By Rupert Taylor on Wednesday 4 May 2016
Stock markets have undergone a significant change of heart with respect to the value they ascribe to listed marketplace lending funds. In the months after the float of P2PGI, its shares traded at a significant premium to NAV. This was all the more impressive given that the NAV dropped by nearly 1.5% on day one as a result of IPO costs. As such, 98.5p of un-deployed cash was valued at over 100p, and indeed as much as 110p, in the immediate aftermath of the float when sentiment towards an exciting new asset class was at its most buoyant. This was despite the obvious challenges of deploying the cash into a scarce asset, and indeed one that was to a certain extent unproven.
Winding the clock forward to today, the manager behind P2PGI – MW Eaglewood – can reflect on some remarkable achievements. They have successfully deployed the cash proceeds of the initial IPO. Indeed they deployed so effectively that they have raised further capital along the way, taking the fund to £870 million of capital today, from £200 million at the outset. This process was sympathetically structured, via C share issues, which ensured that the ordinary shares were not diluted by new inflows of un-deployed cash – effectively the C shares only converted to ordinary shares once the initial cash had been deployed. ,The fund has also acquired equity stakes in some of the most exciting origination platforms that are increasingly recognised as the dominant players in the marketplace lending universe.
Equally impressive is the NAV performance that the fund has delivered when considered in the context of a number of head winds. Firstly, there has been the drag from un-deployed cash when the initial capital was raised. Secondly, there is the cost of establishing leverage facilities. This comprises not only the initial setup cost, but also the associated balance sheet inefficiency that is incurred before the facility is fully deployed. Finally, the equity stakes are marked at cost and are not yet paying dividends, so are not contributing to NAV performance. These head winds will progressively turn into tail winds such that, all else being equal, investors can expect a further acceleration in the NAV performance that has been delivered to date. Certainly performance should soon begin to outstrip a benchmark of marketplace lending assets.
However, in the face of this progress, the stock market is not impressed. The premium has turned to a discount. This discount approached 17% in Q1 and persists today at around 10%. The market seems to be expressing a concern about the likelihood of the assets in the P2PGI book delivering the consistent 6-8% returns that have been promised.
This seems excessively cautious. The Liberum AltFi Returns Index (LARI) is a benchmark of net returns from the UK marketplace lending sector. Its performance demonstrates that, to date, a diverse selection of UK marketplace lending assets has delivered impressive returns, even after taking account for defaults. This benchmark is constructed by tracking the cash-flows of every loan originated by the 4 biggest UK marketplace lending platforms since the industry began in 2005. We can infer from this that, to date, the UK loans that P2PGI hold are continuing to perform. Indeed, when we look into the underlying detail, there is no discernible deterioration in credit quality as measured by either defaults or arrears.
But perhaps the stock market is pre-empting a deterioration in credit quality? In the UK there has been little, if any, sign of the lending rates of newly originated loans rising in order to compensate for an increase in the perceived risk of future default. The charts in figures 3 and 4 are screenshots from AltFi Data’s Analytics product, showing lending rates for Funding Circle (the UK’s largest SME lending platform) and Zopa (the UK’s largest consumer lending platform). Neither indicates that higher interest rates are being required to compensate investors for greater anticipated risks. Whilst there has been a very small increase in the required rate for Zopa’s highest risk bands in the past month, it is a tiny increase in risk bands that represent only a small proportion of total origination.
However the same is not true in the USA. Lending Club has increased lending rates three times in the past five months. This process began when the Fed began raising rates and Lending Club matched this with a 25bp rise in rates across all risk bands. It has since continued to raise lending rates – in an apparent indication that the required interest rate to clear new loans has shifted upwards – perhaps in anticipation of increased credit losses. Rates rose by an average of 32bps in January and by a further 23bps in April. The riskier Lending Club loans saw the largest increases in rate, with rates for higher credit grade loans remaining virtually unchanged. So whilst there is clear evidence that in the US the market for new loans currently requires a higher interest rate to clear, it is also important to put these rises in context. Accounting for the effect of the Fed’s rate rise, the market is now clearing 55bps higher in real terms, which would seem to imply only a modest expected increase in losses.
So there is some evidence of a geographic distinction here. There is no sign of any deterioration in the performance of UK marketplace lending assets. Nor is there any significant sign of the market requiring a higher return on new loans in anticipation of any deterioration in the environment going forwards. This would suggest that the c.30% of the P2PGI book that is exposed to these assets should be on track to deliver the 6-8% that the fund has guided investors towards.
Meanwhile, there are some signs of investors anticipating a tougher environment in the US. Arguably the 55bp increase in required rates would seem to indicate a commensurately higher anticipated rise in charge-offs. Interestingly, with net returns at 7%+ in the US, that would still seem to suggest that net returns on these loans will be sufficient to allow P2PGI will deliver NAV growth in line with guidance. Whilst there are some signs of a deterioration in the credit environment, with, for example, a rise in sub-prime auto loan delinquencies attracting some recent press coverage, it could be that the more prime exposures that P2PGI has acquired continue to perform. It is also possible that the small increase in rates required in the primary market is in part a function of growing pains as the sector navigates the early stages of the development of a secondary market. Tensions have emerged in recent months as institutional appetite for securitizations and loan portfolio purchases has been explored.
Whatever the cause of the recent shift in the US primary market, it seems that a rather small change in required rate has translated into a much larger shift in where P2PGI trades versus its NAV. The discount that the shares are presently trading at may prove to be, as much of anything, a function of market uncertainty. Markets hate uncertainty and marketplace lending originated loans are an entirely new asset class. Investors are not familiar with these loans and indeed many are likely unaware that a benchmark that serves as a proxy for net returns in the asset class even exists. At AltFi Data we track every cash-flow from every loan to calculate the industry return that we represent as the LARI. This gives us huge confidence that, in the UK at least, marketplace lending assets continue to deliver impressive net returns. As such the opportunity to buy 100p of assets, that is scheduled to grow to 106-108p over the next twelve months, and consistently thereafter, for just 90p today looks attractive. Essentially, an implied increase in expected default rates of 55bps in the US primary market, with the US representing around 65% of P2PGI’s book, has translated into the entire book (notwithstanding that most of it represents entirely different cohorts) being priced at a 10% discount. A disconnect seems to have emerged between the equity market’s valuation of these funds and the marketplace lending primary market. In essence, because of a 50bp increase in implied expected losses across 65% of their book, you can buy P2PGI's entire book for 90 cents on the dollar, versus a new loan in the primary market for a dollar with 50bips of extra rate. An extra 50bips for 3 years does not add up to 10%!
The opportunity looks even more compelling when you consider that P2PGI, and other comparable trusts, are increasingly likely to out-perform the sector return benchmark going forwards as recent head-winds become a tail-wind. Perhaps investors will be in a better position to identify the performance of the underlying loans as benchmarks for the asset class gain traction. When that time comes, newfound confidence will likely be reflected in where the shares trade versus NAV.