Sub-par is good for golfers, not investors

The same forces that gave rise to direct lending also caused marketplace lending to grow. Now the latter is experiencing compressed returns. Andrew Hedlund reports

Marketplace lending is booming even if its returns are not.

Returns in the strategy have generally targeted a high-single-digit return figure on an unlevered basis, and if you lever the investment, you would hope for a mid-teen return, according to market sources. But the strategy has been returning significantly less than the expectations, by 2-3 percent, and still been growing.

The Orchard US Consumer Online Lending Index peaked in 2014, when it posted an 8.71 percent return but slipped to a less than 4 percent return in 2016 and 2017 and a year-to-date return of 1.33 percent, figures showed.

The return on investment for LendingClub loans, one of the largest marketplace lenders, has been better in recent years, but not quite high-single-digits. In 2016, LendingClub’s loans returned 4.19 percent and 6.08 percent in 2017. If the ROI of 8.19 percent for the first six months continues, then this year’s ROI will achieve its target.

“For the most part, marketplace lenders aren’t pricing risk properly,” Ivan Zinn, founder partner and chief investment officer of Atalaya Capital Management, says. He notes many consumer installment loans made today in the low teens are replacing credit card debt that historically cost above 20 percent.

The average interest rate on loans from LendingClub, outlined by data provider NSR Invest, peaked at 14.8 percent, also in 2013.  If the average interest rate for 2018 is similar to that through the first six months, at 12.61 percent, it would be the lowest annual rate since 2010.

“We are actively managing marketplace pricing to ensure we continue to deliver attractive risk-adjusted returns,” a LendingClub spokeswoman said. “As an example, we are making a modest increase in rates in some of our higher risk, longer duration grades today. And finally, we’ll be evaluating agreements that further strengthen funding for especially the longer-dated assets.”

“Overall, returns are sub-par because they are basically giving capital to too many borrowers,” adds Zinn, whose firm in May closed a $900 million fund that invests in financial assets. “When we peel back the layers on the analysis, we generally say, they are actively stretching to provide loans because it is not their balance sheet – they are an intermediary.”

There are a lot more institutional investors putting money into marketplace lending, investments that can take the form of buying the marketplace loans and holding them or purchasing securitised packages of those loans, Zinn says.

Those investors can include family offices, mutual funds and hedge funds. In a recent deal, Alcentra agreed to purchase up to $1 billion of small business loans from Funding Circle.

Appetite for securitisations has mushroomed, according to a Morgan Stanley report. The first such securitisation happened only in 2013, while the first rated one took place two years later. Last year, $14 billion of marketplace loans – one-third of all such loans – were securitised. In the first quarter, SoFI alone issued $2.6 billion in loan securitisations.

Marketplace lending shares a narrative arc with direct lending, as the same forces of bank retrenchment and a regulatory crackdown that catalysed direct lending also fueled the growth of marketplace lending, the report notes.

Morgan Stanley also makes a similar investment argument for peer-to-peer lending as direct lenders make for their product: its characteristics make it a good way to diversify an investor’s fixed income portfolio.

In addition, marketplace lending’s “low duration should reduce sensitivity to rising benchmark interest rates”, the report reads. Direct lenders also argue their product reduces exposure to rising interest rates, because many of the securities are floating rate.

In addition, marketplace lending has a “relatively low historical correlation of alternative lending to traditional fixed income”, which is attributed to its consumer credit exposure rather than corporate credit exposure.

Direct lenders make a similar case: that strategy is inoculated from the credit cycle because the credit manager’s capital is locked up, less subject to the whims of the capital markets.

“We believe that alternative [marketplace] lending is here to stay. Indeed, we expect its growth trajectory to continue, reflecting the potential benefits of the asset class to both borrowers and investors,” the report concludes.

All this comes as limited partners have become educated about private credit strategies and begin to look beyond direct lending. The theme came up in this year’s annual PDI US roundtable and is an observation many managers and advisors have echoed to PDI in recent months.

“Their knowledge base has developed very rapidly,” says Pat McAuliffe, the head of direct origination at NewStar Financial, at the roundtable in August. “We used to say, ‘OK, let’s walk back on that and go over what first lien senior secured actually means.’ We don’t find that anymore. [Now], they ask us good, detailed and well-researched questions.”

A Willis Towers Watson report notes the intense focus on direct lending as misguided, an analysis that leaves the door open to speciality finance or other strategies that may seem off the beaten path.

“We continue to advocate for an approach that looks to exploit the full breadth of private debt markets,” the report reads, “and is sufficiently flexible to direct capital towards areas seeking to offer the most attractive risk-adjusted returns.”

Frothy

Another frothy area of the market is financial technology companies that lend money to consumers but aren’t primarily lending platforms, one credit manager told PDI.

“I think lending will become more prevalent for them over time,” the source says. “Sometimes they do a fair bit of lending that makes money.”

For example, Square, the San Francisco-based mobile payment company, started a consumer lending pilot programme last year and with Square Capital, launched in 2014, offers loans to its customers based on their payment processing history.

The company funds the majority of the Square Capital loans by selling them to institutional investors, according to the firm’s most recent quarterly filing with the Securities and Exchange Commission.

Marketplace lenders are also still finding backing from venture capital firms. Upgrade, a two-year-old peer-to-peer lender started by LendingClub founder Renaud Laplanche, announced a $62 million Series C Funding round in August, while Funding Societies raised $25 million in April.

In fact, marketplace lending has drawn the largest single venture financing round; SoFi set a record when it announced a $1 billion equity raise led by SoftBank Group four years ago. SoFi received another large amount from venture firms last year when it announced a $500 million round led by Silver Lake.

As the lending ecosystem continues to evolve and becomes more competitive, marketplace lending may keep booming and disintermediation may fuel additional capital flowing into the space, even if returns don’t recover.