Investors earn 12% from small business loans, while banks won’t
After graduating from Brown in 1995, Brendan Ross went on to become a management consultant and then turnaround specialist. In 2010, he was looking for a new job that doesn’t involve firing people, when his stepfather showed him LendingClub.com, where the older man had started making small loans directly to people paying off credit cards or refinancing other high-cost debt.
“For me it was amazing,” Ross recalls. “I thought: this is the revival of private credit. Then, as a registered investment advisor, Ross began investing his own money and that of his clients in peer-to-peer loans, becoming the first RIA to invest in LC Advisors, a
subsidiary which groups loans into funds.
But he wanted to diversify beyond consumer lending and figured he would find the best returns where bank lending had been cut most severely. After ruling out subprime mortgages (he didn’t feel like driving tow trucks), optional medicine (too similar to consumer loans) and real estate (the online market was too young at the time), he turned towards the little ones business.
Ross was on to something. Karen Gordon Mills, a Harvard Business School Senior Fellow and Former Head of Small Business Administration, concluded in an article last year that small business bank lending is in a secular decline that began long before the Great Recession. Loans under $ 1 million now account for only 25% of commercial bank loans, up from 40% in 2005 and 52% in 1995. Mills predicted that small business online lenders, with their lower costs, faster decisions and their new algorithms to assess credit risk, would transform the bank in the same way ”
has changed retail and Square has changed the small business payments industry. ”
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Ross didn’t want to make loans, but buy them. So he created a top 100 Google search results spreadsheet for “small business loans” and named each business. Many turned out to be brokers who did not subscribe themselves. His 85th appeal, to the CEO of Financial IOU, led to his first chord. After flying to Atlanta in April 2012 to meet with the IOU underwriting team and assess its technology, Ross started his own business, Direct loan investments (DLI), based in Los Angeles. DLI bought $ 500,000 in IOU loans in November and $ 600,000 the following month.
At first, Ross and his relatives were the main investors in DLI. Then, in May 2013, Peter Renton, who blogs about peer-to-peer loans at LendAcademy.com and co-founded the great To lend P2P business conferences, wrote an article explaining why he had personally invested $ 100,000 with DLI. Suddenly, other investors came knocking on the door.
Ross’s direct loan income fund now has $ 220 million in assets and has paid annual returns of 11% to 13% – the highest Renton reports in its quarterly peer-to-portfolio update – peer. The fund is only open to “accredited” investors – those with at least $ 1 million in assets to invest or an income of $ 200,000 per year for a single person or $ 300,000 for a couple. The minimum investment is $ 100,000.
DLI now holds 3,000 loans from eight alternative small business lenders, including Struck Affair, Biz2Credit and District. In May, he bought $ 44 million in loans, using repayments and new investments. Over its lifetime, DLI purchased $ 388 million in small business loans, all of which came from the web. Ross and Renton both say that to their knowledge DLI was the first institutional buyer in this market and is currently the largest.
The borrowers are mainly Main Street businesses – retailers, doctors, dentists, restaurants, hotels. They have been in business for an average of 12 years and have between $ 500,000 and $ 20 million in annual revenues. Loans range from $ 10,000 to $ 500,000 (with an average of $ 60,000) and last from 3 to 36 months, with daily or weekly repayments via automatic withdrawals from business accounts. Homeowners, who must personally guarantee the loans, have an average FICO credit score of around 680. This rating is a little lower and the loans are lower than what banks generally deem worthy.
This money is not cheap. Borrowers pay interest of 15-40% per annum, but there are a lot of costs before that income gets to DLI investors. Loan originators keep 17.5% to 20% of the interest. Ross himself takes a high management fee equal to 1% of assets and 20% of return. And there is a 5% default rate.
Small business loans have touched a number of strengths for Ross, who describes himself as “a predominantly conservative investor” who prefers debt to equity. The short duration of the loans means that investors’ money can be recycled into new loans at even higher rates when interest rates rise. And the wide spread provides a good buffer for default peaks. Ross believes that the current portfolio default rate of 5% would have to quadruple for the fund’s return to drop to 0%. During the last recession, he estimates, small business defaults peaked at around 10%.
Plus, with a growing army of small business web lenders to choose from, Ross says he’ll only work with those who use criteria that match his own. He wants six months of bank data, dislikes businesses that rely on a small number of large customers, and avoids borrowers who write bad checks or have high personal credit usage. (The latter criterion predicts better who is likely to default on loans than the actual FICO score, he says.)
Ross’s preferred potential borrowers are those referred directly to an online lender by the bank that just turned them down for loans. “If you’re a small business lender and tell me you’ve been in business for a year and doing short term loans and just signed a deal with a big bank that will send you all of their cuts , then we’re very likely to be able to do business, ”he said.
The agreements it makes with lenders are designed to protect DLI. It purchases the principal of the loan but does not prepay the interest stream, which means it does not lose money if the borrower prepays. Lenders only get their share of interest when DLI does so, so they’re in the game. It also requires the software to randomly allocate which loans go to DLI – protection against sending the dregs.
Beyond defaults, there is another risk: Yields could be reduced if competition and a more educated borrower reduce the big premium that small businesses are now paying. While Renton doesn’t expect yields to drop significantly, he says investors in the DLI fund shouldn’t “think they’re going to get double-digit returns no matter what.”
Ross thinks rates will stay high but isn’t one to ignore the risk. On his 42nd birthday in early June, while in New York for an investor presentation, he spent the afternoon skateboarding at the Pier 62 skate park. An avid skateboarder, he stood out. , he says, for more than his relatively advanced age. “The difference between me and everyone in the skate park is that I am covered in head to toe protection. I have every type of protection you can put on your body.”
The investment guide / fixed income
– Small investors can participate in peer-to-peer consumer loans online at Lending Club and Prosper. You can buy loan fractions (called Notes) in $ 25 increments, spreading your money over many borrowers. The loans are for two, three or five years and carry rates from 5.3% to 31.9%. (Lending Club also provides loans to small businesses and allows accredited investors willing to shell out $ 250,000 to invest.)
– Fundraising circle USA allows accredited investors to view and purchase individual small business loan fractions or use predefined criteria to invest automatically, with a minimum investment of $ 50,000 and $ 1,000 per individual loan required. It also offers a limited partnership of diversified loans of a minimum of $ 250,000.
— At StreetShares, a DLI provider, accredited investors can bid as little as $ 25 on individual loans or can set criteria for investing automatically; no minimum overall investment is required.