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Pricing credit is major issue as profitability eludes digital lenders

Digital lenders are still working out how to adequately price the loans they offer, a key part of the hunt for profitability that new lenders and incumbents alike are facing.

When LendingClub Corp. and On Deck Capital Inc. went public in December 2015, they spurred optimism around an online strategy and their triple-digit growth profile. Without branches, they stood to record lower costs and the opportunity to reach underbanked consumers. But both have struggled to turn profitable in that time, and a loan manipulation scandal at LendingClub cast a pall over the sector.

Now, another generation of digital lenders with different business models is entering the public market. GreenSky Inc. closed its IPO May 29 after raising $1.01 billion in gross proceeds, and U.K.-based Funding Circle Ltd., which one analyst described as similar to OnDeck, is rumored to be considering an IPO sometime in 2018. The British lender could be valued at more than £2 billion.

The crux of their success will be how well their algorithms and data can price credit, analysts said. The basic digital lending model lets algorithms, rather than loan officers, make credit decisions, and a "sub-optimal or defective" credit algorithm can lead to a borrower base with weaker credit, Maxim Group analyst Michael Diana wrote in a report.

"The worse the mis-pricing of the loans ... the greater the loan volume" as more borrowers take advantage of a good deal, he wrote. While algorithms generally improve over time as more data is collected, losses can accrue before a lender has a chance to replace the defective system.

There is plenty of borrower demand in the U.S. and in the U.K., but inadequately pricing that demand is a risk for all digital lenders, Susquehanna Financial Group analyst James Friedman said.

"The common theme for the public companies in marketplace lending has been the challenge to accurately predict credit performance," Friedman said in an interview.

Funding Circle, which was founded in the U.K. in 2010 and entered the U.S. in 2013, faces the same challenge, he said. Like LendingClub and OnDeck, it has struggled to become profitable, despite rising revenue at all three companies. A company spokesperson, who declined to comment on a potential IPO, said Funding Circle facilitated more net new lending to U.K. small businesses in the fourth quarter of 2017 than all major High Street banks combined. Financial data for the company is only publicly available through 2016.

The U.K. digital lender posted a net loss of $16.5 million in 2016, an improvement from a net loss of $26.6 million in 2015, according to S&P Global Capital IQ data. During those same periods, LendingClub reported a net loss of $146.0 million and a net loss of $5.0 million, respectively, while OnDeck saw a net loss attributable to common shareholders of $83.0 million in 2016 and a loss of $1.3 million a year earlier.

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The stocks of LendingClub and OnDeck have not yet lived up to investors' expectations. The companies have traded between 60% and 80% below their IPO prices for much of the past two years. Both were priced at much higher valuations than they should have been, Compass Point analyst Michael Tarkan said in an interview.

Aside from overpriced valuations and competitive fears, credit performance deteriorated when it should have been stable, during a "still benign" part of the credit cycle, Tarkan said.

"It's a number of factors, and the factors really unfolded at different periods of time," Tarkan said.

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For LendingClub, those factors included a scandal in which its founder took out loans to improve its origination volumes. It was a pioneer of the digital-first strategy others have looked to, and some investors and analysts viewed its failures as issues for the industry as a whole. Legal troubles from former Chairman and CEO Renaud Laplanche's missteps hurt the company's GAAP net income. Laplanche left LendingClub in May 2016 following an internal review that triggered several regulatory and legal inquiries that the company still grapples with today.

A new management team at LendingClub has made righting the ship a priority, and Susquehanna's Friedman expects the company to be profitable in 2018 and 2019. One measure of profitability for digital lenders, the cost of customer acquisition, has been falling at LendingClub: that cost as a percentage of loan originations fell to 2.49% in the first quarter of 2018 from 2.79% in the year-ago period, according to quarterly filings.

Attracting new customers requires a significant investment in marketing and in credit and technology costs, Maxim's Diana said. These development expenses do not drive short-term valuation because they depress near-term earnings.

Analysts have been "wrong on the timing" but "right on the trends," Diana wrote. "However, after a generally disappointing 2017 for stocks of fintech lenders, we believe expectations are now low."

S&P Global Market Intelligence and S&P Global Capital IQ are divisions of S&P Global.