KYC: Know Your Customer(s) – Tech-Enabled Asset Origination

In our many conversations with early-stage asset origination businesses, as well as our experience watching some of our partners and portfolio companies scale, we have noticed that the best management teams understand that they have two sets of customers (three if you include their board of directors/equity investors):

1) borrowers, purchasers, and/or users of their product

2) capital markets participants (specifically asset-backed lenders or asset purchasers), who provide the capital necessary for product origination; this capital can take multiple forms, but regardless of structure, capital markets participation is required to operate.

All founders and investors understand the need for #1, but the most sophisticated and long-term oriented spend as much time, if not more, focused on #2. It is critical to understand the relative value provided to capital markets participants, how this relative value can change over time, and if a platform can shift value between customers #1 and #2 if necessary.

In an era of low-interest rates and easy access to capital, many companies were able to get away with not hiring an experienced head of capital markets or not investing significant resources to gain a deep understanding of their capital providers’ needs. It was easier to provide relative value to capital markets participants, which can mask the need for diverse and strong relationships with capital providers, present an unsustainable unit economic profile, or lead to a disproportionate amount of value accreting to customer set #1 or to the platform itself. But in today’s environment, many are now rowing upstream without a paddle, trying to backfill the experience and relationships, and in certain cases, are coming to the dire realization that they never had product capital markets fit at all.

What’s the difference between product customer market fit and product capital market fit?

Product customer market fit, more traditionally known as product market fit, is very much comparison-driven. For example, in home equity investments, homeowners will compare the pros and cons of refinancing their mortgage, taking out a second lien or HELOC, and depending on age, can consider HECM or jumbo reverse mortgage options*. They will compare the cost, eligibility criteria, cash flow impact, and FICO score impact, among other factors, to determine if a home equity investment makes sense for them. If the originator can educate properly (and compliantly), target the right customers through the right distribution channels, and provide a quality customer experience, they may be able to drive a high enough conversion rate to generate attractive unit economics at scale. This would be an example of product-customer market fit.

On the flip side, the capital markets providing asset capital to buy these home equity investments will have a completely different set of criteria to evaluate, and in some cases, is the exact inverse of the homeowners’ analysis (see (b) below). The investor will need to (a) take a view on the absolute risk/return of the investment – what is the expected return, how is this return impacted by different macro environments, what is the probability of losing money, and is there any regulatory risk or headline risk associated with these investments, and (b) take a view on the relative risk/return of the investment – what other investments could I make with this capital and what are the differences in risk-adjusted returns between those investment opportunities. If the capital provider determines that both (a) and (b) are attractive at scale, then this would be an example of product capital markets fit.

The most challenging aspect of both product customer market fit and product capital market fit is that they can change over time. For homeowners – the cost and terms of their other financing options will change over time, and in certain instances, could become significantly more attractive (product customer market fit drift). For capital providers – the risk-adjusted returns of other investment opportunities will change over time and could also become significantly more attractive (product capital markets fit drift).

Successful asset origination teams will constantly monitor both sets of criteria, adjusting pricing and terms to make sure they maintain both “fits” over time. Even more importantly, the best founders and investors will make sure the business models they choose allow them the flexibility to do so.

*In other asset classes, the comparison may not be the cost of financing driven but could be convenience, access, risk management, or many other reasons.

Justin Ostroff, Senior Managing Director, and Michael Gerold, Director of Innovation Investments, are on the G1001 Innovations Team at Group1001.