Frank Rotman, Partner at QED Investors

Frank Rotman, Partner at QED Investors

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There is a lot of speculation in this industry about the role of banks – how they view this industry and where they will fit in the future. In the latest edition of the Lend Academy Podcast my guest is someone who has a unique perspective on these questions. Frank Rotman is a partner at QED Investors, the leading venture capital firm in this space, but he also spent over a decade at Capital One. Frank is also the author of the new blog, Confessions of a Fintech Junkie, where he writes regularly about the broader fintech industry.

In this podcast you will learn:

  • The thinking behind the formation of QED Investors, the most active VC firm in our industry.
  • What they liked about Prosper back in 2009 when they decided to invest.
  • Frank’s thoughts on the recapitalization of Prosper in early 2013 with the new executive team.
  • What he likes about SoFi, Avant & Orchard – all portfolio companies of QED.
  • Franks’s thoughts on the amount of VC money coming into the space right now.
  • What a new lending business needs today to get QED to make an investment.
  • What was behind the idea for his new white paper, The Hourglass Effect.
  • In the mid-2000’s Capital One had a strong credit card business, so where did the personal loans business fit?
  • Why all the major banks closed their personal loan business during the financial crisis.
  • The huge difference between projected and actual losses in personal loans at the big banks.
  • The many reasons why banks have not come back into the personal loan business.
  • What Frank means when he says we are in a “knife fight” right now.
  • The “lending as a service” concept that he thinks is the big opportunity here.
  • What role the banks will play in this industry in the year 2020.

Please read a transcription of our conversation below.


Peter Renton:  Welcome the Lend Academy Podcast, Episode No. 37. This is your host, Peter Renton, founder of Lend Academy.


Peter:  Today on the show, I am delighted to welcome Frank Rotman. He is a partner at QED Investors and he also spent over a decade at Capital One, including some time running their personal loans business so for that reason he has a unique perspective on this industry. QED Investors is a firm that has made more investments in this space, in the lending industry, than anyone else. His role there has basically exposed him to all of the leading companies that we have today and all the new ideas that keep arising so wanted to get him on the show, talk a bit about that, but also to talk about his White Paper. I’ve put it on Lend Academy over a month ago and I think it’s been a very well received paper. He talked about it at LendIt and we are going to go in depth into that White Paper in the show. Hope you enjoy the show!

Peter: Welcome to the podcast, Frank.

Frank Rotman: Glad to be here.

Peter: Okay, let’s just get started with just giving the listeners a little bit of background about yourself, particularly about your time at Capital One.

Frank:  Sure, sure, so for the past 25 years I’ve been in the fintech space with my formative days being back at Capital One. Back in the Capital One days, I spent most of my time either building businesses from scratch that the company needed or fixing some of the large businesses when they were broken. I was one of the earliest people with my hands on sometimes credit card businesses, an example.

I’ve spent a lot of time in super prime and rewards, spent a lot of time on exotic asset classes and, ultimately, moved on to help outside of the credit card world with everything from diversification into other asset classes in different geographies and even managing some of the exotic asset classes for the company.

Spent a lot of time also in horizontal loans which included being the chief credit officer of the company before I was given official role and managing some of the big operational areas strategically so collection, its recoveries, fraud, some of the big areas there. So I had a variety of different roles and left Capital One in 2005 to build a seed money company and then helped found QED Investors with two of my compatriots from Capital One in late 2007, early 2008.

Peter:  Okay, so then let’s just talk a little bit about QED. What was the thinking behind the formation of that company, why did you join it and what are you focused on there?

Frank: Sure, QED was formed a little more than seven years ago with two other notable ex-Capital One executives. Nigel Morris was the Co-Founder of Capital One and the President/COO and really the heart and soul of Capital One and scaled up to 20,000 individuals across the globe. Caribou Honig was our other initial partner, founding partner. He really helped analytically understand how to originate customers in a repeatable fashion at Capital One, really a marketing genius and spent a lot of time acting the (inaudible) on the different marketing channels within Capital One. The three of us really found ourselves in the market at the same time wondering what we should be doing and what we could do next.

