LendingClub and the Question of Internal Hedge Funds

LendingClub Board Action Sheds Light on the Question of Internal Hedge Funds
By Matt O’Malley, President and COO, Looking Glass Investments. 

LendingClub Corp. has been in the news regularly since the firm’s board of directors accepted the resignation of CEO Renaud Laplanche for, among other missteps, investing in a fund that purchases LendingClub loans. While LendingClub’s challenges are unfortunate, its internal review process successfully discovered activities that should have been disclosed, and the board is to be commended for its swift action. Our firm intends to continue lending on the platform and we are confident that LendingClub will work through these questions and remain part of the asset class for the foreseeable future.

This situation gives rise to a set of important questions that the asset class needs to consider addressing in the near term. Examples include the ability to use capital inflows to mask actual default rates, and false promises of instant liquidity. However, chief among them, in our view, is the lending platform internal hedge fund.

Consider these statements from a May 10 U.S. Department of Treasury report titled, "Opportunities and Challenges in Online Marketplace Lending":

 "In an effort to diversify funding sources, some online marketplace lenders are forming internal hedge funds and registering affiliated entities as investment advisors to buy a company’s own loans or participate in securitizations.”

 "...they (platforms) rely on a variety of funding sources, including institutional investors, hedge funds, individual investors, venture capital, and depository institutions."

One such internal lending platform hedge fund was launched in March by online lender Social Finance Inc. The fund was set up to buy its own loans as well as some from its competitors. As SoFi Chief Executive Mike Cagney told the Wall Street Journal, the new hedge fund, called SoFi Credit Opportunities Fund, has “a real chance to solve the balance-sheet problems facing the industry."

Should lending platforms, their employees, and their board members be permitted to lend on their platforms directly or through hedge funds? If these platforms accept external funding from individuals, banks, credit unions, and independent funds, we believe the answer is an unqualified no. Strong levels of funding exist now, and additional channels will be established without the need to develop internal lending platform hedge funds.

These internal funds may have a significant advantage over all other external funding sources. Lending platforms have access to internal data that is not readily available to external funding sources. For example, borrowers typically apply for loans at a certain amount, interest rate, and term. However, the platform will offer the borrower alternative amounts, interest rates, and terms that may be more acceptable to the borrower. External funding sources such as individual investors, banks, credit unions, and independent funds in some cases may never know how the borrower shifted his or her amount, interest rate, and term from loan application to final loan origination. This information, along with what is likely to be dozens of other pieces of internal data, is available only to the platform and it is extremely valuable.

A troubling hypothetical scenario is the possibility that a data advantaged platform would support one or more of its internal hedge funds competing for the same loans, while at the same time receiving funding from individuals, banks, credit unions, and independent funds to support its capital requirements.

An even more troubling hypothetical scenario is the possibility that a data advantaged platform would create a loan purchase agreement with one or more lending platform internal hedge funds and, after receiving the borrower origination fee, “sell” the loan to one or more of its internal hedge funds. The “sale” transaction would very likely include a fee paid to the data advantaged platform from the lending platform internal hedge fund.

Assuming that external funding from individuals, banks, credit unions, and independent funds remains in place to support capital requirements, those external funding providers would find themselves in a potentially disadvantaged position. In addition to the possibility of working with an incomplete data set, the external funding sources represent zero additional revenue to the platform because the “sale” transaction does not exist. The platform would be strongly incentivized to “sell” optimal loans, and the external funding source may receive lending opportunities that are suboptimal when compared to the opportunities provided to the one or more of the lending platform internal hedge funds.

In practice, if a single loan, from a single platform, were to be funded by a lending platform’s internal hedge fund using data that was not available to external funding sources, the result would be an erosion of trust and external funding could dry up. We are not suggesting this occurs today; however, we must be vigilant and eliminate misaligned incentives before those incentives cause damage to the asset class.

All of us in this industry must recognize that we have a responsibility to protect what we have built. We should be proud of our ability to lend efficiently to borrowers with excellent credit. For those borrowers who may need an opportunity to improve their credit history, we lend at a cost that is affordable, giving borrowers an option to avoid unattractive sources such as payday lenders. Moreover, hundreds of thousands of borrowers have spent years promoting online lending to their family, friends, and neighbors. That valuable goodwill must be preserved.

In a May 18 New York Times article, Columbia professors Colleen Honigsberg and Robert J. Jackson Jr. and Fordham professor Richard Squire described how this asset class adds tremendous value and is winning the battle against the unnecessarily high cost of credit.

“The most common use of these platforms has been to consolidate higher-cost credit card debt with a lower-cost loan from a marketplace,” Jackson told the Times. “If the platforms disappear, are regulated out of existence, or are put in a situation where lending to higher-risk, lower-income individuals is no longer profitable, you can expect the kind of result we found in our paper: that marketplaces will stop doing that lending.”’

Now is the time to address the tough questions. As noted by U.S. Supreme Court Justice Louis Brandeis, sunlight is said to be the best of disinfectants.

Matt O’Malley is President and Chief Operating Officer of Looking Glass Investments, a fixed-income alternative investment firm focused on marketplace lending, and is an officer in the United States Navy Reserve.  O’Malley has been lending online since 2008.