Money Problems: The Playbook for Digital Lending in Emerging Markets
Guest Post. The future of innovation is global. We discuss it here.
One of the foundational infrastructures in global innovation has been fintech. Without payments, digital commerce, digital health and digital education are stymied. Without affordable credit, large purchases become unattainable for most consumers, and smaller ones add lumpiness to cash flow. With 2 billion people around the world that are underbanked, this is a critical piece to get right. That’s why it is a regular theme in this publication.
In today’s special piece, we have a guest post from Alex Branton and Saad Hasan of Sturgeon Capital about lending in emerging markets. Enjoy!
Access to capital in our markets is a fundamental problem faced by private businesses and individuals. A lack of financial literacy, misaligned incumbent incentives, thin-to-no credit files and incomplete and under-connected data points compound this problem. Solving these problems through solutions that scale has helped lending platforms reach the promised land of sticky and scalable revenues, positive unit economics, defensibility, durability, and operating profitability. While all the above present a significant opportunity, some prerequisites for startup success must be understood (startups who fail to understand these precepts are setting themselves up to fail). This blog post will outline these tenets.
There are problems, and then there are money problems
As the title suggests, “money problems” are complex, differentiated, situational and sensitive to economic cycles. What makes these problems complex are three core root causes listed below:
1) Businesses and consumers in emerging markets come in many shapes and sizes.
This is a fundamental concept in lending that is unforgiving when abandoned to chance and is characterised by heterogeneous consumer and business behaviour not just from country to country but city to city and even neighbourhood to neighbourhood.
2) In the face of inflation, Central Banks will always raise rates first and ask questions later.
Emerging markets tend to suffer from supply-chain shortage-driven inflation versus demand-driven inflation because of administrative and capital controls driven by current account deficits that have become harder to finance. Depreciation and supply-chain shortages are hyper-inflationary and lead inevitably to contractionary monetary policy, i.e., raising interest rates. The effects of a contractionary monetary policy are a double-edged sword for lending companies, where higher profitability goes hand in hand with higher impairment risk.
3) Effective lending requires an ever-increasing proficiency in collections.
Businesses and individuals in emerging markets have been borrowing informally for centuries, if not millennia, but through a complex social network of guarantors, credibility reports and penalty systems. Democratising lending builds greater social anonymity within the system, further reinforced through an impersonal relationship with the lender. This disassociation and anonymity often give rise to moral hazard, which can severely affect your collection's performance.
The three commandments of digital lending
Having looked at the underlying root causes of the problem set, it is time we look at some simple ways to ensure you are hedging against them. Together, they form the three commandments of digital lending. These have been collected through experience investing in digital lending companies in frontier eastern Europe and MENAP markets (Zood, Abhi, Trukkr, Billz, Finja and Oasis) as well as broader emerging market leaders globally including Kaspi, Kredivo, Akulaku, Mercado Libre, LendingKart, PayFazz and more.
Commandment #1 - (Scalable) Distribution Is King. Build It Creatively.
In our experience, this is a product of the borrower you are servicing, the data you have access to, and how optimised your service is for the vertical your borrower operates in. Some approaches we have seen work well are highlighted below:
Embedded distribution works well when there is a smartphone app, website, POS machine, or ERP product that a borrower already uses. This partnership-based distribution strategy allows one to generate maximum network effects and multiple clusters for data harvesting. It is a cost-efficient way to acquire customers but can be haphazard when it comes to conversion and engagement if your partner’s product is sub-par. If you find a partner with a super-focused product serving a large borrower base in a specific vertical, then an API-led model combined with a seamless origination and collection process can do wonders. An important consideration here is the ticket size and tenor length of your loans, where most models have demonstrated that lower ticket size and shorter tenor-based loans, i.e., three months or less, tend to perform better. Take, for example, Akalaku and Kredivo, BNPL-focused consumer lending companies that have started disrupting the credit card industry in Indonesia, where 20% of all transactions are paid through credit cards on major e-commerce websites. Kredivo estimates BNPL now accounts for 3-4% of all transactions on its partners’ platforms but, more importantly, has provided access to credit to 10 million customers in less than eight years. This is equivalent to the number of unique credit card holders in Indonesia; comparatively, credit cards have been around for at least 20 years. Additional benefits of the model for BNPL providers are the ability to access purchase history, merchant quality and a charge-back mechanism using the marketplace’s escrow and settlement systems through an API-led approach. Combined, they form an effective mechanism to finance e-commerce transactions effectively and at scale.
