Peer-to-peer pressure

PORTFOLIO POINT: Investors looking into peer-to-peer lending participation should be careful of managed investment schemes that offer fragmented loan exposures.

It’s beginning to feel a lot like 2006 again. US unemployment is back below 8%, Australian house prices are growing at more than 8%, and residential mortgage-backed securities are apparently back in fashion.

But it’s not too difficult for investors to remember that with the rush of innovation and ambition that comes from a growing economy and new investment options there is also great risk.

An example of both – the potential and the risk – is a concept that’s been attempting to gain traction in Australia for several years now: Peer-to-peer lending.

The idea behind peer-to-peer (P2P) lending is a simple one: matching investors directly with borrowers over a web platform. Banks have long been an expensive middleman, and thus a kind of necessarily evil, for investors and borrowers. People have to borrow money from somewhere to buy significant assets and keep the economy ticking over, and other people conveniently need somewhere to park their excess money for a reasonable return. For mid-size unsecured lending, banks are often receiving upward of 13% or 14% interest. Yet nowhere is this kind of return available for investors who fund those loans through term deposits or bank paper paying 5% or 6%.

However, just as technology and the internet have drastically and irrevocably disrupted industries such as entertainment and retail, the theory is that they could change the way we borrow too.

P2P lending is still in a troubled Australian infancy, but there are already several established offshore players including Prosper.com in the US and Zopa in Britain. Prosper.com has brokered more than $405 million in loans since launching in 2006, while Zopa has lent more than £235 million since 2005.

British media reports say the sector is growing quickly there, developing interest from traders, family trusts and hedge funds, while business-focussed variants such as Funding Circle are attracting large sophisticated lenders. At the end of May, the UK Department of Business, Innovation and Skills announced £100 million would be invested in small business “through non-traditional lending channels” and said it expected this would include P2P lending.

New kids on the block

There are several businesses in Australia that have launched, or are on the verge of launching, a P2P lending business.

The most recent of these is SocietyOne, launched in August, which bills itself as “Australia’s first fully compliant peer-to-peer lending platform” and offers loans of between $5,000 and $30,000 with fixed repayments.

For regulatory purposes, SocietyOne is a representative of relatively new Sydney-based outfit Ironbark Asset Management (not to be confused with Ironbridge Capital). It lends via an unregistered managed investment scheme. Its CEO and co-founder is venture capitalist, data analyst and former lawyer Matt Symons, who articulates the vision of SocietyOne in a string of articles on the company’s website. Eureka Report contacted SocietyOne several times seeking comment for this article.

“Our plan is pretty simple – we plan to shake-up the personal lending category by offering borrowers with good credit history and low default-risk a better deal,” he writes.

“But perhaps most importantly we plan to offer borrowers … a fundamentally more empowering and satisfying experience than the one they would otherwise have applying for a personal loan with a traditional bank or consumer finance company.”

This is the same Matt Symons whose LinkedIn social media profile prominently says he “believes the world must de-leverage”, which is perhaps an unorthodox sentiment from the chief executive of a lender, but the logic of P2P lending’s core concept is clear for borrowers – and investors too.

“We think it’s an exciting new asset class that most Australian investors have only previously been able to gain access too indirectly via owning bank shares,” Symons writes.

SocietyOne’s a tech start-up with a financial services edge, and it’s not the only business gunning for the market.

Aside from failed or abandoned attempts at setting up P2P lending here, including Peermint and LendingHub (which never got past the initial stages), there was also iGrin.

The first P2P lender in Australia to get off the ground, iGrin has more than $100,000 loaned from before the National Consumer Credit Protection Act came into force in 2011 and tightened the regulatory environment around lending and credit reporting. iGrin is no longer accepting loan requests, although it continues to service its existing business and was bought out by P2P hopeful Tim Dean.

Dean is the founder of Peerlending Ltd, which has just received its financial services licence. He is in the process of re-launching iGrin as Peerlending, and says he expects it to be launching in February next year.

Peerlending’s model is a slight variant – looking to link capital providers with lenders who promote where they intend to lend, rather than directly to borrowers – and Dean calls it “a hybrid solution”.

“The lenders are licensed in their own right, so you would fit with the peer lending regulations. It’s allowing expertise to participate with funds,” he told Eureka Report.

