Surviving the Tsunami:
How Funding Strategy Impacted Alternative Lenders During COVID
By: Archita Bhandari
Note: a condensed version of this article appeared first in TechCrunch on 08.30.2021. Download the TechCrunch PDF version here or read the full version below.
Rachael runs a bakery shop in New York. Started in 2010, with personal savings and contributions from family and friends, the business has grown, and Rachael now needs additional financing to open another store. So how does she finance her expansion plans?
Because of stringent requirements, extensive application processes, and long turnaround time, Small and Medium sized Businesses (SMBs) like Rachael’s bakery seldom qualify for traditional bank loans. That is when alternative lenders — with short and easy applications, flexible underwriting, and quick turnaround time — come to the rescue of SMBs.
Alternative lending is any lending that occurs outside of a conventional financial institution. Alternative lenders offer different types of loans such as lines of credit, microloans, equipment financing etc, and they use technology to process and underwrite applications quickly. However, given their flexible requirements, they usually charge higher interest rates as compared to traditional lenders.
An intriguing question is how do these lenders raise funds to bridge the financing gap for SMBs?
As with all businesses, there are two major sources for capital- Equity and Debt. Alternative lenders have typically used funding from venture capital (VC) and private equity (PE) institutions, and initial public offerings (IPOs) as the main sources of Equity capital. Under Debt capital, traditional asset-based bank lending, corporate debt and securitizations are the broad sources of funds.
According to Naren Nayak, SVP and Treasurer of Credibly, “For alternative lenders generally, Equity constitutes 5-25% and Debt constitutes 75-95% of the source of capital. A third source of capital or funding is also available to alternative lenders – Whole Loan Sales – whereby the loans (or merchant cash advance receivables) are sold to institutions on a forward flow basis. This is a “balance-sheet light” funding solution and an efficient way to transfer credit risk for lenders.”
Let’s look at each of these options in detail.
RELATED PODCAST EPISODE: Alternative Financing Before, During, and After a Global Pandemic -with Naren Nayak and Sachin Goel. Listen here.
Fig. 1 – Funding Sources for Alternative Lenders
Venture Capital/ Private Equity funding is one of the major sources of financing which provides a boost to the alternative lenders. TechCrunch even quoted the alternative lending industry as a “gold mine” for venture capital investments . In the initial stages, it is difficult to get credit from traditional banks because of their stringent requirements. Once the founders have shown a commitment by investing their personal capital and funds raised from family and friends, VC and PE firms then make institutional investment in alternative lending start-ups based on their team, technology, efficiency, and growth potential. They also provide valuable guidance, expertise, and consultation and through multiple funding rounds – seed round by venture capital firms, rounds A through F by private equity firms – help alternative lenders to scale their business models. However, financing by VC and PE firms is an expensive source of capital- it dilutes the ownership and control of the alternative lender. Plus, obtaining venture capital is a long, involved, and competitive process.
Another option that alternative lenders, who have achieved good growth rates and scaled their operations, have is to raise capital through an IPO. Shares of the alternative lending company can be sold to public investors and be listed on a stock exchange. IPO offers the ability to quickly raise potentially large amounts of capital from the marketplace and provides a lucrative exit for early investors. However, it is a time-consuming process involving significant legal, accounting and marketing costs, and also brings with it, more scrutiny from the regulators and investors. The non-bank lender can choose to remain privately owned or going public as the business grows.
Once the business is in good shape, banks are more willing to lend money through loans and revolving credit facilities. Term loans are the financing provided by traditional banks, credit unions and Small Business Administration (SBA) lenders. Although they offer low interest rates and long payment terms, they require several indicators of security-like substantial track record and collateral- which nascent alternative lenders do not have. Another option, revolving credit facility, is a flexible financing tool that provides the borrower with the ability to draw down, repay, and withdraw funds again. They enhance liquidity for alternative lenders as they have ready access to funds to originate new loans as demand increases, without any fixed repayment obligations. However, banks perceive alternative lenders as risky businesses because repayment obligations not only depend on the lender’s performance, but also the default risk of the end borrower- SMB’s for most non-bank lenders.
To further fuel expansion and increase its portfolio size, the alternative lender can do a securitization to raise debt in a cost-effective way. Alternative lenders can pool the loans they have extended and segregate them into tranches based on their credit risk, principal amount, and time period. The securities backed by these loans- asset backed securities (ABS)- can then be sold to investors. Thus, alternative lenders can fund more loans by selling securities backed by existing loans and transfer the risks associated with the latter to the investors. Investors in turn get to diversify their portfolios and earn quality returns by choosing from different risk-return profiles offered by varying tranches of securities. On a negative note, securitization is an overly complex process and does not offer much flexibility to the issuers, alternative lenders in our case. Unlike bank lending, securitization financings cannot be amended without approval of a majority of noteholders. The noteholders are hard to track down as the notes are traded in the secondary market.
As the lender increases in size and has more stable cash flows, it can issue bonds to raise corporate debt from the primary market. Investors lend money to the issuer in return for interest on the principal and the principal is paid when the bond matures. Since bonds are a means to raise unsecured debt- not backed by collateral, thus highly risky for investors- the alternative lender should have a strong balance sheet and reputation in the market to be able to issue them. The tenure for corporate bonds can be very long compared to bank loans; however, issuing bonds can impose several covenants on the alternative lender to limit risk and ensure stable financial performance.
Forward Flow Sales
Another source that an established alternative lender can use to raise funds is through the sale of whole loans. Whole loans are individual loans issued to borrowers. Alternative lenders can sell whole loans in the secondary market to institutional portfolio managers and agencies to transfer their risk and immediately recoup the principal amount. The deal can be structured in a number of ways to benefit both the alternative lender and the buyer. For example, if an alternative lender is selling a portfolio of its loans, the buyer can pay the servicing fee, a purchase premium and even a back ended performance payment. The buyer would in turn get the principal and interest payments from the loans.
