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This was a 2,500-word feature for AVCJ focusing on how lending start-ups in India and Southeast Asia were responding to the COVID-19 pandemic.

Digital lenders in emerging markets need to survive a tricky year under the shadow of potential defaults, but the survivors might become significant players in a renewed financial landscape 

Financial technology start-ups in Asia emerging markets turned the tables on their Chinese peers for the first time last year, racking up $2.4 billion in venture capital funding to $792 million. Nearly two- fifths of the 156 funding rounds announced in India, Indonesia, Singapore, and the Philippines involved a digital lender. In 2016, there were only 28 deals.

As a group, they represent a more efficient path to profitability than payment start-ups, many of which have received substantial VC funding but are criticized for high levels of cash burn.

These branchless lenders offer a user-friendly interface connecting prospective borrowers with capital providers. They promise to democratize access to finance, serving consumers and small and medium-sized enterprises (SMEs) that are typically dismissed by traditional banks as too great a credit risk.

India and Indonesia, which have the largest unbanked populations and the biggest small business communities, are naturally the core markets. But a large crop of local, regional and even foreign players has emerged. They all start with retail capital and look to graduate to local institutional funding sources, while limited foreign debt funding trickles in from development financial institutions.

VC investors like this combination of stability and a proven value proposition, although it is more easily achieved in some markets than others. In Australia, for example, AirTree Ventures has witnessed the phenomenon firsthand with Prospa’s rapid growth from a Series A round in 2015 to a domestic listing just three years later.

“We felt that the macro trends around small businesses growth being the engine of most economies but not having a finance solution was a gap in the market,” says Craig Blair, a managing partner at AirTree. “A good lending business should be able to get to profitability within Series B if not C.”

Walking on fire

It remains to be seen whether Prospa’s Indian and Southeast Asian contemporaries – which are not supported by developed market financial infrastructure – can replicate its growth tangent and exit trajectory. Much rests on their performance this year, specifically how they cope with a very difficult operating environment.

Mandatory lockdowns enforced across the region due to the COVID-19 pandemic have crippled business activity, pushing companies into distress if not default and causing job losses. Many loans are likely to go unpaid.

Meanwhile, funding sources are being locked up. Banks, the primary source of capital for digital lenders, have taken out bad loan provisions and adopted a conservative stance. Analysts warn that these start-ups’ loan books will sour. On top of that, the credit risk scoring systems that underpin lending policies may not apply in a post-COVID-19 world where many business models will be disrupted. Historical data might not be a reliable guide.

“All assets today in India would look poor in the digital lending space. Asset quality would have worsened because of COVID-19 and a lot of loan books that appear healthy may be window dressed because of a six-month moratorium [on loan repayments] ordered by India’s central bank,” says Asish Mohapatra, co-founder of OfBusiness, an Indian digital lender and distributor of raw materials to SMEs.

Lizzie Chapman, CEO of ZestMoney, a consumer lending platform that facilitates checkout financing for online merchants and retailers, puts it more bluntly: “Nobody’s making a lot of money at this time.”

Needless to say, venture capital funding has dried up and new arrivals in the lending space have dropped to zero. But there is still room for optimism. Whoever survives the harsh summer will probably face reduced competition and have opportunities to consolidate demand.

At the same time, partners – clients, banks and non-banking financial companies – are increasingly turning to the start-ups still standing to learn how to conduct lending online. “It was such a difficult conversation a year ago but retailers now realize that customers don’t want a random agent running around [to help them sign up for a monthly payment plan on the app] if they can avoid it,” Chapman says.

Other processes like in-person meetings or paper-based documentation that were long seen as the norm are now being questioned as well. “People would send an email and then call you up on the phone and ask, ‘I’ve sent you an email, did you receive it?’ A lot of the steps in digital lending were like that and are changing favorably as a result of this crisis,” explains Ganesh Rengaswamy, a co- founding partner at fintech investor Quona Capital.

Unlike their traditional asset-heavy peers, digital lenders were able to continue operations under lockdown. It is also a vertical where there are established players – the top 15 digital lenders have scooped up nearly 75% of all VC capital committed to the sub-sector since 2016.

