Are you missing out on a 25% better rate of return on Funding Circle?

By Sam Griffiths on 5th September 2014

In our first two articles analysing the Funding Circle loan book, we explored the factors that influence lenders investment decisions and the factors that influence the loss rates of Funding Circle loans. This third and final article of the trilogy seeks to bring together both pieces of analysis and examine what it really means in terms of returns for Funding Circle’s lenders.

Are you missing out on a 25% better rate of return on Funding Circle?

The initial challenge we faced was what methodology to use to calculate the return for Funding Circle’s loan book. If you look at the various P2P platforms, you’ll find almost as many ways to calculate returns as there are platforms. Some are more accurate than others and none are wrong, but when comparing returns between platforms investors always need to be aware of the differences. After evaluating several of these different methodologies, the one that AltFi Data decided upon was an Internal Rate of Return (IRR) calculation. IRR calculations use individual cashflows from each loan within the portfolio to compute the combined return. They are commonly used to evaluate the desirability of investments or projects and lend themselves well to circumstances where there is a large number of cashflows involved.

Having mapped out each individual cashflow to date for the Funding Circle loans (including recoveries for loans that have defaulted) we then calculated the discount factor that made the sum of all the discounted cash inflows and outflows equal to zero. We made the assumption that all loans that were not in default were valued at par. The discount factor calculated then gave us our IRR.

Using the above methodology we got a 5.97% IRR for the entire Funding Circle loan book. This is reassuringly close to Funding Circle’s own rate of return calculation of 6.1% (which is calculated in a different manner). Taking into account the spectacular growth that Funding Circle has achieved over the last 12 months (updated daily on www.altfidata.com but 142% at the time of writing), the average age of loans in Funding Circle’s loan book is very young and therefore has not seen a massive number of defaults. As AltFi’s Rupert Taylor discussed a few months ago, rates of return will appear artificially high in a rapidly growing loan book. In order to reduce this effect, we examined the time weighted IRR of the Funding Circle loan book (effectively what would your mean return be if you invested £1 each period – we used quarters). Using this time weighted methodology, we calculated the IRR to be 5.36%.

The findings from our analysis of the 15 risk factors enabled us to select and or deselect a variety of different loan characteristics in order to achieve (hopefully) a better return. We used the five characteristics that, from our previous analysis, appeared to have the greatest impact on loss rate. A key part of any investment strategy is diversification, we wanted to maintain the ability to diversify across different borrowers whilst still selecting favourable/deselecting unfavourable characteristics. Therefore we set a minimum selected loan population of around a quarter of the loan book. There were more risk factors that we could have used to select loan, but this would have left us with an unacceptably small population in which to ‘invest’.

We then ran our IRR calculation upon this selection of loans. The result was that we achieved a 108bps higher IRR on a volume weighted basis and a 132bps outperformance on an equal time weighted basis. That is a 24.6% uplift in returns (before tax). This both validates and quantifies our loss rate analysis. It also shows the value in the (unique) transparency that Funding Circle gives in the provision of its entire loan book on a loan by loan basis to investors.

Obviously, as with any analysis, there are limitations to this research. Whilst Funding Circle’s loan book is certainly the most comprehensive and oldest SME loan book in the UK, it is still relatively small and only has 4 years of lending history. The vast majority (over 75%) of loans have been made in the last 18 months. This means that the analysis is not carried out on full life cycle loans and also there is still potential for idiosyncratic risks to distort findings. Likewise, this analysis is backward looking and as we all know, ‘past performance is no guarantee of future returns’! The calculation also does not take into account tax treatment, which currently in the UK unduly penalises P2P lenders on platforms such as Funding Circle when they experience defaults (as losses cannot be offset against income from other loans).

However, the conclusion is clear: for up to a 25% better rate of return on Funding Circle loans, investors should invest actively (i.e. not use Auto-bid). That means considering factors other than just the Funding Circle credit rating when choosing loans and using the unique wealth of data that Funding Circle provides to inform their investment decisions.

  

We hope you have found this trilogy of articles useful and insightful. For any questions or comments, please contact: data@altfi.com

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