The landscape of lending is changing. Changes in the capital landscape have spurred disruption in the small business lending market & consequently created the opportunity to invest in a compelling, new asset class of small business loans issued by private lenders.
The global financial crisis drove significant changes to banking regulation that ultimately made it more challenging for banks to issue loans to small businesses¹. Banks were required to maintain higher reserves. Additionally, heightened regulations drove up costs of compliance. These factors compelled consolidation in the banking sector – with larger banks acquiring smaller banks and community banks. Small banks and community banks historically issued a large share of small business loans. The net result for ‘Main Street’ businesses such as doctors and restaurants was that capital dried up; it became harder to receive a loan.
The volume of small business loan issuance declined significantly after the 2008 recession². The following chart displays loan volume for loans where the loan principal is $1 million or less.
In actuality, the financial crisis merely accelerated a trend within banking towards a declining share of loan volume allocated to small businesses. For several decades, banks shifted their lending portfolio towards larger businesses.
Even preceding the new dynamics stemming from bank consolidation, banks were increasingly turning away from small loans due to their inability to process these loans cost-efficiently – a reality owing to their costly overhead and inability to apply new technology to the problem. Banks face high transaction costs underwriting small business loans due to the heterogeneity of such businesses and widely varying use of loan proceeds. There are few general standards to assessing applicants. As a result, according to a Harvard Business School study:
The reality is that transaction costs associated with underwriting small loans are high, as processing a $50,000 loan costs nearly as much as processing a $1 million loan, but with less profit.
As a result, small businesses face a challenging environment to gain a loan for working capital, to afford needed inventory for a sale to a client, for purchasing equipment, or for expansion. This despite American small businesses employ 56.8 million people and generate 46% of the country’s GDP (“small businesses” here refers to companies with fewer than 500 employees).
While lending to large business has recovered and grown since pre-recession, small business lending has lagged³.
In this environment, many small businesses are rejected for loans when applying to traditional banks. Over 40% of small businesses either cannot receive credit from banks or do not receive the amount they requested.
The opportunity is millions of small businesses need working capital to expand, but banks are unwilling to meet that need. Large banks are structurally and culturally a poor fit for small business lending; beyond regulatory hurdles, their inability to innovate (such as considering new data sources in underwriting) and their refusal to adopt now widespread ‘big data’ technology meant that others would have to step into the void. What emerged were a set of alternative lenders; private organizations, staffed and led by those with credit and risk management backgrounds, but operating without a banking charter and without the constraints of banking regulation.
Private lenders leverage technology to aid sophisticated underwriting decisions in a time-efficient way. They also use technology to automate application gathering, eligibility assessment, as well as identification and bank statement verification. Innovating on the data front, many pull in data well outside the traditional sources. One such lender, Kabbage, evaluates shipping patterns as a component of borrower risk. Kabbage, through a partnership with the UPS, found that shipping data outperformed FICO credit score in its predictive quality. Through a mixture of data science and machine learning, alternative lenders process everything from legal records to social media data – finding efficient ways to power loan decisioning, usually for small dollar loans under $100,000.
Method Alternative Lending Investments invests in the loan portfolios of private lenders to small businesses. These are typically small dollar loans (under $100,000) and short-duration (12 months or less). The returns from this asset class benefit from a high average APR and a modest default rate. We believe this investment opportunity represents a stable high-yield return for investors that compares favorably to existing fixed-income investments.
- “The State of Small Business Lending: Credit Access during the Recovery and How Technology May Change the Game”. Harvard Business School. July 22, 2014.
- Federal Deposit Insurance Corporation (FDIC) “Consolidated Reports of Condition and Income”. June 2012.
- FDIC Federal Deposit Insurance Corporation (FDIC) call report data; compiled by DePaul University. 2016.