June 4, 2024
The Dangers of Innovation
Happy Tuesday, friends. I know you’re all fans of innovation. So am I. Innovation powers everything and pushes humanity forward. It is absolutely critical to our industry, and there are lots of ways I’ve seen alternative capital investors innovate.
But there are a couple things that should not be targets for innovation. You may remember our friend Chris Atkins from C2FO sharing on our podcast that one of those things is credit. I would expand that to include underwriting or investment analysis more broadly, and I couldn’t agree more. There are a couple things that everyone needs to be careful about. Beware these two ideas, which easily lead to mistakes:
Speed and growth are the most important things. There was a time after Covid where alternative capital providers were deploying capital at an incredible velocity. It was a classic VC-backed grab at market share. The idea was that if a provider could capture market share fast enough, bad loans and defaults wouldn’t matter because by the time the portfolio started to sour, there would be sufficient revenue from good loans to cover the losses. That’s a fine strategy for a software business, but it can kill a capital business. It killed a few, actually. What no one saw coming was the dramatic increase in the cost of capital, so the inevitable portfolio blow-ups (which I predicted) were made worse by margin compression. The result? Big, poorly constructed portfolios. Remember Pipe? Remember ClearCo? I used to wonder how they did what they did…maybe they were smarter than me. Turns out they weren’t; they just made the bet on speed. That’s a tough one when you’re running a business where you need to get paid back. The lesson is simple: Don’t let speed or growth change your decision making.
Underwriting is old school. Look, business fundamentals never change. Revenue and burn matter. They always have, and they always will. The way one calculates associated ratios may be a target for innovation, but at the end of the day, it’s just math. If you’re a capital provider that needs to be paid back for your business to work, deviating too far from what’s been proven to be true is pretty dangerous. It can be fatal. “Lending is hard,” is what Mike Luebbers, our CCO at Novel often says. He’s right. There’s no reason to make it harder by pretending that math isn’t math. The lesson: don’t think you’re smarter than history and math. How you get to your answer might be innovative, but if you’re too clever, you’ll lose. Trust me, I know.
Now, I know a lot of you have a different perspective on this, and I’d love to hear from you. Prove me wrong!