cormac leech / liberum / marketplace lending opportunity

The Market Place Lending (MPL) investment opportunity

Ropemaker Place, 25 Ropemaker Street, London EC2Y 9LY / T: +44 (0)20 3100 2000 www.liberum.com Liberum Capital Limited is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales No. 5912554

17 November 2014

Cormac Leech Research +44 (0) 20 3100 2264 [email protected]

Minh Tran Research +44 (0) 20 3100 2184 [email protected]

How big? How risky? How much alpha? Why is MPL sustainable? Key risks How to invest? Conclusions


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Z opa RateS etter

Funding C irc le LendInvest

Welles ley & C o. Assetz

Thincats

MPL yields offer attractive returns, with $40bn+ of deployment capacity by 2016e in US & UK


•  $40bn of deployment by 2016: From 2014 to 2016, we estimate UK annual deployment will increase from $2bn to $7bn and US deployment will increase at from $6bn to $33bn

•  US strong growth,120% CAGR, but

margin compression: yield margin compression likely as competition increases

•  UK slightly slower growth, 90% CAGR, but yield expansion: yields likely to rise as platforms increase credit risk. Arrival of institutional capital supports higher credit risk appetite.

US: MPL 3y potential yield and annual volume 2014-16e change

UK: MPL 3y potential yield and annual volume 2014-16e change

Source: MPL companies, Liberum, Moneysupermarket, Bloomberg, IPD

5y Junk Bonds

Property

Equities

2yr Cash ISA

Non Investment Grade 2y Bonds

$bn annual volume

2016 total UK volume:

$7bn

2016 total US volume: $33bn

$bn annual volume

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Consumer finance MPL – likely to be surprisingly resilient through the cycle in UK & US…


•  Zopa performed well through financial crisis: net yield has averaged 7.0% since 2005 and remained above 4.5% even during 2008 global financial crisis

•  UK overall : Overall UK consumer finance loans show similar consistent returns over time averaging 8.9%

•  US overall: Likewise for US credit card data

Zopa Net Yield

Source: Zopa

All UK Consumer Loans Net Yield under £5,000

Source: Bank of England, Liberum

US Credit Card Net Yields

Source: Federal Reserve, Liberum

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Adj Net Y ield Adj Annualized Default

Average Net Y ield

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2005 2006 2007 2008 2009 2010 2011 2012 2013

Net Y ield Writeoff Average Net Y ield

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Net Y ield C harge off Average Net Y ield

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MPL SME finance/ property lending data set more limited…. but still encouraging for ‘Through The Cycle’ returns


•  LendInvest: 7 year track record with annual avg returns of 10.0% with zero loan losses

•  Funding Circle: 5 year average net yield of only 4.0% but with signs of improvement more recently. Funding Circle has yet to go through a recession- Credit model relatively unproven.

•  For the UK overall, corporate lending has generated average returns of 4.6% but was more impacted by the aftermath of the financial crisis both in terms of lower gross yields and high writeoffs..

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012S BAC harge-‐Off R ate

Average

Source: LendInvest

Note: Projected loss basis Source: Funding Circle data, Liberum estimates

UK Non Financial Corporate Lending annual net yields US SME Annual Loan Writeoffs- SBA

Source: SBA, Liberum Source: Bank of England, Liberum

LendInvest Loans: Annual Gross, LLPs, Net Yields

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2008 2009 2010 2011 2012 2013 2014

Net Y ield Loan Losses Average Net Y ields

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2H10 1H11 2H11 1H12 2H12 1H13 2H13 1H14

Net Y ield Loan los ses Average Net Y ield

Funding Circle Loans: Gross, LLPs, Net yields* by Cohort

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MPL yields 2-5% ‘more than ‘expected’ based on wholesale ABS market data


•  Low WACCS: We estimate SpringLeaf and Ondeck loans have average costs of capital of 4-5% -based on recent securitisations.

•  High quality yields: The ratio of gross yield to chargeoffs is 5.2x for Springleaf and 4.1x for Ondeck.

•  Zopa WACC likely below 3%: avg ratio of gross yield to chargeoffs is 8.0x (much better than Spring leaf or OnDeck).

