Technological developments have created significant evolution in the private lending space, supporting the emergence of alternative asset classes and enabling automated, non-dilutive lending.
Delivered via a software-as-a-service model, machine learning and artificial intelligence (AI) have the potential to greatly improve operations at financial services organizations. In many ways, this evolution is both necessary and long-overdue.
Customer preferences and expectations regarding financial services have greatly evolved in recent years. In both the business-to-business and business-to-consumer space, people expect a streamlined user experience and high levels of both personalization and automation. There are few financial sectors in which this is clearer than private lending.
Technological development has created significant evolution in the private lending space, supporting the emergence of alternative asset classes and enabling automated, non-dilutive lending.
Before we can explore the depths of this evolution, however, we must first lay some groundwork with a high-level explanation of the two major types of lenders: private and public.
Private vs. public lending
Public lenders typically approve loans based on credit score alone. They tend to be highly regulated, adhering to multiple standards and frameworks such as the banks and related lenders that we’re all familiar with. They tend to be much broader and more general in their focus, offering financing not just to businesses but also to individuals.
This means that interest rates for public loans are typically quite competitive and standardized.
Public lenders typically require that their borrowers provide tangible collateral to obtain their loan such as a steady job with future income potential or relative assets to lean on, but nothing beyond that. A business is under no obligation to allow a public lender input as to how it should run its business — this is known as debt financing. While some debt is secured against the tangible collateral, it’s worth noting that the majority of public debt is unsecured in the form of credit card debt and lines of credit, meaning it's not backed by assets that could be sold to repay investors in the event that the loan defaults.
Private lenders are typically more specialized, focused and complex, offering loans when public lenders won’t. Although they are not subject to the same standards as public lenders, they tend to evaluate borrowers on a much deeper level. In addition to credit history, a private lender may also assess a borrower's character, collateral and capacity alongside the conditions requested for the loan.
It's also important to note that private lenders may use their own credit scoring system versus public lenders — private lenders are typically far more interested in the potential return offered by an investment in a relative sector than they are in ensuring a borrower has a perfect credit score.
Interest rates for loans provided via a private lender tend to vary at the lender's discretion, as well. Typically, this is a measure of a business or venture's volatility and likelihood of default. Finally, private lenders that provide debt financing may accept collateral not directly related to the subject of the loan.
Private lenders are also the chief proponent of equity financing. Whereas debt financing is direct borrowing with some aspect of the business held up as collateral, equity financing is treated as the lender purchasing a direct stake in an organization. This may be achieved either through a public stock offering or via private placement of stock with specific investors.
Equity loans also differ from debt-based loans in that the borrower is under no obligation to pay back the money, and there is no financial burden on the company. Instead, investors in private companies are paid back through profit sharing. They are also given direct input on major decisions impacting the company and its future.While some public lenders do offer equity financing, it's primarily the domain of private lenders such as angel investors, business brokerages and venture capital firms.
Private credit: A new asset class opportunity for retail investors
When a private lender extends debt capital to a borrower, it's typically referred to as private credit, which differs from traditional debt in a few core ways. First, when compared against public debt, private credit is highly customizable and usually fully secure. Second, private credit also provides investors with alternatives to traditional investments such as stocks and bonds.
Because private credit deals are generally more complicated and require greater due diligence than a bank loan, they tend to offer interest rates that are not correlated to changes in the stock market. This is the most significant benefit of private credit as an asset class, as it provides investors with a compelling option for diversification from the more traditional fixed income and equity asset classes and allows for hedging against losses.Hedging, for the uninitiated, is a risk management strategy frequently employed by veteran investors to offset potential losses in the event that an investment goes sour. There is a myriad of ways an investor may hedge their portfolio, from diversification of investments to diversification of asset classes. The trade-off is that a hedged portfolio typically offers lower potential profits than a non-hedged one.
Addressing share dilution via AI, machine learning and digital transformation
Share dilution is one of the most prevalent and long-standing issues in equity lending. Essentially, when a company decides to either go public or sell privately, it defines the number of shares that will be sold. Each share represents a portion of equity in the company.
Every time a company issues shares through an initial public offering (IPO), or as a secondary offering, the float increases because common shares are sold to public investors. This dilutes the stock, reducing the company's earnings per share and each shareholder's equity position.
For private sales, whenever a firm raises additional capital via equity it functionally divides itself into smaller pieces. Existing shareholders often find themselves with a smaller stake of the company than they originally purchased. At the very least, their direct influence on company decisions will inevitably be lessened, as there are now additional stakeholders.
Non-dilutive financing represents a potential solution to share dilution and can be appealing to entrepreneurs/founders as it allows them to retain control of their company. There are scores of non-dilutive financing options, ranging from grants and tax credits to royalties, loans, private credit and revenue sharing. The core issue with non-dilutive financing is one of access and related complexity.
Even for an experienced business owner, it can be overwhelming to determine where and how to acquire non-dilutive capital. Historically, most entrepreneurs and executives generally lack the time to perform comprehensive research on tax credits and where to find loans, and many lack the expertise to assess the full scope of options available to them.
Fintech provides an answer to this problem, courtesy of automation. Businesses looking for financing options which leverage algorithmic software that provides them with solutions tailored to their industry, sector, and business model.
Montfort Capital (TSXV:MONT), for instance, maintains an AI-driven origination and lending platform that combines due diligence by human experts with a comprehensive, multi-phased automated assessment process. This allows the company to offer customized loans significantly faster than if it were to rely on manual processes, with an average timeframe faster than debt financing through a public source or equity financing through a venture capital source.
Companies offering AI lending platforms include Upstart (NASDAQ:UPST), which uses AI to provide loans based on education and employment; Kabbage, which uses automation to provide streamlined funding to small businesses; and Mambu, a cloud-native banking platform that offers lending, enablement and more.
Direct financing represents only a narrow slice of what fintech can support on both the lender and borrower's side. This includes, but is not limited to, portfolio optimization, algorithmic stock trading and portfolio hedging, fraud detection, loan and insurance underwriting, document analysis, risk management, dispute resolution and customer support.
On the lender's side, artificial intelligence and machine learning can provide a range of functionality including portfolio optimization, faster and more accurate assessments, algorithmic stock trading and portfolio hedging, fraud detection and loan/insurance underwriting.
Take the ownership and equity management platform Carta, one of the largest fintech companies in the United States. Carta allows private companies, investors and employees to track capital tables on the cloud. It also maintains a secondary marketplace known as CartaX, which allows shareholders and employees to sell their stocks prior to an IPO.
There's also Stripe, which offers payment processing and financial services solutions to online businesses. Leveraged by some of the largest digital and eCommerce brands in the world, Stripe is admittedly focused more on the retail side than the finance side. With that said, it also provides many other services, including invoice management, fraud prevention, budget management and identity verification.
It's not just the private lending space that's been changed by technological advancement. The entire financial services sector has entered a new era for institutions, lenders and borrowers alike. The technology born from this transformation represents more than a compelling investment opportunity — it's also a means by which investors can make smarter, better decisions regarding their portfolio and its future.
This INNSpired article is sponsored by Montfort Capital (TSXV:MONT). This INNSpired article provides information that was sourced by the Investing News Network (INN) and approved by Montfort Capitalin order to help investors learn more about the company. Montfort Capital is a client of INN. The company’s campaign fees pay for INN to create and update this INNSpired article.
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