A well-known peer-to-peer lending company, which came out with an IPO in 2014, has a $2.7 billion market cap. The company operates an online platform that enables borrowers to obtain a loan, and permits investors to purchase notes backed by payments made on loans.
This business’ rapid growth has resulted in an optimistic valuation. A close analysis of the company’s 10K reveals some potential issues like upfront recognized revenues, rapidly rising marketing costs and ESOP dilution.
As discussed earlier by Prashant Trivedi in “Central Banks, Moral Hazard and the Prospect for Global Markets” QE practices so far have been incentivizing buyers and have indeed raised the moral hazard of investors willing to take risks. In the light of the aforementioned trend, the company has benefited in terms of the growth in operational revenues and loans, owing to the recent enthusiasm amongst yield seeking investors to directly invest in unsecured personal loans. According to the company’s book, the lending volume increased from $128 million in 2011 to $2.8 billion in 2014.
BUSINESS MODEL: DEPENDENCE ON CREDIT BASED GROWTH
Source: Business Insider
The company has entered an agreement until November 2018 with a primary origination bank (which is a similar business based out of Utah). As the borrower approaches the online platform, it forwards request to the primary bank which originates and issues loan; which is then purchased by the company from investor funds.
In April 2014, the company acquired a patient financing business. Hence, the company offers unsecured standard loans and also custom loans which include patient and education financing. For the standard loans category, the company seeks credit data from various consumer credit reporting agencies and then applies its own credit underwriting criteria. Interest rate and duration of loans is matched as to corresponding notes issued. Most importantly, the issued notes are unsecured ones with investor being eligible to receive payment as and when loan is repaid.
In the 2014 10K, the company claimed that it generates revenue from transaction fees from its marketplace’s role in matching borrowers with investors to enable loan originations, servicing fees from investors and management fees from investment funds and other managed accounts. The company has stressed that it does not assume credit risk or use its own capital to invest in loans facilitated by the marketplace, except in limited circumstances and in amounts that are not material.
A key point to note is that by outsourcing the loan servicing function of a bank, it is able to recognize transaction fees generated upfront unlike a bank which recognizes it over the life of a loan. The loans are considered to have been sold to the investors, whereby the company assigns promissory notes directly to investor. The firm then recognizes a servicing asset and corresponding servicing liability as a result of the sale in accordance with FASB ASC 860, and amortizes the asset into interest income as payments are received on the member loans.
The earnings process is believed to be complete when loans are transferred to the investors, and as there is no recourse to the company in the event of a default, the company states that it recognizes 100% of the origination fee as revenue and includes the fee in interest income. Investors pay Lending Club a service fee equal to one percent (1%) of the amount of any borrower payments received within 15 days of the payment due date. And such fee increases in the case of riskier loans as the interest rate is determined by Lending Club and based upon the applicant’s credit rating.
Another warning sign is election to not defer transaction fees on whole loans sold. This is different when compared to a bank’s business model, wherein transaction fees are recognized over the period of underlying loan.
The revenue to be earned from servicing fee depends on recovery of loans. Also in the event of prepayment of loans, service fee will not be received. There is no prepayment penalty to the borrower.
The historical charge off experience which is not much better than an average bank (see charts below). The loans on balance sheet had interest rates ranging from 5.8% to 29.9% and duration of 12 months to 60 months. As per the balance sheet, loans past the due date of 90 days or more increased from near 0.5% in 2013 to 1% in 2014.
Given the rapid growth in business as is the case with this company, cumulative charge offs appear low initially. However, as the portfolio matures and growth stabilises or slows, the real quality emerges.
Also, the company claims to have no underwriting risk but yet it consolidates loans and related issued securities as VIE. The company mentions the consolidation is also due to obligation to repurchase loans from the Trust in certain instances. In which case, there is a possible legal representation and warranty risk that may bite back when charge-offs rise potentially.
CHARGE OFF HISTORY FOR STANDARD LOANS
Thus even if one assumes that upfront recognition is fine, the risk involved is an adverse incentive to grow low quality loans and generate such fees upfront in order to dish out loans to yield seeking investors.
Moreover, what is alarming is the delinking of risk bearer and originators, as was the case with mortgage backed securities which eventually led to the subprime crisis. The transfer of risk leads to a process of separation between the loan origination and servicing functions, and the risk bearers. This separation can then lead to insufficient screening of borrowers.
Management & Governance
Directors and executives owned 53% stock at the end of December 2014. In the same period, outstanding employee stock ownership plan (ESOP) stood at 57.39 million units i.e. 75% of 2014 diluted shares and strike price was at USD 3.15 per unit, whereas the stock price then was around $19.
High and liberal amount of stock option compensation dilutes shareholders and the lower strike or exercise price is on such options the more dilution it will lead.
Real Earnings & Proper Earnings Benchmark
Company highlights Adjusted EBITDA as one of the key performance metrics. However it adds back normal stock based compensation cost to arrive at this adjusted EBITDA. Such compensation cost formed 174% of Adjusted EBITDA in 2014 and 73% in 2015. Compensation Committee established total revenue and adjusted EBITDA margin as the two financial measures to be used as corporate performance metrics as per the Proxy filing.
The company’s business model depends on continued interest of yield seeking investors in unsecured personal loans and could face hurdles in an environment where investors are shunning risk. Importantly, the gap between the originator and the risk bearer could pose significant risks to investors who have so willingly financed the loan book originated by the firm.