With the marketplace lending industry facing a tough climate, many companies will not survive it, but the more established platforms will pull through, according to Pat Grady, partner at Sequoia Capital.
“Marketplaces that have established their core competence will survive the culling of the herd,” said Grady, speaking at the CB Insights Future of Fintech Conference in New York yesterday.
Marketplace or peer-to-peer lenders — tech-enabled platforms that directly connect borrowers and lenders and use algorithms to price loans — have long been heralded as the ultimate unbundlers of banks’ consumer loan operations. Marketplaces use proprietary data and algorithms rather than traditional underwriting and don’t carry the costs of massive brick-and-mortar retail operations.
“The structural advantage an online lender has over a bank is pretty profound,” said Grady, who is pictured above.
However, questions have been posed about the lending marketplace model given expectations of higher interest rates and tightening credit, as well as the question mark of how regulation will evolve. Many of these companies in this young industry have enjoyed a prolonged period of easy credit and less scrutiny than banking rivals.
Not to mention the legal troubles at publicly-traded Lending Club, where loan documentation had been falsified.
The panelists — who also included Kathryn Petralia co-founder of Kabbage, and Ron Suber President of Prosper (backed by Sequoia) — agreed that industry consolidation was inevitable.
Though niche players such as wedding loan marketplaces have proliferated, many of these may disappear. Petralia and Suber both noted that they are often approached for possible M&A deals by credit startups that are closing their doors.
Suber noted that rising interest rate cycles are not new and have not necessarily stalled the development of the credit industry.
“In the past 50 years we’ve seen 17 period of credit tightening,” he said.
There may be one silver lining to lending marketplace’s growing pains (and those of fintech more broadly). Grady, who acknowledged that Sequoia has been “quiet” in fintech in recent years, said that they plan increase their investments in the space in the next three years now that early inflated expectations have been brought back down to earth.
Anand Sanwal, CEO, CB Insights: So, yeah. Let’s just jump into marketplace lending. This will be pretty quick, and then we will get the really smart people out here.
So if we can get to the slides… This is us, which you know. The discussion… All right. So this is traditional lending, right?
Can you get the monitor on?
Kind of the process, sort of slow, cumbersome, inaccessible, and then the promise of marketplace lending came on, and this is a graphic from Prosper. Is there a way to use technology to connect borrowers with lenders?
So it initially began person to person, and I think it has obviously evolved with more sophisticated buyers — or borrowers, rather — on these platforms. So this is kind of the promise of marketplace lending.
What we’re seeing is, again, using this trends tool that we use, you see peer to peer lending kind of used in multiple verticals now. So it’s not just consumer lending. It’s small businesses. It’s student loans. It’s auto loans.
So what we’re seeing with this marketplace model is a sort of proliferation across a variety of now kind of lending types or credit types.
Obviously, the purple line is the consumer lending side, which is the most prevalent today. But we see the model is starting to get into other areas.
Even our regulators here in the states have recognized the need for these marketplaces, and the access to credit that they bring. It’s the lifeblood of the economy. It helps with economic growth.
So I think everybody sort of bought into this idea. What you see is massive growth. This is on the personal loan side, so this doesn’t include the SMB side of things. Massive growth in the lending platforms over time.
This is the top two consumer marketplace platforms, and their organization is at $10 billion in 2015. So, again, really eye popping growth, and you see, over many cycles, there have been unicorns who have come into being. Some of them have gone public.
That’s sort of the good news. There are some headwinds in this space. So, as a result, what we see is, when you look at the funding tally and the deal tally, in early 2016 the number of marketplace lenders who have been funded has fallen off pretty dramatically.
Part of that is reason is headwinds in the public market. So when we look at OnDeck and lending club, you can see that, obviously, in their stock price performance. So these are things that give people pause, and then there’s obviously sort of well documented governance concerns that have come up recently.
We’ve seen some smaller players folding, and then there’s this view that, from OnDeck, Noah at OnDeck, that we’re sort of at the late innings. Is there room for new players? Is the field too crowded?
So kind of an interesting view there.
Then there’s these concerns about the underlying business model. So I think it will be interesting to see what the panel has to say. But a lot of these businesses were born in a very favorable interest rate climate, and a mostly favorable economic climate. How do they weather the storm if that turns?
So with all of that said, it’s worth remembering that this is a giant opportunity, right? Marketplace loans are projected to be $150 billion. So massive opportunity.
Talked about this earlier. Just because there will be casualties doesn’t mean that it’s not a great space. So this is, again, taking that e-commerce example from earlier. Lots of casualties.
Again, there’s gonna be a handful of big players. We don’t expect marketplace lending to be any different. But that is a challenging market right now.
Then we see this marketplace model expanding into other areas. So student loans. I think, when it originated, it was sort of consumer loans, and then for debt consolidation and working capital for small, medium sized businesses. Now we’ve seen it expand into other areas.
