“Watch out for the fintechs” has been the drumbeat for a couple of years from industry pundits. These nimble nonbanks, the refrain goes, aren’t hampered like banks, don’t act like banks, have loads of venture capital, and have technology that can turn on a dime. Much of that is true.
But in all business “revolutions,” there’s always a shakeout.
And we’ve seen that recently with some fintech highfliers brought low, along with increased interest in partnering with previously “irrelevant banks.”
But perhaps a more potent threat is when you have a competitor led by someone with banking experience who has an unconventional, creative mind, where the entity operates within the system as a regulated bank, but is unlike any bank you know.
That describes Live Oak Bank and its chairman and CEO, James S. “Chip” Mahan III.
Live Oak’s leafing out
Mahan started Live Oak eight years ago along with its bank software subsidiary nCino (recently spun off). Bankers of a little longer tenure will recall that Mahan and his brother-in-law, data security expert Michael McChesney, formed Security First Network Bank, the first internet bank, in 1993. Mahan had worked for several banks before that, including Wachovia, and was CEO of Cardinal Bancshares, Lexington, Ky. Mahan also created and led bank technology company S1 Corp.
Live Oak Bank at present is the second-largest Small Business Administration lender in the country, lending to 13 distinct industry groups. Mahan has plans, however, to take the model beyond SBA loans, as you will read.
Live Oak’s assets are nearly $1.4 billion. It has one physical branch and an impressive headquarters campus in Wilmington, N.C., where its 400 employees enjoy the amenities of a tech startup and quite a bit more.
Mahan does everything possible for them. He wants them to be happy, work hard, and stick. Key employees are asked to invest half their personal liquidity in Live Oak stock.
The following interview has been distilled from a 50-minute conversation and edited for clarity.
Q1. What’s the philosophy behind Live Oak Bank and its business model?
A. Our thought was to fundamentally “reverse-engineer” the way you think about a bank. A normal bank operates in a geographic territory.
We said, “Why don’t we lift the geographic restrictions, and why don’t we be smart about it?” Let’s make government-guaranteed loans so we don’t take on as much risk. The SBA allows you to lend to 1,100 industries. Let’s get the data about a particular industry, and then hire a domain expert who has actually operated in that industry.
One of our verticals is funeral home operators. Jerry Pullins is the former CEO of Service Corp. International in Houston, the largest consolidator of funeral homes in the world. Jerry knows something about what it takes to operate a funeral home.
So we hire folks like Jerry or put them on our board, and ask them to make an investment with their own money in our bank. Then we have these experts sit down with the credit folks and design the credit box. We release the credit box to the sales people and say to them, “Go out there in all 50 states and find us good loans.” We have three airplanes to help them do that.
SBA allows you to lend up to $5 million. Our average loan is $1 million—75% guaranteed by the U.S. government. We sell the $750,000 guaranteed portion of the loan in the secondary market, and achieve, on average, a $75,000 gain on sale. So if I go out and spend $4,000 an hour on a private plane visiting ten sites in two and a half days, and those ten sites all average a million dollars in loans, you can do the math.
Those planes are flying branches. Most banks build a branch and hope somebody comes to it. We “build a branch” and go see the customer—for both loan generation and follow up. We make the supposition that if you’re not sending us a current financial statement to compare to your agreed-upon budget, there’s something wrong. And we’re going to go see you. In all likelihood, we’ll end up helping you with your business.
I can’t tell you how many websites we helped set up for veterinarians at our own expense, because if I’ve got a vet that goes down, the paper is worthless. There are no assets there.
Q2. Do you require an investment from every employee?
A. Mainly from the senior lenders and the domain experts. I will ask a lending candidate, “How much money do you have in the bank?” He might say, “Well, I’ve got $100,000.” So I respond, “Okay, I’ll take half.” It’s not the dollar amount, but the percentage of what they’ve accumulated in their life. They need to be partners.
The candidate may say, “You really want me to drain 50% of my liquidity and buy Live Oak stock [a private company for its first seven years]?”
