We’ve seen hundreds of consumer and SME lending companies across Latin America over the past six years. We’ve invested in several SME lenders, most notably Omnibnk, but we have only invested in two companies doing consumer lending. We have also given feedback to those companies that we didn’t invest in. Here’s a quick overview of how we think about the lending space in Latin America.
We evaluate lending startups across five main variables:
- Distribution – how do you get clients without spending a ton
- Risk – Do you know how to do risk?
- Collections – How do you get people to pay you?
- Source of Funding – Where are you getting the money to lend?
- Technology – do you actually use technology for an edge? Or are you making marginal technology improvements?
If you can do 1 of these better than anyone else, you might have a small business. 2 of these, a nice business, 4 of these, a very good business, but you need all five to build a $100M+ or even unicorn business.
Why does each one matter?
We think about startups that only have some of the first 4 as “fin but no tech” companies and startups that fit #5 as “tech but no fin”. Both can kill a company.
If you don’t have a way to get clients without spending a ton of money, you’ll have negative or not great unit economics. And when someone else figures out distribution, your costs will only go up. Make sure to pick the correct niche, trying to attack all potential clients will likely not work. The best fintechs have a wedge that they use to go down market later. A16z’s podcast goes deeper on distribution and segmentation.
Questions to ask: How do you get your clients? What is your distribution edge that others can’t do?
“If you don’t understand risk in a financial business, you have no business.”Francisco Saenz, Magma GP
In the US, there are positive and negative credit scores. You get positive points for paying your bills on time, negative for not doing it. In LatAm, it’s only negative. This means that if you pay all of your bills on time for 10 years, but then miss one payment, the only thing on your credit score is 1 missed payment. This means that LatAm fintech founders need to understand risk better than their US counterparts who can rely on well developed traditional credit scoring to make decisions.
The vast majority of lending startup founders have no finance background and have no idea how to think about risk, much less calculate it.
Many times, entrepreneurs will say that they will create a new credit score, and then sell it to banks. But no bank will trust a startup’s credit scoring system until it’s been proven with hundreds of millions of dollars, sometimes more. They’ll likely say “Great, but I can’t double-check the credit score you’ve calculated.” Or, “If it’s so great, why don’t you take the risk and lend against it?”
Banks will have trouble trusting your new credit score because of Basel 2 and 3. These regulations require banks to hold 35% of a loan size in cash on their books if they can’t get a traditional credit score. The startup’s score won’t be traditional, so a bank is unlikely to partner with a startup until it can show likely hundreds of millions of dollars in loan traction.
We like to see startups that are taking risk on their own book, with at least a percentage of loans, so that they can scale more quickly. If you’re relying on banks to fund your new credit score, you likely won’t be able to scale very quickly.
Questions to ask: How do you think about risk? What’s the biggest loss you’ve ever taken, in your business and in your life, and what did you learn? Why are you the best person to understand this risk, compared to everyone else?
It’s easy to lend $1M. I can go to any Latin American street corner and lend $1M in about 10 minutes. The key is to get it back. How does the startup think about and do collections? Can they get into a payment flow (think Stripe and Square Capital, where they take the money directly out of income) or Libranzas in Colombia, which are loans taken directly out of payroll. Most banks don’t even bother to collect $500 or less debts, as it’s not cost-effective, so if a startup is lending small amounts, how will they do collections?
Questions to ask: How do you think about and perform collections? How will your collections method be better than current banking collections methods? Do you have an unfair advantage? What is your expected loss rate? And how did you calculate it?
Another big question to ask is where are they getting the money to lend? Startups can refer leads to lenders. Startups can lend off their own balance sheet (lending equity money), get venture debt, find funding partners, or fund the loans and then sell them off to other partners. Funding partners can be banks, asset managers, family offices and crowdfunding. Startups can create many different structures that mix equity, debt, funding partners, and selling loans off.
We are not fans of crowdfunding, as to get scale, you likely need larger funding partners. Crowdfunding is very hard to scale, and investors are fickle, taking their money away when things go bad. Startups must think about their funding sources from day one, and work with risk management or else they’ll risk getting trapped as a small business that cannot scale.
Questions to ask: How are you funding operations today? How will you fund in the future? Who will be your partners?
Technology – Fin but not tech
There are many “fintechs” that are “fin” but no tech. And many that are “tech” but no “fin”. We need both to make an investment work. Why? Because if you’re not really using technology, you’ll be at a huge disadvantage when your competitor that does use technology comes along and can offer lower rates, better collections, and better risk management than you can. You will be unable to react or compete because you won’t be able to scale due to the large number of employees you need to offset the lack of technology.
This doesn’t mean that the company must have technology that’s amazing from the start, but that the company should be tech first, and designed to scale from day 1. There are startups in LatAm that have 1000s of employees and less than $500M in their loan book. That’s less efficient than a bank, and when they face real competition from a real fintech, they will have lots of trouble.
At some point, a fintech will be valued as either a real fintech, or it will be valued as a traditional lender, with a small premium for having better technology. Lending Club is the cautionary tale. After IPO’d with a stock price that peaked at $128 and valuation of ~$11B, they have lost ~90% of their value, and are now being valued as a traditional lending company.
Questions to ask: How will you use technology to scale your business, and keep headcount low?
Avoiding LSaaS: Loan Sharking as a Service
The vast majority of consumer lending companies we’ve seen are re-creating loan sharking or making a marginal improvement, but with technology. Some business lending has gone down this path too, but it’s a bigger problem in consumer lending.
We don’t want to invest in LSaaS, because we are not comfortable with it ethically, but also because loan sharking is a crutch that allows you to skip the risk management, distribution, and collections parts of your business that will be extremely important to generate scale.
When you’re charging 100% or even 2000% interest, it doesn’t matter if you have a huge loss rate. Your book can handle it. But when a competitor that understands risk, distribution, collections and technology correctly, they’ll undercut the tech enabled loan shark, and the business will likely have big issues.
We also think it’s short term thinking: if you’re charging astronomical rates, you will only get customers in search of a last resort. Eventually, they’ll find themselves in dire straits, and if they can’t borrow or find someone to plug the gap, you’ll have very high, unexpected defaults at some point. Your high rates are killing your own clients. It’s not only bad karma, but bad business.
If you have a lending business that you think fits with how we think about lending, we’d love to hear from you at Magma Partners.
Nathan Lustig is the Managing Partner of Magma Partners, a Latin American VC fund with 70 investments across Latin America since 2014.