We came together to form QED Investors and we realized that our operating skills were a little bit different than those of other VCs and private equity firms because of our experience. We were going to try to use our own capital, we’ve never raised outside money, to help early stage and even mid-stage companies. We were a little bit different than most where we’re really the operators disguised as investors. We rolled up our sleeves, get in there hands on and we felt like this would make a difference. So for the past seven and a half years we’ve been investing our own capital and really trying to help as many companies as we could.

Peter: Right, right, so let’s start digging into that little bit. You invested in Prosper back in not the very early days, still back in 2009, I think it was, so obviously you did a bit of due diligence there, I imagine, firstly, what got Prosper on your radar and the why did you decide to invest?

Frank: Well, another former Capital One executive, Raj Date, was involved with Prosper at that time. He let us know about Prosper and really spent a little bit of time with us on it. We were talking to some of the other notable platforms that were out in the industry at that time, but we spent more time with Prosper that with the others. You are right, this was not in the earliest of early days, but it was post SEC, very, very soon after Prosper had rebooted. They were originating about a million dollars a month in volume and to put that in perspective before they shut down the were originating between six and ten million a month so it’s still a very early industry.

What we liked about it was the content. It was the first time the consumers were going to have access to an asset class depth in yield was what was being projected at Prosper. The problem was that Prosper just hadn’t been able to deliver on its promise, you know, the earliest of early days and their reasons for not being able to deliver on the promise of returns were very obvious so it was not like it was a mystery where the platform wasn’t generating positive returns. In fact, significant positive returns to investors and wasn’t delivering money saving offers to consumers. That was really the goal, it just wasn’t happening and the reasons for it were obvious. So, again, the lender returns were negative on average, the risk models needed a complete overhaul.

It was really obvious that you couldn’t let the market determine the price when the market consisted of retail investors who didn’t actually understand risk analytics and credit policy. There are even details like the verification process was very underwhelming. The company had a single product with a three-year loan. So there were a lot of very tactical things that we felt comfortable being able to roll up our sleeves and help the company. If you solved these issues and created a very strong set of competencies within the company on behalf of investors, the expandability of the platform at that time seemed limitless.

If you go back and read my original investment memo, which I did recently, it’s interesting how we speculated that this could be applied to the students, this could be applied to auto, this could be applied to other asset classes. At that time we thought that Prosper was the platform to crack personal loans then move on to other asset classes on the platform. It was just very compelling in concept.

Peter: Right, so your partner, Nigel Morris, joined the board of Prosper and obviously, you know, was intimately involved in the company over the next several years. I don’t want to make this all about Prosper, this podcast, I just want to have one more follow-up. You obviously saw the company go through a dramatic change, recapitalization when the Vermuts and Ron Suber came in, what were your thoughts back then and how do you feel the company…what really changed at Prosper?

Frank: Sure, it was a difficult situation when you see an opportunity that is fantastic and there is a crisis within the company that had something to do with the opportunity itself. It has to do with other details that are going on behind the scenes, how the company is managed, something about how the industry participants are looking at your platform. There’s a lot of work to do to really fix the platform.

Some of it dealt with people, some of it dealt with product, some of it dealt with investor relations and when the Vermuts came to the table with Ron Suber, it really was a catalytic event. We were crossing our fingers and hoping that things would be better and getting the right management team in place to really catalyze everything and crystallize it into a strategy that the market liked. You know, it’s what we were were……again, crossing our fingers and hoping for and it ends up that they delivered much greater that we ever expected. They grew them faster than we ever expected.

Peter: Sure, I know you’ve made several other investments in the space, many that Lend Academy listeners would recognize. I feel like you’ve sort of become the most active really equity investor that we have pretty much, so there’s companies like SoFi….let’s just go through some of these really quickly and tell us what you saw when you decided to invest, why it was a good idea. Let’s just talk about SoFi real quick.

