It’s a tough time to finance a startup.
Startups looking to secure capital to underwrite consumer auto loans this year face roadblocks as investors tighten their purse strings, driving up the cost of funds and stymieing the plentiful flow of capital fintechs tapped into two years ago.
Fintechs looking to secure warehouse lines of credit at affordable rates face an uphill battle, Brian Donnelly, director of strategic partnerships at venture capital firm AutoTech Ventures, told Auto Finance News. “In today’s current environment … good luck. No one is going to write those warehouse lines unless the interest rate is so crushing because people’s risk profiles have just tightened to the fact that they don’t want to do that kind of lending.”
Venture capital investments in auto fintechs have been on a downward trajectory since 2021, according to an AFN analysis of public deals last month. In fact, such investments totaled $1.2 billion in 2022, about half of the volume in 2021.
Auto fintech investments soared in 2021 after slumping considerably in 2020 during the COVID-19 pandemic, according to previous AFN analyses of deals. The average investment across 29 deals in 2022 clocked in at $44.3 million each, compared with $112.7 million each across the 22 recorded investments in 2021. U.S. auto startups received a collective $219.4 million in funding for the full year in 2020.
“We are in a phase of the cycle that is challenging for consumer lenders. The consumer today has some level of uncertainty because of inflation and increased cost of living. That presents some impediments to being able to access startup financing for fintechs.” — Daniel Chu, Tricolor
Startup money was easier to come by in 2021 but has proven more difficult to access in the past year amid rising rates and weakened consumer credit health.
“The market today is less friendly for startups and much more difficult to raise capital for early-stage or pre-revenue businesses — not impossible, but more difficult,” automotive strategist Ron Frey with RL Frey Inc., told AFN, adding that there is a tremendous amount of capital in the market, but some investors have become more disciplined. “If you’re a startup that is burning capital, without a clear path to profitability, it’s almost impossible. There are several early-stage or startups out there that are innovating, have proven executives and are raising capital.”
In fact, consumer lending and credit cycles are highly correlated with the overall business cycles, George Sclavos, chief financial officer at Boston-based auto finance startup Lendbuzz, told AFN. “When consumer lending credit is performing poorly, [funding] is a challenge to get … and when consumer lending credit is performing well, [it is] more flush.”
Post-pandemic household debt has increased, and consumers are under more financial pressure, adding to startups’ woes, Tricolor Auto Acceptance Chief Executive Daniel Chu told AFN.
“We are in a phase of the cycle that is challenging for consumer lenders,” he said. “The consumer today has some level of uncertainty because of inflation and increased cost of living. That presents some impediments to being able to access startup financing for fintechs.”
Getting skin in the game
Startups’ first avenue for funding often is the business itself, Sclavos said. “Early in your life cycle, you raise equity. You’re funding loans with your own equity,” he said, noting Lendbuzz funded loans via equity when the AI-based startup was founded in 2015.
Lendbuzz leverages artificial intelligence (AI) and machine learning to extend credit to borrowers who were born outside of the U.S. and do not have a FICO credit score.
“If you get an initial lender to give you high weighted average cost of capital money, as time goes by and your portfolio begins to mature, you’re going to show your retention rates, your defaults and your delinquency curves, and all the performance related to that portfolio, which is ultimately what gives you the ability to get lower-weighted average cost of capital.” — Scott Painter, Autonomy
It is not uncommon, especially in stressed economic conditions, for startups to be required to put in more equity when seeking initial funding, Tricolor’s Chu said.
“In an environment like we see today, a startup should expect to be required to contribute more equity in each loan they originate,” he said. “Lenders who are financing the startups are fine providing some amount of the capital required to make the loan, but we see those lenders today wanting more skin in the game from the originator of the loan. The startup is going to have to be well capitalized to satisfy lenders’ requirements for more equity contributed by the fintech.”
New companies in general are likely to pay more for upfront capital at the start of their journeys, Scott Painter, founder and chief executive of EV subscription service Autonomy, told AFN. Companies in the beginning stages typically are offered low advance rates, or the percentage amount of the collateral’s value that a lender is willing to extend as a loan.
“In the beginning, [startups will likely] take on a very low advance rate. That’s how lenders get comfortable that they’re going to be able to get paid back,” he said.
Startups given an advance rate of 60% to as high as 80%, for example, must come up with the rest by leveraging company equity, Painter said.
“The hard part about building a balance sheet business is that you end up having to come up with the equity for that downpayment while you’re trying to prove out the portfolio,” he said. “That initial advance rate being too low means that you must raise a lot of very expensive equity.”
Advance rates today are becoming more conservative, with rates on funding for auto finance startups ranging from about 55% to 65%, Tricolor’s Chu said.
“Advance rates are lower because lenders who are funding a startup want to see that startups have plenty of [their own] capital to put at risk,” he said.
Graduating to debt funding
New companies that can secure starting capital through debt funding rather than relying on a higher level of equity are in a better financial position from the get-go, Painter said, noting that equity investors tend to want higher returns compared with the typical 20% to 25% initial rate of return required by debt lenders.
“That is fundamentally less expensive money,” Painter said, adding that when he founded used-car leasing company Fair in 2016 along with George Bauer, the startup was able to raise debt funding “right out of the gate.
“We were able to raise $1.4 billion of debt alongside raising about $380 million of equity,” Painter said. “We would put up haircut equity, or advanced-rate capital, to access more debt. We were able to achieve a 90% advance rate in that business. We were putting up $1 of equity for every $9 of debt we were able to raise.”
