The Emergence of Marketplace Lending
For hundreds of years, fractional reserve banking has been the primary means of matching the needs of savers and borrowers, absorbing any mismatches of time and amount. Although banks facilitate credit creation and economic growth, their leveraged balance sheets give rise to systemic risk, taxpayer-funded government safety nets, and morally hazardous decision-making by bank managers, culminating in periodic financial crises.
The banking system is a “public good” that can provide many benefits to society. Banks lend people money, helping them acquire productive capacity that can improve their own economic standing and create jobs for other people. Banks can help poor people become rich and can help rich people become richer. But the banking system must be heavily regulated given the leverage and systemic risk it poses, which can give rise to financial crises, economic slowdowns, unemployment, currency devaluations and widespread human suffering. As a society, we’ve tolerated these risks given the many benefits that banks can provide. But in recent years, direct lending has become significantly more efficient, thanks to the internet, making it more feasible for borrowers and lenders to circumvent the banking system. Direct lending (in its purest form) does not involve leveraged intermediaries, so it does not give rise to systemic risk.
A New Breed of Company is Born
Private, direct lending has co-existed with fractional reserve banking systems from the beginning. However, direct lending has historically been highly inefficient given the prerequisite of a double coincidence of wants: A borrower who needs to borrow a certain amount of money for a certain period of time must find a lender willing to lend that amount of money for that period of time.
The age of the internet has spawned a new breed of company – an eHarmony of sorts for borrowers and lenders – making direct lending more efficient than ever before and making small-balance, private debt more accessible to investors than ever before. These technology-enabled “marketplace lending platforms,” also referred to as “peer-to-peer lending platforms,” have become a viable source for fixed income investments, whether for retail investors or for institutional investment managers who aggregate individual assets into portfolios they manage on behalf of others.
The emergence of marketplace lending platforms has coincided with an extended period of low interest rates throughout the world caused by unprecedented central bank intervention intended to nudge investors into riskier investments in order to promote economic growth and employment. Despite central banks’ attempts to increase the opportunity cost of hoarding cash, new waves of regulations have made banks reluctant to lend, opening the door for the so-called “shadow banking system” to fill the void, including various types of non-bank lenders such as marketplace lending platforms. In today’s investment climate, equity markets are overvalued and traditional fixed income investments offer minimal yield, making private debt investments more attractive than ever relative to more traditional asset classes.
Democratizing Access to Primary Markets
Historically, most types of investments were acquired in the secondary market. Until recently, opportunities to participate in primary market offerings were reserved for large institutional investors or those on the “inside.” For example, for most of us, the chances of getting shares in an equity IPO are slim to none. Most investors aren’t given access to equity IPO shares. Those lucky enough to be allocated IPO shares often benefit from a surge in the stock’s price once it begins trading in the secondary market, and can almost immediately sell their shares for a profit.
Marketplace lending platforms provide primary market offerings of debt securities that anyone can access on a daily basis. Some platforms list newly registered debt securities every day. Others provide a “quasi” primary market by selling pre-funded loans to institutional whole-loan buyers or to groups of retail investors via Reg D or Reg A offerings. The lack of secondary market liquidity and market inefficiency provide opportunities to lock-in alpha/excess returns for the life of the loan. The lack of a robust secondary market also reduces monitoring costs for investors, who need not worry about volatility in the price path as they do with publicly-traded securities. Private debt investments do not have an observable price path, enabling investors to buy the short-term loans originated by marketplace lending platforms and simply hold them to maturity.
The Inverse Relationship between Asset Size and Risk-adjusted Returns
The perennial challenge for active investment managers is to consistently generate sufficient alpha to justify their management fees. This challenge is exacerbated for large investment managers, whose time and resource constraints cause them to gravitate to the largest assets or the largest and most liquid markets into which they can deploy the substantial amount of capital they oversee. But these markets tend to be the most efficient and therefore provide the fewest opportunities for active investment managers to generate alpha. Many active investment managers resort to leveraging beta risk exposures in order to beat their benchmarks, doing a disservice to their clients by overexposing them to beta risk.
Empirically, there is an inverse relationship between an asset’s size and the risk-adjusted returns it offers investors. Small-dollar-value idiosyncratic risks (e.g., micro-cap stocks) tend to receive less attention from the capital markets, resulting in less efficient asset pricing and more attractive risk-adjusted returns. Active investment management traditionally has been an analytic-intensive, and hence, a labor-intensive business. Given the cost of skilled labor, large investment managers could not afford to focus on small-dollar-value idiosyncratic risks, even though they tend to offer more attractive risk-adjusted returns than large-dollar-value idiosyncratic risks. With substantial amounts of capital to deploy, large investment managers simply lacked the time and human resources to manage large diversified portfolios of small idiosyncratic risks. However, marketplace lending platforms are disrupting traditional models of investment management by enabling direct, cost-effective, scalable access to small loans with attractive yields.
Technology-enabled marketplace lending platforms are facilitating a streamlined/scalable investment process that is allowing large investment managers to invest in small-dollar-value idiosyncratic risks that heretofore may have been too small and time-intensive for them to invest in, given the size of their overall investment portfolios and the amount of capital they need to deploy with limited human resources on staff. This theme of technology-enabled direct access to relatively small-dollar-value idiosyncratic risks is consistent across all marketplace lending sectors and loan types (e.g., consumer loans, student loans, small-business loans, single-family-residential development loans, small-balance commercial real estate loans, etc.). Today, investment managers are able to build and maintain large, diversified portfolios of small-dollar-value idiosyncratic risks that offer superior risk-adjusted returns to portfolios of large-dollar-value idiosyncratic risks.
Practical Investment Formats for Different Types of Investors
Different types of investors interact with marketplace lending platforms in different ways.
Institutional investors typically buy whole loans, which they aggregate within their own portfolios that they manage on behalf of others. However, given the time and resource constraints of most retail investors (or their wealth managers), picking individual assets – whether whole loans or fractional interests – is not feasible, so the best way for them to get exposure to private debt may be through a professionally-managed fund vehicle.
Given diversified sources of revenue, marketplace lending platforms can offer professionally managed funds with fee terms that are often far more competitive than those of standalone, third-party fund managers who rely on management fees to “keep their lights on” and to attract and retain talent. And in many instances, the yield coming from those professionally managed funds can be significantly higher than what investors are currently finding in traditional asset classes.
Dan Vetter is the Chief Operating Officer and Co-founder of Money360, Inc., a marketplace lending platform for commercial real estate loans. Mr. Vetter also serves as President of M360 Advisors, LLC, an investment management company that manages diversified fund vehicles for accredited investors. Mr. Vetter earned a Master of Business Administration degree from Harvard Business School, a Master of Public Policy degree from Harvard Kennedy School of Government and a Master of Accountancy degree from Brigham Young University. Mr. Vetter is a CFA charterholder and holds various FINRA securities licenses.