Are Challenger Banks the New Online Lenders?

and Charter Watch: Oportun, Figure & GM (yes, that GM)

Hey all, Jason here.

With the complications of travel this year, I opted to stay home and celebrate my first Thanksgiving in the Netherlands. I treated some Dutch friends to their first authentic American Thanksgiving dinner, complete with green bean casserole, sweet potatoes, and Kamala Harris’ cornbread stuffing.

In between eating and watching holiday classics, I managed to put this week’s issue together. Enjoy!

Are Challenger Banks the New Online Lending?

The fintech sector remains as hot as ever with VCs, with multiple product categories in the midst of major hype cycles, including buy now/pay later, bank accounts for kids, and -- yes -- “challenger” banks continuing to raise, despite (or maybe because of) ongoing economic uncertainty.

If you ask an investor what the role of venture capital is, he’ll (and it’s nearly always a ‘he’) probably tell you something about making big bets on disruptive innovation (and earning a healthy return for their LPs), or perhaps that they do “god’s work” (OK, that was a banker, but close enough!)

The reality is hazier, with billions invested in obviously unworkable business models (WeWork), outright frauds (Theranos), and, of course, the infamous $400 juicers.

I imagine a rejoinder from a VC may be that even if their portfolio companies fail, they often still succeed at innovating and driving incumbent businesses to evolve and better serve their customers.

To a casual observer of fintech investing, it is downright confounding to see so many similarly positioned companies raising monster rounds - especially on the back of business models that leave some wondering how they will ever ‘grow into’ the valuations they’ve earned. 

But remember, a given VC fund may have dozens of investments and often only needs one outsized return in order to earn their carry. The rest of the companies in their portfolio eventually find an exit - often a sale or acqui-hire that’s a loss for all but senior execs and those holding shares with top liquidation preferences.

This environment coupled with a surplus of venture capital and a scarcity of good investments facilitates a trend-driven investing/startup environment.

For clues on how things may play out for the plethora of ‘challenger’ startups, it’s instructive to look at outcomes for the darling of “first wave” fintech: lending.

With the term “fintech” really beginning to take off in 2014/2015, many companies followed a similar investment raise playbook: branding themselves not as financial services companies but as ‘tech’ companies, deserving of ‘tech’ valuation multiples (I had a front-row seat to this, living in San Francisco and working in fintech in 2014-2016.)

For those eventually tested by the public markets, after the shine wore off, those multiples began to look much more like financial services companies over time.

Like some current ‘challenger’ banks, the trendy verticals in “first wave” fintech spoke to underserved segments: savers struggling to earn a decent return and consumers and small businesses unable to access credit from traditional banks.

Peer to Peer

The launch of “peer to peer” lending in the US with Lending Club and Prosper fit well with the “sharing economy” narrative popularized at the time by companies like Uber, Lyft, and Airbnb.

P2P lending companies did innovate by building the technology infrastructure and legal/regulatory framework to enable small, retail investors to directly fund borrowers seeking a loan.

But the business model was based on collecting origination and servicing fees, rather than interest payments on the loans they wrote; this made their quarter-to-quarter revenue growth very sensitive to origination volumes. To continue to scale revenue, they needed to write ever more loans (to be fair, this pressure isn’t unique to p2p lending). 

As the demand for loans outstripped the supply of retail investor capital, “peer to peer” lenders turned to the types of banks and institutional investors that commonly fund non-depository lenders.

By the end of 2018, only 6% of Lending Club’s originations came from individual self-managed accounts, and at the end of 2020, Lending Club will shut down its platform for retail investors altogether.

With its acquisition of Radius Bank (and thus access to cheap deposit funding), Lending Club has transitioned to a more traditional banking model.

Likewise, in the UK, Zopa pursued and was granted a full banking license, allowing it to offer savings products and raise its own deposits. RateSetter was acquired MetroBank for a paltry £12 million.

In the US+UK, this leaves Prosper as the last major player still pursuing a “peer to peer” funding model; though note that, like Lending Club, most of the loans are funded with institutional money.

No “Peer to Peer” lender was able to maintain its peak valuation. All equity raise data from Crunchbase; valuation data from news reports or public markets.

Verdict: P2P lenders created innovative products, but ultimately the funding/business model was not viable at scale.

Consumer Lending

The narrative for many direct consumer lending startups (not P2P) focused on process automation and ‘proprietary’ underwriting -- using “big data”, AI/machine learning-based models, and model inputs like social media or education, etc. 

The outcomes to date are pretty mixed:

Affirm leveraged the POS as a unique customer acquisition strategy and is on the verge of a rumored $10 billion IPO. Only time will tell if that valuation is sustainable.

Upstart also recently filed its S-1 and is looking to raise $100 million before the “IPO window” closes.

SoFI has arguably developed from private student loan refi into a robust “challenger bank,” offering everything from cash management to mortgages, investments, and crypto.

