By James Williams – The USD9 billion IPO by Lending Club last November was a significant shot in the arm for the peer-to-peer (‘P2P’) lending space and sent out a clear message to the banking industry: the old-school way of providing finance to companies and individuals is under threat.
Lending Club is one of a number of platforms that are legitimising the online lending market; one that investors still remain slightly in the dark about but nevertheless one that offers compelling investment opportunities.
“The average person still has no idea this is going on. People in the finance world have certainly stood up and taken notice in recent times though. The reality is that you no longer need banks to provide lending. You can do direct lending in small loan sizes with technology and I think that model is going to extend into a lot of different industries, not just the unsecured consumer space. I think we are on the cusp of moving into a much larger P2P lending market,” opines Brian Weinstein (pictured), Principal at Blue Elephant Capital Management. The firm’s two other principals are J P Marra and Ashees Jain.
Based in Irvington, New York, BECM is one of the pioneers in terms of offering institutional investors access to an alternative source of yield to the fixed income portfolios. Since 2013, the firm has been running a hedge fund that works by allocating to short-term, prime consumer loans issued by a variety of lending platforms.
What makes this lending model so interesting is that the likes of Lending Club and Prosper Marketplace in the US are providing a new gateway to bring investors and borrowers together. Borrowers are able to access loans at lower interest rates, while investors get access a diverse stream of monthly loan repayments.
“This is not about reinventing the wheel. It’s still traditional finance, but stripping out the banks and allowing the lending to be done in a cheaper way. I think pension funds are still a step away, en mass, in terms of allocating to this asset class. They want to see it go through a business cycle and will take their time but the ones that do embark early to get a first-mover advantage do so because the financing model underpinning it all is nothing new,” explains Weinstein.
Currently, online lending platforms are focused on the unsecured market, providing consumers with a new alternative to credit cards. This, however, is only the tip of the iceberg. After all, the industry is still nascent and only eight or so years old; having said that, with a USD9 billion valuation, Lending Club is already equivalent in size to a top-20 US bank. Moving forward, Weinstein sees a much wider opportunity set.
In Weinstein’s opinion, the most interesting opportunities are likely to be in secured assets such as commercial real estate, automobiles, boats, medical and factoring. Factoring, for example, is a space that could see the creation of some interesting products to help support the cash flow of small- and mid-sized companies as they often have to wait months to get paid by larger companies.
What makes P2P lending such a disruptive model is that it targets a fundamental weakness of banks: fixed costs of loan issuance. Regardless of whether a bank originates a USD100 loan or a USD100 million loan, the same fixed costs apply. Originating small loans is simply not profitable enough.
“What’s attractive about the consumer space is that there’s not, by definition, moral hazard. However, one has to be careful. The P2P lending model makes sense because you’re cutting the cost but if you’re getting the worst borrowers, who’ve been rejected for credit cards, mortgages etc., you have to be careful when sourcing the best lenders. It’s not just the technology that’s important; it’s the finance too,” warns Weinstein.
Defining peer-to-peer lending
The simplest definition is that it is direct lending without a traditional banking institution acting as the intermediary.
The ‘peer-to-peer’ aspect requires a broader definition. This suggests that for every borrower there is a peer to lend; in other words I lend to you, you lend to me. This is a slightly flawed definition however.
The important point here is that borrowers need to be able to borrow more cheaply and institutions with high costs of capital and high fixed costs, i.e. banks, aren’t able to give them low rates. For every borrower there is, in reality, not a lender, just more borrowers; that’s the problem with the ‘peer-to-peer’ definition.
This is unlikely to change but what is exciting is that as more institutions step into the fray as lenders the market will continue to deepen.
“For pension funds and other institutional investors, they need fixed income streams. They can come together and pool their capital and choose the lending they wish to do: they can choose their duration, their collateral, their level of risk, and basically they can create new blends of fixed income returns; effectively replacing the role of banks,” says Weinstein.
There are essentially two models to accessing this market. First there’s the public model. This is where institutional and retail investors come together on online platforms such as Lending Club. The second model is a private model where both the borrowers and lenders are sourced in specific areas, as opposed to the scattergun approach of online platforms. Weinstein confirms that BECM utilises both models when putting capital to work in the fund.
Basel 3 regulation
At the heart of Basel 3 regulation is the need for banking institutions to increase their Tier One capital ratios to better protect themselves against systemic shocks to the market. This is great news for the P2P lending market.
Think about the prevailing bank model. Historically, they have been the primary source of financing: they issue loans, service the loans, and take on all the risk. What Basel 3 regulation aims to do is avoid another repeat of the Lehman Brothers collapse. Banks are responding to this by deleveraging, cleaning up their books, and increasing liquidity reserves. In short, banks’ balance sheets have become a precious commodity.
Now think about what the likes of Prosper and Lending Club are doing: providing consumer loans at lower rates of interest. Everything is transparent and investors can decide what risks they want to take. To be clear, this is not to suggest that loans won’t default, of course they will from time to time. What it does mean is that by circumventing the bank model, peer-to-peer lending will help reduce the centralisation of risk at banking institutions.