They are expected to fare better as they are already deeply enmeshed within their target users’ digital universe. Even if marketing budgets have been slashed, online businesses and banking partners still bring these digital lenders to people’s attention.

In the Philippines, non-bank consumer finance institutions are turning to financial technology companies in a bid to reach an increasingly digital customer base. Mikko Perez, CEO of Ayannah Global, an Indian and Philippine fintech solutions developer, has seen lending slow down but he notes a greater willingness to do know-your-customer (KYC) processes using video apps, originate loans through social media channels, and conduct loan management processes online.

“Your ability to acquire users as they start coming online and become more digital will be the key success factor. Those lenders with e-commerce experience or any form of online experience are better positioned to ride the wave,” he says, adding that Ayannah is currently working on digital remittance and insurance products.

Opportunities, threats

As a result, many digital lenders could find they are unexpectedly in demand. And help will come in the near future from unexpected sources as well. Tek Yew Chia, KPMG’s head of financial services advisory in Singapore, believes that family offices, charitable foundations and the likes of Asian

Development Bank might provide debt funding because of financial inclusion imperatives and a desire to let money flow to underserved parts of the market.

It is also suggested that corporates will offer financing, so they can use technology solutions to help preserve the health of their supply chain ecosystems. Many digital lenders are looking to partner with property developers, for example.

Supply chain finance-focused lenders are traditionally the oldest and strongest constituent group in the digital community because they have accumulated plentiful data on SME borrowers through invoice and payment history provided by corporate buyers. They seldom require VC backing.

However, Chia warns that digital lenders could also face competition from banks in some jurisdictions as the latter have shown a willingness to engage with the same group of borrowers. It helps when governments share the risk of the loan portfolio in a bid to kick-start the economy. They are also narrowing down the advantage that digital lenders have in terms of smoother onboarding processes and quicker loan approval times.

Consumer-focused lenders, in particular, are expected to fare poorly in the near term. This is partly due to the uncertainty over the speed of labor market recovery in many countries. OfBusiness’ Mohapatra predicts that it will get worse before it gets better with partial lockdowns likely in the coming months as cases continue to climb in India.

Among consumer lending platforms, loans earmarked for goods or services that meet a clear functional purpose are considered preferable to straight cash loans.

“In good times, payday lending looks good and does well. In downturns, it’s ugly all over the world,” says ZestMoney’s Chapman. Where possible, consumer lending platforms are temporarily looking to increase lending tied to education spending and productivity tools.

For a long time, VC investors have anyway stayed away from the consumer vertical. It has only been in recent months that some start-ups have been able to raise seven-figure funding rounds.

Eddy Danusaputro, CEO of Mandiri Capital, the corporate VC arm of an Indonesian bank, declares himself bearish on consumptive loans and bullish on productive loans. He sees a lot of potential in digital SME lenders as long-term partners that can help the bank win new business.

“As banks were rolling back their branch operations before, and especially after this pandemic, it makes sense to collaborate with these peer-to-peer lending platforms because they have the distribution while we have the funds,” Danusaputro says.

But consumer finance is also a domain where data science can play a crucial role in analyzing alternative non-financial information related to user behavior. Lenders can check how frequently individuals look up their credit scores on an app and compare behavior to that of similar users in the past. When cross-referenced with data from centralized repositories like credit bureaus, digital lenders can make assessments in a way that traditional banks cannot.

“The combination of borrower and data set volumes are typically several orders of magnitude higher in consumer lending than SME lending,” says Quona’s Rengaswamy, adding that for SME lending, experience in being able to understand business intent matters more in the long run.

“There is obviously a lot of leverage possible out of alternate data, but we have to be intellectually honest about the realistic usage of it across the spectrum.”

Waiting for winter

AirTree’s Blair observes that the path for a top-performing digital lender in the current climate is clearly marked out. Should its credit scoring models stand up to COVID-19 scrutiny, it will need to focus on lowering the cost of capital, improving unit economics for more than the first loan, speed up loan processes, and build strong relationships with borrowers so they remain loyal.

