Down the Rabbit Hole

As a longtime fan of Alice and her Adventures in Wonderland, I can’t help but draw upon the well-known imagery from time to time.  And it just so happens that I find it appropriate to use for this post so feel free to smile like the Cheshire Cat and read on.

At QED, we pride ourselves on being operators disguised as investors with a keen focus on the FinTech sector.  From time-to-time we’ve found great businesses outside of FinTech that we thought we could guide, and (surprisingly) the entrepreneurs behind these companies seem to be happy with the advice and hands-on help we’ve provided.  Our experiences at building/managing businesses combined with our collective skills that range from customer origination to data analytics to managing complex, annuity oriented businesses have proven to be valuable to our non-FinTech companies.

So while it would be easy to stick to what we know best by taking the “blue pill”, we’ve gained the confidence that branching out into new sectors ripe for disruption was worth considering.  The result?  We’ve taken the “red pill” and started to learn as much as we can about two new verticals that are tangential to the FinTech space.  And what we’ve found is that the more we learn the more we like what we see.  It feels like we’re about to head down the rabbit hole which is scary and exiting at the same time.

MatrixBluePillRedPill

The first?  Insurance Tech.  It didn’t take much digging for the QED team to come to believe that the Insurance sector is ripe for innovation much like the banking side of FinTech was ten years ago.  You can check out an interview with my partner Caribou Honig on this topic here.

Insurance stats

And to do our part catalyzing the innovation, we’re pleased to be founding sponsors of an upcoming conference, www.InsureTechConnect.com.  It’s designed to bring together entrepreneurs, investors, and leaders from the industry incumbents.  I’ve procured discounted admission, $200 below the early-bird pricing, for the first twenty FinTech Junkie readers who register through this link.  Questions or sponsorship inquiries can be sent to Caribou Honig at: caribou@qedinvestors.com.

InsureTech Connect

The second?  I’m going to leave that for another post with additional detail. Those of you who know me probably can guess what my “second addiction” has become, but rest assured that my core focus is still and will always be the FinTech space.  But, once an addict always an addict….so stay tuned.

I Once Was Lost…

“I once was lost, but now am found,
Was blind, but now I see.”

 John Newton

For those of you involved in the lending ecosystem, you either were at LendIt or you should have been at LendIt. The annual gathering of “all things lending” was over 3,500 strong this year and the agenda was chock full of interesting topics and speakers. It was a well run and fantastic show.

With this said, the mood was much more somber than in years’ past and for all the right reasons. It was a conference focused on whether or not the next generation lending companies could adapt their models to today’s funding environment. It was a conference about Banks wanting to Partner with the next generation players as a means to serve their customers changing needs. And it was a conference that was chock full of “what’s next” vs. “what’s now” conversations.

And while there were many little insightful nuggets that I took away from the conference, I can truly say that one and only one thing stood out that I can’t shake. It’s simple yet profound. And in my truthful opinion this one thing is the key to simultaneously internalizing today’s problems while setting up the industry for its next wave of innovation.

ALL LENDING BUSINESSES ARE CAPITAL INTENSIVE WITH NO EXCEPTIONS

At their core, all loan originators advance cash to borrowers today in return for a stream of revenues that will vary based on future market conditions and economic scenarios. An originator might decide to hold on to the stream of revenues which will require having capital to back the loans or it might decide to sell the stream of revenues to someone who has enough capital to back the loans. Either way, lots and lots of capital is flowing from lenders to borrowers and there’s nothing that can be done about it. Capital is the peanut butter and the jelly in a PB&J sandwich. Without capital there are no loans. Without $20B of capital, our industry wouldn’t have been able to make $20B of loans last year. And without $100B of capital, our industry won’t be able to make $100B of loans in the future. Full stop.

So if lending requires massive amounts of capital as table stakes, why would any non-Bank institution want to throw their hat in the ring? Why would venture money be interested in the category? And why would industry experts abandon their cushy jobs to found companies in the space? The answer is simple:

IF STRUCTURED CORRECTLY, THE ANNUITIES GENERATED BY LOANS ARE ATTRACTIVE TO NON-BANK INSTITUTIONS AND MANY OF THESE INSTITUTIONS HAVE VERY DEEP POCKETS AND ARE LOOKING FOR ADDITIONAL INVESTMENT OPPORTUNITIES

This statement can be broken down to define what the job of a non-Bank lender should be. And the “first principles” that result can be used as a litmus test to determine which businesses models are well constructed.

