For the past few years it has seemed like P2P lenders could do no wrong. Seen as the feisty challengers to the allegedly ineffective and self-serving banking giants, these champions of the honest and hardworking SME were going to revolutionise the way businesses were funded.
Yet revolutions seldom work out the way idealists hope. So where are we now with P2P? There has certainly been an increase in scepticism following the Lending Club fiasco last year, but is this a reason to abandon faith in the model and return to business lending controlled by banking brands that we are all comfortable with? But then there’s the fact that the model itself has changed – and why you’ll hear “direct” or “marketplace lending” more than you’ll hear “P2P” these days. Is this a burst bubble, or is it just the new kid growing up and making some waves?
A look at some headline numbers from Funding Circle, the most well known in the SME lending P2P space, is telling. It operates a pooling system where a retail investor lends to a portfolio of, typically, 100 businesses, with no more than 1 per cent exposure to any one loan. Given average SME default rates, this is a significant risk mitigation tool. And when you overlay this with risk banding, quality underwriting and proactive arrears management and collection, it becomes a pretty tightly controlled environment. The upshot is that investors have received a 7.1 per cent return after fees and bad debts.
That is a good return and predictable. It is not risk-free, but in an Innovative Finance Isa it’s tax-free too. Compare that to the average cash Isa (2-ish per cent?), and I know which one I would rather have.
Nevertheless, the head of the Financial Conduct Authority (FCA) Andrew Bailey has said that he’s “pretty worried” about some aspects of the P2P market. Speaking to the Treasury select Committee, he was referring to attempts by some platforms to draw direct comparisons between their offerings and the returns from bank deposit accounts – implying that the two products are comparable, when they are not.
Banks’ relationships with customers are based on a deposit contract, where the bank holds capital reserves that amount to a fraction of its deposit liabilities. While some P2P platforms have provision funds, which are intended to perform the same function, there is a blurring around capital protection: this money could be lent out and used to achieve maturity transformation.
Bailey’s caution should be taken as a warning. While the concept and principles of P2P have political and regulatory recognition, behaviours that are seen to be misleading investors will not be tolerated. Absolute transparency about risk, return and redress are essential if the sector wishes to avoid damaging itself. Moreover, while banks exist under increasing levels of scrutiny, platforms can currently operate under lighter regulation.
So is there really a problem with P2P? I think there is, but not in the investor protection/regulatory space, or in its customer outcomes (which are largely excellent). The problem lies with the business model itself.
Despite eye-watering marketing budgets, the significant breakthrough to profitability still remains elusive. For the majority of P2P platforms the cost of acquiring a new piece of business is greater than the lifetime value of the deal, and that’s before you take overheads into account.
The key issue to overcome – and it’s pretty unfashionable to say it – is the dearth of quality new customers. For the overwhelming majority of SMEs, their bank is still the first place they go for funding. And as the banks re-enter the market, the rejected scraps the alternative funders have been living off will become more meagre, and some business model assumptions will begin to look pretty optimistic.
For the really big boys, like Funding Circle, this is unlikely to be an issue – they have been astute in cultivating strategic relationships with banks, for whom they are almost another product line. But for other, smaller players, I think it’s going to be fantastically hard and expensive to win credible market share profitably.