By Alistair Barr
SAN FRANCISCO, July 3 Institutional investors
are tripping over themselves to buy so-called peer-to-peer loans
offered by a new breed of Internet lending companies, a
development that could transform the nascent sector into
significant player in the credit markets.
P2P lending, as it is known, started in 2006 with the
founding of Lending Club and Prosper Marketplace. Back then, the
idea was to match individual borrowers with small investors
looking to lend as little as $25.
The loans often have interest rates low enough to make them
a feasible way for individuals to pay off high-cost credit card
debt, yet the returns to investors are attractive compared to
many other fixed-income assets.
These developments have caught the eye of hedge funds,
endowments, pension funds and even banks and insurers who want
to put hundreds of millions of dollars to work.
The influx of institutional money is enabling online
lenders, led by Lending Club and Prosper, to offer far more
loans and compete more directly with traditional banks. Loan
originations are growing at about 300 percent a year, according
to the two market leaders.
But the arrival of Wall Street investors also brings new
risks for the sector. Sharp changes in interest rates or another
economic slump could prompt the new money to depart as quickly
as it arrived. And questions remain about the way the
peer-to-peer lending industry vets borrowers and whether
interest rates on the loans properly reflect the risk.
"The industry says it's more efficient and it uses
technology to underwrite better. That's all a bunch of crap,"
said Mike Cagney, a credit market veteran and founder of SoFi,
an Internet lending platform focused on student loans.
"Peer-to-peer lending in its current form hasn't really gone
through a full credit crisis."
Lending Club and Prosper do not lend money directly.
Instead, borrowers fill out loan applications and post requests
on their websites. Investors commit to fund the loans, then
Utah-based bank WebBank makes the loans, sells them
to Lending Club and Prosper, which in turn sell them on to the
investors in the form of a note. The companies make money from
servicing and origination fees.
The industry is on course to make about $3 billion in loans
this year. But the market opportunity is about $85 billion,
based on the most creditworthy borrowers currently served by the
credit card industry, Prosper executive Ron Suber told a packed
crowd at the industry's first conference, LendIt, last month.
Google Inc took a $125 million stake in Lending
Club in May, valuing the company at more than $1.5 billion. An
initial public offering is planned next year, according to
Lending Club Chief Executive Renaud Laplanche.
P2P loans have annual interest rates ranging from 6 percent
to as much as 30 percent, higher than many other fixed-income
assets. The loans are typically repaid after just over a year.
"Attractive yield and short duration. In a yield-starved
world, it's very interesting," said Jason Jones of private
investment firm Disruption Credit, which is starting a fund to
buy and possibly securitize P2P loans.
Other investment funds that are jumping into the business
include HCG Funds, which recently launched a $10 million fund
for Lending Club loans; Colchis Capital, which has more than
$200 million allocated to P2P loan investing; and Eaglewood
Capital Management and Arcadia Funds.
A new Internet lending site, CircleBack Lending, will launch
this month with an exclusive focus on institutions and
ultra-wealthy investors, according to co-founder Michael
Some institutional loan buyers employ leverage - borrowing
money at a lower interest rate and then re-lending it to the
Disruption Credit, according to Jones, is planning to raise
a $75 million fund to invest in P2P loans, and will then borrow
another $425 million so it can buy $500 million worth of loans.
Eaglewood, which has put about $80 million to work in P2P
lending so far, can leverage its fund 3 to 1, depending on the
risk of the loans and other criteria.
But counting on money from leveraged hedge funds could leave
the industry suddenly starved of funds to lend in the event that
rising interest rates, a slumping economy or unexpectedly high
rates of default were to suddenly send that money elsewhere.
The credit risk is hardly academic: loans originated by
Prosper from November 2005 to June 2009 had a yield of just over
12 percent through the end of 2012. But losses from loan
defaults reached almost 18 percent, leaving investors down 5.36
Prosper now sets interest rates on loans itself, based on
the creditworthiness of borrowers, a big change from letting
borrowers and lenders negotiate rates and an approach it says
that has helped the company attract institutional investors.
Still, the challenges of relying on leveraged investors
remain for Lending Club, Prosper and new rivals like CircleBack.
"If any P2P platform becomes overly reliant on hedge funds
or similar capital that is sensitive to markets and could be
quickly removed, a major market shakeout could cut demand for
their loans," said Jose Penabad of HCG Funds.
Hedge funds represent less than 10 percent of funding for
loans on Lending Club and only half of them use leverage,
according to CEO Laplanche. Lending Club has been working to
attract more stable sources of institutional funding such as
corporate pension plans and community banks, he said.
And Lending Club has sought to prevent too much hedge fund
money from flooding the market.
Colchis tried to launch a leveraged P2P loan fund earlier
this year, but Lending Club did not allow it because the
platform is not originating enough loans to meet the demand that
would have been created by such an investment vehicle, according
to a Colchis investor who did not want to be identified.
A Colchis representative declined to comment. Lending Club's
Laplanche confirmed that there is no leveraged Colchis fund but
declined further comment.
Some of the new P2P investors hope to employ yet another
Wall Street tactic to boost returns: securitizing the loans by
slicing them up into pieces for sale.
Disruption Credit, for one, plans to securitize its loan
assets in the future, dividing them into different tranches that
can be bought and possibly traded by institutions such as
pension funds and insurers.
Cagney said SoFi is planning the first securitization of its
P2P student loans in September, with ratings from the credit
rating agency DBRS and underwriting by banks including Barclays
Securitization will provide another source of capital to
fuel further growth in originations. But it also exposes the
industry to even greater interest rate risk.
If yields on other types of debt jump as firms are preparing
to securitize a pool of P2P loans, that could imperil the effort
by making the offering less attractive to investors.
Junk bond yields have surged from less than 5 percent to
almost 7 percent in recent months. That makes P2P loans
relatively less attractive to investors, said Cagney.
If rates keep climbing, SoFi may have to wait to do its
securitization, he added.
Meanwhile, SoFi's loans are being financed by banks
including Morgan Stanley.
"We could afford to wait a few months," Cagney added.