Assessing risk in peer-to-peer lending

A platform representative approached me recently to talk about the relative risk (or the lack thereof) involved in investing via his peer-to-peer lending operation. To hear this particular entrepreneur tell it, he captains a platform that by far and away leads the UK’s peer-to-peer lending space in terms of the blend of risk and reward on offer to investors. He called it the “safest” peer-to-peer platform in the market. The exchange got me thinking about just how many factors have to be considered when sizing up the validity of such a claim. 

The recent kerfuffle at TrustBuddy is instructive. The company filed for bankruptcy in October, and is now caught up in a lengthy and convoluted liquidation process. Prior to investing, had TrustBuddy’s many individual investors considered the risk of misconduct on the part of the platform’s management team? If they had, had they considered what might become of the company were such behaviour to come to light? Were they cognisant of how complicated the bankruptcy process might become? With the benefit of hindsight, it’s clear that these should have been considered as risk factors in an appraisal of the TrustBuddy proposition.

But of course, at the point of investing, the minds of TrustBuddy’s investors would have understandably been elsewhere. Their minds would have been on the product, on the investment proposition. Not on the likelihood of the entire TrustBuddy operation amounting to what was, in effect, a Ponzi scheme. 

How then might we categorise the many risk factors that ought to be weighed when considering a peer-to-peer investment?

Macro

You start at the top, and you work your way down. From 50,000ft, you wonder what might become of your investment in a less benign economic environment. Will borrowers continue to repay their loans? Will the platform in question remain afloat? It’s extremely hard for investors to appraise this within the still-nascent peer-to-peer lending space. Only one platform in the UK – Zopa – has weathered a recession. The world’s original peer-to-peer platform in fact fared rather well, delivering positive net returns to investors despite the severity of the economic environment. The same cannot not be said for its US counterparts.

Of course, track record in austere economic conditions is but one side of the coin. Perhaps more important is some manner of projection as to how a platform’s existing loan book would fare, were similarly harsh conditions to arise in the future. It’s for that reason that several of the UK’s leading peer-to-peer players have subjected themselves to independent stress testing. Both Landbay and Funding Circle have put their loan portfolios through the Bank of England’s banking stress test. In the most extreme of theoretical scenarios, Funding Circle’s average annualised returns remained upwards of 5.5%. Landbay’s average loss rate before interest payments was projected at 0.48%. In short, strong performances on both fronts.

The simple fact remains, however, that the impact of macroeconomic moves on peer-to-peer portfolios cannot be predicted with a great deal of confidence or granularity. The available source material is simply too scant.

Micro

On the “micro” level, you’re attempting to get your head around the pros and cons of investing in a specific platform, as distinct from investing in the sector more generally. You start by looking at the model. What type of investments is the platform providing exposure to? Unsecured consumer loans? Small business loans? Secured business loans? Selective invoice finance? Asset leasing? Development loans? Buy-to-let mortgages? A great many exposures are covered by the peer-to-peer lending space, and each of them carries with it a different blend of risk and reward.

The credit processes of a particular platform are perhaps the crucial consideration when sizing up a peer-to-peer investment. As an investor, you need to feel confident that a platform is meticulously checking the creditworthiness of a prospective borrower. For consumer lending platforms, how much data is being pulled together on borrowers, and from which sources? What sort of risk segment is the platform playing in? Prime? Near-prime? For real estate platforms, how rigorous a series of checks and valuations are being applied to the properties that loans are secured against? You’ll want to know that your platform – irrespective of its specialty – is adequately equipped to deal with would-be fraudsters. That could mean having integrated with a technology solution, such as AU10TIX or Jumio. In summary, credit is key.

Some platforms point to track record as their primary risk mitigator. Some to management. Others tout the solidity of their secured lending proposition. Then there are the bells and whistles – the provision funds, the insurance wrappers, the “buyout guarantees”, transparency, skin-in-the-game, and so on.

Ultimately, it all comes down to what factor (or blend of factors) investors set the greatest store by. You’ll likely earn somewhere between 3.8%-5% by investing in unsecured consumer debt via Zopa. Conversely you could earn 7% or upwards by investing in buy-to-let mortgages and secured development loans through LendInvest. Why do investors accept this seemingly illogical state of affairs? I’d suggest that it’s because they’re willing to pay for Zopa’s 10 year track record of effectively managing risk, and perhaps also for transparency. LendInvest does not currently publish information on its loan book to the same degree of granularity as Zopa does. Circling back to a slightly more macro consideration, LendInvest loans are at least partially susceptible to shifts in house prices, whereas Zopa loans arguably enjoy a weaker correlation to the state of the global economy.  

The highly scrupulous among investors may even choose to delve into the background of a platform's management team. It’s naive to suggest that a Google search can tell you all you need to know about the people behind a company, but you can to a certain extent at least appraise their expertise within, say, consumer credit – or more generally within financial services.

Brian Bartaby, Founder and CEO of secured peer-to-peer lender Proplend, offered his take on risk assessment:

“Investors should focus primarily on three things. Firstly the platform, who is running it, how has it performed historically and not just who has completed the largest volume. Secondly do I understand who am I lending to, how am I going to get my interest and principal paid back and what happens if the loan goes wrong? Is there any security supporting the loan which can be sold to repay a loan? And finally, what are the risk adjusted returns of my investment not just the headline interest rates.”

Micro Micro

In some instances, coming to terms with the platform itself is not enough. A fair few facilitators allow investors to choose the loans within which they wish to participate – rather than internalising the allocation process. Funding Circle is one such platform. Platforms that operate such a model must by necessity supply investors with information about every loan that lands upon the platform. Such information (for a business lender) may include detail on term, interest rate, sector, type of security, loan-to-value (LTV) ratios, a short description of the business, and so on. Many of the platforms assign loan applications to a specific risk band, according to their own assessment of that loan’s riskiness. Funding Circle’s spectrum of risk ratings ranges from A+ right up to E.

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Far from an exhaustive summary, but you get a sense of the complexity of sizing up a peer-to-peer investment from a standing start. And we’ve not even touched upon, for instance, the difficulty of quantifying risk in P2P (see the musings of Mike Baliman), or on the many different wind-down scenarios that could unfold in the event of a platform failure. The ability of investors to appraise risk will be especially important in 2016, with the advent of the Innovative Finance ISA upon us.

In truth, investing and risk assessment are processes that vast swathes of the population choose to delegate to financial advisers. No need to worry then? Don’t be so sure. A recent Intelligent Partnership survey revealed that a mere 13% of IFAs were aware that some peer-to-peer platforms employ provision funds as a means of guarding against investor losses. I expect the platforms will do their utmost to up that number by April 6^th.