Description

Summary: Recommend short sale of DAVE on existential risk to critical vendor.

Description: DAVE is an app-based payday lender and neobank that caters to low income Americans. Founded in 2017, DAVE came public in early 2022 via a SPAC merger. While the stock is down more than 90% from the peak post-announcement price, it is up more than 700% from its lows in 2023. The recent run-up in the stock price is likely due to the company’s inflection to GAAP profitability in 4Q23, which marked a significant turnaround from the sizable losses that the company reported for the rest of 2023. DAVE has 10.8MM customers, 2.2MM of which actively transact with the company in a given month, the substantial majority of which use the ExtraCash (payday loan) product, which is described in Figure 1.

Figure 1. DAVE ExtraCash Product Overview

Source: Company Presentation

Investment Thesis: In many ways, DAVE has built an impressive business. It has a slick user interface, clever marketing tactics, and a low CAC. It has also managed the credit risk in its payday loan portfolio admirably. The neobanking business—where DAVE acts as the marketing front end for a bank partner to acquire checking accounts—is a far tougher business. While DAVE has a chance to reach minimum requisite scale in neobanking, the business has a far more challenged margin structure than payday lending owing to the fact that a) low-income customers receive and spend relatively little money vis-a-vis customers of JPM, BAC, and SOFI, b) DAVE makes money from debit interchange, which has progressively been trending lower in major everyday spend categories, like gas and groceries, c) it has to share economics with the bank partner, and d) Regulation E is very consumer-friendly and often abused, leading to disputes and chargebacks on checking-account transactions. Nonetheless, DAVE has demonstrated good fundamental momentum over the last couple of quarters.

Here’s the problem: DAVE relies on its bank partner, Evolve Bank & Trust (“Evolve”), for its entire business. While DAVE began its payday lending business by operating in the shadows without state licenses, it restructured its ExtraCash product to a seemingly more regulator-friendly bank overdraft model in 2022. That structure relies on a bank account that is issued by Evolve to the customer, and the customer can overdraft that account to receive the ExtraCash product. DAVE further relies on Evolve to originate checking accounts for its neobank customers. Also in 2022, DAVE began requiring customers to open a checking account when they become a customer, even if the customer only wants a payday loan. This has helped DAVE pad its stats on checking-account customers and likely increased its ability to convince customers to test drive its banking services. Finally, DAVE relies on Evolve as the sponsor bank for ACH and debit-card processing. DAVE is all in on Evolve. See Figure 2.

Figure 2. DAVE Website Disclosures

Source: Company website

Evolve is a tiny, Memphis-based bank that punches above its weight in the fintech sponsor business. It has recently gotten some unflattering media attention because of its role as the primary partner bank to now-bankrupt Synapse Financial Technologies, Inc. (“Synapse”). However, that is only one of the many controversial programs with which Evolve is associated¹. A list of other programs includes:

• FTX
• BlockFi/Deserve
• SoLo Funds
• DogeCard
• Solid
• ZELF
• EZBanc

Many in the fintech space have known about Evolve’s issues for years, yet DAVE has continued to deepen its relationship with Evolve. This decision by DAVE has likely been driven more by expediency than true desire, as many fintech sponsor banks have retreated from neobanking programs in the last 12-18 months. Based on direct conversations with payment processors, very few banks, if any, are willing to take on a payday lending program, even for payment processing. Evolve has been the bank that has remained most open to this type of business. That may have just changed.

On June 14, 2024, Evolve received one of the most comprehensive consent orders² ever drafted by bank regulators from the Federal Reserve and the Arkansas State Bank Department, its two primary regulators (link here). The scope of the consent order is truly astonishing (see Figure 3 for a comparison with prior consent orders with fintech sponsor banks from the excellent industry consultant Jonah Krane of Klaros Group). The consent order requires submission of:

• A written customer due diligence prgram within 60 days
• A transaction monitoring system within 90 days
• A BSA/AML program within 60 days
• An independent compliance review with 90 days
• An IT and information security plan for correcting defencies within 60 days
• A written plan for capital risk management within 60 days
• A written plan to improve liquidity risk management within 60 days
• A written plan to enhance interest rate risk management within 60 days
• An enhanced written internal audit program within 60 days
• Improved lending and credit risk management policies and procedures, including documented analyses of the borrower's repayment sources and overall debt service ability within 60 days
• Several other written policies and procedures in a similar timeframe

The consent order purports to require a re-write of nearly every major policy that a bank requires, and it provides an aggressive timeline for each of them. One of these policies would take a bank two to three months to complete, but the consent order requires more than a dozen of these policies to be produced in the next 90 days. In the meantime, Evolve is prohibited from bringing on any new fintech partners or products without pre-approval of the regulators. Goodbye product roadmap at DAVE.

