Thoughts from this post originally appeared in the TLW Newsletter. Sign up here.
When I’ve talked to a few “industry veterans” within the small business lending space, they all have been very dismissive of some of these “next-gen” lending companies. They mostly have said that while the algorithms and machine learning used to crawl a variety of social/digital metrics are great, they don’t replace industry knowledge or traditional processes like site visits, interviews, or going through resumes, which often take longer.
As I’ve discussed before, time from a loan application to bank wire is a key component for small business loans. This is where a lot of the newer lending companies have become so dominant, touting the ability to approve loans and transfer money in as little as 5 minutes for smaller loans, to even 24 hours for larger ($10k+) loans. And with this increased speed has come better inbound deal flow, as well as an easier sell for the various brokers and ISOs that companies like OnDeck Capital or Wonga use. But are these increases in speed actually sacrificing depth of due diligence?
I always assumed that many of the industry vets were a little stuck in their ways and didn’t like this next generation of companies that came in, essentially de-valued the branding of merchant cash advances or other lending alternatives, and started undercutting them on both price and speed. All of this happened while these companies raised large sums of money from VCs that allowed them to focus on volume (a massively important metric for the factoring/SBL model to work) instead of best practices and risk mitigation.
But recently, Wonga, one of the UK’s biggest payday lenders, was discovered to be poorly evaluating risk and as a result had to write down $340M in loans, and was recently forced to sell parts of its business along the way. At the same time OnDeck is having its own slew of issues related to defaults that are affecting its valuation in public markets (down 42% post-IPO).
Maybe its time we re-evaluate just how reliable the algorithms and metrics are that these next-generation lending companies are using. These high-pressure business models that force a company to optimize for volume growth and velocity of capital, essentially removing the ability to perform proper due diligence, clearly affect the balance sheet negatively in the mid-long term.
Now is the solution for this a more traditional approach? Perhaps. The one silver lining is that with a company operating in public markets now (OnDeck) the entire investment community will be able to see how these businesses truly perform without a safety net of growth equity and late-stage institutional investors to prop them up.
I know this post comes off as largely bearish, but I genuinely believe that the technology-aided small business loan model will work long-term, I just don’t know if we have the right solution yet for a generalist lending model.
And while the market for alternative lending is obviously large, this much uncertainty around specific providers and their business models forces me to look around at the surrounding businesses in the space. And to me, the real winners here are looking more and more to be platform providers such as Orchard Platform.