GreenSky was celebrated for taking relatively little funding and successfully making it to IPO -- only to see its valuation drop to less than 1/5th its peak on the public markets.

Earnest saw a lackluster exit to student lender Navient; LendUp and Avant haven’t had meaningful equity raises since 2015/2016 (disclosure: I worked at LendUp from 2014-2016).

Wonga collapsed amid a changing UK regulatory environment; Zest iterated its way through a number of business models (and law suits), and in its most recent incarnation offers AI-based underwriting technology to other lenders.

Verdict: Mixed bag; SoFI and Affirm have unquestionably built large, meaningful businesses; only time will tell if their valuations are sustainable.

Small Business Lending

Small business lending startups haven’t fared much better. OnDeck, probably the best known, was recently acquired by Enova for a paltry $90 million (vs. its $1.3 billion valuation at IPO).

Kabbage had a better exit to American Express for a reported $850 million. Funding Circle remains publicly traded but with a valuation about 1/5 its peak.

Verdict: SMB lending startups identified a real market need, but struggled to build viable standalone businesses serving it.

Parsing Challenger Banks’ Prospects

While alternative banking products like prepaid debit (eg, GreenDot) date to the late 1990s, and Chime was founded in 2013, it wasn’t until 2018 that the ‘challenger bank’ sector began to blow up the US, with both Chime and Varo raising large rounds that year.

Similar to the lending fintech wave, the challenger banks with the greatest chance of success have either identified a poorly served segment and created an offering to meet their needs (Chime/Varo) or developed a unique customer acquisition strategy (Cash App/Venmo):

As banking products, Chime and Varo have achieved the most traction to date, with 8 million (2/2019) and 2 million (6/2020) accounts respectively.

Their feature sets have attracted customers not well served by traditional banks. No fees, early access to direct deposit, and a small-dollar advance-type product appeal to customers who often get hit with minimum balance and overdraft fees at incumbent banks and face income volatility.

On the opposite end of the spectrum, HMBradley has built a loyal following with its up to 3% APY offering -- if you’re setting aside at least 20% of your direct deposit each month.

And then there’s everybody else: Monzo (still waitlist only in US), Revolut (actually impressive feature set, but carrying a monthly fee for certain product tiers), N26, Aspiration; not to mention companies extending an existing product offering by adding a transactional / debit account:

While ‘challenger’ banking isn’t a winner take all market, there are some clear early favorites (Chime, Varo), some late arrivals that have significant advantages (Cash App, Venmo), some wild cards yet to be played out (Google Pay / Plex), and everyone else.

And like ‘fintech 1.0’ before them, the challengers have some monster valuations. Only time (and the scrutiny of public markets) will test if their business models warrant the valuations they’ve demanded.

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Charter Watch

A busy and surprising couple of weeks in bank charter-related filings! It speaks to the increasing maturity of the fintech sector, evolving business models, and (hopefully) regulatory willingness to encourage competition by issuing de novo charters.

Oportun

Oportun has filed for national bank charter via the OCC. Oportun is quite the anomaly in the fintech sector; not because it focuses on lending to subprime consumers, but that it does so via 300 brick and mortar locations.

If approved, Oportun intends to offer checking and savings accounts, certificates of deposit, and nationwide distribution of personal loans, credit cards, and auto loans.

Oportun has focused primarily on the Latinx market, and has run into criticism for its high interest rates and aggressive debt collections practices.

GM (yes, that GM)

Everything old is new again!

WSJ is reporting that General Motors Financial Company Inc. could file paperwork as early as next month to form a Utah industrial loan company, which would allow GM to own both commercial firms and a bank.

GM has been here before with GMAC, in which GM sold a 51% in 2006, and which nearly failed during the subprime meltdown. After being bailed out by the government, it was eventually rebranded as Ally Financial.

Figure

Todd Baker explains this much better than I can, but, basically, it sounds like Figure is hacking its own version of an OCC “fintech charter.”

By working with a partner bank to hold insured customer deposits, and using (uninsured) high-balance wholesale deposits to fund its business, Figure can avoid the implications of the Bank Holding Company Act and Federal Deposit Insurance Act (important as VC investors in Figure wouldn’t want to be constrained by the Bank Holding Company Act).

Can’t Let it Go

Yes, I’m adopting this feature from my favorite NPR podcast.

Beam: the story just keeps on going.

FTC filed a complaint against Beam on November 18. We already know the core elements: Beam deceptively promised interest rates (4% APY) that it didn’t deliver and “24/7” access to withdraw money.

Customers’ money still hasn’t been returned, though Huntington National says the money is in Beam’s custody account. Only Beam has the individual customer account information necessary to return depositors’ funds — leaving you wondering if they’ve suffered a technical failure where they no longer have access to this information?

It should remind consumers that FDIC insurance protects them only if the bank holding their money fails — not non-bank partners/clients like Beam.