Is it wise for investors to sidestep the banks?

Cutting out the banks and lending your money to borrowers directly can earn your cash high rates of return. But how risky is it? Tim Bennett explains.

Fancy getting an inflation-beating return, while robbing the banks of your business in the process? Peer-to-peer (P2P) lenders promise to cut out the middlemen the banks by matching willing borrowers to potential lenders directly. Sounds good, but what are the risks, and is it right for you?

The new kid on the block

P2P lending has been around for a while. The latest product to join the field is the result of a collaboration between lender and fund manager Innvotec. It is claimed that its ThinCats Bond For Business is the first of its kind. Like the site Funding Circle, ThinCats tries to match business lenders and borrowers via its online market place (taking a fee from every successful transaction).

The difference is that this new bond gives investors direct access to "the attractive returns available via P2P lending with the confidence of knowing that the loans have been selected by an experienced fund manager", as the PR release puts it.

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That, says ThinCats, makes it different to a market for loans, where either the investor has to choose which borrower they want to lend to (essentially what happens with Funding Circle), or where the cash lent is automatically allocated to borrowers if target lending and borrowing rates match up. So how does it work?

How it works

Via ThinCats, an investor can buy a single bond (make a loan). The money invested £5,000 is the minimum subscription will then be used to make a minimum of 14 separate loans to small and medium-sized businesses (SMEs).

That way, no more than 7.5% of the total funds committed to the bond will be at risk with any single firm. This is supposed to keep the default risk down. Better still, the target rate of return interest received by the lender is 8% (before income tax). As Kevin Caley, managing director of ThinCats, says: "The bond is ideal for those who like the idea of P2P lending but would rather delegate the individual lending decisions to an expert." What's not to like?

The pitfalls

As always, you don't get something for nothing. The target yield of 8% is pretty attractive in this climate, so it stands to reason that you're taking more risk than you would in a bank account. With 14 different homes for your money, you are unlikely to lose the lot. But at the same time, you are lending to smaller businesses. These are particularly vulnerable during the sort of tough economic climate we're experiencing now.

Their size means that, even though you are making a loan, rather than buying riskier shares, this is unlikely to count for much should one of the borrowers default. While bonds are usually pitched as being somewhere between cash and shares in terms of risk, this type of IOU must be seen as on a par with most shares, given the nature of the underlying investments. All of which means this is still a pretty risky way to invest cash, and the track record of this type of bond is obviously largely unknown. Remember too that 8% is a target, not a guarantee.

Then there are the fees. The start-up charge is 2.5% plus VAT, to cover "the due diligence involved in making the loans". There's a further management fee of 10% (again plus VAT) of any interest earned above 7%. Although this bond may cut out banks as the middlemen, it's still not cheap compared to a close rival such as Funding Circle (see below).

Also, this is not a home for your emergency capital, or any money you'll need back in the short term: ThinCats anticipates taking "at most, just under four years" to repay your interest and capital and bailing out of any bond you buy early will be tricky. There is no trading platform via brokers in the same way as you get with, say, retail corporate bonds traded at the London Stock Exchange. So what are the alternatives?

Direct loans to companies

Funding Circle allows lenders to make direct loans to borrowers and takes out a 1% annual servicing fee. This is arguably far riskier than the automatic diversification you get with ThinCats and puts more of an onus on you to do sufficient homework on the borrower. In effect you are playing the role of the old-fashioned bank manager, but without the same training or experience in making risky loans. But with no fund manager involved, at least it's a cheaper deal.

However, although you can specify a minimum yield as a lender average yields vary from around 7.3% to 9.4%, according to Fundingcircle in the market-place auction that follows, you may well not get to lend at the minimum rate you want if other investors undercut you. Like ThinCats, any default will destroy your target return. So is there a way you can do P2P lending without making loans to companies at all?

Lending the Zopa way

One of the best-known P2P sites is Zopa. The difference with Zopa is that you can lend money to almost anyone for almost any purpose from buying a caravan to taking children on a trip to paying for a divorce lawyer. You can lend from £10 upwards over three or five years and, again, you select a target rate of return depending on the risk of the borrower. If this sounds a bit hairy in the current credit-starved climate, it is even Zopa acknowledges that default rates have crept up in recent years.

Should you get involved?

Beating inflation and getting one up on the banks are two worthy goals. But be careful direct lending to small companies or individuals is risky (far riskier than putting your money in a bank account) and in the case of the ThinCats offering, quite expensive too. If you fancy your skills as a bank manager, then it's fine for a small part of your portfolio but be in no doubt that what you are doing is high risk. Widows and orphans need not apply.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.