Can A P2P Lending Provider Be Too Profitable?

The last time we updated our piece on profitability (Which P2P Lending Sites Are Profitable?) I received the comment:

“There is a flipside, the more the platform is making, the more they are taking from the lenders who actually fund the loans. And once Lendy was the most profitable platform!”

My correspondent was referring to an online lending platform that closed in disgrace in 2019 and led to overall losses for lenders, which I believe are still being finalised.

I don't know if it really was the most profitable, but the point is well taken. Profitability can be a sign that a provider has truly achieved long-term stability – or of profiteering.

Unlike Lendy, most providers that close their online lending platforms do so much more gently, with lenders achieving good returns overall. But, unfortunately, not enough was in it for those providers themselves.

However, when profits are very large, is it due to excessive risks or fees?

Here are some of the different facts and factors that I often consider as part of a whole when looking at profits:

Let's start with the profitability of the provider

Profits – also called “earnings” – act as a cushion that can help a peer-to-peer lending provider stay afloat and keep serving lenders.

But, when profits are high relative to its most similar competitors, there's a potential conflict of interest going on.

P2P lending is designed to invert banking: we individuals make most of the money and the provider takes lower fees. Usually, banks pay us a little interest and then take the bulk of the profits by lending our savings at much higher rates.

As you learn how to get to grips with understanding profits, you need to steadily learn about such things as gross profit, operating profit and net profit after tax. Generally, you want to focus on those more than many business' favoured way of presenting profits, which is called EBITDA: earnings before interest, tax, depreciation and appreciation.

From the company accounts, alongside profits, also look at revenue (often called “turnover”, and it mostly means the total value of sales in the year), assets (cash, property and other things the company owns) and its debts.

Preferably the accounts are independently audited, not least because the auditors might state if there are material risks that the business will survive.

If you go to Some Company Account Links, it contains a list of some of the pages at the UK's companies registrar where you can see providers' company accounts, typically containing brief assets and liabilities information, and sometimes on profits and losses too. For this to be any real use to you, you need to practice reading the entire accounts, including footnotes, and over time learn more about what it all means.

One other item I lump in with reviewing the accounts is the ability of the peer-to-peer lending provider to raise funds from shareholders.

Shareholders might have indicated they're willing to pay in more cash, or the business might have indicated there are new investors waiting to buy shares in the business.

All that can add to the length of the “runway” that the business has to take off, i.e. get passed start-up status into a full-fledged, ongoing small- or medium-sized business.

Moving on…

With the provider's company accounts, you have to read between the lines while holding a pinch of salt. As you can imagine, that's only a little more useful than, say, mixing metaphors.

To complement what you think you've learned about profitability and overall financial health of the provider, you look at other factors that help build the overall picture.

Here are five of those factors that I look at together with profitability:

1. How high are lender costs?

How much you pay as a lender is a very complex theme.

The starting point is to recognise that the borrower pays x amount in fees and interest to borrow your money, and you receive y amount.

The difference, z, is what the P2P lending provider takes. Those are also your total lending costs.

Those lending costs go towards running the online lending platform, sales, marketing, assessing borrowers, monitoring loans and more. At some point, those costs also contribute towards the providers' profit margins.

It's rare that you can precisely calculate your total lending costs. This is one area where many providers think it gives away too much commercial information to reveal.

For example, showing lending costs would enable competitors such as banks and other lending businesses to ascertain what the average total borrower costs are, which would help them to undercut loan prices.

Sometimes it's because they don't want lenders to know how much they are being charged. There are a variety of reasons.

You can find a table of our best estimates of total lending costs for various providers in There’s No Such Thing as “No Lender Fee”.

What impacts lending costs?

Costs vary dramatically from one provider to the next.

To a large extent, the spread between what borrowers pay and what you get is driven by the type of lending. Some types of lending require far more work and effort on the part of the providers. So it's more expensive.

Beyond that, the very specific, unique nature of the borrowers and loan applications that any provider focuses on is also a factor, because no two providers are identical.

The level of costs can also be influenced by what the provider offers you in terms of spreading your risks, diversifying and any special facilities to lower your risks further.

Plus, your costs are influenced by demand from other lenders. If that demand is much higher than the capacity to find borrowers, it can mean that the provider charges borrowers the going rate but reduces the amount it pays to lenders, since there are still too many lenders anyway.

In some cases, this is reasonable. In other cases, it's simply ridiculous. First to come to mind here is the defunct Wellesley's P2P lending offering, which lowered its annual lender rates on relatively high-risk property development lending to little more than 1%!

I won't lie, the mix of factors to weigh here does make it tricky to assess whether costs are reasonable and so that's probably one of the most difficult tasks I have to do at 4thWay. It sometimes comes down to a judgement call.

