Peer-to-Peer Lending: Sprint or Marathon?

Note: This is the fourth in a series of posts where I’m offering my thoughts as to the role of peer-to-peer (or “direct”) lending within the broader context of the investment landscape.

I ran the Philadelphia Marathon last weekend – 26.2 miles of pounding pavement gave me lots of time to think about the fast-evolving peer-to-peer lending industry.  As I ran…and ran…then ran some more, I thought about the “sprint vs. marathon” analogy as it relates to the P2P lending market.  In today’s post, I’ll offer my view on the short vs. long-term outlook of this finance phenomenon. Warning: in keeping with the marathon theme…this post is a long one!  Let’s start with the conclusion, and build from there:

The question: is peer-to-peer lending a sprint or a marathon?  The answer: I think it’s both, but the sprint looks a good bit different from the marathon.  Let me explain…

In the short-term (it’s not easy to define the time horizon, but let’s say 1-2 years is “short-term”), peer-to-peer marketplaces will be essentially unchanged from their current form.  They’ll continue to operate under the exchange platform model, thereby providing a viable direct income alternative for any and all interested retail investors. Sure, there will be tweaks, nits, and picks that the platforms implement, but I think the big picture is that they’ll dig deep to ensure the fundamental retail experience – the true “peer-to-peer” nature of the model – holds water for the foreseeable future.

Aggressive marketing to creditworthy borrowers will be the bread and butter of the industry’s growth.  This, coupled with increased regulation and monitoring of institutional activity, will ensure this industry maintains its “peer-to-peer” core for at least a little while longer.  We’re already seeing signs of this, as both Lending Club and Prosper are actively managing institutional access to the market.  Many interested parties are currently denied entrance as there simply isn’t sufficient loan volume to satisfy the market’s appetite.  Both Prosper and Lending Club are keenly aware that asset performance is critical to their long-term viability, so I don’t believe we’ll see either relax credit policies to meet demand – but the market will respond to the demand somehow.

Several new exchange-based platforms will come to market.  These will take advantage of the structural legwork completed by Prosper and Lending Club.  My view is that these new players will be slow to gain traction because of platform risk, while Lending Club and Prosper will continue to thrive.  New platforms will have success in markets outside of unsecured personal loans, though – the real estate, student loan, and car loan markets will see traction in crowd-funding based platforms.   The existing platforms will start to expand outside of the unsecured personal loans market as well.

My primary short-term outlook is that I believe the existing platforms will work very hard to protect the existence of an exchange that is fundamentally peer-to-peer, and they’ll do so without making significant sacrifices to the yield profile of the asset class.  This is good news for the market at large, and it implies that in the short-term, it makes sense for investors to “sprint” to the peer-to-peer lending market.

However…

In my view, the real value of the industry is not just that it creates a peer-to-peer exchange.   Rather, the major secret that’s been uncovered is that consumer credit performs extremely well as an asset class.  In the early days of the industry, Lending Club and Prosper have succeeded in providing direct access to some very unique asset characteristics, and they’ve capitalized it through a crowd-funding model.  Yes, the peer-to-peer nature of the model is compelling – but what’s more is that consumer credit is emerging as a vehicle through which investors can obtain consistent cash flow with minimal volatility.  Returns are what capture my attention; I’m not currently interested in participating in a crowd-funded student loan marketplace because the ends (yields) don’t justify the means (both time and dollars invested).  At the end of the day, the market wants a return on investment – peer-to-peer lending ultimately gained traction because it gave investors a viable and interesting way to diversify portfolios and make real money.

In the long-term, institutional asset managers will make up the lion’s share of the market (in fact, they already do), they’ll access from a variety of platforms and exchanges, and retail investors will want it that way.  The broader retail market will look for a way to allocate a portion of its fixed income portfolio to consumer credit.  Institutions such as pension funds, foundations, and endowments will want exposure to the space, but they won’t want to buy up individual loans through an online exchange.  They’ll gladly pay a fee in exchange for expertise and access.  In my view, it’s simply unrealistic for the broad investment community to hold consumer credit in portfolio under the mechanics of the current exchange model.  The level of scale that the platforms would ultimately need to support requires a much less frictional distribution structure, which will take place in models that differ from the current “first come, first served” peer-to-peer exchanges.

That’s not to say the exchange model will cease to exist.  I do think it’s sustainable for Lending Club, Prosper, and other platforms that arise to facilitate access for those “do it yourself” retail investors who want to actually sift through the loan inventories and build their own portfolios.  A slice of the market will likely always be reserved for the true DIY investor to preserve the beauty of the core peer-to-peer model.  I really hope it does, and I think it will.

In the long-term, yields will be somewhat repressed as supply and demand will have to meet in the middle.  Some of the historical mis-pricing of loans for consumers with damaged credit history will be replaced with new underwriting strategies that more effectively price risk.  This, when coupled with the balancing of supply and demand, will ultimately lead to a reduction in yields.  On a relative basis, consumer credit will still fall into the “high yield” category, and will certainly provide stellar risk-adjusted returns for years to come – but it will be difficult to sustain the returns early investors in the space have achieved to date.

My personal hope is that the mechanisms that make this asset class broadly available to retail investors through intermediaries in the long run are able to mirror the great characteristics that have made peer-to-peer lending emerge so strongly.  The held-to-maturity nature of the current market is what shelters investors from volatility.  Minimal default rates are what make the economics worthwhile.  The list goes on – if managers are able to structure products that retain these characteristics, and the current and future platforms are able to effectively acquire creditworthy borrowers on a massive scale, the long-term prospects of broadly distributing consumer credit to the general investment community are very strong.

To sum up, I think the “sprint” perspective of peer-to-peer lending implies that investors should get in the space now.  Clearly I believe it makes sense to hold the asset class today.  It’s only becoming more competitive and complex – that trend won’t reverse itself any time soon.  Sprint to get in the race, and because the asset class works.  The “marathon” component is admittedly vague, but what conclusions we do have imply that we should think critically about what matters at scale – is it asset performance, the “peer-to-peer” component, liquidity structure, or something else?  In any case, investors should position themselves to efficiently access the market in the long run by identifying what matters to them, and developing a strategy to consistently find it.

Best regards,

Dan