“Build a better mousetrap and the world will beat a path to your door.” - Ralph Waldo Emerson
As long time readers of our Insights know, we are fans of the new peer-to-peer (P2P) lending space and have written about it several times in the past (The Hunt For Yield, A Banking Phenomenon, Peer-To-Peer Is Here!). In its simplest form, P2P lending is individuals displacing the traditional banking model by meeting the borrowing needs of other individuals. The P2P platforms facilitate this process by underwriting would be borrowers and connecting them with individual investors, or “peers”, willing to fund their loans. This sector of the credit market has grown tremendously in recent years and continues to be validated as a legitimate investment opportunity as we will explain in more detail in this week’s post.
One of the reasons we are so bullish on P2P lending is because we see it as a technology play in an established and proven industry. Banking and lending have been around for thousands of years. P2P platforms are simply building a better mousetrap through the use of technology in this age old industry. By cutting out the middle man (banks), P2P platforms are able to create a win-win situation where investors earn attractive returns and borrowers can refinance expensive debt (e.g. credit cards) into a lower interest, amortizing loan. Investors are able to spread their risk of default over hundreds if not thousands of pre-screened loans by investing as little as $25 into each loan. For those borrowers that are approved on the platform, loans can be financed and funds delivered in a matter of days.
It is easy to see how this type of lending was built on the premise of individuals helping other individuals, but P2P has morphed into something much bigger than originally expected. This isn’t necessarily a bad thing. Today, P2P lending would better be described as institutional-and-to-some-extent-peer-to-peer lending (I know…not as clean and catchy). The fact that P2P lending has garnered the attention and support of institutional money simply validates the space as we mentioned in our previous post.
Although the original vision for P2P lending, according to Chris Larsen who pioneered the industry back in 2006 when he founded Prosper, was to “completely disintermediate the Wall Street model;” today, institutional and ultra-high net worth investors account for roughly 2/3 of the P2P market according to The Economist. On the margin, this gives credence to the industry as it has attracted the “smart money” of Wall Street. For further evidence, Google made a $125 million investment into Lending Club which counts former US Treasury Secretary Larry Summers as a board member.
The move in the direction of more institutional lenders on the platform was further advanced yesterday when Lending Club, the largest P2P platform, announced a partnership with BancAlliance which counts around 200 community banks as its members. With the newly formed partnership member banks will both direct potential borrowers to Lending Club as well as provide capital by investing in a portfolio of loans on the platform. As the chart below from a recent Wall Street Journal article on this announcement shows, small banks have all but been “boxed out” of the consumer-loan market by bigger banks over the past two and half decades.
Back in the early 90’s, small banks and thrifts accounted for over 70% of the US consumer loan market. That level has dropped to below 10% today. The reason for the dramatic shift is multifaceted according to Bert Ely, a banking consultant who was quoted in the Wall Street Journal article.
Community banks, particularly, have pulled back from the one-off, customized lending that they might have done 25 years ago because of all the regulatory risks and hassles associated with it. Big banks, meanwhile, have built sophisticated software systems to accommodate individual borrowers.
In response, small banks are now embracing the scalability and efficiency Lending Club can provide to put them on level (or potentially higher) ground than the bigger banks. We see this move as yet another validating data point to the staying power of P2P lending.
Our foray into P2P lending began in the summer of 2013 when we first started vetting the opportunity. The formal roll out of our separately managed P2P account offering followed a year later in the summer of 2014. Since then we have been tracking our composite account performance, which has averaged right around 1% per month net of defaults and loan loss reserves.* Loan applicants are screened based on a variety of factors that have shown to be relevant to a borrowers default rate based on data Lending Club makes available on their historical loan performance.
We target a top line yield of between 15%-16% in our managed accounts and expect defaults to run at around 3%-4% during normal economic environments. We expect defaults to potentially spike as high as 15-20% during a severe recession based on historical data from the financial crisis. If these numbers hold true, a well-diversified P2P loan portfolio has the ability to generate similar returns to a diversified stock portfolio but with less risk and volatility. Additionally, a P2P portfolio can add a meaningful diversification benefit to a traditional stock-bond portfolio due to its low correlation to these traditional asset classes. For all these reasons, we continue to support and recommend P2P loans as an excellent complement within a well-diversified portfolio.
* Accounts are added to the composite at month end 60 days after the Lending Club account is funded to eliminate the cash drag on performance from the ramp up period during initial implementation of the portfolio.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.