Crossing Into New Markets
Prime Meridian launched its latest fund, Special Opportunities Fund, in June. With that, it entered into two new markets – litigation finance and life settlements – and included existing sectors it currently invests in such as: marketplace consumer, small business and real estate loans. Don Davis, CEO and portfolio manager at Prime Meridian, spoke about the marketplace lending space as well as the new markets they’ve entered. Here is part one of the conversation.
Q: When you look at the marketplace lending space today, what does it look like and what are its prospects?
A: We’re still excited about the marketplace lending space. It’s still growing at double-digits per year. It’s naturally slowed down over the years. One of the areas where it looks quite a bit different from when we first invested, in 2012 when we launched Prime Meridian Capital Management, is in the number of lenders. Back then, you had Lending Club and Prosper as the only two players and there wasn’t a lot of competition. And it was just consumer lending.
Since then, the industry has matured quite a bit and there’s quite a bit more competition on the consumer side and there’s competition with other verticals such as small business lending, real estate bridge loan lending and other forms of niche lending as well. So the industry has to some extent become commoditized. But the good news is, as that has happened, it’s actually bode very well for us at Prime Meridian. We’re not an originator that is competing against the other originators. So that just allows us as the institutional investor, on behalf of our investors, to be more selective and cherry pick the types of loans we want in our funds.
Q: I listened to your panel discussion from the Lendit Fintech 2018 conference and the market has really matured. The granularity of the data on loans, the use of artificial intelligence, all has really made lending quite interesting and sophisticated today. Does that make it more challenging or open to new opportunities?
A: We think that makes it more compelling to a certain extent. We’ve been doing advanced analytics on the space and loans, back testing and forward testing, since the beginning. Over the past year or so, we’ve been building AI and machine learning software that gives us very fast and near real time predictive analytics on these loan portfolios and all the verticals we invest in.
We think it makes it more interesting and keeps us a step ahead in the game. But it has to be the right technology that you are using. The term AI is being thrown around pretty loosely. And the AI of just a few years ago is not nearly as good as the AI today. There are still a lot of people using outdated technology for the machine learning software. And I’d emphasize that just because you use AI and machine learning doesn’t make someone a great hedge fund manager. It’s just a tool that can make you do what you already do much, much faster. We can get to the same result without it. But AI helps us do it at lightning-fast speeds.
Q: In every market there is a race to get the best deal or trade. Has this market accelerated in terms of execution time, but where you still have an edge?
A: A lot of that applies to the consumer loan vertical. In 2013, they used an API that was very fast and robust. We got in very quickly, with fast execution speeds, up to 50 pings per second. Prosper and Lending Club were a little worried about an arms race at the time – meaning whichever investor had the best technology would take the best loans. So they put in speed bumps. Lending Club said you can ping our server no more than 1 time per second and Prosper said you could ping the server up to 20 time per second. Either way, nobody could go faster.
So we had to come up with other ways to optimize the execution without violating those rules. But it became evident that it did not become as paramount as everyone once feared. A lot of the big institutions that came into this space like banks and other institutional investors, were not cherry picking. They just wanted the loans and would buy it passively, hold it on their books, leverage it up, securitize it, rinse and repeat. So they didn’t have the same objectives as we have, which are risk adjusted returns for our investors. So there wasn’t huge competition for actively selecting these loans. The vast majority of the volume today is done by passive investors. You still need fast execution speed and know what you are doing.
And with the other verticals such as small business and real estate, things are done a little differently. So you can get loans in a different manner.
Q: Has the return of banks to this space changed the marketplace and if so, how?
A: The return of banks to this space – buying up loans – is healthy. And a lot of the banks are buying just the top grades only. Generally, they want the lower coupons with lower risk and then securitize them. And even if they don’t securitize it, they can leverage it either way. So they are usually interested in just the top three grades with Prosper, it’s AA and AB and with Lending Club it might be A, B and C. We think it’s healthy because its extra volume, extra revenues and profits which keeps them healthy. We invest in all the grades but focus a bit more on the mid-grade loans.
Q: You have always been focused on the U.S. market. Any interest in others?
A: We have a global investor base. But our market is the US and is diversified all over the US. I’ve said from day one that this isn’t a lifelong mandate. So if there is something that is very appealing and the risk/reward was exceptional, and you plug in all the factors, we’d definitely consider it. You have to factor in things like currency hedging, risk/reward and the value-add you are bringing into the portfolio. So if we believe strongly enough in it, we would take a look. We just haven’t seen the value that would make it worth it. Emerging markets have a higher yield but there are different types of risk. If you look at other developed markets, the yields are lower.
Q: You come from a very traditional markets background, trading futures and liquid instruments. The past several years, you’ve traded these alternative markets. As you look at the risk profile, are you still happy you made the transition over?
A: What I am good at and wired to do is being a great portfolio manager. I’m very good at portfolio construction, risk management and asset management and deliver above average adjust rates of returns and do not blindside my investors. The team around me has similar experience as well.
We’re not originators. And this question has come up when we launched our new Special Opportunities Fund in June 2018 which includes life settlement and litigation finance, which we haven’t managed before. How we invest then, since we are not originators, is to find the best originators in those markets, and work with outside consultants and credit experts who know those markets. We create what I believe are better risk adjusted portfolios, and therefore better risk adjusted returns than most others, even if they are very experienced in that space.
Am I happy with the move? Absolutely. As early as 2006, my partner Val Katayev, managing partner at Prime Meridian, was one of the very first lenders at Prosper.com. And two weeks after they opened for business, he opened a substantial portfolio with his own money and heading into the great recession. So while the S&P 500 fell over 50 percent, his personal portfolio of Prosper loans was up 0.5 percent during that period. Later he exited from another business and was looking to get into the space in a substantial way and we became partners in Prime Meridian Capital Management. The pivot was successful and timely for us to move on from the prior fund, Novus. At the time, Prime Meridian was going to be a division of Novus, as a value-add and a nice cross-sale. We were just trying to build non-correlated strategies for our clients. Then over time, Prime Meridian just got larger and larger and Novus was put on the back burner. It still is around today but is more or less on auto pilot. We still have some clients on it but it’s just a small portion of our time and revenues.
Q: That is interesting. Where do you think the market and economy is?
A: We are in a late stage cycle right now. Recessions are very normal and very healthy and part of the economy. There’s going to be a recession in our future. That’s probably one of the few guarantees we have in life. And it’s probably closer to one- to three years, than five- to 10 years. Cycles don’t last forever.
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