Season Investments


A Billion Dollar Hiccup

Posted on May 17, 2016

“This is a major hiccup.” – Gilles Gade, CEO Cross River Bank

2016-05-17_LC_logo.pngFor the past couple years our firm has been a strong proponent of the peer to peer lending space. Our strategy, which we rolled out to clients in mid-2014, has produced great returns with little to no volatility over that timeframe. It wouldn’t be an overstatement to say that peer-to-peer (“P2P”) has been a highlight for us and our clients over the past two years. Last Monday Lending Club (LC), the undisputed industry leader in the P2P space, shocked markets when it announced that its well-liked founder and CEO, Renaud Laplanche, had been asked by the board to step down. Over the past week there has been a flurry of articles, most of them exceedingly negative, written about the internal events that led to this decision. What’s more, the company’s stock price has dropped like a rock erasing nearly $1 billion in market value in a week. Given the fact that we use Lending Club’s platform for our peer-to-peer lending accounts we wanted to address this topic, specifically what implications it might have for our strategy going forward.

Over the past decade Lending Club’s business has ballooned to nearly $20 billion in total originations and nearly half a billion in annualized operating revenue. The company is widely hailed as the leading innovator in the “FinTech” space, and has received numerous awards and recognitions along these lines (most recently the 2016 Tribeca “Disruptive Innovation” Award). A public offering in 2014 sealed Lending Club’s position as the largest and most visible player in this burgeoning sector of our financial economy.


But all of this success came to a screeching halt for Laplanche a little over a week ago when the company’s board called him into a private meeting and gave him 24 hours to resign or be terminated. We have read a plethora of articles over the past week in an effort to fully understand the events that led up to this decision. The best synopsis we’ve read is probably Inside the Final Days of LendingClub CEO Renaud Laplanche, published by the Wall Street Journal. This piece and others have thoroughly dissected the known facts which can be broken down into two primary events:

Misrepresentation of Loans Sold to Jeffries
LendingClub securitized and sold $22 million of loans to investment bank Jefferies, LLC. Jefferies required that all loans in the portfolio include recently updated power of attorney language in the underlying borrower agreements. LendingClub employee Andreas Oesterer falsified the dates on $3 million worth of the loans in this portfolio to make them look like they were originated after the power of attorney language had been updated. Mr. Laplanche was made aware of this falsification in March, at which point he immediately spoke to the firm’s chief compliance officer, Tim Bogan. Mr. Bogan investigated the issue and eventually reported his findings to the company’s board. LendingClub ended up buying the loans back from Jefferies in April, at which point another buyer promptly purchased the portfolio.

Nondisclosure of a Financial Conflict of Interest
On April 26th LendingClub revealed in a securities filing that it had invested $10 million into a holding company that in turn invested in funds that bought LendingClub loans. Apparently the company’s board decided to make this investment at the recommendation of Mr. Laplanche who failed to disclose that he personally owned a 2% stake of that same holding company. Obviously Mr. Laplanche had a financial conflict of interest in making this recommendation that he should have disclosed to the board.

In response to these two issues the company’s board, which includes former Treasury Secretary Larry Summers and former Morgan Stanley chairman John Mack, took swift and decisive action in cutting ties with the company’s founder along with several other executives. LendingClub is a publicly traded company, and as such is subject to extreme levels of scrutiny by both regulators and shareholders. Missteps such as these have to be dealt with publicly and with as much transparency as possible.

That said, we are absolutely stunned by the way the financial media has (mis)handled this story. Like sharks smelling blood in the water, the journalists and talking heads have not hesitated to plaster the internet and television with headlines suggesting the collapse of an entire industry. How they connect the dots between the facts and their broad stroke conclusions we have no idea. Consider this video and corresponding article from Bloomberg. This conversation takes place between one of Bloomberg’s primary anchors, Carol Massar, and a well-known columnist Michael Regan.

Regan: Obviously the concern with LendingClub is they’ve had this phenomenal growth…but the problem is how will they keep funding those loans?
Massar: Who’s going to buy those loans, right?
Regan: Who’s going to buy those loans? 

Yes, who is going to buy those loans? Other than the insurance companies, banks, hedge funds, sovereign wealth funds and hundreds of thousands of private investors, who might LendingClub be able to find to buy these loans?

Massar: At some point, though, is there some value in their assets…what’s left?
Regan: Yeah, I think there’s going to be a lot of speculation about what happens with them. Prosper Marketplace maybe will be taking a look at them.

Are we really talking about the company as if it’s a worthless shell on the verge of bankruptcy? There’s absolutely no basis for what’s being insinuated here.

Regan: It’s hard to really say where this is going to go because there are so many question marks about this company. And, you know, their whole growth depends on people investing in these loans and there’s too many question marks now about whether that’s feasible.

Yes, all those question marks about whether or not it will still be feasible for investors to buy loans from LendingClub. Wait…what are those question marks again? The only specifics Regan mentions in the video are a handful of known issues that shouldn’t have any long-term impact on the company’s fundamental business model.

