LendIt 2014: Why I Can’t Wait

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The dawn of the 2014 edition of the LendIt conference is upon us, and I’m like an eight-year old kid on Christmas Eve.  In a few short hours, the best and brightest in the world of crowd and internet-based finance will descend upon the Hilton in Union Square, and we’ll be off to the races.  There will be learning, networking, brainstorming, partnering – swimming deep in this vast ocean of financial market disruption that we call online lending.  I’m genuinely ecstatic for things to get rolling, and I thought I’d write a few quick thoughts on what I’m most looking forward to.

Naturally, I’m excited to connect with and hear from the industry’s pioneers and current titans, Lending Club and Prosper.  They blazed the trails for what are now several widely accepted realities – that a functional marketplace for common sense financial transactions can exist online; that viable alternatives to painful bricks-and-mortar lending institutions can be made accessible for a vast universe of legitimately creditworthy borrowers; that access for income investors to high quality, short-duration, healthy yielding diversified loan portfolios need not be restricted only to banks and other massive financial institutions.

Beyond that, they’ve proven themselves over and over again – as innovators, operators, visionaries, etc.  Prosper has obviously pivoted, juked, jumped, and jived several times in the past few years – and is now on solid footing with a focus on growth in its core business.  Having established itself with a seemingly bulletproof consumer term loan product, Lending Club is now executing its vision to broadly become a global leader in credit origination.  These two companies have not only been pioneers in creating an incredible industry, but they’ve also been great partners to me in establishing my business as an asset manager in the space.  I’m genuinely excited to hear about what’s next from them – but what’s more thrilling to me is the opportunity to build relationships with new partners.

There are so many companies that – standing on the shoulders of the innovations of the past decade – are building new, fascinating opportunities from scratch.  A year ago, things were starting to heat up around online small business term lending, student loans, and real estate crowdfunding – each of these are increasingly active realities in the marketplace, having attracted major investments from reputable and deep-pocketed institutions.  We’re now talking about taking the existing models to “emerging prime” borrowers, creating rewards-based credit products, web-originated short-term business funding, consumer income share agreements, online lending in the secured subprime auto space, specialized patient loan products for medical procedures, innovative centralized models for distributing these various loan products to income investors, new data aggregation tools for advanced decisioning – the list goes on and on…

I’m excited to gather with a group of people who are skating to where the puck is going, not to where it sits currently.  I’m excited to be in the same place at the same time with companies who believe in the democratization of finance, and who share my vision of creating financial products that just absolutely make sense for every link in the value chain.  Basically – I’m excited to work hand in hand with people who get it.  Who see the white space – the massive bifurcation in credit markets between traditional bricks-and-mortar lenders and the classically onerous “alternative lenders” – and who want to do something about it.

From a selfish perspective, I’m candidly looking forward to talking shop with folks who can help grow my business on both sides: groups with asset networks who can help to direct good, smart funds to emerging managers in the space, and companies creating high quality credit products that fit my fund’s value proposition and diversification objectives.  These are conversations I have separately every day, but it’s invariably a pretty cool experience to have so many passionate, brilliant, like-minded people in the same place at the same time.

LendIt 2014 is upon us indeed; I hope to see you there!  If you’ll be there and we don’t know each other, come find me and we’ll chat.  Best regards,

Dan

Peer-to-Peer Lending: Sprint or Marathon?

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Note: This is the fourth in a series of posts where I’m offering my thoughts as to the role of peer-to-peer (or “direct”) lending within the broader context of the investment landscape.

I ran the Philadelphia Marathon last weekend – 26.2 miles of pounding pavement gave me lots of time to think about the fast-evolving peer-to-peer lending industry.  As I ran…and ran…then ran some more, I thought about the “sprint vs. marathon” analogy as it relates to the P2P lending market.  In today’s post, I’ll offer my view on the short vs. long-term outlook of this finance phenomenon. Warning: in keeping with the marathon theme…this post is a long one!  Let’s start with the conclusion, and build from there:

The question: is peer-to-peer lending a sprint or a marathon?  The answer: I think it’s both, but the sprint looks a good bit different from the marathon.  Let me explain…

In the short-term (it’s not easy to define the time horizon, but let’s say 1-2 years is “short-term”), peer-to-peer marketplaces will be essentially unchanged from their current form.  They’ll continue to operate under the exchange platform model, thereby providing a viable direct income alternative for any and all interested retail investors. Sure, there will be tweaks, nits, and picks that the platforms implement, but I think the big picture is that they’ll dig deep to ensure the fundamental retail experience – the true “peer-to-peer” nature of the model – holds water for the foreseeable future.

