After my initial elation at being admitted to business school in December 2013, I had to think through how I was going to finance the MBA. I was surprised at the expensiveness of traditional student loan options. Fixed-rate federal Plus loans were priced at ~8% and offered the same terms for all graduate students. Bank loan rates were similarly expensive and were based primarily on my past credit history than my future earnings potential. They were minimally adjusted for type of degree, quality of school, or career prospects. In other words, the student loan market was incredibly inefficient. My solution was to turn to my parents, who offered me a better rate than the government or a bank because they had greater trust in my creditworthiness. However, if everything I was told about the value of a Harvard MBA was true, I should have been able to convince others of my low credit risk the same way I convinced my parents. Social Finance Inc, or SoFi, is institutionalizing this concept via crowdfunding.
Value Creation and Capture
SoFi runs online lending marketplaces that match lenders with student borrowers. Piloted at Stanford’s GSB in 2011, SoFi’s first fund raised $2 million from 40 Stanford alumni to offer loans to 85 Stanford MBA students (http://business.time.com/2012/04/02/student-loans-for-a-great-deal-borrow-from-alumni/). Soon thereafter, the company raised similar funds dedicated to pairing alumni lenders with students at other top business schools such as HBS, Wharton, MIT, and Kellogg (http://bucks.blogs.nytimes.com/2012/04/03/sofi-tapping-alumni-to-help-with-student-loans/?_r=0).
There are 3 reasons why SoFi’s model makes sense and why students and alumni sign up:
(1) Like many peer-to-peer lenders, SoFi is a lower-friction intermediary than banks. Its use of online crowdfunding to raise funds eliminates much of the administrative/overhead costs that banks are burdened with. This allows it not only to generate cost savings (that are shared by borrowers, lenders, and SoFi), but to simplify the user experience for borrowers and lenders. In fact, SoFi claims to make a rate offer in 2 minutes (https://www.sofi.com/b/registration).
(2) In addition to reducing admin/overhead costs, SoFi’s use of crowdfunding actually improves risk-scoring in the underwriting of student loans. The basic premise is that alumni from top schools better understand the value of an education from their school than existing lenders. Therefore, they should view students/alumni from their alma maters as lower-risk than traditional lenders and should offer them lower-than-market rates. The practical impact is that SoFi enables students to receive more affordable financing and alumni to receive what they perceive to be better risk-adjusted investment returns.
(3) SoFi has leveraged the affinity that alumni have for their schools to create communities that offer mentorship and career advice. The benefit to students is obvious – an opportunity to leverage the powerful networks of alumni and their peers. For alumni, the program offers an alternative opportunity to “give back” to the school while also securing their investment. After all, they’re less likely to lose money on the pool of students they’ve invested in if they help those in transition find jobs.
The hypothesis behind SoFi’s creation has been borne out empirically. To students, the marketplaces offer loan rates that are 200-400 bps cheaper than traditional alternatives – indeed, SoFi offers MBA students fixed-rate loans starting at ~6% (https://www.sofi.com/mba-loan/). To alumni, the marketplaces has offered low-risk returns – SoFi claims it has had a default rate of close to 0% while the figure hovers at ~14% for federal student loan borrowers within 3 years of beginning repayment (http://www.forbes.com/sites/maggiemcgrath/2014/12/10/student-debt-as-an-asset-class-a-1-trillion-opportunity/). Simply put, by giving alumni investors mid single-digit rates of return with minimal risk, SoFi offers “high-yield returns” for “investment grade risk.”
Given that its organizational structure is comprised of investment funds (albeit funds raised online), SoFi captures a portion of the value it creates as a money manager would – by charging asset management fees (its founder was previously a hedge fund manager). The company typically charges a management fee of 0.75% and a service fee of 0.5% (http://venturebeat.com/2012/09/18/sofi-student-loan/). From an investor’s perspective, this is quite reasonable for an alternative asset class.
Initial Growth Challenges and Evolution
Although SoFi’s initial business model made a lot of sense, its scalability was limited. After all, there are relatively few “top” schools where alumni are sufficiently confident in the school’s value and screening process to invest in the students. Hence, the risk-based value proposition to alumni begins to decrease as the model is extended to ostensibly lower-quality schools.
