The Biggest Risk In P2P Lending (And How To Approach It)
Do you invest in Peer-to-Peer Lending? If so, you may be taking on much bigger risks than you think.
P2P lending has been growing exponentially over the past few years, with many investors piling in due to the juicy returns. Especially in the EU, where double digit yields are the norm.
Unfortunately, as many are starting to find out, it’s not all rainbows and butterflies.
In this post, I go over the biggest risk in P2P lending and how to approach it.
I think that my perspective, that of an investor that looks at income investing holistically, could be useful to you as a complement to the advice provided by all the dedicated P2P Bloggers out there.
If I can help even one of you see things in a new light, then this post would be a huge success for me.
One last thing before we start, here’s a very quick overview of my experience in P2P lending:
And with that said, let’s dive right in!
The biggest risk in P2P Lending
We all know that investing in P2P lending is a risky endeavor but we can sometimes lose sight of the big picture and miss the forest for the trees.
As a quick recap, the main risks when it comes to P2P lending are:
- Borrower risk of default
- Loan originator risk (in the case of P2P Lending market places)
- Platform risk of default or, worse, fraud.
But take a second to reflect, which one of these would hurt you the most should the risk materialize?
If you’ve answered platform risk, then you would be correct.
Of course this assumes that you haven’t been putting all your money into a single borrower or into a single loan originator. Because that would be beyond risky.
Now I have another question to ask you, how much time do you spend analyzing platform risk?
Probably not enough, am I right?
Platform risk is the biggest risk in P2P lending because the buck stops with the platform. The materialization of borrower risks and/or loan originator risks would simply increase the ultimate risk, that of platform failure.
No amount of borrower and loan originator diversification or credit risk analysis would save you from severe losses should the platform you’re investing in go bankrupt or mysteriously close due to fraud, or other reasons.
European P2P lending investors in, for example, Envestio, Kuetzal and others, are currently learning the lesson the hard way.
P2P lending investors in platforms across the channel in the UK have been learning these lessons for longer. There have been quite a few cases but the highest profile one was the collapse of Lendy in 2019 (and it looks like it was due to fraud).
Yours truly was invested in Lendy from 2015 to 2019.
Luckily, I managed to get out unscathed.
My strategy of investing only in the safest loans, employing the most conservative strategies and my tendency, when it comes to P2P, to sell it all and withdraw at the first sign of trouble helped me avoid a loss of €5000.
Phew, trust me, it was very close call.
If a platform closes due to fraud, then good luck getting more than a very small fraction of your investment back. I feel really bad for investors that have been burned by P2P platform defaults.
But let’s give platforms the benefit of the doubt for a minute and take fraud out of the equation.
If a platform simply decides to close or file for bankruptcy due to reasons unrelated to fraud, it would most likely already have a plan in place for the orderly wind-down of the loan book.
Heck, even some fraudulent platforms turned out to have such a plan in place.
Platforms advertise it as a safety mechanism and investors often mention it as a key protection measure in case of bankruptcy.
Indeed, if honest platforms decide to slowly wind-down the loan book themselves, then losses to investors could be minimal (provided that most loans are paid back).
However, as soon as 3rd party administrators need to get involved, to wind down the loan book and / or chase bad debts, the story definitely changes. Especially since borrowers might be tempted not to repay if they get wind of the wind-down.
Many platforms tout that they have a contract with a 3rd party in place should “shit hit the fan”, but they don’t make it explicit that it’s going to cost you and that it’s probably going to cost you quite a bit.
These administrators are extremely expensive and they may indulge in dragging the process out so as to be able to spend more time on the “dossier”. And time is money as we all know.
You’ll definitely get some money back in such situations, but it’s going to take a while, it’ll be stressful and you’ll probably take a significant haircut.
Ask anyone going through such a wind-down process. I’m following the Lendy one. It hurts and it costs.
The biggest and most recognized platforms
To try to mitigate platform risk, many investors have adopted the approach of diversifying into as many platforms as possible.
For me, that’s a sure-fire way to get burned. Especially in this industry. Most platforms will not survive in the medium term.
I wouldn’t want to have a diversified portfolio of terrible stocks or have investments in several of the lowest quality ETFs. Why would such a strategy be OK when it comes to P2P platforms?
