Michael Lloyd explores risk mitigation strategies in the sector, which are being put to the test due to the unprecedented challenges of the Covid-19 crisis…
All investments come with a degree of risk – it’s simply unavoidable. But the Covid-19 pandemic has presented a completely new form of risk that no one could have anticipated.
The peer-to-peer lending community has been – by necessity – extremely familiar with risk management processes. Between provision funds, security, secondary markets, credit checks and investor marketing restrictions, P2P has been a hotbed for innovation and risk mitigation.
Now all of these plans are being put to the test.
“One thing that you always need to think about when managing risk is what’s the worst that can happen?” says Mike Bristow, chief executive of CrowdProperty.
It turns out the worst that can happen is that the economy grinds to a halt, property projects are placed on hold, investors rush to withdraw their money amid an uncertain economic environment, and payment holidays are offered to borrowers to avoid an unwelcome spike in default rates.
However, like any other lenders, P2P platforms have to manage risk and protect their investors, and the UK’s platforms are aligned on this core value.
“Mitigating risk is making sure interest is paid and the loan is redeemed,” says Brian Bartaby, founder and chief executive of Proplend.
“Fundamentally it comes down to who you are borrowing and lending money to and how you get the money back.”
Risk management systems differ from platform to platform, but many firms in the sector diversify investors’ funds to mitigate risk. The idea is that by automatically diversifying each investment across dozens, if not hundreds, of loans, the occasional default will impact an investor’s portfolio by merely reducing their projected returns slightly, rather than placing their capital at risk.
The world’s oldest P2P lender, Zopa, cites diversification alongside a prudent credit risk policy as ways of protecting its investors in the event of a downturn.
“Zopa has operated for 15 years, delivering positive returns for our investor community even through the 2007-2008 financial crisis,” says Natasha Wear, chief executive of P2P at Zopa.
“We use the performance of our loans throughout that period to shape our thinking and overlay a range of macro-economic data sources to inform our modelling.
“Our approach to risk and underwriting loans has always been to take a long-term view, building resilience into our products in the knowledge that the economy can face periods of pressure.”
Another ‘big three’ P2P firm, RateSetter, pioneered the provision fund model, which diversifies every investor’s risk across the whole loan portfolio, acting as a safety net against bad debts.
“Full risk mitigation would mean not actually lending at all,” says Michael Hoare, chief credit officer at RateSetter. “And if there was an undisputed best way to mitigate risk, then everyone would use it with no variety.
“Investments like P2P seek to deliver value to investors in exchange for accepting an element of risk. We believe that the provision fund model is a very efficient and effective way to manage risk.”
Lending Works similarly offers a ‘shield’, while Assetz Capital has already proven the value of its provision fund, when some of it was used to refund its wind energy investors last year. Underwriting expertise, effective use of data and stringent due diligence on potential borrowers are also cited frequently by platforms as ways of mitigating risk.
“The single most important thing is expertise in the asset class because wherever capital is coming from, you need to know the asset class you’re lending against,” Bristow explains.
“We deliver that across the funding team which has 75 years of investment experience and have been in the shoes of the borrowers so know all the risks associated with property.
“We have a 57-step due diligence process which we go through for every project. In our view it’s not sufficient to set up a P2P platform if you’re just a tech expert, you need to be an asset class expert.”
Platforms’ secondary markets can act as a risk mitigator, as they give investors a degree of liquidity in an otherwise illiquid asset class. Business lender Rebuildingsociety uses a buy-back guarantee which guarantees that if a secondary market loan is late by more than 60 days, it will be bought back by the lender who sold it to them.
“A lot of highly risk-averse lenders will buy loans with this buy-back guarantee,” says Daniel Rajkumar, managing director of Rebuildingsociety.
“The benefit is it’s up to the lender how much of their portfolio they want to guarantee. It’s pretty efficient and automated.”
For many platforms in the P2P sector, security is intrinsic to mitigating risk. This collateral most commonly takes the form of property and firms are quick to point out their low loan-to-value ratios and careful underwriting processes. Other types of security can also be used as collateral against loans, such as the assets of a business.
“The only way to protect investors is by lending on a secured basis,” says Nicola Horlick, chief executive of P2P business lender Money&Co.
“If your loans are unsecured you can’t mitigate risk because it’s completely open to losing your money. In terms of mitigating risks, the only way is having proper security.”
David Bradley-Ward, chief executive of asset-backed P2P lender Ablrate, explains that his platform layers the security as much as it can to mitigate risks. This can include direct security over the asset, cross collateral securitisation from another asset and personal or corporate guarantees.
“We keep asking for as much security as we can until someone says no,” he adds.
However, Covid-19 has tested even the most robust securities. The property market has suffered from the lockdown, temporarily stalling construction, while property viewings and valuations are subject to strict social distancing measures. This is likely to lead to slower growth in the property sector, and maybe even a short-term drop in property valuations.
Meanwhile, small- and medium-sized enterprise lending to hospitality businesses will be hit harder than most, as will any lender which has exposure to the beleaguered travel industry.
These major market shocks have pulled the issue of security into focus and really highlights the need for risk mitigation to go further than just offering secured loans.
Inevitably, platforms have had to scale back their interest rates and tighten up their lending criteria in response to the economic uncertainty caused by the pandemic.
But there is still a sense that the well-run platforms and their investors are going to be just fine.
“We have acted swiftly in response to the crisis to make further, significant changes to our credit policy, including taking the temporary steps to only lend to new customers in our lower risk markets, in order to both protect investors and take a responsible approach towards borrowers at this time,” says Zopa’s Wear.
Bristow highlights that P2P platforms are very good at using data to improve, saying that the industry has “built good, efficient, nimble businesses that can react to situations quicker than traditional lenders.”
However, he adds the important caveat that “there will be an increase in defaults and some platforms will be more exposed to the economic cycle than we are.”
While P2P platforms are seeing their risk mitigation processes tested in real time, some will inevitably fare better than others, and their success stories will influence the risk management strategies of the future.
“It’s in everybody’s interest for the sector to emerge from the crisis with its credibility intact,” says Mark Turner, managing director, regulatory consulting at business advisory firm Duff & Phelps.
“If there are failures in this sector as a result of the crisis, wind-down plans will be put into effect. If the regulator sees orderly wind-downs, this will be looked on positively by the Financial Conduct Authority across the sector.”
Turner believes the P2P industry is well-placed to mitigate risks due to its close relationships with borrowers, and the fact that the sector’s risk management has improved over time. For example, platforms have hired experienced non-executives who can spot where change is needed.
“I think where the P2P sector has done well is that as it’s evolved its governance structure has grown up, with greater checks for risks,” he says.
“As the sector grows, you’ll see businesses have become quite established. “They’ve learnt, sometimes through experience or mistakes, and that learning is now feeding through and making the sector better and more efficient at managing risk.”
Overall, the consensus among stakeholders is that while some platforms may struggle in the short term, those which have safeguarded risk management will mitigate the waves from Covid-19’s risky waters and come out of the crisis stronger than ever before.
“Platforms that come through this period having continued to deliver returns above cash will have earned a great record, and this could be the moment that really puts P2P investing on the map,” says RateSetter’s Hoare.
With a myriad of risk mitigation options available to them, and innovation always on their minds, there is little doubt that the P2P industry will come through this crisis with an even stronger risk management outlook – one that can withstand even the most unexpected storm.