Institutional investors love finding new niches that allow them to access new types of return, thus enabling them to diversify their risks. Marketplace lending, also known as peer-to-peer lending, is one that has recently piqued the interest of many.

“There are a lot of niche strategies in private debt that are starting to interest clients, looking to expand out of their base private debt portfolio and diversify over time,” says Garvan McCarthy, a principal in the Dublin office of consultancy Mercer. “Peer-to-peer lending is one of these niches.”

Outside the world of peer-to-peer lending, “it’s otherwise difficult to access unsecured consumer lending”, adds Gregg Disdale, the London-based head of alternative credit at Willis Towers Watson.

There is, however, one wrinkle. Institutional investors also like to study the track record of investment niches – going back as far as they can. One might expect the lack of a track record for the relatively new investment opportunity of MPL to become less of a concern for them over time, as each year adds to the fossil record of investment performance.

However, talking to institutional investors and their advisors, one gets the impression that the reverse is the case. This is because with every year that passes, the next economic and credit downturn seems more imminent.

This concentrates minds on the lack of data on how MPL investments performed back in 2008-09, when the credit crunch was at its most severe but the MPL business was in its infancy. For this reason, investors and their advisors are forced to consider how the parts of the economy that MPL lenders service have performed during previous recessions, rather than on how the MPL portfolios did themselves. Many MPL providers were reluctant to talk for this piece about what might happen in a recession, but some have long addressed the spectre of recession with an impressive degree of detail.

Funding Circle is one example. The world’s largest peer-to-peer lender stress tests the projected returns on its UK loan book every year, using the Bank of England’s latest models of a stress scenario. The company specialises in prime loans to SMEs of up to £500,000 ($658,000; €563,360) or its equivalent in the UK, Germany, Netherlands and US. In this wargame, Funding Circle’s client base suffers even worse than it actually did during the global financial crisis, points out Sachin Patel, Funding Circle’s chief capital officer in London.

Funding Circle’s bad debt ratio roughly doubles for its projected returns on loans made in 2017, from 2.5-3.5 percent to 4.7-6.6 percent. Projected returns fall from 5.5-6.5 percent to 2.4-4.3 percent – considerably lower, but still positive.

“There are a lot of niche strategies in private debt that are starting to interest clients, looking to expand out of their base private debt portfolio and diversify over time. Peer-to-peer lending is one of these niches”
Garvan McCarthy

This relatively narrow range of projected returns, even in a recession, may seem hard to believe. However, MPL providers – including Funding Circle – argue that these tight parameters are credible because they are based on a large number of small loans. All other things being equal, this reduces the risk of extremely bad outcomes – a conventional corporate debt fund making 20 large loans, for example, only has to see three of them go bad to show a very poor investment return. On the other hand, the small number of loans also makes it possible that the fund won’t suffer any bad debts at all, which would be unthinkable for a mass-market lender such as Funding Circle.

Funding Circle’s projected returns for a recession tally with the limited data on MPL returns during the credit crunch. This based on information from just a handful of providers active at that time; Funding Circle only started making loans in 2010. Zopa, which claims to be the world’s first peer-to-peer lending platform specialising in prime consumer credit, has declared that its loans were among the few investments of any asset type providing positive returns to investors.

Patel also makes the point that its return scenario for a recession assumes, improbably, that on seeing the signs of a downturn, it does precisely nothing in reaction. In other words, it will act like a man who hears of a hurricane coming, but does not batten down the hatches of his beachfront property.

Patel says that when Funding Circle spies the recession coming, “there will be a tightening of the credit box”. Moreover, “we expect competition to pull away markedly”, leaving the company free to pick the best borrowers.

He makes the additional point that because the typical SME only feels the full effect of a credit downturn after two years, Funding Circle will have considerable time to respond to the coming storm – a period of notice that any weather forecaster would envy. He adds that because Funding Circle only makes loans of up to five years, and these loans are always amortising, much of the loan book established under more liberal lending guidelines will have been paid off anyway by the time the storm comes.

What happens next?

But regardless of such statistics about how MPL books would have performed during the last recession, for many potential investors and their advisors concerns about MPL performance in the next recession are not truly assuaged. What if they are heavily exposed to one type of borrower that suffers worse in the next downturn than in all previous ones in past decades?

Patel acknowledges that “every recession will be different, with different drivers and different consequences”. He adds, however: “I think 2008 was absolutely an extreme recession for small businesses.”

He also describes the Bank of England stress scenario that Funding Circle plugs into its loan book as “more severe than what happened in 2008 – it covers all previous recessionary environments and then a bit more”.

Patel sees no sign of stress in the prime SME sector yet, so he says that a pullback in lending by UK banks since the Brexit vote has increased opportunities for Funding Circle.

The arguments of Funding Circle and other marketplace lenders have, it seems, begun to make headway with institutional investors, who are increasingly considering MPL – but not quite as the mainstream private debt option.

“Every recession will be different, with different drivers and different consequences […] I think 2008 was absolutely an extreme recession for small businesses”
Sachin Patel

Mercer’s McCarthy estimates that clients are unlikely to allocate more than one-fifth of their total private debt allocation to MPL. “Within private debt it would be at the high-risk, high-return end, and would need to be balanced by other private debt investments to fit the client’s risk appetite,” he says.

McCarthy adds that pension funds and other institutional investors that favour fixed income tend to be conservative, and therefore favour asset-based private debt lending in infrastructure and real estate over other forms of private debt such as MPL.

But as always in institutional investment, there are potential rewards from taking the road less travelled. When it comes to the companies that MPL businesses target, “these tend to be smaller companies and therefore should carry a premium”, says Disdale of Willis Towers Watson.

This premium looks particularly attractive at the moment, according to some estimates.

McCarthy says that while private debt offers a structural illiquidity premium to investors of 1-3 percent, “in asset-backed lending we are probably more at the lower end of that premium at the moment”, because of fixed income investors’ conservative attitude to risk. On the other hand, “in peer-to-peer and conventional direct lending we are probably at the mid to high end of that premium”.