Since May 2022, with rising interest rates and increased concerns about the outlook for the economy, equity market support for fintech and non-bank financial institutions (“NBFIs”) has dramatically declined. In Australia, listed NBFIs have gone from being valued richly on multiples of revenue to trade in some instances at less than their tangible net asset value. At GCI, we’ve specialised in funding early stage NBFIs, providing facilities to over 25 such businesses as they seek to grow to scale to attract institutional warehouse funding. Through this process, we’ve been able to form a view on the critical drivers these businesses need to get right to set themselves up for long term success.
In today’s market, we think there are four key elements NBFIs need to nail to prove their viability:
- a compelling customer value proposition;
- a differentiated distribution model;
- the ability to underwrite credit risk; and
- a pathway to a sustainable capital structure with a reasonable cost of capital.
We come to this analysis from the perspective of debt investors, however we think these are the elements that NBFIs also need to demonstrate to increasingly sceptical equity partners too. We are frequently seeing emerging NBFI’s where we would like to provide debt, except only for the fact that they do not have sufficient equity capital. With both debt and equity being essential for NBFIs to scale, it is imperative to be focussing on these at all points of a NBFI’s journey.
Customer Value Proposition
In the first instance, NBFIs need to establish a compelling customer value proposition which fills a gap in the market. Unfortunately, with the broad benefits enjoyed by incumbents in the finance industry which come with scale, new entrants need to provide a differentiated approach.
Fortunately, there are many examples of innovative entrepreneurs coming up with gaps in existing offerings, which have been heightened as banks have been affected by the Hayne Royal Commission and legacy systems. For instance, Buy Now Pay Later (“BNPL”) was an innovative new business model which has changed how a generation accesses credit. On the small business side, new lenders have found underserved markets such as unsecured lending, providing finance offerings for SMEs who the banks would only offer finance to if they could take security over real estate as collateral.
These value propositions can range from new use cases, a substantially better customer experience, or a new underwriting approach. By identifying gaps in the market where end users have a real need for a finance product that isn’t currently being served, NBFIs establish the space to build a platform and grow it to the scale at which they can compete. To fund new models, NBFI’s also need to attract funding from debt providers who can see through this complexity and appropriately structure for the new set of risks. At GCI, we have provided debt facilities to NBFI’s with innovative products such as BNPL, livestock finance, invoice finance, lending against tax rebates and consumer litigation funding.
Distribution
The next key element NBFIs need to solve is building a differentiated distribution strategy. Many of the established distribution strategies for finance companies are expensive and can quickly become a race to the bottom if several competitors are looking to capitalise on the same pathway. A case in point has been the significant commissions paid to brokers in the SME lending market.
In the era of cheap capital, businesses could get away with high-cost acquisition strategies, such as mass media advertising, high-cost referral or reward programs, and sponsoring major events. Today that is no longer an option, and for smaller lenders still getting to scale, distribution channels must be efficient and unique as it will be costly to compete on marketing. An important question to ask is: If you turned off your high-cost marketing spend, can you still originate new deals?
Focussing on differentiated partnerships can unlock huge value.
In a saturating BNPL market, we saw niche players establishing partnerships with distributors of products which weren’t already being served, such as focussing on the auto repairs and accessories vertical, where the higher ticket values and longer loan terms were offset by a higher quality borrower who owned their car. Having identified the new vertical, auto retailers became distributors as it provided a source of finance to customers who otherwise lacked access to it.
At GCI, many of our portfolio borrowers have built their competitive edge on differentiated distribution channels. One example is Property Credit, who offer finance for vendor paid advertising when consumers are looking to sell their home. This product gets distributed by real estate agents as it removes a significant pain point from the agent’s sales process. Another is JustFund, a specialist funder of family law litigation. Their natural distribution partners are family law practitioners, with JustFund’s financing unlocking new business for the practitioner by providing capital that would otherwise be unavailable to fund separation proceedings. They were recently awarded the Positive Impact Fintech of the Year Award at the Finnies for the social impact their funding has had on non-primary income earners going through separation. Unlocking distribution methods that you don’t have to pay for, and where you don’t have to compete with other finance companies are traits that savvy equity investors will value.
Credit Underwriting
As any experienced lender knows, it’s very easy to give money away, but much harder to get it back. Being good at underwriting credit risk means assessing risk accurately and pricing risk appropriately. Being bad at underwriting credit risk means you will go out of business.
Sometimes, NBFI’s can get distracted as they seek to grow quickly and take their eyes off the ball when it comes to credit. This can be dangerous in the long term and even when such businesses are able to turn this around, the process can be long, arduous and distracting. This can be illustrated by Prospa, who had to write off 12.9% of their loan book in 1H FY24. While they’ve been able to turn this around, this was at the cost of a significant reduction in loan volumes and required a meaningful pivot in strategy.
It is important to make sure that credit is a key focus in changing macro environments and if the broader economy is deteriorating. It may make sense to amend products to reflect the new times. We have seen this in our own portfolio, with several of our NBFI borrowers moving up the credit curve by offering new products with enhanced security to protect against downside risk. When this has required us to amend our facilities to allow for the changes, we’ve been happy to provide this flexibility.
Being able to demonstrate that a keen focus on credit underwriting is at the core of everything an NBFI does is critical to stakeholders providing increasing and ongoing support.
Cost of Capital
Finally, the last piece of the puzzle is securing a reasonable cost of capital. The reason this is the least important aspect for a non-bank lender is because access to cheaper funding is unlocked as a loan book scales and matures. A lender accesses lower cost capital once distribution, credit underwriting, and the value proposition are proven – cheap capital does not necessarily enable efficient distribution, robust credit underwriting and a compelling customer value proposition.
What is critical for NBFIs is to show a plan and a pathway to scale. Typically, in the Australian market, we see loan books initially being funded by equity, to a scale of $5m – $10m.
By this point, they should have been able to prove out their distribution, credit underwriting and product-market fit, and they can begin to attract debt support– typically from private credit providers like GCI.
Once an NBFI then grows to scale of $50m – $100m, they should start to become appropriate for securitisation facilities provided by both domestic and international banks which typically offer a relatively cheaper cost of funds.
What is critical is for an NBFI to prepare itself from the beginning for all the steps along this journey and make sure that when they reach the scale where various forms of increasingly cheaper capital are available, they have the necessary infrastructure in place to benefit from it.
Being able to demonstrate that you aren’t just solving for today, but have a well thought out plan to grow your NBFI all the way to sustainable scale is essential to attract equity support.
Conclusion
While equity markets remain challenging for NBFIs that are still growing to scale, we are still seeing great businesses get the support they need from both equity and debt investors when they can demonstrate a compelling fundamental business plan. From the opportunities that we see in the market, we think the businesses today that are seeing the most success are those that can demonstrate a comprehensive plan for each of the four points addressed above.
The right debt partners can be instrumental in helping you attract equity and future bank partners. If you would like to talk our Asset Backed Lending team, who specialise in funding emerging NBFIs, please get in contact.
To read more about how we have helped a variety of businesses transform over the years, visit www.gcifunds.com/case-studies/
Authored by Henry Stewart (Managing Director) and Sunny Xu (Investment Analyst)