Navigating a New Ecosystem: Forming Alternative Finance Alliances
by Charles Wendel September/October 2015
Charles Wendel discusses the changing relationship between alternative finance companies and traditional lenders, which has evolved from competitive to cooperative. He outlines the essential criteria that equipment finance companies should use when evaluating potential alternative finance partners, as well as the potential benefits of establishing these relationships.
Charles Wendel, President, FIC Advisors
With the prevalence of alternative finance companies (AFCs) on the rise, equipment finance companies need to determine whether, and how, to work cooperatively with these financing sources. Increasingly, AFCs are viewing traditional lenders (TLs) as potential partners. This creates an environment where the options available are many and growing. The task ahead for equipment finance companies is deciding upon an optional approach to assist a customer or take advantage of a lead by selecting the best AFC partner.
A Brief History
To some degree, alternative lending has always existed. Independent finance companies have long provided an alternative to bank and captive lenders. Today, a major difference centers on the degree to which AFCs lever technology, which results in what one AFC provider refers to as “digitally enhanced lending.” This means virtually every aspect of a company’s business system depends upon, and is integrated with, the use of technology. This case involves soliciting originations over the internet and screening prospects based upon the application of Big Data. Internal processes are streamlined, largely eliminating paper movement. Credit and pricing decisions result from proprietary analytics that capture many more borrower characteristics than traditional lenders consider. In most cases, every aspect of an AFC’s business has been enabled by technology, resulting in faster response times and higher returns per loan.
In effect, TLs created the business opportunity that AFCs are focusing upon today. As a result of the last downturn, many TLs have limited their exposure to small businesses by increasing the requirements businesses must meet in order to obtain a traditional loan. As TLs narrowed the “credit box” to provide fewer loan offers, AFCs saw an opportunity to step into the small business space by focusing on loans and advances below $100,000.
While initially competing with TLs, many AFCs see the value of establishing a TL partnership for several related reasons:
AFCs want to lever their fixed cost platforms
TLs have access to a large pool of origination leads
AFC processing and risk management capabilities can reduce costs and increase a
TL’s market penetration
Co-branding or white labeling with a TL provides an AFC with a substantial competi-
Properly established, a working relationship between these two groups can be a win-win, with the AFC generating loan volume and the TL gaining increased revenues, deposits and ongoing control over the client relationship.
Alternative Finance Approaches
The best way for AFCs to work with TLs is changing. Initially, many AFCs worked to obtain turndowns from these lenders. However, this area has been deemphasized in light of a limited number of TLs signing on to those programs and the low number of referrals they provided. Instead, more AFCs have been concentrating on working with TLs to help these lenders lend more, both to current customers and prospects or, alternatively, to buy packages of loans from other lenders, whether alternative or traditional players.
AFCs will fund loans that banks are unable to pursue. This is largely due to AFCs’ risk management capabilities, risk-based pricing and processing efficiencies. Virtually all AFCs employ risk-based pricing, a concept that many TLs — especially banks — fail to implement consistently. Additionally, one can argue that AFCs’ approach to risk management is stronger both in depth and rigor. OnDeck, an AFC that completed an IPO last year, uses as many as 2,000 data elements aspart of its risk assessment process. AFCs look at most of the same information that banks do, but also review other data, such as cash flow, payment histories and social media reputation. Most AFCs go beyond relying on data alone and typically have an experienced lender review larger loan applications.
Several AFCs are now going one step further and aiming at full integration with a bank or other lender. In these scenarios, under the guidance of the TL, the AFC takes over responsibility for handling all loans below a set amount, such as $100,000, or focuses on fulfilling specialized lending requirements. For example, Lending Club and Citibank have teamed up to support the bank’s efforts to meet its Community Reinvestment Act (CRA) requirements. Several AFCs are currently negotiating with top 20 banks to integrate their processes with the banks’ small loan activities. TLs, frustrated by their inability or unwillingness to lend to a large percentage of business customers, can partner with an AFC. The AFC may fund a loan itself, or the TL may decide that the loan is of sufficient quality to purchase the loan and include it in its portfolio.