Frank: Sure, I actually have an affinity for student lending because after Capital One we came up with the idea of building a student lending company so when student lending opportunities started to come in and crossed our desk it felt very familiar and Nino and Mike Cagney are two of the best financial engineers I’ve ever met in my life tackling the category like student loans, it felt fantastic. I mean, really, SoFi is about finding upwardly mobile consumers that just happens to have graduated recently with a lot of student debt. If you underwrite the customer, if you underwrite the schools they come from, if you underwrite their free cash flow, the concept is you can find a near zero or zero lost customer and offer them a cutback that’s at far below the rates the government was offering them for their student loans because there really is an overcharge play here where with the government every single school is looked at with the same price, every student is looked at worth the same price. So it’s really finding the best of the best, the upwardly mobile consumers and ultimately, they are the equivalent of trying to become right now the First Republic, well before First Republic could bank the customers.

Peter: Right, and obviously, they’re talking about an IPO now, they’re growing like gang busters and certainly that’s going to work out to be a very good investment for you guys. Another company that’s growing really fast is Avant and you are fairly early on on board there, their bandwagon. What did you like about Avant when you first looked at them?

Frank: So if anyone in the audience has ever met with Al Goldstein, they’ll realize that he is a force of nature. (laughs) This is the third or fourth business that he is building, he is very pragmatic, very aggressive, but measured in the steps that he takes. I remember having a conversation with him very early on and saying we’re either going to be best friends or you’re going to kick me out the door because what I liked about their business is boring consumer financing where you make money on interest. It’s not about anything other than offering the consumer a product that fits their credit profile and there are games being played, you make money on interest.

You know, Al shook my hand and said, you know, we’re best friends, that’s what I want to do, you understand the business, let’s figure out how to build this. Ultimately, we’ve been modestly helpful to Avant and the business, but Al and his team are the superstars. They’ve built lending businesses in the past, they knew what they were doing. Guidance from us was really just offering advice and helping them in the early days get a few things together, but their team could crack any work.

Peter: Right, I agree. Al is going to be a guest in my podcast. I hope here coming up soon. Finally, let’s just talk about Orchard. You know, I had Matt Burton on here a few months ago and they’re obviously at the whole center of the marketplace lending ecosystem and you guys are on board there as an investor. What do you like about Orchard?

Frank: So now that the general idea of market place lending or peer-to-peer lending or even specialty origination of lending assets with non-banks, for everyone at all, now that it’s arrived and people understand it and believe it’s here to stay, it’s time for an infrastructure layer to really pop up to support these new set of players. Matt Burton and a handful of others are actually crossing the divide from ad tech over into fintech because they realized that some of the same tools that were very helpful in the ad tech world are going to helpful as the number of players expand in fintech and Matt Burton is one of those individuals. What he was building felt very familiar with us because in our earliest years of QED we actually invested in quite a few ad tech properties, one of them which was MediaMath which was the first DSP in the ad tech space.

Really, what Matt Burton is building is a DSP for lending where there are obvious people who are trying to find loans. Those loans need to be described, you need to understand the characteristics of them, you need to understand how they perform, you need to create a bidding strategy for them, you need a tool for executing your bid.

On the other side, there is the actual inventory itself and there are players who want exposure to the people who are buying and really matching up the two so that it’s not one-to-one relationship or every time you want to lay it up on a new platform you have to directly integrate. You can integrate with Orchard and Orchard does the work of doing diligence on the platforms and ultimately integrating with them and creating the exposure layer again of all of the data, the reporting, the bidding, all of it, for a very low rent. It just becomes incredibly compelling for all parties in the ecosystem.

Peter: Right, okay, so I just want to pull back a little bit and look at the industry as a whole. I mean, you were at LendIt obviously a month ago and saw this a huge amount of interest, so many deals….I think there’s been more deals done in the last six months than it has in the entire history of this industry, it feels like anyway. So what do you think about the money that’s flowing today, do you feel like it’s too much VC money trying to find the next Lending Club or Prosper and do you think it’s too easy to get funded?

