Dan Barrett, director, corporate debt advisory at CreditSquare, examines the need for extra due diligence in the peer-to-peer finance industry…
Peer-to-peer or marketplace lending started over 10 years ago with the launch of Zopa in 2005. Since then, the industry has grown exponentially with billions of pounds lent to UK businesses and consumers. P2P or marketplace lending platforms (MLPs) have taken advantage of a relatively light-touch regulatory environment and have utilised technology to ensure efficient and quick processes for borrowers. As a result, MLPs can offer a real alternative source of funding for UK small- and medium- sized enterprises (SMEs), while at the same time generating attractive returns for investors.
However, the growth rate in marketplace lending has slowed in 2016. There are numerous explanations for this slowdown, but one recurring theme is that MLPs need to increasingly reassure investors by demonstrating that their business models are robust and sustainable.
Lending Club has seen its share price more than halve following alleged revelations that, via a fund, the company had invested in loans on the Lending Club platform, despite repeatedly promising investors that the company did not invest in loans on its own platform and took no credit risk.
It is worth pointing out the obvious here, that not all MLPs are the same, far from it. However, to give investors the reassurance they seek, MLPs need to be able to demonstrate robust fundamental practices throughout. Paramount to this is the front end process of underwriting, where the creditworthiness of a potential borrower is assessed.
The implicit assumption has always been that it is unreasonable for retail investors (lenders) investing a few hundred or thousand pounds to do much more than read the material produced by the MLP on a borrower and that the responsibility for ensuring the borrower is a safe credit risk sits with the MLP. Given that the amount of auto-selected loans (where the MLP selects the loans on behalf of the lender) is increasing, the credit work done by MLPs is becoming even more important.
The question then is how much credit work do MLPs do and how much should they do? Credit scoring and algorithmic approaches can work for high volume and low value transactions, but as soon as the loan sizes increase, the impact of defaults become more painful. As such, on larger loans the basic credit questions need to be covered: the track record of the borrower, understanding why the business exists, serviceability under different scenarios and understanding what the alternative repayment options are should it all go wrong.
With the combination of larger loan sizes on MLPs and more risk-aware lenders, the question is how and when external financial due diligence should be used as part of the underwriting process. The scope of financial due diligence can vary but the key purpose of it does not. Diligence should check that the business performance is as it appears and identify any material risks. These risks might change the pricing of a loan (to price for risk), or generate conditions that the borrower needs to meet before the loan be issued, or in some cases render the borrower not fit for financing.
Involving an external diligence provider, even with a limited scope of work, adds additional cost to the transaction which will need to be borne by one or more of the parties involved. This cost will not be viable for smaller transactions. But for larger transactions, the cost of diligence needs to be compared to the ‘cost’ of having no diligence done. This ‘cost’ could be either a lack of interest from investors for loans on MLPs, or a higher potential risk of defaults for investors.
Even MLPs that operate robust credit underwriting processes are likely to come under increasing pressure to use more external diligence in order to grow at the rates they want to.
CreditSquare is a corporate finance firm that advises on, structures and sources debt financing solutions for UK SMEs. CreditSquare has arranged a number of debt financing transactions via MLPs in the range of £1m to £2.5m.