Opinion Alternative Lending

Alternative Finance - a closer look at P2P

Since the EU referendum vote last year, inflation in the UK has accelerated (thanks to sterling’s depreciation) but wage growth has remained stagnant, and mortgage rates have risen from their record lows but the interest rates on our savings haven’t budged. Life, as we’re often reminded, just isn’t fair.

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In the current environment of low to negative real yields on cash and other mainstream investments, it is perhaps understandable why the world of alternative finance has seen such rapid adoption from the hoards of investors looking to generate a healthy, inflation-beating return on their capital.

And yet, there is a slight tinge of unease, especially for the more experienced and cynical among us, that the high yields being offered should instinctively not be possible when the finance sector is swimming in liquidity, courtesy of central bank largesse post-2008.

However, while mainstream credit (e.g. residential mortgages, government debt, large cap bonds) has benefited, not all sectors of the economy have experienced lower interest rates or easier lending conditions. In fact, increased regulation and a paradigm shift in the way large banks assess and manage risk has meant that smaller and/or non-mainstream borrowers have been sidelined, thereby creating attractive investment opportunities in the lesser known, niche market segments which P2P lenders and crowdfunding platforms such as ours have rushed to fill.

Thanks to AltFi Data, we have also been able to track how this nascent industry has evolved since its conception. In particular, it is interesting to note how gross yields across the UK’s largest P2P lending platforms, despite the differing characteristics of their various business models, appear to have converged over time and currently sit around the 8 – 9 per cent range (see Fig. 1 below).

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RateSetter, which pioneered the concept of a “provision fund" to shelter investors against losses from borrower default, is an outlier here with its consistently low average yields (around 4 per cent). To us, this is partly explained by the platform’s duration profile (its core offering is a rolling one-month product) as well as the reassurance that investors get from the provision fund (akin to a first-loss, equity-like buffer for debt investors). Understandably, a shorter maturity and greater security make for lower yields.

Another observation worth highlighting is how arrears have crept higher in recent years, driven predominantly by borrowers with lower credit ratings. AltFi Data’s numbers on Zopa, which provide us with the most granular data we have, suggests that borrowers in the A* band almost never fall behind on payments, while those in the lowest bands, C, D & E have seen their arrears rise steadily since 2014 (see Fig. 2 below). This has contributed to more instances of bad debt in the 2014 and 2015 vintages (see Fig. 3 below), although the overall picture remains fairly robust thanks to Zopa’s core A* offering anchoring the numbers.

It should be noted, however, that Zopa’s C, D & E bands are relatively new and as such an increase in defaults is to be expected as the underlying loans season. Furthermore, the adjusted rates of return to investors are still very impressive considering the typical loan in those bands yield 18 per cent to 21 per cent on average – which highlights the robustness of the platform’s borrower screening process and the importance of focusing on quality, regardless of market segment.

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One of the sub-sectors to keep an eye on, where we still have very limited data, is the fast-growing real estate-backed crowdfunding space. Property-related financing, for example, makes up just c.10 per cent of RateSetter’s business, while a recent report from the UK-based Investment Property Forum estimates that real estate-related transactions made up just over 20 per cent of the broader P2P lending/crowdfunding industry. Nonetheless, with the typical crowdfunded real estate debt deal offering double-digit yields on short maturity loans secured against a tangible brick-and-mortar asset (such as the one we recently closed on our platform, Property Crowd), I suspect it won’t be long before investors sit up and take notice.

But if the lessons gleaned from the P2P lending data are any guide, we can say two things about the evolution of the real estate debt crowdfunding industry: a) these exceptional yields are unlikely to stay high forever, and some degree of compression to a lower normal is to be expected over time, and b) quality - of not just the underlying deal assets, but also of the platform’s infrastructure - will be a key determinant of not just the return on your capital, but also the return of it. So in other words, move quickly, but choose wisely.

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