LendingClub: Let The Punishment Fit The Crime

          Price Target $9.00               

May 19, 2016

The idea of “scaled punishment” goes as far back as eighteen hundred years before Christ when the sixth Babylonian king enacted the “Code of Hammurabi” to determine the appropriate punishment for various misdeeds in ancient Mesopotamia at that time.  LendingClub Corp’s (NYSE:LC) founder Renaud Laplanche resigned earlier this month after an internal probe found that he and three top executives knowingly sold investment banker Jefferies LLC about $22 million of loans that did not meet that firm’s criteria, and the market’s reaction to the news has been the equivalent of swatting a mosquito with a sledgehammer.  The punishment certainly did not fit the crime.

As of the first quarter of 2016, LendingClub’s total loan volume since inception exceeded $18.7 billion, and it exceeded $2.7 billion in Q1-2016 alone. The inappropriate loans accounted for less than one tenth of one percent of total loan volume; nevertheless, the stock’s value has plunged by nearly 60%!  Clearly the market has overreacted to LendingClub’s misdeeds.  Indeed, for the past two weeks, the bears in the marketplace have debated ad nauseam what they believe Lending Club has done incorrectly.  We intend to focus on what we believe the company has done correctly.

First and foremost, the responsible parties were terminated almost immediately.  Company founder Renaud Laplanche, who built the largest online lender in the U.S. by volume, was given the option of resigning within 24 hours or else being fired.  The board felt as if it were being misled by Laplanche for two primary reasons:  (1) Between late March and April 8th, Laplanche knowingly sold Jefferies $22 million in loans that violated the terms of the deal with Jefferies, and (2) A review by an outside law firm hired by the board shows he failed to notify the board of his 2% stake in a customer of LendingClub.  Between May 3rd and May 5th, “LendingClub’s board was presented with evidence that Mr. Laplanche knew many of the details of the $22 million loan sale and wasn’t upfront with directors about what he knew.”  On Friday May 6th, the board gave Laplanche 24 hours to resign or be fired.  The three top executives who were similarly involved were terminated concurrently.

Next, the company sought to make things right with Jefferies.  In mid-April, LendingClub bought the 361 loans back from Jefferies and immediately turned around and sold them to a conforming buyer.

LendingClub then delayed by a week the filing of its quarterly financial statements.  The filing was originally scheduled for May 9th, but given the recent happenings, the company took an extra week to ensure a proper review of its numbers.  The company hired an advisor to audit its historical loans.  The audit found that 99.99% of those loans showed no unexpected changes, prompting the company to announce that it would not need to restate its financial statements as a result of the material weakness discovered in its internal controls.  The company also announced that it received a grand jury subpoena from the Department of Justice on May 9th.  The company then contacted the SEC and “intends to cooperate with DOJ and SEC over the matter.”  According to the Wall Street Journal, “LendingClub grew so fast that its internal controls couldn’t keep up.”  The company has announced an effort to step up oversight of loans, do more to detect tampering, and retrain employees.

The company is now proactively looking for ways to obtain additional investment capital in its platform after losing Goldman Sachs and Jefferies.  Competitor Prosper Marketplace recently met with Fortress Investment Group and other potential investors regarding capital injections.  Because of higher rates, it is not difficult to believe that other banks, insurance companies, retirement plans, hedge funds, sovereign wealth funds, and other private investors may very well step in to fill the funding gap.  We really don’t foresee any equity dilution resulting from having to raise funds via a potential secondary offering within the next year, quite the contrary.  The company has stated that if it is not able to secure other funding, it could resort to a reduction in loan origination volume as well as usage of current capital to meet its liquidity needs for the next one year.

The halting of loan purchases by Jefferies and Goldman is not unexpected, given the circumstances.  Jefferies is self-explanatory, but what about Goldman Sachs?  Goldman is also interested in getting in on the P2P action.  In the over $840 billion consumer loan market, LendingClub snagged over $19 billion in loan volume in the first quarter of this year alone.  Last year, Goldman announced its entry into the online lending space.  Goldman Sachs has built its reputation on identifying and seizing profitable opportunities before its competition, and this may not be any different.  Operating in direct competition to industry leaders Lending Club and OnDeck, Goldman will not utilize a P2P system; instead it will act as a direct lender. The new division will operate through a website or an app, offering personal loans of up to $20,000 to individuals and small businesses.  With low-cost structures and no physical bank branches, Goldman Sachs can lend money at lower interest rates while still procuring a hefty profit.  As part of its effort to break into consumer lending, Goldman hired Harit Talwar from Discover Financial Services last year to lead the new 100-person division and is attempting to hire new recruits from the likes of LendingClub and Prosper.  Given Goldman’s plans, we had to raise a sardonic eyebrow at its lowered price target for LendingClub.

While FinTech is a relatively new concept that is experiencing some “hiccups” according to one crowdfunding expert Dara Albright, marketplace lending is by no means dead.  “Millennials are not going to suddenly start liking banks more than root canals.”  This is an opportunity for the young industry to learn and grow and for better business models to prevail.  LendingClub gained popularity on the basis of its unique business model in times when traditional brick-and-mortar money lenders were struggling with declining client activity. The company brought the concept of online peer-to-peer lending (P2P) to the financial services sector.  Traditional lenders were wary of the disruption a new business model could bring to the stability of the financial sector.  According to Albright, a tremendous “growth opportunity exists for marketplace lending – if it can figure out a compliant and efficient way to engage the retail investor and penetrate the $14 trillion retail retirement market.”

Laplanche said it best in his parting statement:  “As difficult as it is to step away from the company and its people, LendingClub is in good hands.  I look forward to watching the team execute on our vision.”  Based on the board’s prompt and proactive actions during this difficult time, we believe the company is in good hands, that the company will find other marketplace lenders, and that the share price will recover.

Disclosure:  We are long LC.  We do not have a financial relationship with the company.
Link to News Story