Speak to any fund manager about their interest in peer-to-peer lending, and they all say the same: “it really needs to go through a business cycle, then I’ll look at it properly”. During the financial crisis, only one P2P lender was in existence – Zopa. Since then, it has been joined by industry heavyweights Funding Circle and RateSetter, and plenty of successful smaller players like ThinCats and LendInvest.
Zopa co-founder and executive chairman Giles Andrews says the last economic crisis was “the making of Zopa” because it gave the platform the opportunity to show the robustness of its model. “Our performance during 2008 was very good. Our investors made a positive net return of 4 per cent during a period when other asset classes were delivering negative returns.”
Other players may soon get the chance to test their mettle too. With volatility in stock markets, patterns of weakness in economic data, central banks with little room for manoeuvre, ongoing troubles in Europe and fears over China, many analysts are predicting another global recession.
Of course, P2P lenders don’t have the same recession-related concerns as banks – such as poor balance sheets (they don’t take deposits, so over-leveraging isn’t a concern). But if you’re a P2P retail investor, what should you be thinking about if an economic downturn really is ahead?
The asset class trap
The key issue, says Robert Wardrop, executive director of the Cambridge Centre for Alternative Finance at Judge Business School, is that there is a growing temptation to look at P2P loans as an asset class. “There is a generalisation going on, and what will emerge in a downturn is that the loans originated by different platforms may behave differently. People are going to become more discriminatory because of that.”
In a worsening economic environment, to continue to meet demand, some platforms may be more willing to accept lower-quality borrowers. “Loss rates are unlikely to be the same across different platforms – some borrowers will move towards those that have lower security and guarantees,” says Andy Sweeney, head of fixed income products at Ablrate.
This means that risk levels between platforms may diverge sharply, underlining the need for investors to understand how the debts they’re lending into are structured. The crucial message for investors, Wardrop says, is to think about the different variables within the loan itself: is it consumer or business lending; how are proceeds being used; is it secured or unsecured? “Investors need to understand that, as platforms grow, you’ll see increasing variation in strategy – and that’s going to produce a variation in performance of loan books.” It follows that it is important to get a detailed sense of how a given platform is undertaking its credit analysis, and how it approaches recovering late payments and bad debts.
Approaching specialist sectors
Within P2P, while larger platforms tend to be a broad church for consumer or SME lending, as the industry has evolved, specialist players have become more common. Property P2P lending is increasingly popular. And Ablrate, for example, provides asset finance in the shipping and aviation sectors. “Niches can be great if you understand them, but it does mean that, if a particular sector suffers, being diversified across 100 loans in that sector could lead to substantially higher losses than 100 loans in different sectors,” points out Sweeney.
Diversification is equally important in trendy areas like property. In London, for instance (and many platforms focus on the capital), tougher legislation, ebbing inflows from the Gulf States, and boosts to supply are already taking the steam out of the market. As ThinCats chairman Kevin Caley told me last month: “we need to be careful that people don’t get swept off in the property boom with their portfolios becoming biased towards it. There are currently a lot of borrowers there, but we need to be prepared for the market to change.” Sweeney adds that, if you already own property, investing your free cash in P2P property deals could be putting even more of your eggs in a single basket.
The central bank impact
If the UK economy begins to sink and the Bank of England follows the Eurozone’s lead and cuts interest rates, what will it do to P2P? According to Sweeney, not much. “Most lending platforms offer rates in excess of 5 per cent, and they seem to be largely uncorrelated to small moves in base rates,” he explains. The rates offered by most platforms are a product of supply and demand – RateSetter, for instance, allows borrowers and lenders to set and alter the rates at which they borrow and lend – so while a move towards zero or negative rates will likely attract more money, Sweeney thinks it’s unlikely to be substantially more than if rates remain unchanged.
A word on bank lending
To what extent would a downturn be an opportunity for P2P lenders, if banks restrict their lending? “Banks are much nimbler and more defensive now than in 2007 and 2008. This means that, as they become more concerned, they can cut lending more quickly,” says Sweeney. He explains that Ablrate has already seen this happen in shipping and global trade, and if and when bank lending falls, it is quite likely that more deals will come onto P2P lending platforms, potentially pushing rates up a small amount.
But many firms using P2P platforms to borrow have existing bank loans. And the question all investors should be asking themselves, says Wardrop, is “what sectors will banks pull back from? They’re not going to universally pull back, so where will they pick and why? Are they avoiding companies that they think are more vulnerable in a downturn? Probably. And if they’re reducing exposure to those that’ll suffer most, are their risk models correct?”
So as an investor, it’s critical that you take the time to look at the businesses that platforms are lending to. Sweeney says that you “need to understand why the company is borrowing, how they are going to repay and what happens if other lending or overdrafts get withdrawn from existing providers”. Any firm that is already living off an overdraft – even if it’s doing well – may struggle to do so well without access to that funding.
Also bear in mind that the risk of liquidity drying up would be heightened during a downturn. “Your investments may be performing but you may not be able to sell out of them. Or, the platform may extend the maturity of the loan without your consent,” says Sweeney. In this scenario, he continues, you’ll be receiving income but may not be able to get access to the capital. “Lenders should make sure that, not only are their investments diversified, but the maturity of those investments are staggered so that they are continually receiving capital back to re-invest or withdraw.”
The platform itself
When it comes to the capabilities of platforms, James Codling of VentureFounders points out that a downturn would mean P2P lenders have to get to grips with debt restructuring. With many employing significant numbers of ex-bankers, this won’t necessarily be an insuperable task, but while banks have entire restructuring teams permanently in place, ensuring similar capabilities will be a novelty for platforms.
Last month, Adair Turner, former chairman of the Financial Services Authority, caused outrage both in and outside the P2P industry when he said that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses.” This ignored the fact that the sector provides resilient returns, with defaults on loans averaging between 2-3 per cent, that SMEs and consumers undergo rigorous credit checks at the hands of platforms, and that underwriting remains strict, with next to nothing in the way of maturity transformation in the industry.
But, says Wardrop, in a way “Turner served a very useful purpose – because he forced platforms to think hard”. In short, platforms need to think very carefully about their rate of growth. Entering a tougher part of the economic cycle will mean they will want to be well-positioned, in terms of the performance of their portfolios, to deal with the changing climate. The majority of P2P lending platforms are not yet profitable and, like any business, they will come under increased pressure during a downturn. Yet ultimately, says Wardrop, “smart platforms realise now that a downturn is an opportunity to really distinguish themselves from the pack”. It just remains to be seen which ones will do better than simply weather the storm.
This article appears in the March edition of City A.M.'s Money magazine, which will be distributed with the paper on Thursday 31st March.