1) Marketing: Efficiently find customers who want to borrow
2) Structuring/Underwriting: Manage approve, decline, credit availability, collateral requirements and pricing decisions to create a stream of future cash flows
3) Projection: Forecast cash flows under a variety of future scenarios
4) Monitoring: Report on results and make appropriate adjustments for future loans
5) Servicing: Ensure customer satisfaction and collection of payments

And finally…..

6) Capital Markets: Find deep sources of capital that want the output of jobs 1-5

The conclusion is that if you aren’t the primary source of capital used to back loans, you have to extract rent from the system based on your ability to efficiently find borrowers and structure attractive future revenue streams. If you aren’t generating attractive profit margins it means you aren’t good at efficiently finding customers or you’re not extracting enough value for brokering transactions. If you aren’t good at finding capital to back your production then you’ve either structured the wrong cash flows or you’re talking to the wrong sources of capital.

So you might be thinking: “Why lend?” I say: “Why not?” We live in a world where people want to buy things today and pay for them tomorrow. There’s gigantic demand for borrowing money that will never go away and lending is a great business if managed correctly. Just don’t forget that you need to find a dollar of capital to lend a dollar to a borrower and there are no exceptions to this universal law. Full stop.

 

Welcome Back My Friends

Welcome back my friends to the show that never ends
We’re so glad you could attend
Come inside! Come inside!

LendIt is here once again and I have to say that I’m actually excited to see 3,600 of my closest friends all in one place at one time.  If you’re like me, your calendar is already full and you still have a long list of people you want to see but couldn’t fit in.  And in addition to finding time for meetings, I’ll be one of the judges for the PitchIt competition on Monday and on a panel discussing “Valuation Trends” on Tuesday.  So, come see me if you happen to be at the Conference!

But, unlike last year, I’m not publishing a comprehensive paper this time around.  Trust me – I wanted to – but I just didn’t have the time to pull it off for LendIt.  Those of you who have read the two papers I released last year know that I’m not good at writing “short form” about serious topics.  (You can find them here: The Hourglass Effect and The Brave 100).  I’m in therapy for this and making progress!

With this said, I did pull together a quick 2 page primer with a few thoughts to consider if you’re at the conference.  The mood is likely to be more somber than in past years and some real skeptics will be present and vocal.  But as an industry a lot of great things are happening and in a few quarters we’ll look back at this time and recognize it for the speed-bump that it is.

Welcome Back My Friends

Have fun reading and see you at the show!

What Happens When The Cash Runs Out

Earlier this week an article I wrote appeared in the American Banker that laid out four simple questions that could be used to frame a lender’s chances of “surviving, thriving or dying” in today’s tumultuous environment.  Based on the feedback, it seems to be resonating almost as much as my “Shipping Code = Life!” entry (best interaction by far).

Based on the feedback I decided to follow it up with another short article that was picked up by The Lending Times this morning.  The title says it all: What Happens When The Cash Runs Out? and I’m guessing there will be a fair bit of debate about the conclusions in the piece.  It won’t be universally loved because of its implications to investors.  It won’t be universally loved because entrepreneurs don’t take failure well.  And it won’t be universally loved because there’s nothing to love about the topic.

And before you decide to shoot the messenger, make sure you internalize that all I’ve shared are generalities.  The truth?  Each and every company is unique in its own way. There isn’t a master puppeteer controlling the fate of companies that have yet to climb the scale curve — and if there is one it isn’t me!

Feedback always welcome.

Until next time,

fintechjunkie

Thriving, Surviving or Dying

Today, American Banker published a short piece I pulled together that you can find here:

Answers to These Four Questions Will Determine Online Lenders’ Fate

The piece describes a framework for thinking about what it will take to survive in today’s ever changing environment.  Everyone I talk to seems nervous about something — be it the securitization markets or the ability for companies to raise needed equity capital or the general health of the economy.  The truth is that we’ve been living in magical times the past few years which couldn’t last forever.  But, just because things are about to get a little more difficult doesn’t automatically imply that it’s “game over” for the specialty lenders and originators.  It does mean that the weak will struggle (and possibly die out), the good will survive, and the best-of-breed will thrive.  There’s nothing like a good stress-test to shake things up a bit and separate the wheat from the chaff.  Thriving, Surviving or Dying — Pick One!

