Is Alternative Lending Your Next Best Move?
The alternative lending industry has enjoyed continuous, double-digit growth over the past several years. When will this upward trend plateau? When big banks approve more loans than they decline. In other words – we don’t see the dark at the end of this well-lit tunnel. Even though savvy lenders have already carved out their niche, new players will find plenty of unclaimed opportunity.
In this article, we’ll define alternative lending, calculate the size of the opportunity, outline the barriers to entry, review the technology requirements, and provide resources for specialized alternative lending software.
What is alternative lending
The pure definition of alternative lending is any financial vehicle for business or personal use, that’s not a traditional loan from a traditional bank.
This includes loans from non-bank sources, like private lenders and online crowdfunding platforms. It also includes a variety of funding vehicles that are not loans. In fact, when it comes to alternative lending the terms financing or funding are often more accurate descriptors.
These non-loan financing vehicles include options like invoice factoring and equipment leasing. The funders are careful to distinguish their products from loans in order to avoid the complex regulatory rules that govern the lending industry. For example, invoice factoring is the sale of an asset in the form of an outstanding invoice. An invoice is an intangible asset, but it has just as much value as a tangible asset like manufacturing equipment or real estate. The factor (or an investor) purchases the invoice, advances a percentage of the face value to their client (usually within 24-48 hours), and then gets paid directly from the client’s customer. We’ll review more non-loan alternative financing vehicles later in the article.
How big is the alternative financing opportunity
The growth potential is impressive. Alternative financing is a robust category that’s expected to top $241 billion in worldwide transaction volume in 2019. The top five markets are China, United States, United Kingdom, Switzerland, and Italy. Currently, the Chinese market delivers the lion’s share of transactions, while the other countries are considered emerging markets with tremendous growth potential.
The compound annual growth rate (CAGR) for the next four years is estimated at 12.9%, which translates to $341 billion in total transaction volume in 2022. The average dollar amount per transaction is expected to increase by 16% during this timeframe from $4,803 to $5,566
What’s fueling this decade long, double-digit category growth? The basic principles of supply and demand. Big banks are shrinking the money supply as they shift their focus to large corporate clients; while small to midsize enterprises (SMEs) and entrepreneurial innovators are creating substantial new demand. In the US the number of large enterprise loans has increased by 37% at the same time that the number of small business loans has decreased by 40%. The dollar volume of small business loans has dropped from $74.5 billion to $44.7 billion. That’s a $30 billion void – waiting to be filled by alternative lenders.
What are the different types of alternative loans
When it comes to alternative financing the only limit is our own imagination. The possibilities are endless, so let’s focus on the top five alternative vehicles:
- private lending
- invoice factoring and accounts receivable financing
- equipment leasing
- merchant cash advance.
Crowdfunding is the most common form of alternative lending for businesses. It’s a type of peer-to-peer lending that’s referred to as marketplace lending when the funds are used for personal purposes. The technology platform is new, but the concept is based on an age-old practice where investors come together and pool their resources to diversify risk. This model provides lenders with two ways to participate. First, you can create, host and manage the online marketplace. Your job is to bring borrowers and lenders together, and then provide account management services like payments processing and investor disbursements. Second, you can participate solely as a lender, by investing in a loan pool and earning interest income on the investment.
Private lending is another large category for alternative lenders. This is a traditional loan from a non-traditional source like a private individual or an online lender. These can be business or personal loans. The most common business loans are for real estate developers and builders seeking mobilization funds or bridge loans. Other common types of business loans are term loans and business line-of-credit (LOC). The most popular funding for the consumer market is home mortgage lending.
Successful private lenders understand how to evaluate and control risk. So it’s good to enter this niche prepared. A banking background is an asset because you’ll already understand the dynamics of a loan portfolio, including the metrics used to calculate potential bad debt. Business category expertise is another asset because you’ll already understand the revenue model and business processes. For example, an investor with a medical background who owns an urgent care clinic is well positioned to evaluate the repayment strength of a medical device manufacturer and price the loan correctly. Or a property manager who is familiar with local zoning laws and building codes is well positioned to evaluate the return potential on monies advanced to a real estate developer. Mobilization funds and bridge loans tend to be lower risk because they are short-term financing options and they’re collateralized by real estate. However, if the borrower defaults, then the time and legal expense required to take possession and liquidate the assets could wipe out any profits.
Private lenders can partner with banking and business category experts when they don’t have the necessary expertise. Or they can invest passively in a private lending fund.
Invoice factoring and accounts receivable financing
Invoice factoring and accounts receivable financing are not loans. Factoring is a funding vehicle where an investor, also known as a factor, buys outstanding business-to-business invoices at a discount. Then the factor collects payment directly from their client’s customers. Accounts receivable (AR) financing is a first cousin to factoring. Instead of purchasing individual invoices the investor provides a business line based on a percentage of the AR portfolio. This line is referred to as a facility to differentiate the process from a traditional loan. Factors are not encumbered by regulatory compliance rules specific to lenders, and they’d like to keep it that way.
Factoring is a great alternative for lenders who want to reduce the risk associated with servicing new businesses with thin credit or distressed companies with bad credit. Factors reduce their risk by leveraging the credit history of their client’s customer, instead of their client, because the customer pays the invoice. Factoring has become more competitive over the past 20 years, driving discount rates as low as 1.0% for a 30-day invoice. This is an ideal financing vehicle for a wholesaler working with slow pay customers like big-box retailers and government entities.
Equipment financing is a great option when your borrower owns physical assets. Equipment leases can be a less risky proposition because the funding is collateralized by the equipment. This is another creative area of financing that’s tailor-made for smaller lenders who understand how to evaluate the viability of the business and the resale value of the assets.
