Sam Hodges is Co-Founder and U.S. Managing Director of Funding Circle, which was created with a big idea: to revolutionize the antiquated banking system and secure a better deal for everyone. Funding Circle is currently the world’s largest online marketplace focusing exclusively on small business loans.
Prime Meridian’s Don Davis sat down with Sam to discuss the peer-to-peer lending industry, small business loans and Funding Circle.
DD: There seems to be so many different types of loans under the small business umbrella. What types of loans and borrowers do you specialize in at Funding Circle?
SH: At Funding Circle we specialize in small business term loans – between $25,000 and $500,000 — that allow the borrower to expand on an existing business that they want to take to the next level in terms of growth. Loan terms currently range from 24 months to 60 months.
DD: Why did you choose small business loans? Will you add other loan types in the future?
SH: We chose this focal point for two reasons: first it’s an area that my (US) co-founder and I understood very well, as owners of a small business ourselves. We own a successful network of fitness businesses, but getting access to capital was a horrible experience – we were turned down over 90 times! Second, we know that this segment, which is established, growing, and in need of expansion capital is one that performs very well from a credit perspective; it’s a core part of the market that’s not served primarily because of loan size, rather than riskiness.
DD: What are the loss rate expectations during normal times, and how is this likely affected during a recession?
SH: Our global annualized loss rate is well below 2% (across the US and UK). We believe that this is a reasonable long-term estimate of what the average loss rate will be. In times of a recession, the default and loss levels will go up, but by a reasonable margin – and very much supported by our current loan pricing.
DD: How can investors feel comfortable that your loss rates in the US will be accurate?
SH: We’ve spent a lot of time in the US over the past 3.5 years gathering credit performance data for a wide range of businesses and loan types, and have translated that into a scoring framework that’s also informed by over four years of default and loss history in the UK. Our models are only improving, so our predictive quality will only improve over time.
DD: Funding Circle is one of the few platforms that offer collateralized small business loans, which can vary widely among loans originated. How important is asset coverage ratio in the underwriting process?
SH: Asset coverage ratio is one of the factors we look at alongside debt service coverage, and inherent attributes of the business and the borrower – but it’s only one part. Our core risk-scoring model is weighted more toward debt service coverage than asset coverage, and includes hundreds of specific sub-factors.
DD: What is your projected dollar volume in small business loans at Funding Circle over the next 12 months?
SH: In 2015 we hope to do upwards of $250M in originations. We’re finishing 2014 with a run-rate of ~$100M/year. We’re investing heavily in marketing, underwriting and risk, team scaling and technology so that we can deliver a strong 2015 without outstripping any of our infrastructure. Our goal is to grow the business at a prudent rate, while still growing to address the tremendous demand we see in the market.
DD: Liquidity issues? Any plans for secondary market in the future? Are investors asking for that?
SH: We’ve seen really strong appetite for our loans from a wide range of different investor (lender) types. These range from individual accredited investors through global asset managers, and even one pension. We expect 2015 will be another good year to bring capital into this asset class. At this point, we’re overweight capital (relative to origination).
In the UK, we have a robust secondary market – probably the most liquid in the industry. In the US we don’t yet have a secondary market, but intend to faze one in as soon as we can. Secondary liquidity will be great for investors who need to manage their liquidity. Additionally, some investors only want to buy (parts of, or all of) seasoned loans, so a secondary market really can be a big mutual win.
DD: What are the regulatory challenges as well as opportunities for the crowdlending/marketplace lending industry?
SH: The first thing to keep in mind is that crowdlending and marketplace lending, though conceptually similar, have a major difference (at least how I define them): marketplace lending uses well-established securities and lending law to create a workable format for lending. Crowdlending speaks more to “crowdfunding”-like platforms that seek to use exemptions created in the JOBS Act to leverage the Internet to form capital on behalf of businesses and individuals. Though we’re eager to see how the final enforcement rules of the JOBS Act shape up, we’re in no way dependent on any changes there to permit our business. For folks who are hoping for change here there’s definitely an element of regulatory uncertainty.
More generally, the trickiest thing about this business may be in developing a model that works well in all 50 states, as well as under federal lending and securities statutes. My first senior hire here (2.5 years ago) was our General Counsel, and we view a thoughtful approach to legal, regulatory and compliance as one of the things that distinguishes our business in the segment.
DD: Are partnerships with traditional lenders key to the success of this industry?
SH: We think that partnerships with existing lenders will be an important way for this industry to reach its full potential. For example, in the UK we have a partnership with Santander, to help process smaller loans that aren’t a great fit with their commercial lending business. In the US, we’re in active talks with a wide range of banks and other lenders about how we can work together. For them that’s a great way to serve borrowers they might otherwise leave un-served, and for us it’s a great way to build our originations and help a new set of prospective borrowers.
DD: As volume significantly grows on the platform, is it a challenge to maintain strict underwriting? Does underwriting ever change in order to facilitate growth?
SH: We will never change our underwriting standards – the expected default or loss levels at a particular fixed risk tier – to facilitate growth. We fundamentally think about our business for the long term. Any marketplace lender that moves around standards to seek growth will underperform and eventually not have any lenders left. Underwriting quality is one of the most critical elements of what we do.
DD: Are there internal objectives to how you want the originations of each grade to be distributed? Is this affected by investor demand?
SH: We seek as many great borrowers as we can possibly find across the range — we’re in the fortunate position of having investors excited about all of our risk tiers and loan terms. As such, we don’t overly focus on origination mix, though we’re happy to see that we have a diversity of borrowers (across risk and term, and many other factors as well).
DD: With Lending Club’s recent IPO and several on the horizon, i.e. Ondeck, Sofi, where do you see the industry heading?
SH: I think Lending Club’s IPO as well as the coming wave, are a bellwether for the industry: as a category we (this type of business) present an important, generational shift in how borrowers of all types can get access to the finance they need to achieve their aspirations. We think 2015 is going to be a year of tremendous growth in the industry at large, and especially for Funding Circle.
DD: Do you see any new innovations coming?
SH: We’re focused on delivering a tremendous borrower experience, expanding our loan product offering (still very much focused on small business) and advancing our thinking on a risk and capital markets front. 2014 has been a tremendous year, and we’re excited about all that’s ahead.
Don Davis is a Managing Partner and Portfolio Manager of Prime Meridian Capital Management, an early adopter P2P/online lending investment management firm which manages the Prime Meridian Income Fund and Prime Meridian Small Business Lending Fund, and has an established track record of outperforming P2P lending platforms. Mr. Davis also serves as President of Novus Investments, LLC (“Novus”), an Independent Introducing Broker and Commodity Trading Advisor. Novus, founded by Mr. Davis in July, 2004, is an alternative investment management firm specializing in investment programs that have low correlation to traditional equity and bond markets. The Novus Precious Commodities program, managed by Mr. Davis, was ranked the Top Performing Commodity Trading Advisor (CTA) program in the US by Autumn Gold over both 5 and 7-Year periods by Compound ROR. Prior to starting Novus in 2004, Mr. Davis was an independent consultant and advisor to financial institutions specializing in research, analytics, and client retention.