Risk and returns go hand in hand, so how do peer-to-peer lenders offer competitive returns while protecting their customers? Marc Shoffman investigates…
RISK is an unavoidable component of investing and peer-to-peer lending is no exception.
The collapse of Collateral, rising arrears at platforms such as Lendy and concerns about the way Innovative Finance ISAs (IFISAs) are promoted to consumers have shone a spotlight on the risks of investing in the sector.
With any investment, it is widely acknowledged that higher returns come with higher risks, and the P2P sector’s competitive returns are particularly attractive when compared to paltry savings rates.
However, it is important to note that P2P is an investment product, not a savings product, and to ensure that the specific risks within the sector are clearly understood by investors.
There are three major risks when investing in P2P: defaults, platform management and the wider economic environment.
“Providing you spread your investment over a large number of loans, credit risk relates to a number of borrowers defaulting on their loans,” explains Iain Niblock, chief executive of P2P analysis and investment firm Orca Money.
“If the default rate rises above the interest rate you may lose capital.
“The P2P platforms themselves also pose a risk to investors. Your investment would be affected if a P2P platform were to become financially unstable, suffered a cyber-attack or if fraud existed at the platform.
“Finally, there is a macroeconomic risk, similar to other investments such as listed products.
“However, unlike listed investments the impact of an economic downturn would not be felt immediately.
“Instead unemployment rates would rise, businesses may go out of business and property prices may fall, all factors that would affect borrowers within the P2P market.”
When it comes to platform management, Frank Wessely, partner at business advisory firm Quantuma, says platforms must assess how much capital they need to operate and work out the actual demand for their product.
“We often see businesses that are under capitalised and underestimate how much capital is required to fund longer-term investment and expansion,” he says.
“The other aspect we see as a major cause of difficulties for business is inadequate management capabilities, experience or skillsets.
“It is a bit of a fallacy that someone is suitable to set up a business simply because they have previously worked in a particular role or industry.
“Platforms also have to consider if their products are solving problems currently faced by investors and are something the market wants, or the business is unlikely to be successful.”
All platforms will have various policies on underwriting and assessing borrowers in order to keep default rates down.
For example, Darren Cairns, chief marketing officer of business lender LendingCrowd, says the platform combines risk modelling and human interaction for the final lending decision.
“We focus on the borrower’s ability to repay their loan and only lend to established and creditworthy businesses that have been approved by our credit team,” Cairns said.
“When assessing a loan application, we look for proven management ability, a strong and considered business plan and the ability to meet repayments.
“We are a fintech business, with a proprietary risk band modelling tool, but the personal approach is still important – a human always makes the final lending decision. Investors need to remember that their capital is at risk when lending to business, and only invest if the risks match their appetite.”
The lending segment in which a platform operates will also have an impact on its risk profile.
“We follow the typical process for a buy-to-let mortgage,” John Goodall, chief executive of Landbay, says.
“We treat borrowers like a business and look at the costs and cashflow attached to buying and renting out a property. “We also value the property with independent valuers and do fraud checks.
“Rather than benchmarking ourselves against other P2P lenders we are more similar to other buy-tolet providers, just quicker.”
However, Orca Money’s Niblock warns that most platforms are not so public on their underwriting processes, making it harder to assess how risky the loans are.
This brings us to the main weaponry for an investor, a platform’s statistics page.
“It is very difficult for a retail investor to assess the underwriting processes of a P2P platform as this information is generally not in the public domain,” Niblock says.
“In the absence of physically visiting a P2P platform and sitting down with the appropriate people, investors can review the statistics pages of the P2P platforms.
“Although this does not offer an understanding of the underwriting processes it does give an indication of credit performance.
“Defaults are expected and the magnitude of defaults generally relate to the credit quality that the P2P platform is targeting. If defaults fluctuate between the years, or do not meet the platform’s original estimates, we can assume that these are not expected and may be the result of poor underwriting processes.”
Investors can help mitigate the risk of defaults with diversification, ensuring their money is spread across different loans and even different platforms.
However, diversification can be a little more challenging if a platform purely offers a manual lending function. In this case, investors choose their own loans and are responsible for their own due diligence and diversification.
Other platforms offer auto-lending functions which automatically allocate funds across a number of loans, ensuring diversification with less effort.
For example, auto-lending platforms such as Zopa, Funding Circle, RateSetter and Lending Works break investors’ money down into small chunks and spread it across different loans, so that one default doesn’t create major losses in a portfolio.