Bumps in the road

The failures to date in P2P lending in Australia are hard to ignore.

Dean is realistic about the challenges facing peer lenders in Australia, but is also confident the concept has the potential to “disintermediate the banks” and provide capital to small organisations or other borrowers struggling to get it.

“I think certainly the increased financial services footprint in terms of licencing requirements has put a number of companies off,” he says.

On this issue of licensing, the structure that SocietyOne employs to be compliant places certain restrictions that reduce the attractiveness of the product and efficacy of the core idea.

SocietyOne is a private company and credit licence holder, as well as an “authorised representative” of Ironbark, a financial services licence holder. SocietyOne is also the trustee of an unregistered managed investment scheme: the SocietyOne P2P Lending Trust. Investors hold interests in the fund, and the fund enters into loan contracts and pays investors.

Since the scheme is not registered with the Australian Securities and Investments Commission (ASIC), investors must be classed as ‘sophisticated’. In practical terms, this means earning more than $250,000 a year for at least two years, or having a total of more than $2.5 million in net assets. The company says it will open to sophisticated investors this month, but allows other interested investors to register in case it opens up in future.

There’s something of a catch in the rates on offer too. With loan rates offered “from 12.95%” and investor returns “from 10%”, before tax, the fine print reveals returns are “less Trustee fees and expenses of between 2.45%pa and 2.95%pa”.

This means that instead of eliminating the middleman, SocietyOne arguably creates a different one. Peerlending’s plan, while different, runs into a similar place, and Dean says in its model “you’re not actually cutting the middleman out, you’re working with the middleman”.

Dean says the problem with true, direct peer lending is credit risk.

“The fundamental problem that people are struggling with is that peer lending is looking for individuals to make credit decisions. How does Joe Blow in the street make a credit decision? Do they credit score them? Look at a photograph? Do they research them?" he says.

Fragmenting and MIS

SocietyOne achieves this credit decision through two emerging and potentially controversial investment themes – fragmentation and managed investment schemes. These are both topics recently covered in ambitious property start-up DomaCom, and they are each notable in their own right.

“Today all the work to apply for the loan sits with the loan applicant and all the power sits with the bank who decides whether they want to write that loan and if so on what terms,” Symons writes. “We plan to … have investors compete to invest in part of their loan.”

This means rates are set by investor bids, but individuals can only actually fund small parts of each total loan. SocietyOne’s measures to protect investors include the company making credit assessments so that all potential borrowers are creditworthy, using a bankruptcy-remote vehicle in the managed investment scheme through which the money actually flows, and the forced diversification of investors across a loan pool.

ASIC chairman Greg Medcraft identified managed investment schemes as one of the core concerns for the regulator going forward in a recent parliamentary oversight committee hearing.

“The managed investment scheme area we regard as extremely high risk,” Medcraft said.

“It is a very open system and one where we have freedom but at the same time we have to remind investors that they need to be educate themselves appropriately and hold gatekeepers to account.”

The other issue SocietyOne raises is fragmentation. As with DomaCom – seeking to allow investors to spread property investment over dozens of minority shares in properties – and with the rise of ETFs and index investing, a selling point for investors is the reduction of concentrated risk. P2P lending is fragmentation of unsecured debt. Instead of a single entity – a bank – taking the risk and providing a loan, the funding is fragmented across investors.

It also undermines one of the core attractions of P2P lending, which is direct investor involvement.

Peerlending’s Dean says this is a key element: “People, to some extent, like being involved in their own investments. Investing isn’t a pastime, but there is an element of involvement and you can see that with the take-up of things like crowd funding. There’s lots of portals popping up all over the place.”

The lure of yield

Investors are undoubtedly looking to new places for yield (see James Kirby and Alan Kohler on video) in the current financial environment.

The attraction of P2P lending is that it picks up on that theme, and uses another major trend – the internet as a disruptive medium – to offer investors a new idea, and a way to take it to the big banks.

If borrowers have the credit quality to get a loan with a bank, they could benefit from shaving a percentage point or two off repayments and, most importantly, not have to deal with a bank. For investors, that ideally means getting the margin the banks are currently pocketing.

But investors should be watchful of the growing popularity of “extremely high risk” managed investment schemes and attempts to break down traditional investments into fragmented and diversified pieces – both for the vast creative and entrepreneurial potential, and also for the risks.