$m Amount Rate Class A Notes 500 2.4% Class B Notes 40 3.5% Class C Notes 19 4.5% Class D Notes 33 5.0% Sub total 592 2.7% Equity 52 20.0% Total implied cost capital 644 4.1%

SpringLeaf Funding Trust – estimated cost of capital

Source: Springleaf, Bloomberg, Liberum

$m Amount Rate Class A Notes 157 3.2% Class B Notes 18 6.9% Total 175 3.5% Equity 8 30% Total implied cost capital 183 4.7%

OnDeck – estimated cost of capital

Source: Ondeck, Bloomberg, Liberum

SpringLeaf asset net yields and ratio charge-offs to gross yields

Source: Springleaf, Liberum

OnDeck asset net yields and ratio charge-offs to gross yields

Source: Ondeck, Liberum

Zopa asset net yields and ratio charge-offs to gross yields

Source: Zopa, Liberum

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R atio g ross yield to charge offs (RHS )

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Adj Annualized Default

Adj Net Y ield


MPL net yields should be c5% based on ABS

market

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Market Place Lending (MPL) – bigger story than just P2P


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8

Traditional banking- 12th Century solution to ‘Market for Lemons’* problem!


*The Market for "Lemons": Quality Uncertainty and the Market Mechanism. http://www.iei.liu.se/nek/730g83/artiklar/1.328833/AkerlofMarketforLemons.pdf

Timeline: Banking 1100 to present

Banking: a pre-internet solution to i) network needs and ii) information requirements in financial services

1100

1397 1694

1695 1818

1880

1913

1930

1986

1989

1998

2005

2007 2008

2012

Knights Templar est. European wide/Mideast banking

until the 14th century.

The Medici Bank of Florence established

& operates until 1494.

Scottish parliament est. the Bank of

Scotland.

Scottish parliament est. the Bank of

Scotland.

The first savings bank of Paris was

est.

The Rothschild family establishes

European wide banking.

The Federal Reserve Act created the Federal Reserve

System.

Start of online commerce

Berners-Lee invents Internet.

Zopa was founded.

Paypal Founded

Financial crisis that led to the failure and bail-out of a number of the worlds biggest

banks.

Run on Northern Rock.

Washington Mutual collapses, at the

time the largest bank failure in history.

Banks start to close branches.

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Traditional banking model…. increasingly anachronistic…


Timelines: Banking / AltFi/ Crowd sharing

*Market for Lemons: The Market for "Lemons": Quality Uncertainty and the Market Mechanism http://www.iei.liu.se/nek/730g83/artiklar/1.328833/AkerlofMarketforLemons.pdf

Crowd sharing in other industries

as ‘lemons’* problem solved.

Traditional Banking

Digital payments sector

Marketplace lending sector

Start of online commerce

1989 2005 2007 2014

Financial crisis that led to the failure and bail-out of a number of

the worlds biggest banks.

Washington Mutual collapses, at the time

the largest bank failure in history.

Banks start to close branches due to shifting customer

behavior

1998 – Paypal Founded

Berners-Lee invents Internet.

1994 - Amazon founded

1995 – EBAY founded

“Banking may be on the cusp of …the most radical reconfiguration in centuries”, Andrew Haldane- Chief Economist Bank of England, Aug 2013

2005 -ZOPA Founded

2006 – Lending Club Founded

2013- UK government lends via Funding Circle

2013- Xoom IPOs for $0.5bn

2009- Chicago Sun Times Files for bankruptcy

2011 - Borders declares Bankruptcy

2013 - HMV declares bankruptcy

2013 – Blockbuster goes into

administration

2014 AirBnB valued $10bn

2014 - UBER valued $18bn

2014 - Alibaba IPOs for $168bn

2014- P2PGI IPO

2014- Union Bank buys loans originated by LC

2014- Ondeck file IPO valuation e$1.5bn

2014- Lending Club file IPO valuation e$5bn

2014 - Square valued at $5bn

2014 - Apple Pay is launched

Dis-intermediated incumbents start

to fail…

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Internet sourced credit information has become a robust way to underwrite loans effectively and cheaply


Web-enabled game changers in lending

Big Data, social media

Real time health check for companies

Bank A/C Scraping

Market cap

Credit Scoring

Can run credit check on any individual or company in UK for

£18 in seconds

Experian $16bn Equifax $9bn FICO $2bn

Use of big data to enhance credit scoring

Linkedin $24bn Facebook $190bn

Automated analysis of borrower’s bank a/c; cash flow health Market cap $0.3bn

Real time health check for companies. Intuit serve c1% of

Global small businesses

Intuit mkt Cap: $23bn Xero mkt cap: $2bn

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No efficiency gains in banking since 1900

