Prospa's precarious prospects

The big banks are facing increased competition from a range of existing players and new entrants, as we highlighted last week in The Big 4's biggest battle. Among the latter are a host of small financial technology companies, known as (get this) ‘fintechs'.

These nimble young players, focusing on profitable areas and unencumbered by legacy products and systems are all set to steal the bank's lunch – more likely a few tasty morsels.

Prospa – which was set to list on the ASX on Wednesday but is now delayed – is one such player. The online lender focuses on loans to small businesses, usually unsecured amortising loans that are repaid within a year. This is high-risk lending, but returns can be great. Historically the major banks have dominated this area, but lately they've largely been unwilling to match demand.

There are a few reasons for this: capital requirements are typically high (to reflect the risks), while returns have historically been eclipsed by safer home loans; administration costs are also relatively high, while loan sizes are typically below that of a mortgage; and it can be hard to assess risk, especially if the business has no assets to offer as collateral – banks have typically insisted that small business owners pledge their homes instead.

Filling a gap

Prospa was set up in 2012 to fill the gap. Founders Greg Moshal and Beau Bertoli, who are now joint chief executives, say they were frustrated at missing out on opportunities due to a lack of small business financing options. So they decided to do something about it.

The company has grown quickly, but is still small in the context of the market opportunity – with a loan book of only about $200m – so continued growth seems likely.

There are other attractive features. The lender's technology allows for speed and scale and is unencumbered by costly legacy systems (common to banks). Newer data analysis methods also help its credit decision making, which is an important capability for risky lending.

As a non-bank, Prospa is also not subject to the burdensome capital requirements. And it's unlikely to face capital constraints any time soon, as the raising will provide it with healthy lending resources. In time, it may also be able to find more cost-efficient sources of financing that'll boost margins.

All the same, we recommend you steer clear. Successful investing means imagining what the business might look like in the future, and that warrants caution.

Tough competition

Prospa's growth prospects are countered by rising competition. The prospectus lists a range of similar fintechs and more are likely to enter the market. There's nothing to stop these new entrants from gaining similar capabilities, such as with systems and data analysis.

We also expect the major banks to be more active in small business lending, though history suggests their appetite can wane.

QuickBiz was recently established by NAB and is likely to develop into a large competitor. NAB can also offer small businesses a wider product suite thereby increasing customer stickiness.

Major banks may also develop partnerships with existing fintechs, as with Commonwealth Bank's tie-up with OnDeck (a multinational small business online lender). In this arrangement CBA can manage the customer relationship and offer services, while passing on the lending risk (and avoiding capital requirements). At the same time, OnDeck has scale to earn a sufficient margin.

Numerous barriers

Large technology companies might also enter the market. The likes of Alibaba and Amazon have been offering loans to customers and merchants (often small businesses) around the world. Using unique data from transactions on their platforms, they can make better-informed lending decisions. Prospa may not have access to such rich data, despite open banking.

It will be hard for Prospa to compete with these larger players, which can use established customer relationships to drive profitable growth. Prospa doesn't have such capability, with its sales largely through intermediaries.

Prospa does provide some loans directly to customers and it aims to do more, but that might require a big uptick in marketing costs. Large partnership deals could also eventuate, but that might also eat into margins and Prospa isn't in a strong bargaining position. Existing customers may not all stick around.

As it stands, Prospa's offering is subject to commoditisation. That means slim margins and higher risk for investors.

Least resistance

In any case, long-term profitability is dependent on sound lending practices. Loan growth can often follow the path of least resistance. That is, cheaper loans with fewer conditions attract willing borrowers.

The quality of lending is, however, difficult for outsiders to determine. The lack of collateral and riskiness of the loan portfolio makes it tougher still.

Prospa's data and risk assessment capabilities are likely to improve over time, but they are also still to be properly tested in a market downturn. It's the unexpected that can hurt lenders. We're unsure of the implications given that the business model is still in the early stages. Prospa is also outside bank regulatory purview.

Pricey IPO

All businesses have risks and, for the right price, can make an attractive investment. A margin of safety is needed. But that's not on offer here.

With the expected offer price of $3.64 representing a multiple of around 3.8 times book value, Prospa is priced for significant growth. And it is indeed well set to grow, but it's questionable whether it will be able to maintain its market position and profitability as it does so, particularly in a tougher economic environment.

We wish Prospa well – but we recommend that you give it a wide berth.

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