No one gave it much thought when Russian scientists used Morse code to send an intentional broadcast of a message into space in 1962, mankind’s first attempt to contact extraterrestrial civilizations.

No one has answered, but we have not given up. METI International, an organization focused on messaging extraterrestrial intelligence, was recently founded to elicit a response from alien life “… even if they already know of our existence from accidental leakage radiation.”

Before he died, Stephen Hawking suggested that reaching aliens may not be such a great idea. He assumed that other civilizations able to detect our message would be far more advanced than ours and might see us simply as bacteria to be eradicated. But what did he know?

We’ve written recently on the growth of our digital finance universe in The End of The Beginning and, before that, in A Galaxy Far, Far Away. We described our sector as a lonely outpost in the universe of private debt that has come of age with founding companies having attained escape velocity and maturing into established players.

But what if noise escaping from our galaxy has caught the attention of distant, more advanced life forms? IPOs, press releases, social media — accidental leakage radiation — may have drawn the attention of one far more advanced civilization: banks.

The growth of marketplace lending and digital finance has not gone unnoticed by the largest banks. They have heard the noise and it is unlikely they will ignore the opportunity, or the threat. Banks had a clear view into the demolition of the retail sector by tech firms and are not likely to suffer the same fate. They have smart, aggressive people, huge technology budgets and the capital to fund several fronts of a long-term struggle. They will not be easily disrupted.

So, the stage is set for a land grab of epic proportions. The banks are ready to defend their turf, and some, like Goldman Sachs with Marcus, have already launched their first forays.  Newer companies, like Square, LendingClub and Kabbage, as well as established technology companies, like PayPal, are leveraging their momentum to solidify dominant positions at the center of the board. Smaller players will be gobbled up or swept aside as the key players take full advantage of a significant wealth creation opportunity.

We expect victories on both sides. The banks will fully participate — perhaps as both investors and originators — while newcomers will carve out strong positions, whether as stand-alone originators or investment managers. Just as the banks have a strong presence in private equity and asset management, many standalone firms have managed to thrive alongside them.

We believe that this sector’s growth will be driven by the continuing, insatiable demand for private debt and direct lending. The first five months of this year have seen incredible commitments to new funds and aggressive hiring by established players, and we expect the trend will continue with increased acceptance of risk and interest in alternative markets, including digital finance.

The first word broadcast into space by the Russians was “MIR.” It means both peace and war. Our galaxy has been broadcasting signals for more than five years now, and the word that seems to have finally caught the attention of the universe is “opportunity.”

Industry Update

Macro: The U.S. expansion continues despite higher rates. In May, the unemployment rate fell to 3.8%, the lowest level since April of 2000, average hourly earnings climbed 2.7% year-on-year (“yoy”) and U.S. consumer confidence continues to climb with consumer’s assessment of current conditions reaching a 17-year high.^1,2 On the corporate side, S&P 500 earnings are expected to grow 18% yoy in the second quarter, the fourth straight quarter of double-digit growth and the second-highest growth rate in seven years according to FactSet.³ Small businesses also continue to thrive with the NFIB’s Small Business Optimism Index reaching a 34-year high in May.⁴  U.S. home prices continue to rise with the S&P/Case-Shiller national index up 6.5% yoy in March.⁵  Regarding credit performance, default statistics have increased, a normal occurrence in a growing economy, but remain low by historical standards.  Revolving consumer credit charge-offs across all U.S. commercial banks rose to 3.7% as of first quarter 2018⁶, up from 3.6% in January 2017, and Paynet’s Small Business Default Index was at 1.8% at the end of April 2018, roughly flat yoy.⁷ Lastly, the delinquency rate on single-family residential mortgages was 3.5% across all U.S. commercial banks as of first quarter 2018, the lowest level since the end of 2007.⁸

Divergence in short-term and long-term yields suggests uncertain path for rates. This year, the Federal Reserve has raised the Federal Funds target range by 50 basis points (“bps”), pushing up yields on short-term debt instruments.  One-month LIBOR has climbed 49 bps to 2.05% while the 1-year U.S. Treasury yield has risen 55 bps to 2.31%.^9,10  While short-term rates appear to be pricing in additional rate hikes, longer-dated yields seem to be telling a different story. Since the start of the year, the 10-year U.S. Treasury yield has risen 56 bps to 2.96% though the spread between 1-year and 10-year Treasuries has collapsed to 65 bps – the lowest level since 2007.  If the long-end of the curve remains near current levels, subsequent rate hikes could lead to a flat or even inverted yield curve which historically has been a leading indicator for recessions.   While the macroeconomic data has been strong — and we think the probability of recession is likely low — the divergence in short-term and long-term yields is an important dynamic to watch and may signal that further rate hikes may not be a foregone conclusion.

