Financial technology start-ups in Asia emerging markets turned the tables on their Chinese peers for the first time last year, racking up $2.4 billion in venture capital funding to $792 million. Nearly two- fifths of the 156 funding rounds announced in India, Indonesia, Singapore, and the Philippines involved a digital lender. In 2016, there were only 28 deals.

As a group, they represent a more efficient path to profitability than payment start-ups, many of which have received substantial VC funding but are criticized for high levels of cash burn.

These branchless lenders offer a user-friendly interface connecting prospective borrowers with capital providers. They promise to democratize access to finance, serving consumers and small and medium-sized enterprises (SMEs) that are typically dismissed by traditional banks as too great a credit risk.

India and Indonesia, which have the largest unbanked populations and the biggest small business communities, are naturally the core markets. But a large crop of local, regional and even foreign players has emerged. They all start with retail capital and look to graduate to local institutional funding sources, while limited foreign debt funding trickles in from development financial institutions.

VC investors like this combination of stability and a proven value proposition, although it is more easily achieved in some markets than others. In Australia, for example, AirTree Ventures has witnessed the phenomenon firsthand with Prospa’s rapid growth from a Series A round in 2015 to a domestic listing just three years later.

“We felt that the macro trends around small businesses growth being the engine of most economies but not having a finance solution was a gap in the market,” says Craig Blair, a managing partner at AirTree. “A good lending business should be able to get to profitability within Series B if not C.”

It remains to be seen whether Prospa’s Indian and Southeast Asian contemporaries – which are not supported by developed market financial infrastructure – can replicate its growth tangent and exit trajectory. Much rests on their performance this year, specifically how they cope with a very difficult operating environment.

Mandatory lockdowns enforced across the region due to the COVID-19 pandemic have crippled business activity, pushing companies into distress if not default and causing job losses. Many loans are likely to go unpaid.

Meanwhile, funding sources are being locked up. Banks, the primary source of capital for digital lenders, have taken out bad loan provisions and adopted a conservative stance. Analysts warn that these start-ups’ loan books will sour. On top of that, the credit risk scoring systems that underpin lending policies may not apply in a post-COVID-19 world where many business models will be disrupted. Historical data might not be a reliable guide.

“All assets today in India would look poor in the digital lending space. Asset quality would have worsened because of COVID-19 and a lot of loan books that appear healthy may be window dressed because of a six-month moratorium [on loan repayments] ordered by India’s central bank,” says Asish Mohapatra, co-founder of OfBusiness, an Indian digital lender and distributor of raw materials to SMEs.

Lizzie Chapman, CEO of ZestMoney, a consumer lending platform that facilitates checkout financing for online merchants and retailers, puts it more bluntly: “Nobody’s making a lot of money at this time.”

Needless to say, venture capital funding has dried up and new arrivals in the lending space have dropped to zero. But there is still room for optimism. Whoever survives the harsh summer will probably face reduced competition and have opportunities to consolidate demand.

At the same time, partners – clients, banks and non-banking financial companies – are increasingly turning to the start-ups still standing to learn how to conduct lending online. “It was such a difficult conversation a year ago but retailers now realize that customers don’t want a random agent running around [to help them sign up for a monthly payment plan on the app] if they can avoid it,” Chapman says.

Other processes like in-person meetings or paper-based documentation that were long seen as the norm are now being questioned as well. “People would send an email and then call you up on the phone and ask, ‘I’ve sent you an email, did you receive it?’ A lot of the steps in digital lending were like that and are changing favorably as a result of this crisis,” explains Ganesh Rengaswamy, a co- founding partner at fintech investor Quona Capital.

Unlike their traditional asset-heavy peers, digital lenders were able to continue operations under lockdown. It is also a vertical where there are established players – the top 15 digital lenders have scooped up nearly 75% of all VC capital committed to the sub-sector since 2016.

They are expected to fare better as they are already deeply enmeshed within their target users’ digital universe. Even if marketing budgets have been slashed, online businesses and banking partners still bring these digital lenders to people’s attention.

In the Philippines, non-bank consumer finance institutions are turning to financial technology companies in a bid to reach an increasingly digital customer base. Mikko Perez, CEO of Ayannah Global, an Indian and Philippine fintech solutions developer, has seen lending slow down but he notes a greater willingness to do know-your-customer (KYC) processes using video apps, originate loans through social media channels, and conduct loan management processes online.

“Your ability to acquire users as they start coming online and become more digital will be the key success factor. Those lenders with e-commerce experience or any form of online experience are better positioned to ride the wave,” he says, adding that Ayannah is currently working on digital remittance and insurance products.

Opportunities, threats

As a result, many digital lenders could find they are unexpectedly in demand. And help will come in the near future from unexpected sources as well. Tek Yew Chia, KPMG’s head of financial services advisory in Singapore, believes that family offices, charitable foundations and the likes of Asian Development Bank might provide debt funding because of financial inclusion imperatives and a desire to let money flow to underserved parts of the market.

It is also suggested that corporates will offer financing, so they can use technology solutions to help preserve the health of their supply chain ecosystems. Many digital lenders are looking to partner with property developers, for example.

Supply chain finance-focused lenders are traditionally the oldest and strongest constituent group in the digital community because they have accumulated plentiful data on SME borrowers through invoice and payment history provided by corporate buyers. They seldom require VC backing.

However, Chia warns that digital lenders could also face competition from banks in some jurisdictions as the latter have shown a willingness to engage with the same group of borrowers. It helps when governments share the risk of the loan portfolio in a bid to kick-start the economy. They are also narrowing down the advantage that digital lenders have in terms of smoother onboarding processes and quicker loan approval times.

Consumer-focused lenders, in particular, are expected to fare poorly in the near term. This is partly due to the uncertainty over the speed of labor market recovery in many countries. OfBusiness’ Mohapatra predicts that it will get worse before it gets better with partial lockdowns likely in the coming months as cases continue to climb in India.

Among consumer lending platforms, loans earmarked for goods or services that meet a clear functional purpose are considered preferable to straight cash loans.

“In good times, payday lending looks good and does well. In downturns, it’s ugly all over the world,” says ZestMoney’s Chapman. Where possible, consumer lending platforms are temporarily looking to increase lending tied to education spending and productivity tools.

For a long time, VC investors have anyway stayed away from the consumer vertical. It has only been in recent months that some start-ups have been able to raise seven-figure funding rounds.

Eddy Danusaputro, CEO of Mandiri Capital, the corporate VC arm of an Indonesian bank, declares himself bearish on consumptive loans and bullish on productive loans. He sees a lot of potential in digital SME lenders as long-term partners that can help the bank win new business.

“As banks were rolling back their branch operations before, and especially after this pandemic, it makes sense to collaborate with these peer-to-peer lending platforms because they have the distribution while we have the funds,” Danusaputro says.

But consumer finance is also a domain where data science can play a crucial role in analyzing alternative non-financial information related to user behavior. Lenders can check how frequently individuals look up their credit scores on an app and compare behavior to that of similar users in the past. When cross-referenced with data from centralized repositories like credit bureaus, digital lenders can make assessments in a way that traditional banks cannot.

“The combination of borrower and data set volumes are typically several orders of magnitude higher in consumer lending than SME lending,” says Quona’s Rengaswamy, adding that for SME lending, experience in being able to understand business intent matters more in the long run. “There is obviously a lot of leverage possible out of alternate data, but we have to be intellectually honest about the realistic usage of it across the spectrum.”