Transcapitalist

The limitations of the current credit risk modeling approach – the FICO score – are manifold, but nowhere are they more glaring than the complete inability of FICO to evaluate young people. A system based entirely on prior payment history discriminates against youth who are just entering the financial world. For students seeking to continue their education, and needing loans to get there, the consequences are severe – automatically labeling as a credit risk may shut them out of the private loan market and prevent them from attaining higher degrees, regardless of their potential.

Around this striking weakness of the current education finance market is where People Capital, a p2p student loan platform, is seeking to innovate. I wrote about them nearly a year ago when they secured a major funding round and became further intrigued with their recent announcement of the beta launch of their platform. This past week I had the opportunity to speak with Alan Samuels, their Chief Product Officer, about the company and its fresh approach to credit risk modeling.

Our discussions focused on the Human Capital Score (HCS) – a methodology developed by the People Capital team in conjunction with leading labor economists and academics that provides an alternate measure of credit risk. Alan explained the need for this alternative, saying “there is a world of different between an 18 year old with a poor credit score and a 30 year old with a poor credit score.” HCS seeks to value ability to pay rather than propensity to pay and calculates future income potential based upon a variety of variables including GPA, standardized test scores, college and major. Alan explained that “there is a body of knowledge around early achievement” and the data sets of the above variables – representing hundreds of thousands of individuals tracked through their college experience and after graduation – were pulled into their model. With this theoretical and data-driven underpinning, student borrowers can enter in the necessary attributes into People Capital’s model to receive their HCS, which is used in conjunction with, or in place of, FICO on the site to help lenders evaluate credit risk.

I asked Alan why he thought lenders would participate in the platform, whether the main selling point was social (helping students achieve their goals) or financial (accessing a strong asset class). His quick response was that there is a clear “socially responsible element” that is helping them gain traction with community development organizations and credit unions. He also emphasized the “double bottom line” that can be achieved via the platform for mission-driven organizations that are also looking for a return. Finally, from a purely financial perspective, “student loans typically have a lower default rate and we provide an additional mechanism to improve that” and their construct offers “a slightly different asset class than on Lending Club or Prosper in that the loans are tax-efficient for borrowers (because they can be deducted from taxes) and good for lenders (because they cannot be discharged in bankruptcy).”

People Capital is currently focused on the undergraduate experience, but I asked, given the potential of disruption offered by their innovative risk approach, about their plans for the future and whether they could see themselves transforming the way young people interact with the financial system. Alan responded that the HCS really focuses on future potential and sees possible applications in a variety of spheres, including the recruiting industry to rank the potential of individuals, financial services to serve as a platform for youth, and major purchases such as when young people buy their first house or their first car. I would add that the HCS approach holds promise as a robust way to evaluate individuals who are entering the emerging market of selling equity in themselves.

Something Alan said during our conversation has really stuck with me: “It is shocking that given how expensive college is, people don’t have a more rigorous way to evaluate whether they are going through a good decision process.” Answering my question from a previous post on investing in people, Alan has the data to show that, “the Yale English graduate may be more interesting to talk with at a cocktail party, but the score shows that you have a much more solid income stream from the person who chooses to study engineering at a third tier school.”

The HCS innovation shows potential to greatly improve the current approach to education financing in two major ways: 1) More fairly and accurately evaluating the risk of young people seeking loans for educational purposes; and 2) More robustly challenging future students to think critically about what the education they seek will realistically help them achieve post-graduation before making such an investment in time and debt.

For small businesses with cash flow challenges, the current loan environment is difficult and sometimes non-existent. Because many proprieters start out putting business expenses on credit cards, their credit score suffers and that alone is enough to disqualify them from traditional bank loans. On Deck Capital, however, believes "that a small business with a healthy cash flow should be supported." They facilitate loans exclusively to small businesses and open up credit to many companies that were previously shut out because, "by reviewing business performance in addition to credit history, we extend loans to companies that we believe in, but may have been considered too risky by traditional lenders."

Their model offers several distinctions and innovations:

• Loan approval based upon business performance (cash flow, credit card revenue, and payment behavior) in addition to credit score
  
• Daily Direct Debit payments. On Deck Capital processes direct deposits to repay the loan rather than sending monthly notices. This approach is "proven to prevent the snowball effect often caused by missing larger monthly payments"
• Short loan terms of either 6 or 12 months

Unlike p2p lending companies like Lending Club, On Deck Capital doesn't promise rates that beat the bank's. They acknowledge that traditional bank loans are generally the most favorable option, but also recognize that the credit score required makes such loans often inaccessible to small businesses. On Deck Capital's rates are in the "ballpark" of banks' but are priced higher to reflect that small business is risky and many small business owners have less-than-excellent credit. Still, they are clearly a better option (they claim 50% better) than putting business expenses on credit cards or turning to cash advances.

I'm intrigued by On Deck Capital's narrow focus on small business loans. Alternative financing options clearly are clearly needed for the small businesses that drive much of our country's growth, but I've been skeptical of the ability of p2p lending companies to fill that gap. In my personal experience as a lender on Lending Club, I steer clear of the small business loans because 1) they seem to be an excessively risky proposition, and 2) they are nominally "personal" loans that the borrower should be able to repay regardless of the success of the business, but that case is not made convincingly. I don't feel particularly comfortable judging small business loans and prefer to stick with the personal loans with attributes I know how to evaluate (debt to income ratio, credit score, etc). 

On Deck Capital is managed by people who know small business risks and can make the right evaluations based on a composite of attributes that form their patent-pending algorithm. With 223,000 transactions completed, totalling $45M in loans, they seem to be one of the few firms that is constructively helping small businesses cope with the credit crunch.

Internet platforms are springing up to connect western lenders directly to developing world borrowers in the name of ending poverty, embracing different philosophies on how to achieve the same end. We've covered (here, here, here and here) Kiva and Microplace, who each embrace micro-entrepreneurship; Samasource who challenges you to "give work"; and Acumen Fund, who invests patient capital. The latest is Vittana Foundation, a non-profit startup specializing in education microfinance.

Vittana is seeking to bring change to the developing world by expanding access to student loans. On the site, you can lend to students though microfinance institutions (MFIs), helping them attend school and ostensibly opening up additional opportunities for social mobility:

Your student goes to school. He graduates and then gets a real, stable, salaried job. Congratulations! Your student has taken the first step towards a thriving, successful life. Real change has begun.

But I wonder whether an education necessarily means opportunity in many of these countries. Are the jobs there to provide gainful employment to new graduates? I embrace increased access to education as a step towards reducing poverty, but how does Vittana fit into the increasingly dense international p2p lending space?

Is it targeting a different population than the micro-entrepreneurs on Kiva? Kiva co-founder Jessica Jackley is on Vittana's advisory committee, so clearly she sees it as providing an important additional service. Could it be a complement to the job training and work focus of Samasource?

Over the past two weeks, the Twitter-scape has seen a minor flurry of speculation regarding Pertuity Direct, a more recent entrant to the social lending space. As a PD lender, I was mildly worried about the status of my deposits and confused by the lack of formal notice on the platform's website. This past week, I had my full deposit (plus ~2% interest) returned unceremoniously to my bank account, confirming my suspicions that the site is closing its doors.

This is an unfortunate development for the social lending industry. I interviewed the PD CEO back in April and was impressed with the caliber of the team and also the different approach that the company was taking, as they sought to make social lending a more mainstream concept. Unlike the major players at the time, Prosper and Lending Club, PD eschewed the typical borrower profile pages, instead embracing the concept of a pool of anonymous super-prime borrower loans. This approach earned them some flak at the time for being more of a bank than a p2p lending destination, but I always appreciated the approach of targeting a more mainstream segment of the population with more traditional banking and investment products that were nonetheless informed by some of the goals of the social lending movement. This seemed like an important complement to the other players that were more community-based, holding interest auctions or creating borrower profiles.

At the time of their arrival on the scene, I thought that this model might have ended up being the more long-lasting, but it appears that is not the case. PD has offered no explanation as to the reason for their disappearance, but I would speculate that the hybrid approach just didn't catch on.  Like Lending Club, PD is SEC-registered, so legal woes were probably not their challenge (as in the case of Prosper), but there was still something non-traditional in their tactics that lacked the appeal of direct borrower-lender connection that many entrants expected from the space.

Yet, while Pertuity Direct closes, the broader social lending space is still going strong. Lending Club is thriving, fast approaching their 25,000th investor. They, too, are seeking to take the p2p lending concept mainstream, offering a great alternative investment product for lenders and loan conditions for borrowers, and currently offer the best hope for the nascent industry in the US.

Kiva's recent poll of its members shows that there remains a sharp divide among lenders regarding Kiva's recent pilot program for American borrowers: 48% are in favor, 44% are opposed, and 9% are unsure.

As we profiled earlier, upon the announcement that Kiva would open its doors to borrowers not only in the poorest countries but to those in the U.S., many Kiva forums exploded with cries that this decision was counter to the Kiva mission to alleviate poverty. We never quite understood that rallying cry, since lenders, after all, retain full freedom to choose the recipients of their funding and there are plenty of Americans living in poverty. A more serious complaint, perhaps, is that such a move would divert money from the neediest borrowers, where the poverty is more extreme.

Kiva's study proves that this is not the case: lending is up across the board. June was a record month for the peer-to-peer microfinance lending site:

• Excluding the U.S., more loans were made to the developing world than ever before -- $4,682,025
• 4.6% of the loans were made to U.S. borrowers

Regardless of whether you agree with Kiva's policy, you have to admire how much they are engaging their community around the issue. This is one reason why social lending will continue to be the way of the future -- communities on both sides of the transactions have a say in how it is evolving.

It's been a long and arduous road (see here, here and here), but Prosper announced today that it is officially back, this time with the gold standard of proof: their statement with the SEC has been declared effective.
They are offering some innovative changes to the p2p landscape. From today's blog post by CEO Chris Larsen:

Trade Existing Notes
We’re also incredibly excited to introduce an Internet auction-priced trading platform for Prosper Notes. As many early Prosper lenders know, we’ve been working on this feature since we first launched in February 2006. We know that financial markets thrive on liquidity, which in P2P lending means lenders will have the opportunity to sell Prosper Notes any time regardless of the loan term. The note trading service is provided by Foliofn Investments, Inc., through their Folio Investing Note Trader platform.

Prosper Ratings
Other significant improvements include a new Prosper Rating system to make bidding easier and more rewarding. The new Prosper rating is built on Prosper’s huge database of approximately 28,000 loans. We have also introduced a minimum 640 credit score requirement for borrowers and a minimum bid floor for each Prosper rating to improve and optimize returns. Finally, to improve the ease of diversification, we’ve lowered the minimum bid amount to $25

Peer-to-peer lending may now be making its way to the mainstream. Federal Reserve Chairman Bernanke in a speech three weeks ago: “emerging technologies like peer-to-peer leading also show promise.”

As reader comments from my last post made clear, people approach social lending for charity/microfinance quite differently than they approach it for investment reasons. So while the platforms may operate similarly, lenders/investors explore the sites seeking varying characteristics and values. With that in mind, this decision tree divides the social lending space into two different trees right at the beginning. The same key differentiators are highlighted, but perhaps this method of bundling investment and charity sites is more useful to aspiring lenders seeking the right platform for their needs and goals.

[Note: Click "full" on the bottom left of the widget for the best view]

There is significant buzz around the concept of social lending these days. From the dramatic re-opening and prompt re-closing of Prosper Marketplace, to the calm (and dare I say bank-like?) steady returns of Pertuity Direct, mainstream borrowers and lenders across the spectrum are wondering whether social lending may be a legitimate pursuit. But who is it for? Is it an alternative reliable source of returns for investors? An option for borrowers who seem to have no other options? A platform to lend to the working poor around the globe? A risky, high-payoff avenue for lenders? A way to feel good about helping people reach goals that you support?

The truth is that social lending is an incredible diverse market space. If you’re thinking about entering the social lending sphere, ask yourselves these questions to know which platform may be right for you:

1. What originally drew you to social lending? I see three main classes of people interested in social lending: 1) Investors looking for an alternative return stream; 2) Idealists looking for a concrete, high-impact way to contribute to social good; and 3) Casual lenders intrigued by the possibility of cutting out the bank to earn returns and create a more transparent financial experience. You should know immediately which type you are—investor, idealist, or casual lender—and your options will narrow considerably based on these goals.
2. How much personal connection are you looking for? As the term “peer-to-peer lending” has evolved to the broader “social lending”, some sites are moving away from the direct p2p connection. Pertuity Direct, for example, has very consciously tried to move to the mainstream lending market by relegating the typical “borrower profile” to an optional community page. Instead, lenders buy into a pool of borrowers of a given asset class. This approach is excellent from an efficiency standpoint—no need to browse through profiles to try to create your own diversified portfolio—but the lenders looking for the feel-good sensation of getting to know your borrower will be disappointed. Lending Club offers the more traditional profile-browsing approach which gives you a direct connection to your borrowers. On both Kiva and LendforPeace, you select the individual micro-entrepreneurs that you want to support; whereas on Microplace, you choose a microfinance institution—in your chosen country, target demographic, etc.—that chooses the individuals for you. Through Virgin Money, you simply formalize deals with people you already know; no new relationships are gained, rather the site creates the framework to help prevent existing relationships from deteriorating when they are complicated by a financial bond. The latest entrant Unithrive connects Harvard alumni with current Harvard students – the possibility for a durable bond between individuals is there with both the financial and university connection.
3. How much risk are you willing to take? Initial challenges with high default rates when the p2p lending space was in its infancy led to many charges that borrowers on these platforms are an adversely-selected population and lending is risky business. The industry has made great strides since then and has instituted far more stringent borrower requirements, but the risk factor is still relevant. Pertuity Direct and Lending Club are the only two companies that are registered with the SEC, so if the government’s blessing matters to you, your options are quite limited. The international microfinance sites have very low default rates (1.7% on Kiva). Pooled lending, like on Pertuity Direct, achieves the highest rate of diversification, but if you’re willing to accept the risk, you can choose borrowers paying a higher interest rate based upon their profiles at Lending Club. Prosper is still shut down, but many early lenders were burned on the site – often due to their own lack of judgment, but an issue nonetheless.
4. Do you want to make money? At Kiva and LendforPeace, p2p microfinance sites, you earn no interest, but the sites offer a high-impact way for you to park additional money (as little as $25). At Microplace, you can earn up to 6% interest (although most investments fall more in the 1-3% range). At Pertuity Direct, the average interest rate is around 13.4% (minus fees). Lending Club claims a 9.05% average annual performance.
5. Are you interested in a particular cause? Many sites target very niche markets. If you are appalled by the usury of payday lending, check out alternative Yadyap (“payday” spelled backwards). Passionate about education financing? Look into People Capital or Unithrive. If you are looking to provide economic opportunities in Palestine, LendforPeace is your site. To help mainstream American families, Prosper and LendingClub are the best known.