By guest contributor John Baini, CEO, TruePillars
A new asset class?
As an asset class, an investor taking exposure to loans is not exactly new. Mortgage funds have been around for many years. Some investors may have even had experience with old style “solicitor’s loans”, where a local solicitor helped connect clients who wanted to borrow with those that wanted to invest via a private mortgage.
P2P lending is closer to a solicitor’s loan than a mortgage fund in the sense that an investor has a unique exposure to a specific loan or portfolio of loans, whereas a typical mortgage fund generally results in all participants having pro-rata exposure to the same portfolio of loans.
P2P lending is however similar to a mortgage fund in the sense that in most circumstances, investors will participate in a managed investment scheme (MIS), usually via a trust structure. In the Australian landscape, there are a growing number of P2P offerings, but there are clear differences in the legal structure they are administered through, along with the associated investor protections offered.
Doing your homework is important
Whilst it can be tedious, it is always worth taking the time to read the product disclosure statement (PDS) if the MIS is retail investor compliant, or the information memorandum if it is restricted to sophisticated / wholesale investors. Some key things investors need to know are exactly what it is they are investing in, what risks they are taking on, how liquid their investment is likely to be, how will taxation work and exactly what role the P2P operator will play.
In all cases, the role of the P2P operator is similar to a professional fund manager. That is, to use their expertise and experience to approve the right borrower applications, then administer the loans through to their scheduled maturity.
Some P2P platforms will share information about each borrower / loan with investors, but even when that is the case, in most instances the investor is at least in part relying on the expertise of the investment manager. The relevant disclosure documents will explain exactly what role the investment manager (or platform operator) will play.
Loans are not a commodity
Investors should review the profiles of the people behind each platform and consider whether they have the relevant experience to competently perform the roles they have signed up for. It is an unfortunate reality that when there is money to be made, entrepreneurs from all backgrounds will gravitate to an opportunity. In my experience, lending is both a science and an art, where experience, instincts and qualitative judgements still have a critical role to play.
Making the initial lending decision is a core skill, but so is knowing what to do when things go wrong, which is a unique aspect of being a P2P investment manager. Dealing with distressed borrowers is challenging at any time, but especially if you have no experience. Too many times I’ve heard lending talked about as if it’s an off-the-shelf commodity like any other widget. Anyone with long-term lending experience will know that’s a very dangerous way to think about credit and risk.
Transparency can be more loosely defined than it should be
At its heart, P2P lending is about connecting investors directly to borrowers. P2P operators should be there to facilitate this connection openly and transparently. Some operators allow investors to see exactly what interest rate and fees the borrower is paying and some do not. Investors should consider the fairness of not knowing what a borrower is paying when it is they who is taking the ultimate risk.
Running a P2P platform is not cheap and most borrowers and investors would freely accept the right of an operator to earn a reward for the service they are providing. But if the operator is not openly telling you what the borrower is paying, then they might be taking more of the investor return than you think they are, even though they are not taking the ultimate risk. If an investor isn’t receiving a fair return for risk, then the probability of that investor losing money is increased.
Risk transfer never comes free
One of the hot topics for P2P investors is whether the platform operator provides some type of cover in the event of borrowers defaulting on their loan obligations. In Australia, some operators offer a form of insurance and others have a separate discretionary fund that may be used to compensate investors who have lost money.
There are merits in the above approaches, but investors must be realistic about the cost of transferring risk from themselves to another party. There are not many parties who will assume risk for free so it’s vital investors understand the cost of this transfer.
In very simple terms, if a borrower is paying an amount in excess of the capital they have borrowed, that amount forms part of the financial return to the lender. If that return is not being passed on in full to the investor(s) who funded that loan, then those investors are giving up part of their return.
Lending is a simple pursuit. The idea is to earn enough return from loans that perform to expectations to offset any losses incurred due to borrowers defaulting on obligations. If other parties are intercepting part of that return, the lender may not earn enough to cover their losses. A lender may well be happy to sacrifice part of their return to transfer part of their risk of loss to another party, but the risk/return equation must add up.
Investing in loans requires the consideration of a range of qualitative and quantitative risks. P2P platforms endeavour to do some of this work for investors in return for part of the economics paid by borrowers. In some cases, part of the return is used by the platform to mitigate investor risk on their behalf. I believe the reasonable investor understands and accepts all of this, but P2P investment managers must be upfront on where the financial return paid by borrowers is going.