There are some concerns circulating around peer-to-peer (P2P) lending as an investment. The sector was subjected to an investigation by the financial services regulator, the Financial Conduct Authority (FCA), whose report did not paint the prettiest of pictures. The FCA is concerned that many P2P investors do not fully understand the sector, nor how important it is to choose the right platform. Some platforms price loan interest rates on investors' behalf, which means you're at the whim of someone else's risk management protocols. If you choose a P2P platform that gets this wrong, then you might be taking more risk than you initially intended.
The FCA's analysis showed some significant pitfalls for investors, and easy ones to fall into for those who eagerly chase the high returns expected from the sector. The regulator is consulting on measures to improve platforms and better protect investors, but these are not likely to come into force until Spring 2019. In the meantime, P2P investors need to know how to best get the benefits of the asset class while mitigating the risk of a poor provider.
Understand how your platform works
The rates available through P2P lending can be appealing, with platforms offering returns from around 3 per cent to 15 per cent. But remember the higher the rates on offer, the higher the risk you are being exposed to. And P2P loans are not protected by the Financial Services Compensation Scheme (FSCS), unlike cash or regulated investments such as unit trusts and open-ended investment companies. So you should look beyond headline rates and be able to answer these key questions before investing through a P2P platform.
What is the platform model?
There are three main types of P2P platform. Conduit platforms allow investors to select the loans they want to invest in and negotiate the interest paid directly with the borrower. But these types of platforms need to provide a good level of information to work well, so investors can make informed decisions.
Pricing platforms allow investors to pick their own loans, but the platform negotiates the interest rate with the borrower. Investors are therefore reliant on how effectively these platforms price loans, assess borrower risk, and the quality of information provided so investors can choose loanees.
Discretionary platforms both set the interest rates of loans and allocate investors’ capital into a portfolio of loans. Investors here are also reliant on how effectively these platforms price loans, assess borrower risk and keep records as to which loans belong to which investors.
What track record does the provider have?
Research the platform provider to see what what relevant experience the management team has, and how long the company has been running. It’s also good to find out what track record the platform has built up over that timeframe. You can do this by seeing how much the platform has lent, and what percentage of the loans have defaulted and/or been repaid late. Many P2P platforms publish this information on their websites.
You can also look at some third-party sources of information and due diligence on P2P platforms. But as the industry is still relatively young there are far fewer sources of information available than there are for investments such as shares or funds. Some useful resources include platform comparison tools offered by AltFi.
Who are the borrowers?
Borrowers tend to fall into three groups: individuals looking for personal loans, small businesses or property developers. Some platforms, such as RateSetter, allow you to loan money to all these types of borrowers. Others specialise in particular borrowers. For example, Zopa only does consumer loans, Funding Circle only facilitates loans to businesses and Landbay focuses on the buy-to-let sector. Investors will be exposed to different types of investment risk depending on the types of borrowers they lend to.
What are the charges?
Find out what fees the platform charges and who pays them. Many P2P platforms do not charge investors to lend money, and may charge borrowers instead. Platforms might also make money by taking a differential between the interest lenders receive and borrowers pay.
Julia Groves, partner and head of crowdfunding at Downing LLP, says borrower rates are often a better indicator of risk than the rate investors are offered. “You may not be getting a good deal if the gap between the borrower rate and your rate is wide,” she adds.
The platform’s charging structure may create conflicts of interest, the FCA warns. Providers who take the difference on rates could be tempted to facilitate riskier loans at higher rates to create more profit.
How does the platform mitigate borrower default?
There’s always a risk the borrower will default whenever you lend money. Platforms aim to mitigate this using different methods. Some offer a provision or contingency fund – a pot of money that can be used to compensate lenders if borrowers default. Others only originate loans secured against an underlying asset such as property. Other platforms diversify lenders' money across a basket of loans.
So it's important investors take a look at exactly how the platform manages risk, and ensure it makes sense to them, and is suitable for their needs. Looking at default rates is helpful, but it is worth remembering that most of the sector – which sprang up in the wake of the financial crisis – has not gone through a full economic cycle and recession yet. So we have not seen what happens when defaults spike – normally in the recession phase.
What happens if you need your money back early?
Some providers allow investors to cash out of their loan early by selling them on a secondary market. However, there is no guarantee there will always be buyers. Check with your provider how liquidity is created and what happens if it dries up.
Diversification options
Create your own portfolio of platforms
As well as arming yourself with information about how the platform works, it could be worthwhile spreading your P2P exposure across different platforms. This way you can protect yourself from the risk of being overexposed to any one platform.
“It’s also a good idea to have exposure to different underlying loan assets and different types of security,” says Daniel Kiernan, associate director at Intelligent Partnership. “Personally, I think investing in six or seven different platforms is the best way for a motivated P2P investor to [manage their portfolio].”
One downside of this approach is that it is time consuming to monitor multiple portfolios on different platforms. You also need to think about how much of your total portfolio you want to allocate to P2P lending as it might not be worth the hassle if it's only a small amount, especially as P2P should only really be a small part of your overall portfolio given the risks.
It can also be difficult for investors to compare platforms, particularly as they have different ways of calculating borrower defaults. The FCA is proposing bringing in a common industry standard, but at the moment only members of the Peer to Peer Finance Association (P2PFA) use the same method to provide comparable statistics for investors. Current members include: Crowdstacker, Folk2Folk, Funding Circle, Landbay, Lending Works, Market Invoice, ThinCats and Zopa.
Platforms of platforms
Platforms of P2P platforms may appear to offer a way to diversify your portfolio but you will have an extra layer of fees and you may face extra risk as the platform may not be regulated. You are also reliant on the company’s ability to assess the underlying platforms’ robustness and you may be exposed to non P2P lenders.
Goji Investments offers access to secured loans from eight different lending platforms, via two fixed-term bonds. Goji's Diversified Lending Bond invests mostly in loans to small businesses over a one-year term and its Renewables Lending Bond invests in loans to UK renewable energy projects over three and five years. The bonds aim to provide a steady return in excess of 5 per cent, net of fees.
As it is done via a bond, Goji investors do not have ownership of the underlying loans. Investors in the bonds need to confirm they will put less than 10 per cent of their portfolio in these investments, or be investing via a financial adviser or certify as a wealthy or sophisticated investor. The minimum investment is £1,000. Goji charges a management fee of 0.95 per cent on the value of investor’s funds. This will be waived if investors do not earn returns. Goji is regulated as an investment platform, not a P2P platform.
Orca runs a platform that allows investors to invest in the loan books of six P2P platforms, namely Assetz Capital, Landbay, LendingCrowd, Lending Works and Octopus Choice. There is a minimum investment of £1,000. Orca says portfolios are likely to yield a target return of 5 per cent, net of fees. The company charges an annual fee of 0.65 per cent.
Although the P2P platforms included in its portfolio are regulated by the FCA as is the company that provides segregated bank accounts for Orca clients, Orca’s platform is not regulated by the FCA.