“Yes, I do,” I tell him. “It’s like owning your own car versus renting. We’re all in this together. I’ll give you options, and they vest this way: 10% a year for each of the first five years, and 25% a year for years six and seven.”
I explain that we’ve got a bank that’s grown to 400 employees, a software company that has 265 employees, and a brand new trust department. “I think I can keep you interested for the rest of your life. But if this is really all about you, you should work for somebody else.”
I’ve had experience with software companies. People work a year or two and want their options to vest on the way to lunch. I didn’t want to do that this time.
I wanted to approach it completely differently. We all know about the three-legged stool—shareholders, customers, employees.
I thought, what if we really, really, really spoiled our folks? And so we pay 100% of their health care. We have a 6% 401(k) match. We built a $3.5 million restaurant for employees here at our headquarters, and we built a $1.5 million gym and an outdoor track around the lake next to our building. Our three airplanes get lenders and domain experts home at night from visiting clients.
We have virtually no turnover. Each of the past two years, we’ve been voted the best bank to work for in America. And still, every day I try to figure out a way to throw another log [employee perk] on the fire. Some of this stuff people say is stupid, but every time we do it, profits get better.
Until we went public and raised all this money, we had 30%-35% return on equity and 4% return on average assets.
Q3. How many verticals do you have? How do you choose them?
A. We now have 13. We started with veterinarians and added dentists, death care, hotels, poultry, government contracting, self storage, family entertainment centers, insurance agencies, independent pharmacies, investment advisors, and renewable energy. Up until a couple of years ago, truth be told, it was just me waking up in the middle of the night with an idea for a new vertical.
Now we have “Seal Team Six.” Three of our best and brightest are responsible for trying to find three or four new verticals a year. We have five data scientists here to help them analyze payment data, D&B data, SBA data, and a lot more.
Sometimes, we just back into one. For example, I was in New York for a Fox Business News interview, and a guy who was in the investment management business says to me, “I went to your website, and you’re missing the boat. No bank will lend money to registered investment advisors because there’s no collateral. But there’s a lot of recurring income. You ought to look at it.”
So I did and ended up hiring the only lender Charles Schwab had, and now we’re doing a couple hundred million dollars in loans to RIAs. There are about 58,000 of them. When one of them wants to sell out to a younger guy, we’ll lend the buyer the money. He gets a 1% management fee on maybe a $1 billion book of business. That’s a pretty good business.
Q4. Live Oak Bank is highly capitalized (Tier 1 of 11.12% at midyear). Is that a response to regulatory pressure or by choice?
A. When I owned Cardinal Bancshares in Kentucky [the parent of Security First Network Bank], Nick Adams of Wellington Asset Management was an investor. After chatting with him about my plans for nCino and Live Oak, I sold him 24.9% of the bank. On a handshake, I agreed to take the company public sometime in the next five to seven years.
We took the company public a year ago and raised about $90 million. Sixty million of that is still sitting in a checking account at the holding company to support our growth.
Last year, we did $1.15 billion of originations. We told the Street that we’ll do $1.3 billion to $1.45 billion this year, and we’ll probably do better than that. We’ve got a tiger by the tail here.
I learned from S1 that raising capital when you don’t need it is smart. At Live Oak, we have over $200 million of capital at the bank and holding company. Our loan losses this year are under 30 basis points, and total nonperformers are $2.5 million. And that’s for the unguaranteed paper alone.
The reason earnings have been relatively flat is that we keep adding construction loans.
Let’s take two of our newest verticals: self storage and hotels. We’ve got 10-12 people in each division, and we make a self storage loan for $2 million. It will take two and a half years to monetize that because the borrower has to build the storage building and then lease it up. Between self storage and hotels, we have about $800 million worth of construction loans tied up, representing $60 million in profits.
Analysts that take the time to understand this don’t really care if we monetize it today or two years from now.
It’s a little bit like Jeff Bezos and Amazon. I’m certainly not trying to compare myself to him, but he didn’t care about quarterly results; he knew what he was building for the long term.
