Peer-to-peer (P2P) lending is a rapidly growing but still nascent part of the financial services industry, with the first P2P company only launched in February 2005. In essence these are online platforms that match people (such individuals or small businesses) who want to borrow money, with those who are prepared to lend money.
P2P platforms therefore cut out the traditional middlemen of the banks and credit card companies, who have earned handsome profits over decades through the wide gap between the meagre interest often earned from savings accounts and the interest charged on loans – which can be very high for those borrowing on credit cards. P2P platforms also avoid the need for a physical presence on the high street, and the associated costs incurred by banks.
The industry emerged in the aftermath of the credit crisis when banks cut back their lending activity to rebuild their balance sheets. Without a bank or credit card company sitting in the middle, interest for both borrowers and lenders is much more competitive. However, it is very important to understand that the risks are much greater. Unlike a bank account, where your cash is covered by the Financial Services Compensation Scheme (FSCS) to the value of £75,000 per institution, P2P loans are not currently covered by the FSCS.
P2P lending therefore carries risks, notably that the borrowers fail to pay back the loan either entirely or on time, which is known as "default risk". Those seeking to borrow money on platforms will have their credit history assessed which will determine the level of interest charged. We understand the “default rate” for P2P is around 2.5%, but as the industry is young there is clearly scope for higher defaults – for example, in a recession.
Unlike loans that trade on the markets, i.e. government bonds and corporate bonds, P2P loans are illiquid as there is no real secondary market. However these loans do tend to be short term in nature, typically measured in months, whereas bonds may trade for years before the capital is repaid. The longer a bond has until maturity, the great the potential volatility it carries as, for example, interest rate expectations change. So while P2P loans, like bonds, carry default risk (the risk that lender can't repay the loan or on time), as time periods are shorter and they are not traded on a secondary market they should theoretically prove less volatile.
Mitigation of risk at banks used to be the remit of the “Captain Mainwarings” (for those who remember the TV series “Dad’s Army”), i.e. local bank managers or credit checking departments. Now credit scoring is very detailed and computerised.
UK Government is supportive of P2P
In the Summer Budget, the Government confirmed plans to allow P2P loans to become eligible for inclusion in ISAs from April 2016. This comes with the launch of an additional ISA allowance called the Innovative Finance ISA, rather than allowing direct P2P loans to be held within existing ISAs. In explaining its motivation for allowing P2P in ISAs, HM Treasury states that improving "competition in the banking sector" is a factor alongside widening investor choice for ISAs.
At this stage details are scant over the size of this new allowance and which P2P platforms will be offering them. The news of an additional ISA, if it is available alongside existing ISAs, sounds positive for those who are prepared to make these loans as the interest earned will remain within the tax-efficiency of an ISA.
However, for those interested in P2P there are ways to access this growing asset class within an existing ISA without the need to wait for the introduction of the Innovative Finance ISA in April 2016. That's because it has also been confirmed that investment companies listed on the stock exchange that invest into P2P loans are now eligible for inclusion into existing ISAs.
P2P investment companies
While some enthusiasts for P2P prefer to scour the various lending platforms to pick and choose which loans to invest in, assessing the returns on offer versus the risks, P2P has also attracted institutional investors - notably in the form of investment companies. These investment companies allocate into a huge range of loans using computerised models to scoop up loans that appear on lending platforms that meet their investment criteria. Importantly the lending platforms will randomly allocate some loans for individual investors and others for institutional investors, so the little guy will not be competing directly with institutional investors that can grab all the best loans in nano-seconds.
The principle advantage of investing in P2P through an investment company is therefore diversification, for which of course there are also management charges. Instead of picking one or a few loans, your risk is spread across many thousands. Additionally, by investing through listed investment companies, investors can sell their shares at any point when the markets are trading, whereas individual loans may need to be held to maturity.
Three investment companies which are listed in the UK and are operating in this space include P2P Global Investments (which also have a separate C share class which is currently trading), Ranger Direct Lending and VPC Specialty Lending Investments. However, existing shares in all of these are currently trading at prices above the net asset value of the investments held - premium pricing that despite the risks reflects demand for the income available.
Investors considering investment in these types of companies might therefore look for new fund raising opportunities from these or new entrants rather than purchasing shares already trading at a premium.
Please note that the Intermediaries Offer for recent C-share issue for P2P Global Investments has closed early and applications are no longer being accepted.