While investing in the originations of digital lenders can be attractive to investors, a robust and detailed due diligence framework is essential before deploying funds. Because there are often differences between lenders, such as reporting and data, it is essential to have a standardised approach to due diligence, combining experience, hands-on examinations, data ingestion and analytics. Victor Marques, digital lending investment specialist at CrossLend, outlines some of the key aspects that a due diligence process should examine, and its importance to investing.
Hi Victor, can you please give an introduction to yourself and your professional history?
I have been working with investments related to the digital lending market since 2015. I started at Eiffel Investment Group, a French alternative asset manager, working mainly on digital lending strategies there. I enjoyed a broad experience, from back office, to risk management and investments. After almost four years, I moved to Lisbon and joined Pedro Carvalheiro’s team at Banco BNI Europa, where I started to focus exclusively on investment prospecting, due diligence analysis and portfolio management. Finally, last year I joined CrossLend, and I’m working on digital lender prospecting and analysis, including investment due diligence.
Given that background, what is your view on the maturity of the digital lending sector in Europe?
We have seen exponential growth in the sector since its creation. Today we see some very established players, including those that have IPO’d, and others that are still private but have huge origination volumes, as well as plenty of new players. Public companies present a very positive development for the sector, given that they must comply with a higher set of regulations and provide highly transparent updates for investors, depending on the requirements of their exchange. Additionally we see that regulations, including the new European Crowdfunding Service Providers Regulation, are leading to a more transparent and accessible investment environment in this asset class, ultimately reflecting a more mature sector.
But zooming in, we see there are quite different players at different stages of development. The market is still maturing. At one end of the spectrum we see large players with huge origination volumes, and large staff. There are also niche digital lenders – which are experienced but with lower volumes. There are also new digital lenders, and investors have to understand that the risks around these are different in order to properly filter the digital lenders that match their investment strategy and objective. In conclusion, a market screening, followed by in-depth due diligence analysis will aid in investment selection.
For investors carrying out due diligence on digital lenders, given that there is a range of professionalism, available data (and standardisation), as well as local market dynamics, what are the main challenges?
From the starting point, it’s really important to understand what are the services that digital lenders are providing to investors. At a general level, they are providing access to specific asset classes, but behind this, there are several steps. One is the sourcing of borrowers, so for example marketing campaigns targeting a specific customer segment. Lenders have to carry out know your customer (KYC) checks, anti-money laundering (AML) and compliance checks. They also have to perform the credit analysis of each borrower, and after that, if the application is approved, they will do the intermediation between the investor and the borrower. But it doesn’t stop there – they also do all the servicing related to the loans and conduct the recoveries for delinquent loans. Across this chain, there are several risks that investors have to address.
When it comes to measuring performance in the main areas you’ve highlighted, what are some examples of red flags or issues arising from the due diligence?
Each one of the stages has a certain type of risk, which could be reflected in certain behaviours on the portfolio level. For example, for the AML and KYC checks, you can see this in relation to fraud. If an originator has a high volume of fraud cases – typically a loan that defaults after the first or second instalment, this is the characteristic behaviour – it can indicate a problem with the KYC and fraud checks of the digital lender.
Looking at sourcing, the number of loan applications and how many are approved are important indicators. If their conversion or acceptance rate is very high, this is a bad sign, which may indicate that the digital lender has a loose credit analysis standard.
In the next stage, there is a risk related to pricing. Namely, that the estimated risk for a loan is in accordance with the actual risk, and it is reflected on the return rate. There can be several issues here, such as the pricing being biased due to the offer and demand mismatch. If a platform feels under pressure to deploy capital, – for example, to generate fee related revenue – a conflict of interest can arise: they may choose to lower their pricing in order to entice borrowers and deploy the capital, resulting in the risk of loans being under-priced, which may affect investor returns.
What are some other red flags?
Other red flags include high turnover of key management positions, borrower concentration, and a misalignment or conflicts of interest between the digital lender and investors. Additionally, defaults above the expected rate are obviously a huge red flag. There is also a risk related to the originator itself – as they are doing the loan servicing, there is a risk that the digital lender may not be there during the whole investment term, to service the loan. Investors also need to take a look at digital lenders: how they’re funding themselves, who their investors are, and the quality of the management team.
Are there platforms where the fee revenue structure is better aligned with the interests of investors?
Yes. One important thing to analyse is how originators are generating their revenue. They are offering a service to both the investors and the borrower, but how they generate their fees can play a really important role in aligning the interests of all parties. Usually, a platform will have a mix of up-front and running fees, charged to borrowers, investors or both. However, some can have only an up-front fee; theoretically, this removes some of the incentives related to the servicing of the loans. For example, for loans with longer maturities, in cases where there are no servicing fees to be paid to the digital lender, normally it means that after the origination, the lender would tend to focus on origination of new loans instead of the servicing of the current loans. As such, we view it as desirable to have a running fee over the life of a loan not only for better follow up and monitoring, but also to foster the alignment of interests between investors and digital lenders.
