Should you follow the crowd into P2P?

The peer-to-peer lending sector is booming but it's risky and has yet to endure a recession. So if you're tempted, ensure you understand what you're investing in and why, says Ben Judge.

The story of how peer-to-peer (P2P) lending part of the world of "crowdfunding" or "alternative finance" got its big break is now well known. The financial crisis left traditional banks broke and unwilling to lend to consumers and small businesses. Meanwhile, ultra-low interest rates meant savers were getting little or no return on their cash.

That provided a gap in the market for P2P lenders. These online platforms bring individual borrowers and lenders together to exchange money without the need for a bank. The idea is that if you cut out the middleman, investors get a better return and borrowers pay less interest. Zopa, now the UK's biggest P2P platform, was around pre-crisis, having launched in 2005. But it was rapidly joined by RateSetter and Funding Circle and others adapting the P2P model for a whole range of lending.

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

Potential returns on these platforms aren't as high now as when they first launched, but with an average annual return of 4.96% (for the 12 months to 30 June, according to AltFi Data), they're still eye-catching in our low-rate world. So it's little wonder that alternative finance has grown quickly. In the UK a total of £11.6bn has been lent out in this way, says Altfi Data. In the US it's almost $55bn. Around 41% of the UK figure £4.7bn has been lent to individuals and 40% (£4.5bn) to businesses. The remainder (£2.1bn) is lent against property. That's still a fraction of the lending done by traditional banks, but it's a decent rate of growth.

Now, a decade on from the financial crisis, P2P has its own trade associations in the form of the Peer2Peer Finance Association and the UK Crowdfunding Association, and since 2014 has been regulated by Britain's financial-sector watchdog, the Financial Conduct Authority (FCA). But it's by no means a mature industry. Other than Zopa, none of the P2P firms have seen a full economic cycle they've been enjoying the boom, but they've yet to endure the bust. A recession or even rising interest rates could see a wholesale industry shakeout. So what should you be aware of before you invest?

The main players

The first thing to remember about P2P lending is that, while it has been regulated by the FCA since April 2014, your investments are not covered by the Financial Services Compensation Scheme (FSCS). These are not banks. The return of your money depends on the people you lend it to paying it back. So if things go wrong, you could lose some or all of your money. Some platforms operate provision funds, which aim to shield investors from a certain level of bad loans. But these can't be guaranteed to protect you from loss, and as we'll see in a moment, platforms may not continue to offer them, particularly as the FCA questions their transparency. There are currently more than 30 P2P lenders operating in the UK. By far the biggest four accounting for nearly three-quarters of all UK P2P lending are Zopa, RateSetter, Funding Circle and Market Invoice. Zopa lends to individuals, Funding Circle lends to small businesses (SMEs), RateSetter does a bit of both, and Market Invoice lends to businesses, securing the loans against outstanding invoices (invoice financing, or factoring).

Zopa offers a maximum loan of £25,000 and spreads investments over multiple loans, so that no single borrower has more than 1% of any investor's total investment. As of 20 July, Zopa had made loans worth £2.46bn since launch, with a one-year net return of 4.58%. Zopa also now offers an innovative finance individual savings account (IFIsa). This variant on the traditional Isa allows you to invest in P2P lending tax-free. Zopa's "core" product targets a 3.9% annual return, while its riskier "plus" product aims for 6.1%. The IFIsais open to existing investors, but Zopa is currently running a waiting list for new investors. This highlights another difference between P2P and traditional banking because borrowers and lenders must be matched up, this can mean there is a wait before your money can be put to work, if more people want to invest than want to borrow.

Zopa has a provision fund, but is now running this down so that it can provide higher interest rates to investors. From December 2017 no new lending will be protected by the fund (but it will continue to back all loans currently covered). Zopa's rationale is that new rules, which allow investors to claim tax relief on losses from bad debts, make it redundant.