But David Bradley-Ward, chief executive of manual lending platform Ablrate, suggests auto-lending isn’t the panacea for P2P risk.
“Diversification is a good mitigant for risk, but that should also be across sectors,” he states.
“If you invest in 100 chip shop loans and suddenly everyone wants salad and not fish and chips, your diversification won’t really matter. The auto-invest platforms are great for ease of use if that is your main criteria, but a little work on manual platforms with good secondary markets can produce great results as well.”
Read more: Autobid vs manual: Which is truly P2P?
Sophie Pearce, managing director of manual P2P lender MoneyThing, echoes Bradley-Ward’s comments.
“Manual lending is best suited to lenders that have the time to choose their own loans and manage their own risk,” Pearce explains.
“The gross interest rates are much higher than the discretionary fund models, so if you have the time, you can get a better return by diversifying your lending yourself.” Others, such as LendingCrowd, offer a choice between the two.
Cairns of LendingCrowd says auto-investing offers a quick and simple way of diversifying a portfolio, while self-select can work for more sophisticated investors who have the time and knowledge to review individual borrowers and build their own portfolio.
“There’s no such thing as a risk-free investment, but diversification is the easiest way to manage risk and improve your opportunity for better returns,” he says.
“We believe that investors appreciate the choice between automatic and manual investing, so we continue to offer both options. We work hard to make investing with us as easy as possible while maintaining a diversified portfolio.”
Pearce adds that risk profiles on manual and auto-lending platforms can still be similar.
“Lenders can diversify by selecting loans themselves on manual lending platforms like MoneyThing, where gross interest is around 12 per cent, or invest in an auto-invest or account product where gross returns are six to seven per cent,” she says.
“The key thing to remember is that borrowers can still pay similar rates of interest and meet the same risk profiles as the manual lending option.
“This is because the account products need to take cash-drag and liquidity into account.”
Platforms offering asset-backed loans also highlight the underlying security as a way of mitigating risk, although there is no guarantee that the asset can be sold in the event of a default.
Bradley-Ward adds that it is important to ensure the security is registered properly. He says the documents listed in a proposal should be registered at Companies House and any charge should have a deed of priority.
“If it doesn’t you should be sure you are being compensated by a low overall LTV or a high interest rate or both,” he adds.
There are other ways of judging the riskiness of a platform beyond the rate, security and defaults.
The industry’s relative nascence – namely the fact that most P2P lenders were not in existence during the last downturn – is commonly cited as a risk to the industry’s future outlook.
However, some of the larger platforms such as Funding Circle and Landbay have stress tested their loanbooks and published the results, with investors still predicted to make a profit in the event of a financial crash.
Goodall says stress testing shows platforms are prepared. He also suggests institutional backing can provide a seal of approval on the way a platform approaches risk.
“Having institutional investors on a platform is a huge positive, at least you know they have been through a serious due diligence process,” he adds.
“If you look where there has been issues, it’s where there hasn’t been institutional investment.” However, retail investors must also take some responsibility in the decision-making process.
Wessely says investors should remember that P2P lenders aren’t advising on loans and are merely promoting them.
“Platforms are putting potential loans up to be filled, and perhaps investors are coming at it from a perspective that it’s a recommendation, but the final judgement is for the investor,” he says.
“An investor needs to be able to make a distinction in their own mind.”
The Financial Conduct Authority (FCA) has highlighted its concerns about the sector, warning that investments held in IFISAs are “generally high-risk with the money ultimately being invested in products like mini-bonds or P2P investments.”
The industry has criticised the City regulator’s warning, suggesting that it is unfairly tarring the P2P industry with the same brush as less-regulated mini bonds, in the wake of the high-profile collapse of mini bonds provider London Capital & Finance.
“I understand why the P2P community has reacted the way it has and criticised the FCA for not drawing sufficient distinctions between mini bonds and P2P and also the different types of P2P products,” Wessely says.
“A more specific detailed comment is needed to clarify this statement and draw a distinction between mini bonds and more traditional P2P products.”
The latest FCA statement follows last year’s proposals to introduce investor marketing restrictions and more transparency to help manage risk in the sector.
The P2P industry has never shied away from admitting there are risks involved, and as with any investment, there will be peaks and troughs.
Platform transparency and investor education will help ensure both sides can work together effectively in mitigating these risks as much as possible.
This article featured in the May issue of Peer2Peer Finance News, now available to read online.