The recent collapse of Greensill reminds us that credit is not a market share game
Most business school courses would teach the conventional wisdom of the benefits of winning and maintaining market share. Larger players in a market can typically improve their margins and profitability and create a sustainable competitive advantage. The benefits of winning market share is true in most industries, but as has been seen time and again and most recently in the collapse of Greensill, we don’t believe this is necessarily true in the case of lending businesses. Our experience has shown us that lending businesses are a unique case and demonstrate this below using some comparative examples.
Our first example is a consumer products business (e.g. food and beverage) where there are many benefits of winning market share. Being larger than competitors allows a business to get better deals on materials, improve the utilisation of assets, reduce unit costs, gain more leverage in deals with channel partners (e.g. supermarkets), spend more on advertising and marketing and invest more in new products and innovation. All of these benefits will build competitive advantage and improve returns for shareholders.
So what are the risks to a consumer products business if their campaign for market share fails? If a business expends excessive capital and operating expenditure and the market share gains do not emerge, there is typically sufficient time to course correct. This could include cutting operating costs, reducing marketing expenditure and selling assets. There are many levers that can be pulled and if the business does need to change strategy (e.g. from chasing market share to a niche market strategy), this change will not necessarily be a terminal experience for the business. They can still produce their products.
A second example would be a software business seeking to grow and win market share. The benefits of market share to this kind of business would include more users providing feedback to rapidly improve the product, a larger user base supports greater product investment and a larger marketing budget, and a larger user base encourages more complementary products to integrate with the software, increasing the “stickiness” of the user base. All of these dynamics will, in time, also increase competitive advantage, enhance profitability and increase returns to shareholders.
As with the consumer products example, failure to win the targeted market share will not necessarily kill the company. There are many levers a software business can pull to refocus and preserve capital, this could include reducing product development spend and reducing marketing spend. This may in time diminish the competitive advantage of the business, but it will allow management and shareholders to continue and adapt their product and business model. They still have a product to sell.
By contrast, the team at GCI have seen time and again that lending businesses that chase market share have a much greater potential to blow up substantial amounts of capital – and the scale of the destruction can be existential to both debt and equity capital before the results of a poor strategy can be realised and corrected. The most recent example is Greensill but other examples in the Australian market would include AxsessToday, an equipment finance business that was listed on the ASX. Why is this the case?
Businesses providing credit will never have a problem winning market share. There will always be demand for credit from a large universe of borrowers, and market share will be easily gained if that credit is not properly priced for the risk of the borrower. In our experience, the key to sustainable competitive advantage for credit businesses is defining their market as the pool of borrowers who meet their underwriting standards (i.e. borrowers who will be able to repay their loans!). This is much more challenging than simply finding borrowers who need credit. Strong credit businesses require effective origination strategies to find their target borrowers, robust credit underwriting models and a competitive cost of capital.
Sustainable growth of market share in a well-defined credit market will deliver benefits which could include a lower cost of capital, more data to enhance underwriting models and lower customer acquisition costs from investment in marketing. However, many rapidly growing credit businesses succumb to the temptation to reduce underwriting standards or reduce pricing in a campaign to win share in a market they have not defined precisely enough. Unlike consumer products or software businesses, the results of this type of strategy can be catastrophic. In lending businesses you don’t just lose the margin on an incremental customer, you lose the equivalent in a consumer products business of all of your margin and your inventory. Moreover, with many finance companies offering long term finance (or offering rolling short-term products), losses can remain hidden in portfolios for extended periods. By the time errors are identified, course correction can be impossible and the business can implode.
Where capital is the primary input for a product (as it is for a lender), suppliers can be very fickle once distress is detected. The supplier of corn to a food manufacturer is more likely to continue to maintain supply. The capital supplier to a finance company will pull their lines when credit losses begin to become uncontrollable. Now there is no “product” and the death spiral begins!
While the Greensill story is still unfolding, it seems a number of these elements have been at play. It is perhaps not surprising that the SoftBank business model of providing overwhelming amounts of capital to promote growth at any cost was particularly unsuited for a credit business. Time will tell, however, Greensill appear to have fallen for age-old traps of mispricing credit, ignoring prudent concentration limits, and outsourcing credit decisioning to third party insurers – all to grow market share at an admittedly spectacular pace. Notably, the catalyst for Greensill’s insolvency was Credit Suisse getting concerned about these credit issues, and pulling their lines – once this was done, there was no return.
In the case of AxsessToday, more of the dust has settled and with an administration and DOCA process complete, the lessons are clearer. The business sought market share at the expense of prudent credit decisioning in several directions. It under-priced its competitors as a matter of principle, it rapidly expanded into new product verticals and geographies which it arguably didn’t understand as well as those it began in, and it demonstrated a culture of tolerating exceptions to credit policy if it would get a deal done. In doing so, it achieved phenomenal growth, increasing total receivables from ~$30m at the beginning of 2016 to almost $350m by mid-2018. Unfortunately, once a change in accounting standards made investors (and funders) look closer at the quality of the credit being originated, the deterioration was too far gone, causing the equity value in the business to be completely wiped out, and one tranche of debt capital (provided by mum and dad investors through a listed simple corporate bond) taking a substantial haircut.
All this points to the additional skepticism that investors should have towards credit businesses growing market share. Recently, we’ve seen an ASX listed consumer lender boast of increasing the conversion of leads to funded loans by ~100% by implementing their new credit decisioning and pricing engine. We hope that as investors are excited by this top-line growth in portfolio size and revenue, they keep their eyes as closely focused on whether credit quality has been truly maintained as the business strives for greater market share.
Authored by Gavin Solsky (Managing Director, GCI), Steven Sher (Managing Director, GCI) (gcifunds.com)