How to get started in P2P lending

You can reap the rewards and mitigate your risks in the peer-to-peer sectorby following three key strategies, says David C Stevenson.

Last month, I took my first in-depth look at thefast-growing world of alternative finance, exploring the three main platforms (Zopa, RateSetter and Funding Circle), all of which offer yield-starved investors the chance to boost their income by lending either to small businesses (Funding Circle), or to other consumers (Zopa and RateSetter).

In that article, I said that if you're going to put money to work in this fast-growing space, you need to think like an investor not a saver. I'm aware that much of the peer-to-peer (P2P) lending sector likesto use the language of saving, butthat makes me very uncomfortable.

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In each and every case you are lending to borrowers who aren't covered by the government's FSCS compensation scheme. So if the borrower defaults, you may lose all of your money.

Although risk levels are incredibly low with RateSetter and Zopa also offering protection funds the best attitude is to think like an investor and assume the worst will happen. Don't put rainy-day emergency cash to work on these platforms.

Thinking like an investor doesn't mean you have to be quite as fearless as many investors in equities (shares). P2P lending is closer in style to what bond investors call credit' corporate and consumer debt. It's riskier than government bonds, but arguably less risky than equities.

That makes these products ideal for what I like to call my middle pot of capital' at one extreme I need risk-free cash for day-to-day stuff while my equity risk capital is tied up for decades, with the inevitable ups and downs of the market cycle.

P2P lending can be made to work in a middle bucket of capital where I'm trying to make cash work harder over the next one to five years a time frame that is not ideal for equity investing.

But thinking like an investor also requires you to think long and hard about the risk/reward trade-off. Anything that yields above 10% in this economic climate needs to be treated with some considerable caution, whereas anything yielding below 3% is unattractive unless there's a chance of a big capital uplift.

But how should we manage the risk/return trade-off on P2P platforms? I'd suggest using three different, but interrelated, strategies.

The first is to look at platform risk, which in my book means proper diversification across platforms and within platforms. That means you should put money to work on at least two to three platforms, and within each platform make sure you are diversified at the borrower level.

My own A-list of platforms would include Zopa and RateSetter for consumer loans, Funding Circle, ThinCats, and Assetz for business loans, Wellesley & Co and LendInvest for property, and lastly MarketInvoice and Platform Black for lending to businesses based on their invoices (a specialist niche aimed largely at bigger institutional investors).

My key concern with any of these is to pick platforms with lots of volume', ie, lots of lenders and investors investing sizeable amounts of money. You can see this volume data issued on a monthly basis on a site I've been developing at www.altfi.com, as well as on the individual platforms' own websites.

Personally, I'd look for a platform to be generating at least £1m, if not £5m in flows a month (although frankly I'd be happier at the £10m level). Smaller platforms can offer great value for the adventurous, but you need a proper due-diligence checklist I'll provide one of these in a later article.

But for now I'd look at the charges, investigate whether there's a secondary market being offered (this means you can get out of a loan earlier than the term date), as well as working out what's the minimum size for lending to an individual or business.

I'd also hope that the platform gives you lots and lots of data and I'd be keen to see an automatic reinvestment option, ie, when your money matures, you are automatically reinvested back into another loan on the platform.

The next key strategy is to diversify your interest-rate risk. In other words, you need some protection if interest rates do start to rise. I think it's highly likely that interest rates could go to around 2% in the next year or so.

A rate rise is traditionally bad news for any fixed-income security, such as a government bond. The impact on P2P loans might vary enormously depending on the borrower, whether the rate is fixed and a range of other factors but I'd be keen to set in place a couple of key targets.

Personally, I'd be looking for around 40% of my total pot of money to be invested in shorter-duration products. So that would include RateSetter's monthly and yearly products, bridging loans offered by the likes of LendInvest, and invoice-based products offered by Platform Black and MarketInvoice, where the average duration of a loan (backed by an invoice) is between 60 and 90 days.

I would also look to have no more than 50% of your investments in five-year fixed loans these are very vulnerable if interest rates suddenly start rising.

My last strategy is to make sure I am diversified in case of borrower risk ie, default risk through a business cycle. This is closely related to the interest-rate cycle and the key idea here is to make sure that you are not solely lending to riskier small businesses.

We know from past experience that in a recession (which is usually proceeded by interest-rate hikes) the number of consumer-credit defaults can increase three- to fivefold, whereas businesses that default can increase by between five and seven times in numbers.

So, whatever levels of default you see now as low as they are could go up drastically in a bad recession. Another risk is arrears these could start building up even though defaults are low. Carefully scrutinise the statistics on this and look for trends that suggest risk levels are increasing.

In practical terms, I'd be focused on balancing the risk levels between consumers (likely to have lower default levels, but also paying out lower interest rates) and businesses with, say, 50% of my capital in each broad segment.

You could use a fund manager to help you run these strategies. Here in the UK the dominant player, Eaglewood Europe, is run out of hedge fund Marshall Wace. It's just launched a London-listed closed-end fund, P2P Global Investments, which is a great alternative.

You're charged a 1% annual management fee and a performance fee for a fund that manages the process of putting money to work on the key UK and US platforms (Zopa, RateSetter, Funding Circle and, in the US, Lending Club).

The managers will run all the strategies I've detailed above and their aim is to pay out 85% of the total loan income received to investors on a quarterly basis the fund has just raised £200m and will probably take a good six to nine months to put that money to work.

The target yield is between 6% and 8% per annum, which is, I think, a higher rate than you should expect as a private investor if you stick to my strategies above this institutional manager can use leverage and can invest internationally.

They can also invest in specialist markets that aren't open to private investors, but where yields are higher. By my own rough-and-ready yardsticks, a diversified private investor running the three strategies above should expect a blended net yield (after any costs or defaults) of between 4.5% and 6.5% per annum by following the ideas above.

So, this fund could be an interesting, higher-yielding alternative even though you're paying a manager to run your investments.

You can find news about the major plays as well as key statistics for the sector at www.altfi.com.