Figure 3. Recent Enforcement Actions Against Fintech Sponsor Banks

Source: Fintech Business Weekly, Klaros Group

The biggest concern is that Evolve likely will not complete all of these remediation tasks on the timeline required by the regulators, which could lead to further oversight and penalties for the bank. It seems possible, if not likely, that Evolve will have to exit certain businesses that it has supported, including banking as a service ("BaaS"). This is problematic for DAVE, since it went all in on delivering its core product, the payday loan, through a bank account, and it has required every customer to open a bank account upon enrollment for the last 18-24 months.

DAVE’s CEO is its founder, Jason Wilk. CFO Kyle Bielman has been in his role for many years, as well. These are smart individuals, so they surely recognize the existential risk that they face. However, their alternatives to Evolve are likely limited. As previously mentioned, sponsor banks in the neobanking space are running for the hills. Recall that DAVE changed its model to a bank overdraft line of credit, which requires a bank to issue it. Where will DAVE turn for that product? Recent regulatory guidance suggests that delegating important functions like credit underwriting to a partner for a bank whose customers have a deposit agreement with the bank’s name on it will be far more difficult in the future than it has been during DAVE’s massive growth years. DAVE might be able to return to its previous model of offering payday loans in an unlicensed manner, but it would still need to find a sponsor bank for sending and receiving payments. This would not be a small volume of payments, either, as DAVE does more than $1B in ExtraCash advances per quarter. 

Then there’s the issue of Synapse. Evolve’s consent order specifically states that the matters requiring attention in that document do not account for Evolve’s central role in the Synapse bankruptcy. According to the briefing of Chapter 11 Trustee Jelena McWilliams on 6/20/24 to the bankruptcy court, there are still $65-96MM of end-user (aka customer) funds missing roughly two months after Synapse filed for bankruptcy protection. Synapse was a middleware provider for the banks. It provided software allowing fintech programs, such as Mercury and Yotta, to create bank accounts on behalf of Synapse’s four partner banks, the longest-standing of which was Evolve. It should be noted that Synapse provided the ledger for the accounts that its fintech programs created. In this function, it was the “single source of truth” for the account balances. If Synapse’s ledger shows $65-96MM more customer funds than the bank partners have, that’s a major problem. It is hard to see how the partner banks will not have to honor what was on the official ledger. As expected, the partner banks are pointing fingers, and perhaps someone other than Evolve will be held accountable for the missing funds. However, there is also a chance that Evolve is held responsible for honoring the Synapse ledger balances. According to the FFIEC Call Report for 1Q24, Evolve had $158MM of equity. The potential loss that Evolve could face from covering the missing funds could render the bank critically undercapitalized. Even if the losses were socialized among the four banks, Evolve could still face a material blow to its regulatory capital. For DAVE, it will be tough to build its business around a bank with viability questions of this nature. At a minimum, the torrid pace of growth that DAVE has exhibited for the last several years may have to stop.

There are also questions that need to be answered about how something like the Synapse debacle could ever happen. Synapse apparently made active use of omnibus (a/k/a FBO) accounts that pooled all of its customer funds into a single bank account at the partner bank. This is logical, given that Synapse was maintaining the ledger for these accounts. They were not recorded by the bank partner’s core processor, likely for cost-saving reasons (banks often pay core processors on a per-account basis). However, one might wonder how the banks were not tying out their internal ledgers to that of Synapse at least on a nightly basis. Perhaps it is more difficult than it seems, but how can regulators not demand this of banks on a prospective basis? "The impact of Synapse’s bankruptcy on end-users has been devastating. I understand that, without these funds, many end-users are unable to pay for basic living expenses and food," McWilliams wrote in a memo to federal bank and securities regulators on 6/20/24. Did Synapse customers realize they would bear the risk for an accounting error on another customer’s—over even another platform’s—account? Testimony before bankruptcy judge Hon. Martin R. Barash indicates that many did not. Even if customers remain oblivious to such risk in the future, will regulators allow fintech programs to continue to pool customer funds? Omnibus accounts--used in this manner--are likely dead, which begs the question, what value do the BaaS middleware providers, such as Synapse, Galileo, and Marqeta really provide in a world in which banks are simply opening up individual accounts for individual customers, maintaining their own ledgers, and performing all of the KYC/AML/BSA due diligence and credit underwriting? The answer is, “Not much.” When regulators, and potentially legislators, get done altering the guidance for fintech programs, BaaS may also be dead.

Turning back to DAVE, if Evolve can no longer support its growth ambitions and product roadmap, can or will anyone else? Will Evolve even be able to support DAVE's existing business? Time will tell, but with the stock running from $5 last fall to roughly $40 today, this existential risk does not appear to be discounted in the share price. As equity investors build in a viability discount for DAVE's most critical vendor, the shares are likely headed materially lower.

Endnotes:

¹https://fintechbusinessweekly.substack.com/p/evolve-hit-with-fed-enforcement-action

²https://www.federalreserve.gov/newsevents/pressreleases/files/enf20240614a1.pdf

Catalyst

• Awareness of the risk identified above.
• Further regulatory action against Evolve.
• Disruption in service due to Evolve exiting one or more business in which DAVE operates.