RateSetter perhaps Zopa's main rival launched in 2010, and has since lent £2bn to individuals, as well as SMEs and property developers. RateSetter's "Everyday Account" currently offers annual rates from 2.1% to 3.2%, depending on the length of the loan. It was the first platform to introduce a provision fund (Zopa followed suit), which currently holds £22.2m. That, says RateSetter, is enough to cover expected losses 1.22 times over, given an anticipated default rate of 2.8%. If that rises to 3.6%, the provision fund will be depleted, and investors will have their interest rates cut. If it rises to 8.7%, investors will start losing capital.

That said, RateSetter did recently reveal that it had taken over two corporate borrowers and taken a minority stake in a third, taking on millions of pounds worth of bad debts itself, rather than letting them hit the provision fund. The bad debts arose as a result of the platform's foray into "wholesale lending" (lending to other lending businesses), which the FCA has now cracked down on across the board (see below). Co-founder Peter Behrens has assured investors that "we do not intend to intervene like this again". Overall, the issue sounds like it's been dealt with in a relatively transparent manner, but it's a valuable reminder for investors that this is a fast-growing area that's still relatively new, with all the potential for missteps that this implies.

Funding Circle, the other big name in P2P, has lent some £2.5bn to SMEs since it launched in 2010. Investors are given the choice of investing in specific businesses or spreading their investment around via Funding Circle's "autobid" feature. Lending to SMEs is riskier than consumer lending, and Funding Circle offers no provision fund. As a result, returns are correspondingly higher than on Zopa and RateSetter Funding Circle estimates average returns of 7.2% a year, although Altfi Data's verified one-year return for the platform is 5.83%.

Asset-backed P2P lending

Lending through the above platforms is unsecured (ie, no assets underpin the loan). But other lenders offer secured lending asset-backed financing. One significant P2P sector is in lending money to companies, secured against their invoices. The biggest platform in this niche is Market Invoice, which so far has lent out just over £1bn. The one-year net return, according to Altfi Data, is 6.66%. The minimum investment, however, is £50,000, and the platform is only open to sophisticated investors.

Other specialist platforms lend against property. The biggest is LendInvest, which has lent out £1.1bn so far. It specialises in providing secured short-term finance to property professionals, mostly in London and the southeast primarily bridging loans, but also refurbishing loans, development and pre-construction finance. LendInvest is also only open to institutional and sophisticated retail investors. Other property-based options include Lendy, Landbay, and Proplend. Not all of these are easily accessible to private investors, but one alternative for accessing the more exotic areas of the P2P market is to use a P2P investment trust see the box below for more.

Questions to ask yourself

So should you invest in P2P? The idea of bypassing banks is attractive to many and, in its short life so far, the sector with few exceptions, see box on page 24 has delivered on its promises of higher returns without any nasty surprises. But if you're tempted, there are a few key points to bear in mind.

Firstly, don't compare P2P to savings accounts. Of course, by comparison, the returns look great, particularly now that P2P interest even outside an Isa is mostly tax-free, assuming you benefit from the £1,000 personal savings allowance (£500 for higher-rate taxpayers). However, P2P offers none of the benefits of a savings account instant access with no loss of capital, plus a 100% government guarantee on your first £85,000 being the main ones. Does 1%-2% a year extra really compensate for the risk to your capital?

Secondly, can you afford to lock your money up? One problem with P2P is liquidity you can't guarantee it will be there when you need it. Many platforms have secondary markets where those who want to exit early can sell their loans to others, often for a fee. But you can only exit if someone else wants to buy. In a depressed economy, this might not be possible. So think about whether you can afford to invest for the full loan term.

Finally, if you can tie up your money for five years, say, then is P2P really the best option? Do you understand the risks you are taking, and are you being paid for them? The mainstream platforms are fairly straightforward, but if you venture into mini-bonds or property, it gets complicated quickly. And if the economy goes into recession, default rates will rise. If interest rates move higher, P2P returns may no longer appeal.