Frank: Yeah, I mean, I mentioned it at LendIt, but we talked to the order of 200 new lending businesses a year now and if you go back a few years that number might have been 50 so an increase in the number of businesses. A lot of them start to feel very much like need to businesses and what I would say is there are certain industries and certain types of businesses that are very smart, generalist and investment professionals who are very smart, generalist entrepreneur to crack and lending is not one of it.

Competencies needs to be built, practiced, experience cycle, asset classes, customer profiles, credit segments, marketing channels. I mean, it’s a very, very complex business and I know some incredibly smart VCs that are investing in the space and the unfortunate part is they don’t know what they don’t know because this is a complex industry. What we’re seeing is a lot of these platforms, the new entrepreneurs also, don’t know what they don’t know so when you have funding sources that don’t know the right questions to ask and you have very compelling entrepreneurs trying to tackle big problems that also don’t know what they don’t know, it creates some gaps that are going to appear over the coming years as they grow.

For instance, very few of the platforms or investors really understand the true nature of regulatory risk. A lot of these platforms have been trying to use the data sources, for instance, and if you don’t understand the Reg B then you don’t have the right perspective on whether it’s a good idea or a bad idea or the platform is going to get in trouble or not be allowed to use the data. There are too many platforms also launching with not enough differentiation and understanding how to launch a new different service product in a saturated or a competitive market place, I should say. That’s a whole other set of questions.

In one of my earlier blog posts, I actually talked about one of the questions that I ask all businesses which is that if faced with perfect information, would a rational consumer choose your product and very few of these new platforms can answer yes definitively. So, again, I think, to cut to the chase, too many platforms are trying to emerge, too much money is being thrown at it, but there’s still room for some next generation of giant to emerge as by no means have the emerging winners covered the entire space.

Peter: Right, so then what would it take on that note…..obviously, you say you look at 200 lending businesses a year, how does one really position themselves such that you would be willing to open your checkbook and make an investment?

Frank: Yeah, it might sound a little crazy, but looking for (inaudible) event so in a new platform you want something that’s so differentiated, you almost want to be able to say no else has that. Another need to platform that’s a little better on one dimension, maybe they’ll succeed, maybe they won’t, but, ultimately, that’s a tough game and I don’t like playing tough games. I’d prefer… know, these businesses are difficult enough to build on their own that you want to make sure that you have a reason for existence in the ecosystem.

So I’m looking for things like privilege to access the customers, like some marketing channel advantage. Too many people are fishing in the open waters of the Internet competing with the other players that are out there and to me that’s not a winning strategy in a segment that’s already been cracked by some other players. I’m looking for a world class team and that consists of not just the founder but some of the things I talked about from an experience standpoint and if they don’t have the world class team yet with all of the experience, they recognize that they’re willing to let us actually help hire into their organizations.

Another very important point is that we’re looking for a moral compass that points towards true north. There are too many ways of making money in financial services, especially when you start to get into high price lending, but if you don’t have a moral compass that points towards true north, I mean, even one or two degrees off of true north, will ultimately get you in trouble over time and we have no interest in that. So, I mean, that’s really it. There are a lot of asset classes out there that have yet to be cracked, there are a lot of business models and propositions out there that will resonate with consumers and small businesses. So it’s really about us handling everything in the right way.

Peter: Okay, I want to switch gears right now and talk a little bit about the White Paper that you penned….just a short time ago, the Hourglass Effect. So I guess a couple of questions.

First, give the listeners a little bit of summary about the White Paper, how it came about and what you’re actually trying to achieve by producing this paper.