Figure 2 below shows the sources used by the top SMB non-bank lenders in the US . Based on their growth trajectory, most lenders use funding by VC and PE firms as the main source of equity capital and bank lending and securitization are the major sources for debt financing.
Fig. 2 – Funding Sources Used by the Top SMB Alternative Lenders in the US
(Since Square Capital is a part of Square Inc, its individual funding sources are unknown)
Fig. 3 – Kabbage Funding Timeline
Depending on the growth stage of the business, alternative lenders utilize the pool of available sources. If we see the pattern for Kabbage, we will observe something similar . Kabbage started with venture capital in 2011 and expanded initially through multiple VC rounds. Then it got a credit line in 2014 and went for securitization in 2017 to increase the loan originations. Post that it got financed through a mix of securitization and lines of credit.
In the normal course of business, this is how the funding cycle of non-bank lenders would work to fuel business performance. What happens when the circumstances become dire? How will the alternative lenders then raise funds and perform in response to shocks? Let us see how the current available funding sources have aided the alternative lenders to navigate the Covid crisis. Alternative lenders like most other businesses, have been hit hard by Covid. Halting the origination of new loans, furloughing employees and mergers and acquisitions were common in 2020. With small businesses defaulting on payments and even banks stopping the origination of new loans but PPP, it has been difficult for alternative lenders to get capital not only to mitigate the liquidity crisis they faced but also lending new loans. There were no new VC rounds or new credit lines issued to the top alternative lenders in the first half of 2020. Most of the lenders with securitization faced a degradation in the bond ratings as well. Could it be said that the funding sources utilised by alternative lenders have some role to play in their performance during a crisis?
Fig. 4 – Impact of Covid on Alternative Lenders
Big lenders like LendingClub [4,5], OnDeck , and Kabbage , suffered the most during Covid and ultimately got acquired or shut down their alternative lending platform. On the other hand, small lenders like BlueVine and Fora Financial, though had a rough sail, but they were able to survive and make it to 2021. There are 2 factors whose combined impact could explain this phenomenon. First is the restrictive covenants and complexity associated with funding sources like credit facilities and securitization which did not offer the much-required flexibility in the time of uncertainty. And the second is the size of the alternative lender along with the number of funding sources it had at its disposal.
As the loan delinquencies increased, alternative lenders would have approached banks and investors with additional financing needs and amendments to the current credit facilities and securitizations. But given the restrictions and risk appetite of banks and the complexity and approval from investors involved in getting securitization amendments, big lenders-with more than $15 million of monthly operating expenses- did not get the access to timely funds. With no other funding options available, they had to limit their operations as resources dried up. At a deeper level, we can say that if the alternative lender goes public, it raises a huge sum of money no doubt, but faces a decline in its tolerance to volatility and risk, as can be seen for OnDeck and Lending Club in figure 4. The scattered shareholding resulted in a loss of flexibility for the alternative lenders, and they were unable to get quick approvals for amendment requests during a time of need.
Smaller lenders-with less than half the funding requirements as that of the bigger players- were in a better position to negotiate with banks and ABS investors. For example, Credibly proactively reached out to its noteholders for securitization amendments and was able to continue funding new loans throughout the pandemic . As seen in figure 5 below, Kabbage-one of the bigger players- had raised $1.2B through securitization, around 85% of its capital structure during Covid . And in a dire situation, it got difficult to modify the covenants or expand the funding. Securitization imposes a lot of restrictions on the issuers and relying exclusively on securitization for funding when the portfolio size is big, leads to loss of flexibility. Though Credibly and Kapitus had securitizations as the major source of their funding as well, their relative size was small- 95% and 78% less than Kabbage’s securitization respectively.
Fig. 5 – Capital Structure of Alternative Lenders During Covid (as of July 2020)
Even if the smaller lenders had to pause origination of new loans, given their size, they could brace themselves till the situation normalized a bit. For example, BlueVine paused lending for a while but recovered and secured a $75 million revolving credit facility in September 2020 . However, at an overall level, the current sources were not enough to survive the crisis, especially for those with large funding requirements. Only those who were able to find a way through the complexities of the existing sources were able to maintain their performance, rest were left to perish or find new funding sources.
Alternative lenders have several sources of capital to fund their growth: 1) public markets – such as IPO, Securitization, Corporate Debt and 2) private markets – such as venture capital, private equity and bank credit facilities. While the public markets allow issuers to obtain large amounts of low-cost funding it can be onerous for the alternative lenders to live up to the expectation of the investors. On the other hand, private markets can be expensive but could provide the desired flexibility to the alternative lenders.
Alternative lenders utilize technology and non-traditional data sources in their underwriting algorithms to make credit decisions. Hence, they are also called “FinTech” (Finance-Technology) lenders.
Naren mentioned, “It is important for these lenders to emphasize the financial services aspect of their business and not as much on the technology aspect of their business, to build a stable enterprise. This would require them to ensure that they have adequate liquidity and diversified sources of capital. Building a stable and a profitable enterprise would enable them to monetize the profits to provide good returns for their investors over time. Credibly did not grow aggressively for the sake of growth, nor did we go after the cheapest source of capital. Credibly was able to manage itself through the Covid crisis because it has a world class executive team that was focused on building a long-term profitable enterprise to serve the working capital needs of small businesses in the United States.”
In conclusion, we can say that alternative lenders need a well-diversified funding strategy and have the liquidity to tackle different economic circumstances.
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