Given the recent headlines regarding the struggles in performance of Lending Club’s models, I wanted to revisit some of our closely-held views on loan investing. Over the last two years, I have been focused on two major themes – both of which were met with a lot of skepticism. First, I was convinced that we were mid-to-late in the economic cycle, meaning that economic weakness was more likely than explosive growth. While the Fed managed to sneak in a rate hike, the capital markets have spoken and most investors are starting to believe that the cycle is turning. The second belief, connected in many ways for the first, was that marketplace lenders would overextend themselves, making too many risky loans at low yields. The Lending Club article confirms what we have been telling our investors for months – stay focused on high-quality lending. The first decision we made when looking at emerging lenders was that investing in high quality loans was likely to provide better returns than equity. Venture capital firms had already driven up the valuations of “marketplace lenders” to levels at which we couldn’t realize return on an annual basis like we could from investing in the loans. Lenders were, and still are, being valued based on some multiple of the volumes of loans they underwrite. This makes sense given that their earnings stream comes from the origination fees they collect for each loan and the corresponding servicing that they collect for the life of the loan. That said, no one knows if the originate-to-sell model will succeed, or, if they do, who the winners will be.
While it is interesting to discuss the “Uberization” of finance, the parallels are limited. Uber succeeds in some way due to its scale – said simply, they have a lot of drivers in a lot of places. If you started a better car service today, it would be hard to get the same scale over any survivable period of time. Lending is different – while people may be frustrated with traditional banking, at end the day loyalty to a lender is not determined by scale, but by price. Most people choose to borrow at the lowest possible rate, assuming that their borrowing experience is reasonable. To achieve higher volumes, marketplace lenders are forced to lower rates and seek out riskier borrowers, which is a toxic cocktail that always ends in tears.
This highlights the importance of an active management team with a deep capital markets background like ours. We make decisions based on our view of the economy, the rate offered by the lender and the quality of the underlying borrower. If we stop liking loans, we stop buying them. As far as the equity performance goes, here is a chart of Lending Club’s performance:
Obviously the loans have held their value far better than the company’s equity. We continue to find loan product, often from niche lenders that are not part of the “marketplace”, that offer around 10% returns annually. I would not bet on replicating this in the equity markets.
Does it matter that the larger marketplace lenders do not retain any loans on their own balance sheet? In November of 2014, I wrote that: As securitization heats up and we get closer and closer to rated transactions, we’ll go with “eventually, but not now.” Here we are – just over a year later – and rated securitizations are being done across a number of marketplace products. For those unfamiliar, a securitization allows a pool of loans to be turned into a security and sold off into the public bond markets. A rated securitization is likely to be purchased by a large asset manager, pension fund or insurance company. These huge pools of capital change the economics of lending. In a world without securitization, if a marketplace lender lowers their rates too far or if defaults increase unexpectedly, investor capital would flee until that lender raised lending rates. Now that securitizations have opened the door to buyers who are less rate sensitive, platforms have an excuse to be less sensitive to deterioration in performance. In other words, they are being too slow to raise lending rates. Until marketplace lenders raise lending rates meaningfully to the lower-quality borrower, we will assume that performance of down-in-quality assets will suffer.
We have fastidiously resisted the urge to chase low-quality assets in the Blue Elephant, even though it would have made our returns look better in the short run. We own nothing resembling near-prime or sub-prime risk. We are marked conservatively, with any non-performing asset written down near zero. We’ve created an extremely high quality book of loans with sector and geographic diversity. We should now benefit from that conservative positioning. If my capital markets experience is any guide, this is only the beginning. Staying conservative for a little longer will pay dividends over the coming months. Our views will continue to evolve and we look forward to sharing that information as it happens. In the meantime, we will stay focused on making smart, conservative investments.
All the best, Brian