Closed-loop distribution works well when you own the ecosystem you are lending to. This model comes with significant upfront customer acquisition costs and higher short-term non-performing loan provisions, especially when building in a high-competition environment. However, once the portfolio and customer base mature, there are significant advantages around profiling the borrower and minimising non-performing loans long-term. A typical business model that works well is a vertically controlled marketplace that can control all touchpoints the borrower encounters, such as purchase history, logistics, warehousing, and payments. Enhancements to the model are based on the ability of the business to consume and integrate other sources of data concerning the borrower in their origination strategy, which provides an advantage that ages like a fine wine. For example, Kaspi has proven the merits of patiently building closed-loop models to deliver outsized profitability, engagement, and growth. For those unfamiliar with the company, Kaspi has 11 million monthly active users, against a population of 19 million and has become ubiquitous through layering almost any service a person in Kazakhstan requires on top of a bank account; claims of it being the operating system for Kazakhstan are not too far from the truth with almost any digital service available through Kaspi. Their outlier approach has enabled them to build a deposit-led balance sheet, offer payments, and offer e-commerce and lending across many verticals. The combination of these verticals has enabled a truly engaging lending flywheel while maximising customer utility driven by their “one-stop-shop” approach. This has culminated in their earning a multi-billion-dollar IPO on the London Stock Exchange.
Being agile means embracing multiple paths often.
It is important to understand, that there are multiple paths of distribution, and these are simply the most common ones we have seen in emerging markets. Your distribution strategy should focus on your customer’s characteristics and stickiest problem sets,, factors, which ultimately drive what channels you dedicate more resources to. It is also worth mentioning that as you scale and the markets you are addressing mature, your distribution strategy may ultimately change drastically and building optionality early into your distribution model, may pay considerable dividends in the future.
Commandment #2 - Overinvest in Risk Controls that are Battle Tested and Data Driven.
Most lending companies that are good at distribution but do not build a risk management function that is data/technology-led over time fail horribly. The only way to be non-tech enabled and survive in lending is to do lower volumes and chase bigger ticket sizes, but as a strategy that builds in long-term value accretion, this is a non-starter. Therefore, as a digital lender, your IP is your risk model, and that model generates a coordination mechanism that will be a category leader in profitability and online volume once the company reaches a sustainable growth state.
Using Big Data, AI, and effective data harvesting integrations should be a priority for digital lenders, and failure to use this unfair advantage is a cardinal sin. Risk management is a day-zero activity and starts with building a team of professionals who understand risk from both a conventional and experimental sense.
I urge you to consider the following age-old advice whenever you want to bet the farm on an opportunity to be a digital lender:
“Bulls make money, bears make money. Pigs get slaughtered.”
Every successful digital lending company in the world has played the long game, and those who have not tend to be consigned to the history books as either crooks or fools.
Commandment #3 - Cultivate your supply of capital by any means necessary.
If you are a founding CEO reading this, make no mistake: this is your most important job. Period.
So, you have distribution and a world-class risk management system in place, but you are a lending company without a supply of ready-to-deploy capital. This is potentially the worst possible situation for a Digital lender because you have created a customer churn and repayment delinquency scenario. The former will lead to your strongest competitors gobbling up your best customers, and the latter can make your business insolvent. Delinquency risk is especially important, true, and prevalent because of the absence of widespread credit-reporting systems and the use of credit scores in other transaction types, such as renting, for example, in emerging markets, that serve as deterrents in developed markets. This is understandable from the customer's point of view when their returns on capital borrowed outweigh any past-due payment penalties imposed, and very few alternatives are available to replace your company as a source of capital. Furthermore, the recovery cost may exceed the exposure at risk and the availability of law enforcement resources to enforce small recoveries. Therefore, you should always feel compelled enough to arrange capital, and your supply planning needs clear, long-term thinking around it.
Fear not, in emerging markets, what has worked for our portfolio companies and the greater universe is four fundamental processes:
1. Equity-led balance sheets in skeleton-style lending business models
2. Bank partnerships to generate credit lines and/or revenue share
3. Securitisation if there is a large and sophisticated enough money market
4. Syndication with specialized FinTech lenders, emerging as increasingly relevant balance sheet co-allocators.
Early-stage success is built upon raising your way to relevance
Equity-led balance sheets can provide a quick go-to-market solution but serious dilution for the company even when using venture debt backed by generous equity warrants. However, when there is no appetite for other models in sight, you must default to this model, but with a strict focus on building maximum dilution limits into the round and with unit-economics level profitability as a minimum requirement. Many businesses like LendingKart in India and PayFazz in Indonesia have raised efficient equity rounds to demonstrate proof of concept before engaging non-dilutive sources of funding meaningfully.
One point to note about how quickly you need to turn to non-dilutive financing is that equity-led models only work in markets where incumbents are tech-challenged, and higher competition can be a death sentence. This is especially true in markets where incumbents can catch up quickly and you are engaged in a slow and low APR lending vertical.
