Fixed-income investing is in a weird place, caught between historically low interest rates and the Federal Reserve’s looming interest rate hike that will usher in the end of the three-decades-plus bull market in U.S. debt and likely hammer the price of existing bonds. Given that, it’s little wonder why many investors don’t know what to do with the fixed-income portion of their portfolios.
One possible alternative is peer-to-peer (P2P) lending, which has been around since the dawn of money in the form of hitting up family and friends for money to help fund a business venture, purchase property or whatever. In recent years, technology and the Internet have changed the game by spawning efficient online platforms that match borrowers and lenders on a wider scale, thus creating a whole new investment opportunity.
P2P lending—also known as marketplace lending—works like this: Borrowers unable to get a bank loan go to an online P2P site and fill out some personal information and specific financial details about the loan. The P2P company analyzes the data and, if there are no red flags, approves the loan and assigns a credit grade and loan terms. Investors on the P2P platform provide money for the loans and choose which ones to fund in return for the promise of making returns generally exceeding what’s available in the fixed-income market (other than, say, investing in Greek debt).
The online P2P market began in the middle of the last decade and has grown beyond the fad stage as P2P lending platforms have proliferated and the amount of money flowing into the space, particularly from institutional players such as hedge funds, endowments, pension funds and the like, has increased exponentially. According to industry statistics, online P2P lending platforms originated roughly $9 billion in loans last year, up from $100 million in 2009.
Some people predict that number could zoom to $1 trillion within 10 years. And now that Goldman Sachs plans to start its own online lending platform to compete against entrenched leaders including Lending Club and Prosper Marketplace Inc., it’s kind of like the Good Housekeeping Seal that says, “Hey, this is legit.”
The P2P space is an area financial advisors are tiptoeing into. Jeff Nauta, a principal at Henrickson Nauta Wealth Advisors in Belmont, Mich., says his first real exposure to P2P lending came a few years ago when a client who operates in investment banking circles suggested the firm should look into this asset class. “My initial thought was there’s no way we’re going to invest client money in P2P lending because it seemed too risky to make uncollateralized loans to individuals.” (Many P2P loans, such as those on the Lending Club and Prosper platforms, are unsecured.)
But to satisfy the client, Nauta’s firm contacted a hedge fund the client recommended, Colchis Capital Management in San Francisco, which runs the Colchis P2P Income Fund investing on the Lending Club and Prosper platforms. Colchis educated Nauta’s firm about its proprietary data feeds with those platforms, about the software it developed to bid on loans and about P2P lending in general.
Nauta liked what he heard, and today at his firm qualified clients who have at least $5 million in investable assets have a dedicated allocation to P2P lending ranging from 2% to 6%—that is, if the clients are comfortable with this type of investment. “We have some clients who just can’t get over the hump of this asset class,” he says.
So far, he’s pleased with P2P’s ROI for his clients, noting that the Colchis fund has had consistent returns of 0.7% to 0.9% a month. “Our goal is an annualized return of 9%,” Nauta says.
“We consider P2P lending to be a fixed-income alternative and we put it into the alternative sleeve of client portfolios,” he adds. “We want to be clear with clients that we’re investing in a hedge fund with limited liquidity, and even though it’s a fixed-income alternative, it’s not your government bond fund.”
For lower-net-worth clients, Nauta has been kicking the tires on the managed account platform offered by NSR Invest, a Denver-based outfit that was created earlier this year after a merger of two entities staffed by P2P lending veterans.
NSR offers both a private fund for accredited investors and managed accounts for non-accredited investors. Retail investors, and the financial advisors who serve them, are a key market for NSR.
“We work almost entirely with financial advisors, and our core audience is independent advisors,” says Bo Brustkern, CEO and co-founder at NSR. He adds the company is working with various industry players to integrate its offering on major portfolio reporting platforms used by RIAs.
NSR’s P2P Fund has a $250,000 investment minimum and invests in small-business and consumer loans on the platforms of Lending Club, Prosper, Funding Circle and Upstart. The fund’s target annual return is 10%, and it charges a fee of 1.5%.
