4 Scenarios for Lending Club – the proxy for Fintech disruption or hype $LC

When Lending Club did its IPO in December 2014 I declared it as the Netscape moment for Fintech (when it became conventional wisdom that this was going to change the world). I could be accused of contributing to the Fintech hype, which became intense in 2015 with investors flooding into Fintech ventures. Meanwhile the $LC stock price tanked to such a level that by late May 2016, after the Lending Club CEO ouster, the conventional wisdom became that yes this was the Netscape moment for Fintech and we all know how the Netscape story ended – they were crushed by Microsoft.

That is one of the 4 scenarios that we analyze in this post – that incumbency wins, that big banks crush Lending Club and that Marketplace Lending becomes a footnote in banking history. In that ending, George Foreman beats Muhammad Ali in Rumble in the Jungle.  Conventional wisdom expected that George Foreman would win. But that is only one of 4 scenarios that we analyse.

Disclosure: I bought some Lending Club stock after writing this post in May (I was fortunate enough to get in at 3.51). In two of my 4 scenarios that was a dumb move. However, spoiler alert, my analysis is that one of the other two scenarios is more likely.

4 Scenarios

# 1 Like Netscape getting crushed by Microsoft, Lending Club will be crushed by big banks.

How this would play out. Banks refuse to lend to borrowers via Lending Club, so they will be dependent on retail lenders (which is only one of three lender channels that Efi Pylarinou analyses in this post and not enough to fuel rapid growth).

Evidence that this is true. After the problems that led to the Lending Club Board firing the Founder CEO, banks put a hold on lending via Lending Club (and other MarketPlace Lenders). Given the old world disclosure problems analysed by Efi Pylarinou in this post, it would have been amazing if banks had not put a hold on this while they did extra due diligence.

What will happen to Lending Club stock in this scenario? A big bank buys them for a firesale price to get access to technology and talent. There will be competition from multiple big banks, so a competent investment banker should extract a reasonable price, but there won’t be any champagne corks popping among Lending Club shareholders in this scenario.

What will happen to other MarketPlace Lenders in this scenario? They will also be acquired for firesale prices and nobody will back another MarketPlace Lending venture. It will be game over.

Likelihood rating: Least Likely.Conventional wisdom currently favours this scenario, yet I rate it as Least Likely (the next scenario is even worse for Lending Club shareholders and a bit more likely). The reason I rate this conventional wisdom as Least Likely is that it is based on a fundamental misunderstanding. Banks don’t own this money. it is a Liability on their Balance Sheet because when we Deposit money with a Bank, we are lending money to a bank. When we wire money to a Credit Hedge Fund, we are lending them the money in the hope that they will return it with profit later.  Banks and Hedge Funds are intermediaries just like Lending Club is an intermediary. So if the real investors (you and I and richer versions of you and I) decide we get a better risk adjusted return by lending via Lending Club than by lending to a bank or Credit Hedge Fund, then that is what we will do (for some more on this idea, read this post).  For some insight on how this could happen, read Jessica Ellerm’s brilliant post on how Fintech innovation may finally be coming to the deposit part of banking.

Note: even Least Likely is a possible scenario. We can declare this scenario Totally Unlikely if and when the Jeffries securitization deal that was put on hold during the disclosure problems finally closes. (I put Goldmans in a different category because they clearly have their own ambitions in marketplace lending).

# 2 The first “run on a marketplace”.

Like a run on a bank, when trust goes, it goes fast and leads to panic. This is “reverse network effects”. We have seen a run on a bank many times before in the past. A “run on a marketplace” would be unprecedented, but these times are different.

How this would play out. Lenders cannot withdraw their money (as bank depositors can) so it is not exactly like a run on a bank, but lenders can refuse to lend any new money and that will have the same fundamental effect. In a vicious cycle, retail lenders and equity investors get scared away, leading to more bad news, leading to… In this scenario, I worry less about what a few bankers think (Scenario #1), but I worry about what millions of consumers (retail lenders and equity investors) think.

Evidence that this is true. Just look at the $LC stock price.

What will happen to Lending Club stock in this scenario? Not even a firesale buyout, total loss.

What will happen to other MarketPlace Lenders in this scenario? One may prove reliable enough and emerge triumphant in a Rocky like “last man standing” result. But that is a very slim chance. More likely is the same as Scenario # 1.