Aggressive marketing to creditworthy borrowers will be the bread and butter of the industry’s growth.  This, coupled with increased regulation and monitoring of institutional activity, will ensure this industry maintains its “peer-to-peer” core for at least a little while longer.  We’re already seeing signs of this, as both Lending Club and Prosper are actively managing institutional access to the market.  Many interested parties are currently denied entrance as there simply isn’t sufficient loan volume to satisfy the market’s appetite.  Both Prosper and Lending Club are keenly aware that asset performance is critical to their long-term viability, so I don’t believe we’ll see either relax credit policies to meet demand – but the market will respond to the demand somehow.

Several new exchange-based platforms will come to market.  These will take advantage of the structural legwork completed by Prosper and Lending Club.  My view is that these new players will be slow to gain traction because of platform risk, while Lending Club and Prosper will continue to thrive.  New platforms will have success in markets outside of unsecured personal loans, though – the real estate, student loan, and car loan markets will see traction in crowd-funding based platforms.   The existing platforms will start to expand outside of the unsecured personal loans market as well.

My primary short-term outlook is that I believe the existing platforms will work very hard to protect the existence of an exchange that is fundamentally peer-to-peer, and they’ll do so without making significant sacrifices to the yield profile of the asset class.  This is good news for the market at large, and it implies that in the short-term, it makes sense for investors to “sprint” to the peer-to-peer lending market.

However…

In my view, the real value of the industry is not just that it creates a peer-to-peer exchange.   Rather, the major secret that’s been uncovered is that consumer credit performs extremely well as an asset class.  In the early days of the industry, Lending Club and Prosper have succeeded in providing direct access to some very unique asset characteristics, and they’ve capitalized it through a crowd-funding model.  Yes, the peer-to-peer nature of the model is compelling – but what’s more is that consumer credit is emerging as a vehicle through which investors can obtain consistent cash flow with minimal volatility.  Returns are what capture my attention; I’m not currently interested in participating in a crowd-funded student loan marketplace because the ends (yields) don’t justify the means (both time and dollars invested).  At the end of the day, the market wants a return on investment – peer-to-peer lending ultimately gained traction because it gave investors a viable and interesting way to diversify portfolios and make real money.

In the long-term, institutional asset managers will make up the lion’s share of the market (in fact, they already do), they’ll access from a variety of platforms and exchanges, and retail investors will want it that way.  The broader retail market will look for a way to allocate a portion of its fixed income portfolio to consumer credit.  Institutions such as pension funds, foundations, and endowments will want exposure to the space, but they won’t want to buy up individual loans through an online exchange.  They’ll gladly pay a fee in exchange for expertise and access.  In my view, it’s simply unrealistic for the broad investment community to hold consumer credit in portfolio under the mechanics of the current exchange model.  The level of scale that the platforms would ultimately need to support requires a much less frictional distribution structure, which will take place in models that differ from the current “first come, first served” peer-to-peer exchanges.

That’s not to say the exchange model will cease to exist.  I do think it’s sustainable for Lending Club, Prosper, and other platforms that arise to facilitate access for those “do it yourself” retail investors who want to actually sift through the loan inventories and build their own portfolios.  A slice of the market will likely always be reserved for the true DIY investor to preserve the beauty of the core peer-to-peer model.  I really hope it does, and I think it will.

In the long-term, yields will be somewhat repressed as supply and demand will have to meet in the middle.  Some of the historical mis-pricing of loans for consumers with damaged credit history will be replaced with new underwriting strategies that more effectively price risk.  This, when coupled with the balancing of supply and demand, will ultimately lead to a reduction in yields.  On a relative basis, consumer credit will still fall into the “high yield” category, and will certainly provide stellar risk-adjusted returns for years to come – but it will be difficult to sustain the returns early investors in the space have achieved to date.

