By Alicia Robb and Dane Stangler, Ewing Marion Kauffman Foundation
When Lending Club went public recently at a valuation of more than $5 billion, it seemed to mark the start of a new financial era. Excitement about “marketplace lending” (née “peer-to-peer lending”) is indeed spreading. Other platforms, such as Prosper and Funding Circle, also have experienced tremendous growth, and secondary platforms add liquidity to the emerging sector.
With this excitement has come a high level of anticipation about the impact marketplace lending platforms will have on access to capital for new, young and small companies. Already, Funding Circle says it is one of the biggest lenders to small business in the United Kingdom.
The rise of such platforms and their growing importance to entrepreneurs is reflected in recent data on credit to small and young companies. A joint survey by four regional Federal Reserve banks found that more than 20 percent of young companies applied for credit through online lenders (such as Lending Club and Prosper, but also OnDeck, Kabbage and others) during the first half of 2014. Considering that this market was nonexistent not too long ago, that is impressive.
The growth, perhaps unsurprisingly, has been uneven: Only 3 percent of older firms used online lenders, and only eight percent of “growth firms” used online lenders. Online lenders remain the smallest source of credit among firms seeking financing, with large banks, regional banks and community banks attracting more applicants across firms of all sizes and ages. Approval rates vary substantially: Two-thirds of credit applications to community banks were approved, but only 31 percent of companies received credit from large banks. And, most of those securing credit from large banks were larger and older firms. Growing firms had the highest approval rates from community banks. Yet over half of young firms (less than five years old) had their credit applications denied, far higher than older firms.
Why Deny?
Why do new and young businesses get credit denials? Low credit scores appear to be the top reason, followed by insufficient collateral and weak business performance. Given the lingering effects of the housing bust, these reasons are to be expected. Overall, the Federal Reserve banks found, there was weaker demand for credit in 2014 among smaller firms. Some of these findings are in line with other recent research, and reinforce a sense of despondency about small and young firms’ access to capital.
A Harvard Business School (HBS) working paper by former SBA Administrator Karen Mills found that, while small business lending fell steeply in the recession and has only recovered slowly, it has actually been in long-term decline. Small business loan portfolios at banks have been shrinking for two decades. With consolidation in the banking sector, the number of community banks has been falling since the 1980s—the Federal Reserve survey shows that these remain an important source of capital for young and small companies.
The Fed survey, however, does present reasons for optimism. While young and small companies were hit hard by the recession, many are looking for growth capital. Business expansion was one of the top reasons given for borrowing across all types of companies. In fact, difficulty in attracting customers was the top challenge cited by young firms—building a business model with traction and then growing it are (still) the core challenges of entrepreneurship. Capital is a means to this, not an end itself.
It’s possible that the Fed survey findings do not capture national trends: Over half of respondents to the survey were from New York and Pennsylvania; the sectors most represented among respondents were professional/business services, construction and manufacturing.
Transformation Potential
It’s hard to conjure a crystal ball out of one survey, but could the growth of online lenders help address some of the challenges listed above and reverse long-term trends? Online lending platforms claim to bring more sophistication to analyzing credit applications through algorithms and the use of non-traditional data. It’s not hard to imagine that, especially for new and young companies, online lending platforms will transform the landscape of entrepreneurial finance.
Traditional banks historically have been a very important source of capital for new companies—through personal loans, business loans, credit cards and lines of credit. Marketplace lenders such as Lending Club and Funding Circle could hold the potential to blur the lines of traditional bank lending in the same ways that AngelList has done in venture capital. The platforms typically have lower costs than banks and, together with the rise of equity crowdfunding (as yet unauthorized by the Securities and Exchange Commission), could promise a new era of democratized entrepreneurial finance. Technology, too, may be on their side: “forward valuations of any marketplace lender include a percentage chance that they become the way money moves in the future.”
Some observers, including Scott Shane, see online lending not as a threat to traditional bank lending, but as an alternative to sources such as credit cards and less savory alternative lenders. The growth in the provision of credit to small and young companies through online lenders may be partially driven by the platforms’ collaboration with traditional banks. In Britain, Funding Circle now receives referrals from Santander UK; Lending Club has forged similar relationships in the United States, both with banks and Google, according to a recent Financial Times story.
Institutional investors also appear to be pouring into the space, providing the capital that is then offered on the lending sites. (Hence, the understandable shift in terminology from “peer-to-peer” to marketplace lending.) One wonders, then, how sustainable the growth of these platforms will be once the era of ultra-low interest rates ends. The higher yields promised by marketplace lending have been sucking in capital by investors searching for yield. The “zero lower bound” of monetary policy may turn out to be the “peer upper bound” for such lending.
But, it could be the case that, in the next downturn, marketplace lenders fare better than traditional lenders. As Brian Weinstein of Blue Elephant Capital Management points out, high-yield, short duration assets, with relatively easy diversification, will be in a stronger position than other financial assets.
The tremendous diversity of entrepreneurship and small business should mean comparable diversity in the funding and capital options available to those companies. Even if things like marketplace lending and equity crowdfunding aren’t nearly as transformative as some hope they will be, the alternative pathways they create should be a boon to small and young businesses, and thus to the overall economy.
