Giving Credit

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Giving Credit
Primed for Overseas: Douglas Merrill at the Hollywood office of ZestFinance

Hollywood alternative lender ZestFinance appears to have hit its stride as bigger industry rivals struggle to cope with slackening investor demand for their loans.

The algorithm-driven online lender and underwriting service last week announced a deal with Chinese search engine giant Baidu Inc. in which it will use data from the Beijing internet firm’s users to determine their creditworthiness and underwrite loans for them, a first in the consumer lending industry. Though it’s primarily a search engine, Baidu entered the financial services industry several years ago. The company has also made an investment in ZestFinance, though the amount remains undisclosed.

ZestFinance Chief Executive Douglas Merrill said he sees an opportunity to sell underwriting services to a country of nearly 1.4 billion people that have little to no credit history.

“The Chinese credit market is a mess,” said Merrill, noting that 75 percent of Chinese consumers have no credit score. “There is this massive green space because the credit bureaus are so poor and have such poor credit coverage.”

Launched solely as an online lender in 2008, ZestFinance uses its algorithms to glean borrowers’ creditworthiness based on factors as subtle as the way potential clients fill out online forms – even incorporating such seemingly granular data as which words they capitalize.

Though it’s still a lender, most of the company’s revenue now comes from licensing its underwriting services, charging fees to other businesses that use its algorithmic software. Its deal in China takes things even further by adding data previously never incorporated into the underwriting process.

“This model runs entirely on Baidu search data and other Baidu data,” said Merrill, declining to be more specific about how exactly Baidu will use the company’s services. “It’s their data, so we don’t own it or control it.”

Monumental challenge

Demand for consumer credit in China is growing rapidly and outpacing old-fashioned, typically state-owned credit rating institutions, said Baizhu Chen, a professor at USC’s Marshall School of Business.

“Coming up with credit scores and measuring creditworthiness is an extremely challenging task in China,” he said, noting that many state institutions do a poor job of sharing credit information with each other and third parties. “The information is very fragmented, it’s not organized, and it has not been fully utilized.”

That’s created an opening for ZestFinance to partner with Baidu and use novel techniques to determine creditworthiness.

Ultimately, going to China may offer ZestFinance a chance to escape the highly competitive online loan underwriting market in the states, said David Choi, director of the Fred Kiesner Center for Entrepreneurship at Loyola Marymount University.

“In China, if you have great technology and then if you partner with a big Chinese company, you get so much traction,” he said. “The market is just not as competitive.”

Risky loans

After the 2008 market crash, U.S. banks deserted the subprime consumer lending category, leaving online lenders such as ZestFinance, Avant, Prosper Marketplace Inc., and industry leader Lending Club to fill the void.

In order to more precisely price risk for subprime borrowers, these firms started considering tens of thousands of alternative credit variables, including how long borrower applicants have had their current phone number, social network connections, and Web-browsing habits – anything that indicated creditworthiness.

But now the market has diminished due to lackluster loan returns and questions about loose financial controls.

“The institutional investor appetite for this asset class has tempered somewhat,” said Tom White, New York-based analyst with Macquarie Group. “There have been some early signals for some of these guys that credit performance is worsening.”

Case in point: After investor appetites for its subprime loans abated, online lender Avant of Chicago reduced its loan volume by about two-thirds and has plans to lay off about 40 percent of its 760 employees, according to reports.

Lending Club fired its chief executive, Renaud Laplanche, in May partly due to issues with the company’s lending practices. The Justice Department sent a grand jury subpoena to the firm in May as part of an investigation into the matter, according to a securities filing. The company’s market capitalization has fallen more than 80 percent in the last 18 months to $1.77 billion.

“Some investors are still waiting to see what will happen at Lending Club,” said White. “The buyers, the institutional investors who were driving the origination growth on some of these platforms, are not in a rush to come back to them.”

To be sure, ZestFinance is a smaller player. Avant has raised more than $654 million compared with ZestFinance’s $262 million. And the company, which originally used its software to underwrite online payday loans as part of a now-shuttered venture called ZestCash, hasn’t given up on lending.

It launched its subprime Basix loan product last year with $150 million in backing from New York investment management firm Fortress Investment Group. The loan program targets the top slice of subprime borrowers, so-called near-prime borrowers.

License to grow

Though Merrill said Basix is doing well and is expected to grow, the majority of ZestFinance’s revenue now comes from licensing deals with third-parties including credit unions, auto lenders, and BlueChip Financial’s online payday lender Spotloan.com. Notably, it’s that model that ZestFinance is taking to China.

“There are certainly benefits to the software-only model. On the balance-sheet side, you are not taking risk,” said Macquarie’s White. “You don’t have direct exposure to the loans, so it’s kind of an asset-light model, a higher-margin type of business.”

In addition to its new deal underwriting loans for Baidu, the firm formed a joint-venture underwriting company last year with Beijing e-commerce website JD.com called JD-ZestFinance Gaia.

Merrill said his company’s focus on underwriting rather than originating loans has struck the right balance.

“We are really a technology company that happens to be a lender,” he said.

“Ultimately, there are advantages to being a lender and advantages to being a tech company. Over the years, we decided we are a tech company. It’s just a better business model for us.”

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