Higher short rates are boosting platform borrower rates.  In our last commentary, we posited that credit originators would start to increase borrower rates following moves in short rates. Since then, several digital credit platforms, including Prosper and LendingClub,^11,12 have increased platform borrower rates. If rates continue to rise on CDs, money market funds, and other competing yield products, we would expect to see platform borrower rates continue to rise.

Higher platform borrower rates are not deterring platform loan demand. In our view, higher platform borrower rates should not be an impediment to loan origination growth because some other competing products are increasing borrower rates at a faster pace. For example, interest-bearing credit card rates rose 146 bps yoy through February 2018¹³, with 1-month Libor increasing 88 bps over the same period.  In fact, we expect that higher rates on competing products, especially credit cards, should drive increased loan demand at marketplace lending platforms as consumers seek budget-friendly ways to manage a rise in their cost of debt.  During the first quarter, LendingClub reported loan applications up 36% yoy versus loan origination growth at 18% yoy, underscoring the consumer demand function as well as the platform’s credit underwriting discipline.¹⁴

Digital finance asset-backed issuance on pace with last year’s record. On the securitization front, issuance and pricing remains robust and picks up right where it left off in 2017.  Consumer and marketplace loan ABS issuance has totaled approximately $6 billion year-to-date, on pace with 2017’s record of $12 billion for the year according to data provider Finsight. On pricing, spreads on senior tranches have averaged about 69 bps year-to-date over comparable swaps, roughly 76 bps tighter than the average in 2017 for similar notes.¹⁵

Sector: Capital continues to flow to Fintech firms with a defensible moat. Recently, there have been several high-profile capital raises in the digital finance space across both public and private markets.  We believe this is further evidence of investors’ optimism surrounding the long-term growth potential of the opportunity. In May, financial technology provider GreenSky priced its initial public offering and raised $874 million.¹⁶ Additionally, Bloomberg reported in May that an activist hedge fund is seeking to raise $400 million in a special purpose acquisition company to acquire financial technology companies.¹⁷ In private markets, Ant Financial – the Fintech affiliate of Alibaba – raised $14 billion in a Series C funding round, valuing the company at $150 billion – almost double Goldman Sachs’ market cap.¹⁸

Recent high-profile M&A transactions and strategic initiatives highlight diversity of participants. The world’s largest company, a 149-year old investment bank, a billion-dollar cross-border tie up of payment behemoths, and a merger of credit originator and analytics provider illustrate the range of activity and players in the evolution of digital finance.

• PayPal in May announced plans to acquire iZettle – a European point-of-sale payments provider. This transaction comes nine months after PayPal’s acquisition of Swift Financial.  PayPal’s market capitalization is now $102 billion, or about 19% larger than American Express.¹⁹
• Apple, per the Wall Street Journal in May, was preparing to launch a new joint credit card with Goldman Sachs, another effort that underscores the consumerization of finance.^20,21
• Goldman Sachs in April acquired Clarity Money – a personal finance app to bolster Goldman’s Marcus platform and deepen relationships with consumers – in our view, a critical element of future success in digital finance.
• Kabbage in April acquired Orchard – a high profile marketplace lending analytics provider that was recognized as a Fintech 250 firm by CB Insights in 2017.²²

An increased focus on profitability and cash flow generation characterized first quarter earnings. The publicly-traded U.S. digital finance firms continued to report growth in loan originations; notably, they seemed as focused on profitability as on revenue growth.

• LendingClub originations were up 18% yoy to over $2.3 billion, adjusted EBITDA was $15.3 million, and 2018 adjusted EBITDA guidance was reaffirmed at $75-$90 million. Cash at quarter end was about $470 million.^{23, 24}
• Square management reaffirmed 2018 adjusted EBITDA guidance of $240-$250 million and noted that Square Capital’s origination volumes increased 35% yoy with over 50,000 new business loans totaling approximately $340 million in the quarter. Cash at quarter end was $1.2 billion.²⁵
• OnDeck originations grew 8% yoy, the net charge-off rate declined to 10.9% from 14.9% yoy, cost-cutting initiatives helped deliver $6.4 million in quarterly adjusted net income, and 2018 adjusted net income guidance rose by 5%.²⁶ 

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.