Jonathan Kramer, head of capital markets at Zopa, which claims to be the world’s first peer-to-peer lending platform, makes an eye-catching assertion. At the height of the credit crunch, “Zopa loans and gold were the only things providing positive returns to investors”.
Experts might question this claim, given the money made by shorting hedge funds and distressed investors at the time, but positive returns during this period were rare. The declaration is all the more enticing since many think the next credit downturn could hit Europe and North America as early as next year.
Kramer says “2008 marked the real point of acceleration” in increasing investor interest in the company, whose focus on prime consumer credit inured it to the worst effects of the crisis. The average net return for Zopa loan investors was 4.9 percent that year.
The credit crunch also helped P2P lenders generally by forcing banks to reduce their exposure in a number of loan markets. Banks chose to become more conservative in their lending after suffering large losses from ill-advised loans, and partly because regulators imposed higher capital charges for riskier loans.
Having said this, banks have in fact withdrawn less from the prime consumer credit market where Zopa plies its trade, and more from loans to smaller businesses – a furrow ploughed by Funding Circle, the world’s largest P2P lender – and loans for property development, a niche occupied by P2P lender LendInvest.
P2P lenders act as intermediaries between borrowers and investors, both retail and institutional, willing to make loans. Most observers regard the term as broadly synonymous with marketplace lending. Because of this new type of company, “a very traditional asset class that has been around for centuries, but just hasn’t been accessible to investors before, is made available to them for the first time ever”, says Sachin Patel, chief capital officer at Funding Circle in London.
The investment case made by P2P lenders rests partly on technology. “Every loan is manually underwritten, but by the time it gets to the underwriter it has already been through a very rigorous process,” says Patel – with many having been rejected by artificial intelligence.
“This means our underwriters spend their time on the loans we think are the best and have the highest chance of getting through, rather than spending a day looking through paper applications, of which they’ll reject 90 percent.”
Because of its efficiency, Funding Circle can make thousands of loans a year up to a maximum of about £500,000 ($680,000; €567,000) to small businesses, rather than the £20 million-£50 million loans that mid-market private debt funds typically offer to a much smaller number of borrowers. Patel argues this reduces risk relative to private debt funds because “you get a lot more diversification across sector and geography”.
P2P lenders also say their underwriting decisions are better because they are more specialist. “We think our data analytics are more advanced than those of banks themselves because we focus just on one specific problem, which is SME credits,” says Patel.
MPLs generally target returns of mid to high single digits, net of fees – similar to those of conventional private debt funds that make senior and unitranche loans. Funding Circle’s average annual return since its 2010 launch is 6.4 percent after fees and bad debts, with an annual bad debt rate, after recoveries, of 2.1 percent. LendInvest, which makes loans that are in theory safer as they are secured against UK property, targets a return of 6-10 percent for its £175 million Real Estate Opportunity Fund.
P2P lending has certainly enticed many institutions. Investors in LendInvest’s Real Estate Opportunity Fund include, according to Rod Lockhart, head of capital markets and funds in London, one bank each from the UK, Germany and Portugal, “a large Swiss corporate pension scheme”, and a Korean securities house selling securities based on its investments in the fund, using a feeder fund structure.
Taken together, banks make up the biggest group of investors in LendInvest’s Real Estate Opportunity Fund, says Lockhart. Why do they not just make their own loans?
“We have 130 people, including large teams for origination, underwriting and specialist servicing,” explains Lockhart. “If a relatively small bank wants to set up this kind of operation, that’s quite an investment for them to make. So why not invest in another originator’s loans, and not have to carry the operational costs?” They do, however, incur the same capital charges as they would if making the loans themselves.
The banking arm of Aegon, the Dutch financial services group, has firmly embraced the notion of outsourcing loans through MPL, though it prefers the term “close co-operation”. In January 2017 it announced plans to invest €1.5 billion over the following three years in consumer loans made by Auxmoney in Germany. It has also backed loans made by Funding Circle and Zopa in the UK, and Younited Credit in France.
Eric Rutten, CEO at Aegon Bank in The Hague and member of the board of Auxmoney, in which it also has an equity stake, cites two reasons for its investment in marketplace lenders’ debt. One is the ethical consideration of financial inclusion: fintech lenders’ different processes for making loan decisions, including “the innovative use of data”, mean they will sometimes reach borrowers who are excluded from mainstream finance but will pay off their debts on time.
The second: “I’m much more nimble and agile when I use specialised fintech companies rather than when I erect my own consumer loans department: when there’s a downturn it’s easy for me to turn the button down on different platforms. If I have a big department within the bank I have to lay off people, which costs a lot of money and a lot of agility.”
But although banks and other institutions have invested in P2P loans, some investors, and their advisors, are cautious.
“We are big proponents of the diversity of credit risk: we think there’s absolutely huge value in it,” says Gregg Disdale, head of alternative credit at Willis Towers Watson, the consultancy, in London. “We have been cautious about marketplace lending so far, but it could be part of achieving that diversity.”
However, Disdale regards many of its supposed virtues as untested. For example, “it’s hard to extrapolate past performance into future performance, because many MPLs operating in 2008-9 were still working on their credit underwriting, monitoring and filtering”.
Concerning the argument that the large number of loans reduces the volatility of default rates, “problems with MPL loans tend to cluster,” says Disdale. “For example, some investors have backed MPLs to go into new markets. Some of these untested markets could show higher defaults than expected, and this has been a source of poor performance for some MPLs. Moreover, unsecured consumer default rates will be affected by the market cycle.”
Investors are also wary because most P2P lenders do not put their own capital into their loans, in contrast to private debt fund managers. “There’s clearly a strong preference among investors for them to have skin in the game,” says Disdale. “A strong, strong preference.”