The business of Lending Club Corp (LCC) is pretty simple.
It’s a US peer- to-peer lending company which enables borrowers to obtain a loan and investors to purchase notes backed by payments made on loans. The attraction for borrowers is that loans can be obtained at lower interest rates than offered by traditional lenders such as banks and the company charges borrowers an origination fee, and investors a service fee. Founded in 2006, it was floated on the US stock market in December 2014 at a price of nearly $30 per share. Today it is valued at $3.70, down nearly 90%.
There are a number of things that have gone wrong or been mishandled at the company but one of the key issues is that the company constantly needs to grow the number of loans to grow profits. Unlike a traditional bank that would earn money on the interest paid on the loan, LCC only gets income from the upfront fees. Indeed, around 90% of income comesfrom these fees and if it dries up, the company would move into heavy losses.
The Three R’s
Over the years a number of clients have come to us with a range of adverts or websites from companies that provide peer-to-peer lending, crowdfunding, lending to small companies or loans for property investments. Many of these companies offer the chance to invest in their lending via some sort of investment bond or similar arrangement.
Potential investors are understandably tempted by the high returns that are often shown prominently on the first page. However, clients are rightly sceptical about these claims and ask us to investigate. We are always happy to do so but this article gives some guidance as to the 3 main factors to consider for these products: risk, return and regulation.
End of the Peer
As with any investment, the probability of permanent loss of your money is a paramount consideration. The problem with some of these businesses, however, is that there is little history to refer to; peer-to-peer (P2P) lending sounds like a good idea but it’s untested into an economic downturn. Even Lending Club was in its infancy when the Credit Crisis struck.
This does pose a problem but some ‘alternative’ lenders do provide estimates of the lifetime range of predicted bad debts. One UK company, eMoneyUnion, for instance, claims that its lifetime bad debt rate will be “less than 1%”, whilst competitor Funding Circle (one of the largest lending platforms) claims between 1.2% and 10.6%*.
Given that in the Credit Crisis around 10% of the poorly-rated corporate bonds went into default, a figure of 15 – 25% for unsecured lending to companies would seem reasonable to us (probably double that for lending to individuals). These are broad brush figures and will depend on levels of diversification, quality of borrowers, etc. but give an indication of what could be expected.
However, this figure changes dramatically if you are lending to start-up companies. A number of lenders claim that they offer lending to early-stage companies, an area of the market where the banks have retreated. Fair enough, but when we look at the figures, the UK government’s Department of Trade and Industry figures will show that 69% of businesses cease to trade within 10 years of registering for VAT. Indeed, including businesses that do not register for VAT, this figure would be as high at 80%.
So, with a reasonable chance of losing the majority of your capital, we must consider the next important factor: return.
Returns to Lender?
The average returns for Lending Club lenders are between 5.5% and 10.2%. With the vast majority of bank accounts paying no interest and UK 10-year gilts yielding 1.6%, it may seem tempting to invest in loans with this rate of return. However, considering the risks, this does not seem at all high enough. The prospect of material losses in this form of lending requires much higher returns – we would require a return of at least 25%.
Of course, this is not going to happen because then LCC would have to charge its borrowers that level of interest rate which, of course, they would baulk at. Thus, potential investors (lenders) are seen to pay for the default risk which the borrowers benefit from. If this was a large bank, this default risk would be implicitly payable by the taxpayer in the form of a bail-out.
By way of a benchmark, one of our ideal fixed interest bond funds, which holds a diverse spread of large company corporate bonds (around a third of which are investment grade or better), pays a gross income yield of 6.7%. The return required on any P2P, start-up or property lending investment needs to be multiples of this income. The fund, however, also comes with the third important element when considering these investments, namely regulation.
The fund referred to above is regulated in the UK by the Financial Conduct Authority (FCA) and the assets are held in a trust that is covered by the Financial Services Compensation Scheme (FSCS). If the fund management company goes into liquidation, the value of investors’ assets will be unaffected and in the event of any claim, the FSCScould provide compensation for up to £75,000 per person.
Fortunately, since 1 April 2014, most crowdfunding companies are now regulated by the FCA. Of course, this does not mean you cannot lose money, after all, the FCA’s predecessor oversaw the banks during the last Credit Crisis to no avail. However, this does ensure a higher level of scrutiny and hopefully less malpractice.
No Safety Net
Unfortunately, this does not stop plenty of companies offering out unregulated investment opportunities.
Several of these include ‘guarantees’ or ‘insurance’ that are intended to convey some assurance that money will not be lost. Be very wary of these – if the investment was so safe, why isn’t it regulated by the FCA? Investigations into the real money behind these schemes have revealed that they usually involve some suspect offshore company or a pot of money that would be able to pay out if all investors claimed at the same time, as would be the case if the company goes bust.
Hopefully this has given a flavour of a few of the main factors to look out for when appraising such schemes. Whilst the promised returns might look mouth-watering, try to picture the scene at the trough of the economic cycle and ask yourself would it have been worth it after the loss of half of your money - or worse?
The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions.