Thread by @fintechjunkie

1/27: We’ve seen a few $10B+ lending companies emerge from the fintech ecosystem in the past few years. We’ve also seen a few fintech lenders meltdown in the public markets.

Are lending companies VC backable? Thoughts plus a framework to answer this question👇

2/27: I have to start with a “no duh” statement that too many fintech Investors and Founders don’t do a good job of internalizing. It’s the foundation of every lending business. Effectively Lego block #1.

Simply put: Lenders sell capital

3/27: Lending companies advance capital to borrowers today in return for a stream of payments that will vary based on future market conditions, economic scenarios and borrower characteristics. The volatility of future payment streams is what makes lending challenging.

4/27: A lending company doesn’t own the capital it sells. It needs a sourcing strategy that’s reliable, deep and cost efficient. Banks do this through 50X50 boxes on street corners. Non-bank lenders can borrow money from capital providers. Or future cash flows can be sold.

5/27: Truism #1: ALL LENDING BUSINESSES NEED TO SOURCE CAPITAL. THERE ARE NO EXCEPTIONS.

Capital is what’s being sold, so it’s a question of where the capital is coming from, not whether the capital is needed.

6/27: Truism #2: THE CASH FLOWS AREN’T AFFECTED BY WHO OWNS THEM

The cash flows should theoretically be the same whether a loan is held to maturity or securitized or sold the minute it’s manufactured. There are nuances to this truism, but it’s “mostly” true.

7/27: Truism #3: IF MANAGED CORRECTLY, LENDING BUSINESSES ARE MACHINES THAT CAN CRANK OUT ATTRACTIVE ECONOMICS AT SCALE

Lending is an asset class where trillions of dollars can be put to work to produce attractive streams of income. Most at-scale lenders can originate billions.

8/27: Truism #4: CAPITAL EXTRACTS MOST OF THE INTEGRATED ECONOMIC RETURN

Lending portfolios need to produce great returns to capital providers when times are good and can’t suck when stress scenarios manifest. Satisfying this requirement consumes much of the return.

9/27: Putting the four truisms together leads to “The Immutable Law of Lending”:

PER DOLLAR LENT, EITHER YOU’RE CAPITAL LIGHT AND EARNINGS LIGHT OR CAPITAL HEAVY AND EARNINGS HEAVY

10/27: This “Immutable Law of Lending” has a profound impact on how lending businesses are assembled and how attractive they are to different constituencies. It has an impact on capital intensity. It has an impact on destination economics. It has an impact on necessary scale.

11/27: Much of the disconnect in the startup community around lending companies (and in the public markets) is that many Founders and Investors don’t understand or haven’t internalized the impact different constructs have on “enterprise value.”

12/27: Specialty Originator Model

Some lending companies want to stay as capital light as possible and therefore sell off their loan production as soon as it’s manufactured. Many VCs like this model because they THINK it produces the best venture returns.

13/27: But with very little/no participation in the future cash flows, specialty originations are addicted to new loan production and they give up more than half the economic return of their efforts. These businesses can suffer from volatility and scale issues.

14/27: The unit economics can be attractive but still underpin a really crappy business if the proper level of scale isn’t achieved. Annual contribution margin has to overcome annual costs inclusive of SG&A if the originator wants to be self-sufficient.

15/27: At the unit level, turning $250 of marketing and originations costs into $475 of revenue in 30-60 days sounds great until you realize that you need to put $5B+ of originations volume through the system annually to overcome marketing and SG&A.

16/27: If the next $5B produces $100MM of EBITDA then it’s possible to make money at scale. But unless it’s obvious that the originator can originate $20B or $30B or $50B+ annually with regularity, how much is this EBITDA worth?

17/27: But there are Specialty Originators that have built efficient and profitable machines. I’ve Invested in/personally built more than a few with cost structures that make money at a few hundred million in annual originations with billions a year in addressable potential.

18/27: Balance Sheet Model

Many VCs hate Balance Sheet Models because they THINK they produce terrible venture returns. Balance Sheet businesses consume capital and the return on this capital is typically less than the IRR expectation of a Venture Investor.

19/27: These businesses build “books of business” and participate in the future cash flows of their originations. Equity is trapped at the company level and the money they lend has to be sourced. But they capture more economic rent and can therefore make money at reduced scale.

20/27: And once they hit “escape velocity”, they switch from being capital consumptive to capital accretive. That’s when the magic occurs. Additional growth doesn’t require the same amount of new capital (if any!) and profit comes rolling in.

21/27: I’ve heard the logic that Specialty Originators should command a premium to Balance Sheet Lenders because they’re removing the volatility of credit losses/future cash flows. While interesting in theory, this is just flat out wrong.

22/27: If historical loans underperform, then Specialty Originators could struggle to sell new loans. What’s an originator “worth” that can’t originate any sellable loans? Not much, especially if it burns cash when sub-scale. So, these businesses are exposed to credit risk. QED.

23/27: I’ve also heard that there are attractive Balance Sheet Models that are capital efficient as a direct result of originating short duration assets. This is absolutely true but they don’t benefit from the math that underpins “building a book”. It’s not all wine and roses.

24/27: By no means am I saying that one model is uniformly superior. When assembled correctly, each model can be attractive. But Specialty Originators will struggle if they overbuild their machines and Balance Sheet Models can struggle to achieve escape velocity efficiently.

25/27: So much of the “enterprise value disconnect” that surrounds lending companies (both in the private and public markets) can be attributed to different (and often mistaken) interpretations of how a lender has been assembled and the size of its addressable market.

26/27: You might be thinking: "Why lend?" I say: "Why not?" We live in a world where people want to buy things today and pay for them tomorrow. There's gigantic demand for borrowing money that will never go away and lending is a great business if managed correctly.

27/27: This thread merely scratches the surface of various lending models but hopefully it frames a few of the most important concepts. Just don't forget that you need to find a dollar of capital to lend a dollar to a borrower and there are no exceptions to this universal law!