If you want to understand LendingClub (NYSE:LC), one of the first things you need to grasp is where the money to finances its marketplace loans comes from.
It's tempting to think that LendingClub's main business is to match small mom-and-pop investors who are looking to earn a little extra yield on their savings with small-time borrowers who want to consolidate their credit card debt or student loans. But this is an outdated assumption about LendingClub's business model.
Of the three types of investors that finance loans in its marketplace, the standard retail investor is far and away the least important.
You can get a sense for this by looking at the flow of funds through LendingClub's three investment channels: the issuance of member payment dependent notes, the sale of trust certificates, and the sale of whole loans to qualified investors.
Since LendingClub's inception, only 19% of the loans originated in its marketplace have come from member payment dependent notes, which is how the typical retail investor invests on LendingClub.
The second largest category consists of the sale of trust certificates to accredited investors (high net worth individuals) and other types of qualified purchasers. This adds up to 29% of LendingClub's total originations. "Certificate investors typically seek to invest larger amounts as compared to the average note investors and often desire a more 'hands off' approach to investing," states LendingClub's most recent 10-K.
The third and largest category, accounting for 52% of total originations, consists of whole loan sales to institutional investors, such as banks, hedge funds, and others who seek to hold the actual loans on their balance sheets. "To meet this need, we sell entire standard or custom program loans to these investors through purchase agreements," explains the company. "Upon the sale of the loan, the investor owns all right, title and interest in the loan."
LendingClub's business model is becoming increasingly dependent on the third sources of funds in particular. In the latest quarter, a full two-thirds of its loans were originated for investors in the final category -- that is, purchasers of whole loans.
All of this matters because the investors in the third channel are the most sophisticated. Unlike small retail investors, who may or may not have a good understanding of LendingClub's fundamental strengths and weaknesses, large institutional investors track these things closely, ready to pull their funds from LendingClub's marketplace at the first sign of trouble.
This in fact is exactly what happened to LendingClub last year, after a number of questionable practices surfaced leading to the resignation of the online lender's CEO. As the company explains in its latest quarterly regulatory filing:
As a result of the circumstances relating to our board review into certain private loan sales to a single institutional investor in contravention of its requirements and other matters, and the resignation of our former CEO, a number of investors that account for, in the aggregate, a significant amount of investment capital on the platform, have paused their investments in loans through the platform. While many of these investors have returned, many have invested at reduced levels, and it is possible that some investors may not resume investing through our platform. As a result, we may use a greater amount of our own capital, compared to past experience, to invest in loans.
The fact that investors "paused their investments in loans" cuts to the heart of LendingClub's business model. As the company goes on to explain: "Failure to attract investor capital on reasonable terms may result in the Company having to use additional capital to invest in loans or reduce origination volume."
Many of these investors have since come back into the fold, but that won't always be the case. The next time LendingClub runs into trouble, these investors may decide to remain on the sidelines.
In short, while it's tempting to think that the risk of owning LendingClub's stock is decreasing as its track record lengthens, the company's growing reliance on a small number of large, sophisticated institutional investors to fund its marketplace lending platform suggests otherwise.