With rapid technological innovation during the past decade, business lending has increasingly moved away from brick-and-mortar banks toward more “non-traditional” sources. Some of these new, alternative lenders have been so successful that entire departments have now been added to sell their debt to larger institutional investors.
For instance, if a lending institution —Bear Sterns, Goldman Sachs, Lending Club — has $100 million (or $1 billion) worth of loans on their books, it becomes prudent to resell some as assets in order to pass along the associated risk.
Last year Kabbage, a leading alternative lender established in 2009, agreed to a $500 million deal with Guggenheim Partners to securitize their loans and sell them on to other qualified investors. It was the first time a deal this large had ever been made with a non-banking institution.
What is Kabbage?
Kabbage has led the way for other unicorn alternative lenders to follow — undergoing a stratospheric rise since its founding in 2009, reaching a $1 billion valuation in 2015 with money primarily raised through venture capital funding. Other rising alternative lenders quickly followed suit, with SoFi and Funding Circle reaching the $1 billion mark shortly after.
While profits have generally soared, there are also some industry predictions that aren’t so rosy. For instance, publicly traded alternative lenders On Deck Capital and LendingClub have experienced sharp declines in their share prices due to concerns about a still largely unregulated market. LendingClub has seen a particularly dramatic decline, from a valuation of over $10 billion to less than half of that.
But Kabbage seems to be in a more seaworthy boat than similar companies. With strong financial fundamentals and gross yearly revenue of nearly $150 million, Kabbage is well positioned to weather the storm. And institutional investors are taking notice.
What is an asset backed security?
In return for the $500 dollars in funding from Guggenheim Partners, Kabbage was able to clear their balance sheets of bundles of loans, selling them in an effort to spread out risk. Large investors, who are always looking to diversify portfolios, are warming to CLOs (collateralized loan obligations) as an area for high yield with relatively little associated risk.
Kabbage has a particularly diverse base of loan types and can sell the loans on in bundles by type. By providing a variety of options, Kabbage can allows the risk for Guggenheim Partners to spread across different sectors and business types. Guggenheim Partners (like a bank underwriter for an IPO) then organizes these bundles of loans into various quality levels (what are called tranches) and sells them to interested investors. So a CLO is just a drop of 125 to 175 individual loans with a very specific risk grade.
As small businesses repay their outstanding debt, investors in the CLO are gradually paid back. But the repayments are made through a tiered system, which allows for higher customization than normal venture capital funding.
For instance, an investor who wishes to take on little risk will be paid back first, but at lower rates. But an investor chasing higher yields will have to wait. High risk investments are paid back over a longer period of time as the less predictable, higher interest loans are slowly fulfilled. Or sometimes the borrowers default.
If this sounds familiar, it happens to be the same process used to collateralize mortgage loans (mortgage backed securities). As the financial crisis of 2008 has shown, investing in ABS (asset backed securities) can be a risky strategy. In the event that lower tranches of the CLO (or CDO) never repay their loans, the entire house can crumble — cue Ryan Gosling and his Jenga tower of debt…
But profits are always there for those who understand risk.
By chasing riskier ventures, those who can figure out how to maximize yield — while keeping the risk reasonably low — will win out in the end. By partnering with Kabbage, Guggenheim Partners seems to have done just that . It is unprecedented for a non-bank to receive $500 million for a securitazation, which means Guggenheim must know something everyone else doesn’t.
For an inside look, here is Guggenheim proposing asset backed securities (in the form of CLOs) to potential investors in a research portfolio published in 2013:
“In the aftermath of the subprime mortgage crisis, the negative connotation of securitization led some investors to summarily dismiss structured finance as a suitable investment. In reality, there was significant variance in the performance of structured finance securities… With the focus squarely on monetary policy and its associated impact on interest rates, increased credit risk is unlikely to be a near-term concern.”
i.e., Asset Backed Securities aren’t as risky as everyone thinks.
Guggenheim’s deal with Kabbage shows that qualified, big fish investors are bullish on alternative lending. But the good times might not last forever. In the same report Guggenheim recognizes that decreasing underwriting standards might hollow out the industry:
“Low debt financing costs and improved interest coverage ratios may be obscuring the looming risks that gradually increasing debt burdens and softening underwriting standards will pose over the next several years.”
But they clearly think Kabbage (at least) is doing top-notch underwriting, and will continue to be profitable for the long haul. Otherwise, they wouldn’t have bet $500 million on it.