In the years after the financial crisis, small businesses that needed credit were stuck. New capital rules discouraged big banks from touching any borrower perceived as risky. The bond and loan markets, where larger businesses flocked for inexpensive debt capital, have little use for sums under $100,000 — which is what most small enterprises need.
A handful of non-bank lenders, payment and e-commerce companies have leapt into the gap. In an environment of easy money and economic expansion, small business lending operations at OnDeck, Kabbage, PayPal, Square and others have grown fast.
The question now is whether these new, branchless business models can thrive in a market where credit is tightening and the economy slowing. The interest rates on the loans are high — often the equivalent of a 30-40 per cent annual rate, or higher — and the borrowers tend to have short credit histories.
There are some signs of vulnerability. Morgan Stanley analyst James Faucette notes that in periods where credit has tightened in recent years, the online lenders “have done worse than traditional lenders . . . they have all had to rework their underwriting in a significant way. Once they have done that, they try to re-engage during an expansion and take advantage of what they have learnt.”
The lenders themselves say they have found an under-served market and that new data sources mean they can underwrite risks that were previously too hard to capture.
“FICO [credit scores] are a great predictor of consumer credit performance, but there is no FICO for small-business lending . . . so what banks have been doing to underwrite a loan is expensive,” says Kevin Phillips, head of commercial development at the online lender Kabbage. As a result, “small loans are not economic for them,” creating a big opportunity.
Real-time access to bank account, tax, credit and other data means lenders can assess their small business “continuously” says Eyal Lifshitz, chief executive of BlueVine, which has originated $1.5bn in lines of credit and loans against receivables to date. “We underwrite the accounts every day,” not just when the loan is made, he says.
The sums handed out by this new class of business lender are considerable and growing rapidly. New York-based OnDeck, which started lending in 2008 and is a trailblazer in this area, carries $1.1bn in loans on its balance sheet and originated $650m of loans in the third quarter, up a fifth from the year before.
Privately held Kabbage, founded a decade ago, has lent out a total of $6bn, $2bn of that in 2018. The lending division at payment company Square — now five years old — has made $3.5bn in loans so far. The lending unit of PayPal provided $1bn in credit to businesses in the third quarter last year alone.
PayPal’s core business is online payments but its customers wanted credit too, says the company’s head of business development, Darrell Esch. “Back in ‘11, ‘12, it kept coming up with our smaller clients . . . there was massive demand [for credit] that was going unmet,” he says.
Kabbage, like some of its competitors, links its underwriting software to multiple sources of borrower data — not just bank accounts, but accounting systems, shipping data, and more. This allows Kabbage to approve credit lines of up to $250,000 within minutes, in almost all cases with no human involvement except from the borrower. The incremental underwriting cost for a new borrower, Mr Phillips says, is close to zero.
Payments and e-commerce groups like Square, PayPal and Amazon have additional advantages: not only can they see directly into companies’ transaction histories, but they can take money owed directly out of payments coming into the borrowers’ businesses, on a daily basis.
Banks are beginning to catch on. In August last year, OnDeck extended a partnership agreement with JPMorgan Chase, through which Chase offers business loans of up to $200,000 with approval within 24 hours, using OnDeck’s underwriting tools. The partnership has helped to revive OnDeck’s previously moribund shares, sending them up nearly 50 per cent in the last year.
Most of this new breed of lenders rely on banks, either for temporary funding until loans can be sold on to investors, or for longer-term capital. This raises the concern that should the non-bank lenders get into trouble, federally-insured banks might be hit as well. The FDIC, in the wake of governance problems at consumer platform Lending Club, said that it would “evaluate lending activities conducted through third-party relationships as though the activities were performed by the institution itself” — signalling that it would not sit idly by as banks effectively outsourced their credit risk management to non-banks.
For their part, the newer lenders argue that risks are reduced by a combination of advances in underwriting technology, loans with durations that are often less than a year, and repayments that are often automatically taken from the borrower’s cash flows.
“We think [our] strategy will perform equally well in bull and bear markets,” says Christine Chang, chief executive of 6th Avenue Capital, which provides small businesses with short-term, uncollateralised bridge financing. “We fund for growth and expansions. If your business is not doing well, and you need to make payroll, we are not for you . . . in a bear market, banks will tighten up even more, creating more opportunities. And because of the short-term nature [of the financing], we can change our risk position quickly,” she says.
Mr Phillips of Kabbage says that losses will naturally rise in a recession but “will run off quickly.” He notes that the company sees “day to day what is happening” in all 155,000 of the businesses it works with, allowing it to see recessionary signs “in real time” and to adjust exposures accordingly.
Mr Esch of PayPal says that the past half-dozen years have been good for everybody, “given the imbalance between supply and demand.” But the next downturn will bring a “great thinning of the herd,” he says.
“A lot of companies have popped up and will learn the hard way the old truth that it is easy to lend money. The hard part is getting it back.”
