Why Peer-to-Peer Lending Makes So Much Sense

Note: This will be the first in a series of posts where I’ll offer my thoughts as to the role of peer-to-peer (or “direct”) lending within the broader context of the investment landscape.

Much attention has been garnered in recent months by the evolution of peer-to-peer lending.  Mainstream press and major financial institutions are paying close attention to the space.  The model’s large-scale viability is no longer in question as Lending Club and Prosper continue to grow steadily at significant volumes while the loans they produce maintain consistently strong performance.

The fundamentally attractive characteristics of this asset class are turning heads on Wall Street, and justifiably so.  Where else in this market can you find a product with these unique traits packaged into one opportunity?

  • Yields conservatively over 5%
  • Short durations
  • Sheltered volatility
  • Low default risk
  • Monthly amortization (consistent cash flow)
  • Track record of capital preservation

Such asset profiles are difficult to come by in any market – this one certainly no less.   By this time, it’s fairly well documented that those characteristics are sought after and they are what is driving investors to the market in droves.

But to me, aside from the obvious traits mentioned above, perhaps the single most attractive characteristic of peer-to-peer lending is what the platform facilitates: the ability for investors – big and small alike – to directly hold a diversified portfolio of monthly-amortizing debt to maturity.  Prior to the emergence of the peer-to-peer lending model, the existing market mechanisms didn’t broadly facilitate that capability.  In most cases, retail investors wishing to allocate a portion of their portfolio to fixed income would do so through a public bond fund – which is, at the end of the day, an equity investment in a debt fund with equity-like volatility due to typically fickle interest rate environments.  Add to this mix that public bond funds are often not providing real returns after inflation, and the investing world is asking itself how to get real fixed income.  Make no mistake: owning shares of public bond funds is quite a different beast from directly owning the bonds themselves.

Part of the problem is diversification.  The existing mechanisms historically didn’t facilitate the purchase of bonds in small denominations. While it is possible to purchase corporate and municipal bonds directly, it’s almost impossible – due to factors of both magnitude and logistics – for most investors to build a diversified portfolio of them.  That’s why they wind up buying equity stakes in funds that hold the underlying debt, but again – in doing so, they sacrifice part of the original intent of holding bonds in the first place.  Ultimately what they hold is frequently volatile with inconsistent cash flows that may or may not correlate directly to the performance of the underlying asset.

What I love about peer-to-peer lending is that it introduces a broad distribution method for investors to directly hold debt to maturity (i.e., the loans aren’t up for sale).  By doing so, an investor can build a diversified portfolio of assets whose performance depends solely on the borrower’s ability to repay – not changes in interest rates, not fund prices being bid up or down by supply/demand, and certainly not trading glitches on Wall Street.  If the investor doesn’t really care what someone else would pay to buy his portfolio – because after all, he’s interested in regular cash flow – then the value of the investment is only contingent on the borrower’s ability to repay.

Obviously, the trade-off is liquidity.  What the markets are teaching us, though, is that investors are willing to trade that liquidity for less volatility, more predictability, and ultimately greater transparency (not to mention – better returns!).  As a fund manager in this space, I am continually striving to facilitate entrance into this asset class in a way that is similarly transparent, as though the investors were directly holding the debt themselves.  The appetite is for consistent cash flow that mirrors the underlying asset performance – actually not a very complicated concept, but somehow it’s an anomaly that has escaped the world of investment management in recent decades.

Surely as the peer-to-peer lending market evolves, more liquidity will come to the space (it’s already happening) and we will have volatile public funds whose underlying assets are P2P loans.  This is a good thing as many investors would prefer to just invest in a fund and stomach the price volatility of a publicly traded security.  Even so, I will advocate for the continued availability of a platform that facilitates direct loans in small denominations through a transparent and user friendly interface.  This avails to the broad investing public the opportunity to hold a diversified cash flowing loan portfolio to maturity – a beautiful thing.

Tune in next week as we continue to dive into the role of this asset class.  Best,

Dan