In short, understand what you're investing in, and why. A turn in the economic cycle may or may not be just around the corner, but one thing's for sure: we've come a long way since the bottom of the market.

Three investment trusts that invest in P2P

If you want exposure to P2P, but don't want to lend money directly, you might be interested in an investment trust that invests in the sector. These have the advantage of being liquid (you can get your money out when you like) and diversified (the money is spread across many loans). On the flipside, you have to put up with the ups and downs of owning an equity.

Several trusts both target and offer attractive-looking dividend yields, but it's always worth remembering, once again, that you don't get high yields without taking commensurate risks. Also, many of the underlying investments are complicated.

Analysts have criticised the level of transparency of some trusts one, Ranger Direct Lending (LSE: RDL), recently took an unexpected hit as it had to write down the value of its holding in one fund that in turn had owned a chunk of a failed US direct-lending platform called Argon Credit. However, Ranger might be worth a second look if you have an appetite for risk Hong Kong-based activist LIM recently took a large stake in the trust (which trades on a near-30% discount), so it could be a turnaround play.

Another option worth considering is the oldest and biggest P2P investment trust, P2PGlobal Investments (LSE: P2P). P2P is mainly focused on the US, but is shifting its focus towards the UK. It trades at a discount to net asset value (NAV) of around 12.6%, and yields 5%. The trust which is backed by Neil Woodford has been rallying this year after struggling last year in the wake of Lending Club's travails. It has seen the discount narrow sharply.

The manager of the P2P Global trust MW Eaglewood is merging with Pollen Street Capital, which runs the Honeycomb Investment Trust (LSE: HONY). This trust which Woodford also backs launched in December 2015, trades on a near-20% premium to NAV, and yields around 7%. It invests in loans to both consumers and small businesses, "as well as other counterparties", sourced from partners including "a leading UK challenger bank".

What happens when P2P platforms blow up?

The P2P lending sector has so far been fairly robust. But there have been casualties both here and abroad. In 2011 UK lender Quakle collapsed, mainly due to "shoddy" credit checking, says Robert Powell on LoveMoney.com. Quakle had attempted to introduce an "innovative" model where borrowers were rated based on "social trust", says Matthew Howard of 4thWay, a P2P lender comparison site. But it had "no debt-collection measures" and attracted too many high-risk borrowers, many of whom failed to make a single repayment. Thankfully, just a few hundred unfortunates had invested via the platform, which is estimated to have lent out just £20,000. In 2014, meanwhile, GraduRates, a platform offering loans for postgraduate study, closed down. However, its loan book was taken over by RateSetter, and no lenders lost money.

There have been more serious cases abroad. In 2015 Swedish P2P payday lender TrustBuddy, a listed company which had promised returns of 12%, filed for bankruptcy amid claims of management misconduct and a £3m hole in the accounts. Shareholders lost their money, while those who had lent money through the platform had their funds frozen. They were later told that they would lose at least 25% of the cash as £24m in outstanding loans was sold to a debt-collection agency.

But US lender LendingClub had the biggest fall from grace. It went public in 2014 with a $5bn valuation, making it one of fintech's biggest "unicorns". In May last year it was caught up in a scandal of its own making, which shook confidence in P2P around the world. It was accused of mis-selling $22m in loans and manipulating another $3m. CEO Renaud Laplanche resigned, and the share price tanked, although the company remains in business.

The relative calm in the UK so far is no guarantee that there won't be problems in the future, of course. The Financial Conduct Authority has regulated P2P since April 2014. In December it raised several concerns, highlighting the difficulty for consumers of comparing platforms and assessing risks; the rise of complex structures that introduced new risk for lenders; poor money-handling procedures; and inadequate wind-down plans in the event of a platform going bust. It also tightened rules on lending this year, putting a stop to "wholesale lending", whereby platforms lend money to other lenders.