Nick Rees, CEO of Blu Family Office, examines whether private debt exposure might be gained from the likes of Zopa, Funding Circle and RateSetter.
Unless you have been locked in a vacuum in recent years, it would have been hard not to notice the impact Peer to Peer lenders have made on the UK investment landscape. Since the first ‘platform’ (Zopa) launched in 2005, with less than £2m in assets, this lending asset class has grown at a meteoric rate to represent more than £4bn in assets today.
It’s also not rocket science to understand why this growth has occurred: the platforms meet a structural need. Their launch has coincided with risk appetite at banks being dramatically reduced post the 2008 credit crisis, which has led to all but the most credit worthy of borrowers with very limited ways to access credit. At the same, time individual investors have been earning next to nothing on their cash balances, as interest rates have fallen precipitously, so there is a natural appetite from this client base to look for alternative sources of ‘low risk’ returns. Enter stage right P2P platforms.
As a family office, this is a space you may reasonably have thought we would have exposure to, and yet we don’t. Below I shall attempt to explain why.
Our Starting Point
The first obligation we have to our own families, and our other families and clients who invest alongside us, is to ensure that we can meet our liabilities – mortgages, insurance, school fees etc. Once we have done this we can focus on preserving the wealth (i.e. investing to gain a return above our inflation rate, i.e. the real inflation rate of the wealthy which is substantially higher than RPI or CPI would indicate). Beyond that, we can take more risk in our investment portfolio in order to ‘create’ wealth. This is shown graphically below.
Conceptually, P2P Platforms would help us in our ‘wealth preservation’ box to help protect against inflation, given the risk profile of the asset class, but there are several reasons why we can’t get comfortable.
Falling Returns and Higher Defaults
Returns from P2P platforms can vary substantially. At the time of writing, Funding Circle, one of the bigger platforms, is advertising ‘projected returns’ of 6-7 per cent per year; Zopa is advertising 4 per cent for its Core portfolio and 4.6 per cent for its Plus – the return profile being determined by whether the loans are secured or unsecured, as well as their duration. However, as more money chases a limited number of opportunities, returns have fallen substantially across the board and today do not represent good value in our eyes (investors could have earned 8-12 per cent+ for similar risk only a few years ago).
At the same time, projected defaults are rising, as commented on by the FT in their Feb 22 ’18 article entitled ”Zopa warns over defaults as investor returns decline”, see link here. These two factors do not make a compelling case to invest today.
Lack of Transparency
Transparency has been an issue for P2P platforms since inception. Broadly, I think that more information is available to investors today than five years ago, but risks remain opaque. By way of example, let’s focus on collateral management. When issuing a loan via a platform, and where the loan is secured (often they are not, but that is another story), it is often not clear who is responsible for ensuring that (a) the collateral secured against the loan is ringfenced to the lender (only) and not someone else as well, that (b) it is readily realisable and (c) it is still valued at or close to it’s value at the start of the initial term. Whilst some platforms do now provide some collateral governance, many do not, and many retail investors are not sophisticated enough to identify the key risks.
However, transparency issues don’t just reside within collateral management. Other areas such as loan duration, borrow creditor history and legal risk (particularly when lending to individuals and entities in foreign jurisdictions, which is a growing trend) are also opaque and require much more visibility.
So where then?
The obvious question to the above high level and rather broad brushed insight is, if not P2P, where? Interest rates are still ultra-low and are likely to remain so; bond yields have risen in the US but are still at lock bottom levels in Euroland and are only mildly better in the UK.
An answer, we think, lies in the private debt market, but outside of the P2P platforms. Specifically, in three areas (1) short term transactional asset backed lending (for example, trade finance lending), (2) bridge finance in the European real estate market (the UK is a step too far for us at the moment, given the unquantifiable Brexit risk which hangs over the UK housing market), and (3) niche lending in very specific markets with high barriers to entry. Examples of the latter would include divorce litigation funding, probate funding or some speciality healthcare funding opportunities.
Of course, there are nuances and specific risks associated with each of these alternatives and I’m not suggesting that they represent the holy grail for investors. Some transparency issues no doubt do exist and there are other specific operational risks which should be given consideration. However, in our opinion, loan collateral is much more easily identifiable and quantifiable and, importantly, because these are more niche opportunities, a funding premium can be charged which means that better security can be obtained for a similar credit risk. In other words, 6-7 per cent in net return is achievable but with more visibility and security than many of the P2P platforms.
Within this world there are ways you can further mitigate risks. Below I outline three things we have done to manage our private lending portfolio:
A portfolio approach – in many other strategies I could make a strong case for taking concentrated bets, however in lending I strongly believe in diversification. We are sector and geographically agnostic; what we care about is having broad exposures across both. Over the last two years, we have worked hard to achieve this and now have a portfolio of over 3000 underlying loans across Asia, South America, Southern Africa, Europe and the UK (we are also looking to get exposure to the USA shortly).
Sector experts – we have engaged sector experts who we feel have an edge. Whilst we want to be globally exposed, we acknowledge that we are not experts in every field. We are therefore happy to pay third parties who are on the ground in those jurisdictions, in order to give us the diversification we want. Of course, that comes at a cost, but it is a worthwhile investment in our opinion.
Conservative expectations – in lending it is possible to generate double digit returns if you are prepared to be unsecured and/or lend to the riskiest borrowers. We have taken the view that as we only need to inflation protect this element of the portfolio (i.e. preserve wealth), we don’t need to generate north of 10% returns, 5-6 per cent is fine. We therefore seek relatively conservative opportunities in the hope that our expectations in a downside scenario are more likely to be met versus more aggressive portfolios.
There are other things investors can do to mitigate the risks I have highlighted and others I have not been able to address. My point, though, is that the risks of investing via P2P platforms are not reflected in their very stable returns. Their growth has coincided with an extremely benign credit environment. If and when this deteriorates, defaults will rise and returns will fall. Buyer beware. Go in with your eyes open and lean on experts where possible to reduce as many of the systemic risks as you can.