Archive for the ‘Financial Markets’ Category

Banking without Banks

Banks said it couldn’t be done.  But innovative entrepreneurs are capitalizing on social media, Big Data and machine learning technology to make capital available to people who couldn’t get it before or couldn’t get it at affordable rates.

One company enables middle-class consumers in emerging markets to gain access to short-term loans by using social media to prove their credit worthiness.  Another has, in just 7 years, made $1 billion in business loans to small businesses with poor credit.  A third manages a credit marketplace of borrowers and investors in order to facilitate personal and business loans at lower rates than borrowers can get from banks – $7 billion in loans in 7 years. The fourth provides micro-loans without collateral to low-income Hispanic families who lack a credit history.

The companies are Lenddo, OnDeck, Lending Club and Progreso Financiero, and their founders told their stories at the Data Driven NYC Meetup in May.

The Situation

According to James Gutierrez, Founder & CEO, Insikt, Inc., a financial data analytics company, and formerly CEO of Progreso Financiero, which he founded:

  • New regulations for banks have changed lending:

o   Credit Card Act

o   Dodd Frank

o   Basel II

o   Basel II/II.5.

  • The availability of revolving credit is down – affects small business lending by banks – non-prime consumers are hit hardest
  • Technology is changing lending across the value chain, driving the price down

o   Applications drive higher volume and lower costs

o   Underwriting – big data makes more sources accessible and results in lower risk and increased capital

o   Servicing – electronic payments – ACH means lower costs and lower risks

o   Mobile payments by lower income borrowers – lenders use SMS for collection to lower cost and lower risk.

  • Banks can’t keep up with nonbank alternative lenders, which are transforming all loan products.

Four Nonbank Alternative Lenders Speak

Jeff Stewart, Founder & CEO, Lenddo

  • Launched early 2011
  • Serves middle class consumers in emerging markets
  • Goal was to involve the crowd in lending to the middle class using micro finance techniques and social media data to establish creditworthiness where none exists
  • Social data add value by making it possible to map good vs. bad borrowers in terms of affiliation because “birds of a feather  gather together” – “even two degrees out tells us how you will perform”
  • Integrates social networks with mobile & the cloud to use data sources
  • Works with the community on both demand generation and collections/repayments
  • Storage was a major technology issue – Chose MongDB at the outset with Amazon Web Services – database grew explosively – all opt in
  • User data = social data – grew exponentially – expensive even when only 20K members.
  • Realized “It’s big data, not big database” so they moved data to simple storage, created cache MongoDB for queries and cut costs 70% – they think about data use cases.
  • No database frees you to solve problems
  • Looking closely at bitcoin block chains to add value for transactions.

Noah Breslow, CEO, OnDeck

  • Has made $1 billion in business loans to small businesses with poor credit over 7 years
  • Loan size is small – $100K-$300K; banks need larger loans or they lose money – they need $1 million and up
  • SMEs represent a large and underserved addressable market
  • Built a platform to connect Main St. to Wall St., with OnDeck playing all four essential roles:  originator, servicer, credit bureau for collecting and aggregating data, and credit scoring (FIC0)
  • The database tracks small businesses from birth to death.
  • The digital footprint of different stores is totally different and depends on different data sources
  • Co. adds private performance data to public data and does a lot of fraud management and triangulation
  • Developed a different kind of credit score – it’s a business credit score, not a personal one with the focus on debt service calculations:  cash flow, trade credit, business attributes.  Social data is noisy – need to look at patterns.
  • A large number of small transactions – restaurants, retailers, doctors & dentists, small manufacturers, etc.
  • Gather data for scoring a business from many sources.  Building a data aggregation and learning platform that includes Mechanical Turk and common sense.
  • They price to risk.