•  Unit cost of financial intermediation relatively constant for the last 30 years at just under 2%

•  No economies of scale suggests an oligopoly

Net US revenues of financial intermediaries as % intermediated assets (i.e. unit cost of intermediation)

Source: Has the U.S. Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation; Philippon Thomas, http://bit.ly/1gRuAEB

Source: Has the U.S. Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation; Philippon Thomas, http://bit.ly/1gRuAEB

Net US revenues of financial intermediaries as % US GDP

•  Finance share of GDP is at a historical – high- surprising vs. similar intermediation sectors

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Productivity gains in Wholesale & Retail trade but not Finance; inefficient banks cost UK est. £30bn annually

•  Wholesale and Retail trade have become much more efficient due to IT investment. Opposite is true for the finance industry

•  Internet enabled supply chain innovation has revolutionised retail and wholesale trade but not finance – so far…

•  Financial sector currently at c8% of GDP, about 2% higher than it ‘should’ be (vs. other sectors and IT investment) =>lost annual income of $325bn in the US (UK £30bn)- £10 per person / week

US Wholesale Trade as % of GDP

Source: Finance vs. Wal-mart: Why are Financial Services so expensive, Thomas Philippon, 2012



US Retail Trade as % of GDP US Financial Intermediation as % GDP

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MPL offers efficiency; lower systemic risk; better credit access


•  MPL operating costs are 60% lower than banks: implies better rates for both savers and borrowers

•  MPL enjoys considerable Government support: •  Decentralised financial system

improves financial resilience for bank regulators by eliminating single ‘points of failure’

•  UK Government sees MPL as additional credit access channel for SMEs

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Peer 2 PeerGovernment endorsedAttractive RatesConvenient & flexible

425bps LowerOperating Expenses

Cost base comparison 2015e: Banks vs. Lending Club (costs as % loans outstanding)

Source: McKinsey / Lending Club

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10170

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BanksCost inefficienciesHigh marginsRestrictive lending

UK Govt lending via MPL platforms: £75m

Source: Liberum

Systemic Risk Comparison: Traditional Banking vs MPL

Source: Liberum

Traditional Banking Structure MPL market structure

0 10 20 30 40 50 60 70

MarketInvoice Zopa Funding Circle

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UK retail investment in P2P could increase 35x once in ISAs- to c£50bn of outstanding balances


Current total NISA outstanding balances (£bn), potential P2P market size if NISA eligible, £bn

Source: www.gov.uk, Zopa, Funding Circle, RateSetter

•  P2P lending likely to become ISA-able (tax-free retail wrapper) in UK in 2015

•  Using ZOPA (3yr term) as an example: •  After tax Zopa net yield for top

45% marginal tax rate payer is 2.2% currently vs. 2.4% in best available cash-ISA (equivalent weighted maturity)

•  Once ISA-able the tax free ZOPA return increases to 4.0% which is 67% higher than the equivalent bank deposit

•  If P2P was to take just 10% of the total

cash and equity ISA market, UK gross P2P balances would increase 35x to £47bn

•  Influx of capital implies MPL net yields likely to fall…

Best cash NISA rate vs. i) 3yr Zopa yield net of tax and ii) Zopa yield if NISA- able

* 45% Tax rate Source: Zopa, moneysuperamrket.com, Liberum

£Bn

0 10 20 30 40 50

P2P Loans Outstanding

P2P Loans10% of Market

3,470%

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300

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500

Total IS A P2P LoansOuts tanding

P2P Loans10%of Market

S tock C ash

3,470%

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C ash IS A Z opa Net Y ield post tax* Z opa Net Y ield via IS A

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Survey data suggest MPL still in early adopter phase implying 10-20x upside in terms of public participation rates


Number of obvious catalysts over the next 6-12 months: •  Sector IPOs: Lending Club (Q4/Q1) / OnDeck (2015) – likely to increase public

trust / confidence in sector •  UK ISA-ability: An implicit endorsement of sector by UK government- we expect

the first MPL ISA products to launch in mid/ late 2015; building on recent FCA regulation of the sector

P2P Survey of UK Population

Source: Liberum Consumer Survey

UK population penetration rates by investment type

Source: Liberum

MPL investments could easily reach c 30% penetration of population- c mid

point of equity and cash ISA takeup

0%

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Aware of P2P Would cons ider inves ting inP2P

Have invested already inP2P

Have already invested in P2P

Equity Investors

Potential P2P take up

Cash ISA Holders

14% 50% 2%

•  P2P will move from ‘early adopter phase’ to mass market phase over the next 5-10 years..

