Why does one lender borrow at 3% and lend at 15% while another borrows at 10% and lends at 8%? Moreover, why can some originators who sell off their loans command meaningful origination and servicing fees while others earn slivers?
These questions were top of mind when I saw Frank Rotman take to Twitter to ask: “Are lending companies VC backable?”
The answer is yes, of course. Rotman, cofounder of QED Investors, ultimately lands on this point in his 27-point thread: “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.”
After reading through and engaging with this thread something was missing: necessary commentary covering the cost of capital. Here’s the most important thing to keep in mind: The lending business works like any other business. Defensibility begets value. That’s my First Rule of Lending.
Look at Carmax. Half of Carmax’s profit comes from their captive lending business. The business is so profitable because they are able to charge consumers high rates due to convenience and amortize their marketing costs across selling cars and making loans, while they borrow at the market rate for high quality auto loan pools, circling around 2-3%. Their cost of capital comes from the market — every high quality auto lender gets similar terms — but their return comes from their unique distribution channel to borrowers.
Here’s the most important thing to keep in mind: The lending business works like any other business.”
My advice to fintech entrepreneurs is always to focus on defensible distribution first and balance sheet design second. By the way, this is my advice to all entrepreneurs! Build a great business that attracts customers in unique ways. Become the destination for something. When you are, your customer acquisition cost (CAC) is low. Once your CAC is low, you can optimize your loan-to-value (LTV) ratio. Balance sheet design is about optimizing LTV. Not to say it’s not important, it’s just not THE MOST important item on the entrepreneur’s priority list.
As far as balance sheet design goes, however, I do think it’s important to point out that on- and off- balance sheet financing is not binary. While it’s true that some VCs don’t like balance sheet models (because of misconceptions around venture returns), the reality is that it’s possible to build a business that originates and sells risk sometimes and keeps that risk in a capital pool it manages other times. In fact, almost every bank has a syndication desk that sells off pieces of its loans to the market while most investment banks have merchant banking or principal investment arms that invest or co-invest in deals the bank is originating. As a fintech entrepreneur you want to be in control of which tool you choose, depending on the market environment.
Unfortunately, few are in control because they sign restrictive long-term credit facilities with lenders at above market prices. The result is that as their markets become more competitive, the cost of capital to borrowers falls faster than many pioneering originators can match by renegotiating their credit facilities or taking on new ones. As you know, it is incredibly common for a new originator to be locked into their lender’s cost of capital for extensive periods of time which puts them at a disadvantage to new entrants (like insurance companies) with cheaper capital.
All this leads me to my Second Rule of Lending: Do not lock yourself into high cost capital for extended periods of time. Don’t do it. Not if you want a steady stream of income, regardless of the ultimate methodology by which you charge for originating and servicing loans.
Or as Rotman put it: “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!”