The Peer to Peer (P2P) lending market has risen from zero, around 10 years ago, to an outstanding investment level of more than £8.7bn of loans in the UK alone.
Investors of all shapes and sizes are continuing to flock to the market, attracted by the prospect of a fair, risk-adjusted return on their capital and to beat the low rates offered from traditional sources.
However, among the eye-catching advertised rates and marketing initiatives, it’s critical that investors don’t lose sight of what really matters when it comes to P2P lending – loan security and the risk mitigation that this can provide.
In fact, you’ll find what differentiates the various players in the market is how they deal with loan security.
An obvious point perhaps, but the first thing to understand about P2P platforms is that no two operate the same model. Despite residing in a busy market-place, every platform takes a different approach to security, risk assessment and its lending processes.
While the FCA has set guidelines that all platforms must abide by, outside the core rules, platforms can take different forms of security on their loans.
The obvious risk is in the event of a major financial crash, defaults and losses may exceed the value of the provision fund, essentially meaning the fund runs out.
The options for investors are substantial, and it can be both difficult and confusing for investors considering P2P for the first time to choose a platform that truly meets their needs for returns as well as their appetite for risk.
Therefore it’s important to understand what distinguishes platforms in terms of any security that they take and the credit criteria around this.
There are two key aspects to be examined in detail:
1) Pre-approval of loan: The checks put in place to ensure that high-quality loans are approved, where the loan can be afforded by the borrower but still recoverable in case one day it is not.
2) Post-approval of loan: The measures put in place to deal with loans defaulting and the recovery of capital in that situation.
Pre-approval of loan
Firstly, investors would be wise to check both the track record of a platform and also that of its team members. How long has the platform been established; how does that time compare to the average term of their loans; has long enough elapsed to see substantial repayments of loans or their defaults; what have been the default and loss rates to date?
Cautious investors might choose to be wary of recent entrants to the market without a track record, particularly if this comes with a new and untested credit model.
As with every sector, many new fintech businesses don’t survive their first year, and those that come in promising huge returns do so because of significantly increased risk factors somewhere in the model.
As is the case with all investments, high returns are commonly offered to attract people to higher-risk options. This could be because a platform is untested or because the loans themselves are high risk.
As an industry, P2P is still in its infancy, but some platforms have already earned the trust of investors over several years of careful lending and proven repayment and recovery track records.
The backgrounds of the core management team are also worth exploring. Because of the nature of P2P, you’ll find that many senior teams are made up of those with a strong tech background, but little in the way of finance.
While this makes some sense from an operations point of view, platforms also need senior teams with strong finance and banking backgrounds that can assess and manage risk from deep experience, not just learn the ropes with investors’ capital and shiny, but untested, new automated credit models.
Affordability is a key test for ethical lending as no-one should be offering or taking a loan without believing that it can be repaid. This should always be the first test, and in the case of unsecured lending, it is the only test.
Assessing affordability takes a lot of skill as well as good systems and data. It takes human experience to assess larger business lending - accounts can mask a multitude of issues that need to be cut through to see the underlying cash flows and whether a business is likely to be around in a few years’ time.
For example, Assetz Capital has a dedicated team of Regional Relationship Directors that visit businesses that have applied for a loan to carry out some of the due diligence.
This can include the corporate and director’s track record and previous experience, reasons for loan request, financial history, growth estimates and much more. In short they ‘kick the tyres’ and use their decades of experience to decide whether to proceed with the application or not.
Nonetheless, if a belt and braces approach is required some platforms also secure their loans against realisable security. For maximum security, loans should be backed by tangible assets, such as property.
This ensures that if a loan defaults, the chances of a loss are kept to an absolute minimum provided that the loan only represented a conservative percentage of the assessed value of those assets at the time of the loan.
Post approval of loan
No matter how strict a platform is at credit approval and assessment of a borrower’s ability to afford the loan, there’s always a chance that a loan could default and, for whatever reason, a borrower can’t repay their loan.
How platforms work to ensure a default doesn’t turn into a loss is crucial. Platforms take different approaches to recovering capital, but this is where businesses such as Assetz Capital can draw on the tangible assets that are taken as security for the loan in an attempt to ensure that some or all of the capital is recovered.
Having a dedicated in house recoveries team is key and they need experience of handling bad debts and the various processes that can be undertaken to recover the loan capital from the security provided.
Lastly, many investors will likely be attracted by a dedicated provision fund - a pot of money that platforms keep aside and draw from to repay investors should a loan default. Available funds can be transferred to investors if the lending platform does not fully recover all outstanding funds lent to the borrower.
In theory provision funds are an attractive method of ensuring investor’s capital is protected in the case of a default. However, a provision fund isn’t a cast iron safeguard. The obvious risk is that in the event of a major financial crash, defaults and losses may exceed the value of the provision fund, essentially meaning the fund runs out.
How P2P should be classed
This is one of the reasons P2P lending is best classed as an investment. Capital is at risk even if there are several protection layers ahead of that risk such as the borrowers own equity in the transaction, the credit process, the security taken and a provision fund.
In addition, when interest payments on P2P are typically 3 per cent to 10 per cent pa there is also that “interest-earned” buffer that an investor has to further act as protection to their capital.
As a result of this it is quite likely that several platforms will, over the years and through the cycles, achieve that much sought after status of absolute returns, where every year produces no capital losses and just some degree of interest gain according to the economic conditions.
That applies to a lot of platforms today but they have not mostly been through any kind of extreme economic cycle yet to be fully proven but may have processes and teams that might produce this outcome.
Overall, no matter your risk tolerance, security in the P2P sector is an incredibly important factor for both veterans and those new to the market.
Investors should base their choice on which platform to choose largely on its attitude to credit risk and security and the processes put in place to mitigate risk to capital.
Stuart Law, CEO