So this model… A more efficient model of getting lenders and borrowers together, is one that’s not getting into real estate and student loans, and other areas.
Kind of open questions. I know Jon has probably better ones, but here’s what’s happening from a regulation perspective. Who is gonna do this, and is there clarity in the market around what’s happening?
And then sort of applying the model, what’s next? What are the other categories within financial services that the marketplace model can be expanded into?
So that’s all I had. Let me get to the chief guest. So we have Jon Marino. He’s with CNBC. He’s a Wall Street reporter, joined from Business Insider earlier this year, worked at The Street, Thomson Reuters, Source Media, Mergermarket, and a few other financial publications.
Kathryn Petralia is co-founder and chief operating officer at Kabbage, which is a small business lender, spent 20 years working with both startups and established companies. Focused on credits, payments, technology and e commerce.
Ron Suber. He’s the president of Prosper. Brings more than 20 years of experience with sales, marketing and biz dev across hedge fund, broker dealer, and registered investment advisors.
Finally, Pat Grady. Pat describes himself as a random guy from Wyoming. He is at a firm that probably most of you have not heard of, called Sequoia Capital. He has been there for the last 10 years. Some of his investments include ServiceNow, Prosper, Medallia, Klarna and OpenDNS.
So, with that, let me turn to over to Jon and the panelists.
Jon Marino, Reporter, CNBC: All right. Thank you for the intro.
So let’s start off with the elephant in the room. Lending Club ran into trouble because of too many conflicted interests within the company. Right now, are there too many conflicts of interest within the marketplace lending industry?
Do you want to start off, Ron?
Ron Suber, President, Prosper: First of all, it’s great to be here. I know Pat and I flew in from San Francisco. This is an important opportunity for us all to get to know each other and share our observations and experiences. So for Prosper, we think of ourselves, to answer your question, really as a three legged stool.
On one side of Prosper are the borrowers. That’s the product. On the other side is the money. It’s the capital markets or the liability side. In the middle of Prosper is technology and credit and operations and accounting, and marketing. So there are risks to every marketplace. One is, does the business work? Is it efficient? Do the unit economics work? Are you building a 100 year company?
The other is, does the supply chain work? Can you find the capital, and can you find the right borrowers at the right time, at the right cost per acquisition?
There are regulatory requirements, and then the known unknowns, right? The things we all fear as entrepreneurs. The lightning bolts that come out of nowhere.
So, for us, the focus is on quality and it’s on growth. But it’s really about equilibrium. So we’re trying to grow, but have equilibrium so we’re in compliance and we have the right number of borrowers and the right numbers of investors at the same time.
As a private company with lots of skin in the game, we’re really not as focused on growth as we are on quality and equilibrium, and regulation.
JM, CNBC: Alright, any input there?
Kathryn Petralia, Co-founder, Kabbage: From my perspective, I would say it’s no different from any other industry. It really depends on the business. I don’t think we’re talking about Enron here, and certainly that kind of behavior can happen anywhere, in any industry.
Pat Grady, General Partner, Sequoia Capital: Yeah. I think there is certainly a temptation to take an individual, or perhaps company level behavioral issue, and elevate it to a market level structural issue. I don’t think that that’s a fair interpretation of anything that’s happened over the last handful of weeks.
To the point that Ron and Kathryn made, if you look at conflicts of interest, in this specific case, it was a related party transaction, which is something that exists in every business out there. You would actually expect to have less of an issue with that in these sorts of businesses, given the amount of oversight, and the scrutiny to which everyone is subject.
So I think the focus on quality and on doing things the right way is what you find more often than not with most of the actors in these markets.
JM, CNBC: So the chart that we had up earlier about A round deals in marketplace lending was actually a bit of a shock. Maybe this is your fault. I don’t know, Pat.
Is right now there a drought of funding for marketplace lenders?
PG, Sequoia Capital: You know, any financial market is gonna ebb and flow. I think what we’ve seen recently is a little bit, not of a drought in funding so much as a culling of the herd, meaning not all marketplace lenders are created the same. Credit is a core competency. Some often more established platforms are the platforms that have taken a very thoughtful angle to pricing risk and understanding fraud, and trying to issue good products, have great businesses that are gonna be able to give funding in any environment.
I think there are also companies that maybe didn’t have as much of that core competency that are gonna take a pretty big hit as some of the investors in these products become more selective.
RS, Prosper: I would add to that very quickly. If you think about, when you go home, how do you listen to music or how do you watch a movie? It’s all online, whether it’s through iTunes or Sonos or Spotify, however you get your information. Well, that’s where online lending and borrowing is going. It’s all going online, from offline to online.
What we’re seeing here is an air pocket in the evolution or in the innovation of lending going online. It’s not a question of, will it go? It’s, how is it gonna look in the end?