As always, thoughts are welcome.  And if you happen to be a new reader that found their way here from the American Banker article, feel free to check out some of my previous posts (scroll down) and come back frequently for new content (about twice a month).

 

Be That Annoying Kid

Why?  It’s a very important question and one that isn’t asked enough. Investors need to be like that annoying kid that just keeps bugging everyone who’s willing to listen.  Why is the sky blue?  Why can’t we see the wind?  Why does the moon keep changing shape?

But many Investors don’t ask questions that are two and three layers deep.  Worse, some Investors are willing to accept the age old answer “just because” or are willing to trust that the company they’re evaluating has the “details” under control.

Example conversation:

Founder: We have an extra layer of protection in our student loan portfolio because 90% of all loans are co-signed.

First why: Why does co-signing help?

Founder: Because there’s someone with solid credit that’s responsible for the loan if the student isn’t able or willing to pay.

Second why: Why would they co-sign for the student?

Founder: Because they know him/her and believe in his/her character

Third why: Why does belief matter in a credit risk decision?  Do you have proof?  And aren’t these loans going to students that haven’t yet had much of a chance to prove their ability to handle financial matters on their own?  Aren’t they unemployed and living off the loans or other money from relatives?

Founder: Sure.  But we also feel good because there’s a credit worthy person on the hook in case the student isn’t able to pay.

Fourth why: Why are you comfortable that the co-signer will be able and willing to pay if the student ends up defaulting? 

Founder: Because they have good credit scores and have paid all their other bills in the past.

Fifth why: Why do you believe that using a generic credit score from the bureau correlates with a co-signer’s willingness to pay?  What checks have you put in place to make sure that the co-signer understands their obligation and is mentally willing and financially able to pay for the loan in case of default?

And so on….

It ends up in this case the “whys” matter because not all co-signers are equal and not all co-signers actually intend on paying in case of default.  Some co-signers wouldn’t have the ability to pay even though basic models would say they do (i.e. – Many grandparents on fixed income have good FICO scores and low DTIs but are living paycheck to paycheck).  Other co-signers haven’t internalized the obligation (i.e. – Uncle who fundamentally believes that his niece/nephew will be able to support the loan and is co-signing because the parents are maxed out).  And some co-signers are as good as gold (i.e. – Both parents co-sign and know that there’s a good chance they’ll have to step in to help because their son/daughter is studying art history).  The FICOs and incomes and DTIs of these various co-signers might be very similar, but without building a policy based on first principles this would never be discovered.

(And in case you’re intellectually curious, there are actual cases where the presence of a co-signer can be a signal that a loan will perform worse than if the co-signer didn’t exist….)

So…be that annoying kid and keep asking questions until you fundamentally understand what the heck is going on!  Q.E.D.

Smelling The Weeds

 

I was talking to a former Capital One alumnus a while ago and we talked about a host problems that still needed solving in the financial services space.  He made a very important distinction that’s stuck with me ever since.  There are problems that can be solved by Entrepreneurs that possess skills in the strategic thinking and financial engineering arenas and there are those problems that require industry specific expertise and very specialized skills to crack.  I found this categorization quite interesting and started to mentally map the businesses I’ve come across into the two buckets.

One conclusion popped out that I think is profound:

THERE ARE MANY FANTASTIC BUSINESSES THAT CAN ONLY BE BUILT BY INDUSTRY INSIDERS BECAUSE THEY UNDERSTAND THE PAIN POINTS INTIMATELY AND CAN DEVELOP PRAGMATIC SOLUTIONS BASED ON TRADE SPECIFIC SKILLS AND KNOWLEDGE OF HOW THE ECOSYSTEM WORKS  

And there was another conclusion that I found equally profound:

MANY OF THE PAIN POINTS EXPERIENCED IN AN INDUSTRY AREN’T EASILY UNDERSTOOD OR APPRECIATED BY OUTSIDERS AND THEREFORE THE BIAS IS FOR INVESTORS WITHOUT INDUSTRY SPECIFIC OPERATING EXPERIENCE TO QUICKLY DISMISS CERTAIN START-UPS THAT HAVE SIGNIFICANT POTENTIAL

Building these businesses is equivalent to “smelling the weeds”.  At 50,000 feet you can’t spot a weed in a garden.  At 500 feet you might be able to identify that there are weeds in the garden.  When you’re on your hands and knees crawling in the garden you can identify every type of weed and one-by-one pick them, pull them or (gasp) even smell them.

