How P2P funds fell from favour

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Alternative lending is down but not out

The world of investment is brutal. One minute you’re the hottest new idea in town, the next nobody wants to return your call. The world of alternative finance funds (also known as P2P lending funds) fits this pattern perfectly – and hence may now offer an opportunity for contrarian investors.

Not so long ago, income investors were queuing up to put their cash into listed funds that lent capital on big online platforms such as Zopa, Ratesetter and Funding Circle in the UK, and Lending Club and Prosper in the US. A collection of funds led by sector giant P2P Global Investment (P2PGI), which was founded by hedge fund Marshall Wace, raised a total of £1.5bn. They promised yields of between 6% and 8% – attractive in a low-interest-rate environment. What could go wrong? Well, virtually everything as it turned out.

From bad to worse

Last year the pioneering US platform Lending Club fired its chief executive after a scandal involving questionable lending practices, which promptly crashed the share price. The sudden decline in the value of sterling caused all manner of hedging problems for UK-based funds. Then the banks started turning the screw, pushing up costs for fund managers who were using leverage to increase returns. But worse was to come. Many alternative finance platforms are relatively new and it’s reasonable to expect the defaults on their loan books to evolve over time.

As the platforms mature, the expectation is that lending standards will improve, but over the last year some funds have been hit by a steady drip feed of defaults. If this wasn’t bad enough, these funds have had to cope with rising US interest rates undercutting the attractiveness of these alternative sources of income.

In truth, the sector over-promised and under-delivered. Promise an income yield of 8% and deliver 6%, and guess what happens next? The share price slips, a discount opens up between the net asset value (NAV) and the share price, and new fundraising dries up overnight. Which is precisely what has happened with many of these alternative income funds. Major funds such as P2PGI and VPC Speciality Lending Investments now trade at 15% to 20% discounts, although a few smaller and much newer funds such as Honeycomb Investment Trust and RM Secured Lending are trading at a small premium to NAV.

My guess is that the sector will continue to struggle in the short term with rising US rates and increasing defaults by the underlying borrowers, but at some stage in the next 18 months the cycle will turn – as it always does. The parallel is with businesses development companies in the US, which also lent money, in their case to smaller businesses. They went through the same cycle, with discounts widening to 40% before snapping back for the better-run funds that delivered on their promises.

Get ready to buy if discounts widen

I don’t think US interest rates will rise much above 2.5% and, even if they do, they’ll come down very soon afterwards. That will make funds that pay a return of between 6% to 8% attractive again, especially if they trade at discounts of 10% to 20% which could narrow to 5% in just a few weeks. By comparison, many asset-backed lending funds on the London market have delivered on their dividend promise and they trade at a chunky premium to book value. In this scenario, contrarian investors could score a double win – they ride the discount tightening and they get the solid 6% to 8% yield. I’d keep a beady eye on the consistency of those dividend payouts, and buy the better funds as their discounts widen past 10% and 20%.

David C Stevenson writes about alternative finance for AltFi.com. He is a non-executive director of the London-listed SME Loan Fund.

Merryn

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