Frank: Sure, sure, occasionally there’s just a topic that’s begging to be written about and I think this is one. The way I think about is….I don’t know if you’ve ever been to a party where a group of people are discussing a topic and it’s really obvious that no one in the group actually understands the topic that they’re talking about. So you as an outsider are listening in on this conversation and you realize it’s an interesting question, but no one has perspective or, you know, the insight to actually answer the question.

That’s what this really felt like where the Hour Glass Effect was meant to tackle the topic of why haven’t the banks come back. I mean, it’s a very, very simple question where you look at Prosper and Lending Club and some of the other platforms and SoFi and Avant and you see this growth in next channel lending, whether it’s a marketplace model or a balance sheet model and say, what’s happening at the banks because they have a lot of advantages and if they decided to some back into the space, wouldn’t that mean doom for a Lending Club, Prosper, Avant, SoFi or any of the other players?

I found myself answering that question a lot, whether it was to a VC looking at a new platform or it was to an entrepreneur that I was meeting with and talking to, it came up frequently. When your partner in crime, Jason, actually asked me the question about a month before the LendIt Conference and I said, look, this is something that I’m being asked a lot. Do you have any answers I should be giving people? It was really the catalytic conversation to just say, look, let me just write a paper on this and get some information out there with my perspective on the topic, that’s really the origin of the paper.

Peter: Right, right, I think that’s one of my questions as well and Jason and I would chat about it on a somewhat regular basis because it’s sort of been the big dark cloud, I must not say dark cloud, but the big unknown that has been hanging over this industry now for many years. So I want to actually go through some of the parts of your paper because you really take this on a very interesting historical journey.

In the paper I just want to briefly touch on some of the different eras that you talk about where…you talk about firstly, the “boom era” where the banks were lending freely, I mean, you said you did like $4 to 5 Billion in personal loans at Capital One. I’m really curious about , firstly, Capital One built their business, their a credit card business primarily. That’s what…..correct me if I’m wrong, but it seems to me where they position themselves so then how do you go along and justify building up personal loans business at Capital One?

Frank: Capital One had a very dominant position in the credit card market, but it also did have other product lines so expanded into personal loans, had aspirations on being in home loans and Helocs, you know, a variety of different asset classes as it went down the path of actually buying banks. Personal loans is just one of many business units within the company even though its largest business and most established business was credit card. So in the personal loans business, when I took it over, had been around for a few years. For a while it had grown and then it started to kind of level off and then it was forecasted to actually either stay flat or, I don’t remember, if it was going to shrink a little bit, but profit was going to be disappearing from business.

When I took it over, it was really trying to figure out why and what could be done to actually fix that growth trajectory and it was a very competitive environment. I mean, the first thing you have to ask is does this product have a place in the market for any particular customer segment? And that was a really difficult question to answer because at that time people were really capping into their homes for equity. Their home was as I called them, ATM machine, in the paper and whenever you had a large project to do…..if you’re a homeowner and you had equity in your house, the most logical thing to do was to tap that home equity for a home improvement project or for debt consolidation or for a vacation because it was an advantaged product, very low interest rates, very significant access and availability of credit if you had equity in your home, very easy process at that time to get a loan and tax deductibility of interest.

So really hard to compete against that product on one side and credit card on the other where there were many offers out there, zero percent for 18 months, zero percent for 12 months, all sorts of rewards seeded with spend and balance transfer checks just flying around the industry. So it was just very, very difficult trying to find the segments that personal loan actually appealed to and it was really digging where the industry’s at and found segments where it did appeal.

Peter: So what were those segments…and so you felt like you actually weren’t cannibalizing other business slots, is that correct?

Frank: There was a little bit of that, it’s hard not to when you’re offering something that maybe some of your own customers would want. The fixed rate nature of an installment loan that amortizes over a fixed period of time can be very appealing for consumers trying to work their way out of debt.

What we did is we found a couple of segments. One was a longer term product, a five-year/six-year/seven-year personal loan product that kept payments very, very low and fixed. It appealed to people who were trying to pay their way out of debt. There is another segment which would be the renter population that didn’t have access to home equity loans which therefore made their personal loan product more competitive. Those are just some examples, but there were some segments out there that this product did appeal to.

