Nassim Taleb, the author of The Black Swan. The Impact of the Highly Improbable, once said: “If you are in banking and lending, surprise outcomes are likely to be negative for you.” This statement seems to be truer than ever, after we have witnessed the recent collapse of Silicon Valley Bank and subsequently of Credit Suisse within just two weeks.
However, all of the troubled banks we have seen recently were large and relatively established institutions. What about the up-and-coming ones from the alternative lending space? Manuel Silva Martínez, general partner at Mouro Capital, has some advice on how they can navigate a tricky market.
Mouro Capital is a venture capital firm, which originally started as the venturing arm of Spain’s Banco Santander but spun out to become an independent organisation. It also happens to be one of the most active investors in alternative lenders, with a portfolio covering everything from lending to small and medium-sized enterprises in developed economies such as the UK and the US through to consumer credit in emerging economies like Brazil and Mexico.
Mouro has invested in companies such as MarketFinance, Creditas, AutoFi and A55. The firm has also scored exits from digital mortgage platform Roostify as well as cash flow management solution provider Kabbage, among others. Kabbage filed for bankruptcy in October last year after it was acquired by American Express for $850m in 2020.
The alternative lending space is unlike many other VC-backed fields, according to Silva Martínez: “Alternative lending is a peculiar sector within the venture-backed [startup] community, in that growth is not always desirable. Quality growth is, but that at times comes as a contradiction to the advice many non-specialist VCs voice in the boardroom!”
“Quality growth” means growth in a very specific customer base: customers who want to borrow money regularly but who are solvent enough to pay it back.
The cost of living crisis is certainly forcing more clients to turn to lenders more often, says Silva Martínez. Furthermore, traditional lenders may tighten their acceptance requirements, which generally tend to increase awareness around alternative lending options.
“This may come as a benefit to the alternative lending sector, but only as much as those new lenders are able to keep the discipline of their underwriting policies and not accept lower quality risks,” warns Martínez. The turmoil in banking sector means investors like Mouro Capital will monitor the alternative lenders in their portfolio more closely than before.
Alternative lending is less risky, however, when it doesn’t just target a previously underserved demographic but aims to do something better than traditional lenders. “In many cases, it follows more of a “substitution effect”, aiming at replacing existing products (i.e. in served categories) with better ones: better user experience as more digital or more embedded, better rates due to better or more “real time” underwriting etc.,” says Silva Martínez.
This also translates into particular competitive advantages that venture investors may look for in a startup: “We would pay attention if the company has a “data advantage” because if it incorporated a unique data set into its underwriting that would make its approach to credit unique. For collateralised lending, [we watch] if the company is able to generate a new type of collateral, such as what we call a “behavioural collateral”. That is a behaviour conducive to repaying, which we find, for example, in group lending, microfinance or lending with a first need collateral).”
But the capital structure of the lender also matters a lot: “We also pay attention as to whether lenders are “full-stack” and thus rely on building their own balance sheet, or whether they have a lighter structure, as this has implications in terms of company building lifecycle and expected VC fundraising needed.”
The three key challenges of alternative lenders
Building an alternative lender of quality is no easy task. Silva Martínez highlighted three major challenges that alternative lending startups face – scale, connectivity and attracting the right customers.
“Lending is a scale game,” says Silva Martinez. “With scale come larger data sets on which to underwrite and train your AI. Scale reduces customer concentration and allows for better risk management. Finally, scale allows [the startup] to have more bargaining power with capital providers, and thus more efficient funding structure, typically resulting in higher margins spreads and thus more profitable companies.”
But scale can usually only be reached once an alternative lender has convinced the market of the benefits and differentiation of their loan products vis-à-vis the rest. It can be a “chicken and egg” issue for many lender startups at first.
The lack of scale may lead to some troubles, especially for alternative lenders in emerging economies that are highly sensitive to fluctuations of their local currencies versus hard currencies like the US dollar or the euro.
Those with certain scale and size tend to finance their own originations in local currencies with local warehouse lines and securitisation. But, it is the earlier stage ones that may face a scarcity of reasonably priced warehouse lenders in emerging markets, according to Silva Martínez: “Sometimes such startups need to take currency risk by borrowing in US dollars or euros and lending in [their] local currency, with expensive hedging in the middle to cope with currency fluctuations. This risk is typically reduced with scale – again, another example of why scale in lending matters.”
Another problem startups face is achieving sufficient connectivity with the rest of capital markets: “The language and KPIs that guide the capital markets world tend to be less innovative than what startups are building, so it is not unlikely for capital providers to have a hard time understanding a particularly novel type of lending risk, or changing data sets in “real time lending” experiences.”
This is a critical part which may often be missing, according to Silva Martínez. “Many alternative lenders take a long time to build a credible interface with such an important part of their operations, and this may hamper their growth or result in suboptimal funding structures.”
Finally, there is the customer acquisition and retention challenge. “Customer acquisition is not a trivial matter for startups: building a (digital) brand takes time and money. Once the brand starts to get some recognition, the next challenge is fighting the first wave of “early adopters”, which in lending tends to come with lower credit quality. It thus takes double the effort until not only clients approach the startup, but the right kind of clients, those that will be profitable and long-term partners of the lender.”
Will new lenders sink or swim?
Despite the turmoil and jitters in the banking sector, there is still no shortage of liquidity, as central banks in both the US and Switzerland have swiftly stepped in to avoid bigger disasters and contagion.
It is still not clear what all this means for alternative lenders. They are certainly vulnerable — like any lender — to the economic cycle. “In hard times, default rates and late payments increase, that is unavoidable,” says Silva Martinez.
On the other hand, Mouro’s portfolio companies fared relatively well during the most recent period of stress back in 2020 when the covid-19 pandemic broke out.
“In our emerging market portfolio, because our alternative lenders had responded to a market need that was latent and underserved, their clients behaved relatively better than those in more saturated lending categories,” he says.
Similarly, in developed markets, the pandemic shock benefited Mouro’s portfolio companies. “In the US and Europe, our lenders typically serve customer categories that have been more resilient to the 2020 shock (ecommerce, SaaS companies, affluent clients, etc.) and have thus benefited from that higher underlying quality of clients.”