Likelihood rating: Unlikely. Calm voices who look at the actual returns of retail investors such as the ever insightful Peter Renton at Lend Academy show that the risk adjusted returns are good. Individual retail lenders tell a similar story. The panic at the moment seems restricted to the media and this sort of hype/despair cycle is normal. The Lending Club Board clearly understands the issue and that is why they took decisive action in May.

# 3 Like Priceline, the stock will bounce along the floor for years and then return 100x for really patient investors.

Management slowly get past all the serious execution challenges and, because digitisation is unstoppable and digitisation means that marketplaces and networks always win in the end, the eventually upside is stunning. That is what actually happened to Priceline (no, not a measly 10 bagger but a “10x 10 bagger” aka 100x return).

How this would play out. Scott Sanborn and his team get the Board’s backing to patiently execute on their plan. There are two big execution challenges:

• Employee stock options are under water. They either face a talent drain or issue new options that hurt common shareholders. Both choices are ugly.

• The growth is outside America, but going for that growth will be expensive.

This will be difficult. Their Q2 results are likely to be ugly. There will be lots of setbacks and bad news cycles. That is why the stock will bounce along the floor for years (and years is a long time when day traders are considered long term investors compared to HFT).

Evidence that this is true. Hiring a credible Chief Capital Officer. In this scenario, it takes years to execute on a recovery plan, so yes that is only one of many results that the management team needs to deliver on.

What will happen to Lending Club stock in this scenario? For most investors, who give up during the years when it bounces along the floor, a loss. For a tiny number who stick with it (based on conviction or just forgetting they own the stock), a massive return.

What will happen to other MarketPlace Lenders in this scenario? Few will have the patience to execute like this and will take acquisition offers, making the last man standing even more valuable.

Likelihood rating: Possible. I am not an insider. I have no idea what is going on inside the Lending Club Board. However I do know that a) these are solvable execution challenges with a lot of patience and hard work and b) Boards are typically not very patient these days and so while this is Possible, I think the next Scenario is more likely. Also I think the value of MarketPlace Lending (which will be massive) will get distributed across an ecosystem rather than sticking to only one or two Facebook style behemoths.

# 4 Buyout, probably from a Chinese company.

How this would play out. The Lending Club Board accepts an offer.

Evidence that this is true. None, there won’t be evidence until the Lending Club Board accepts an offer, but we do know that one Chinese investor bought after the stock crashed and now owns over 11%.

What will happen to Lending Club stock in this scenario? Some premium to the market price at the time of offer.

What will happen to other MarketPlace Lenders in this scenario? Investment bankers representing them have their phones ringing off the hook.

Likelihood rating: Likely. Not only do we already see a big Chinese investor in the company, the business logic is impeccable:

• To be a big player, Lending Club has to get into China, which is a huge market but very difficult to get into without a) deep pockets b) local partners.

• China is a huge market for consumer loans but none of the MarketPlace Lenders in China has the organisational strength and technology of Lending Club (or Prosper or SOFI or Funding Circle).

Combine huge market and good platform and you get a great result.

Note on Scenario Ratings. I only have 5 – Totally Unlikely, Least Likely, Unlikely, Possible, Likely. I don’t try to put % numbers on this as that gives a false sense of certainty. I am looking at this as an investor and the end result for an investor is binary – profit or loss. Even a Least Likely scenario could come to pass and investors simply have to a) have confidence in their analysis and b) enough diversification to not be “weak hands” that are shaken out by a negative news cycle that drives trading sentiment and drops the share price temporarily.

Personal Note. Like most people, I love a triumph over adversity story such as Muhammed Ali in Rumble in the Jungle but my personal sport is skiing and the triumph over adversity story that I love is Franz Klammer’s comeback in 1984 as an “old man” of 30 on his home run – the Hahnenkamm.   Watching at the time, I hoped he would win but thought it Totally Unlikely.

There are two types of Fintech innovation. One type of Fintech innovation says to Banks “we bring you lunch”. It is a variant of traditional Fintech where the venture prices on a transactional revenue share basis instead of via a traditional software licensing model.

The other type of Fintech innovation says to Banks “we eat your lunch”. It is disruptive and the potential and risk for backing this type of venture is much higher. The fate of Lending Club is a bellwether for this latter type of disruptive Fintech innovation. How it prospers or fails will impact the broader sentiment about whether disruptive “we eat your lunch” Fintech innovation is viable.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge Network. Bernard Lunn is a Fintech thought-leader.