Surely the best way would to be to diversify across the biggest and safest platforms. That’s my hypothesis and the one I’ve been adopting for my personal P2P investments.
So let’s take a look at the most established platforms to see whether they would provide the safety net we seek.
We’ll start with the US and then we’ll quickly move on to Europe.
Lending Club
U.S. based Lending Club is the biggest p2p platform in the world. It was founded in 2006 and IPO’d on the New York Stock Exchange in 2014.
Check out this impressive total loan issuance chart courtesy of the Lending Club website:
That’s a whole lot of billions!
As a public-listed company, and given the financial domain it operates in, it is safe to say that Lending Club is heavily scrutinized on a regular basis by extremely qualified auditors, analysts and regulators.
So far so good right? This is the biggest and most regulated P2P platform in the world. As safe as can be, at least from a fraud risk perspective.
Lending Club publishes audited financial statements that are filed with the U.S. Securities and Exchange Commission (SEC).
Let’s now take a look at the income statement related to their latest annual results (2019):
Over $750 million in revenues in 2019 (numbers are expressed in thousands) and growing very nicely since 2015!
That’s where the good news stops however.
As you go further down the income statement, you quickly notice that Lending Club has been continuously loss making since 2015 (and probably since inception).
It may be tempting to say “but that’s because they’re investing in their growth and they could easily reduce “Sales and marketing” and / or “Engineering and product development expenses” to become profitable”.
But I’m not so sure. This industry is notorious for relatively high customer acquisition costs. As soon as you stop the marketing spend, you’ll start impacting revenues to the downside.
On the R&D side as well, it’s not so easy to just say you’re going to stop investing in your core business.
Regardless, it’s a fact, the biggest P2P lending platform with one of the longest track records and unparalleled scale is unprofitable and consistently so.
Could the P2P lending business model be nonviable? Food for thought!
I’m not qualified to determinedly answer this question but I am definitely skeptical.
I do know that banks are infinitely more profitable than P2P lenders though.
It looks like P2P lending threw out the proverbial baby (profit) with the bathwater (middle-man banker).
Now, let’s take a quick look at the Lending Club share price over the years:
Ouch! It doesn’t look good does it?
As of the time of writing, Lending Club has a market cap of around $400 million. That puts it somewhere in the small/micro-cap category. A not very exclusive club.
Now don’t get me wrong, $400 million market cap is definitely an OK size, but for the biggest P2P lending platform in the world operating in the most sophisticated and accommodating financial market, it’s quite underwhelming to say the least.
I’m surprised at how small it is in the grand scheme of things.
OK enough with Lending Club, I think I’ve made my point. It’s now time to travel across the Atlantic to Europe.
Mintos
Mintos is the biggest P2P platform in Europe, by far. It was founded in 2015 and has been growing ever since.
As we did for Lending Club, let’s check out the total loan issuance chart for Mintos:
Approaching the €6 Billion mark, not bad at all, though note that it is an entire order of magnitude less than the Lending Club statistics.
And we can clearly see the deceleration since the Coronavirus crisis hit but it’s too early to say what the long term impact will be.
Regarding financials, on July 14th 2020, Mintos published its annual report for 2019. The report is audited by EY, which is good.
Now let’s take a look at the income statement related to their latest annual results (2019):
Revenues are incredibly low at around €9 million. Now this is a small business!
Yes the revenues have practically doubled since 2018 but it is still tiny and will remain tiny for the foreseeable future. Especially considering that Mintos is the biggest EU P2P platform by a landslide.
Once you go down the income statement, as was the case for Lending Club, you realize that Mintos is quite the loss making entity.
Having lost almost €1 Million in 2019, Mintos is going to continue to depend on raising capital in order to stay in business. Revenues have less than doubled but losses have more than tripled?
I don’t know about you, but it all looks very underwhelming, and quite risky.
P2P lending from the risk-reward perspective
Now the point of this post was not to do a detailed financial analysis of the biggest P2P platforms.
Nor to beat down on Lending Club and Mintos.
Not at all.
Rather, the aim is to provide some perspective on the bigger picture, the forest not the trees.
That even the biggest platforms with the most impressive track records are still very small and chronically unprofitable companies, despite the huge loan volumes that are being serviced through them.
