Season Investments


Growing Pains

Posted on July 11, 2017

“This is the first time in history that non-bank investors can get access to unsecured consumer-credit products.” – Aaron Vermut

2017-07-11_Summit_Peak.jpgBack in 2013 we penned our first blog post entitled The Hunt For Yield on the burgeoning industry of marketplace lending, which at the time was still known as peer-to-peer or P2P lending. We spent the second half of 2013 and the beginning of 2014 researching the space to get a better understanding of the potential risks and returns for marketplace lending investors. Then in the summer of 2014 we officially announced a new separately managed account offering on the Lending Club platform for our clients. As part of the offering, Season Investments would build a diversified portfolio of consumer loans on the Lending Club platform which matched our proprietary screening criteria. Today, we manage around 60 accounts on the Lending Club platform. In today’s post, we will look at how these accounts have performed and what we think about this space going forward.

When we first entered into the marketplace lending space back in 2014, the major platforms were advertising average returns in the high single digits for investor accounts. From our original post referenced earlier:

Both Lending Club and Prosper publish average return statistics for investors on their platforms of a little over 9% after factoring in defaults and fees going back to 2007 for Lending Club and 2009 for Prosper.

Based on the research we had done by looking at historical loan performance across a variety of different screening criteria (e.g. Does the borrower own or rent their house? What is their income? How many credit inquires have they had in the past six months?), our expectation going into this investment is that we could beat the “average” return by a couple percentage points by screening out borrowers that were more likely to default on their loans. We understood that defaults were inevitable, so our goal was to simply try to tilt the scales slightly more in our favor through our screening criteria and the diversification benefit of holding hundreds of different loans in very small (as low as $25) increments. From a follow up post we wrote entitled Peer-To-Peer Is Here:

As one might expect, not all loans are created equal and there are a variety of different factors investors can screen for when choosing their loans. Part of our research in this space included historical back testing of the various criteria borrowers disclose on their application to see which are relevant to the rate of default and subsequent return on investment (ROI).

Making unsecured, personal loans to individuals is in no way a risk-free endeavor, but by diversifying exposure with small investments into hundreds of different loans, the risk of excessive defaults and fraud can greatly be diminished. Putting it all together, the long-term return potential in this space of 8%-10% for a full market cycle, with better returns during good markets, greatly outweighs the risk of excessive defaults.

So that was our expectation going into the investment, but how have the accounts actually performed? The answer is mixed. First off, the screening criteria we implemented performed as expected by adding a handful of percentage points to our composite performance. In fact, for all accounts over 18 months in age (our cut-off for being fully "seasoned" for defaults), 95% of them are generating above average returns when compared to other accounts on the Lending Club platform of similar vintage. The chart below illustrates this point for the oldest account in our composite as we can clearly see how the blue dot (this accounts performance) is hovering in the upper quartile of the return cloud for accounts of similar vintage (21 month weighted average age of notes in the account). So that’s the good news. 


The bad news is that the returns have been lower than expected. As previously stated, we originally thought that we could best (or at least match) the 9% long-term returns being advertised by Lending Club and Prosper back in 2014. Since then, the advertised and realized returns have come down significantly due to an uptick in default rates. The average annualized return in that same group of accounts that are 18 months or older is only around 5.5% since inception or roughly half of what we initially expected to be earning during “good economic times.”

Additionally, the variance in the account level returns by client has been much larger than we expected. The histogram below shows the spread of account level returns for the 18 month or older composite that is averaging around 5.5%. We didn’t think that time of year would have such a big impact on returns. For example, if you were lucky enough to put your money to work at the end of 2014 and into the beginning of 2015, your account is in the upper quartile of our composite. But by the same token, if you were unlucky and opened your account just a couple of months earlier in the fall of 2014, your account is most likely in the bottom quartile of our composite. 


The returns for this investment have been disappointing relative to our original expectations, but obviously still positive. We attribute the higher than expected default rate and subsequent lower return profile to fraud and abuse. The messaging by online lending platforms has always been that they are able to do a better job underwriting their borrowers than traditional banks due to their technology and that they are able to offer more competitive rates to borrowers due to their lower overhead. That may still end up being true, but what we are seeing in the space today are the growing pains of a rapidly growing industry. The pickup in default rates has also corresponded with the growth in the industry. More investor capital and competition in the space has led to looser lending standards in order to attract enough borrowers to pair off with the flood of investor capital. This in turn has led to higher defaults from normal causes as well as fraudsters who have taken advantage of the looser standards. We knew fraud was a real risk going into this industry as we wrote about in A Banking Phenomenon, but we failed to account for increase in fraudulent activity associated with a rapidly growing industry:

Although ripe with opportunity, P2P lending is not without its warts and a somewhat steep learning curve. No matter how much screening platforms do on their applicants, fraudulent individuals are sure to slip through the cracks. The only defense an investor has against these individuals is to make small investments in a large number of loans to dampen the impact on the entire loan portfolio.

Lending Club and other online marketplace lending platforms realize that low returns due to an increased level of defaults is a serious problem and are taking steps to address this going forward, but for many accounts the damage has already been done. We still believe that marketplace lending has the opportunity to deliver above average returns for the level of risk being taken, but we are no longer convinced that a managed account on a single platform is the best way to achieve this goal (especially in light of new investment vehicles that have become available just in the past year or two). As such, we have decided to turn-off the reinvestment option in our Lending Club accounts and build up cash as loans payments hit the account. We plan on redirecting that capital to better solutions in the private lending space including mutual funds which have come to market and now offer better diversification (both in the number and vintage of loans) and liquidity, with comparable to slightly better returns.

elliott_headshot_bw.jpgAuthor 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.

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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.