Additionally, TLs can participate in loan kiosks such as Fundera or Biz2Credit, which allow an AFC to refer loans to a lender based upon screening criteria it establishes. The loan kiosks present potential borrowers with multiple lending options, allowing for direct negotiation with the lender. The value to the TL centers on the new client introduction and the resulting ancillary cross selling. Whether or not this approach can be a significant revenue generator remains to be seen.
TLs also need to assess their preference for working with a direct or a marketplace lender. As the name indicates, a direct lender such as Fundation or OnDeck has “skin in the game,” risking its own capital to fund a loan. Marketplace lenders such as Lending Club and Funding Circle do not. Instead, they provide a platform through which potential borrowers request a loan and investors determine their willingness to make that loan, based in part on a credit assessment provided by the AFC and its associated risk-based pricing. Marketplace lenders emphasize transparency, usually provide a risk assessment, but encourage investors to make their own decision.
Options for Equipment Finance Companies
Equipment finance companies are already highly productive, given their industry expertise and niche focus and, compared to banks, are usually more advanced at the risk-based pricing than an AFC. Therefore, where can AFCs and equipment finance companies partner most effectively? Four possibilities exist:
Refer turndowns to alternative lenders
Participate in loan kiosks
Business extension into smaller loans
Work with alternative lenders on cross-
The first two areas will likely provide limited potential and revenue to equipment finance companies. The issues limiting opportunities in referring deals include privacy and customer service concerns and the relatively low amount of referral fees that such an effort is likely to generate. Similarly, participating in loan kiosks may generate some leads, but the best equipment finance companies already operate with a segmented focus. Therefore, kiosks are unlikely to generate significant new volume for a targeted lender.
While the first two possibilities provide limited appeal, other avenues can lead to revenue growth. Many bank-owned leasing companies may be overlooking opportunities to provide equipment financing to their smaller business customers because of the high costs involved in origination, processing and underwriting a loan. AFCs can provide the analytics required to assess a bank’s customer and prospect base in order to identify smaller equipment finance prospects. AFCs’ streamlined operations and risk management processes often result in a lower per loan cost than TLs. AFCs can either underwrite a small loan themselves, paying a fee to the TL, or the TL can decide to buy the loan for its portfolio based upon its independent credit assessment. In effect, smaller equipment loans, which are currently unattractive to many lenders, can become a new revenue generator.
Working with AFCs to cross sell to current customers may provide a significant opportunity. FIC Advisors has worked with equipment finance companies that are experts in equipment and commercial real estate lending. However, these companies lack the skill and experience in other areas such as working capital lending. While many of their customers use working capital loans to meet short-term cash needs, equipment lenders often fail to pursue this opportunity. Working with AFCs allows them to cross sell this product and other appropriate loans to their customers, either generating fee or net interest income from doing so. This approach can deepen the relationship with a customer and increase its “stickiness,” as selling more products to a customer typically enhances account retention.
As an equipment finance company is determining its best approach to partnership, it also must assess and select its optimal partner. New alternative finance players seem to enter the market almost daily, but despite their claims, relatively few will possess the experience and characteristics that most equipment finance companies should demand. Equipment finance companies need to evaluate several criteria before partnering with an AFC: current partner relationships established by the AFCs, compliance capabilities, ability to provide a turnkey process that minimizes any disruption to the ongoing business and overall execution capabilities, among other factors. Success in selecting an AFC requires a rigorous process that balances the requirements of the equipment finance company with the capabilities of a prospective partner.
Alternative finance companies have become part of the permanent lending landscape. They can provide equipment finance companies with opportunities to reduce costs, increase productivity and develop new revenue streams, all of which should cause equipment finance management to consider the best way to partner with these new lenders.
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