“Prospa used a lot of software to understand clients better. They wanted to know when clients would value more lending and when they wouldn’t. I think the key metrics Prospa tracked were net promoter scores and repeat rates,” he says. The company kept these numbers up through a constant customer education process. It found that not many SMEs had been socialized on the importance of a good credit record.

As the loan book grew, Prospa was able to attract larger sources of capital beyond banks and securitized its loans in order to focus on its core strength – digital origination. The company raised debt across multiple tranches to bring in a wider variety of funding providers, which reduced the cost of capital because potential lenders used attractive terms as bargaining chips. It took time to reach that scale, though.

“You have to demonstrate that you can price, understand and manage risk and that just comes through time,” Blair says. “The number one focus area right now would be around managing the loan book and the risk and defaults around the book. It’s a real test of whether your decision models or your credit risk models are working as expected.”

Should they end up seeing a rapid rise in non-performing loans, digital lenders will feel pressured to go for safer assets – such as secured lending at higher sums – but then they would stray from their original mission. Right now, few in developing Asia are thinking about changing their business models because they believe they have achieved a suitable level of specialization.

Those that are unable to manage the risk on their loan books and who are not well-capitalized might have to agree to be acquired or sell their portfolios.

However, OfBusiness’ Mohapatra argues that populist economic policies result in far too many digital lenders convincing themselves they can run on fumes and will eventually get some form of government assistance.

An IPO could be another rescue scenario, provided there is sufficient investor interest. Mandiri’s Danusaputro predicts some start-ups will rush to list and get much-needed external financing while others scale back expansion plans.

A longer term threat comes in the form of leading payment start-ups that have all declared an ambition to enter small business lending or consumer finance. However, there are two obstacles. First, it is unclear if they have the necessary capabilities to assess credit risk. Second, their vast user bases could translate into a volume of loans that cannot be contained on a single corporate balance sheet. Outside help from a bank or other financial institution might be required.

“Payments is actually a business centered around deposits – people deposit money in a wallet so they can make payments,” says KPMG’s Chia. “You could ask them to use any excess funds to buy

insurance or asset management products where there’s no additional risk involved, but lending involves credit risk.”

Missing unicorn?

In the meantime, digital lenders anticipate room for further expansion when the dust finally settles. And they are looking to private equity to provide the growth capital, much as it has been channeled into payments, education and healthcare in recent years.

“Not a single lending start-up or digital lender in India has raised a $100 million round. That’s quite damning because India has one of the biggest untapped demand pools for credit,” says ZestMoney’s Chapman. “There has been a bit of nervousness or reticence from the larger investors to back digital lenders.”

Even the debt capital pools are thin. ZestMoney is courting global banks that might be open to working with digital lenders in emerging markets. Towards the end of last year, Goldman Sachs led a $15 million Series B round for the five-year-old start-up.

In time, ZestMoney and others would like to follow Prospa’s lead and securitize their loan books so they can accelerate growth. However, Asian regulators are wary of encouraging the use of complex financial products that have often been abused in other jurisdictions.

“No one had figured out how to price the risk and it was considered risky to lend to unproven small businesses with unsecured lending facilities,” says AirTree’s Blair. “I think now it’s a much better- understood asset class.”

Whoever gets it right in Asia is expected to reap rich rewards. With the right economic conditions and infrastructure, support from regulators and banks, and with sufficient VC funding, they can become significant financing sources. “Most SME lenders are not even worth $500 million,” Chapman says. “I’m surprised there haven’t been more [big ticket] investors given the size of the opportunity.”

Ultimately, digital lenders can even go lower down the value chain and truly help businesses and individuals that are truly unbanked and have little option but to pay sky-high interest rates for an array of gray market products. Right now, for many this represents too large a step outside their comfort zone.

“I don’t want to sound ironic since I work for a large bank, but we lack good quality lenders in the world right now,” says Mandiri’s Danusaputro. “I think there are not enough start-ups that serve the unbanked or the underbanked. They don’t do it because it’s either difficult or there’s no money in it. If done properly, it could be sustainable.”