So we think we know where we’re going, and that others will have a difficult time keeping up with us. But you would not want to go in and out of our stock on a quarterly basis.
Q5. You rolled out a new e-lending initiative earlier this year. Is it your version of marketplace lending?
A. No. Historically, we have not been interested in a loan under $350,000. The average government-guaranteed loan has 150 documents, so it’s going to take just as much effort and time to do a $350,000 loan as a $5 million loan.
But we figured out how to use nCino’s technology to get all that data in one place for the customer—not just internally. So when a borrower goes to our website and drags and drops a document, it will say, “Hey, Bill, you’re 19% complete. When you get me these documents, I’m going to get you an approval, or not, in 24 hours.”
Once approved, of course, all you care about is getting the money. And here’s what that takes. You get your lawyer, or your paralegal, on the phone with our paralegal. And they’ll say, “We’ve got to have this appraisal, this environmental—whatever it is—to get you the money.”
We said, “Why don’t we go down-market inside our verticals where we would automate a bunch of this stuff?” So again, our data scientists jumped in there, and we partnered with about 18 separate companies to do it.
But we’re not marketplace lenders. I affectionately call a lot of those guys charlatans because at the end of the day, it’s not really going to work, right? And we’re beginning to see that now.
Let me ask you this: Do you know any business that can be run well when you don’t know your cost of goods sold?
With a lot of these fintech lenders, it isn’t their money. So they’ve got to rely on the capital markets—hedge funds—and we know hedge funds are here today, gone tomorrow.
Being regulated by FDIC, the state of North Carolina, the Securities and Exchange Commission, the SBA, and the Federal Reserve Board is not fun. But I know what my cost of funds are because we’re a bank.
Q6. What about the other side of the balance sheet: Where do you get your deposits, and how will that change when you roll out your new online banking platform?
A. Just think of us as an Ally Bank model. We have about $400-$500 million in local deposits in our Wilmington, N.C., branch, but otherwise it’s the full faith and credit of the U.S. government at higher interest rates gathered in an efficient fashion—some brokered, but mostly online.
It occurred to us that we do lending business with about 900 veterinarians, and there are 80,000 veterinarians in this country. There are 23,000 independent pharmacies, and we do lending business with 500. Every one of them has a checking account, but certainly not every one needs money, right?
So let’s take a next-generation online platform with a clear user interface with remote deposit capture tightly integrated into bill pay. And say we give away merchant services tightly integrated into Checkfree, so you can do financial forecasting and benchmarking. And we offer that inside our 13 verticals. A lot of big banks thrive on these merchant fees because they’ve got to support a branch infrastructure. Not us. We’re testing this package today, and it will be operational in the next three months.
Q7. So how do you see the future unfolding for banking overall? Is the industry at a turning point not seen historically, or is that overstating it?
A. No, I think that’s understating it, and here’s why.
Brian Moynihan used to be the general counsel at Fleet, and Fleet was an investor when we raised $300 million at S1. I think the world of Brian Moynihan. And I felt so sorry for him when [this summer,] on the front page of The Wall Street Journal, he announced that he was going to take another $5 billion worth of cost in the next 24 months out of Bank of America and lay off thousands of employees. He has to.
Because if you go back—and I have done this—and look at the top ten banks in this country over the last five years with interest rates what they are, and margins that have been squeezed, these are declining revenue model businesses.
And I don’t care if you are running a bank or a chicken company or a funeral home; if you’re running a declining revenue business, you’ve got to fire somebody.
So who wants to work there? Brain drain.
I’d rather invest in a utility than in a declining revenue business where you’re investing in a blind pool of credit risk that’s leveraged ten to one.
And when are we going to have the next cycle of downturn from a credit quality standpoint? We know it’s coming, right?
So it’s a crappy business, unless you can do something a wee bit different. And that’s what we try to do here.
We’ve been growing our business in excess of 30% a year for a long time. I do not have any trouble attracting and retaining talent.
This article originally appeared in the October-November 2016 edition of Banking Exchange. Read the article in magazine form
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