P2P and Balance Sheet Lending: Same Same but Different…

This guest article was written by Hadar Swersky. Please read more about the author at the end of the article. 

Many investors approach us asking about this new world of P2P lending and how to invest in it. As these discussions develop, I am always surprised by the lack of knowledge that people have about the world of online lending. This knowledge gap is not always limited to new investors, but is also common amongst seasoned P2P investors, and so I would like to attempt to create order in this chaotic field.

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Basically, all online platforms, lenders and marketplaces are ‘loan originators’ allowing potential borrowers to apply for a loan. But this is where the difference ends.  While all online lending sites can be classified as ‘marketplaces’, some marketplaces are also the lenders themselves (such as Uncle Buck, a leading UK based short term lender), while others act as matchmakers, connecting borrowers and investors (who become lenders in this case). These investors are both private and institutional investors, who share a portion in multiple loans (such as Zopa in the UK and Lending Club in the USA).

These two forms of lending are often confused. When Goldman Sachs recently announced that it is launching an online lending business for consumers and SMEs using the bank’s capital, meaning it would be a balance sheet lender, it was widely reported as ‘Goldman Sachs is entering peer to peer lending’. There could be many reasons as to why this happens, intentionally or unintentionally, but it is clear that this ‘revised’ title would probably drive more traffic to a news website then ‘Goldman Sachs starts lending to consumers’, and so the confusion continues.

OK, I want to invest, what’s next?

Once an investor has decided to invest in online lending, the first thing we recommend is choosing the type of marketplace that they would like to invest through. One can find both formats in consumer loans, invoice financing, real estate funding and other forms of financing, yet in our opinion the risk profile is significantly different. While loans are originated in a similar way, the money flow is different; in the case of P2P lending, the investor has an account with the platform (or a fund that invests through the platform) and the investor’s capital starts accumulating interest only once a loan is found, matched and funded, while in the case of a balance sheet marketplace the funds are already in the marketplace’s account and can come from other proprietary capital or from investors. If the funds were provided by investors, these investors are already accumulating interest regardless of whether the money was lent or not.

Who’s got skin in the game?

The next thing to evaluate is risk, and who priced that risk. In any investment I ever make, one of the most important things I consider is risk, and more specifically who carries it. Whether you are investing in a startup or in a joint venture, you want the other side or your partners to have skin in the game for obvious reasons. While we all wish it wasn’t so, this is the reality of investment and a rule I learned the hard way when I took my first steps as an investor. The same principle stands when evaluating online lending. As most of us are not underwriters, we do not have the ability to price the risk, that is to determine who we should fund and what should be the associated interest rate, and so we rely on the platforms to ‘rate’ potential borrowers. This is quite a daunting task, as the volume can be significant; for example, Uncle Buck reported in November 2014 that it had received more than 300,000 loan applications the previous month with acceptance rates ranging between 5%-10%.

With these staggering numbers in mind it is easy to understand how tempting it might be for marketplaces to ‘ease up’ on their lending criteria for various reasons such as increasing volume, achieving business goals or other reasons that are unrelated to the actual underwriting. This means that investors should perform significant due diligence checks and cover them to include the marketplace as well as the borrowers, as we have already seen surprising platform shut-downs such as the publicly traded TrustBuddy who left investors with significant losses when they shut down without notice.

This of course does not exist in the world of balance sheet lending, as the marketplace uses its own funds to fund loans. While these marketplaces may raise capital from investors and other forms of financing, they still carry the risk and it is the marketplace’s capital that acts as a ‘first loss’ buffer for investors. As far as risk goes, it seems as though these marketplaces are more cautious when evaluating and underwriting risk as they stand to lose if they do not perform well. This of course sounds very appealing for investors, but finding balance sheet lenders that are looking for investors is not straightforward, and we have seen a few attempts at aggregating investors, much like crowd funding, for balance sheet investments, either in the form of a fund or in more innovative ways such as the Basset & Gold Fixed Monthly Income Bonds.

What do P2P marketplace operators say?

When approached with this conflict, P2P marketplaces have responded that it is in their interest to price loans properly and I agree. However, extreme circumstances can be quite testing and can lead to good people making bad decisions, especially if there is no direct consequence to these decisions. It remains to be seen what the outcome will be, but for now, on a pure risk management basis, a savvy investor would be better off working with a balance sheet lender or some other form of lender who offers some kind of protection or first loss cushion.

About the author:

Hadar Swersky is an award winning hedge fund manager and entrepreneur. Widely regarded as a savvy investor with accurate trend spotting, his fund was an early mover in multiple fields including algorithmic trading, online option trading and online alternative finance. Hadar originally founded his hedge fund, Smart Box Capital, to focus on algorithmic trading but has since expanded to multiple verticals including a specialty team focused on online lending.