When Investors Become The Banker

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.