Peter: Right, right, okay, so then you, obviously….like this business was going great in the mid-2000s, but then as we all know the bust came and it’s curious that every single bank exited this business. I mean, I know you talk about Discover being the exception, but pretty much every bank exited this business. Why do you think they couldn’t ride it out?

Frank: Yeah, it’s a very interesting question and when we talk about the businesses actually shutting down their units, they shut it down to the point where you couldn’t even find a personal loan on a website, there were no collateral materials in the branch offices. I mean, it was as if it didn’t exist so it was an extinction event for the personal loan business and the banking industry.

Part of that really came down to the forward looking forecast and all of the big battles that the banks were fighting at that time. There was of us who believed in banks understand that you have a forward looking forecast that affects how you think about your business today and when you have to look ahead a year or two years or three years in terms of the lawsuit that you expect on a product and from an accounting perspective actually book an entire year worth of losses the day that you book the product.

It’s really difficult to justify its keeping the business around even at subsistence levels of originations because you don’t know if you should be originating anything at all when faced with a business that’s projected to lose hundreds of millions of dollars and in some banks’ cases and billions of dollars in other banks’ cases. It was easier to just shut the doors, let the loan book amortize, figure out how to collect against it as best as possible and then figure out how to deal with the bigger issues the banks were fighting because the personal loan business was still a drop in the bucket.

If you look at the Bank of Americas of the world….you know, Citibank was facing its problems, Capital One was navigating some of the losses as well. All of the banks had bigger issues and when you’re faced with big issues, you got to focus on them. So shutting the doors on the personal loan business was the easiest thing to do, especially when faced with a business that was projected to lose massive amounts of money.

Peter: But then you also say that these projections were made like in the depths of 2008/2009 where everyone thought the whole world was falling apart, no one knew what would happen. You point out that losses were nowhere near as bad as the most pessimistic projections and if banks stayed it would have actually…it wouldn’t have been that bad. I mean, just talk a little bit about what actually happened now, we’ve many, many years passed that date and we have the benefit of 20/20 hindsight, but at that time banks shut it down but in reality they didn’t need to, right?

Frank: Yeah, I mean, one of the jobs that is responsible for at Capital One was loss forecasts and I would never wish that on my worst enemy. I mean, it’s a really, really tough job because you know you’re wrong, it’s a matter of by how much and are you even close to the projections or are your projections even close to what reality is going to unfold. You’re dealing with backward looking data, you’re dealing with some forward looking projection methodologies and, again, you just know you’re going to be wrong. Part of the problem is when you’re forecasting forward looking losses when you’re at the peak of a recession, you don’t know you’re at the peak so if all you’re seeing is a climbing curve, if all you’re seeing are economic figures that are getting worse not better… know, the job loss rate was at a very, very high level.

If you look at some of the backward looking metrics like the personal saving rate of the consumer in the United States, it was at really bad levels. You can match economic variable by economic variable. Until these things are getting better, I better project a bad economic environment into the future. And then what happens is the world starts correcting, I mean, you’re not willing to project up that it’s going to continue to cure, it is not the prudent thing to do.

Peter: Right.

Frank: So you’re always going to be wrong, but I would say is the best business you can focus probably at the peak of a recession because you’re projecting things are going to be much worse and pricing it accordingly than it’s actually going to end up being so that could end up being some of the best book of business that you end up writing.

Peter: Sure, so then obviously we’ve been in the recovery now for many years and we all know the story. Lending Club and Prosper just doing phenomenally well as new other players like Avant, SoFi doing phenomenally well and banks have been largely absent from this rise.

I want to actually talk about the future because we all know the boom right now is happening in this industry and part of this recovery that we’re still experiencing. You talk about reasons why a big bank hasn’t got in and I wanted you talk a little bit about why and some of your prognostications on the future and talking about where banks may come in. Let’s just first start about why, despite the very public success of this industry, that banks haven’t come in.

