Opinion Alternative Lending

Proving the peer-to-peer lending principle

Is transparency fit to cure what ails peer-to-peer lending?  

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Investor suffering equals originator suffering: the equation that is supposed to sit at the heart of the peer-to-peer/marketplace lending model. What does this mean? That bad investor experiences will swiftly and inexorably result in the evaporation of lending capital for the guilty peer-to-peer lending platforms.

The equation is important because peer-to-peer lenders, as we all know, do not risk their own capital on the loans that they source. So there has to be some alternative method of aligning incentives between the investor and the platform. That alternative method, according to many within the sector, is transparency. The logic is that the full and frank disclosure of a lender’s track record is sufficient to satisfy investors that good loans are being sourced, or not, as the case may be.

But does this really work?

Speaking at a recent industry event, Victory Park Capital principal Cormac Leech suggested that while transparency is all well and good, any potentially negative surprise on credit losses takes time to manifest itself. What he meant is that transparency in peer-to-peer lending works as a means of aligning interests, but that information feedback is not immediate. Leech believes that lenders that take a first-loss position in the loans they source are the more attractive investment propositions.

But balance sheet risk is no silver bullet, as the chart below demonstrates. 

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There seems to be a general acceptance that transparency can bring about alignment in peer-to-peer lending. But is it the cure-all that it claims to be? 

A look back at the market

There are gradations of transparency, as AltFi Data CEO Rupert Taylor regularly reminds us. Some peer-to-peer lenders are entirely opaque. Others publish only top-line statistics, such as cumulative lending and historic losses. Then there are those that make their full loanbooks available for download. And finally there are a handful of platforms that have opened themselves up to the scrutiny of third-party analytics firms, such as AltFi Data in the UK and PeerIQ in the US.

If we look at the UK specifically (where standards of disclosure are best developed), we see a clear trend emerging: the most transparent platforms are also the largest by volume.

AltFi Data currently sees loan-by-loan, cash-flow level data from four platforms: Zopa,Funding Circle,RateSetter and MarketInvoice. It is no coincidence that the first three of these firms are the only peer-to-peer/marketplace lenders in the UK to have topped the billion pound mark in cumulative lending (Zopa and Funding Circle are now over £2bn).

MarketInvoice will likely be the fourth platform to top a billion pounds in cumulative lending, so long as LendInvest doesn’t pip it to the post. But MarketInvoice’s outstanding principal is not comparable to that of Funding Circle,RateSetter or Zopa, due to the short-term nature of its product. MarketInvoice is doing well within its niche, but it’s difficult to measure the impact of its high level of transparency in quite the same way that we might for “the big three”.

It is a requirement of the Peer-to-Peer Finance Association that members must publish their full loanbooks online. The five platforms mentioned in the previous paragraph (the biggest five in the UK by loan volume) are all members of the association.

The remaining members are Landbay,Lending Works,Folk2Folk andThinCats. ThinCats has lent close to £220m to date, according to AltFi Data. Folk2Folk has lent c. £134m. Landbay has lent £43m and Lending Works is on £42m. Not exactly huge, but far from small, by the standards of the wider peer-to-peer space. It should also be noted that both Landbay and Lending Works are still relatively young, with each having launched in 2014.

Admittedly, there are big peer-to-peer lenders out there which do not publish their loanbooks online. Assetz Capital, Wellesley & Co. and Saving Stream stand out. But the simple fact remains: the biggest and best-known platforms are also the most transparent.

Are we to assume, then, that investors are happy with the performance they’re seeing on the Zopas, RateSetters and Funding Circles of the world? They almost have to be – if the fundamental equation in peer-to-peer lending (investor suffering equals originator suffering) is to be believed.

A closer look at the data

The chart below, from AltFi Data, represents the net returns (factoring in losses and fees) that have been delivered by the three largest (and most transparent) platforms to date.

chart, line chart

As can be seen, over the past couple of years – during which time the vast bulk of the industry’s origination has taken place – the average net return of the largest three platforms has never failed to drop beneath c. 4.5 per cent. There’s been some fluctuation in the performance of the individual platforms, granted. But the numbers show that each firm has fared well enough to justify them being the favoured destinations for capital within the wider peer-to-peer lending sector.

A fund manager’s view

What is more difficult to discern, coming back to Mr. Leech’s earlier point, is whether transparency can deliver a sufficiently timely view of performance.

There are stories of online lending-focused funds jumping in and out of originators based on performance. Blue Elephant Capital Management, for instance, stopped buying Prosper loans in 2015, only to resume in May of the following year. The investment manager identified “tighter models” and “higher rates” as the key factors in its decision to restart the programme.

Institutional investors in the marketplace lending sector typically demand a high level of transparency from the platforms that they work with. And so this series of incidents seems to be a case of transparency killing off and later rekindling capital supply for one of the US’ largest marketplace platforms.

Institutional investors also benefit from access to tools like those provided by AltFi Data,dv01 and Orchard. But the key question remains: are investors in the marketplace lending sector getting a sufficiently timely view of performance?

Jean-Benoit Gambet is a partner at Eiffel eCapital – a purchaser of marketplace loans in Europe and the UK. His fund is partnered with major insurance firms like Aviva. In an interview with AltFi, Gambet said that transparency is a “must-have” for institutional investors.

However, he conceded that it usually takes at least nine months for problems in a cohort of loans to come to light, and that by then it might be “too late”.

“If we see a problem, we will arrange a call with the platform to discuss the cohort in question,” explained Gambet. “If they are not transparent then we point to our own analysis.”

He said that the purpose of these conversations is to identify the source of the deterioration in performance, whether that be a new origination channel, changes to a platform’s credit model, or specific to certain industry sectors.

“You are trying to find the solution and what you want to see is that the platform has also spotted the same problem and that they are dealing with it,” he said.

“In some instances we have seen a deterioration in the origination and we have stopped investing. This happens when we realise that a default spike it is not a false alert but indicative of a broader trend. We do not have any deal that forces us to invest even if defaults are increasing. We stop if we are not comfortable.”

Mixed views, then. On the one hand, loan portfolios inherently take time to display signs of trouble, and thus transparency cannot always save the day. If things go wrong in a hurry, then it may be “too late”, as Gambet put it.

However, in less extreme scenarios, the idea that investor suffering equals originator suffering seems to ring true. Gambet’s overarching point is effectively that Eiffel will (and has) cut ties with originators if it sees portfolio problems as endemic, but it will endeavour to work with platforms to resolve problems if they can be shown to be anomalous. 

But AltFi Data CEO Rupert Taylor still thinks we're missing a trick. 

"Effective disclosure should invite scrutiny, and allow timely appraisal of loan performance and historic lending track record," he said. "But creating alignment is as much about motivations as timeliness of review. Investors should identify platforms that are prepared to demonstrate the accountability that will ensure that the platform is motivated to perform the due diligence required to source well priced loans."

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