Partnering for success is an incentive alignment exercise
Bank partnerships require immense levels of relationship building and maintenance where clear segmentation of markets and strategies is especially important. Beware the middle manager who feels you are in the way of their promotion and looks at you as an adversary. Strategic integrations with the bank are also hard to manage, with disastrous effects in terms of focus diversion and adhering to bank-led risk assessment criteria that are unreasonable/overly risk averse. Hiring the best and most-networked-in talent possible from the banking world is a responsibility that you must take on early with a mandate built on diversification, clarity of goals, and executive-level sponsorship. Southeast Asia has taken the lead on bank-based financing lines, with Mizuho Bank providing a $100m credit line to Kredivo as part of their Series D. We have also seen our portfolio companies raise mixed rounds earlier with strategic investors looking to provide a mix of equity and debt. We cannot encourage this enough because great partnerships are built on aligned short-term and long-term incentives, and being a revenue centre for an established financial institution is never a bad place to be.
Securitisation is always the end-state
Securitisation is an expensive process that requires one to prove that their debt product can deliver meaningful risk-adjusted returns to debt investors. Balancing gearing ratios and adhering to optimal capital structure requirements becomes a natural requirement. It also requires third-party verification credit rating issuances and requires the business to be cash-flow positive.
Why local debt is always better
In our experience, companies leveraging local debt markets and utilising localised instruments are best placed to win. The main reason is rooted in depreciation risk and its consequential unit-economic impact on your loan portfolio, which is likely more sensitive because of its shorter tenor. Another notable reason is that as an early-stage business, hedging programs for debt raises under $100m are not worth the administrative costs and premiums paid. Therefore, raising local debt is the right move, but how it needs to be accomplished is a function of localisation. Not too far in the past, we saw Nubank build a balance sheet using money market funds to support their credit card portfolio in Brazil. General Atlantic famously passed on Nubank over multiple rounds because they thought a bank without a traditional balance sheet could not succeed; with a current market cap at nearly $40B, this decision must still hurt. The hunt for alternative local funding sources means you must innovate and offer a debt product that attracts alternative sources of liquidity locally.
Example: Abhi has proven that local investors are hungry for debt
Most emerging markets have large and liquid pools of local capital invested into incumbent sectors that are poorly managed and lack innovation. Pakistan’s financial sector, for example, is under-rated and overly defined by a shallow equity market. The debt market is overlooked, and money market funds have been quietly growing at double-digit growth rates every year to the point of having hundreds of millions of dollars of liquidity now available. Knowing this, the team at Abhi was able to execute an over-subscribed multi-million-dollar Sukuk raise using a local investment management firm in less than three months.
History certainly rhymes because, not too far in the past, we saw Nubank build a balance sheet using money market funds to support their credit card portfolio in Brazil. General Atlantic famously passed on Nubank in multiple rounds because they thought a bank without a traditional balance sheet could not succeed, a decision that must hurt today.
Example: Mercado Libre has re-defined the bar for digital lending success in emerging markets
Look no further than Mercado Libre and associated businesses to understand what a closed-loop distribution model can achieve with a sophisticated securitisation program. As investors, we look for positive signals and patterns worth paying attention to. With that said, we’ll leave you with the following passage from Mercado Libre’s Q4’22 Investor Letter, which offers an insight into what we look for when assessing a Digital Lending company.
“Mercado Credito continued to deliver strong results in Q4’22 with a period-end portfolio of $2.8bn and IMAL spread of 48%. This was the highest spread achieved in 2022, a function of adjustments to our APRs, broadly flat originations (which means the slower formation of new provisions than earlier in the year), a larger mix of lower risk cohorts in all markets, and better asset quality. The steps we took in mid-2022 to mitigate the risks of a weaker lending environment - particularly in Brazil - have worked as intended, and, as a result, our early <90-day NPL improved sequentially to 10% in Q4’22 and was broadly stable year-on-year. Brazil contributed notably to this improvement in both the Consumer and Credit Card books. Looking at the year, we are pleased to have been able to strike a good balance between risk management, profitability, and growth at Mercado Credito. Nevertheless, we remain alert to the short-term headwinds that the business faces and we will maintain a cautious posture until we are confident that the cycle has turned.”
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Emerging markets remain an exceptional opportunity for lending startups that can find business model fit and focus on structurally low Non-Performing Loans use-cases, with digital collections and locally sourced debt as cornerstones of the strategy. Characteristics of emerging markets retain a bias towards significantly higher rates than developed markets, lower cost of operations and under-developed incumbents, leaving the long-tail of consumers/SMEs under-or-unserved. With higher rates throughout the world, liquidity is at a premium and lending companies need more liquidity than the average startup, therefore making fundraising a much more difficult activity than ever before. More than ever however, a focus on unit-economics and building in the basics of lending into your business model is a base-line requirement to raise capital, and if the numbers work, there is enough foreign and local capital available and ready to invest.