What form do lending costs take and where do they come from?

Is the spread largely from ordinary fees, charged nominally to you and/or the borrower?

Or is it from a fat pile of default fees and default interest that the provider retains most of it for itself? Some lenders do still take such payments for themselves, even though I believe that a court ruling a year or two back probably should have put an end to it.

After all, it's your money at risk, not that of the P2P lending provider, so the borrower has defaulted to you and owes you.

If the provider takes fat default charges for itself and the outstanding loanbook is full of bad debts, that is a conflict of interest. The provider makes more money when more loans are bad and when it drags its feet in recovering those debts.

That is the exact opposite of what you want, as it is much more likely to lead to losses for you.

Last year we published: Which P2P Lending Companies Boost Lender Returns With Default Interest?

2. Growth trajectory

Growing fast is not a bad thing for a business to do per se. It is not wrong for a provider to start with under £1 million in lending and hit £100 million per year five years later.

There have been many cases of rapid growth in this industry that were benign. This has been when the P2P lending provider has had a good business model for finding and attracting the right kinds of borrowers and lenders, with a large pipeline to both.

But very rapid growth can be at the expense of good lending practices: “Approve more loans to earn more fees now!”

It can be driven by the desire for making a quick profit or even to make the business look attractive so the provider can sell it quickly.

Or it can be driven by pure vanity: “I'm the CEO of a big company.”

If expansion means suddenly ratcheting up the number of approved loans, or the number of very large loans, or if it means rapidly rolling out high volumes of new types of lending in which the provider has no prior experience, or in new countries: those are some things to watch within the bigger picture as profits rise.

3. Governance

4thWay attempts to look into each provider's history in governance. That means internal controls to prevent fraud, wrongdoing, major issues from conflicts of interest, disreputable accounting practices, legal issues and so on.

If such negative events have ever occurred, did the provider seem to react to it with the required energy, swift transparency and decisiveness?

4. Aggressive sales and marketing, and the tone coming from the leadership

I'm turning now to what we call moral hazard, meaning signs that the psychology behind what is driving or influencing those running the P2P lending platform is dangerous for lenders.

Again, none of this by itself means that the provider is bad; you see this as part of a whole, with the size of profits, governance and the rest.

A potential sign of moral hazard is very aggressive sales and marketing. I don't just mean an advertising campaign, which is fine.

But it could for example be presenting radical numbers and facts, misrepresenting interest rates, understating the risks, constant direct marketing efforts and frenetic lending bonus campaigns.

Another sign of moral hazard is just how much the directors and senior staff talk about their growth plans, growth achievements and growth trajectory, along with innovations and ideas for expanding, and raising investment from shareholders to achieve their big goals.

Conversely, how does that compare to the energy and time they spend talking about their obsession with loan quality, high-quality borrowers and such factors? Is lending quality coming closer to being an afterthought? That is well noted.

In combination with that, I'm interest to see how strictly each provider actually sticks to its lending criteria when approving borrowers and how often it allows itself the discretion to approve weaker loans.

How are salespeople incentivised?

At 4thWay we try to ascertain payment and bonus structure, especially for people who are bringing in the borrowers.

Some of the poorest lending results have occurred when sales teams have been able to earn large bonuses purely for closing as many deals with borrowers as possible, with no regard to quality.

5. Transparency and honesty

The overall picture of saying it like it is, being quick to admit mistakes, quick to update lenders, being candid about problems, offering more information than requested and above all maintaining that approach is the overriding factor.

Are they consistent and do they ring true throughout?

Do unicorns exist?

You usually expect some weaknesses or potential issues in some of the above – and that's fine. It's the reading of the bigger picture that matters.

But it's not as if some providers don't tick all those boxes. Proplend* (read review) leaps to mind as a straight-talking, non-profiteering provider that only cautiously tries out new types of loans.

After 11 years, I think it's just now on the verge of becoming consistently profitable, as its loan book hits £70 million in outstanding loans.

It has low lending fees and pays out all the default interest to you, which probably raises final returns on its few bad debts by about 3-4 percentage points.

That's not everything

All the above factors are about just one particular angle when assessing providers, centred on whether profits seem reasonable.

Naturally, other things matter just as much: such as the lending processes they use, the people, the quality of their loans and loan performance. A lot more goes into a wider assessment!

Read more

See wider assessments of many P2P lending providers by reading the reviews.

Pages linked to above

Which P2P Lending Sites Are Profitable?

There’s No Such Thing as “No Lender Fee”.

Which P2P Lending Companies Boost Lender Returns With Default Interest?

Some Company Account Links.

List of 4thWay's reviews.

Proplend* l Proplend review.