How about when an originator’s equity or balance sheet is involved in loans?
This is a really good mechanism to align the interests of the investors and a digital lender. Whether this is the case normally it depends on the specific terms of a deal. In some deals it is required that the originator has skin in the game, wherein a percentage of the investments is funded by the equity from the digital lender. This attaches the risk of the credit performance to the digital lender, therefore the digital lender is not going to have just operational exposure, but also credit risk exposure during the term of the loan.
Given the substantial number of digital lenders in Europe, can an initial screening approach help to more quickly identify which are the better performing platforms?
It’s a really diverse market. There are hundreds of digital lenders in Europe. But for discerning investors, the pool of viable platforms is in reality far smaller, so the first challenge is to identify this set of platforms. Using an initial screening is a good approach to identify a pool of digital lenders within this universe that matches an investor’s specific strategy and requirements. The screening should take into consideration several aspects, such as underlying characteristics, geography, currency, investment horizon, collateral, and governance structure. This provides a first filter, before moving to a deeper analysis, the due diligence, on each digital lender within the selected pool of potentially viable platforms.
Can you please talk about the role that enhanced on-site or virtual due diligence can play?
So, previously on-site due diligence was common, but obviously that changed with the pandemic. Everyone had to go digital. But being on-site is still the best market practice. Before advancing on an investment deal, it’s important to meet the managers and key people of a digital lender, and see how their processes are executed. You can analyse the policies and procedures, case studies and presentations, but being on-site and following the whole underwriting process – sourcing, checking, analysis and so forth – helps the investor to better understand the originator and assess how the governance structure is reflected in the operations of the digital lender.
What is a likely timeline for completion of a full due diligence cycle?
The whole process, if it goes smoothly, usually takes around three months. That means being able to analyse everything in detail, in order to confidently start the investment process with a digital lender.
Once an investor has deployed funds, what should they be tracking? How do you ensure that your due diligence observations remain relevant over a longer time cycle?
The due diligence analysis looks to establish the first deep view and to gain confidence to start working with a lender. But in order to be sure that the conclusions and opinions remain valid, it’s important to have a really close and well structured monitoring process. Naturally the monitoring should not be limited just to the investor’s own portfolio, but also to the whole portfolio originated by a digital lender, as well as the digital lender’s framework, policies and processes, management team, financial health and regulations.
Nevertheless, the main topic is loan delinquency rates, is that correct?
The delinquency rates are a significant output of the whole process that we are discussing. However, this information shall be carefully analysed, in order to identify the drivers of the delinquency rate and, therefore, be able to take the correct decisions regarding the portfolio management. Sometimes we are going to face some unforeseen circumstances in the economic environment, which might affect specific sectors or a specific origination cohort of the digital lender. The challenge here is to understand if it was something general that affects the market as a whole, or if it’s a structural problem on the part of the digital lender. In the second case, an investor would reassess if they’re going to keep investing via them.
Due diligence: is it an art or science, or a mix of both?
I think it’s a mix of both. Obviously it’s important for investors to have a very robust and standardised approach. They have to be sure of the risks that are present when they start investing through a digital lender, that the expected return is a good match for the risk. However, there might be so many different types of risks that you have to use different mechanisms to mitigate it and control it. All of this is of course negotiated with the digital lenders. So you have to find ways to make the deal possible, and create value for both parties, which consists of the “art” side of it.
Looking at the broader investment thesis for private debt, especially diversification, can the data and insights generated through a due diligence process help investors to better understand portfolio correlations and opportunities for diversification?
It definitely does, because in some cases there are digital lenders who originate through-out the whole spectrum of the economy, across all sectors. Then you have some very niche digital lenders, who specialised in financing one specific type of business, for example real estate, agriculture or renewable energy. When you invest via a niche originator you’re not getting exposure to the broader economy, or the broader SME segment, you’re getting a specific type of risk that might be exposed to certain idiosyncratic shocks.
There is also a question of geographic exposure. While in Europe there are some large originators that are present in multiple countries, the vast majority only operate or are concentrated in their home markets. This happens due to cultural differences, due to access to data, to understanding borrowers, and also the country-specific legal frameworks. Diversification across maturities is another important aspect.
Data from originators, often gathered during the due diligence, can be used for portfolio construction. By implementing very detailed and extensive analysis, this can result in a more diversified portfolio across some of the aspects previously mentioned.
It all sounds like a lot of work, with the need for investors to have a very granular focus on originators during the pre-investment phase, portfolio construction and on-going monitoring..?
That’s very true. For institutional investors, I still see the digital lending market as a niche market that requires a specific type of analysis and monitoring. For those institutional investors that do not have the required expertise inside their investment team, the most efficient way to get exposure to this asset class is through specialised investment funds or dedicated investment mandates.