...the impact of rate hikes, increasing credit losses and tighter equity markets
We all know that rates have increased dramatically over the last 24 months as central banks have combated rising inflation. In all truth, Fintech lenders were probably among the most impacted compared to other tech start-ups. Let me explain.
The unit economics of a lender essentially consists of four parts;
1. the interest rate charged to borrowers,
2. the incurred credit losses,
3. the cost of capital paid to the debt investor, and
4. the cost of servicing the borrowers.
Let’s focus on 1-3 for the sake of simplicity (as the fourth is somewhat unrelated to the current situation). To make a long story short, credit losses have increased due to the impact of inflation on the borrowers (and their clients if SMEs), and cost of capital has increased due to the rate hikes. As a lender, you just pass these increasing costs to your borrowers, right? Actually, it’s not that simple.
Because of the vicious circle of inflation's impact on the cost of capital and credit losses, many lenders have had difficulties passing on their increasing costs to the borrowers. They need to manage worse unit economics than what they were used to just 24 months ago.
Increasing credit losses and cost of capital with limited room to adjust pricing by increasing the interest rate towards borrowers doesn’t sound too attractive. That’s absolutely right. And this is of course one of the reasons equity investors have been shying away from lenders recently.
If we take a step back and rewind to 2020-2021, Fintech lenders and VCs were in equilibrium. What I mean is that they shared a “grow at all cost” mentality. Debt capital was cheap, credit losses were low, and VC capital was available in excess.
But with an all-growth focus by the Fintech lenders and their owners, risk got de-prioritized. Fintech lenders didn’t prioritize what it meant to be a lender enough – they forgot to manage risks because they always had someone to bail them out; the VCs.
It’s easy to lend out money, the hard thing is to get it back.
So, what happened when the VC funds stopped flowing? Fintech lenders were stuck with a portfolio of loans which had negative unit economics because the focus for them was to acquire new customers, not good customers. It’s easy to lend out money, the hard thing is to get it back.
While “too big to fail” may be true for banks – “too big will fail” became true for Fintech lenders.
To be honest, debt investors had their part in this as well. The covenant structures were (and still are) too reliant on the availability of VC capital, and not on the performance of the underlying loans. Because as long as VC capital was available, debt investors could deploy larger sums of capital, which meant more returns to the debt investors as the loan books were growing rapidly.
This is where the debt investors outsmarted the Fintech lenders and their equity investors.
The credit exposure that Fintech lenders (with the help of VC capital) aggressively built up was structured in a way that shielded the debt investor from losses. More or less all of the credit risk remained with the Fintech lender and their shareholders – as a matter of fact, you can say debt investors for all intents and purposes used VCs as insurance against downside scenarios.
In short this is because of the seniority of the debt investor vs. the Fintech lender where the lender (usually) continuously needs to “buy back” all defaulted loans given that only the performing loans are financed by the debt investor.
What will happen now with Fintech lenders? If they haven't already done so they need to rethink the “grow at all cost” mentality and not be too reliant on new equity capital bailing them out. Fintech lenders need to find their segment of the market where they get positive unit economics while managing risks long term. We’ll probably see fewer hyper growth Fintech lenders, but an increasing number of long-term sustainable lenders instead.
Fintech lenders and their equity investors need to level out the balance between growth and risk, which need to be equally important from the start, so that capital is more efficiently utilised and not wasted on poor lending standards.
With the tide turning, it's going to be interesting to see if the history repeats itself or if we're looking at more sensible growth ambitions from founders and equity investors...
What we do at Scayl is to focus on the performance of the loan book portfolio and managing the risks long-term – we’re not pushing the Fintech lenders to chase short-term growth. Lending is a marathon, not a sprint. Our product is designed in a way that neither we nor the Fintech lender is overly reliant on the capital from VCs or some other shareholder coming to their rescue if credit losses increase.
This way, a larger portion of the Fintech lender’s precious capital can be used for building better products for borrowers.
We think this is more sensible for the Fintech lender, for our Financing Partners, for the VCs and for us. We will get to play a role in creating stronger and more sustainable lenders who are ready to capture the existing market opportunity.
Comments