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Lack of transparency and misalignment of interests are two key risks for MPL


What key issues for MPL do critics flag Ways to address/ our view..

Alignment of incen=ves: Pla$orms should have capital at risk (Wellesley & Co already operate in this way). CEO compensa?on should be linked to net 3 year yields remaining above a minimum threshold ( e.g. 2%)

Insufficient ‘skin in game’: Many lenders rely heavily on pla$orms’ credit risk assessment; pla$orms incen?ves not aligned with lenders

Transparency & regula=on key to long term health of sector. Without ra?ng agencies, transparency is vital to avoid MPL becoming the next sub prime crisis. Retail lenders must have info to make informed decisions.

Mis-‐selling risks: i) Lack of disclosure around loan type on some pla$orms with returns to lenders inconsistent with credit risk. Simplicity should not mean opacity. ii) Some Retail investors apparently using rate offered as risk proxy heuris?c. iii) Risk that Provision funds are implicitly posi?oned as guaranteeing capital.

Web enabled credit assessment technologies: new ways to solve ‘market for lemons’ problems: XERO / YODLEE/ Big Data/ Experian etc..

Lack of borrower rela=onships: adverse selec?on problems, leading to poor lending decisions.

Frequent external audit requirements; regulatory oversight by FCA/ SEC of lending; transparency clearly segregated clients accounts; investor scru=ny.

Fraud risk: Significant risk that a pla$orm engages in fraud nega?vely impac?ng the sector’s interna?onal reputa?on.

Banks likely to respond too slowly: Impeded by employment contracts; social contract ; Short term CEO incen?ves ; ‘Denial’ mind-‐set.

Pro-‐ac=ve digital response by banks: improved user experience; step change improvement in efficiency by closing branches inves?ng in digital offering

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Transparency an emerging point of differentiation


•  Simplicity of basic offering shouldn’t limit information availability

•  Lack of transparency increases risk of high profile failure- adversely impacting MPL sector

•  Transparency lower in the UK under

the mantra of simplicity

Transparency by platform

‘Transparency score’ by platform

Source: Liberum

Prosper Lending Club

Funding Circle Lendinvest Zopa RateSetter Wellesley

Expected Net Yields Yes Yes Yes Yes Yes Yes Yes Loan Losses Yes Yes Yes Yes Yes Yes Yes Historical Net Yield Yes Yes Yes No No Yes No Historical Loan Losses Yes Yes Yes Yes Yes Yes Yes Downloadable loan book Yes Yes Yes No No No No Use of Proceeds / Borrower Profiles Yes Yes Yes Yes Yes No No Max size of loan Yes Yes Yes Yes Yes Yes Yes How many intermediaries No No No No No No No How much £ spread rev to broker No No No*** No No No No Risk band of borrower Yes Yes Yes Yes No No No Size of Provision Fund if any? NA NA NA NA Yes Yes Yes

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P rosper Lending C lub Funding C irc le Lendinvest Z opa RateS etter Welles ley

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Despite the risks, banks/ former bank executives betting on MPL sector


Equity Investment Equity Investment & Buying Loans

Banks investing in / through platforms

Former bank executives etc joining/ investing in market place lending

Equity Investment Buying Loans Buying Loans Loan Referrals

Board Members

John Mack (CEO Morgan Stanley)

Larry Summers (US treasury secretary)

Mary Meeker (Kleiner Perkins)

Investor

John Mack (former CEO Morgan Stanley)

Investor

Dick Kovacevich (former CEO Wells

Fargo)

Investor

Nigel Morris (founder Capital One)

Investor

Lachlan Murdoch

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$250bn equity market cap for US & UK MPL sector by 2025e


Avg Balances

MPL Balances

MPL Revenue

Equity Market Cap

Mortgages Consumer SME Total

17,829 4,847 1,264 23,940

1,729 1,212 379 3,320

18 24 10 52

106 109 36 250 Assumptions: MPL market share: Mortgages 10.0%, Consumer 25.0%, SME 30.0%, Revenue as % of Balances : Mortgages 1.0%, Consumer 2.0%, SME 2.5%, Net Income / Rev % : Mortgages 40.0%, Consumer 30.0%, SME 25.0%, Net Income: Mortgages $7bn, Consumer $7bn, SME $2bn PEx assumption: Mortgages 15.0x, Consumer 15.0x, SME 15.0x, Source: Liberum

