By James Hedges on Tuesday 16 May 2017
Let’s be candid. The hedge fund landscape is a wreck. Mediocre performance for years. Heavy fee burdens. Limited disclosure. No real asset flows in years (except for performance increases). Finally, uncorrelated alpha seems to be a thing of the past.
However, in the past few years, there is a new industry emerging offering the promise of uncorrelated alpha, and, the holy grail: current income. It’s not exactly a hedge fund, but it falls under the alternative investment banner that families and institutions rely on to enhance performance and meet funding goals. Peer-to-peer or marketplace lending is a relatively new segment of the alternative investment landscape, one grown out of the ashes of the 2008 financial crisis. As banks were slapped with increased regulatory oversight, they exited many segments of the direct lending market, most notably unsecured consumer credit and small business credit. The result created a void of lending solutions which have now been gradually replaced by fin-tech powered platforms focused on loan origination.
The peer-to-peer or market place lending space includes a broad array of segments which include:
Unsecured consumer credit for debt consolidation and emergency expenditures
Real estate lending (often secured by real property)
Small business credit
Retail installment contracts (RIC’s)
Solar equipment financing
Automotive repair financing
Each of these segments has unique drivers and underwriting procedures, and consequently, many of the segments offer differing yields, default rates and durations.
With current yields ranging from high single digits to the upper 20’s (and in some cases, even higher), it’s easy to see the appeal for family offices and under-funded pensions and insurance companies. Even with high default rates, these loans can provide a very strong current income stream, and with average loan durations typically under 2.5 years, there is very little comparable in the traditional investment market.
As an investor in this space, it’s critical to first establish one’s point of view on:
Duration of assets
True Lender requirements
Investing in this space can be done using both active managers and passive managers. Active Management includes investment funds dedicated to a single segment or a diversified group of segments. Investors can also establish managed accounts by entering into forward flow agreements with lending platforms, provided they have sufficient scale to meet high minimum requirements. Finally, there is a small group of fund of funds dedicated to the space, though it seems their fee structures could pose problems for exposure to lower return segments.
As ever in the alternative investment landscape, manager due diligence is paramount, and this new field is populated with portfolio managers who are more likely to have worked at Capital One on a credit desk than on the trading floor of Goldman, Sachs. The lack of a traditional pedigree and track record in this field makes it more difficult for one to assess a manager’s relevant skills and experience. Likewise, the use of leverage in this field is not confined to swaps and broker/dealer leverage, but is more analogous to the leverage debt fund markets (i.e. CDO’s, CLO’s, etc.). Finally, many of the niche segments in the marketplace lending landscape are somewhat new to direct lending, and as such, historic performance of borrowers’ behaviors is less understood.
In order to meet its funding offer obligations, an originator platform must rely on a steady demand for its loans, and one way to insure ample demand is to sponsor a captive asset management vehicle. Many of these companies have registered vehicles available to accredited investors, but most of them are seeking to sponsor private partnerships offering a passive exposure to all the loans issued off the platform. With low- or no-fee funds, originator platforms offer an efficient way to gain access to the asset class on an unlevered basis, but the compromise is the lack of professional risk management and investment criteria.
First, I want to shine a light on something we should all be terribly concerned about. Valuation practices in this space have lacked consistent methodologies. Managers frequently accrue for loan losses using differing standards. The result is that performance can be overstated or that returns appear to be smoother than they would be using different methodologies. For instance, I offer the following excerpt from the performance report of a very large fund in the space.
When I first saw these returns, I instinctively thought of Madoff. The narrow band of returns is, in my experience, highly unusual and inconsistent with the returns of investments being marked-to-market. To be clear, I am not saying that this fund is a fraud. I am stating that the performance they’ve reported is, in my experience, unlikely indicative of a valuation methodology that accurately reflects the month-to-month performance of the underlying assets. What this could mean is that investors could be disadvantaged when they come in or leave the fund.
Over the past year, I’ve met with and, to varying degrees, evaluated nearly 50 funds in the peer-to-peer space. Some funds are structured as registered vehicles, but most are private placement entities with a broad spectrum of liquidity terms. Certain funds look more like traditional hedge funds, while others are more like long-term drawdown private equity funds. What is abundantly clear is that the majority of funds appear to offer liquidity terms which could be inconsistent with the underlying duration of the investments in their portfolios. By example, an alarming number of funds offered annual liquidity (some with gates, others not) where the underlying assets were 36 and 60 month stated duration. When a manager tells you that current income and all the new investor in-flows of capital should be sufficient to meet any redemption requests, one should take pause.
Given the current rate environment and lack of performance in mainstream alternatives, there is no doubt that the landscape of direct lending is entering an explosive growth phase. Two factors could derail its progress: increased bank regulation and fund blow ups rooted in sloppy valuation and liquidity management. The coming years will surely see billions of dollars of investor capital flow into this asset class, and there will naturally be a wave of new products, intermediaries and experts. In spite of a cautionary message to move carefully into these waters, the sector offers some very appealing uncorrelated returns and current income for those who execute superior due diligence.