Today, the landscape is more challenging.
“What [startups] do is raise enough equity to lose money on the interest rate arbitrage until they can get enough volume to bring their rate down. They must be smart about the long-term possibility and be willing to lose money until they get there.” — Scott Painter, Autonomy
An expensive start
Early-stage debt funding has become more expensive, Lendbuzz’s Sclavos said, noting that private credit firms, known as hedge funds, have seen their expected returns double.
“In flush markets, you’re talking about [interest in] the mid-teens. Today, it could be as high as 25%,” he said. “It is expensive capital. Your business cannot survive on that capital. It will lose money, but it is capital that is available to you to get off the ground.”
Santa Monica, Calif.- based Autonomy, formerly NextCar, in 2020 secured a $50 billion credit facility with a hedge fund, Painter said. “We put the company on the line for the facility, got into business and bought our first dozen cars,” he said. “From there, we went out and got a facility from Westlake Financial that understood automobiles, and they only used the cars as collateral. That’s how we bought our next 500 cars.”
On top of interest, investors in new businesses might require representation on the company’s board of directors and warrants, Sclavos said. Warrants grant the holder the right to buy or sell a security, commonly an equity, at a certain price before the expiration.
“What [investors] will tell you is these businesses are startups; they have no experience, they have no data … you have to price for that risk, and they almost always will require some amount of warrants or equity in your business,” Sclavos said, adding that Lendbuzz granted warrants to the hedge fund that provided the startup’s initial debt capital.
“As Lendbuzz has aged out of [the hedge fund] being a debt provider, they have continued to be an equity investor in our business,” he said. “That is not usually the case. Typically, as you age out from [the fund], they give up their board seat because you don’t have any debt outstanding with them, and they just have an outsized amount of equity left over.”
Following high-cost hedge fund capital, startups typically can secure financing through private credit firms at “low double digits” and later from large private equity firms with a credit business — such as Ares Capital, Castle Lake, Victory Park Capital and Waterfall Asset Management — at “high single digits to low double digits,” Sclavos said.
Startups “will transition away from some of these hedge funds or keep the hedge fund around but in their lowest cost of funds buckets, and transition into some of these [larger] groups,” he said.
Private funding as well as large, nonbank firms such as Apollo Capital can provide an opportunity for startups, Tricolor’s Chu said. “There are firms that want to do lender finance that have a lot of capital to deploy,” he said, noting some firms focus resources on smaller-size facilities for lenders. “What new fintech startups must keep in mind is if their borrowing costs are substantially higher than their peers in the marketplace, it’s going to be difficult for them to be successful long term.”
Tricolor started out in 2008 with a $5 million warehouse facility through a regional bank, which carried a 60% advance rate, Chu said. The Dallas-based lender leverages machine learning and AI to finance auto loans for thin- and no-file Hispanic consumers.
Startups inevitably must prove out a sound lending strategy that nets predictable results, Chu said.
“As a fintech, you have to make sure you have a sound strategy; if you’re going to be lending at the same terms as a larger lender, you need to make sure that the cost of capital that you’re going to pay is going to be sufficient to achieve the needs of the company,” he said.
“It’s a function of the right strategy and slowly deploying capital and proving up that strategy in order to continue to access more capital at a lower cost.” — Daniel Chu, Tricolor
Proof of concept
After about two years of credit performance, startups typically can access bank financing starting with smaller, middle market banks before progressing to larger money center institutions such as Bank of America, Goldman Sachs or JPMorgan, and eventually securitization markets, Lendbuzz’s Sclavos said.
“The middle market banks are smaller in size and scale and prices are little higher. You’re talking mid- to high- single digits in flush markets and probably nine or 10% in higher cost markets,” he said. “As you get to the largest banks, they’re not going to ask for warrants. They’re going to want investment banking services.”
Goldman Sachs and JPMorgan, for example, provide Lendbuzz with the company’s two warehouse lines of credit and act as lead underwriters on the financier’s asset-backed securitization (ABS) deals, Sclavos said.
The securitization market is the horizon for startups looking to lend on assets, Autonomy’s Painter said, adding that funding becomes less expensive as startups prove out their portfolio performance over time.
“If you get an initial lender to give you high weighted average cost of capital money, as time goes by and your portfolio begins to mature, you’re going to show your retention rates, your defaults and your delinquency curves, and all the performance related to that portfolio, which is ultimately what gives you the ability to get lower-weighted average cost of capital,” he said.
Relief in sight?
While it is anyone’s guess when low-cost funding will return to the market, spreads in the ABS market often are the first indicator of what’s to come in earlier stages of a startup’s funding journey, Sclavos said.
“Public securitizations tend to get stressed first, and then it cascades backwards,” he said. “The most private credit [financing], the earliest-age hedge fund [financing], that is the last thing to get stressed.”
Auto spreads have been tightening in the first months of 2023 after widening at the end of 2022, pushing auto ABS volume up 60% year to date, according to data from JPMorgan Securities. AA prime fixed auto spreads over swaps fell to 88 basis points as of Feb. 9 compared with 161 bps on Dec. 1, 2022, pointing to improving conditions for fintechs seeking funding.
“The time lag is often a function of what the underlying stressors are and how much they’re truly impacting any part of the individual business,” Sclavos said. “If you want to get into mortgage as a specific asset class, it is basically closed; no one wants to participate with an early-stage mortgage business. … If you want to be in private auto credit, you can still do private auto if you do something unique.”
— Additional reporting by Marcie Belles, Joey Pizzolato and Riley Wolfbauer