Last month I took my first in depth look at the fast growing world of alternative finance, exploring the three main platforms (Zopa, Ratesetter and FundingCircle) all of whom offer yield starved investors the chance to boost their income by lending to either small businesses (Funding Circle) or other consumers (Zopa and Rateseter).
One of my key concerns expressed in that article is that if you are going to put money to work in this fast growing space, you need to think like an investor - not a saver. I'm aware that much of the P2P lending sector likes to use the language of saving but that makes me very uncomfortable. In each and every case you are lending to non bank institutions who have no savings guarantee via the FSCS scheme. I don't think there's anything wrong with that - in fact I think by avoiding that safety net you get a better deal. But I also think this makes the idea that these are cash equivalent savings products, slightly dubious. Risk levels are incredibly low, and the chance of losing money after a default by a lender are currently small - with consumer platforms such as Ratesetter and Zopa also offering up protection funds. But I think the best attitude is think like an investor and assume that the worst might happen at some point in the future - we could have a recession, defaults could shoot up and you could risk some of your capital. Don't put rainy day emergency cash to work on these platforms !
Thinking like an investor who is willing to take some risk with their cash doesn't mean you have to be quite as fearless as many equity investors - where markets frequently go up or down by 20% a year without any major economic upheaval. P2P lending is closer in style to what bond investors call 'credit' - corporate and consumer debt. Its riskier than government bonds but arguably less riskier than equities. That makes these products ideal for what I like to call my middle pot of capital - at one extreme I need risk free cash for day to day stuff with a government guarantee while my equity risk capital is tied up for decades, with the inevitable ups and downs of the market cycle. P2P lending can be made to work in a middle bucket of capital where I'm trying to make cash work harder over the next 1 to 5 years - a timeframe that is not ideal for equity investing.
But thinking like an investor also requires you to think long and hard about the risk/reward trade off. Put simply anything that yields above 10% in this economic climate needs to be treated with some considerable caution, whereas anything yielding below 3% is frankly unattractive unless there's a chance of a big capital uplift.
But how do we manage the risk return trade off of putting money to work on these platforms and P2P niches? I'd suggest using three different but inter related strategies all based around the idea of diversifying your exposure to the alternative finance sector.
The first is to look at platform risk which in my book means proper diversification across platforms and within platforms i.e make sure you have money at work on at least two to three platforms and within each platform make sure you are diversified at the borrower level. The big platforms (Zopa, Ratesetter and Funding Circle) all let you put as little as £10 to work with each borrower and I think a minimum of 100 hundred different borrowers makes some sense especially for Funding Circle - this would imply say putting £1000 to work on each of these three major platforms.
To be fair to this vibrant and fast growing sector, I wouldn't be completely restricted though to these big players - there are some specialist niche players that I think absolutely warrant attention especially in lending to property based assets where well backed returns of more than 7% per annum are possible (especially with Assetz and LendInvest).
My own A list of platforms would include Zopa and Ratesetter for consumer loans, Funding Circle, Thincats, and Assetz for business loans, Wellesley and Co and LendInvest for property based assets and lastly Market Invoice and Platform Black for lending to businesses based on their invoices (a specialist niche much more aimed at bigger institutional investors).
My key concern with any of these is to pick platforms with lots of 'volume' i.e lots of lenders and investors investing sizeable amounts of money. You can see this volume data issued on a monthly basis on a site I've been developing at www.altfi.com as well as on the individual platforms own websites. Personally I'd look for a platform to be generating at least £1 million, if not £5 million in flows a month (although frankly I'd be happier at the £10m level). Smaller platforms can offer great value for the adventurous type but you need a proper due diligence check list - I'll provide one of these in a later article but for now I'd look at the charges, investigate where there's a secondary market being offered (this means you can get out of a loan earlier than the term date), as well as working what's the minimum size for lending to an individual or business. I'd also hope that the platform gives you lots and lots of data and I'd be keen to see an automatic reinvestment option i.e when your money matures you are automatically reinvested back into a platform.
The next key strategy is diversify what I call interest rate risk i.e making sure you have some protection if interest rates do start rising. I think its highly likely that interest rates could rise to around 2% in the next year or so. That rate rise is traditionally bad news for any fixed income security like a government bond. The impact on P2P loans might vary enormously - depending on the borrower, whether the rate is fixed and a range of other factors - but I'd be keen to set in place a couple of key targets. Personally I'd be looking for around 40% of my total pot of money to be invested in shorter duration products i.e Ratesetters monthly and yearly products, bridging loans offered by the likes of LendInvest and invoice based products offered by Platform Black and Market Invoice where the average duration of a loan (backed by an invoice) is between 60 and 90 days. Personally I would also look to have no more than 50% of your investments in 5 year fixed loans - these are very vulnerable if interest rates suddenly start rising.
My last strategy is to make sure I am diversified in case of borrower risk i.e default risk through a business cycle. This is closely related to the interest rate cycle and the key idea here is to make sure that you are not solely lending to just riskier Small to medium sized enterprises. We know from past experience that in a recession (which is usually proceeded by interest rate hikes) the number of consumer credit defaults can increase 3 to 5 fold whereas businesses that default can increase by between 5 and 7 times in numbers. So whatever levels of default you see now - low as they are - could go up drastically in a bad recession. I'd also be very alert to another risk which is arrears - these could start building up even though defaults are low. Carefully scrutinise these stats and look for trends that suggest risk levels are increasing. In practical terms I'd be very focused on balancing off risk levels between consumers (likely to have lower default levels but also paying out lower interest rates) and businesses - with say 50% of my capital in each broad segment.
One last thought - you could use a fund manager to help you run these varying strategies. Here in the UK the dominant player Eaglewood Europe is run out of hedge fund Marshall Wace. They've just launched a London listed closed end fund called P2P Global Investments. I'm going to look at this fund - and others that invest money in more adventurous income opportunities - in much greater detail next week but for now I think this is a great alternative. You are charged a 1% annual management fee and a performance fee for a fund that manages the process of putting money to work on the key UK and US platforms - Zopa, Ratesetter, Funding Circle in the UK and the US, Lending Club in the US and specialist trade provider Crossflow. The managers will run all the strategies I've detailed above and their aim is to pay out 85% of the total loan income received to investors on a quarterly basis - the fund has just raised £200 million and will probably take a good 6 to 9 months to get that money to work. The target yield is between 6 and 8% per annum which is I think a higher rate than you should expect as a private investor if you stick to my strategies above - this institutional manager can use leverage and can invest internationally. They can also invest in specialist markets which aren't open to private investors but where yields are higher. By my own rough and ready yardsticks a diversified private investor running the three strategies above should probably expect a blended net yield (after any costs or defaults) of between 4.5 and 6.5% pa by following the ideas above, so this fund could be a very interesting - and higher yielding - alternative even though you are paying a manager to run your investments.
21 March 2023
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