Since my recent foray into commenting on select specialty finance companies I’ve received a number of requests to do more. So time and interest permitting, I am happy to oblige.
$42 million in venture funding is pretty big news – and On Deck Capital (“On Deck”) recently landed this amount, reportedly in favor of a $250 million buy out offer. This is enough to make it interesting to examine what this company has to offer.
On Deck is a company that claims to have developed a technology and process that enables making better quality loans to small businesses. The advertised term loan sizes range between $5,000 and $250,000 (note: the top end of the range appears to have been increased recently to $250,000 – from $150,000)
Here are the two primary features that On Deck claims as the core of their “secret sauce”:
- Actual borrower bank account activity data is used in the risk assessment algorithm, and,
- Technology that they claim efficiently enables and controls loan repayment via ACH (Automated Clearing House).
There are a number of other risk management features listed on their website and each seems practical – so far as they go.
On the one hand, in specialty finance there certainly is value in focusing on a specific type of risk and becoming an expert on it. There are any number of specialty finance companies that have built good businesses doing just this.
On the other hand, however, let’s also agree that anyone can look at bank account data and/or use ACH (which has been around since the 1970’s). In fact, the merchant cash advance industry already does both today – and the merchant cash advance space also happens to be focused on the same small business market. This being said, the merchant cash advance space is generally rudimentary and unsophisticated in analyzing data and understanding the risk.
So might there be an opportunity to professionalize the risk management in this space? I think a compelling argument can be made that the answer is “Yes”, and using the “special” tools highlighted by On Deck also seems quite reasonable. It is also important to remember, however, that while focused attention, expertise and technology may well aid in a better understanding of the risk (which is admittedly an important step) – it won’t change the risk one iota.
This is where I see two big challenges that I believe will ultimately and significantly limit the opportunity On Deck is currently pursuing.
Challenge #1: Will the assembled information be meaningfully more useful than what we already know – or can easily be found out elsewhere?
On Deck states that they make loans (effectively unsecured ones) to businesses, but I struggle with this conceptually. What makes a business after all? When an entrepreneur is funding his or her business with 25%+ capital, isn’t that really betting on the entrepreneur’s vision – and not so much the “business.” When it comes to understanding how much unsecured credit should be extended to an individual – entrepreneur or otherwise – doesn’t Fair Isaac (the inventors and keepers of the FICO score) have that pretty much figured out?
I must admit, however, that my interest was peaked when I learned that Fortress Investment Group made a loan to On Deck. Several years ago I had the good fortune of riding co-pilot with Fortress on the first ever securitization of wireless tower assets. As a result, I can say from direct experience that when it comes to figuring out whether or not an asset class can access the securitization market, Fortress is the gold standard – or at least very close. But the important point here is that Fortress is only making a loan (and a secured one) to On Deck. They apparently don’t seem ready to sign up for the equity risk at this point – rather they seem interested in grabbing an option placeholder on whether or not this works.
In the end, these “businesses” or entrepreneurs don’t seem a lot different to me than other sub prime borrowers – credit card, auto, manufactured houses, etc. So I guess I’m hard pressed to think that “new” information will be meaningfully more valuable than what we already know about these folks from their FICO score. A little more valuable and a little more focused – perhaps – but not a massive step forward.
Challenge #2: How much will it cost to assemble enough of this information (i.e. these “business” loans)?
I don’t set out to be a downer, but consider me a bit of a skeptic on this front also – at least from a long term value point of view. Building a brand is an expensive proposition in any industry – and specialty finance is no exception. Let’s say that the average On Deck asset is a $25,000 loan on which they earn 30% annually, will be held for two years, and will realize only 5% annual losses. With this, they have an asset with a life time value of $12,500 – which seems like it should be enough from an origination point of view. Even if On Deck spent $5,000 to acquire this asset, the remainder would probably be enough to provide an adequate return to capital providers so long as the assumptions held – primarily losses remained in check.
The acquisition costs are, importantly, likely to be large relative to the life time value of the asset and I don’t see an alternative to the brute force spending of marketing dollars to acquire these assets. So it seems there is little opportunity to reduce acquisition costs and/or for viral marketing to take hold. After all, who would Facebook or Tweet their friends about their new 30% “business” loan?
Here is why I think this matters: in challenge #1 I’m suggesting that the incremental value add from better risk management will have its limits, and in challenge #2 I’m suggesting that costs will be high relative to both the absolute value of the asset and the volatility of that asset value over a credit cycle. In combination, these challenges are similar to those of many other subprime lenders that have come before On Deck – and result in the largest challenge of all – which is how to finance this business model over the long haul.
Maybe sub prime financing markets will change and become more reliable in the future, but I wouldn’t bet on that. They have certainly been volatile over the last the few decades. So where does this leave On Deck?
From an addressable market point of view, On Deck will probably end up focusing on smaller “business” loan sizes to better manage their losses – in my view not even their old top end of the range at $150,000 – much less the new and larger $250,000 top end. Credit cards mostly won’t even go to $15,000 for a subprime borrower – so I’ll be generous and suggest that On Deck might be able to do $50,000 with their better information and management. They probably also have an opportunity to build a little franchise in this segment, but doing so will be expensive and the operating details won’t be trivial. This addressable market and brand opportunity is probably sufficient enough to make a go of it and the competition – or lack thereof – disparate enough for a niche opening to be had.
However, the investor side the equation seems tricky. Like sub prime financial plays before it, On Deck will likely end up working great during up portions of the credit cycle and either dying, having a near death experience, or at least a very difficult time during down portions of the credit cycle. Which of the above downside scenarios ultimately plays out will depend on two key variables – (1) managing risk well (i.e. not being tempted to stretch too much when times are good, and (2) how they are capitalized. As I’ve already suggested above, expanding loan size doesn’t strike me as a good idea. On capitalization, I think two times leverage should be the top end – because of the volatility of the asset.
All this doesn’t mean that money can’t be made for On Deck investors (provided their purchase price makes sense), it just means that timing – and playing the cycle – will likely matter more than it does for most other companies in most other sectors. It also means that investors will probably be best served by focusing on the absolute returns to be generated by the business as opposed to returns that are augmented by the use of leverage (debt), as the leverage game is an especially risky one when the underlying asset is so volatile.
So far my feelings on this one are mixed – with the best case (in my view) being a modest upside opportunity. But regardless, I’m looking forward to watching what happens.