A typical leasing contract would fund new software, new manufacturing equipment, or new technology in order to scale an existing business. An interesting twist on equipment financing is a two-step process called a sale and leaseback. During step one of this scenario, the borrower sells their existing equipment to the funder but maintains physical possession of the machinery at their place of business. The funder owns the equipment on paper, but the client continues to use the machinery for revenue-generating activities. During step two the client leases the equipment from the funder and makes monthly payments until the lease is paid off. At the end of the lease, the client takes back legal ownership of their equipment. In this way, the business gets the cash they need, without taking out a loan. And the funder earns investment income without the onerous banking regulations that govern the lending process.
Merchant cash advance
Merchant cash advance is considered the last resort for a retail business that needs financing because the fees can be high. However, it’s a smart business decision when the cost-benefit analysis shows a positive return. And it’s a lucrative transaction for a funder with the knowledge and tools to control the risk inherent in an unsecured cash advance that will be paid back from future credit card receipts. This type of financing is similar to invoice factoring. It’s not a loan. It’s the sale of an intangible asset in the form of credit card receipts that will be generated from retail sales occurring over the next 2 to 12 months.
Merchant cash advance is a good financial vehicle for the funder who has two areas of expertise. First, they must understand how to evaluate the health of a retail business. And, second, they must understand how to manage the borrower’s merchant bank relationship. As a funder, you’ll need to take short-term control of your client’s retail credit card receipts in order to draw down your payments directly from their merchant account.
A key step in the due diligence process is to learn how the borrower intends to use the cash infusion. Don’t pour money into a sinking ship. Do invest in a solid business taking advantage of an unexpected opportunity. For example, a strong candidate for a merchant cash advance is a retail business owner who could purchase extra inventory at liquidation prices from a wholesaler that requires payment in full at the time of the transaction.
Successful funders in this category nurture long-term relationships with their best customers, who often take out 2-3 cash advances per year. Repeat customers contribute more revenue per account; and they reduce the funder’s marketing costs, due diligence costs, portfolio risk, and bad debt.
Should you specialize or cast a wide net
You’ll notice that most alternative lenders specialize in one type of funding vehicle, and many specialize in one industry within that funding category. That’s because each funding vehicle is distinct, and each business category has its own operational nuance. For example, private lending to residential home developers, or equipment leasing to restaurants.
Deep industry intelligence is invaluable when you’re evaluating the opportunity and the risk of an individual transaction. For example, as a purchase order funder or invoice factor you’ll need to understand the steps and timing required to manufacture and ship products (potentially from overseas) along with remote quality control inspections and international customs inspections. Without this knowledge, your 30-day investment could turn into a 120-day investment with a limited return. You don’t want to learn the hard way that invoice factoring in a retail environment might not be a good fit for your lending operation.
Today’s borrowers have far more choices than prior generations, who relied almost exclusively on the local bank. The secret to your success as an alternative lender is to understand your prospect audience, understand their financing options (your competition), and understand the value of a long-term relationship.
The primary prospect audience is likely to be a millennial or an SME in startup mode who is too small and/or too creative to get approved by a traditional bank. The executive team skews young and tech-savvy. They display an entrepreneurial spirit (and a bit of swagger) compared to older business owners. And they demand the kind of online lending process they’ve come to expect in their personal financial world. As an alternative lender, you need to deliver a streamlined, paperless digital process. It must include an online application, a quick decision, competitive pricing, and an online funds transfer.
Expect your prospects to submit several loan applications at the same time, in order to bid out their financing and negotiate the best terms. On the surface, it might sound like there’s not a lot of brand loyalty with this group. However, we’ve seen lenders like CaixaBank use a customer-centric approach to book multiple banking services with individual clients. It’s an excellent example of how to nurture a long-term relationship and maximize lifetime value (LTV).
How to work around the obstacles
Millennials and SMEs can be tough cookies. They expect you to vie for their business, and earn their brand loyalty. The path to victory with this crowd is to simplify the application process, approve the right account at the right price point, and complete a digital funds transfer as part of the approval process. This seamless user experience requires a specialized technology platform and software system that will resolve a myriad of origination and account management challenges on autopilot.
FinTech platforms with state-of-the-art functionality provide an exceptional user experience for the borrower; as well as automation, processing efficiencies, and profitable credit decisions for the lender. There’s no need to invest the time, expense, and outside expertise to build an in-house, proprietary system from scratch. There are a number of good LaaS platforms that cater to the needs of alternative lenders. These platforms automate processes for much-needed speed, accuracy, and efficiency. Regardless of whether the system is reviewing a new application, managing payments, or using predictive bad debt triggers to monitor borrower credit scores. They also provide sophisticated data analytics and advanced credit scoring features that maximize earnings potential within your risk tolerance parameters.
Look for a cloud-based system that’s fully managed, easy to deploy, and easy for your team to master. It should be a rules-based system that can be customized to meet individual requirements, and it should be regulatory compliant right out-of-the-box. The platform should include a proprietary scoring model that uses machine learning and ongoing data analysis to constantly fine-tune the scorecard. And it should include alternative scoring models that can evaluate borrowers who have no credit history, or only a thin credit file with traditional credit reporting agencies.
Alternative lending is a great long-term strategy as more and more borrowers demand fast, easy financing options that traditional banks can’t provide. At TurnKey Lender we understand the world of alternative lending, and the exact challenges you’ll face. And we’re proud to provide lenders worldwide with the most intelligent, end-to-end lending automation software on the market.