Lenders will outlast online loan platforms

Founders building a business for the long-term (ie. 10+ years) will need to consider the disadvantages of platform models.

In India, where regulations require lenders to be licensed, entrepreneurs building digital credit companies must make an important call: whether to become a licensed bank or non-bank finance company (NBFC), or to set up as a “platform” that connects prospective borrowers with existing lenders.

In India, licensed lenders include NeoGrowth, CapitalFloat and AyeFinance. Platforms in the market include Indifi, SMECorner and Faircent. Within the platform approach, some companies only seek to arrange loans between borrowers and financial institutions. Others take a “peer-to-peer” approach and try to match borrowers with lenders who are not just institutions and banks, but also well-off professionals and individual investors.

Platforms are sexier business models

Between the two, the platform concept is definitely more popular: among roughly 50 digital lending ventures in India that I’ve tracked, about 40 (or 80%) are platform plays. This is not surprising — setting up a platform does not yet require obtaining a license, although the RBI will require this soon.

But more than regulatory arbitrage, it’s the business model that appears attractive. Say “platform play” to many VCs or young entrepreneurs and their eyes will light up at the idea of an Uber for loans. “Oh it’s like Uber! No assets! No big teams! Just an app connecting zillions of borrowers with buckets of capital sloshing around seeking returns. BOOM!”

In reality, choosing the platform approach means important long-term trade-offs. It’s perfectly fine for founders and investors to ignore these long-term implications if they have a shorter-term horizon. But I suspect younger entrepreneurs and those less experienced in the financial sector are simply not thinking about these trade-offs as they make their decision.

First principles: build to last… or build to sell?

Choosing between the platform or licensed lender model follows naturally from the vision founders have.

Some founders want to build a company that can last 10–20 years if not many more. Although most early-stage investors will want to exit their investment within 5–7 years, there is a smaller number of patient investors who do seek out founders that have a long-term vision for their baby.

Other founders identify opportunities to build something that they can sell to a bigger player, or that they can grow for a few years and then cash out. This aligns with the time horizon for most VC investors, who want to buy low and then sell high at a subsequent financing round or IPO. Such teams and their backers would be very happy to grow a digital lending platform business from zero dollars in loans facilitated to 100 million dollars in loans facilitated over 5 years, and then sell their stake to a later investor without concern for what the business will look like 20 years on.

Three requirements for a long-term digital lending business

Still, if I’m a founder who wants to set up a company with the potential to be around for decades, I’ll know to expect a few ups and many downs on the path. To realize my long-term vision, I’ll worry about three factors:

1. Freedom to adapt. I’ll need to be able to change directions to ensure my company’s survival. Within the lending business, this means that I must be able to adapt my loan products, my interest rates, and my sources of capital in response to market pressure or competition. At some point I may need to diversify away from my core target segments if they become over-served. I may even need to re-examine my identity as a digital lender, and consider getting into a branch-based approach.
2. Sustainable margins and cash. Lenders operate a net interest margin (NIM) business: attract low-cost funds (ie. deposits at 8%) and lend them out at a higher rate (ie. personal loans at 28%) to earn a profit after losses. If I’m a lender, my NIM may be 10–20% depending on the type of lending being done and my capital costs. On the other hand, as a middle-man between lenders and borrowers, I’d earn only a slice of that.
3. Avoiding over-dependencies. Like any business, I’ll be watchful about becoming over-dependent on a single customer, industry focus, or supplier(s). Banks lend using many types of deposits and capital sources, but can be over-dependent on certain sectors to build a loan book. MFIs try to rely on a range of wholesale lenders and banks for their capital, but may risk concentration in a few rural settings. Lending platforms ostensibly match large numbers of borrowers and lenders, but often it’s just a few institutions who buy the bulk of loans.

Unsexy wins

When assessed with a long-term perspective, loan platforms fall short as a business model. Compared to financial institutions, loan platforms have less freedom to adapt, smaller margins, and are more dependent on capital sources to operate. Yes — some platforms will win and become long-lasting players. But the combined picture of the deficiencies I highlight below suggest that platform models are structurally weaker.

Constrained ability to adapt
Companies that sell to banks — whether online platforms selling loans, business correspondents opening bank accounts, or others —soon find out that they have very little control. I’ve been in this situation myself several times. An innovative loan product can’t get launched because the bank already has an unpopular but slightly similar offering. Or a critical change in pricing or process doesn’t happen for months until multiple department heads are convinced.

Whatever the specifics, the bottom line is that as a middleman for the bank, I can’t simply find customers and offer them what I think may be best. I’m dependent on what my banking or lending partners want to do.

Small, commodity margins
Middlemen are usually commodity players. Sure, online loan platforms may introduce or match borrowers and lenders, and some even purport to guide a borrower through the process (such as by educating her about her credit score etc). But ultimately, lenders view these platforms as substitutes and won’t pay them anything more than a token slice of their NIM.

Is it possible for a platform to differentiate and dominate? Yes. Platforms that are first movers, specialists in industry verticals, or those that focus heavily on optimizing the loan application process or a credit decision engine may stand out. But overall, the middleman role is structurally weak.

Over-reliance on capital sources. While loan platform companies talk ambitiously about a large supply of lenders, most end up being reliant on a small number of institutions to buy the loans they source. By mid-2016, 85% of Lending Club loans in the U.S. were from institutions rather than individuals. And Lending Club’s dependence on big buyers like Jefferies & Co led it to mis-represent what it was actually packaging for its client.

Wait — don’t licensed lenders like NBFCs also face the risk of being over-reliant on a few lenders to provide their capital? The answer is yes. However, these licensed lenders have a lot more options when it comes to their capital structuring.

Most will be levered at most 7:1, allowing them to tap in to a base of equity if lending capital is required. They also have the ability to act like a platform should they want to, and therefore combine on-balance with off-balance sheet financing. They can sell or securitize their portfolios to free up capital. And larger, more ambitious players who aren’t already deposit-takers can seek banking licenses to open up that source of capital.

Conclusion: the combined risks make platforms vulnerable

Short-term, platform plays look easier. They don’t need to raise as much equity t0 anchor a loan book. They may not need a license from the regulator. And ostensibly they can focus more on acquiring borrowers and lenders than companies that need to manage their own balance sheets.

But taken together, the weaknesses on each dimension above make platforms a far less viable business model, long-term. When crisis after crisis hits (as it does until a business matures), the recipe for survival is adaptability and control and independence and a sizeable cash hoard. At the end of the day, compared to platform players, licensed lenders are more resilient and adaptable, have more financing options, and are building a direct connection — a brand — with consumers from day one.

Several loan platforms in India will grow big and even go public. But in 10 years the overall volume of direct digital lending will vastly surpass the volume done through platforms. Long-term, direct lending as a licensed financial institutions is simply a safer bet.