Then, is there such a thing as safe P2P lending platform? If this is what we get from the “crème de la crème”, then what about all the much smaller and newer alternative platforms that are out there?
That is a rhetorical question. But if you’re curious on the profitability of the main EU P2P platforms, I encourage you to consult this invaluable list maintained by P2P-Banking.
If you’re like me, then you got into P2P lending because of its accessibility, the “story” of cutting out the greedy banking middleman resonated with you.
Let’s be honest though, it was also mostly because of the juicy returns.
But how juicy are they and are they worth it from the risk-reward perspective?
Especially since, and I hope we all now agree, the risk is substantial.
Lending Club returns and risk-reward
Again, let’s start with Lending Club.
These are the ranges of returns as from their website:
Looks like a range of around 4 to 9%.
I don’t know about you, but, immediately, I look at these returns and I’m not impressed at all.
You’ve been able to consistently get a yield of 5 to 7% simply from investing in AT&T (a mega cap with decades of consistent and growing dividends).
You can also easily get these yields from investing in preferred shares and bonds of multibillion market cap companies.
And don’t forget the high yields you can get from well-chosen Closed-End Funds, with Assets under Management worth several Lending Clubs and a decade-long track record of consistent dividends.
Now let’s go on to Mintos.
Mintos returns and risk-reward
According to the website at the time of writing, the average return on Mintos is 12.34%.
These are incredible returns no doubt, and I’ve been benefiting from them since I started investing in Mintos in 2016.
But let’s not forget that Mintos is in fact a really small, loss making business. And they’ve already had been many issues with loan originators. And the current Coronavirus environment is precarious to say the least.
In terms of income investment alternatives, it’s not as clear cut with Mintos as it is with Lending Club because there are very few comparable high yield alternatives denominated in euros.
There are no euro denominated preferred shares that are listed on a stock exchange (to my knowledge) and no euro denominated Closed-End Fund equivalents either.
On top of that, European bond yields are incredibly low unless you’re playing the mega junk space.
Speaking of mega junk bonds, One of Mintos’ loan originators Mogo issued bonds at a yield of 9.5%.
Furthermore, they mature in 2022 and they are currently trading at under 90 par value. This means that you will get more than the original 9.5% coupon investing today at 90 and will also receive 100 par value (instead of 90) if Mogo manages to make its principal payments in 2022.
And I say if, because the Mogo credit rating is non-investment grade and since it’s trading below par, it looks like creditors think that there is a decent chance Mogo might not make it in 2022.
However, if Mogo makes it through, this investment under par value would amount to around a 10% capital gain in 2 years. Let’s divide by 2 for simplicity and this would approximately be an extra 5% per year in capital gains.
So you can get an approximate 15% return by buying the Mogo Finance bonds today.
But guess what? Mogo originated loans only provide around 12% on Mintos.
Who do you think is more likely to get paid by Mogo? The investors owning the bonds that have to be repaid for Mogo to ensure its survival or its P2P investors on Mintos?
This is an oversimplified view no doubt but the point I’m trying to make is that you need to look at the big picture when you’re investing and place your bets accordingly.
Should you invest in P2P Lending?
I want to conclude on my thoughts regarding the viability of P2P Lending.
For U.S. investors, I really don’t see the value of investing through P2P lending platforms. There are so many alternative income investments denominated in USD that are much better from a risk-reward perspective. That’s my honest point of view.
For EU investors, myself included, it is a bit more nuanced.
I would recommend very carefully screening platforms before investing due to the lack of opportunities in the fixed income space.
EstateGuru and Mintos are the top two platforms in my view (my only P2P platforms, I’m putting my money where my mouth is).
It looks like Kristaps Mors, who compiles a very useful platform ratings list, agrees with me.
Just keep in mind that all platforms are very small businesses, mostly loss-making and that platform risk is probably much higher than you think.
Focus on the safest loans, the safest loan originators (remember the buyback guarantee is only as safe as the entity making it) and don’t get greedy, invest only a small portion of your portfolio and get ready bolt at the first sign of trouble.
In the meantime, always stay on the lookout for better euro-denominated fixed income alternatives!
And always remember, don’t miss the forest for the trees.