HIGH YIELD ON MAIN STREET
AS BANKS RETREAT FROM SMALL BUSINESS LENDING, INCOME-HUNGRY INVESTORS CAN EARN 12%. JUST ASK BRENDAN ROSS.
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.