Money manager Brendan Ross recognized a while ago that small business people in the U.S. are fully capable of growing—if someone would only provide them with loans.

“If there is a group in this country that is totally unable to access traditional credit, it is neighborhood businesses,” says Ross, chief executive of Direct Lending Investments.

Ross launched the Direct Lending Income Fund in November 2012 to meet this unmet demand for small business loans. The fund buys loans directly from high-yield business lenders with which it has negotiated long-term acquisition and servicing relationships.

The fund focuses on the doctors and dentists, restaurant owners, personal care providers and the like who need to borrow $10,000 to $100,000 for a year or less to upgrade their operations. They can’t turn to the Small Business Administration, Ross says, noting, “When the SBA talks about small business, those are the businesses in the industrial park.” The average SBA loan in 2012 was $337,000, while neighborhood businesses borrow a 10th as much, he adds.

Loans are short term—six to 12 months—and average $41,000. They are repaid either daily or weekly via Automated Clearing House’s nationwide electronic funds transfer system, which makes withdrawals from the borrowers’ bank accounts. “I believe that the sweet spot for credit is daily or weekly repaid sub-one-year business loans,” Ross says. “Those people overpay the most for credit. That’s where there’s alpha.”

The fund currently has about $21 million under management and aims to reach $100 million by the end of the year, he says. Investors are high-net-worth individuals and a private credit funds of funds.

In 2013, the fund’s first full year, it returned 12.7%.

The fund has a $100,000 minimum investment and charges a 1% management fee and a 20% performance fee. There is no lockup, and redemption is available with a 35-day notice.

Acquiring Loans
“The key to successfully growing an alternative lending business is to find pools of attractive borrowers,” Ross says. “It’s all about the borrowers because the money is not that hard to find.”

Ross says that when he started the fund, he looked for management teams that were able to creatively identify and reach borrowers so they could make them loans. “I wanted to grow the fund and tell the story to investors without being limited by my own ability to find new borrowers myself.”

He developed his first relationship with online lender IOUCentral in 2012. A second online lender, QuarterSpot, came on board last August. IOUCentral buys loans from brokers, while QuarterSpot acquires borrowers through Google advertising, he says.

These lenders are able to make loan decisions in a fraction of the time it takes traditional banks. “The best way to make small business loans is not with the business’s income statement or balance sheet; it’s with the business’s bank statements and tax statements,” Ross says. The online lenders go to documents that cannot be misrepresented—by getting direct access to the borrower’s bank account—and make a lending decision based on that information.

“The thing that’s new right now is not making loans to small businesses,” Ross says. “What’s new is platform lending.”

Traditional banks accumulate money, lend it out and, when the money comes back, make a new loan. “Lending Club [an online, alternative lender that opened in 2007] introduced the notion that you could actually lend without your own balance sheet, and instead use the balance sheets of hedge funds and other institutional investors,” Ross says.

Ross says that at the start of his relationship with IOUCentral, he worked to convince chief executive Phil Marleau that he could grow his business faster if he didn’t have to make all the loans from his own balance sheet. He could keep some of the loans and sell Direct Lending some of the other loans, against which he would charge a servicing fee.

Direct Lending currently owns more than 750 loans, with more coming in every month, Ross says. The fund does not underwrite most of the loans in its portfolio.

“When you’re making loans that average $41,000 and you’re making hundreds of them a month, the best process is to establish relationships with underwriters you trust and then work out the mechanics to ensure their underwriting quality continues to stay high,” Ross says.

At present, the fund acquires 75% of its loans from IOUCentral. The loan acquisition process ensures the quality of IOU’s underwriting, Ross says. DLI buys loans from IOU by means of software that randomly selects those that are between six and 30 days old from IOU’s balance sheet. “They don’t get to pick the loans they’re going to sell me, and I don’t get to pick the loans I’m going to buy,” he says. IOU keeps half the loans and holds them to maturity.

As a result, Ross is confident IOU will underwrite every loan with the same seriousness. “They have a lot of skin in the game,” he says.

DLI’s due diligence is ongoing, Ross says. “I get the data for all of the loans IOU underwrites, including the ones I don’t own, so I’m able to confirm their portfolio is performing the same as mine.” Software exists that allows the fund to see real-time portfolio performance.

In weekly calls, Ross also receives reports from IOU describing conversations the lender has had with the borrower—perhaps about a bounced payment and what is being done. The two parties speak monthly about whether the credit scoring model needs to be tweaked when things change. “There’s a continuous test-and-learn cycle,” he says.

Direct Lending buys 25% of its loans from QuarterSpot. For these loans, it does a credit overlay. Ross says he expects the two providers to balance out over time. He doesn’t favor one over the other. “I’m looking for management teams that can get a good flow of high-quality borrowers. You never know which management team will be able to execute against that mandate more effectively.”

The fund experiences defaults of 6% or so. “We know that some of our loans are going to go bad,” Ross says. “That’s factored into the model that delivers returns.” The fund writes down defaulted loans to zero. “We don’t keep loans on our books that will one day have a 30-cent-on-the-dollar recovery, which is IOU’s historic legal recovery goal. The returns each month are net of bad loans being written down to zero.”