KP, Kabbage: I would say what you’ve seen over the last 12 to 18 months is a lot of niche players entering the market. I saw at an event earlier this year there was a company that had a marketplace for wedding loans.
So it seems like that might be a little bit too niche, and I think you see that in the evolution of any particular market. I think they are gonna see consolidation or culling of the herd.
JM, CNBC: All right.
I was kind of surprised when I saw a firm’s partnership to finance consumer trips on Expedia, specifically to that point. So how micro can microfinance go?
KP, Kabbage: I wouldn’t say that that’s the same kind of specificity that you have with financing weddings. Their objective is, frankly, just to finance consumer purchasing, regardless of whether it is on durable goods, or whether it’s on travel, or whether it’s on vacations, or any of those things. So I think that’s an interesting spot.
You’re finding people. This is the real goal of consumer lending in particular, is finding people at the exact moment when they need something. So they are in a great position to do that.
RS, Prosper: I would agree. Just think about Uber or Airbnb, right? It’s this great experience. It’s matching up a person who has a ride and a person who has a car to give someone a ride with a great experience at the right price over and over and over, where you never go back to the old way.
That’s really what we’re doing in online marketplaces for credit. At Prosper, we’re finding people that are super prime and prime, that want to debt consolidate, that want to do large purchases and considered purchases, including debt consolidation, wedding loans, travel, healthcare, home improvement, and people who want to borrow on their personal credit for the purpose of their business.
But it really is all about having a model where you can set the right price for the each person, and then finding the money, from retail or institutional, to match off with that borrowing.
PG, Sequoia Capital: And if it’s a question of how micro can micro go, so a firm financing trips, that’s still a pretty big ticket item. If you’re looking at what Klarna is doing over in Europe, their average transaction is under $100.
So they are underwriting people instantaneously at the point of sale online for very small ticket sizes, and they are doing that to remove all of the friction from that process. You enter your email address. Bam, you’ve got funding. That’s a pretty spectacular consumer value proposition, and everybody in this room would know the name Klarna if they were based in San Francisco, and not Stockholm.
I think that actually generalizes to one of the principles that makes FinTech so attractive, which is, if you look at financial services as a percent of GDP, that percent has been increasing monotonically for the last 200 years.
That makes absolutely no sense. It’s an information business. It’s an intermediary business. Technology should have exactly the opposite effect on that percent. t should be going down over time.
If you look at how efficient the internal operations of trading organizations or banks have become, we’re talking about fractions of fractions of a penny that actually make a difference to them. The same amount of efficiency has not necessarily been turned around and applied to the consumer, and that’s what FinTech is attempting to do.
So as far as how micro can micro go, I think we will get to a point where we’re financing pennies worth of transactions in a very fluid and seamless way that some artificially intelligent thing might be doing on a consumer’s behalf. That’s probably a long way out, but we’re in the early innings of this evolution.
JM, CNBC: I want to follow up on this, in part because it’s also my panel for tomorrow. But what does that mean for the unbanked and the underbanked consumers out there, really quickly?
PG, Sequoia Capital: Huge opportunity. Huge opportunity. A couple of hundred Americans don’t have access to mainstream financial services. That’s crazy, right?
If you look at companies like Elevate Credit, it’s a pretty simple business. They use technology and use all the data signals that are available, both online and offline, use an online distribution channel, which is inherently more cost effective, to go out and underwrite people who have been left out in the cold. That is a very good service for them to be providing to a lot of people who otherwise just don’t have access to financial services.
RS, Prosper: I would add, there’s a lot of people with the wrong credit, the wrong term, the wrong rate, the wrong dollar amount, and I think we’re able to add efficiency not just to the unbanked or the underbanked, but those that are banked in the wrong way.
KP, Kabbage: I know we’re talking about regulation a little later, but I think it’s getting harder and harder to serve those underserved populations, because there’s a huge focus on making sure that lending is fair to them. In the process, it actually puts a lot of obstacles in the way so that it’s hard to lend to them.
A great example is, this is sort of a paradox, but Sasha Orloff’s company, LendUp, they now can’t advertise on Google because they are blocked from payday lending advertisers. But what he is trying to do is really fantastic, and delivering really small dollar loans to an underserved population and get them an alternative to payday loans.
But now they can’t advertise. So I think it’s a really difficult challenge.
PG, Sequoia Capital: So I’ll actually take the other side of that.
So I think that’s a good point, but I think that’s a one off example that is not indicative of the more general trend. If you look at the rules that the CFPD proposed a week ago now as it relates to payday lending, it is an incredible intelligent, well informed, well crafted piece of legislation that, if it goes into effect as drafted today, puts some very reasonable guardrails around the product, and actually makes life easier, and actually helps to extend opportunity.
