What advisers need to know about peer-to-peer lending

About $1 billion a month is being exchanged through a relatively new marketplace of peer-to-peer lending, and advisory clients are likely to want in the game soon.
Sam Hodges, a founder of Funding Circle, said investors increasingly will demand advisers consider how these loan investments can fit into their fixed-income portfolios.
San Francisco-based Funding Circle, which has lent $1.7 billion in its first five years, focuses on capital for small businesses.
He describes the business as an easy, fast and transparent way to get access to credit, and a great way to earn a healthy, risk-adjusted return.
He spoke with InvestmentNews on Thursday, shortly before addressing advisers at the annual Schwab IMPACT conference, and answered some adviser-critical questions.

What is peer-to-peer lending?
Also known as marketplace lending, it is a novel way of connecting providers of capital with borrowers who are needing credit. Beginning in the early 2000s, a whole set of lenders in the U.S. and the U.K. sprung up initially in the consumer space, basically forming capital from individual retail investors. Over the last five to six years, particularly, there’s increasingly been a shift where more institutional capital is coming into the market. Today it’s about $1 billion per month for consumers and small-business owners all across the country. And the industry is growing more than 100% year over year.

What type of advisory clients would want to do this?
A piece of a portfolio in marketplace lending makes sense for a wide range of investors. It’s not correlated with many other kinds of fixed-income products, it’s a monthly yield product and in certain markets is reasonably liquid. It would allow an investor to put part of their fixed-income portfolio into something where you can get 600 to 800 basis points, or even a little bit more than that if you’re willing to take more risk, as opposed to getting 200 basis points. It’s a pretty attractive alternative.
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What’s the benefit for advisers?
Some of the products you can manage directly through an advisory platform. Many platforms, ourselves included, are working to structure products that can be easily distributed through a platform like Schwab, which would allow the adviser to actually get paid on it. People are working on creating 1940 Act funds that would bundle the loans and make it easy for an RIA to distribute the product through to investors.
I think investors will begin to demand this. If an RIA is looking to diversify beyond just selling investors a pool of ETFs and some mutual funds, this is pretty nice. How much of a portfolio should be in this depends on an individual’s risk appetite and time frame, but 15% of an overall portfolio in the fixed-income allocation I don’t think is crazy.
How many of these platforms are there and how can an adviser help clients choose?
There are dozens of platforms in the United States and hundreds all over the world, and they are in every category you can think of. We are the market leader in small-business lending but a number of folks are doing similar things in consumer lending, others in student lending, mortgage lending, real estate. For an investment adviser, just make sure you do your homework. Look for businesses with a track record — that have done actual money in volume and are rigorous from a risk analytics perspective, and have put a lot of thought into the regulatory and compliance framework.

Will the attractiveness of this product erode when the Fed raises interest rates?
Even if rates go up, it’s likely to be a small increment and go up gradually. At some point they have to go up, they have to normalize. On the demand for credit side, generally a rising rate environment speaks to a growing economy, so we expect rising rates to be correlated with additional borrowing rates. On the investment return side, as a platform we can reset our rates every single day. So each instrument is a fixed-rate product, but it’s a reasonably short amortization, one to five years — the average is a little over three. So over the time you’re holding one of these notes, you’re not taking that much rate risk. There’s so much excess return built into this product — 400% to 500% premium over what the expected loss rate is — that even if rates start going up a little bit and eating into that, it’s still a healthy risk-adjusted return.
(More: Investors, bond market warm to December rate increase)
Describe your average borrower.
A small business that, on average, has been around eight years with $1.7 million in revenue, is profitable and is looking for expansion capital. The average loan we give is $130,000, the range is $25,000 up to $500,000. In the U.S. right now, we’re only open to accredited investors.
Why don’t borrowers just go to banks?
Bank processes are really long; they are very painful and in many cases businesses are turned down for reasons that don’t really make sense, and most alternatives are extremely expensive. Our interest rates start at 5.5%.
What is Funding Circle’s role in the transaction?
We originate the loan, we do the credit evaluation, we price it, approve the loan and then open it up to our marketplace. The way our loan allocation mechanism works is we randomly split them between our fractional marketplace, where we split the loans into securities so people can buy a piece of the loan, and our institutional whole loan marketplace, where someone can build a large portfolio at once.
How do you make money?
We charge the borrower a one-time origination fee that’s only paid if the loan funds. On the lender side, they basically pay a servicing fee of 1% to 2% per year based on the risk of the loan and the deal that we have with them. Investors view us as an efficient way to acquire those loans and service them. The investor owns the loan, we interact directly with the borrower and send the investor a check each month that’s a mix of principal and interest for the life of the loan.
Is this related to crowdfunding?
It’s a cousin, but it’s not the same. Those platforms are either basically a donation-based model or equity crowdfunding, where a crowd writes very small checks to give equity to a business. This is pretty different. The crowd isn’t deciding, the platform is actually doing the curation.