...and why the market needs to be revolutionised to capture its full potential
This is a three-part series about what’s wrong with the Fintech lending value chain as we know it and why we believe it needs to be revolutionised for it to truly prosper and grow into what it can be. Enjoy!
We all have a love/hate relationship with clickbait headlines, but there are some well-kept industry secrets I rarely hear anyone talk about. Founders of alternative lenders may complain about it over an informal coffee chat from time to time, but they rarely speak openly about it to others, especially to their equity investors. They have an incentive to keep a polished exterior; “a thriving Fintech on its journey to becoming a Unicorn”. In truth, lending is probably the most difficult sector to become a Unicorn in, let me explain.
Fintech lenders, like other start-ups, have shareholders, technology, product, customers, etc., to keep happy. But, lenders also have another dimension of stakeholders to consider compared to traditional tech start-ups: the debt investor.
The debt investor is absolutely essential for a Fintech lender throughout its journey in becoming a Unicorn. But it begins already day one to even get off the ground and start building a loan book. Lenders need to gain the debt investor’s long-term trust and for them to be a strong partner.
Being a debt investor usually means that the upside in a transaction is limited to the interest rate and fees. There are no scenarios where the debt investor will be better off than what has been agreed in the loan documentation, only worse. This means that the primary incentive of the debt investor is to get their money back - as soon as possible. But the Fintech lender and their other stakeholders want a larger and larger loan book, creating the first layer of misalignment in the partnership.
The lack of supply of financing leads to a risk-reward imbalance in favour of the debt investor
Minor misalignments in interest between the Fintech and its debt investor such as this should be simple to overcome by compromising around the credit terms. But the lack of supply of financing leads to a risk-reward imbalance in favour of the debt investor, with a huge amount of complexity and lack of transparency of what the arrangement will actually cost the Fintech lender (come back for Part 2 to find out the details).
This is what we believe to be the biggest issue with the industry today. The debt investors as we know them have taken a financial product invented decades ago, for the purpose of financing huge books of traditional assets such as mortgages or credit card receivables, and applied it to innovative start-ups with exponential growth business models. Essentially trying to push a round peg into a square hole. Remember our blog post about the 600 pages of legal documents? Exactly that.
But on top of this sub-optimal product-market-fit, there is one thing in particular that might not make sense to founders. The fee and cost structure.
A term sheet from a debt investor will most probably include many, and in a worst-case scenario all, of the following fees; Interest rate, commitment fee, legal fee, unused fee, SPV setup costs, management fee, penalty fee, amortisation fee, exit fee, origination fee, and most importantly, warrants.
Let me break down the fees in a few buckets for you;
Interest – exactly what it sounds like, you pay an interest on the drawn (utilised) amount from the debt investor,
Set-up costs – cost of legal advisors (and corporate services to set up an SPV), generally at least €100-200k (but can be way more if you’re unlucky),
IRR enhancing fees – fees that makes it complex for the Fintech lenders to estimate what their actual costs are or what they will be, but it’s really great for the debt investor since it can amount to 1-4% on an annual basis over the course of the facility, and,
Warrants – debt investors ask for a share of the business because “they help the Fintechs grow”. It’s only fair that they get a piece of the pie, right?
The first bucket is straight forward, it is what it is, even though it in some situations can be aggressive, but that’s at least something Fintech lenders can control to some extent. The other buckets are more difficult to assess and compare…
Follow along in Part 2 where I go into more detail on what these costs actually are and how they work in practice.