A cautionary tale typically comes in three chapters: we learn of a taboo, an actor disregards the warnings and performs the forbidden act and, finally, the violator comes to a tragic and often grisly end.  The value of such a tale is usually in the extent to which it reinforces the importance of choosing to not cross the prohibited line or to act despite the taboo. Of equal importance is understanding what was the exact prohibition.

In the case of recent events in the digital finance industry, we have heard that some investment managers crossed the line by allowing too much money to flow into their strategies, that under pressure to perform they moved too far out on the limb in pursuing the poorest quality loans, that they invested in balance sheet loans with exposure to platform collapse, and that they allocated meaningful capital to opaque third parties even though they knew the dangers of concentration risk.  As we see it, the line that was crossed was to abandon investment and risk management discipline.

To be a prudent investor in digital finance it is not sufficient to buy loans in any asset class and from any platform just because they are available. A prudent investor should seek to identify, understand, and evaluate diligently every prospective asset class, within a given macroeconomic environment, and every platform, including its management and their execution effectiveness. In our view, it is imperative to conduct rigorous fundamental analysis via iterative and extensive due diligence on key aspects of each source of alternative credit before and after engaging in an investment program, with the goal of seeking answers, on a recurring basis, to many questions, such as:

• Have underwriting standards held and improved, even at the expense of higher loan origination volume?
• Does the platform offer full transparency into its originated loans, servicing and controls?
• Is there a commitment to enhancing internal risk controls?
• Is the platform company’s management team being upgraded, and do they listen to feedback?
• Is the originator maturing from startup through its lifecycle?
• Does the asset class’ risk-reward proposition still make sense?

Since inception, HCG has prioritized discipline throughout our investment and risk management processes, especially vis-à-vis asset classes and platforms. We pay close attention to developments, both good and bad, in the digital finance arena and listen to and learn from every cautionary tale.

Industry Update

Everyone Loves Digital Loans: Goldman Sachs. Amazon. PayPal. Square, Inc. (“Square”). They all want a seat at the table of the U.S. digital loan market, underscoring the attractiveness of the overall asset class.  Through mid-year, Goldman’s Marcus platform has originated $1 billion in unsecured consumer credit, 7 months after launch¹. Amazon has originated $3 billion in small business loans since launching its effort in 2011, with $1 billion being issued in the past year alone², while PayPal has originated $3 billion in working capital loans since 2013³. Square’s purported interest in starting a consumer loan program was disclosed in a Wall Street Journal story in late June⁴; we applaud their involvement to grow the digital finance opportunity, and to make the sector more transparent.

The Long and Winding Road to Regulatory Clarity: Confusion and conflict in Washington politics is not limited to the front-page headlines in the New York Times. Local, state, and national regulatory bodies in the U.S. have engaged in a pitched battle against one another to control regulation of the digital finance sector, as, in our view, it increasingly becomes clear that the future of finance will have to be viewed through a digital lens. While clarity remains elusive, we are encouraged by the politicians’ desire to claim their “seat at the table” of the digital finance industry. Over the next few months, we intend to publish a comprehensive review of the regulatory landscape, as well as the potential opportunities arising from the shifts taking place.

To Verify or Not to Verify: The mainstream business press can sometimes lead readers to confuse reality and perception⁵.  Take income verification of prospective borrowers.  In early June, a story was published by Bloomberg that consumer loan marketplaces were not always checking borrower incomes⁶, suggesting that this practice was a root cause of digital loan credit underperformance.  While there were a number of reasons for general credit underperformance in 2016, as discussed in previous HCG commentaries, the data does not necessarily support this particular headline. For example, through HCG’s analysis of LendingClub consumer loan origination data from 2010 through 2016, we concluded that borrowers with unverified income have experienced lower charge-offs each year compared to borrowers with some level of verified income. Drilling down into the data, our analysis found that higher credit quality loans receive less income verification due to other credit attributes, and that loans sourced through the mail are subject to less income verification since the borrower receiving the invitation was pre-qualified at the credit bureau prior to the mailing. As with most analysis, the devil is in the details, and the details warrant understanding before conclusions are drawn.

Strengthening the Core: The three largest sources of digital loans for HCG – LendingClub, Square, and LendingHome – continue to consolidate their leadership positions in their respective markets.  Two of the publicly listed bellwethers in the digital finance sector – LendingClub and Square – reported solid first quarter results marked by healthy origination volumes⁷ and sequential growth in operating cash flow⁸ despite the first quarter being seasonally soft.  At Square, management raised 2017 Adjusted EBITDA guidance by 10% to a range of $110-120 million and noted that Square Capital’s origination volumes increased 64% year over year with over 40,000 new business loans totaling ~$250 million in the quarter⁹.  Square also launched its product suite in the UK during the quarter, adding a fourth international market which should provide ample runway for future growth. At LendingClub, banks continue to increase their purchasing activity, funding 40% of total originations in the first quarter, up from 31% in the fourth quarter¹⁰.  Additionally, LendingClub raised the 2017 Adjusted EBITDA guidance range to $45-55 million from $40-55 million. Lastly, both LendingClub and Square, Inc., ended the quarter with a healthy amount of cash with $781 million and $891 million respectively¹¹.  For more details, please see each company’s release (click here for LendingClub, here for Square).

DISCLAIMERS AND OTHER IMPORTANT INFORMATION

Confidentiality and Non-solicitation: No information herein constitutes an offer or a solicitation to buy or sell any securities or any interests in any product or investment strategy managed by HCG Fund Management LP (“HCG”).  Any offer or solicitation relating to any such investment will be made only by means of confidential offering documents relating to a particular fund  or investment contract and only in those jurisdictions where permitted by law.

Reliance: This information may not be relied upon for investment decision-making purposes. It does not contain all the information necessary to make an investment decision, including the risks, fees, and investment strategies of investment products advised by HCG. Eligible investors are described in official offering documents, all of which must be read in their entirety and will supersede the information contained herein.  No offer to purchase any securities or interests by a prospective investor will be made prior to receipt of all official documents, and no offer to purchase any securities or interests will be accepted without receipt of all official documentation that has been completed to HCG’s satisfaction.

Opinions — No obligation to update:  The information contained herein represents the views and opinions of HCG.  It is intended solely for informational purposes and is not intended to constitute investment, legal, tax or accounting advice.  The views about digital finance investing and estimated future investment opportunities expressed herein reflect those of HCG management as of the date herein and are a reflection of our best judgment at the time.  They are subject to change based on market and other conditions, and we have no obligation to update.  Actual results, however, may prove to be different from our expectations.  No warranty is given to the completeness or the accuracy of the information contained herein.

Suitability and Risks:  Any investment in products managed by HCG is appropriate only for financially sophisticated investors capable of analyzing and assessing the associated risks fully disclosed in the Private Placement and/or Information Memoranda. Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The Private Placement and/or Information Memoranda contain this and other information about the investment. A prospective investor should have no need for liquidity with respect to its investment and should view it as long-term and not a trading vehicle.  Additional risks are disclosed in the Private Placement and/or Information Memorandum including, including, limited liquidity and restrictions on transfer of the securities, dependence on HCG’s principals, and short operating history of certain products. As with all private investment funds, investments are deemed speculative and involve risk of loss.

Third Party Data: We do not verify third party data used in certain calculated metrics shown here.