$bn

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Some listed MPL equity opportunities…


Funds Market Cap2 $m P/NAV Yield1

P2PGI 348 1.1x 8.4%

GLI Finance 133 1.2x 8.6%

Invoice Finance Market Cap2 $m P/Revenue 2015e 2015e P/E

Basware 674 3.5x 30.3x

Tungsten 540 10.4x NA

Listed / IPOing Market Cap2 $m P/Revenue 2014e P/Revenue 2015e

TrustBuddy 60 4.7x 2.5x Lending Club (exp. valn) 5,000 22.7x 13.4x

Valuation metrics for listed MPL securities

1. 2015e for P2PGI, 2014e for GLIF; 2. as of 15th Oct Source: Bloomberg, Liberum estimates

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•  UK listed MPL funds offering yield and capital appreciation

•  Significant revenue potential from

combination of e-invoicing and MPL

•  Listed/ IPOing P2P platforms

Case study: Basware – Arrowgrass JV unlocking value via innovation


Source: Preliminary Liberum Estimates

Preliminary analysis Basware not under Liberum coverage

“Basware and Arrowgrass Capital Partners LLP to jointly develop a new e-invoicing based factoring service”, September 2014

total spend across the Basware Commerce Network

‘Basware 2013 annual report’ Estimated valuation impact for Basware of Arrowgrass JV

EURm

Basware E-processing annual volume 600,000 Financed by JV % 10.0%

JV Financed volume 60,000

Processing balances 7,500

Margin 2.0%

JV revenue EURm 150

Cost income ratio 20%

PBT 120

Net Income 96

Basware share of JV 50%

Attributable net income 48

PEx 20.0x

Equity value of JV to Basware 960

Basware current market cap 550 Implied min upside 75%

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Key conclusions

1.  Banking faces disruptive change: on the cusp of the most radical reconfiguration in centuries – should help save UK economy £30bn pa (2% of GDP) as banking gets more efficient

2.  Risk management: Alignment of incentives and transparency essential

3.  MPL listed equities still good value given the sector outlook; currently much more diverse range of unlisted opportunities.

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Disclaimer


This material is the commercial property of Liberum and may not be disclosed or distributed to any third party without the express permission of Liberum. You shall not remove or modify any disclaimer or copyright or trademark notice contained in any Material. If you have received this material in error, please immediately notify the sender and destroy the material. This Material is for information only and it should not be regarded as an offer to sell or a solicitation of an offer to buy. It is based on current public information and/or from sources which Liberum believes to be reliable, but the accuracy, completeness, timeliness or correct sequencing of the information included herein cannot be guaranteed. Neither Liberum nor any source will be liable for the accuracy of, or availability of, such information or will have any duty to verify, correct, complete or update any material. Neither Liberum nor any source will be liable for any loss, cost, claim or damage (including direct, indirect or consequential damages or lost profits) arising out of or otherwise relating to any material or the use or access to or unavailability of any material. Any information or opinions contained herein are subject to change without notice. Unless stated otherwise, this material is not investment research or a research recommendation for the purposes of FCA rules or a research report under U.S. securities laws. It is provided on the understanding that Liberum is not acting in a fiduciary capacity and it is not a personal recommendation to you. The securities referred to may not be suitable for you and this material should not be relied upon in substitution for the exercise of independent judgement. Liberum and/or its officers, directors and employees may have or take positions in securities of companies mentioned in this communication (or in any related investment) and may from time to time dispose of any such positions. Liberum may act as a market maker in the securities of companies discussed in this communication (or in any related investments), may sell them or buy them from customers on a principal basis, and may also provide corporate finance or underwriting services for or relating to those companies, for which it is remunerated. United Kingdom and the rest of Europe: This material has been prepared and issued by Liberum. Liberum is a trading name of Liberum Capital Limited, who are authorised and regulated by the Financial Conduct Authority (FCA) and a member of the London Stock Exchange. Ropemaker Place, Level 12, 25 Ropemaker Street, London EC2Y 9LY.Tel +44 (0)20 3100 2000 Fax +44 (0)20 3100 2299 United States: This communication is distributed to US institutional investors by Liberum Inc, which is a member of FINRA & SIPC. 441 Lexington Avenue (15th Floor), New York, NY 10017, Tel +1 212 596 4800 Fax +1 212 596 4898.

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cormac leech / liberum / marketplace lending opportunity

Presentations & Public Speaking