Disrupting Auto Finance

Last year, I woke up to the sleeping giant of auto finance. Over the last decade, we’ve witnessed an explosion of startups building software that dramatically cuts inefficiencies in the exchange of information, goods, and services – disrupting industry incumbents in the process. In the last year, Silicon Valley is finally turning its attention to the auto industry, and we see good reason to be excited about the next-gen upstarts that are changing the way we buy, sell, use and pay for cars.

Bigger than an Escalade

Auto sales and finance is a massive industry – with over 51 M units sold in 2013, and total leasing and finance revenues projected to hit nearly $98B in 2014. State laws, like those Tesla is currently battling, have historically prohibited direct sales from manufacturers to consumers, which means that in the age of Amazon efficiency, buyers are still stuck footing the bill for dealer overhead and OPEX. Resources like Truecar, Kelly Blue Book, and Edmunds.com have reduced – but hardly eliminated – asymmetry of information between dealers and buyers regarding car value, but can’t alter the fact that fees and mark-ups are essential for dealers to cover their overhead. Thus dealers will continue to push features and pad margins through obscure little line-items like dealer documentation fees – which vary as much as $500 by dealership.

Start-ups like Carvana and Beepi are taking used car sales online – reducing opex and passing on savings to both buyers and sellers. Carvana, which acts as a virtual dealer, leverages online distribution and direct-to-consumer delivery to manage inventory more efficiently and eliminate costs associated with managing a physical lot and salesforce. Beepi facilitates P2P sales via an online marketplace – managing the delivery process and offering sellers a purchase guarantee if no one buys within 30 days. Both companies are able to shave as much as $1,500 –to $2, 000 off the price of a used car, with Beepi further promising sellers a premium over dealer trade-ins (they just raised $60m).

Dumber than a Hummer

Like auto sales, auto finance is ripe with opportunity to reduce costs and improve customer experience. Misclassification of borrowers is a persistent problem within auto, just as in other consumer finance verticals. For example, 66% of generation Y (16-33 year olds) are classified as subprime. Clearly, 66% of this cohort is not conventionally high risk – a large majority simply have little to no credit footprint, or relatively large debt/income ratios due to student loans. Companies like L2C and Neo Finance are looking beyond credit scores and traditional data to segment thin/no-file borrowers from truly high-risk auto loan applicants. And better data is just part of the puzzle. Better models that can parse, contextualize, and learn on complex data sets are also needed. Companies like Cognical and Zest are already pushing the boundaries of underwriting technology in consumer finance – similar innovation can be applied in auto.

Maserati on a Mazda Budget

The complexities of underwriting aside, there is also significant opportunity to increase efficiencies via better distribution of auto finance and insurance – and opportunity to improve customer experience in the process. Consider buy here pay here lots (BHPH) and aggregate auto financiers. These are lenders of last resort – charging 18% -29% APR to high risk borrowers, and offering less flexible terms than banks, credit unions, or the captive lenders (Ford Finance, etc). Yet over one in five BHPH borrowers are prime or near prime. Collectively BHPH and aggregate lenders control 23.12% of the auto loan market (or ~$225B loans outstanding), meaning anywhere from $45B to $55B in capital could be more efficiently deployed in lower cost products.

This is clearly a distribution problem waiting for a marketplace solution. A large segment of borrowers would benefit significantly from increased access to and understanding of the financing options available to them. Likewise, a large segment of lenders (such as credit unions) would benefit from the opportunity to compete for these borrowers. We anticipate auto finance will follow evolution seen in consumer and SME credit – where the rise of online to marketplace and aggregation platforms have enabled borrowers to find and compare a variety of products from numerous lenders in a transparent and efficient way. This evolution is already occurring in auto insurance. Coverhound, (disclaimer, we’re invested), allows customers to browse, compare, and buy plans all online – saving them literally hundreds of dollars on their premiums.

Transparent online and mobile platforms will not only empower borrowers to access the best products available to them in the market, they will also cut out the spreads that dealers currently layer on to finance and insurance (“F&I” in industry parlance) products. Dealers make most of their margin on F&I sales – over $1,200 per vehicle on average for the publicly traded dealers. While F&I is just 3% of dealer revenues it accounts for about 20% of profits. These spreads are added to base rate in order to compensate the dealer for selling the product on behalf of the lender or carrier. In the case of financing, dealers often have discretion over the amount of the spread, and may add on anywhere from 1-2.5% APR. Unfortunately, this incents dealers to land customers in the priciest car (and loan) they can afford (or can’t), to increase the value of that spread. Even worse, recent CFPB analysis found evidence of discrimination in the application of APR mark-ups, with African Americans, Hispanics, and Asians consistently receiving higher discretionary mark-ups than white customers.

Given these misaligned incentives and potentially biased behavior, it’s no wonder that consumers are now spending 11 hours on average researching a car before they set foot on one lot – presumably to arm themselves with information and avoid the car sales guy like Ebola. Disrupting information asymmetry was a natural first step for online auto – but the next wave of energetic start-ups will finish what TrueCar began, by closing the loop between knowledge and action. Very soon, customers will be able to research, browse, finance, and insure their car online – with the vehicle delivered to their door in less time and for less money than ever before.

(Thanks to Colleen Poynton for her thought-leadership on auto finance)

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