Because, to steal a line from one of the slides that Anand just had up there, clarity provides competence. I think the rules that they’ve proposed will only knock out people who are bad actors anyway, and for people who are good actors, it allows them to move forward more aggressively. Now they know exactly what they can do and what they can’t do.
The Google thing is a good point. I think, somewhere within Google, somebody maybe conflated payday with shorter term higher rates consumer loans, and there’s a confusion in there somewhere.
But I think, more generally, the regulatory environment is actually enabling this, not holding it back.
KP, Kabbage: I would agree with that, except that it can often be a blunt instrument, and it’s very hard for regulators to be really plugged into all the various options… All of the regulation that’s out there today, whether it’s FCRA or GLB. Most of it didn’t contemplate the methods that we use today to deliver funding, or to gather information, or to deploy data assets, and I think that’s a real challenge in general.
JM, CNBC: You want to chime in, Ron?
You’re not getting anywhere near this one? All right.
RS, Prosper: I’ve read all 1200 pages, and I’m still digesting it.
JM, CNBC: All right. Well, I appreciate the segue. We’ll go with regulation now.
How do you expect, or how do you think, regulators should interpret the quote unquote “black box” that’s used to determine borrower quality by startups?
For those of you to whom this is applicable for, and I mean everyone but Pat, how does FICO impact the decision making process? Where does it, you know, rank in terms of the hierarchy of quality that goes into the decision?
RS, Prosper: So, for Prosper, go back to that analogy of the three legged stool. At the top of the middle stool, which is under the hood at Prosper, is the proprietary pricing, credit, risk and underwriting, the big data, the machine learning, the people that decide, what’s the price, what’s the dollar amount and what’s the term?
So, for us, we combined that science with the art of marketing, trying to find the borrowers in lots of different channels who fit the model where we have the investors.
So, for us, we’re getting literally 500 pieces of data, of which FICO is one, of which 135 pieces are very important, and 35 are absolutely critical.
For us, FICO is really just a floor. We do 640 FICO and higher. So it’s an important number, but it’s really not the number that we use to do lending. If you’re familiar with that chart, it’s called the ROC chart, or Receiver Operator Chart. It shows lending based just on FICO, and then what does each marketplace or lender do to improve on just FICO based lending?
Ours is public. It’s in our Ks and Qs. It’s in our website. It shows how much better Prosper is in lending to people based on the data we get, and then what we do with the data. So we think that’s really one of the unique things that differentiates us, is our ability to do credit in such an improved way for each person, unique to their situation.
KP, Kabbage: I think the concept or the notion that it’s a black box is a little misguided, because every one of us in this space is, frankly, quite regulated. We all partner with institutions that are, for the most part, FDIC regulated institutions.
We have regular audits. We have to unpackage our models for the various regulatory agencies that may exist. We have partnerships with other financial institutions that require that. So this idea that we’re all operating in the wild west, and it’s unregulated, is not particularly accurate.
At Kabbage, for example, we’re a small business lender. So we don’t really use FICO very much. But the idea that anybody uses FICO is a little misguided in general. Even traditional lenders, credit card lenders, they don’t rely on FICO. They have custom models. They use the underlying attributes.
Mike Cagney from SoFi came out and said, “We’re not using FICO anymore.”
But that wasn’t really news, because nobody does.
So I think, for the most part, it’s important for reporting and securitization and investors, because they want to see your portfolios stratified by FICO. But it’s not something that most folks are using internally.
JM, CNBC: Right. And I feel like the term “black box” has been thrown around by regulators. It wasn’t my idea. But I agree with you. It is kind of a loaded term, because the only time that a black box is really important in the real world, is after a crash.
KP, Kabbage: Which is not happening.
JM, CNBC: And, again, a good segue. So part of what fostered the rise of marketplace lending was accommodative monetary policy, which still lingers even today. But what happens when the cost of capital begins to rise for startups?
KP, Kabbage: We’re a little bit different. We’re a little bit different just, again, because we’re a direct lender. So we take balance sheet risk, we securitize the receivable. So we don’t have the exact same risk because we don’t have retail investors. For us, what happens is rates go up. We pay more. Our customers pay more. That kind of sucks. But we don’t have that same exact kind of platform risk, I think, that folks like Prosper may have.
RS, Prosper: So, for us, the left side, the liability side of Prosper. There is this insatiable demand around the world, for short duration credit. For something that yields and pays monthly. And what we’re able to do for people in the peer-to-peer aspect of our business, and banks, and institutions, and family offices, and U.S., and non-U.S. entities, is help them get access to something that is a 13-month duration. That does pay 7.3% net interest. They have not been able to get this asset class. And on the other side, we’re able to take all these people, these U.S. consumers that are super prime-in-prime, and reduce the cost of their funding, and help them get funding for new things. So for us, we think this is really just the beginning. And that the opportunity the addressable market on both sides, the consumers, and on those looking for yield, is really just beginning. We’re literally just in the third, maybe the top of the fourth inning of this opportunity.
