By James Levy on Monday 17 August 2015
On reading the title of this article, many Altfi readers will think, “of course marketplace lending is a new asset class”. However, the answer is not nearly so clear, especially to the asset management industry. This is true despite the exponential growth of market lending platforms worldwide in the past several years, and the increasing participation of institutional money as an alternative funding source to traditional bank lending. In fact, to the best of my knowledge, at this time no significant private bank or major asset management firm has included marketplace lending assets among their traditional asset classes such as cash, bonds, stocks, commodities and real estate.
Investments that form an asset class tend to share the following three characteristics. Firstly, they are influenced in a similar way by major economic factors, and thus the variations in their valuation tend to have a very high degree of correlation among themselves. A classic example is the way that the value of bonds move inversely to the direction of interest rates. Secondly, members of an asset class have similar overall risk and return characteristics. Finally, and crucially for Marketplace Lending assets, the members of an asset class are typically bound by similar legal and regulatory structures.
How well do marketplace lending investments qualify under this definition of an asset class? There are some complications to strictly applying the criteria developed for assets intermediated by banks and listed on a central exchange to assets that are precisely the product of the new age of bank disintermediation that do not trade in a single organized marketplace. For example, are marketplace lending loans impacted in a similar way by the same economic factors? Not really, unless we consider the most extreme scenarios of a severe economic dislocation where inevitably defaults on all kinds of loans would rise to unprecedented levels. The high degree of correlation test for members of an asset class is meant to apply to such economic factors as fluctuating interest rates, changes in the exchange rates, or GDP growth expectations (factors that directly impact the value of stocks and bonds on the secondary exchanges). However, such considerations are of no direct concern to marketplace lending investors if the real economy is functioning under normal conditions. The primary factor that should influence the value of a marketplace lending asset is the credit worthiness of the borrower, that is, the ability to repay the loan under the agreed terms. The legions of City and Wall Street analysts and talking heads who discuss ad nauseaum the expected impact on the markets of this or that new event or latest economic indicator are largely superfluous when discussing expected returns from marketplace lending.
Do marketplace lending assets have similar risk and reward characteristics? Here the answer is unequivocally yes. In fact, one of the most consistent characteristics of marketplace lending, a trait that makes it a very attractive place for investors to put their hard earned savings to work, is precisely the consistency and predictability of the risk and reward characteristics of marketplace lending. It has long been my assertion that marketplace lending brings finance back to its classic meaning, that is “to provide funding for a person or enterprise”. What is such funding worth? Basically, in the current times of very low inflation, borrowers will typically need to pay an interest rate of between 6% and 12% per annum, depending on the risk profile of the borrower. This is the real value of money, when set apart from the distortions to bond prices (and the minimal interest rate on saving accounts) caused by central banks and their long extended policies of low interest rates through quantitative easing to stimulate the economy (as well as to assure that government deficits can be financed at these same low interest rates).
This general rule of thumb, that the return from financing credit worthy businesses and individuals is approximately between 6% and 12% per year, can be observed consistently across the various types of marketplace lending, be it loans to individuals, small business, invoice funding, trade finance or real estate finance (see, for example, the historical performance of the Liberum AltFi Returns Index). While there will be higher or lower risk loans that fall outside of either extreme, the vast majority of marketplace lending investors will experience returns within this range on a diversified portfolio of loans that are adequately screened for credit quality.
Are marketplace lending assets bound by similar regulatory structures? Here the answer would have to be not yet, but moving in that direction. Governments worldwide are taking steps to put their bureaucracies into motion to regulate marketplace lending platforms, with the pro-fintech UK government far in the lead. At the same time, the new marketplace lending Closed End Funds (CEFs) on the London Exchange or SICAVs listed in Luxembourg must obey the rules of their regulating bodies, as well as being subject to rigorous auditing and depository requirements.
There are other common characteristics among marketplace lending assets that can be used to bolster the case for qualifying these loans as a new asset class. Marketplace lending assets tend to be relatively short term (30 to 120 days for invoice finance and trade finance, and a typical maximum of 1 to 3 years for personal, small business and real estate loans). This is far short of the 10, 15 or even 30 year maturities of many corporate or government bonds. As marketplace lending loans are normally not listed on an exchange, liquidity for investors is normally provided by the maturity of these same loans rather than through the sale of loans on an organized secondary market. Additionally, marketplace lending as an asset class can be characterized as a source of very consistent, attractive, low volatility returns for investors where credit quality is the central factor to control risk. Unlike stock market investors (or crowdfunding investors) who may seek to find the next unicorn to multiply ten or a hundred fold their initial investment, marketplace lending investors do not need to pick winners, they simply need to avoid losers. Adequate screening for credit quality and short maturities do the rest to provide the expected return of 6% to 12% p.a. in the vast majority of cases.
Finally, why does it matter if Marketplace Lending is broadly accepted by traditional asset managers and private banks as a new asset class? The reason is that this is fundamental to achieving mainstream legitimacy with the gatekeepers of private banking and asset management. Until this legitimacy is established, and these gatekeepers feel secure in recommending Marketplace Lending to their investment advisory clients with the full backing of the analysts, strategists and legal department of their firm, the huge reservoir of investment funds controlled by the private banks and asset managers will not be available to participate in the market place lending revolution.
Currently there are only three types of investors benefiting from the many advantages of marketplace lending as an investment as compared to traditional alternatives such as bank deposits, bonds and common shares. The first kind are early adopters who have taken the plunge and actively allocated a portion of their savings through one of the many platforms competing for retail investors. The second kind are those who invest though specialized institutional level funds only available to affluent investors. The third kind are investors who purchase shares in the London Stock exchange listed P2P Global Investments, or one of the similar CEFs that will be launched in the coming months. What is missing here is the huge middle market, that is, investors who have signed discretional asset management contracts with professional advisors, private banks and asset management firms, or those who follow the recommendations of these firms to choose their investments.
These investors represent a very large portion of all available investment funds. Most of the assets of these same investors are currently earning very low returns in bank deposits or bonds. However, their advisors will not begin to recommend allocating a part of these funds to the more attractive alternative represented by marketplace lending until this alternative becomes more widely accepted as an asset class by their employers. This acceptance will only take place after a much more detailed analysis by their investment analysis departments, and vetting by their legal advisors and investment committees.
When will this happen? I would guess within the next couple of years. As the volumes of transactions on the marketplace lending platforms continue to grow, and the pioneering institutional investors consistently obtain the projected returns on their investments, it is only a matter of time until private banks and asset management firms begin to consider marketplace lending as an asset class. This step in many cases will be accompanied by plans to develop and bring to market lucrative (first for them, secondly for their clients) products to facilitate investment in this new asset class. Once one of the major names in the industry launches a marketplace lending fund of its own branding, the others will quickly follow so as to not miss out on a high growth potential new market segment.
When leading private banks and investment management firms allocate significant portions of their investor´s funds toward the new asset class of marketplace lending, the amount of money flowing towards the platforms will increase by orders of magnitude. Very large flows of savings will earn attractive, stable returns, while ever increasing numbers of businesses and individuals will be able to obtain financing on more competitive terms than those currently available from their banks. This will mark the point where the financial markets return to their basic and crucial function to serve as an intermediary between savers who have accumulated investment capital and people and enterprises who seek funding in exchange for a reasonable rate of interest.