NSR’s managed accounts have a $10,000 minimum, invest in consumer loans made on the Lending Club and Prosper platforms, and come in three flavors—conservative, balanced and assertive—based on the credit quality of the underlying loans. The targeted returns range from to 5% to 9%, and the fees range from 0.45% to 0.90%, depending on the aggressiveness of the funds.
Investors in the P2P lending space need to understand the credit quality of the underlying loans and the liquidity of their investment. With NSR’s managed accounts, for example, Brustkern says the default rate typically is 1% in the conservative account and close to 5% for the assertive account. The loans are three to five years in length, and they’re fractionalized, which means investors can invest with as little as $25 per loan.
“It’s easy to create a diversified portfolio with a small amount of invested money,” he says, noting that the underlying securities are illiquid and should be considered illiquid on the managed accounts side.
Filling A Void
Online P2P lending is growing because bank lending to individuals is shrinking. And that’s because tighter regulations on capital requirements and various other activities wrought by the Dodd-Frank Act in the U.S. and international Basel III standards have caused banks to leave or minimize certain businesses. And in order to maintain profits, they’re less inclined to service individual loans.
P2P borrowers typically are creditworthy folks who can’t get loans in a very tight credit environment. As described in a Goldman Sachs report, the combination of big data analytics and new distribution channels has enabled online P2P players to fill the gap in the lending system by catering to individuals.
According to Brustkern, P2P lending started in 2005 with a U.K. company called Zopa. That was followed in the U.S. with the launch of Prosper and Lending Club. “The volumes really started increasing in 2011 because it took time for Prosper and Lending Club to build large enough portfolios where institutions could start to trust their underwriting, processes and returns,” he says.
In the case of Lending Club, for example, a person can invest in notes that represent small fractions of loans for as little as $25, which means a $2,500 overall investment can be diversified over 100 notes. Investors can either choose their own investments or use the company’s automated investing tool that matches orders with investor-supplied criteria.
Lending Club offers both consumer and small-business loans, with the majority being the former. As mentioned earlier, all of its loans are unsecured. As borrowers pay back their loans, investors get a monthly income stream. Lending Club charges 1% to process the payments borrowers make on their loans. An example on the company’s website says an investor with a loan portfolio paying an average of 13% should expect a net return of 8% after factoring in a default rate of 4% and the aforementioned 1% fee.
The four main sectors of P2P lending are consumer loans, small-business loans, student loans and real estate loans. Money360, a P2P platform based in Ladera Ranch, Calif., focuses on commercial real estate and is open to accredited investors. “We like real estate because it’s a large market and the loans typically are secured and are backed by the real estate, which is safer than an unsecured loan,” says company president and co-founder Dan Vetter.
Money360 originates bridge loans, which are short-term loans maturing in one to three years aimed at people who need to borrow money quickly either to acquire a property or stabilize the finances of an existing property. Bridge loans are charged at rates between 10% and 12%, and Vetter says investors are expected to remain in the loans for the term because, at least for now, this isn’t a liquid market.
“Part of your high interest rate, or return on your investment, is the liquidity premium you’re capturing,” he says. “The good news is these are short-term loans, and most of our loans mature in one to two years.”
Money360 says investors can expect to net 9% to 11% a year on their investments, after deducting a 1% fee for servicing the loans. Vetter says the company is seeing more interest from—and is starting to court—financial advisors. “We find many accredited investors typically rely heavily on financial advisors to manage their financial affairs, particularly when it comes to investing in a private placement or private debt offering such as our product.”
Re-envisioning Fixed Income
Another company trying to make inroads with financial advisors is Direct Lending Investments, a Los Angeles-based hedge fund that buys small-business loans directly from business lenders. It operates the Direct Lending Income Fund, which is aimed at financial advisors and requires a minimum of $100,000 (lower than the fund’s usual $250,000 minimum) and charges a 1% management fee (along with a 20% performance fee).