Regan: You know, one thing I wrote about is that if you buy a loan from LendingClub you’re basically stuck holding it to maturity.

This is literally one of the most obvious things you could possible say about a LendingClub loan. It’s not insightful, it’s not shocking, it’s not concerning, and technically it’s not even true…there is a secondary market called FOLIOfn for those who really want to go through the trouble of selling their notes to another investor.

Regan: People are questioning now, well is the credit cycle turning? Is now a good time to be investing in these loans?
Massar: Right, or is the FinTech model not kind of perfect with these kind of lenders?

When are investors NOT questioning whether or not the credit cycle might be turning, or when it might be a good time to make a certain investment? And how does that have anything to do with the recent events at LendingClub, or the efficacy of peer-to-peer lending as an asset class, or whether the FinTech model is perhaps “not kind of perfect”? These comments are total fluff.

I would have loved to been at the table during the pre-interview huddle. “Okay, let’s show a chart of the stock price going down, then you talk about how bad things are, then I’ll ask a leading question about how negative everything is, then you talk about something obvious that everyone already knows - but don’t forget to make it all sound super horrible!” This kind of journalism is frustrating to say the least, but it’s a product of the 24/7 news cycle that is required of media outlets in today’s information age. Everyone always has to be talking about whatever is the latest hot story – even before they fully understand it - and the more negative something is the better it sells. That’s the bottom line, and everyone knows it. The problem is that often times the mishandling of otherwise important and interesting information can become a self-fulfilling prophecy in its own right – just look at LendingClub’s stock price.

The real facts, as we see them, related to the Jefferies transaction are as follows:

  • LendingClub decided to begin securitizing its loans as a way to feed the appetite of institutional investors looking to place large amounts of capital into this attractive asset class. Securitizations have not played a role in LendingClub’s growth to this point, and the deal with Jefferies was one of the first they had worked on. Dipping their toe into the securitization market was part of LendingClub’s evolution. It was (and still is) a good idea, and will surely be an interesting growth channel for them in the future.
  • In the process of creating the security for Jefferies, an underling made the stupid decision to adjust the origination date on a chunk of loans by a handful of days in order to make those loans adhere to a technicality in the requirements for the securitization. Why he did so we’ll never know. Maybe he was under some sort of deadline, maybe he was just lazy and he didn’t think it would be a big deal, or maybe a superior directed him to do so.
  • This decision put the entire securitization out of compliance with Jefferies requirements. LendingClub executives investigated and addressed the issue. They bought the $22 million loan portfolio back from Jefferies and promptly sold it to another investor who was eager to own it.
  • Additionally, the company hired an adviser to audit historical loans. That audit found that 99.99% of those loans showed no unexpected changes. The only real discrepancy was in the $3 million worth of loans with the adjusted origination dates. We’re talking about $3 million…out of total historical originations of nearly $20 billion.
  • It’s important to note that absolutely none of this has anything to do with whether or not the underlying loans themselves were good investments! Whoever ended up with that $22 million portfolio will almost surely enjoy the types of consistent positive returns P2P investors have grown accustomed to over the last ten years.

The facts, as we see them, related to Laplanche’s non-disclosure of his financial conflict are as follows:

  • Laplanche is worth tens of millions of dollars. He surely has investments spread across many different things, and it’s natural that he would own a stake in an entity that invests in peer-to-peer loans. He is “eating his own cooking” so to speak.
  • It’s also natural that he would advocate for the corporation to make a similar investment. It’s not uncommon for large companies to try to make a return on some of their operating reserves by spreading them across certain types of investments. The dollar amount in question here, $10 million, is an insignificant amount in relation to the company’s balance sheet which carried over $500 million in cash at the end of the first quarter.
  • Why he failed to disclose his personal investment in the holding company we’ll never know. Maybe he forgot, maybe he didn’t think it was necessary or maybe he had some ulterior motive that he was trying to hide. Does it make sense that he knowingly risked his career to hide the fact that he owned a small stake in a company that LendingClub invested $10 million into? We don’t think so.
  • Regardless, it’s important to note (again) that this issue has absolutely nothing to do with peer-to-peer loans themselves, or even with LendingClub’s business model. It doesn’t even suggest that the $10 million investment won’t end up being a great one, and it really has nothing to do with anything fundamental to the company.

At this point we see no reason to believe that the past weeks’ events will have any bearing whatsoever on our peer-to-peer lending strategy. Our results are based on our ability to screen for attractive loans, and to minimize default rates relative to the yields we are generating in client accounts. Our strategy continues to perform well and is one of the highlights in our client portfolios. It’s LendingClub’s actual shareholders that have been feeling the pain, and the question for them is whether or not this will turn into more than a billion dollar hiccup along the company’s growth path. If not, then we may look back on this moment as a great buying opportunity in a stock that has been unduly beat up as a result of bad financial journalism and a fear-dominated market. It wouldn’t be the first time, and it surely won’t be the last.

david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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