Joining the Club: How Lending Club’s Improved Borrowing Experience Drives Company Performance
To what extent do operations drive the growth of a fast-growing fintech company?
To be considered “highly effective,” a company must deliver on its customer promise. To do so, its operating system must be three things: good, fast, and cheap. The rapid growth and success of Lending Club, the leading peer-to-peer lending platform, can be explained by its ability to leverage these three characteristics of its operating model to create and sustain a competitive advantage against banks, as well as a myriad of upstart competing lending platforms.
Operating Model
Good (High quality, innovative, and achieves customer promise)
The sophisticated use of data has enabled Lending Club to build a proprietary credit decisioning platform that offers differentiated underwriting, faster credit decisions, and a fully automated/online system. Over time, the company has garnered individual loan data on over $13 billion of loans. It uses risk assessment factors, including credit history, employment data, and online footprint, to more accurately predict payment behavior and charge-off rates. The platform also uses innovative features, such as real-time credit monitoring, to reduce the number of defaults.
Lending Club’s advanced use of data is central to its ability to deliver to customers: by more accurately pricing risk, Lending Club established a strong underwriting track record over the past 8 years, attracting the greatest interest (of any platform) from large institutional investors. Having investors with deep pockets enables Lending Club to attract more borrowers due to the increased likelihood that their loans would get funded quickly and at a better rate. This virtuous cycle creates an effective two-sided platform.
Fast (Flexible, with short cycle time)
The simplicity and speed with which Lending Club operates relative to a bank cannot be overstated. Lending Club’s marketplace reduces much of the friction in the existing loans application, approval, and servicing processes. The application is online, borrowers generally receive the money in less than one week, and there are fixed monthly payments with no prepayment penalties or hidden fees. Customers love that they can apply for a loan in the comfort of their home and on their own timeline, without dealing with endless paperwork. Lending Club continues to refine and automate its backend employment and income verification process to make it easier for low-risk people to get funded faster. As a result, Lending Club has been able to grow the addressable market of borrower demand in addition to servicing existing debt consolidation demand.
Cheap (Low cost)
Lending Club, unlike most banks, is an online-only platform. Its technology-driven cost advantage vs. banks includes a purpose-built platform, online-only application process, data-driven automated underwriting, scalable origination and servicing platforms, and lack of overhead related to brick and mortar stores. Together, these features drive a ~3-5% cost advantage relative to traditional lenders (Lending Club’s operating expense is ~2% of outstanding loan balance vs. 5-7% for branch-based incumbents). Since Lending Club has lower costs, it can afford to offer better rates to borrowers, essentially sharing a piece of the value created with its customers.
Business Model
How Lending Club Creates Value
Lending Club is an online platform that connects borrowers and lenders. Traditional banks profit off the spread between what borrowers pay (e.g. ~21.6% for credit cards) and what lenders get (~1.0%). Lending Club creates value by sharing part of this spread, offering borrowers lower rates and lenders higher returns. How can they afford to do this? The answer lies in its operating model, which supports ~3-5% lower operating expenses due to a technology-driven cost advantage.
How Lending Club Captures Value
Unlike banks, which earn revenue based on net interest income, Lending Club collects a transaction fee for each loan originated and bears no credit risk for the loan volume generated on its platform.
Transaction fee. Lending Club generates revenue primarily from transaction fees from borrowers, which range from 1-6% of the initial principal amount of the loan depending on the credit quality of the loan. In Q3’15, transaction fees contributed 89% of total revenue.
Servicing fee. The company also generates a servicing fee on a monthly basis from investors who receive a payment. Investors generally pay a servicing fee equivalent to 1% of the monthly payment . In Q3’15, servicing fees contributed 8% of revenue.
Management fee. The company charges Certificate investors through LC Advisors (LCA) a monthly management fee of 0.7%-1.2% per year of AUM. In Q3’15, management fees contributed approximately 3% of total revenue.
