Blue Elephant Capital Management

Marketplace Lending’s “Hobson’s Choice” Problem and the Need for Fiduciaries

The marketplace lending landscape has been changing rapidly over the past few months and I’ve been quite vocal that this is a great opportunity to allocate capital into loan investments. The more I think about the landscape, the more excited I get. Based on Prosper’s most recent estimates, the loans that they originate after April of 2016 will have over one-percent higher returns than their 2015 vintage. My guess is that the performance differential will be even greater, as the pressure on the marketplace lenders to perform is only increasing.

While the opportunity set has become more attractive, it does not mean that gathering loans blindly is a good strategy. Lenders, no matter how careful, are going to make loans that default. Part of this is simple – no lending model is perfect. Beyond that, there are forces well beyond a lender’s purview, such as broad economic forces that change the landscape faster than their models can adjust. There is a wide gap between being a lender and being a fiduciary to those buying loans. The lender guarantees that the loans that they issue fit a certain set of criteria — a FICO band, for example. From there, they distribute those loans to investors without any guarantees regarding their actual performance. Blue Elephant is the fiduciary, making the determination on whether the loans will perform as described.

One of the unique aspects of marketplace lending is that loan investors are offered a “Hobson’s choice” when it comes to buying loans. The term has an interesting origin. Hobson owned a large stable in England where customers could come and ride horses. In order to protect the best ones from being overused, Hobson gave customers only one option – either take the horse that was in the stall closest to the door, or leave without riding. There was no room for negotiation or other alternatives – Hobson’s choice is essentially to take it or leave it.

This Hobson’s choice is how marketplace lenders function. They do not give any options – they use their models and knowledge of supply and demand to set each borrowers rate. The borrower may either take the rate offered or move on. Similarly, the lender on the other side must either fund that loan or leave their cash sitting idle. When the demand for loans outpaced the supply of quality loans, lenders simply cast a wider net to fill the demand. Note that they did not advertise this – only those of us closely looking at the details noticed. Some would still disagree with my assessment, but the statistics are pretty revealing – 2015 will mark both the peak in volume and the low in performance for the marketplace lenders.

Here’s the point. There is a huge difference between “loan gathering,” the act of buying whatever loans are offered, and “loan investing,” which is what Blue Elephant does. Loan gatherers are simply accepting the next horse available in the barn, regardless of whether it is a good choice or not. A loan investor acting as a fiduciary cannot take this approach. Over the past three years, Blue Elephant has looked at just over 100 different lenders of various styles and business models. Of those 100, we’ve approved six. Beyond that, we’ve completely stopped buying loans from all of our lending partners at various times. In every case, our decision to turn off a lender had to do with our not liking their underwriting for one reason or another.

Active management is the key to success in lending strategies. There is no “index” to buy and no ETF to trade that represents the broad array of lending investments. Marketplace lending, while generating all the headlines, represents only a piece of the broader opportunity. The recent announcements by Lending Club have managed to create an investment window by forcing marketplace lenders to increase lending standards at the same time that they raised rates. It does not change our broader thesis that a successful direct lending fund needs to invest based on constant surveillance of underwriting and broad economic conditions. We continue to do due diligence on other lenders, looking for more secured debt and other opportunities that fit our view. We don’t want any horse in the barn – we want the best one.