Get set to buy into the altfi revolution through your Isa

Last year wasn't great for public markets, but it was a big yearfor alternative finance. Total loans via the big peer-to-peer (P2P) lending platforms tracked by AltFi Data more than doubled from £2.8bn to £5.3bn. The average total return on these loans (measured by the AltFi LARI index) rose from 5.9% in January 2015 to 6.26% by the year end.

As for crowdfunding, a much smaller universe, total investment via the big platforms jumped from £124m in January 2015 to £198m by year end. There's still a long list of very early-stage start-ups being given ridiculous valuations by naive investors, but more and more established businesses are looking to raise capital for genuine transformational growth.

One crowdfunding expert, who invests more broadly in early-stage venture capital, recently told me that he could go for months in 2014 without seeing a single well-established business looking to raise equity. Now he sees potential candidates every couple of weeks.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

A bright outlook

However, this coming year might be even better for alternative finance. The new innovative finance individual savings account (Isa) launches in April, allowing investors to put money into P2P lending through their Isas for the first time. You should also keep an eye on the growing array of listed alternative finance funds (for full disclosure, I am a non-executive director on one, the GLI Alternative Finance fund).

I'd estimate that more than £1.5bn in new capital has been raised over the last 18 months from a handful of funds, such as P2P Global Investment (LSE: P2P the granddaddy of the sector), VPC Speciality Lending (LSE: VSL) and Funding Circle SME Income (LSE: FCIF). These funds offer attractive yields, averaging around 7.9%.

How have these funds done? Over the past year, a few of the early funds, such as P2P Global Investments, became so popular that their share prices climbed well above net asset value (the value of the underlying portfolio). At one point, this fund traded at a 16% premium, for example. But we've since seen an overdue correction, and the average P2P fund now trades at a 3.2% discount. I suspect this could widen further maybe to 5% but we're probably at about the right price, barring imminent recession.

A resilient and growing niche

The funds have been relatively resilient in the face of recent market turbulence. According to stockbrokers Numis, over the last three months the average fund in the sector has fallen by 4.2%, compared to 8% for the FTSE 100 and the S&P 500. The nearest American equivalent of P2P funds (called business development companies) have averaged a 9.8% loss. There are also now more options for investors to choose from. Ranger (LSE: RDL) doesn't focus on lending via P2P platforms, but lends direct to businesses.

Honeycomb (LSE: HONY) is an investment trust that aims to yield 8% a year by lending to consumers via direct lenders, as well as through its own unit, Honeycomb Finance. Its third-party lending partners include Freedom Finance (the UK's largest personal loan broker); Entu (financing on consumer energy efficiency products); Pay4Later (point of sale consumer credit); and Shawbrook (one of the UK's "challenger" banks).

Loans made through Honeycomb's partners include everything from wholesale finance (secured against portfolios of loan receivables) through to portfolios of credit assets bought from third parties. No single consumer credit asset will exceed 0.15% of gross assets, and no single small business loan will exceed 5% of gross assets. The trust is managed by Pollen Street Capital, which has invested more than £1.2bn across a range of business, and was formed in November 2013 from the spin out of the RBS private-equity team. Key shareholders include Invesco and Old Mutual, who will own more than 75% of the shares between them.

Focus on the consumer

These new players focus on traditional loan structures usually consumer loans but operate like shadow banks: lending directly to borrowers and often using internal leverage to amplify returns. This focus on consumers is attractive. Consumer lending is beloved of the banks for good reason it makes solid cash profits and in the long term, consumer default levels are far lower than they are for comparable businesses.

Of course, net returns are correspondingly lower too. But even allowing for that, with sensible levels of leverage, long-run returns of 6%-8% a year should be possible and that includes a potential sudden spike in defaults following a recession. Investing via a well-run fund should avoid the unfortunate potential side effects of punting money on bank shares, and provide what might be a fairly robust source of income.