Renaud Laplanche, Founder & CEO, Lending Club

  • Has created a credit marketplace of borrowers and investors, where Lending Club facilitates loans but is not involved on the credit side.
  • As a result, LC can operate at a lower cost than banks – banks have 5%-7% of amounts lent in operating expense vs. LC , which is under 2% and declining.
  • LC incurs none of some bank costs, such as the cost of branch offices, reserve requirements, and has lower costs or more advanced technology for customer acquisition, underwriting, origination and servicing.
  • Bank’s intermediation cost for credit cards is 16.99%.  LC’s range is 7.9%-127% with average intermediation cost of 4.83%.
  • A lower lending rate means a higher return to investors.
  • Have consistently controlled LC’s growth.  Now have 550 employees; hire 100 people every 6 mos.
  • Use data for marketing, credit, fraud and collections – receive about 9,000 loan applications a day.  Less than 10 are fraudulent, so that fraud becomes a needle in a haystack.
  • Fraud predictors:  time of day, frequency, etc.  New data sources:  device, online footprints, application use.  Look at consistency of the information provided, behavior online footprint, machine/device and location signal.
  • LC uses machine learning to assess risk and predict fraud based on more than a thousand attributes
  • Fraud attempts have declined from 5% to 2%.
  • Just formed a partnership with Union Bank in San Francisco, which overcomes the challenge of complying with 49 sets of state regulations for Lending Club and opens the way for a traditional bank to offer products it could not otherwise offer.  (Probably an indicator of a future trend.)

James Gutierrez, Founder & former CEO, Progreso Financiero

  • James was a 2005 MBA from Stanford
  • Micro finance gave him the idea for Progreso Financiero – unsecured micro loans and debit cards – delivered from a table in the supermarket – to help immigrants with no FICO scores
  • Typical loan size was $1,000 for 12 months.  Had to make 10,000 loans to get $1,000 back.
  • Immigrants with no FICO scores are a challenging population to underwrite
  • What he did:

o   Took an eHarmony approach with a robust application with extremely detailed personal data.  Detailed data turned out to be valuable.

 o   Booked some bad loans – a learning experience – the most valuable data is performance data – having a huge amount of data helps build a model – data science is no help

 o   Aggregated and analyzed alternative data:

      • 300 attributes on the application
      • Separate borrowers into nodes
      • Later 2,500 attributes from multiple sources
      • Over 120 segments
    •  Data helped simplify the process & determine the score
    •  Merged alternate data with bureau data
  • Fair equal Opportunity Act – the jury is out on what data you can use to deny credit, the actual underwriting decision
  •  Made more than 500,000 loans with single digit loses
  • Partnered with Prosper, the first peer-to-peer lending marketplace, with more than 2 million members and over $1 billion in funded loans.
    •  Risk model design
    • Loan valuation framework
    • Valuation stress testing.

Today James’s focus is on Insikt Inc., a financial data analytics company that uses data for risk models to apply to consumer markets.  He and his team are working on how to originate loans in the subprime market and how to create a more curated market for securitization – concerned with both bond performance & loan performance.

Panel Discussion, Moderated by Matt Turck, Organizer

  • Banks are encumbered by regulation
  • Alternative lending is only 5% of consumer finance

o   In 5 years we’ll see a lot of new entrants

o   More partnering with banks

  • Transforming the bank system to be more transparent and customer friendly
  • There are four different segments with lending opportunities

o   SMB

o   Consumers

o   US

o   Emerging markets

  • Top ten global institutions will be big players in financial services
  • Rates for consumers can be as low as 6.5%, average 12.5%; for business, 5.9%
  • Rate risk is better through the use of data and marketplace dynamics drive interest rates down
  • A virtuous circle continues to make credit more affordable and drives interest rates down
  • Most credit cards are priced at prime plus
  • Alternative lenders return a higher return to investor
  • Rates rise in a better performing economy and defaults come down so we expect our proceeds to be stable.

Mayday or Payday?

By Eleanor Haas

Just how far-reaching is the
fallout from July’s credit crash? Major
financial markets firms took big hits, and two lost their CEOs – Merrill and
Citi.  Morgan Stanley just lost a
co-president. News commentators wonder aloud
whether we’re headed for a recession. In
fact, news media are full of gloom and doom. But perhaps their heads are too high up in theoretical clouds to see the
reality that the sky has not fallen – smart investors are still making money.

My friend John says his HNI
friends (High Net Worth Individuals) are fleeing to the security of mutual
funds. My friend Jeff is having success
raising a new venture fund.  My friend Arthur is
judiciously managing his portfolio of real estate investments, buying or
selling, wherever the best advantage lies.  Three different kinds of opportunity for three different kinds of savvy investors.

In other words, financial life
goes on. maybe It’s not mayday after all – at
least not yet.

Speakers from three private
equity funds bore this out last evening in the course of a panel discussion on
Exit Strategies and Fundraising in a Changing Environment, which was sponsored
by WAVE (Women’s Association of Venture and Private Equity). Opportunities abound for those who know what
they’re doing.

