SME financing: some interesting fintech case studies
By Bruno Gremez and Samir Kasmi, Co-founder of Fincluziv, Smart Fintex and CT&F Partners and ex-bankers (BNP Paribas, Société Générale, ABN AMRO).
Recently, we wrote about the difficulties of SMEs to access financing from local banks in the UAE and explored possible reasons why local banks may not have huge risk appetite to finance SMEs in the region. In that respect, we thought it would be interesting to look at success stories of some fintechs active in the US and Europe whose core business consists of financing small local businesses.
Before examining these success stories, we should first describe shortly this new fintech phenomenon. The banking industry has gone through huge transformational changes over the last 10 years. Regulations have become much stricter following the 2008 financial crisis, in order to make banks safer and less vulnerable to events similar to those we noticed back then. At the same time, regulators have surprisingly opened the door to new entrants, like fintechs.
Many fintechs have successfully entered the banking industry thanks not only to unprecedented technological developments that have enabled them to reshape the traditional, offline client — bank relationship that we were used to not so long ago, but also to regulations enabling fintechs to operate very efficiently with limited capital requirements provided that funds of stakeholders are adequately protected.
Adequate protection can be achieved by avoiding so-called transformation risks. In simple terms, transformation risks are taken when a bank takes deposits from a client on the one hand and lends to another client on the other hand. It faces the possibility that a loan may not be repaid on time while a deposit may be withdrawn at any time.
Many new fintechs have been able to develop their business with limited regulatory capital, mostly because they assume no transformation risks. For instance, a crowdfunding platform arranging online lending to SMEs enables individual investors to lend directly. Individual investors take the risk. The crowdfunding platform is only a pass-though. Any individual investor takes a discretionary decision to lend to a borrower and entirely assumes the risk of default by that borrower.
In the SME financing space, many fintechs have developed with some success in recent years. Out of many examples, we have singled out three of them, which we believe show particularly innovative developments.
Ondeck is one of the largest of these alternative new lenders. Based in the US, it was launched in 2007 as a non-bank online platform for small business lending. Like many other platforms, Ondeck uses its proprietary technology and credit models to assess the financial strength and risk profile of small businesses. Clients can apply in a few minutes. Ondeck takes a credit decision almost instantly and funds within 24 hours.
It was funded originally by VC funds, and has now a diversified funding provided by sophisticated investors through a mix of securitization and warehouse finance. In short, Ondeck packages loans to SMEs in such a way that loans are eventually funded by sophisticated investors who take all risks. As a result, Ondeck can operate with relatively limited capital.
Last August, Ondeck reached the cumulated amount of USD 7 billion of originated financing and is now active in the US, Canada and Australia. In December 2014, it completed its IPO. It expects to be profitable in 2017, which is quite an achievement given the fact that, contrary to a traditional bank with an existing brand and branch network, a platform like Ondeck must incur client acquisition costs to create brand awareness.
Their lending model starts to attract interest from banking institutions. JP Morgan Chase entered into a partnership whereby Ondeck provides the origination and loan servicing technology to enable the bank to offer a digital and streamlined lending process to its small business customers.
Kabbage is another alternative lender based in the US providing funding to small businesses. In many respects, Kabbage is comparable to Ondeck. It has an automated decision process, which enables quick lending decisions. While it lends some smaller amounts for shorter durations than Ondeck, it is more flexible in terms of minimum turnover threshold that the customer must meet. Both platforms secure their loans with general liens on the company’s assets and with unsecured personal guarantees from business owners.
Kabbage made its first loan in 2011 and now extends over USD 1 billion of financing each year. In size, it is thus roughly comparable to Ondeck. Where Kabbage seems to innovate is in its credit assessment process. Kabbage indeed incorporates non-traditional metrics in its assessement of the customer’s business consistency and stability, such as the business’s Twitter and Facebook followers and online reviews by the business’ clients. According to Kabbage, having thousands of followers won’t assure any customer that it will get a loan, but Kabbage may increase the cash available to the customer if it has an active social media following because that establishes the credibility of the business among its clients.
Another interesting example of fintech is the new alternative Dutch lender New 10. Although it is only starting now, we understand that it intends to serve SMEs online, from loan application until disbursement, and to lend fast (within 15 minutes) and cheap, at financing rates between 3 and 8% p.a. That is much more attractive than its American competitors, where real financing rates are around 40% p.a.
One could say that it is just another alternative lender. This one is actually unique in the sense that it was developed as an “in-house” start up by a traditional bank: ABN AMRO. This is a very interesting development in the fintech space. A traditional bank starts a new activity by developing it separately from its existing (heavy) procedures, (conservative) corporate culture and (outdated) IT infrastructure.
ABN AMRO will probably be very successful with this new venture. It should be able to combine the agility and flexibility of a start-up with the lending experience of a bank. ABN AMRO after all has an existing track record of lending to SMEs in the Netherlands, which should enable New 10 to assess and price risks appropriately. New 10 will also benefit from the balance sheet of the bank.
Interestingly, each of the above fintechs has made SME financing its sole core business. Maybe one of the keys to their success is precisely this deep level of specialization, which enables each of them to perform efficiently without the burden and complexity inherent to a large banking organization serving many different types of customers with a multitude of financial products.
One thing is sure: SME financing is a scalable business. While traditional banks make a lot of money with larger loans to larger organizations over longer periods, there is a growing small-business funding gap. And that’s the void alternative lenders like Ondeck, Kabbage or New 10 try to fill. This has led to a booming industry, with new players arriving all the time, from startup peer-to-peer lenders to spinoffs from companies like Amazon or PayPal, to now banks like ABN AMRO.