My personal hope is that the mechanisms that make this asset class broadly available to retail investors through intermediaries in the long run are able to mirror the great characteristics that have made peer-to-peer lending emerge so strongly.  The held-to-maturity nature of the current market is what shelters investors from volatility.  Minimal default rates are what make the economics worthwhile.  The list goes on – if managers are able to structure products that retain these characteristics, and the current and future platforms are able to effectively acquire creditworthy borrowers on a massive scale, the long-term prospects of broadly distributing consumer credit to the general investment community are very strong.

To sum up, I think the “sprint” perspective of peer-to-peer lending implies that investors should get in the space now.  Clearly I believe it makes sense to hold the asset class today.  It’s only becoming more competitive and complex – that trend won’t reverse itself any time soon.  Sprint to get in the race, and because the asset class works.  The “marathon” component is admittedly vague, but what conclusions we do have imply that we should think critically about what matters at scale – is it asset performance, the “peer-to-peer” component, liquidity structure, or something else?  In any case, investors should position themselves to efficiently access the market in the long run by identifying what matters to them, and developing a strategy to consistently find it.

Best regards,

Dan

Peer-to-Peer Lending: Why You Won’t Lose Money

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Note: This is the third in a series of posts where I’m offering my thoughts as to the role of peer-to-peer (or “direct”) lending within the broader context of the investment landscape.

Over the past few weeks, we’ve been discussing the role of peer-to-peer lending in an investment portfolio.  The conversation started around the advantages of directly holding debt to maturity; then we focused on the essentiality of capital preservation.  Next, we’ll drill down a bit further into the theme of protecting principal by analyzing the reasons for how this asset class minimizes downside.  What are the underlying factors that make peer-to-peer lending – something seemingly risky and definitely “quirky” – a comparatively safe investment?

Fundamentally, it’s an issue of the spread between two basic, primary variables: a) gross interest rates and b) default rates.  The spread between them is “net yield.”  Sure, there are lots of other factors that come into play in determining a net bottom-line return.  Servicing fees charged by the platform (Lending Club, Prosper, etc.) will reduce yield.  Timing of defaults – as opposed to a flat absolute default rate – can either negatively or positively effect returns.  Borrower pre-payments, idle cash, and asset manager fees are other factors that can repress returns below the fundamental spread between interest rates and charge-offs.  In the spirit of keeping it simple, though – and to illustrate the point of how the characteristics of this asset class are akin to capital preservation – let’s focus on the delta between these two simple parameters.

Data from a variety of sources (US Federal Reserve, US Bureau of Labor Statistics, BankRate.com, CardHub.com, among a host of others…) generally lead us to coalesce around one straightforward conclusion.  Over the past 25 years, average gross interest rates that consumers pay on unsecured revolving credit lines range from 13% to 19%.  There are ebbs and flows in these rates, and there is some correlation to shifts in broader interest rate climates.  Regardless, at no point do they fall below the teens, and it’s very realistic that peer-to-peer lenders can construct a diversified loan portfolio of notes that mirror that 13% – 19% range.

Conversely, a high level analysis of historical credit card charge-off rates by banks and other financial institutions shows that default rates seldom even remotely approach the teens – even in the worst of consumer economic cycles.  Over the past 25 years, average reported charge-off rates are roughly 4.5%.  Dating back to the beginning of 1991, default rates exceeded 6% in only 16 of 90 fiscal quarters.   The highest reported charge-off in a single quarter was 10.97% in Q2 of 2010 – a time when unemployment rates were also historically high (between 9-10% throughout 2010).  At that time, credit card interest rates were approximately 14% – indicating a still positive net yield of approximately 3%, in what was by far the worst consumer credit cycle in the past quarter century.  The net relationship between these two variables has never been such that charge-off rates exceed interest rates, and, in a normalized environment, will range anywhere from 6% to 12%.

The fact that the spread between the two is positive in both good times and bad is remarkable.  It signals opportunity.  To be clear, credit card interest rates and charge-offs of bank credit card receivables are not entirely analogous to peer-to-peer lending interest rates or charge-offs in online lending portfolios.  Risk averse brick-and-mortar institutions will typically lend at a lower price point in exchange for limiting losses; on the other hand, peer-to-peer lenders can play anywhere on the borrower risk curve – an investor can, if he so chooses, mirror what banks have historically done and lend to a subset of higher quality borrowers at lower interest rates with lower estimated write-offs.  A peer-to-peer lender can alternatively construct a portfolio at a yield point much higher than would be typical of a book of credit card receivables.  The comparison is admittedly not apples-to-apples for obvious reasons, but the data are a relevant starting point to illustrate the compelling characteristic of persistently positive absolute yields in various climates.  (Lending Club and Prosper have published historical loan performance data, so by back-testing various strategies we are able to conclude that there is a strong relationship between the referenced data sources and actually peer-to-peer loan performance.)