PG, Sequoia Capital: I agree with what Ron said. I think we’re still pretty early, here. The complexion of the borrowers and investors is going to change over time, as macroeconomic gyrations take place. But if you just look at the structural advantage that an online marketplace business has, versus the traditional banking system, it’s pretty profound. So the question is, as the operator of the marketplace, how do you allocate the economic surplus created by that structural advantage?
You can choose to allocate it to the investor in the form of higher yields. You can choose to allocate it to the borrower, in the form of lower rates. Or you can choose to allocate it to yourself, in the form of higher fees. To date, fees have been pretty well fixed across all the different marketplaces. They haven’t really moved in last 10 full years. And so the question has been, how do we balance between the borrower and the investor? And I think as the asset class has evolved, we’ve necessarily seen a little bit of a dampening on some of the yields that were going to investors, as the novelty premiums that you would expect of any new market has been eventually taken out of the system.
And so I think where we’ve sort begun to level-off is a very healthy place in between the 50 basis points, you might be able to get on a savings account. And the 30% you might pay on a credit card. Between those two guard rails, there’s an enormous amount of room for these marketplaces to operate.
JM, CNBC: Pat, I’m going to go to you last on this question, because I hope that this question is more difficult on your end, after everybody goes first.
Talk about an entrepreneur in the space, Kathryn, who is either exciting to you, or who you find fascinating? The only caveat is they can’t work at your company.
KP, Kabbage: I gave you a prelude to this earlier. I would say Sasha Orloff at LendUp, because what they’re doing is incredible for consumers who have limited access to lending, really, to borrowing. So payday lending traditionally has incredibly high rates. It’s hard to get out of the loans. It’s sort of a trap. And, really, the only way to solve this problem is through technology. Because you get to the question of, how micro is micro?
It is really hard to make a $200 loan profitable, especially when you’re operating a bunch of retail stores. So deploying technology to serve that market, I think, is really exciting and important to the incredible number of Americans who lack access to traditional options.
RS, Prosper: So in the Gold Rush, there were the gold miners, and then the people that sold the picks, and the axes, and the jeans. And the people that made the most money, as we all know, were the people selling the infrastructure, and the picks, and the axes, and the jeans.
And so I would ask people to think about, you could buy the debt, or buy the product that marketplaces sell, or you could invest in the equity of the marketplaces, or you could invest in the ecosystem and infrastructure around all the marketplaces around the world. So who’s visualizing the data? Who’s normalizing the data? Who’s enabling us to really, really scale and get the securitization, secondary markets, and derivatives? Where this business get’s really big, I think there’s a lot of money to be made in the ecosystem, and infrastructure, around each of the platforms.
PG, Sequoia Capital: As Ron was talking about picks and shovels, and I noticed that he didn’t name any names.
KP, Kabbage: I noticed that, too.
PG, Sequoia Capital: But a couple of names that I know that Ron is familiar with. Speaking of picks and shovels, there’s Perry [Rabhar] at dv01, there’s Matt [Burton] at Orchard. If you look at other marketplace businesses, I think Nav [Athwal] at RealtyShares is doing a really nice job in real estate. Matt Humphrey, at LendingHome, is a very impressive guy who’s built a full stack technology to go after a very tough market. So there are a lot of great founders in this business.
Actually, the one that I would like to mention if we zoom out a little bit from marketplace lending to FinTech. The one that I want to mention is one that I think has a pretty profound impact, already. That will become even more for some of the business that I’m in, which is venture capital. And that’s actually the guy who was up here about 20 minutes ago—Anand, with CB Insights.
And the reason I say that, you think about the fundamental value chain of venture capital: find investments, assess investments, build market leaders. And over the last 10 or 20 years, as information has become a little bit easier to access, the find investments and assess investments part of that has gradually become more and more commoditized. And I think if we play the clock forward, that’ll be almost entirely done by technology, not by human beings. And the company that is, today, positioned to be the market leader in that evolution is CB Insights. And actually I view that as great thing for our business because it means that the only value that we provide is the back end, the company building. And that’s the only reason that people should be getting into business with us to begin with.
JM, CNBC: And you’re not angling for a keynote, next year, right?
PG, Sequoia Capital: No, I’m not. No. Nice of him to invite me. I thought I’d pay it back. But I mean it.
JM, CNBC: All right. Fair enough. And you threw a lot of companies out there. So I want to go back to you for the next question. Talk about investable opportunities in 2016, in this space. Because I get the sense that, yeah, in some parts of marketplace lending, it has grown crowded.
