This publication examines the world of peer-to-peer lending. While the sector gains traction, wealth management figures say clients must be alert to the risks.

The world of non-bank finance has taken another step with the UK government’s move to allow peer-to-peer lending investments to be held inside retail fund wrappers, but it appears P2P has some doubters because the 2008 crisis continues to cast its shadow.

Peer-to-peer lending is about how creditors and borrowers can hook up and bypass banks, typically using internet platforms to do so. With banks retreating to some degree from forms of lending because of more stringent capital rules, this has left a gap in the market – and P2P players are only too willing to fill it. This is a busy area: there is a move to let investors access P2P lending through wealth management platforms as a result of an agreement between technology company FNZ and RateSetter, a P2P lender. Platforms that are powered by FNZ, such as those offered by HSBC, UBS and Friends Life, as well as UK independent financial advisors, can offer products to clients from RateSetter although it is not yet clear from reports if all such firms using the FNZ platforms will do so, or soon.

The Financial Conduct Authority, the UK regulator, now oversees peer-to-peer lending, which is designed to offer some degree of comfort. Another stamp of approval came earlier this year when UK finance minister George Osborne proposed that from the start of the next tax year in April 2016, P2P savers can get their interest free of tax by using what is called an Innovative Finance ISA. At present, P2P lenders have to declare interest they earn. 

There are a plethora of organisations offering P2P lending. Funding Circle, one of the largest players, announced this week that it had agreed to buy German lender Zencap, enabling Funding Circle to expand its market footprint to the European continent. Other operators include Lending Works, Lendinvest, MarketInvoice, Zopa and Assetz Capital. Another firm goes by the wonderful name of ThinCats (as opposed to “fat cat” bankers) and it focuses on relatively large individual loan sizes of around £400,000 ($619,145). The market is, to be sure, relatively small at present when set aside conventional bank lending. According to data from the Peer-To-Peer Finance Association (P2PFA), the trade association representing the UK sector, cummulative lending, in the third quarter of 2015, stands at £3.733 billion. In a move to bolster confidence in this young market, P2PFA recently unveiled new “Operating Practices” standards. The measures require platforms in the association to publish debt data to a common standard, make their loan books transparent, and ensure that retail investors are on a level playing field with institutional investors.

Meanwhile, in a recent report by the University of Cambridge Judge Business School, and EY (formerly Ernst & Young), it said that the overall European alternative finance industry (including the UK) is on track to grow beyond €7.0 billion ($7.95 billion) this year, based on recent growth rates.

The whole market of non-bank lending is thriving. While not strictly comparable with P2P, there is also a thriving market in what are known as direct lending funds – pools of capital where the managers act rather like banks in financing projects, sometimes plugging gaps left by reluctant bankers. Such funds typically lend to business rather than individual consumers. Data from Preqin, a research firm tracking alternative investments, says that in the third quarter, direct lending funds in market continue to be the largest part of the private debt market, accounting for $9 billion of the $19.3 billion raised by private debt funds closed in the quarter.

Nerves
The outlook may appear bright but the realm of P2P makes some investors and advisors uneasy. A concern is that P2P has not yet sustained a run of big defaults; also, lenders are not protected by the UK’s Financial Services Compensation Scheme, which covers customers’ funds in banks and other institutions for up to £85,000.

“This is still a very young industry which hasn't really been tested under very stressed credit conditions which means we are naturally applying a big dose of caution,” Jason Hollands, managing director, business development and communications at UK wealth management house TilneyBestinvest, told WealthBriefing. He offered this point of reassurance, however: “The nearest comparison might be the credit card market which didn't come unstuck during the credit crisis in the way the banking sector did.”

There is still a long way to go in persuading independent financial advisors that P2P is a sensible investment, although there are signs of a shift. ThinCats – already mentioned – says 40 per cent of 500 ordinary investors it has surveyed would consider P2P. Even more boldly, ThinCats found that the expansion of investors will lead to peer-to-peer loans “far outstripping” allocations to equities (28 per cent) and fixed rate bonds (24 per cent). 

“The findings of our research show that the industry is poised for expansion. Early adopters are still very much core to our business, but the government’s changes will open up peer-to-peer to a whole new audience. It is the industry’s job to manage the current concerns and communicate the huge benefits and security available for peer-to-peer investment,” Kevin Caley, managing director of ThinCats, said. 

“All ThinCats loans are secured and we have a sponsor for each auction to help investors make informed decisions. So far, we have facilitated loans of over £135 million, and it’s our aim to continue aiding significant investments to businesses and delivering 9 per cent average returns for investors across the British Isles.”

Risks/rewards
There is an old saying in finance – as for other matters – which is that if something looks too good to be true, it probably is. An issue for P2P could be that if there was to be a heavy influx of capital into the sector, this could push down returns as, other things being equal, is the case whenever such an influx occurs.  

Financial advisors are so far not jumping in. A survey issued in July by the Yorkshire Building Society, which was conducted among IFAs, found that fewer than one in five advisors (18 per cent) would invest, or already have invested, their own money into peer-to-peer lending schemes. Nearly half (45 per cent) believe interest in P2P will grow as new savings rules come into effect, however, and 20 per cent have already seen increases in enquiries from clients about investing in P2P over the past 12 months. Nearly two-thirds (62 per cent) of the advisors questioned say they would never invest their own money in P2P despite the potentially attractive rates on offer, while another 20 per cent are undecided.

There are stirrings of interest that this publication hears about from the wealth management and family office community. This publication asked Caley of ThinCats about what makes his business different, and he said the size of individual loans agreed via his platform are typically larger than for rival P2P operators – of the sizes that wealth management clients might adopt. The average transaction size on ThinCats is almost £400,000, whereas most of the other platforms are significantly smaller than that, he said. Demand outweighs supply, so there is plenty of headroom in this market, he said.

“Loans [on the ThinCats platform] are currently running at about £5 million a month but the sponsors have a deal flow which requires about £25 million a month and they are frustrated that we have a shortage of funds to lend. This is unusual, most platforms have a shortage of deals,” he said.

The “sponsors” Caley referred to work with the platform; they approve the loan request before it is put on the platform. The loans are then auctioned, with the winning bidder (creditor) offering to charge the lowest level of interest. The minimum loan size for which bids can be made is £50,000. Sponsors are paid a fee when a loan is drawn down and typically are paid 4 per cent of the loan’s value. Borrowers pay the ThinCats platform 1 per cent to list on it; they pay another 1 per cent on top of the weighted average interest rate for the loan.

Asked about the risks involved, Caley said sponsors have a strong vested interested in only bringing good-quality loans to the platform because their reputation, and hence ability to do more deals, will be damaged if they approve poor deals. In other words, there is no sort of moral hazard problem arising from the old “too big to fail” risk-taking approach of banks in the past – the sponsors’ reputations are constantly on the line and they have a strong incentive to only approve robust business.

Caley said his firm is looking at using new software to make it easier to access the secondary market in P2P loans. 

Caley is upbeat, but says there is no room for complacency. Referring to his firm’s research, he reckons P2P lending is “poised for expansion”.