We are seeing more innovation and disintermediation (taking out the middle man) now than in the past ten years. Some of it has been going on quietly behind the scenes as finance companies have been building portfolios and reducing the points of “friction” between the borrower and lender. Announcements of new companies and the resulting capital raises for those companies are reported with some frequency. There is a tremendous amount of activity and innovation from new and existing small business lenders in the market.
Since the banking difficulties in 2008, regulatory authorities have insisted on improving credit quality for loans. Many institutions abandoned the traditionally less-creditworthy market altogether. This action created a vacuum, and many small businesses simply did not have access to capital. Commercial Finance Association data for 2009-2010 showed a reduction in loan portfolios by banks and a pick-up of loans by non-regulated entities.
Between 2010 and 2012, new specialty lenders started to enter the market. Initially, the small lenders limited themselves to single proprietor businesses, and with increasing experience and data, they gradually increased loan sizes and captured more clients. At the same time, increasing sophistication in the automation of the underwriting process enabled faster turnaround. This process continues to accelerate rapidly.
Banks will always have a lower cost of funds, but the specialty finance company can mitigate the “bank advantage” as follows:
- Lowered overhead through better use of automation,
- Speed of response and approval,
- Emphasis on the approval and funding process,
- Reduction in cost of funds and
- Increase of leverage.
Need for Change
Let us start with the premise that the model we have been using will require upgrading, and perhaps, replacing. Why? First, look at the changes in publishing information. Do you get your news from the newspaper delivered to your home or office, or online? Do you go to the movies or do you download from Netflix? (A recent article in The New Yorker states that Netflix has more members in the U.S. than HBO or Showtime.) Are you reading this magazine on paper or online? Do you shop at Amazon or in a big-box retailer?
The questions above may (should) apply to your finance business. Why wouldn’t your client get to you online rather than on the phone? Does that customer want to be serviced online? How about approving the customer online?
How about your product? Are you a generalist or a specialist? If a prospect is searching the Internet for financing, he or she is seeking specific financing requirements. Search criteria will get a better “hit” on a specialist rather than a generalist listing. Think about it: The first big shift in direction is towards niche markets.
By utilizing information technology and database applications to research publically available date sources, the specialty finance company can select small business markets where access to financing is an absolute requirement. One can identify, analyze and review prospects that, for example, do not fit the profile of a commercial bank prospect. Then the lender can develop programs according to customer profiles based on general and customer-specific information, and develop risk-based pricing to manage risk.
The backroom management has to be transformed to an electronic product, moving information through process of review, underwriting and approval, delivery to the prospect, and finally, if accepted, to loan servicing by means of software technology. The result is that one can shorten the time to market, and the results (structure, price, covenants and approval) can be transmitted very rapidly. The portfolio management system keeps control of aging, eligibility and collections in real time.
The nature of a specialty finance company is somewhat static. (By the way, this is not a criticism: By static, I mean “status quo.”) Of course, you have incurred some changes: You may have software to manage the portfolio and a website. You are aware of market changes, e.g., the entry of purchase order financing, merchant card financing and mobilization funding, to name a few. However, there are bigger, tectonic shifts going on right now that you need to think about.
Let us start with December 2013. The Volcker Rule was approved. You might think that Volcker does not pertain to you, that it is a “Big Bank thing,” but you would be wrong. The rule will stimulate banks back into traditional lending that was more or less abandoned quite some time ago. If more banks go after the small business owner and offer loans at bank rates, you can expect some erosion in your portfolio.
For a refresher, the Volcker Rule prohibits banks from making loans using depositors’ money where the loan profile is risky. You will recall that this is what caused the banks to go into crisis in 2007-2008 and led to the big crash. The idea is that if a bank is deemed too big to fail and needs government support, it ought not to be making loans that imperil its status. How does this impact small business? Banks are required to stop trading activities (deadline July 2015), and they will be looking for other sources of income. Small business lending will be under the microscope. When banks look at the margins that the specialty finance companies achieve, they look very enticing. And with their cost of funds they can pick up almost the same spread. But what don’t they have?
- Management and monitoring on the scale necessary to run a small business loan portfolio and
- Sales and administrative personnel necessary to build portfolios.
What do they have? A growing certainty that real estate transactions are not going to be the engine for bank income in the future. Therefore, as they cast a covetous eye on the specialty finance industry, you might well see acquisitions on bank radar screens.
Friction-Free / Low-Friction Loans
You have probably seen the pay day loan business expanding and now contracting as it becomes apparent that it can be predatory and against public interest. But there is a parallel development, not in pay day loans, but utilization of technology to create “friction-free” or “low-friction” loans. After all, the pay day loan is pretty low friction: no liens and low credit checking. All the applicant has to do to qualify is to mist a mirror, have a job where he or she gets paid by check and have an employer that is a credit-worthy entity. The pay day lender drafts the bank account, or the employer assigns the wages (if permitted by law). This has driven the need for the lender to return to mathematical algorithms and accounting metrics that optimize the likelihood of getting repaid.
To give you an example, one algorithm — known by its inventor’s name Hans Luhn — is a check sum formula used to prove the authenticity of identification numbers (e.g., social security numbers, bank account numbers, etc.). Developed in the 1960s, the Luhn algorithm immediately returns a true/false result. Ongoing research in this branch of applied mathematics is very accurate and is used for facial recognition, traffic patterns and fraud detection.
Rapid Business Loans
In the matter of approving business loans, the advance can be approved in a few minutes — a process that is being applied to small business in a big way. Some names to watch: Ondeck, Business Financing Group, Sam’s Club and Kabbage. These and others like them are funding smaller transactions at the lower end of the funding spectrum. Further up the lending ladder are CommonBond, Prosper, Lending Club (Google is an investor) and Fundbox, to name a few. Lending Club recently announced a small business product. Some are peer-to-peer lending institutions, while others are small business lenders. Some are very specific. For example, CommonBond only makes loans to cover repayment of student loans.
Why are these businesses growing so rapidly?
- They cater to a much smaller loan size,
- Banks are not lending to this business profile,
- The loan size is not profitable for a specialty finance company based on traditional overheads and
- Typically, the loans will not qualify under existing criteria for eligibility.
Substantial changes are happening in many areas of day-to-day business and social interactions. These changes are modifying the way you will exchange information with your prospect and, hopefully, your client. I think you will agree that our future growth and success requires more than having a website. We need to utilize technology and personnel intelligently to be competitive in 2014 and beyond.
John Fox is president and CEO at Forest Capital.