PG, Sequoia Capital: So we’ve been very quiet in FinTech in the last few years. We’ve met a whole lot of companies. We have not made a whole lot of investments. We plan to be very, very active in FinTech, in the next three years. I think over the last few years, risks have been grossly under appreciated. And upside has been grossly overestimated I think that, now, there’s been a little bit of a shock to the system.
Anybody who’s been in the FinTech business because they think it is easy money is going away. And people who have identified real problems, and created compelling solutions who are doing it for the right reasons are going to stick around. And those are the people that we want to be in business with.
And so in terms of what’s interesting in FinTech, or what’s coming next. I think, number one, is more of the same. Companies like Prosper are just starting to scratch the surface of the available market opportunity. I think number two is, applying better solutions to existing known problems. And real estate is a natural place for this business model to take off. Very, very difficult because unlike most other financial services, you’re dealing with atoms, not just bits. There is a physical property that you have to assess. And that has all sorts of complexity associated with it. I think insurance, and I know Daniel [Schreiber] from Lemonade was here earlier. I think insurance is a natural place to apply this sort of a business model. And then I think probably step three is, not just taking existing products and making them better. It’s creating entirely new products. I mentioned Klarna earlier, I think credit online at the point of sale, like Klarna provides in Europe, or like Max Levchin at Affirm provides here, in the U.S., I think that’s a very natural thing that we’re going to see more of.
RS, Prosper: And I’ll just add to what Pat said. And I think Kathryn might agree. As entrepreneurs, we know we need to right amount of capital, but we need the right partners to be with us in the good board meetings and in the more difficult board meetings. And I think as a person who, now, I’m working at my second Sequoia backed company. You really, really want to have the right company, and the right people in that room with you, to make sure you’re not going off the rails in the good meeting, and staying focused in the meetings that are a little more challenging. I think that cannot be overstated at all.
KP, Kabbage: I would agree with that. If I was investing in a company, right now, that doesn’t seem like it could be in this space, it would be anything around machine learning and artificial intelligence. There’s so much more data to which we have access that we can use, than we had even five years ago. Kabbage’s business itself couldn’t have existed 10 years ago, because ready access to the data didn’t exist. So I think you’re going to see a lot of momentum and those particular areas. It’s going to be hard because regulation is going to be confused by this, and how do we use the data? And is it a black box? But if we can remain transparent with how we use the data, I think it could be a huge opportunity.
JM, CNBC: Ron, I’ll come back to you for the next one. What’s the biggest impediment, in terms of scaling in the FinTech marketplace?
RS, Prosper: It’s interesting. I think the biggest impediment for me, or for some of us in the room and in the industry, is focus. I think a lot of us see shiny objects, we’re told go left, go right, go bigger, go abroad. Go into some other vertical. And I think the key thing, and an impediment is really staying focused on your true core competency, what got you there? Where is it that you can make these hundred billion dollar/hundred billion companies? And not get distracted by people who were pointing you, and showing you, and these things that shine and blind you, sometimes. So for me, the answer is focus, and really executing on the focus you set out for.
KP, Kabbage: For us, it’s striking a balance between… our equity investors invested because they believed there was a really big opportunity, and a big vision to do something very different. And if you juxtapose that with the expectation of traditional debt investors who want to see things like: What is the average FICO score of your portfolio? And you’re constantly being pushed. And said, “That doesn’t make sense. Nobody’s ever done that before. You can’t do that. That’s really hard. I don’t understand it.” It’s really hard to strike the balance between those two types of investors, both of which we have to manage very closely.
JM, CNBC: All right. Very general and blunt question. Feel free the answer any way you like. Is it 2007 all over again?
PG, Sequoia Capital: I’m not sure exactly what is meant by that. But if you’re trying to make an analogy between marketplace lending and the mortgage crisis that we ran into in 2008. I think that’s a pretty flawed analogy. Partly because, the financial engineering around what happened in 2008 was orders of magnitude more complex, than anything that we’ve seen thus far. Which ends up obscuring the underlying asset from the person investing in the asset, which is not something that we’ve come anywhere close thus far in this market.
I also think the other difference would be, that was a time when the average consumer was dramatically over levered, and was essentially treating their home as a piggy bank. And so the quality of the underlying assets, themselves, was not very strong. So there was deterioration of the underlying asset, plus ridiculous complexity sitting on top. Whereas, today, American consumers are actually in a pretty good spot. So we’ve got a strong underlying asset with very, very minimal, if any complexity on top. Which suggests that, today, we’re in a much better position than we were back in 2007.
