Emotions are running high right now. After more bad news from Lending Club on Monday afternoon it is understandable that some investors are getting nervous. And not just the investors in Lending Club equity but also investors in Lending Club loans.
Since 2010 I have hosted over a half-dozen conferences, produced over 60 podcasts, written over 1000 articles, and had tens of thousands of conversations about one thing: the peer to peer lending industry. To boil down my collective thoughts about our current situation to a single blog post feels very difficult, but I have set out to do it nonetheless. Now, this post can only scratch the surface of the issues. It is a summary of my thoughts as of this day, which run deep and broad, and may change tomorrow as this complex situation continues to unfold. Here goes.
I have had several emails and comments in the last couple of days from investors asking me if they should take their money out of Lending Club. That is, either cease investing (and reinvesting) in Lending Club notes, or sell them outright on the secondary market via Folio. While I can’t recommend any course of action for others I am happy to tell you what I am going to do with my Lending Club investments: stay the course.
Between all the Lending Club accounts that my wife and I own, including my portion of the Lend Academy P2P Fund that has about 1/3 of its invested capital in Lending Club notes, the total is well over $250,000. That is not an insignificant percentage of our liquid assets. And I am not changing anything – I continue to reinvest my principal and interest in new loans.
I am very confident that Lending Club loans will continue to perform well despite the governance issues that cropped up and came to light over the past two weeks. Renaud Laplanche’s departure is sad and unfortunate to say the least. But the likelihood that more departures will occur, that perhaps a large reduction-in-force is in the works, that banks will cease buying Lending Club paper, that origination volumes will go down, that profitability of the company itself may plummet, that Lending Club may participate partially by investing in loans using its own balance sheet, and that “experts” and pundits like Jim Cramer will cry sell! sell! – nothing in this narrative shakes my confidence in the underlying business model of Lending Club, nor the ability and willingness of my fellow Americans to pay their debts in a responsible fashion to the best of their ability.
Lending Club’s business model is about providing a lower rate of interest to American borrowers using a more responsible structure than credit card-style revolving debt, and at the same time providing a high return by passing through 99% of the cash flows (that’s 100% minus a 1% servicing fee) to investors. Lending Club’s underwriting model – the way in which it selects loans to list on its marketplace – has absolutely nothing to do with the recent events that ended in the resignation of its CEO and founder.
Possible Outcomes for Lending Club
Many have expressed concern to me over the last couple of days that Lending Club may not make it as a company. I think that is highly unlikely. To illustrate, let’s look at a few of the possible outcomes that could occur for Lending Club over the next few months. Here they are in descending order of likelihood in my opinion:
- Originations are reduced sharply – This will in part be due to a pullback from banks, which currently comprise a material percentage of buyers on the LC platform (34% as reported in Q1). To position itself for contraction rather than growth, LC conducts a large reduction-in-force (layoffs), management changes, and raises additional cash on its corporate balance sheets to weather the storm. The company works its way through the crisis. And what becomes of my invested capital in LC notes in this scenario? It is safely generating income throughout the turmoil.
- Lending Club is taken private – This could be done by a private equity firm and the new owners may conduct many of the above changes, and weather the storm in a more private fashion. The company returns to profitability, and goes public again at some distant point – let’s say five years out from today. Under this scenario, a more comprehensive change in management is likely. What of my invested capital? Safely generating income.
- Originations are reduced but not as sharply as we anticipate – Lending Club is able to use its current stockpile of cash (in the high hundreds of millions of dollars) to push through the crisis, continue operations as normal and return more quickly to sustainable growth. Again, my capital would generate income in this scenario as well.
- Lending Club is acquired by a strategic investor – Let’s say a large bank buys Lending Club and the new owner simply uses LC’s origination engine to satisfy its own thirst for high yielding prime consumer loans, improving its profitability and shutting the market to outside participants. This, in my view, is the actual worst-case-scenario for outside investors and our industry as a whole, as it would kill one of only two marketplace lending companies that serve individual retail investors at volume. In this scenario, while I would certainly expect my current investments to be serviced by the new strategic buyer, I would have to find a new place to reinvest my principal & interest.
- Lending Club is unable to right-size its operations, unable to attract a buyer – There is no going-private transaction, no strategic purchase and it is unable to raise new equity investment at any valuation, and eventually runs out of cash and goes bankrupt. This, in my view, is a very distant possibility. But I know this is a concern for many people so more on this below.
In the first four scenarios, which I consider to be the most likely possibilities for Lending Club’s future, my family’s money is taken care of and my capital is unaffected. The likely “worst case” scenario as I see it is that Lending Club is forced to wind down their marketplace by a new owner, in which case we may be prevented from investing in new loans. While our currently invested capital would continue to be serviced, as I mentioned above, the detriment to retail investors seeking high, uncorrelated yields would be severe.
The Worst of Worst Case Scenarios
But let’s consider the case of a Lending Club bankruptcy even though I believe it is unlikely. One reason I believe it is unlikely is taking a look at Lending Club’s balance sheet. They have plenty of cash and very little debt outside the loans themselves so it is difficult to surmise what could trigger a bankruptcy.
If you are concerned about a bankruptcy I suggest you read the Lending Club prospectus closely. There are 25 pages of Risk Factors that include discussion of bankruptcy. If Lending Club was to cease operations a backup servicer is in place and they would take over the servicing of the loans – this would happen in a quick and efficient way and borrower payments would continue as before. Now, I should point out that even with a backup servicer in place, there is no guarantee that payments will flow to investors in a bankruptcy. Attorneys I have spoken with have said while borrower money will likely still flow in there is no guarantee that this money will continue to flow to investors. It says as much in the prospectus.
As I said I think that a bankruptcy is an unlikely scenario although certainly not impossible. In the end, everyone must weigh the risks, and measure the estimated consequences, for themselves.
Lending Club Has a Powerful Franchise
Here is why I think Lending Club will continue to be a going concern for a long time to come. First, I am assuming that the problems discussed ad nauseam in the press over the last nine days are isolated incidents and not a systemic problem. There is nothing I have read that indicates these problems are systemic at Lending Club.
Lending Club has a powerful franchise even after all these problems. They have well over one million borrowers, most of whom have high opinions of the company. They have an efficient system in place to obtain these borrowers and now they are not focused on growth I think we will see customer acquisition costs come way down as they cut the least profitable marketing programs.
They have a large number of diverse investors, many of whom still believe in the company, like I do, and will continue to invest. Many of these investors have automated reinvesting, which will provide a consistent source of fresh capital to fund loans as previous loans are repaid.
I am under no illusions that this will be easy. Lending Club did $2.75 billion in new loans the first quarter. I expect that number is going to drop significantly in Q2 and drop again in Q3. They may not get back to that $2.75 billion number for quite some time. But that is ok with me as long as they keep to their strong underwriting standards and continue to make the marketplace available to regular investors like me.
As long time readers know, I have always been a glass half full kind of person. But I do believe that Lending Club will get through these problems and emerge a better company and one that will have the best compliance and internal controls in the industry. I am very comfortable with my decision to stick with them.
I know others may have differing opinions – feel free to share them in the comments below.
Disclosures: Peter Renton, the founder and CEO of Lend Academy, and Ryan Lichtenwald, Senior Writer at Lend Academy own LC stock. The information in this article should not be considered investment advice.