Frank: Well, banks actually have a long institutional memory. I would say, probably any big company in any industry does, but banks, in particular, if bad things have happened within a business unit or within a product, it’s hard to undo that organizational memory. I do know of quite a few people, some very good friends who have tried to re-launch some of these businesses within the banks, and they just keep encountering barrier after barrier after barrier. There really is a long organizational memory.

In addition to that organizational memory, you have to recognize that today’s environment is different than the environment when all of the systems and products were live in market place. So there is a bunch of IT debt that would need to be paid, old systems would need to be dusted off, or new systems were built were contracted with third parties to get these systems up and off the ground. There’s actually a lot of IT work associated with launching a product that you’ve shuttered the doors on and that requires even more institutional fortitude to make the leap and build the product again. So, there are a lot of reasons why the banks aren’t coming back directly.

You are seeing some of them dip their toes in the water in a very expected fashion so some of the banks have decided that the first thing they’re going to do is make the product available as a cross sell to their existing customers. They’re tired of losing their own assets to another organization so the first thing they’re going to do is not aggressively cannibalize themselves, but at least make the product findable. There are a handful of banks that have put it back up on their website and have been able to back in the fringe. In fact, some of these banks are allowing you to start the origination process online, but they drive you into a bank to close the loan, which is the opposite of what a lot of these customers are really looking to do.

Peter: Right.

Frank: They start online, they want to consummate the product online and the banks still don’t get it. They want to do the verification face-to-face, they want to try to cross sell them incremental products face-to-face, they’re just more comfortable with the regimen where they can see and touch the customer.

Peter: Right.

Frank: They really haven’t re-launched again.

Peter: Yes, you talked about the future where, obviously, one option is going to be that they’re not going to do anything. I want you to talk a little bit about the concept that you discussed about the “knife fight” which is you say we’re in right now, what do you mean by that exactly?

Frank: It’s actually pretty funny, I was in a board meeting the other day, I won’t say which company, but their marketing person came out and said, we’re in a “knife fight.” I don’t think they realized that I wrote the paper that referred to “knife fight,” but they talked about the industry and how things were unfolding as a “knife fight.” Truly it just means that you’re in a competitive market place and it happens in all industries eventually when there’s good economics and good products to be bought.

So, you know, I remember in the late 90’s and early 2000’s at Capital One, we had a set of competitors that we were aggressively competing against on a regular basis and it was the same, just means that if you’re all in the same channels and you’re all trying to originate similar customers that it’s a battle. It means that your acquisition costs are going to be slowly going up unless you can figure out channels or products that differentiate and that’s really what’s happening in the industry right now.

Peter: Okay, so then you talk about…it’s unlikely that banks are just going to re-start for the points you just made. I want to talk a bit about the fifth thing that you talked, prognostication, about lending as a service. This is something that I personally think is a huge opportunity that is not talked about enough yet. I want you just to give the listeners a little bit of explanation what you mean or what that is and how you think it’s going to evolve in the coming years.

Frank: Sure, Prosper was our first investment in the space of next generation specialty originator of lending assets and over the past seven years, we’ve invested in 15 origination platforms that directly originate small business or consumer loans. Really, we came upon this trend because we saw fragmentation occurring at the value chain where no longer did you need to be every single thing in the value chain in order to make a loan. You didn’t have to have a bank charter, you didn’t have to have deposits, you didn’t have to have world class capabilities and credit underwriting, you didn’t need to have servicing and collections. It was really about tearing apart the value chain and re-assembling it any way that you wanted to.

So if you wanted to become a specialty originator where you had a lot of your focus on originating the customer but you didn’t want to service, well, there are players out there who could service for you. You could fragment off that piece of the value chain and let someone else do it for the business model. Or, if you felt like servicing was a big advantage, you could have that as part of the value proposition and then charge your customers accordingly for that.