RS, Prosper: I’d like to remind all the young people in the room that over the last 50 years we’ve had 17 periods of credit tightening, or credit crises, or credit stalling. And we’re just in one of those periods. And nobody actually knows how long we’re going to be in this period, where securitization isn’t quite there, where spreads are wide, and costs of funding is high. But this is not anything new. This is something we need to continue to stay on top of, to work our way through it. And maybe rebuild some of the supply chain in marketplace landing. But for me, this is not 2007
KP, Kabbage: You’ve heard me tell this before. So I’m sorry. I’m going to tell it again. Hopefully nobody else has. But I was sitting at a Treasury event last summer. Next to a head of the huge consumer banking lobby. And this individual said, “Well we just want to level the playing field.”
And I was like, “That’s so fantastic. We’re going to get access to all this cheap capital, and all your customers, and data. You’re going to help us move money. I’m really excited.” That’s not what he meant, at all. So what he meant was “You guys need to be regulated just like we are, because you obviously do the same staff.”
But we don’t do most of the stuff that banks do. We don’t take consumer deposits, I’m not packaging securities, I’m not making real estate loans. None of these things that create systemic risk. So the idea that this tiny little industry, frankly, in comparison to the real estate market, is going to cause some massive global economic disruption is really comical.
JM, CNBC: And earlier… and this is really what I was referring to. You had mentioned, Pat, that there is going to be a culling of the herd. And I would imagine that the place that this might start happening is in personal loans. But what does the beginning of the culling of the herd look like?
PG, Sequoia Capital: Well, we’ve seen announcements over the last week of companies that are shutting their doors. Right. I think if you go talk to a lot of the folks who are investing either on the balance sheet, or directly into the assets being produced by a lot of these companies, they’re starting to really, really, really separate out individual companies from a market level notion of the asset class.
Because, a loan is not a loan. A loan actually depends on who originated that loan, what all the internal processes look like? The quality of the underwriting, the quality of the of all the data on the models on which that underwriting is based, the quality of their fraud operations. The quality of their verification procedures. The quality of the servicing. There are a lot of different things that go into making a good loan. And so I just think we’re going to see investors become far more discerning about where they put their money.
KP, Kabbage: How many “prospecti” have you received in the last three months for companies looking to sell themselves to you? We’ve had tons. I’m sure you have too.
RS, Prosper: So the answer is: A lot. And I think if you, again, just one more time go back to the three-legged stool. You’re seeing companies who don’t have equity to fund the middle leg, to make payroll, to invest in technology, to invest in their brand, and to spend money on marketing to find the borrowers. And you’re seeing lots of those groups going to look to raise equity. And it’s a lot more expensive today, than it was before, which is part of the culling of the herd.
And to what Pat said, you’re also seeing the credit quality… a loan isn’t the loan. It’s not the same in every company. So you’re seeing the left-leg, or the capital side, or the liability side dry up. And so platforms aren’t able to fund to borrowers who came to the platform. And so you’re seeing some companies fall because the middle leg collapses, or the left leg.
KP, Kabbage: And the value of those portfolios is not face value. Because, we all have our own processes for originating those loads. And I have no idea, exactly to your point, what the process was that was used to originate that loan. We really rely on access to specific data points in order to make decisions, and make ongoing decisions. And I’m not going to have that same data on some portfolio that I’m buying from some other random small business lender. So that’s not even a great value. So those smaller companies that think they have a lot of assets in their portfolios probably don’t have as much as they think.
JM, CNBC: Or at least valued the same way. I have to give the audience time to chime in. And we’re not even sure to whom I should be pointing with a microphone but I think that there’s probably somebody somewhere out there… he’s back there. You there, go ahead. Fire away, please.
Nikhil Krishnan, Tech Industry Analyst, CB Insights: Yeah, we have some questions from the audience. So when Sequoia evaluates companies in this space, what do you prioritize? Is it the credit assessment models, the types of instruments, the customer experience? How do you look at companies in this space?
JM, CNBC: I think that’s for you, Pat.
PG, Sequoia Capital: That’s probably right. Very good question. And the answer is: Exactly the same as we look at companies in any other sector. It is the founder’s ability to articulate the market opportunity. That is the single most important characteristic. The market opportunity, itself, determines how big the company can get. The quality of the founding team determines how big the company will get. And so it comes down to founder and market in financial services, like it does in any other category.
JM, CNBC: Next.
NK, CB Insights: There was recent story that mentioned that Prosper stopped courting new borrowers from loan referral websites, like Credit Karma. Could you speak a little bit to the reason behind that?
RS, Prosper: So I’ll answer the question in a general way without using any specific names. Every marketplace that’s finding a lack of equilibrium between the capital side and the borrower side, is turning down their higher costs per acquisition, or higher CPC borrower acquisition channels. So a platform might do less direct mail, where that direct mail brought volume but didn’t bring contribution margin.
And if that platform only had X number of dollars, it might turn down some of the higher costs per acquisition channels, whatever they might be. And that’s what’s supposed to happen in a marketplace. It’s supposed to be dynamic. It’s supposed to move in both directions. And that’s really what’s happening, here. Is, we’re determining what’s the right price that the investor should be getting? And to your question, what’s the right price that the borrower acquisition channels, or the lead gen channels should be getting? So we’re finding equilibrium on both sides, including the borrower acquisition side.
