Middle market lending lending to small and medium sized enterprises, or SMEs has long been the forbidden fruit of banks. While there is a significant need for capital amongst SMEs in most global markets, banks have not yet developed a profitable lending model for SME customers for two primary reasons. First, the sheer number of borrowing relationships to be managed by a large SME lender could be in the hundreds of thousands. Second, the diverse SME risk profiles create significant uncertainty in assessing credit risk and determining appropriate pricing.
The first wave of net-based business models, such as US-based LiveCapital.com and BizBuyer.com, provide borrowers with the ability to auction their loan application to multiple lending institutions. These models enable customers to get better prices, but have not impacted the underlying business approach in banks beyond the customer acquisition process. The next wave of business models, like Hong Kong-based SMEloan.com, is using the net not only to lower customer acquisition costs, but also to dramatically improve bankÆs core credit and customer management processes. This will radically impact the economics of lending to the SME market.
The first wave
The first wave of middle market lending models have been aggregators which match potential borrowers and lenders, but do not fund the loan or carry the associated credit risk. Two different credit-scoring models are evident: one for loans under US$100,000 and another for loans over US$100,000.
For loans under US$100,000, the market leader in the US is LiveCapital.com, a focused on-line loan broker, which originates applications via the net and auctions those applications to banks. LiveCapital.comÆs approach enables customers to get better prices through the auction process and provides banks with an additional distribution channel. LiveCapital.com makes money by charging the lender a commission between approximately 1.5% and 2% of the loan. The lending institution handles the paperwork and is responsible for the credit risk, loan funding and ongoing customer management. BizBuyer.com uses a slightly different approach. Lenders pay a fee of $3-$10 for each application received, rather than a success fee when they fund the loan. To date, both businesses have only scratched the surface of changing the end-to-end lending process and cost structure, and consequently have had only a minor impact on SME access to capital and cost of funds.
For loans over US$100,000, there has been limited progress even in the automation of the loan application and approval processes. Online applications for larger size loans are merely an alternate channel for borrowers to access a bankÆs traditional lending process. Upon receiving an online loan application, the lending officer usually calls the applicant in 24 hours to gather the relevant information that was not provided online. Loans are usually approved in 2-3 days, but a face to face meeting is required to verify the information provided. After disbursing the loan, the loan officer typically relies on out-dated financial statements, often of questionable accuracy, and bi-annual reviews to manage the performance of the account over time.
The first wave of middle market lending models on the net has only made limited progress in revamping the underlying SME lending process and therefore it has had limited impact on the fundamental economics. Banks have changed little in the way they manage credit, serve accounts and manage their overheads.
The next wave
The next wave of middle market lending models is beginning to emerge, particularly for loan sizes over US$100,000. New entrants are successfully overcoming many of the limitations of traditional lending. They can leverage the net not only to originate loan applications, but also to re-invent the entire credit and customer management process. The net can enable lenders to have direct, real time access to information about the day-to-day performance of the borrowerÆs business û e.g. daily operating cash flow. This approach gives new entrants the ability to manage a large number of borrowers while closely managing the credit risk of each individual account. New entrants are also putting their own capital on the line through taking on credit risk and funding the loans themselves. The use of loan securitization also reduces the capital constraint-related barriers to entry previously enjoyed by established lending institutions. However, new entrants also face significant challenges to grow scale. Generating loan applications is the most significant of these challenges. LiveCapital.com has first-mover advantage and has locked up much of the best real estate on the net through extensive partnerships. Banks have substantial financial resources at their disposal and strong brand awareness to generate traffic through their proprietary web-sites. New entrants also have been unable to get around the need to perform face to face due diligence for larger loans. While they should be able to perform credit scoring at a lower cost than banks, their need to put people on the ground constrains the pace of geographic expansion.
Who will win?
The next wave will drive another round of change in the middle market lending business. The success of aggregator models will be limited to the few market leaders who are able to build a sustainable, scale business. The next wave will gain share and expand the market. It will also put increasing pressure on banks to lower prices and revamp their core credit and customer management processes. While the game has not yet fully played out, it is certain that the end customer û the SME û will be the benefactor, with cheaper capital to fund its business.
Michael Woolhouse is a manager with Bain & Company in Hong Kong.
