Forbes - - Contents - By Laura shin

As banks re­treat from small busi­ness lend­ing, in­come-hun­gry in­vestors can earn 12%. Just ask Bren­dan Ross.

A fter grad­u­at­ing from Brown in 1995, Bren­dan Ross be­came a man­age­ment con­sul­tant and then a turn­around spe­cial­ist. By 2010 he was look­ing for a new pro­fes­sion that didn’t in­volve fir­ing peo­ple, when his fa­therin-law showed him Lend­ingclub.com, where the older man had started mak­ing small loans di­rectly to peo­ple pay­ing of credit cards or re­fi­nanc­ing other high-cost debt.

“To me it was amaz­ing,’’ re­calls Ross. “I thought, This is the re­birth of pri­vate credit.” Then a reg­is­tered in­vest­ment ad­vi­sor, Ross be­gan shov­el­ing his own and clients’ money into peer-to-peer loans, be­com­ing the first RIA to in­vest in LC Ad­vi­sors, a Lend­ing Club sub­sidiary that pools loans into funds.

But he wanted to di­ver­sify be­yond con­sumer loans and fig­ured he’d find the best re­turns where bank lend­ing had been cut most se­verely. Af­ter nix­ing sub­prime auto (he didn’t fancy him­self run­ning tow trucks), elec­tive med­i­cal (too sim­i­lar to con­sumer loans) and real es­tate (the online mar­ket was too young then), he set­tled on small busi­ness.

Ross was on to some­thing. Karen Gor­don Mills, a Har­vard Busi­ness School Se­nior Fel­low and for­mer Small Busi­ness Ad­min­is­tra­tion head, con­cluded in a pa­per last year that bank lend­ing to small busi­ness is in a sec­u­lar de­cline that started well be­fore the Great Re­ces­sion. Loans be­low $1 mil­lion now

ac­count for just 25% of banks’ com­mer­cial lend­ing, down from 40% in 2005 and 52% in 1995. Mills pre­dicted online small busi­ness lenders, with their lower costs, speed­ier de­ci­sions and new al­go­rithms for judg­ing credit risk, would trans­form bank­ing in the same way “Ama­zon.com changed re­tail and Square has changed the small busi­ness pay­ments busi­ness.”

To be sure, ac­cord­ing to Mor­gan Stan­ley, small busi­ness loans from online lenders to­taled only $5 bil­lion in 2014, a speck on the $4.4 tril­lion in small busi­ness debt out­stand­ing. But the bank projects new online loans will grow 50% a year through 2020.

Ross wanted not to make loans but to buy them. So he cre­ated a spread­sheet of the first 100 Google search re­sults for “small busi­ness loans” and called ev­ery com­pany. Many turned out to be bro­kers who did no un­der­writ­ing them­selves. His 85th call, to the CEO of IOU Fi­nan­cial, led to his first deal. Af­ter fly­ing, in April 2012, to At­lanta to meet IOU’S un­der­writ­ing team and as­sess its tech­nol­ogy, Ross set up his own firm, Di­rect Lend­ing In­vest­ments (DLI), based in Los An­ge­les. DLI bought $500,000 worth of IOU loans in Novem­ber and $600,000 worth the next month.

At the start Ross and his rel­a­tives were the main in­vestors in DLI. Then, in May 2013, Peter Renton, who blogs about peer-to-peer lend­ing at Len­da­cademy.com and co­founded the big Lendit con­fer­ences on the P2P busi­ness, wrote a post ex­plain­ing why he per­son­ally had in­vested $100,000 with DLI. Sud­denly, other in­vestors came knock­ing.

Ross’ Di­rect Lend­ing In­come Fund now has $220 mil­lion in as­sets and has been pay­ing 11% to 13% an­nual re­turns—the high­est Renton re­ports in his quar­terly up­date of his peer-topeer port­fo­lio. The fund is open only to “ac­cred­ited” in­vestors—those with at least $1 mil­lion in in­vestable as­sets or in­come of $200,000 a year for a sin­gle per­son or $300,000 for a cou­ple. The min­i­mum in­vest­ment is $100,000.