“Each country has a certain number of large banks that control all of the risk and the point of Basel 3 regulation is to move that risk around, to dis-intermediate it. Where are the largest pools of liquidity? In central banks, banks themselves, and pension funds. So where can you transfer some of that risk? To large institutional pension funds,” says Weinstein.
It’s a good point and one that will surely resonate with institutions moving forward.
Given the decent return streams potentially on offer by investing in P2P platforms one could be forgiven for understanding why the banks themselves want in on the action. The Australian bank Westpac, for example, have bought a USD5 million equity stake in Sydney-based lending platform SocietyOne. This is unlikely to be the start of a significant trend though. Ultimately, lending platforms don’t want close relationships with large bank institutions.
“It’s just not a symbiotic relationship; in fact, it’s parasitic in many ways,” notes Weinstein. He notes that for an institutional fund manager like BECM the debt side of the equation is more interesting than owning an equity stake in one of these platforms, adding:
“We think the value of a seven to 12 per cent (annualised) cash flow over a three- to five-year period is more valuable than the equity upside in one of these platforms.”
Although the biggest platforms are US-based, BECM’s second biggest partner right now is a New Zealand platform called Harmoney. New Zealand recently passed legislation to promote P2P lending and the fact that Harmoney is able to offer more competitive credit card rates than national banks gives Weinstein cause for optimism. “We hedge everything back to US dollars.
Other platforms we use are Funding Circle US, Prosper and Marlette,” confirms Weinstein.
Regulatory fears in the P2P lending space
One question that institutional investors will surely want answered when speaking to investment managers operating in this space is how well vetted the platform operators are. After all, these are non-banking institutions issuing loans without any regulatory oversight.
The first point to make to address this issue is that platform lenders are very open; these are not black box operations. Investment managers can see exactly what loans they are buying, and can themselves share that information with their own end investors. There is nothing shadowy about what these platforms are doing, according to Weinstein.
The second point is that lending platforms are being very proactive with the regulators. Even before Lending Club went public last year they were filing regularly with the SEC. Transparency is taken seriously.
“I think what will be interesting is when the platforms try to raise their rates (in response to higher market rates) and whether the Consumer Finance Protection Bureau steps in to try and regulate them. Prosper and Lending Club are licensed in every State they lend in, and everything they do is registered. The chances of regulation increasing are high, but the chances of regulators coming in and saying they are doing something wrong is low,” comments Weinstein.
Leveraging technology
To succeed as an investment manager in this alternative lending market requires a highly sophisticated technology framework. This is vital from a risk management perspective. Firms like Blue Elephant have had to build systems from scratch. Typically, these systems will hold thousands of loans, each of which pays its own schedule.
Managers running such strategies must be certain that they have the system capabilities in place such that every time a loan payment is made, if it happens to be the wrong amount, or it is paid on the wrong date, the entire payment schedule forward changes automatically.
Also, managers should ensure that they have the necessary interface in place to effectively screen loans and determine the criteria for buying them for their fund(s).
With respect to risk management, there are myriad questions that a risk officer will need to keep on track of.
According to Weinstein, the most common questions include: What does the fund own? What is the overall exposure of the portfolio? What is the quality of the loans? Where are they, geographically speaking? Who are the people that the fund has lent to?
“The platforms are focused on the lending side and have the technology in place to facilitate that so a lot of times we have to teach them about the technology that’s needed for the finance side; just because you are a technology company you still have to report the payments on time and provide monthly statements. There’s still a fair bit of hand holding involved to make sure everything runs smoothly. No two platforms are the same,” says Weinstein.
An awful lot of due diligence has to be performed by managers building fund portfolios of unsecured loans. Once a suitable lender has been identified, Weinstein confirms that the first question they ask is, “What problem are you trying to solve?”
Prosper Marketplace is worth using as an example here. When the company was established in 2005 credit card rates in the US were around 18 per cent annualised and the 5-year Treasury was yielding 1.5 per cent. Then yields rallied 400 basis points yet the credit card rate rose. The best rates available on Prosper are 6.68 per cent today.
The second question managers should ask is: How does the platform lender screen for moral hazard? If Prosper, for example, were only lending to people who are unlikely to pay on time it would fail to attract institutional interest.
The third question: How does the platform price its credit?
“Another question we ask is, ‘How do you find borrowers?’ It sounds easy but guess how Prosper and Lending Club source the majority of their borrowers: via direct mail; a postcard through the letterbox.
“As this market evolves, the most successful platforms are going to be those that get better at sourcing borrowers in different ways,” suggests Weinstein.
Managers should also be clear on a platform’s operational framework. Once the loans have been issued they need to be serviced. If a borrower doesn’t pay on time, what does the platform do? What remediation steps are taken?
As can be seen, the screening process involved when selecting platforms, which will likely proliferate in the next few years given the success of Lending Club’s IPO, has to be comprehensive.
“Lending Club is the barometer for the P2P lending space. If they make bad loans their equity is going to fall. If they continue to grow and challenge the traditional financing industry their stock will rise. If anyone still believes that this is not a real market then the Lending Club IPO has put a stake in the ground and others will follow,” concludes Weinstein