How the Operating Model Drives the Business Model and Sustainable Competitive Advantage
Efficient cost structure drives lower APR to borrowers, higher returns for investors. Lending Club’s more efficient cost structure, driven by lower branch infrastructure costs, regulatory overhead, and automated approval and servicing processes, allows the platform to offer lower interest rates to borrowers and higher relative returns for investors. Over the past year, the average interest rate for borrowers was 14.8% compared to 21.8% credit card APRs, while the average return rate for investors was 8.6%, which is meaningfully more attractive than the 1.0% from the average savings account or 6.8% from the average high yield corporate bond.
Robust network effects creates sizeable barriers to entry and drives superior rates and returns. Marketplace models often demonstrate network effects, as has often been observed in other industry verticals where there is often one dominant marketplace platform – AirBnb for online rooms, Uber for mobile taxi hailing, GrubHub/Seamless for online food ordering, and eBay for auctions. Buyers are likely to come to the platform where there are the most sellers, and vice versa. There are network effects inherent in Lending Club’s model: as a result of its scale and number of loans originated, Lending Club has access to a treasure trove of its own data, creating a flywheel effect that continually increases the defensibility of its business. Data from loan performance feeds back into Lending Club’s model, creating an even more accurate model. As the accuracy of the data and model increases, so does investor trust and funding, so Lending Club can offer borrowers lower rates. As rates decrease, more borrowers flock to the platform, driving more data into the model. These network effects reinforce the company’s market leadership position.
Key Risks and Contingencies
Because it is a market maker that charges transaction fees to borrowers and servicing fees to investors, Lending Club is incentivized to rapidly grow loan originations. In benign credit environments, this strategy works. In many ways, Lending Club has benefitted from a close to ideal environment over the last few years as it reached scale. Specifically, the combination of low interest rates and low charge-off rates in a growing economic environment has made Lending Club a relatively more attractive investment. As such, the risk of (1) interest rates rising, and (2) charge-offs increasing over the next credit cycle could test the limits of Lending Club’s credit model.
Key Sources:
- Lending Club 10-K, 10-Q, and investor presentation.
- Goldman Sachs and Morgan Stanley research.
- Personal interviews with Lending Club.
- Mad Money interview with CEO Renaud Laplanche on Lending Club business model: https://www.youtube.com/watch?v=pji5VLnevZY
- Loan funding time at Lending Club: https://orchardplatform.com/blog/2014522loan-funding-timing-for-prosper-and-lendingclub/
Thank you Christine for writing this post. It is amazing to see how online platforms are dis-intermediating players in the banking industry and providing better pricing compared to traditional banks. However, one question that came up in my mind was, how does lending club conduct credit rating checks on their borrowers if they are completely online based? (as providing quality of the output of their process (loans) would be vital to ensure their business is sustainable). And on that note, do you see their fees rising in the near future, as regulation on online transaction and data security increases?
Excellent and fascinating post. Below my follow-up questions:
1. How do you see crowdfunding impacting/disrupting other investment vehicles with relatively high overhead and low differentiation (i.e. venture capital or private equity funds)?
2. From a risk management standpoint, how do you prevent money launderers from accessing the investment side of this successful equation?
3. ATMs did not eradicate bank branches, would this model finally represent the demise of the brick-and-mortar way of banking?
Many thanks!
Great post Christine! I have not used Lending Club myself, but I’m curious as to how transparent the company is in how it assesses creditworthiness of its borrowers and assigns an interest rate. For example, as an investor who is lending money to someone, I am relying on Lending Club’s algorithms and processes to have correctly analyzed the risk of this borrower. What happens if someone who was graded a “AAA” borrower suddenly defaults on what I thought was a risk-free loan? Do I have recourse against Lending Club for irresponsible risk management?
Interesting post! Curious how much you believe the network effects are going to create barriers to entry. It feels to me like other entrants like Prosper, Avant, and others are still able to attract capital and borrowers.
I am not too sure about the online platforms’ long-term profitability as I think competitors will bid up prices for customer acquisition until returns for the industry reach more normal level.