Additionally, although there is $1.3 trillion of outstanding student debt in the US (http://www.inc.com/zoe-henry/5-things-to-know-about-student-loan-refinancing.html), new originations each year are a fraction of that figure. As such, in order to build a large business solely through new originations, SoFi would have had to capture a particularly outsized share vs. the federal government and bank programs that are much better-known and marketed. However, to achieve the same degree of awareness and distribution could have introduced the very administrative/overhead costs that SoFi seeks to avoid.
Furthermore, SoFi could have been constrained by the supply-side. Very simply, it would require a huge “crowd” to raise hundreds of millions (or billions) of dollars from individuals online. Similarly, the community-based mentorship/career guidance element could limit growth because it’s difficult to find alumni who will volunteer their time in addition to their money.
SoFi’s business model has evolved in response to these growth challenges. To address demand-side scalability, the company very quickly extended its offerings to undergrads and graduate programs beyond business school. Importantly, it added student loan refinancings to its repertoire (https://www.sofi.com/refinance-student-loan/). This allows it to address the much larger pool of outstanding student debt in addition to new loan originations. It also allowed SoFi to supplement its risk-scoring framework with career/salary data in addition to quality of school/program. Additionally, SoFi began targeting the ancillary market of loans for parents who fund their children’s education (https://www.sofi.com/parent-loan/).
On the supply-side, SoFi has grown beyond its original single-school funds, enabling investors to access pools of students at various schools. It has also supplemented crowdsourced funds with institutional investments. This includes equity capital of its own – the company has raised $1.4 billion from blue-chip investors such as SoftBank and IVP and plans to go public in the next year (http://techcrunch.com/2015/09/30/online-lender-sofi-seems-to-push-back-ipo-plans-raising-1-billion-instead/). Additionally, it led some of the first securitizations of student loans in the industry – as was famously done with mortgages, the company/equity investors capture a spread between the cost of an individual loan and a pool of loans (http://www.lendacademy.com/sofi-adding-leverage-for-their-alumni-investors/).
Today, only ~20% of SoFi’s loan money comes from its crowdsourced sources. SoFi has also supplemented its crowdsourced mentorship / career development with hired professionals.
Challenges to Future Growth
SoFi has begun expanding beyond student loans. In fact, it has entered the online mortgage origination business (http://www.thestreet.com/story/13282079/1/online-mortgage-lenders-are-beating-traditional-bank-loans.html) as well as the online market for personal loans. Underwriting standards in these markets are less obviously inefficient than student debt was when SoFi entered – as such, they offer less obvious profit opportunities. Moreover, these markets are already crowded with more online competitors such as Quicken Loans, Lending Club, etc.
More generally, it is unclear how defensible SoFi’s platforms are. On the one hand, SoFi benefits from an indirect network effect similar to a stock exchange – students should flock to platforms with more lenders and lenders should operate through platforms with the most students because this will ensure maximum liquidity. After reaching a critical mass, it is difficult for a new entrant to replicate the liquidity of the first mover. On the other hand, unlike with stock exchanges, neither students nor lenders are locked into using a single lending platform and there are few switching costs between them. It is relatively easy for both sides to “multi-home” when originating a loan or when refinancing one.
In its original incarnation, SoFi could claim a competitive advantage through crowdsourcing by creating unique communities that capitalized on alma mater-based affinities. This arguably created direct network effects – a sort of financing/career-based Facebook. However, this becomes less relevant as a decreasing share of lenders invests based on school (or any) affiliation and the community advice element is being contracted to professionals instead of alumni networks. SoFi is beginning to look more like a mainstream financial company that happens to have superior underwriting criteria.
However, the very underwriting criteria that distinguish SoFi today could incur the wrath of consumer advocates going forward. After all, it doesn’t sound great to say that students at prestigious schools should have an easier time funding their education than students elsewhere (even if this makes perfect economic sense).
To the degree that the underwriting criteria and aggressive pricing don’t result in public outcry, it might be replicated. For instance, Citizens Bank is already offering fixed rates as low as 4.74% to some borrowers (http://www.forbes.com/sites/maggiemcgrath/2014/12/10/student-debt-as-an-asset-class-a-1-trillion-opportunity/).