A few examples of businesses that are being built by “smelling the weeds”:

1) Signifyd – (QED Portfolio company) – Fraud detection, prevention and insurance services for e-commerce businesses.  The founder (Raj Ramanand) had a background in the fraud space, having previously been the Head of Payments and Shipping Risk at FedEx and the Head of Emerging Markets Risk at Paypal.  As a result, he understands the complexity of the e-commerce fraud problem, he is keenly aware about how bad the current market solutions are, he knows what potential clients care about, and he has been able to build a nearly frictionless solution that in many cases can be turned on with a single click.  4 years into its life and Signifyd has hundreds of paying clients that range from small Shopify merchants to giant e-commerce retailers.  What’s interesting to note is that some of the recent entrants to the space are well funded but struggling mightily due to the “outsiders looking in” syndrome.  They don’t come from the space and as a result haven’t been able to build or sell a compelling solution.

2) Nestiny – (A personal Angel investment) – A Netflix style walled garden of original content, tools and games for homebuyers.  The founder (Jody Clower) has a workflow automation background but also spent nearly a decade ploying her trade as a real estate agent.  She realized how dangerous the internet was for homebuyers because it was chock full of outdated content, false information, and bad advice.  She had to constantly undo the damage done by the internet searches her clients had conducted and the trend was pointing towards more and more clients heading towards this cliff.  Since much of the consumer facing innovation in the real estate space had been focused on “home search” rather than “education”, Jody felt there was a clear weed worth smelling.  Less than 1 year into the build and a few months of being live in the market and Nestiny has hundreds of pieces of content being read daily and a weekly growth rate that’s definitely exponential.  With volume they’ll be connecting buyers to agents and allowing agents to brand the experience for their own clients.  And what are the big guys doing to help agents and buyers?  Fighting for more market share in the home search space and being disliked so much by agents that the major portals have massively negative net promoter scores (REALLY bad).

And sometimes success relies not on being “one of them” but rather on assembling a team with specific industry specific skills and knowledge.

3) LendUp – (QED Portfolio company) – Just about every business that has a creative business model that wants to extend credit to the working poor needs to be built by industry insiders.  There are so many Entrepreneurs that feel like they have an “ah ha” moment about how to crack the problem of extending credit to the working poor without charging exorbitant rates.  Models that are sold through employers and tap directly into payroll for payments.  Models that rely on some form of co-signer to enhance credit performance through social pressure and backstops.  Models that tap new sources of data to effectively find the “cream of the crap” or “fallen angels” (not my terms).  This is a space where the details actually matter a lot and if you haven’t lived them you’re very likely to fail and fail hard.  The founders of LendUp (Sasha Orloff and Jake Rosenberg) are on a mission to create best-in-class financial services products for the working poor, new entrants to the credit market, and the credit damaged.  Along the way they’ve assembled a fantastic team chock full of “been there done that” people.  The resumes read like a who’s who of the sub-prime lending industry and I can attest to their talent having managed or worked with many of them personally.  Approve/decline/pricing decisions?   LendUp has a 15+ year veteran from Capital One and Paypal along with a team full of experienced credit talent.  Fraud detection and prevention?  LendUp hired a 20+ year veteran from Capital One with specific operations and analytic experience in the fraud space.  Compliance and Regulatory Affairs?  LendUp has many experienced people on staff including a former Enforcement Attorney from the CFPB.  Scaling a lending business from dozens into the hundreds/thousands?  LendUp hired a 25+ year veteran from Capital One and Travelers Insurance who’s managed a variety of customer facing departments (i.e. – collections, recoveries, customer service, etc), some with thousands of employees and multiple geographic locations.  Mistakes will still be made but not the big ones.

As an operator turned investor I can say that I relate to Entrepreneurs that are busy smelling the weeds.  Sometimes they smell pretty good….