So when I talk about lending as a service, it really is just a continuation of the fragmentation of a value chain. Where now you have some smaller banks, even large banks, and you have brands that are non-banking institutions and you’re allowing them to basically say the asset that we bring to the table is access to the customer and maybe that’s all they want to do. If they have the ability to access the customer in this world of a “knife fight,” it gives them an advantage, right, because they have access and channels to customers that a lot of these platforms might not have access to at a reasonable cost.

So if they can access the customer and with the brand they’ve built, the channels they’ve built, they can get their attention. They no longer need to do everything downstream in the value chain to be able to make loans. The platforms enable them overnight to basically deliver competencies around credit upgrade, you know, competencies around account management, around collections, recoveries. It enables them to basically manage an investor group or capital markets group or even just a reporting function on how the assets are doing if the originator wants to balance sheet them.

So the capabilities that have been built by these larger platforms, it really enables a complete fragmentation to the point where all you have to do is deliver the customer or even access to the customer and everything else could be done by one of these lending as a service platforms.

Peter: Okay, so one final question and I’ll put you on the spot here. Say, we are five years out, it’s year 2020 and this industry is still growing well, what roles are the banks playing? Are they primarily partnering, have they acquired platforms? I’m talking about sort of mid to large-sized banks because the smaller banks has a pretty clear trend going on there with the partnering piece so the large to mid-sized banks, how are they playing in this industry?

Frank: You know what, I think the mid-sized banks are already starting to partner as well. You have some companies like SunTrust that are very vocal in their earnings calls about how they’re partnering with one of our other fantastic portfolio company, GreenSky, to originate assets. There are other mid-sized banks that are doing the same already. So I think the regionals are going to pick and choose the asset classes that they want to originate themselves and they’re going to have in-branch origination of customers and in-footprint origination of customers, but in order to make use of all the deposits that they are able to gather because they really are deposit gathering machine……they are fantastic at getting people to walk into their branches and hand them money.

As a result, I think they have to develop capabilities or I should say they have to borrow or rent capabilities from other people because they don’t have the ability within their own footprint to make use of all deposits.

I think for some of the other larger players it may even be somewhat the same, you know, picking and choosing the asset classes that they want to be world class on and they do have the ability to invest and hire world class people to manage large business units, they can build the capabilities. A lot of them already have the capabilities in-house, competing against Capital One in sub-prime auto or Capital One in credit card is something that’s a daunting task. I think you are going to see come competitors emerge there, but Capital One is always going to do that business themselves rather than outsource it to someone else, but you might find some of the bigger banks picking and choosing asset classes that are less competitive and finding a player to partner with them to do it.

So I think you’re going to see lots of different things emerging from the banks. You might see some banks looking to acquire some platforms, I mean, SunTrust did it years ago with LightStream and you might see some banks find some platforms that have merged to buy their way into a marketplace that they have kind of abandoned, but you’re going to see different things from different banks.

Peter: Right, okay, thanks, Frank, I can keep talking about this for hours but we have to bring it to a close. I really appreciate your time today.

Frank: Well, appreciate being here and if there’s anything I can do, let me know.

Peter: Thanks, Frank, see you.

I just want to touch on one point there. Frank talked about SunTrust and their acquisition of LightStream and they are basically acquiring borrowers online, but what’s interesting to me is that SunTrust, in the latest round at Prosper, actually invested in Prosper’s latest equity round so they certainly don’t see themselves as competing against the platform, it’s much more of a partnership.

It’s also interesting to me that Frank never mentions the likelihood in the White Paper that a bank is actually going to restart one of these installment loan businesses and go head to head with Lending Club and Prosper. He expects that’s a very low likelihood so it doesn’t mean it’s going to be all smooth sailing. These banks have very deep pockets, but it seems to me that the partnership route is going to be one that is most likely.

Anyway, on that note, I’ll sign off. I very much appreciate you listening to the show and we’ll catch you next time. Thanks. Bye.