered by these marketplaces, with few exceptions. JOBS Act Title III means to allow wider participation of non-accredited (i.e., retail) investors in securities offerings by these marketplaces. Some commentators think that once allowed by Title III, the size of investments by non-accredited investors might be as high as $300 bn. Even with current exceptions, the number of non-accredited investors who are allowed to participate in any offering today is miniscule. Refer following slide for additional discussion… Currently, marketplaces are in a holding pattern with regard to Title III, which explains their absence of focus on retail investors. As of March 2015, existing alternative lending offerings operate under Securities Act 1933 Reg. D, and NOT under JOBs Act, Title III. RAJESH KAMATH © 2015
  20. 20. Note: Study limited to the US market Regulation - Details 20 General Offering Private Offering Securities Act 1933 - Reg. D JOBS Act 2012 – Title III In effect. Being used today. Expected. ETA Q4 2015. Governs Types of Marketplace Offerings Allowed Note: All current offering types expected to file Form D with the SEC Reg. D Rule 505 Reg. D Rule 506(b)Reg. D Rule 506(c) Non-accredited investors? Not allowed Allowed. Max = 35 Allowed. Max = 35 Accredited / Inst. investors? Allowed. NO number restriction Allowed. NO number restriction Allowed. NO number restriction General solicitation? Allowed Not allowed Not allowed Non-accredited sophistication? Not applicable Not required Required Annual fund raising maximum No restriction $ 5,000,000 No restriction SEC Disclosure burden Lower Higher Lower Governs Issuers & Marketplaces Issuers: Exempts issuers from Securities Act, Sec 5 requirements for issue < $ 1 million, if they use an intermediary* - broker or ‘funding portal’ Funding Portals (Marketplaces): • Required to register with SEC as ‘funding portal’ • Required to be member of a NSA (e.g. FINRA) • Cannot offer investment advice or recommendations • Cannot solicit purchases, sales on securities offered • Cannot pay compensation for solicitation • Cannot hold, manage or handle funds or securities * In addition to other conditionsRAJESH KAMATH © 2015
  21. 21. Note: Study limited to the US market Major recent investments in marketplaces 21 Data sources: Primary research on investments in alternative lending conducted by the author using CrunchBase, AngelList and other public domain sources. Sample size ~50. Sample was meant to be representative, not comprehensive. Only investment deals with size > $50 million shown in this representation. Represents total investments made in marketplace sample (size ~50) in that calendar year. USD millions. Direct Lending Investments 250 Q4 2007 80NelNet, Vikram Pandit + 120 Q4 2012 100GarrisonQ4 2013 65Accel Partners + Q3 2013 270 Q1 2009 866 IPO 12/2014, Google Capital, BlackRock + 125 6557Q1 2007 200130100 7775 IPO 12/2014, Thiel, Goldman Sachs, Google Ventures +Q2 2006 350 Q3 2011 70Phenomen Ventures + Q1 2006 200200 8077 60 Peter Thiel, Renren Inc., QED Investors +Q2 2011 143 1,198 318 2,575 12/31/201412/31/201312/31/201212/31/2011 12/31/201412/31/201312/31/201212/31/2011 Platform & launch date Major Investors RAJESH KAMATH © 2015
  22. 22. Note: Study limited to the US market Alternative lending investments 22 Most of the early funding for marketplaces came in the form of angel / seed / bootstrap and venture capital. In contrast, funding today is increasingly coming from more ‘mainstream’ institutional players in the form of equity and debt / debt commitments. Two marketplaces also went public in 2014 through IPOs. Data sources: Primary research on investments in alternative lending conducted by the author using CrunchBase, AngelList and other public domain sources. Investment types: Angel / seed / bootstrap, Venture capital, Private equity, Debt & lending commitments, IPO Sample size ~50. Sample was meant to be representative, not comprehensive Investments in 2011 and earlier were going into alternative lending that offered mostly non-segmented personal and business credit. However, marketplaces since then have become increasingly product & customer-segment specific, and investments in them can be thought of as reflecting those specifications. RAJESH KAMATH © 2015
  23. 23. Note: Study limited to the US market Some active considerations 23 Regulation How will the ‘final’ rules under JOBS Act Title III affect the way marketplaces work? Segmentation Which borrower segment(s) to target? What should the product mix look like? Differentiation How to differentiate ones offering in an increasingly crowded business? Acquisition Costs How much should be spent on acquiring new borrowers? What channels? Operational Cost Will costs in the model increase? Especially with human-in-loop decision making? Brokers in small business lending can charge as much as 10-15% of loan amount as brokerage charges Previously specialized lenders have now started diversifying into new products. e.g. SoFi For example, there are 60+ marketplaces targeting real estate funding in the US alone Investor Mix What is the ideal investor mix? Especially after Title III comes into force? This is also connected to how fast the marketplace can scale, to handle investor growth Marketplaces today explicitly say that they do NOT operate under Title III Investor Access How much access to provide institutional & technology-based investors? Some marketplaces have started limiting automated access by algorithms that select loans for investment Technology costs are lower than human costs in the operational context Technology What strategy should be followed for the platform technology? Build? Buy? Mix? While the user-facing features are common across most platforms, the decision-making algorithm is the differentiator RAJESH KAMATH © 2015
  24. 24. Note: Study limited to the US market Key success factors 24 Scale • Influences marketplace top-line – (fee) revenues ᾱ loans originated • Key driver in attracting customers, capital, growth and survivability Agility • Bringing new products to market • Rolling out offering in new states • Reacting to introduction of new regulation • Modifying technology & data to align with real world observations Customer Experience • Drives return business to the platform • Influences customer (borrower and investor) referrals • Contributes to differentiation & reduces acquisition costs Access to Capital • Drives scale – especially capital from institutional sources • Can influence cost of capital, which has a direct bearing on bottom-line Risk Management • Implemented in underwriting technology (algorithm) and processes • Drives sustainability, and in the longer term, access to capital • Especially important during downturns in the credit cycle Cost Structure • Governs cost of capital to borrowers, influencing customer acquisition • Drives bottom-line, and return on capital • Technology used to break co-relation of scale with human costs RAJESH KAMATH © 2015
  25. 25. Note: Study limited to the US market What the future might look like 25 2014201220082006 2010 WE ARE HERE 25+ commitments of more than $50 mm each in this period SunTrust launches online lending – ‘LightStream’ S&P provides rating for SoFi’s securities offering Number of ‘independent’ alternative marketplaces Number of bank online lending / marketplaces Key: Alibaba offers loans to US businesses through Lending Club Lending Club & OnDeck go public FOLIOfn offers secondary market for P2P securities Number of alternative marketplaces might reduce drastically through cash burn without scale, consolidation & effects of bad credit cycle Mainstream banks will have to adapt to online lending to acquire / retain millennials as customers Lending club surpasses $1 bn. in loans issued Prosper surpasses $2 bn. In loans issued OnDeck records annual loan origination volume of $1.2 bn. Union Bank agrees to buy loans from Lending Club Steady state Marketplaces & lenders that excel at the key success factors will survive. Customers will move to the survivors. Rate of new platform launches will be low, and will require really robust differentiation and / or sharp niches. Marketplaces and banks will compete, but also collaborate. Smaller banks are likely to see marketplaces as partners in expanding / sustaining business RAJESH KAMATH © 2015
  26. 26. Thank You https://www.linkedin.com/in/hsejarhtamak RAJESH KAMATH