My belief is that this opportunity may contract over time, and peer-to-peer lending is actually a step in that direction.  In a market this big, however – with roughly a trillion eligible dollars – it’s going to take a while before direct online lenders become the lion’s share of the market and push yields down further.  Eventually the mis-priced risk, the faulty assumptions of consistently astronomical default rates, and the stigma of high-interest consumer borrowers will start to fade, and the opportunity for investors to obtain such upside with minimal downside will be more difficult to find.  In the meantime, though, those of us who understand these fundamentals have a unique opportunity to capture significant yields with the peace of mind that comes from a historical track record of surprisingly low default rates.  Say what you will about the presumed risks of peer-to-peer lending, but this consistently positive net yield – access to which was traditionally reserved only for brick-and-mortar institutions – warrants serious consideration for each of us as a mechanism for capital preservation.

Best,

Dan

Peer-to-Peer Lending: Follow Rule Number One

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Note: This is the second in a series of posts where I’m offering my thoughts as to the role of peer-to-peer (or “direct”) lending within the broader context of the investment landscape.

If you’re reading this, you probably know that I am a major believer in peer-to-peer lending as a viable asset in the majority of investment portfolios.  Today’s post will focus on perhaps the single most important characteristic of this asset class: the protection of principal and preservation of capital.

Warren Buffett’s famous elementary rules of investing are…

“Rule Number One is to never lose money.  Rule Number Two is to never forget Rule Number One.”

Of course, we typically read this as a warning against aggression.  There are lots of ways to lose money by investing it.  People buy assets for more than they’re worth every single day.  They can take on too much debt and watch a portfolio crumble under the weight of leverage.  We can invest in things we don’t understand, only to later learn that the fundamentals were bad from the beginning.  Maybe we’re just bad at poker.  The list goes on – there is no shortage of creative ways to lose money.

The unfortunate reality is that within our financial system of behemoth institutions, decades of savings and investments can be wiped out by occasional shenanigans on Wall Street.  The impact of such events can’t be completely avoided in a properly diversified portfolio – but too much of any bad thing will inevitably result in negative overall returns … which breaks Rule Number One.

This isn’t to say Buffett advocates a strategy of fear – on the contrary, this man made his billions by stopping at green lights and going at red ones.  Independent thinking is a necessity to achieving real returns. Ultra conservative investors will actually lose money in an inflationary environment because inflation outpaces the rate of return on their savings.  Cash and savings are almost always depreciating in value, so we can’t afford to sit still.  If we do, we’re losing money – and breaking Rule Number One.

So how can we follow the rules?  That’s a tough question with lots of moving components and there are plenty of defensible answers – but I contend that peer-to-peer lending (more generally – and better yet – direct, held-to-maturity debt) is a valid piece of the solution.  As of the date of this writing, data published by Lending Club indicate that 99.9% of properly diversified accounts achieve a positive net annualized return, and over 90% of these accounts achieve yields north of 6%.  Arguably Lending Club’s “net annualized return” isn’t the greatest metric for real returns, but the shape of the data is conclusive: virtually all properly diversified peer-to-peer loan portfolios have historically preserved capital and generated yield.

Critical to the argument is that this is true regardless of timing of market entry and exit.  Enter in 2007 when public REIT funds were about free falling?   (…wiping out decades of savings in the process?)  Steady yields of 5%+ across the vast majority of peer-to-peer lending portfolios.  Enter in 2010 when they had a roaring recovery?  Relatively little change in performance in the P2P market.  How about in recent months, when rises in interest rates led to a tumble in bond fund values?  Still yet, the performance of these consumer loan portfolios was effectively unaltered.  Sure, as long as you time market entry and exit right, you probably won’t lose money in public markets in the long run either – but if per chance your timing is off, you can bid adieu to a nest egg.

