Differentiate or Die Trying: What's Next For the Alternative Lending Market Smart organizations will find ways to engage with their customers outside of the direct sale.

Small business lending has not always been seen as a hotbed of innovation. With only traditional bank loans, credit cards and a few local merchant cash advance or factoring firms to meet their capital needs, small businesses have typically been left behind when it comes to advances in financial technologies. However, it seems small business luck is about to change.

A wave of highly scalable alternative lending providers is hitting the small business market with higher acceptance rates and faster capital deployment than traditional channels -- often bringing the lending cycle down from a few weeks to as little as a few hours. Small businesses who have struggled to gain funding in the past are turning to alternative providers en masse.

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As a result, these lenders have seen tremendous growth in the market. Large providers like OnDeck and Lending Club have gone public and it seems as though new startups are launched in the space almost weekly. With this increased attention, scrutiny, and competition, it's reasonable to assume that it will be more difficult for these lenders to grow and succeed in the future. I've had the opportunity to work closely with a number of players in this space in my role as the CEO of BodeTree, and I believe that one key factor will determine the winners and losers in the space going forward: differentiation.

A crowded market.

While specific statistics are hard to pin down, we estimate that there are approximately 1,300 companies operating in the alternative lending space today. These 1,300 organizations are competing for about 1 percent of the overall market, compared to about 6,500 traditional banks competing for the remaining 99 percent. This view of the market may seem shocking at first, but in our discussions with hundreds of banks nationwide we've heard time and time again that the alternative lenders are having no impact on their market share. Instead, it's the view of the banks that alternative lenders are pursuing the 1 percent of the market that has long been considered "unbankable."

With so many players competing for such a small sliver of the overall market, consumers are bound to become overwhelmed. Even organizations that have tried to focus on specific industry verticals are now forced to compete against an ever-growing number of clones in their attempt to reach potential customers. It's clear that going forward, lenders are going to have to find ways to market their products and solutions as substantially different in order to stand out.

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Capital is capital.

While the cost of capital may vary a bit from product to product, it all spends the same at the end of the day. As a result, it's difficult to differentiate a lending product when it is by its very nature, a commodity. However, the difficulties facing the alternative lending market go beyond product similarities.

The homogeneous approach adopted across the marketplace when it comes to acquiring, retaining, and serving their customers is a key issue in the alternative lending space. Save for an enlightened few, nearly all of the players in the market inundate potential borrowers with a strikingly similar array of direct mail, email, and online advertisements. Most of these lenders make credit decisions and deploy capital with similar speed, have a similar cost of capital, and charge roughly the same rates. Moreover, most lenders have nearly identical customer acquisition costs, ranging from around $2,500 to $3,500 per loan. This systemic lack of differentiation across all aspects of the industry is inevitably going to lead to slower growth, higher costs, and degraded customer experiences.

Differentiate or die trying.

The good news is that there is a huge opportunity for smart players in the industry to seize the moment and find ways to fundamentally differentiate their organizations. This differentiation can potentially manifest in three different areas of the business.

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1) Lower the cost to acquire and retain customers.

Today's small businesses want offers and products tailored to their specific needs and delivered in a context that they understand. Smart organizations will find ways to engage with their customers outside of the direct sale, either through interactive platforms or content, that will enable them to employ a more nuanced approach to customer acquisition. In doing so, they should be able to reduce their customer acquisition cost from an average of $2,500 to less than $100 per year.

2) Expand the scope and scale of the products offered.

It takes time to build relationships with small business, and not everyone is in the market for capital 24/7. Alternative lenders who recognize this will find ways to expand their product offering to include advisory services and other long-tail engagement tools that help serve their needs in a holistic sense and prime the pump for loan opportunities in the future.

3) Lower the overall cost of capital for customers.

Finally, I believe that the real winners in the industry will be the ones who figure out how to deliver affordable capital to their clients. Today, the combination of extremely high customer acquisition costs, non-traditional capital sources like private equity or peer funding, and lack of solid risk-based pricing leads to high interest rates for customers. It isn't uncommon to see average rates that range from 30 percent all the way upwards of 75 percent for these types of loans. Anyone who can figure out how to leverage technology and innovative approaches to lower the cost of capital can truly shift the demand curve in the market in a big way.

Alternative lenders play an important role in the small business economy today, but they should not mistake their recent rapid growth as something that is sustainable in the long-term. Unless these lenders find out how to differentiate themselves in meaningful ways, it's unlikely that they will be able to change the market on a fundamental level. Instead, they'll continue competing in an environment with ever-increasing costs and increasingly numb customers. However, if they can solve the differentiation challenge, alternative lenders could become more mainstream than ever.