Risks and rewards of peer-to-peer loans

    4 November 2017

    Early in 2016, Lord Turner of Ecchinswell — chairman of the Financial Services Authority in the years before it was abolished in 2013 — was quoted thus: ‘Losses which will emerge from peer-to-peer lending over the next five to ten years will make the bankers look like lending geniuses.’

    Some months later he had what looked like a Damascene conversion, telling the peer-to-peer (P2P) industry conference LendIt Europe in October 2016 that he had made his prognostication of doom to a BBC journalist after he thought the interview had ended, and offering a much more nuanced version: namely that while the credit assessment of individual investors on P2P lending platforms might still be bad, very few individual investors ‘select specific portfolios of loans, and even those investors rely crucially on the platform’s centralised credit assessment of the relative riskiness of different loans’.

    Either way, P2P lending is an activity to be undertaken only with your eyes wide open and a proper understanding of how the mechanism works. Sometimes known as ‘crowdlending’, P2P began in the UK in 2005 with Zopa, and gained momentum after the financial crisis with the launch of Funding Circle, Market-Invoice, Platform Black (since rebranded as Sancus Finance) and a cluster of others. The pace of development has been rapid, and whereas Zopa started with personal consumer loans, other companies have gravitated towards lending to small and medium-sized enterprises. If you’re an income investor in search of yield, P2P lending offers you a return of 6 to 8 per cent, usually on investments with a duration of between six weeks and two years.

    ‘We’re taking business from the banks, from the invoice discounters and from the traditional suppliers of finance, in ever larger amounts,’ says Angus Dent, chief executive of ArchOver, a P2P lender that launched in September 2014. ‘We only lend to companies with strong balance sheets and we only lend against accounts receivable (ARs). We will loan up to 80 per cent of the value of the ARs. Once the loan is made the ARs must be maintained at 125 per cent of the value of the loan, monitored by us on a monthly basis. This provides a quickly realisable asset for our investors in case the borrower gets into difficulties over repaying for the loan.’ The minimum amount that ArchOver expects clients to invest is £1,000 per project.

    What gives ArchOver its USP is that it uses credit insurance to provide extra security for investors. The Hampden Group — a Lloyd’s members agency with underwriting capacity in excess of £2 billion — is a shareholder in ArchOver as well as an active lender across the ArchOver platform. In addition, it has teamed up with Coface, a leading global credit insurer and expert in inter-national trade risk, to create future protection of up to £100 million.

    For Anil Stocker, chief executive and co-founder of MarketInvoice, P2P lending against receivables (amounts owed to a business) offers a particularly interesting investment class ‘because it’s of short duration, a liquid product, with invoices typically taking 45 to 50 days to be paid. There are no lock-ups, no minimum fees, and the risk-return profile is very attractive. Technically, investors are not lending to businesses; they are buying an asset, a receivable, which is transferred to them by way of a true sale, so that in the event of a delinquency there is a much higher rate of collection because we can go to the end-customer as well as to the small business in the recovery process. Our recovery rates have been between 85 and 90 per cent. This is the first time that investors have been able to get into this asset class. Invoice receivables have always been factored through the banks, which make healthy margins on that activity, even though they have very high cost bases.’

    An income investor could buy, say, British Airways corporate bonds which might yield a couple of per cent — or they could buy a receivable due to be paid by British Airways to a small business and earn 7 or 8 per cent on it. Also, the investor can diversify very easily by buying only fractions of the invoices. So if there is a £100,000 invoice to British Airways, they can take as little as 1 per cent of that one, and similarly small slices of others with different counterparties. ‘You can actually build a very diversified portfolio of underlying invoices from small businesses to end-debtors and you can also limit your exposure to the small business,’ says Stocker.

    MarketInvoice has active investors who do their own due diligence, take bigger exposures on certain trades, and spend more time directly building their portfolios. However, most of its investors are passive. They put money into their account and set up the ‘AutoBid’ tool which allows them to build a portfolio without having to bid manually each time. They set criteria which allocate their money into ten different risk bands. They can also set limits for how much money they wish to have outstanding from any particular underlying small business.

    Britain’s P2P lending sector has fared well so far as a result of a regulatory approach that is pragmatic and flexible; the Financial Conduct Authority puts P2P lenders through a rigorous process before granting them full approval, but is keen to let it be known that it is here to help, not hinder. (In the US, by contrast, P2P had to be squeezed into the corset of a pre-existing regulatory model and is nothing like as big or successful in proportion to the size of the economy as it is in the UK.)

    ‘It took us two years to get through [the FCA] process and it has taken others a lot longer than that,’ explains Angus Dent of ArchOver. ‘The FCA allowed us to apply for interim permissions. We then had to prepare an application for full regulation, which we submitted in September 2015. They reviewed it, we changed it, and in April of this year we got our full permissions.’ There are now around 20 P2P lenders that have been granted full permissions.

    ‘We’re just on £50 million of borrowing and lending matched,’ Dent continues. ‘We’ve paid over £2 million of interest so far. We have not lost any money, nobody’s defaulted on any of the loans. There are two businesses we’ve had to work with. Although they never missed a payment, our monitoring picked up that there was a bit of an issue and we needed to help them out. Both have now repaid the loans in full and are doing well. Part of what we’re here to do is help businesses through those problems, not make a bigger problem.’

    Though Lord Turner complained of failures in credit analysis by P2P lenders, it’s a fact of life that even a good company can have a sudden disaster. One problem ArchOver encountered came when the director of the borrowing company was in a car accident. ‘How do you factor that into your analysis?’ asks Dent. ‘He wasn’t doing anything super-risky; just driving from home to the office.’

    For that reason investors need to recognise they are getting returns of 6 per cent plus because they are taking real risks — and should only ever put a sensible proportion of their money into this asset class.