We’ll talk through why this is true next week – what some of the factors are that dictate such consistent performance – but for now, let’s let the data speak for itself.  A .999 batting average regardless of market timing is pretty compelling to me, and I think it just may help us follow Rule Number One.   Best,

Dan

Why Peer-to-Peer Lending Makes So Much Sense

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Note: This will be the first in a series of posts where I’ll offer my thoughts as to the role of peer-to-peer (or “direct”) lending within the broader context of the investment landscape.

Much attention has been garnered in recent months by the evolution of peer-to-peer lending.  Mainstream press and major financial institutions are paying close attention to the space.  The model’s large-scale viability is no longer in question as Lending Club and Prosper continue to grow steadily at significant volumes while the loans they produce maintain consistently strong performance.

The fundamentally attractive characteristics of this asset class are turning heads on Wall Street, and justifiably so.  Where else in this market can you find a product with these unique traits packaged into one opportunity?

  • Yields conservatively over 5%
  • Short durations
  • Sheltered volatility
  • Low default risk
  • Monthly amortization (consistent cash flow)
  • Track record of capital preservation

Such asset profiles are difficult to come by in any market – this one certainly no less.   By this time, it’s fairly well documented that those characteristics are sought after and they are what is driving investors to the market in droves.

But to me, aside from the obvious traits mentioned above, perhaps the single most attractive characteristic of peer-to-peer lending is what the platform facilitates: the ability for investors – big and small alike – to directly hold a diversified portfolio of monthly-amortizing debt to maturity.  Prior to the emergence of the peer-to-peer lending model, the existing market mechanisms didn’t broadly facilitate that capability.  In most cases, retail investors wishing to allocate a portion of their portfolio to fixed income would do so through a public bond fund – which is, at the end of the day, an equity investment in a debt fund with equity-like volatility due to typically fickle interest rate environments.  Add to this mix that public bond funds are often not providing real returns after inflation, and the investing world is asking itself how to get real fixed income.  Make no mistake: owning shares of public bond funds is quite a different beast from directly owning the bonds themselves.

Part of the problem is diversification.  The existing mechanisms historically didn’t facilitate the purchase of bonds in small denominations. While it is possible to purchase corporate and municipal bonds directly, it’s almost impossible – due to factors of both magnitude and logistics – for most investors to build a diversified portfolio of them.  That’s why they wind up buying equity stakes in funds that hold the underlying debt, but again – in doing so, they sacrifice part of the original intent of holding bonds in the first place.  Ultimately what they hold is frequently volatile with inconsistent cash flows that may or may not correlate directly to the performance of the underlying asset.

What I love about peer-to-peer lending is that it introduces a broad distribution method for investors to directly hold debt to maturity (i.e., the loans aren’t up for sale).  By doing so, an investor can build a diversified portfolio of assets whose performance depends solely on the borrower’s ability to repay – not changes in interest rates, not fund prices being bid up or down by supply/demand, and certainly not trading glitches on Wall Street.  If the investor doesn’t really care what someone else would pay to buy his portfolio – because after all, he’s interested in regular cash flow – then the value of the investment is only contingent on the borrower’s ability to repay.

Obviously, the trade-off is liquidity.  What the markets are teaching us, though, is that investors are willing to trade that liquidity for less volatility, more predictability, and ultimately greater transparency (not to mention – better returns!).  As a fund manager in this space, I am continually striving to facilitate entrance into this asset class in a way that is similarly transparent, as though the investors were directly holding the debt themselves.  The appetite is for consistent cash flow that mirrors the underlying asset performance – actually not a very complicated concept, but somehow it’s an anomaly that has escaped the world of investment management in recent decades.

Surely as the peer-to-peer lending market evolves, more liquidity will come to the space (it’s already happening) and we will have volatile public funds whose underlying assets are P2P loans.  This is a good thing as many investors would prefer to just invest in a fund and stomach the price volatility of a publicly traded security.  Even so, I will advocate for the continued availability of a platform that facilitates direct loans in small denominations through a transparent and user friendly interface.  This avails to the broad investing public the opportunity to hold a diversified cash flowing loan portfolio to maturity – a beautiful thing.

Tune in next week as we continue to dive into the role of this asset class.  Best,

Dan

Birchmere High Yield Fund Launches

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Good day, all.  Just a brief note to officially announce that Birchmere High Yield Fund LP has formally launched.  We’ve privately raised a seven-figure amount to get the fund off the ground, and should be able to start reporting performance figures to our private investors at the close of either September or October.  (Of course, please note that this announcement isn’t a solicitation to attract investors to the fund.  I’m basically required to say that.)

