Peer-to-Peer Lending Investment: The Ups and Downs

With a big drop in most asset class returns, investors are tempted to invest via peer-to-peer lending businesses, which has been around for many years albeit in different disguises and has already and attracted almost £6bn of savings, which is more than ever!

With rates of typically being quoted of up to 12% annualised, these types of investments are being considered as real alternatives to the to the more traditional route of Isas and pensions.

But is it safe?

Because of economic uncertainty, investors are having doubts if is it wise to be lending to individuals and small businesses via peer-to-peer and crowdfunding methods which in many cases have not been affected and have become more popular since the downturn. To understand the risk and how safe it is, you need to do your research and understand the business models.

The basics

Unlike banks, peer-to-peer (or P2P) are using websites to match and facilitate transactions between investors or lenders with borrowers. In P2P, lenders earn more on their investments while the borrowers receive more flexibility than a typical bank. There is usually an agreed term, with corresponding fees if a fund is withdrawn post a successful campaign.

4thWay, a specialist P2P analyst, is comparing peer-to-peer lending platforms and developed a “stress testing” formula to measure the ability of platforms to cope with a downturn. This also includes evaluating how borrowers would fare – in terms of continuing to make repayments – in a downturn that could occur and as drastic of for example, a 50% crash in house prices!

Some P2P firms differ with their scores carried out by 4thWay and has a range of credit ratings, as well as with their tranches of loan.

A lot of P2P firms split their loans into their own risk category, often labeled by letters “A”, “B” and so on, and 4thWay then applies its own grade to each of these. The highest return available, along with the best stress-test score, is Funding Circle’s currently at 8% provided through the firm’s “D” business loan tranche according to 4thWay’s analysis.

Funding Circle also offers the next-highest returns, through its B and A+ loans, at 7.2% and 6.5% respectively.

Out of the 11 tranches of loans of the six P2P platforms covered by 4thWay, eight received the highest stress test score.

According to the test, Funding Circle’s “A” and “C” tranche of business loans and Proplend’s “B” and “C” tranches of commercial property loans didn’t get the top scores. It only means that investors here could possibly wait longer to recoup losses in the case of a serious downturn, 4thWay’s analysis suggests.

The firm explained that the large percentage of high scores was due to the transparency of the platforms on their loan book tended to be the more established players.

Lenders, like all investors, are advised to always treat less transparent investment opportunities with a lot more caution. It’s either don’t invest or invest less.

Adrian Lowcock, a fund manager and investment director at Architas, warned that while stress-testing is useful, the weaknesses within a market would only occur after a “full cycle of boom and bust” had completed. He made the situation to that of the late Nineties before the technology stock correction as an example.

What’s in reserve?

Some platforms hold a reserve (capital) to rescue investors in the event of borrower’s failure to pay.

Ratesetter has the biggest buffer fund of all, at just over £17m, with the firm claiming that this represents to 128% cover for all the claims it expects to receive. Thus, the firm claims that none of its 45,000 investors has ever lost money.

While on the other side, Funding Circle has no reserved funds against bad debts at all. The firm explained that having a fund can represent a new risk, of having either too much or too little in it. The platform said scattering investments across different borrowers was a better way to protect investors.

Neil Faulkner, the founder of 4thWay, said backup funds were “not essential”.

He also said that if a pot of money is being put aside returns will be lower. Not having that pot of money means that the interest rate would compensate for that risk. What is important is spreading your money across lots of borrowers and lots of different P2P platforms.

Perhaps because of the struggle in evaluating the risk of differing P2P propositions, financial advisers have been slow to bring them to the attention of their investing clients.

The adviser support firm threesixty, Phil Young, said there were also uncertainties that P2P lending was being regarded as low-risk or a “proxy for cash”.

Mr. Young informed that rates of return were going down and that the demand from borrowers was weaker than that from lenders, which forces some platforms on taking more risk to generate higher returns.

For an example, Zopa has already announced that it will cut the rates across its three accounts by 0.2 percentage points, this gives the idea that the industry is facing a shortage of borrowers.

“To date, investors have done too well, better than they deserve to, given the risks they have taken,” said Mr. Faulkner.

“Rates are coming down, but if you invest steadily and spread your money you can expect satisfactory returns.”

Final thoughts

Risk is just one ‘relative’ element when investing in anything and each person will have a different threshold of what would be deemed comfortable against the potential rewards on offer. Generally, the higher the returns, the higher the risk. So without giving advice, how about starting small and spread the risk by investing in more than one unit/deal which may offer different rates of return and workout your overall risk to reward ratios?

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