Technically it’s not a new sector as the underlying assets – consumer and SME loans – have been around for centuries. But the appearance and rapid growth of this new market has made these assets available to institutional investors in a form which, ten years ago, just didn’t exist.
Investors in MPL see returns in the range of 5%-15% - where high yield used to be – from income paying assets similar to bonds both in structure and from a risk perspective. Despite numerous differences (discussed below) the key similarities are enough to bring a steady flow of bonds investors to the MPL sites. To understand how this came about we need to go back about ten years to the first P2P site in the UK.
The launch of the UK company Zopa in 2005 was partly driven by a banking sector which, at that time, took deposits at 5% and lent them unsecured at 15%. Zopa argued, successfully as it happened, that by very careful screening of borrowers and using diversification to limit idiosyncratic risk, they could take funds from investors at around 9% and lend them at around 11%. Zopa drew heavily on advances in financial technology (“fintech”) to not only provide users with an impressive user experience and interface but also to use data differently to limit credit losses.
Zopa’s business model was emulated around the world and soon grew from consumer lending to SME financing (both lending and factoring). Names such as Lending Club, Prosper, Funding Circle and RateSetter are now associated with a new non-bank lending market. This global market has originated approximately $40 billion of debt instruments – small by banking standards, but big enough and growing fast enough to attract institutional investor interest. At the same time a market for equity or equity-like financing has also grown with names such as Kick Starter becoming better known than most of the MPL companies.
The rapid growth of the MPL market has been accompanied by significant yield compression within fixed income markets. High yield returns have moved to the area once occupied by high grade which in turn has displaced government bond returns. The appearance of a new debt market offering returns in the range of 5%-15% was bound to get noticed by institutional investors stuck in a world where high yields returns in the US and Europe are between 4% and 7%. In the space of just a few years the “crowd” and “peer” characteristics of this new lending market have been replaced by institutions, now thought to provide over 75% of all funding to MPL sites.
Such has been the rush of institutional money into the MPL space that there is now a material imbalance between the supply of funds and the origination of loans. This has caused some spread compression within the MPL sector; it has also created what looks like an efficient secondary market. Furthermore, due in part to careful borrower selection by MPL originators and in part to a very benign interest rate environment, default rates continue to be very low. This ensures that retail investors find the sector increasingly attractive though some market commentators worry that low default rates and good liquidity year after year have created an artificial environment.
Despite the attractive returns and debt-like characteristics, investing via MPL is not the same as investing in bonds. In fact, aside from the return characteristics and the fact that both deal in debt instruments, the two markets have little in common. MPL, for now, focuses on consumer and SME loans which may be secured, sometimes by real estate. The loan sizes tend to be tens of thousands of USD equivalent for consumer loans and up to a few hundred thousand USD equivalent for SMEs. In the US, MPL issues notes to investors backed by loan assignment from a bank that has extended a loan facility to the borrower; elsewhere the investor directly lends to the borrower. In both cases the debt instruments held by the investors are transferable but there is no established secondary market and no institutions making markets.
Analysis of the risks of MPL differs materially from the bond market. For consumer loans, investors are relying on the MPL sites to provide identity and fraud checking and, where available, credit scoring information. On some sites investor funds are allocated to large diversified pools of loans, on others investors specify lending criteria such as minimum credit score, base salary etc. and are allocated loans that meet their criteria. Clearly the investors are not doing individual risk assessment.
For SME loans, whilst the MPL sites provided the same identity and fraud checks, investors are given varying amounts of financial, commercial and strategic information by the SME allowing them to perform rudimentary credit analysis. In many cases the MPL sites will initiate a dialogue with the SME and may even visit the business location. Whilst the package of information made available to investors enables some analysis, the absence of input from a rating agency, industry comparables etc. makes the process very different from the bond market equivalent. Furthermore, due to the very small deal sizes, an institutional investor will need hundreds of positions for even a small portfolio where the fund economics just want justify a large research group performing detailed analysis. As a result, diversification based on simple filtering criteria is the only realistic strategy for most investors.
It is likely that MPL will continue to grow and evolve at a rapid pace. The sector is transparent, easy to understand and is mainly unlevered. With millions of participants exposed to millions of relatively small risk positions, it is hard right now to point to any systemic event that could affect financial markets. Even the failure or closure of a large MPL site would be contained by putting its matched book into run off. If the sector continues to deliver returns in the 5%-15% range then it is bound to intrude further into the world of bond market investors.
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