How platform lenders come of age

In ‘direct lending 2.0’, transparency may be a crucial advantage over private debt funds (or ‘1.0’ lending), argues James Newsome of Arbour Partners.

James Newsome

Online lending platforms are graduating from their P2P origins. Several have become large credit sourcing operations deploying data and teams of credit assessors to serve, in some cases, tens of thousands of SMEs. Meanwhile, a large proportion of the capital now being lent through the top platforms is from insurers and pensions attracted not only by the yield but also game-changing granularity. Leading platforms Auxmoney, Zopa and Funding Circle, a pure-play SME platform, have each secured billion-plus commitments from European insurers in recent quarters. “Direct lending 2.0” is here.


In part, the institutional take-up stems from the many similarities to the ‘traditional’ online lending funds. The returns are in line with SME loans on platforms typically yielding 8-10 percent. Default rates in the past 10 years have also been at 5 percent per year or less and recoveries are around 50 percent of credit outstanding.

Lending, like that in the 1.0 private debt market, is typically against cashflow rather than asset-backed. The ‘look-to-book’ ratios are similar, with platforms lending to only a small portion of the eligible borrowers they see. The funds are also similar, with two to three years of investment and a run-off period distributing all interest and principal. So far, not much difference.


But there are crucial differences in the credit assets, which in turn requires a different economic and philosophical basis to how platforms are run.

Asset pools are highly granular. A €1 billion fund brought by an SME platform will offer exposure to more than 11,000 different credits. Loans, which are to community businesses rather than to buyout situations or growth firms, are typically between €50,000 and €250,000 in size. By contrast, single loans are now being made in the direct lending 1.0 private equity sector of up to €500 million in size. Loans on the platforms amortise fast enough to deliver an average life of less than two and a half years. This means that firms getting into difficulties have often already repaid a significant amount.

To source this large number of credits while retaining large look-to-book ratios requires not only powerful and hyper-efficient sourcing and selection methods but also a significant human-run risk operation.

Funding Circle, which operates in the UK, Germany, Netherlands and the US, has over 900 staff, more than a quarter of which are working in risk and credit assessment functions. Its proprietary risk models process thousands of data points about each credit being put through the system before being manually assessed. A comparable lending 1.0 platform with a similarly-sized lending record of €5 billion will have less than 50 investment professionals carrying out all sourcing, credit selection and monitoring functions.


The systems and staff that deliver such large granular pools of credits do need significant upfront investment. This is where the economics of the proposition start to look different. As in online lending 1.0 the lending platforms charge upfront fees to SME borrowers of between 1 and 4 percent. However, this is a source of revenue for the platforms that facilitates global platform development rather than something to add to fund IRRs.

The prospect of sustained scale in the future has attracted the world’s most prominent equity investors to the platforms. The likes of Index Ventures have backed the platforms at seed, whilst Sands Capital and Baillie Gifford among others have since provided equity investment. This capital has been used to build out the systems and the people required to run professional organisations, which in turn have attracted over €25 billion in investor capital to lend to borrowers over the platforms.


So, when it comes to the important topics of incentives and alignments of interest there are key philosophical differences in online lending 2.0 which institutional lenders are now getting their heads around.

The platforms do not charge performance fees to institutions to incentivise talented rainmakers to do the most complex and profitable deals. Management fees are not typically charged to funds. A servicing fee of around 1 percent is charged to investors, whilst borrowers incur an upfront arrangement fee. These fees cover the cost of all post origination operations, including servicing, collections and recoveries as well as ensuring the sustainability and continuous development of these global platforms.

The incentives therefore look different. Repeat business becomes increasingly important to platforms as they scale, which means building successful lending relationships with prime borrowers is key. On the other side, performance transparency ensures they are held accountable by investors. Discipline is therefore paramount.


What has really tipped the scale in favour of the leading platforms is the transparency of their models. Institutions have become comfortable once they have seen the processes at work.

An effective framework with which to look at any credit market processes is either as virtuous circles or as vicious circles. This is particularly key to the understanding of the SME platforms which are attracting prime borrowers. In the virtuous circle the most eligible borrowers come forward. Lending platforms then get clean, direct data about potential borrowers. They can then build better models. Pricing is appropriate. Their investments perform. More capital is attracted. More prime borrowers can be reached and more data is accessed. Round it goes and everybody benefits.

But before the advent of platform lending, in the pre-2008 vicious circle, as more capital was committed, pressure was increased to lend. Underwriting processes deteriorated. Chains of intermediaries introduced the borrowers. Data was often poor, sometimes fraudulent. Modelling worsened. Covenant-lite dominated the private debt market and ‘liar loans’ infected ABS. Ratings kept the party going, until it stopped and capitalism itself of course nearly ended with it. There is much talk at present about similar pressures currently building in private debt 1.0.

Institutional investors which can prove to themselves that platforms they invest with have look-to book-ratios, the robust modelling and the right underwriting resources are not acting on faith in a few talented rainmakers incentivised to do 20 great deals.

Yes, smart leaders and solid corporate governance help, but comfort comes from the processes themselves. To this end, platforms publish performance data. Dutch insurer Aegon and other institutions lending through platforms have spent time getting to know the models, testing the underwriting.

Institutional investors will not put up with asymmetries of information. They require transparency and proven discipline. They need to see that the virtuous circle is there. In online lending 2.0, faith in talent is not enough. Shared knowledge rules.

James Newsome is managing partner at Arbour Partners, the capital raising network.