KP, Kabbage: I would love to add on to that. Because, we try very hard not to work with those aggregators. Largely, from my perspective, because of intellectual property. Why would but I want to pay a third-party to learn how to find my customers, when I can spend the money to learn how to find them myself? I think it’s a very inefficient method. We’re talking about cutting out the middleman — that’s a middleman. So I think a lot of companies are realizing that they should be able to do that themselves, because the cost gets bid up just like it does with Google AdWords.
JM, CNBC: All right. More questions from the back?
NK, CB Insights: Another question is: Intuit and OnDeck recently announced a partnership. Is there a partnership model that makes sense between incumbent financial service firms and marketplace upstarts?
RS, Prosper: I think the answer is unequivocally: yes. I think you’re going to see partnerships on all three legs of the stool, with banks, and institutions, and sovereign wealth funds, and insurance companies who are looking for this asset class. I think you’re going to see it with groups who have people who were looking for credit.
You saw the HomeAway-HomeAdvisor deal that we did. Where people, who are now looking to do home improvement, or healthcare landing, or Prosper daily, download our app and see how we’re partnering with technology companies on the borrower side. And clearly you’re seeing us partner with other groups to help us make better decisions in the credit model, and in marketing, and in the technology stack. I think you’re going to see some more partnerships along the one you just mentioned, that are really going to shock people about how much we’re working with banking, and with technology, and other financial services companies.
NK, CB Insights: Last question. What are ways to marketplaces are approaching populating platforms with users from either side of the marketplace? Is there a customer acquisition strategy that tends to work?
KP, Kabbage: We are not technically a marketplace but I’ll talk first anyway. So we got our start making loans to eBay sellers five years ago. So we really started with digital marketing at our core. I think the competition and the pricing for that really fluctuates wildly, depending on how many folks are in this space, and who wants to find them that way?
I believe that the partnership model that Ron was just talking about is an incredible opportunity. Because, it matches the folks who have interests that are aligned. And so the rising tide lifts all ships. In this case, if you’re a small business lender and your partnered with another company that serves small businesses. To use the Intuit example—you provide accounting services. The more revenue that your customer, the borrower is generating. It’s good for me—Kabbage. It’s good for Intuit. So I think that’s a really important model. And it’s also very streamlined for the actual customer. So they don’t feel like they’re having this really choppy experience, and that’s really important, too, just from a customer longevity perspective.
PG, Sequoia Capital: Yeah, when we think about customer longevity, we think about engagement. And we think about this both, with borrowers, and with our retail and institutional investors. And, again, go back to see BillGuard, which is Prosper Daily. It’s a company we bought out of Israel, last year. And we see people, now, coming to Prosper via this app—Prosper Daily—four, and five, and six times a week, to look at their credit, to look at their checking, to look at their savings, to see if their identity is secure, if anybody is selling their iTunes account in the third market? And seeing if they should optimize their personal financial balance sheet? Should they refinance a loan? Should they take another loan? If they’ve paid off a loan for debt consolidation, do they want one for healthcare, or home improvement, or something else?
So customer attraction is great. But if we do something once with somebody and don’t engage them to do it again, and again, and again on the borrower side or the investor side, I don’t think we have a long-term business. So we focus a lot on engagement on both, the inventor side and the borrower side.
JM, CNBC: All right well, that leaves us with a minute. And I’m actually out of questions that I’ve already written, so we’ll go with an unscripted one. Both Wall Street and Silicon Valley have, depending on who you are and how much you want to argue it, somewhat well deserved reputations for not being diverse. Our panel is not terribly diverse today, unfortunately. What can FinTech, as an industry do, to be more diverse?
KP, Kabbage: I’m diverse. I agree, in general. I don’t often notice the lack of diversity, at least from a female-to-male ratio perspective. But I think it’s really hard. We’re in a space—financial services and technology—that traditionally does not attract a lot of adversity. I think you actually have to go and do it. I think we’re hiring a CTO, right now. I think I actually have to go out and say, “Dude, I want someone of color in that position. And I’m not going to stop until I find that person.”
I think you have to work really hard in order to find diversity. It’s easy… we have a lot of women in our senior leadership team, probably, because I’m a woman so that makes it easier. But it trickles down. So because I don’t have someone who’s African-American on my leadership team, it’s harder for me to make a point of hiring people. I don’t have that network that they would have. I think it has to be an effort.
RS, Prosper: What makes you do diverse, today, is you’re wearing flip flops, and Pat and I are not.
JM, CNBC: I guess that’s it. The red light is flashing. Lucky for you fellas. Thanks very much.
RS, Prosper: Thank you.
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