Trouble In Paradise: Lending Club And Prosper

Lending Club and Prosper are going through a rough patch. Renaud Laplanche, the CEO and founder of Lending Club, just resigned amid allegations of financial irregularities, while Prosper recently laid off more than a quarter of its employees.

But those are only the ripples on the pond’s surface. What’s going on underneath is that Wall Street is losing faith in the business model – that is, losing faith in the quality of the loans made on the Lending Club and Prosper platforms.

Not long ago, Wall Street financial institutions couldn’t get enough of Lending Club and Prosper loans. Now the same institutions are cutting back and the effect is severe.

To me, there are two lessons.

This is a Brand New Business Model, and It’s Going to be a Bumpy Ride

Marketplace lending started with the observation that banks pay much less interest to depositors than they charged to borrowers, and that technology should allow someone to decrease that spread, making a profit in the bargain. Lending Club and Prosper grew by substituting proprietary algorithms for traditional bank due diligence. The algorithms seem to work,and institutional investors rushed in.

But marketplace lending has been around for less than 10 years and nobody knows how the algorithms will perform during a down cycle. It’s not a big surprise that Wall Street money managers, aware that the economy might be due for a downturn, are hedging their bets.

The fickleness of Wall Street money managers doesn’t mean the business model of Lending Club and Prosper is broken. To me, there is little doubt that algorithms and big data will replace traditional bank due diligence – not only in consumer lending, but in other parts of the Crowdfunding ecosystem as well. But the algorithms and business models might well have to be adjusted, and nobody should expect a straight line from A to Z.

The fickleness of Wall Street money managers leads to the second lesson.

Wall Street is Fickle

Soon after launching a Crowdfunding platform, you realize there’s a choice where you look for investment capital. You might have begun with the idea of raising money from the public – that is, from retail investors – but you realize quickly that you can also raise money from institutions.

Raising money from institutions is often much easier because, well, institutions have more money. But there are a couple downsides:

  • You started off hoping to become a household brand, but if most of your money comes from institutions you risk becoming merely a deal originator for institutions, with far less clout and long-term brand value.
  • You started off idealistically hoping to bring high-quality investments to the public, but if most of your money comes from institutions, you aren’t.

The experience of Lending Club and Prosper reveals another downside: Wall Street is fickle. If you build your Crowdfunding business based on large investments from a handful of institutional investors it’s a lot of fun on the way up, but when the institutions pull the plug it’s a hard fall.

Ideally, a Crowdfunding platform can have it both ways, using institutional money to build the business while building its brand with the retail public, to the point where the business can survive and prosper even if institutional tastes change. I don’t know whether that’s possible, but I hope so.

Questions? Let me know.

Scalability in Crowdfunding

Growing plant stepThe Crowdfunding market continues to grow rapidly, increasing in deal size, deal volume, and sophistication. The rapid growth will likely continue for the foreseeable future, as more investors and entrepreneurs learn about the opportunities. And the growth will accelerate if and when:

  • The SEC finalizes regulations under Title IV
  • Congress refurbishes Title III
  • Portals move toward pooled assets
  • Portals are created in more vertical markets
  • Deals become standardized across portals
  • Formally or informally, we get a secondary market for Crowdfunded investments

All those things will move the dial toward a larger, more robust Crowdfunding market. But to penetrate the mass market – to truly scale – Crowdfunding needs something more, and that thing is coming.

Like a telescope, a Crowdfunding portal has two ends: an investor end and a deal flow end. Today, the investor end of the telescope is almost infinitely scalable while the deal flow end has proven much more difficult. Even given the best technology and the best people, how do you push more deals through the narrow opening? More exactly, how do you perform effective due diligence on all those deals?

Look at the P2P sites, Lending Club and Prosper. They’re doing Crowdfunding, too, and they pushed more than $5 billion of consumer loans through their due diligence processes during 2014. They did it mainly by reducing due diligence to a series of algorithms. In fact, they perform so little due diligence of the old- fashioned variety that some states don’t allow them to sell securities.

Three factors have allowed Lending Club and Prosper to streamline due diligence and scale up:

  • They started with a built-in technology for determining a consumer’s creditworthiness: namely, a FICO score.
  • Starting with FICO scores, they created their own proprietary scoring systems using their own data. The more data they accumulate the better their scoring systems become, in a virtuous cycle.
  • They have educated their investors. Rather than allocate their entire investment to a single loan, investors diversify, trusting the averages.

In some respects what Lending Club and Prosper have done with consumer debt is no different than what Billy Beane did with baseball players: replacing a traditional process that relied on human expertise (scouts) with a new process that relies on data (sabermetrics).

At first glance, the typical Title II Crowdfunding site, whether real estate sites like Patch of Land and iFunding or venture capital sites like FundersClub, look a lot different than a P2P site. Fundamentally, however, they are in the same business. The question is not whether Title II (and Title III and IV) sites will move toward the P2P model, the question is is how quickly and in what ways.

I believe the convergence will happen from both ends.

First, portals are going to create the equivalent of FICO scores and the scoring systems of Prosper and Lending Club, even for complex real estate projects and hi-tech startups. Living in a world of big data, I believe this is not only possible but inevitable. As we speak, lots of smart people are looking at lots of data and trying to draw meaningful correlations between data and outcomes.

Is there a correlation between the FICO score of a real estate developer and the success of his next two projects? If an entrepreneur has had one successful exit is she more likely to have a second? If an angel has invested in three successful deals is he likely to have a fourth?

The world is flooded with data and fast computers. I believe Crowdfunding portals will crack the code, a little bit at a time, moving from a traditional, hands-on due diligence process to a data-driven, algorithmic process. Like old-time baseball scouts, those comfortable with the traditional processes are likely to cry foul, pointing out the inevitable gaps in statistics. They’ll be right in a narrow sense, but the world will move on nonetheless.

Second, because of the pressure to scale, portals will gravitate toward products that lend themselves to being scaled. It’s not a coincidence that Lending Club and Prosper sell consumer debt! The market suggests that real estate debt is likely to be the next product to scale, with real estate equity going to the back of the line. Going a step further, I’m guessing that the more difficult to crack the code in a given product, the higher the margin and the lower the volume.

If I knew exactly how the market will play out I wouldn’t be a lawyer! Nevertheless, it’s an incredibly exciting time.

Questions? Contact Mark Roderick.