DLI now owns 3,000 loans from eight al­ter­na­tive small busi­ness lenders, in­clud­ing Deal­struck, Biz2credit and Quar­terspot. In May it bought $44 mil­lion in loans, us­ing re­pay­ments and new in­vest­ment money. Over its life­time DLI has pur­chased $388 mil­lion in small busi­ness loans, all orig­i­nated on the Web. Ross and Renton both say that as far as they know, DLI was the first in­sti­tu­tional buyer in this mar­ket and is cur­rently the largest.

Bor­row­ers are pri­mar­ily Main Street busi­nesses—re­tail­ers, doc­tors, den­tists, restau­rants, ho­tels. They’ve been in busi­ness an av­er­age of 12 years and have be­tween $500,000 and $20 mil­lion in an­nual rev­enue. Loans range from $10,000 to $500,000 (with an av­er­age of $60,000) and last 3 to 36 months, with re­pay­ments made daily or weekly via au­to­matic with­drawals from the busi­nesses’ ac­counts. The own­ers, who must per­son­ally guar­an­tee the loans, have an av­er­age FICO credit score of about 680. That score is a bit lower and the loans smaller than what banks typ­i­cally find wor­thy.

This money doesn’t come cheap. Bor­row­ers pay 15% to 40% in­ter­est an­nu­ally, 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 hefty man­age­ment fee equal to 1% of as­sets and 20% of re­turn. And there’s a 5% de­fault rate.

Small busi­ness loans hit a num­ber of sweet spots for Ross, who de­scribes him­self as “mostly a con­ser­va­tive in­vestor” who prefers debt to eq­uity. The loans’ short du­ra­tion means in­vestors’ money can be re­cy­cled into new, even higher rate loans when in­ter­est rates rise. And the wide spread pro­vides a good buf­fer should de­faults spike. Ross es­ti­mates the port­fo­lio’s cur­rent 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%.

More­over, with a grow­ing army of small busi­ness Web lenders to choose from, Ross says he’ll work only with those that use cri­te­ria that jibe with his own. He wants six months of bank data, doesn’t like busi­nesses that are de­pen­dent on a small num­ber of big cus­tomers and shuns bor­row­ers who bounce checks or have a high uti­liza­tion rate for their per­sonal credit. (The last cri­te­rion bet­ter pre­dicts who is likely to de­fault on loans than the ac­tual FICO score, he says.)

Ross’ fa­vorite prospec­tive bor­row­ers are those re­ferred di­rectly to an online len­der by the bank that just de­nied them loans. “If you’re a small busi­ness len­der and you tell me you’ve been op­er­at­ing for a year and you make short du­ra­tion loans and you’ve just signed a deal with a large bank that will send you all its declines, then we’re very likely to be able to do busi­ness,” he says.

The deals he strikes with lenders are de­signed to pro­tect DLI. He buys the loan prin­ci­pal but doesn’t pay in ad­vance for the in­ter­est stream—mean­ing he doesn’t lose money if the bor­rower pre­pays. The lenders get their cut of in­ter­est only when DLI does, so they have skin in the game. He also re­quires that soft­ware ran­domly as­sign which loans go to DLI—A pro­tec­tion against be­ing sent the dregs.

Be­yond de­faults, there’s another risk: Re­turns could be squeezed if com­pe­ti­tion and a more ed­u­cated bor­rower re­duce the fat pre­mium small busi­ness bor­row­ers now pay. While Renton doesn’t ex­pect re­turns to drop dras­ti­cally, he says in­vestors in the DLI fund shouldn’t “go in think­ing they’re go­ing to get dou­ble-digit re­turns no mat­ter what.”

Ross be­lieves rates will re­main high but isn’t one to ig­nore risk. On his 42nd birth­day in early June, while in New York City 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 difer­ence be­tween me and ev­ery­one else in the skate park is I’m cov­ered in pads from head to toe. I own ev­ery sin­gle kind of pad you can put on your body.”

Di­al­ing for dol­lars: Bren­dan Ross Googled online lenders and called 100 to find the best sup­pli­ers.

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