It’s been a pleasure watching closely as the industry has evolved over the past several years – now to the point where many institutions can deploy significant capital in the consumer credit markets.  This was and continues to be a primary goal of Birchmere Advisors – to locate attractive high-yield investment opportunities and package them in a way that makes sense for investors, providing access to assets that may be otherwise difficult to hold in an investment portfolio.  We’re very pleased to be at the point where this – democratizing passive income for our investors – is a reality.

Stay tuned for further evolutions of how we’ll seek to productize this asset class – we’ve only just touched the tip of the iceberg.  We’re diligently working to consider how to best distribute the attractive characteristics of consumer credit to income-seeking investors.  As always, your input, suggestions, and questions are welcome – just shoot me an email.  In the meantime, I’ll be focused on building a great base of assets to anchor Birchmere’s newest fund.

Regards,

Dan

Consumer Defaults at Record Lows: Why Does that Matter?

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Data released recently by major indices and industry aggregators (S&P / Dow Jones and Experian) indicates that defaults on consumer credit continue to decrease across the country.  See the WSJ’s brief write-up on this data here. Clearly this bodes well for those who currently hold consumer credit in portfolio – it’s a relevant data point for favorable macroeconomic dynamics that set the stage for profitable lending.  That said, the shape of the data isn’t new – charge-off rates of bank credit card receivables are typically in the 3-5% range.  So it also further validates one of the fundamental tenets of direct peer-to-peer lending: the rates charged by brick-and-mortar institutions are reflective of additional costs of lending over and above the risk of the asset.

This is becoming increasingly obvious as the industry trends towards stability and greater critical mass.  The rates charged by banks and credit card companies are high for two reasons: default risk and overhead costs.  Companies like LendingClub and Prosper are reducing the overhead cost of lending by implementing models that are primarily data-based by effectively utilizing modern technology.  With lower overhead costs, a more efficient market is created wherein the primary component to pricing loans is risk.

This is also accomplished by parsing out the lending function from the underwriter.  Since LendingClub and Prosper don’t hold the loans on their own balance sheets, the pricing of the loan isn’t intended to cover operating costs – unlike many brick-and-mortar institutions.  Of course, this brings with it a whole host of other agency issues – e.g., shouldn’t the underwriter’s compensation be tied to the performance of the loan?  Sure – and to the extent that the long-term viability of the peer-to-peer market-maker depends on the skill of the underwriter, this issue is adequately addressed.  That’s another topic for another day, but its implication holds constant – the loans should be priced for risk.

The point is this: direct lending models already make credit markets more efficient by utilizing technology to reduce operating costs.  Then, by delineating the investor from the underwriter, the cost of credit is more accurately dependent only on risk.  With respect to that exposure, we’re learning a lot these days.  Those whom traditional institutions have black-marked as non-creditworthy are actually pretty good at paying back their loans – and that’s good news for those of us who are willing to participate in the market.

Regards,

Dan

Bears & Bonds

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Readers:

Here is an interesting NY Times commentary highlighting the need to re-think our traditional methodologies for generating income within the portfolio.  Clearly, we at Birchmere Advisors are in agreement with many of the observations highlighted in the article.  This sentiment is increasingly visible to the public eye – and rightfully so, as the wave of principal loss has begun.  Investors are losing precious capital invested in bond markets due to expected changes in the interest rate environment.

Though not cited in the aforementioned article, peer-to-peer lending offers a diversified method to participate directly in debt markets without the exposure to loss of principal that is inherent in traditional bond funds.  The infrastructure and scalability of the online direct lending model must leave investors reconsidering the age-old assumptions concerning the risk profile of bonds – and even more so, public bond funds.  Investors generally hold debt securities for downside protection and income.  Bond values are supposed to be intrinsically tied to the borrower’s ability to pay.  Yes, interest rates, durations, etc., all should and do impact the value of bonds – but then, are they truly “fixed income” securities?  We suggest it’s time to reinvent the framework – the direct lending model makes the return of true fixed income a real possibility for today’s investor.

That’s some food for thought.  Regards,

Dan