Timing is everything, said Raquel
Palmer, a partner with KPS Capital partners, which buys troubled companies and
fixes them. “We had nine exits in
fourteen months,” she said, “the foreign market is still open. The US is on sale. European and Japanese
strategists get good value.”

“The market is open, but
selectively, by company and by sponsor” said Linda LaGorga, Managing Director,
Financial Sponsors Group, Goldman Sachs, who sees good exits for strong assets
in the $50 million EBITDA and above market. “The financing market is volatile. It’s there for some assets, not others. You have to get ready and time it.”

“Strategics were not hurt by the
bank pull-back on financing, as private equity funds were,” said Bill Jarrett,
Managing Director, Lower Middle Market, Goldsmith Agio Helms/Lazard Middle Market. “We’re more selective. Some industries are out of favor –
housing. Service industries are dong
well, for companies with good cash flow and EBITDA.”

Services with good cash flow and
steady growth, which are not cyclical, sell well in this market, and buyers are
out there, agreed Ms. Gorga. Large
private equity funds want to buy by the end of 2008, so they play at the lower
level, $750 million, look at smaller assets in order to put money to work. PIPES are another way to put equity to work
now and be in a good position later.

Niche companies in their
segments – often with consolidation – are a good bet. Mr. Jarrett sees “lots of buyers for rollups
and synergistic acquisitions. An
international component to the transaction can be a deal sweetener – a foreign
buyer or an international component of the company.

What private equity buyers have
to look at in making an investment is the exit opportunities, so they look for
companies with strong market share – a good niche player with a franchise, Ms.
Palmer pointed out.

What about valuation, pricing
and terms?

  • There’s still a backlog of leveraged loans, and this
         impacts big buyouts, as does concern about a potential recession and the
         volatility of the housing market. Most deals in the $50 million and above market have covenants,
         going back to the more traditional deal. Leverage has come down. It’s
         2002 all over again. The market
         will recover.
  • Valuations are down. There’s a shifting of risk – escrows, warrants, liabilities. Sellers may take lower multiples if the
         terms remove certain escrow commitments. Seller financing is coming back, which can help bridge the gap
         between expectations and valuations.
  • The lower middle market depends on smaller banks for
         financing. The pullback is at the
         high end of the market, not this one, where lending may now be a 3 times
         EBITDA as opposed to 3.5 times. Smaller banks are cautious now, but they’re still financing
         transactions.

What kinds of deals have you had
since the credit crisis began?

  • KPS is having “great deal flow” because companies
         can’t readily get bailout funds. Two of four companies KPS is looking at are operating in Chapter
         11. This makes them easy to clean
         up and recapitalize. KPS expects to
         see more of this. Investment banks
         used to dictate pricing with staple financing, but people are not seeing
         these any more.
  • The Middle East has huge amounts of money –  multiples of the largest US funds – and offers good ways to sell a company. New lenders are stepping up – new banks are entering the market. Mezzanine funds are key. Goldman has a $9 billion fund that is stepping in and taking a subordinated part of the capital structure.
  • Typical deals take six months but now often take longer. On the other hand, a strategic – a domestic strategic – just did a deal at 10 times revenue in two months – with no book. International buyers take longer.

What about buy side
opportunities?

  • There’s still a lot of liquidity in the market. People will have to put in more equity,
         and sellers have to have more reasonable expectations. Private equity funds raise funds to buy
         debt and then take on debt to do this. That’s high risk. Many
         private equity funds won’t be successful raising funds because they can’t
    differentiate or create value for investors. Smaller PEs will vanish.
  • It’s a good time to buy a business and to buy it
         cheaper, and lots of companies in distress is an incentive to buy. Hedge funds are tempted. Their managers know how to run funds but
         lack experience with Chapter 11 and restructuring. They’re getting smart about Chapter 11
         strategies with distressed companies.
  • Seller expectations will come down, i.e., valuations. The credit market will stabilize. 2002 buyers did very well. You just can’t predict the timing of the cycle.
  • PEs continue raising a lot of money. This adds to the buy side. Boomers are aging, are concerned about
    possible increases in the capital gains tax and so want to sell now. Corporate performance is strong. The stock market is off but companies still make acquisitions. Smaller banks will continue to lend.

To quote the French, the more
things change, the more they are the same. Those who remember 2002 and other periods like this have the confidence
to make wise decisions. Those who know
what they’re doing do it right. For
them, it’s payday. For the unknowing or
under experienced, beware. For them, it
could well be mayday.

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