“We’re available for custody at Charles Schwab, Fidelity, Pensco, Millennium and others,” says Brendan Ross, president and portfolio manager at Direct Lending Investments.
Direct Lending says lenders are willing to sell their loans to the company because it frees up their capital to underwrite more loans and earn more servicing fees.
The largest borrower groups on the Direct Lending platform are retail store operators, medical professionals (doctors and dentists) and restaurants and hotels. The loans are between $10,000 and $500,000 and range from three to 36 months in duration. The company says it uses 300 data points to evaluate loans and that borrowers on average have been in business for roughly 12 years.
Borrowers pay rates of 20% to 30%, and according to Direct Lending are willing to do so because it’s cheaper than the alternative (credit card advances). And Small Business Administration loans aren’t always an option. The reason: SBA loans made by banks, which increasingly aren’t making the types of small-size loans to businesses found in Direct Lending’s portfolio.
“Consumers do overpay for credit and that’s where the alpha comes from,” Ross says. The Direct Lending Income Fund started operations in late 2012; it returned more than 13% in 2013 and 12% in 2014. And Ross says that level of alpha provides protection if the economy goes south.
“Because the returns are high it means the defaults could be a lot higher before we get to breakeven,” Ross says. “Our portfolio’s average default rate is 4.8%. We can have a default rate of more than 20% and still break even for investors.” He notes the default rate on small-business loans during the Great Recession was about 10.2%.
Ross clearly sees P2P lending as a fixed-income vehicle. “Fixed income is dead in that it’s not a place where advisors can justify their fees and earn their clients reasonable rates of return. So fixed income is being re-envisioned.”
Keeping the “P” in P2P
P2P lending seems intriguing, but what about potential yellow flags? For starters, this sector has come of age after the Great Recession, and if and when the economy tanks again it will mean more loan defaults that could impact the performance of loan portfolios.
Some P2P lenders say their careful vetting process should provide some downside protection. “The average borrower on our books has been around for nine years, so they survived the market crash,” says Albert Periu, head of capital markets at Funding Circle, a London- and San Francisco-based company focused on small-business loans. “Our loans are secured commercial term loans, which is a different product than unsecured consumer loans.”
Funding Circle offers loans at rates ranging from 5.99% to more than 22%, depending on their credit rating. Accredited investors participate with minimums of $50,000 spread across $500 pieces of loans, or fractional loans, to ensure diversification.
“We charge a 1% servicing fee, but all the coupon goes to the investor,” Periu says. “Performance can vary; there will be some defaults, but we feel we price the risk accordingly. Historically, we’re yielding about 12%.”
Another potential concern is fraud committed by would-be borrowers, which was discussed in Congress during a House Small Business Committee hearing on peer-to-peer lending in May. One of the companies that spoke at that hearing was Funding Circle. “Fraud is something we combat every single day, and it’s a big focus in the industry,” Periu says. “We make sure we do a lot of identity verification, pulling information from third parties, tracking the location bases of things like cell phones and IP addresses as we underwrite the loans and make lending decisions.”
Periu and other P2P lenders don’t believe higher interest rates will cause a mass exodus of P2P lenders back to traditional fixed-income vehicles. “Given the shorter‐term nature of our loans, when interest rates eventually start to rise we should be able to adjust our rates in tandem,” Periu says. “For now, though, fixed-income yields remain low and investors continue to look for higher-yielding products with reasonable risk-adjusted returns.”
Given the growing role of institutional investors in the space, P2P lending is increasingly being referred to as “marketplace lending” to better reflect the growing diversity of lenders. “The industry’s pioneers were concerned it would become just another institutional game, so the major players such as Lending Club banded together with companies such as ours to ensure the true individual peer investor will always have a seat at the table in peer-to-peer lending,” says Bo Brustkern from NSR Invest.
And as NSR, along with companies such as Funding Circle, Direct Lending, Money360 and others continue to reach out to financial advisors, they hope to attract their share of peer investors.