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How Many Small Business Loans Should Lenders Spread Across?
This article covers:
How much diversification is enough for P2P lending to small- and medium-sized businesses?
Depending on how prime the borrowers are, a P2P lending company might see less than 5-in-100 small, unsecured business loans turn bad at some point, over the course of those loans being repaid. But it could also be as many as around a dozen-in-100.
The bad debt is then passed to a team to try and recover as much of it as possible. Annual interest earned over many years on that batch of loans offsets those one-time bad debts, and any excess annual interest is the profit.
But, when I say from 5-in-100 to 12-in-100, I'm talking about the average across what could well be thousands of loans. Possibly even tens or hundreds of thousands of them. It's all the loans that the P2P lending company has approved.
You won't be lending across all of those loans. So, as a lender, random chance has a greater impact on your own loans' performance. The smaller your own personal basket of loans, the more random chance plays it's part. This could lead to substantially better or worse results.
So what is the risk and how many loans do you need? That's the main point that I'm going to build up to, but it's an educational journey for you to get there.
What is unsecured small business lending?
Before I go on, let's just take a step back to take apart precisely the kind of lending I'm talking about today. I'm looking at standard, unsecured small business P2P lending. This means lending in the kind of typical, ordinary loans that banks approve to the businesses that drive the nation, which have 250 or fewer employees.
These loans are usually for three to five years, although they can be repaid early. They are usually paid down every month and charge a fixed interest rate.
To a great extent, P2P lending companies approve or reject these loans, and set the interest rate, using automated checks on the borrower.
They are most similar to standard personal loans, with a noteworthy difference being that it can be a bit trickier to assess the chances that a business borrower will be unable to repay in full. So interest rates can average out a little bit higher.
When do small business loan bad debts occur?
With these kinds of loans, you expect some to turn bad and not repay in full.
Typically, many of the loans that will turn bad do so early on, but substantial bad debts continue to occur for a few years, after some repayments and interest payments have been made.
Lenders rely on the interest from all the good loans, over the full term of all the loans, to make a profit. They sometimes also rely on some recoveries eventually trickling in on bad debts.
During an ordinary economy, a 20% recovery on amounts that turn bad is a typical baseline for an operation that has a modicum of ability in recovering bad debts on small business loans.
Recovering an average 40% of bad-debt amounts, for these sorts of loans, is the absolute pinnacle.
That's across all the loans that a P2P lending company approves. Your own, smaller basket of loans is going to be impacted to an extent by the fortunes and actions of your particular borrowers.
How and when will I make a profit?
The interest you earn is not just how you make an overall profit. With these loans, the lending interest earned over a large number of loans is also your primary defence against losses.
With the very best business loans to exceptional, high-prime borrowers, you're most likely to be in profit very quickly despite any early bad debts and you would remain in profit until the loans are fully repaid.
In contrast, if you're lending across the full spectrum of creditworthy borrowers, it will mean from the primest down to the borrowers who can only just get approved for a loan at much higher interest rates. In this case, you might well find yourself sitting on losses for a bit longer when the early bad debts transpire. You'll need to wait longer for the high interest rates on your good loans as well as the recovery of bad ones to catch up.
When lending to the full spectrum, we're generally talking about borrowers being charged competitive interest rates that filter down to still pay above at least 8% lending rates for the lender, before bad debts, on average across your loans. During times of high or rising interest rates, borrower and lender rates on new loans should naturally go up further.
What do I need to do to reach a profit?
Whether you're focusing on the primest business borrowers or the full spectrum of risks, you will seriously reduce your chances of ending with a profit if you sell your peer-to-peer business loans early.
Selling means that you sell only your good loans, which would have paid you interest every year, all the way until they are repaid by the borrowers. Meanwhile, you hold onto your bad debts, most of which will be written off.
Thus, I consider the greatest risk in small business lending to be the decisions made by us lenders, as shaped by our own personalities.
Clearly, small business lending is for patient lenders who have done enough research to feel confident and comfortable with our decisions, so that we are willing to just sit and do nothing – even if bad debts start to increase.
How much does platform ability, borrower quality and spread of risks matter?
The ability of the “platform” – meaning the skills of the people behind the P2P lending accounts – is extremely important. The figures I'm writing about today, and my opinions, are completely irrelevant if the loans are being approved in an incompetent way or the interest rates that are being set are inappropriate.
That aside, competent P2P lending companies offering small business lending can offer a wide spread of risks. They might focus on the prime end only or approve loans to all sorts of borrowers, including the ones that are only just creditworthy. You might have the opportunity to narrow your risks by choosing the types of borrowers you lend to.
When you are not choosing loans yourself, you also need to keep an eye on how your money is being spread out between borrowers. If you are assigned a very high proportion of the least creditworthy borrowers, this will clearly increase your risks and it will also mean that you need to lend in far more loans to contain those risks.
How many loans are needed to contain the risks?
4thWay's specialists have crunched the numbers quite a few times over the years, and we've done so again this month. The results are broadly in line with our previous findings.
We're assuming that you're lending across the full spectrum of creditworthy borrowers, where the average borrower is sort of middle-of-the-road risk.
In this case, you should be looking to lend in at least 180 loans. By doing so, we think you reduce your risk of making an overall loss by the time the loans are repaid in full of perhaps less than 2%, if you started lending just prior to the outbreak of a severe recession similar to 2008. So less than two-in-100 people would make an actual loss in the end, and most of those would be very small losses that you can overcome when lending in the following years.
This compares extremely favourably to riskier investments, such as the stock market, where many more people suffer deeper losses.
I'll contrast that with if you just lend in 100 such loans. We estimate that, in a severe recession similar to 2008, perhaps 11-in-100 lenders who sensibly hold onto their loans until they are fully repaid will make a loss on that batch of loans. (If you sell early, you increase your risk of loss substantially and potentially also the size of your losses.)
How many loans is the optimum number?
More loans is always going to be better, but the benefits of diversification reach a plateau at around 230 loans. The difference in risk between 230 and 250 loans is now getting small.
At 210 loans, the risk of losses in a severe recession could see fewer than one-in-100 lenders making a loss, if they lend until all good loans are repaid, without selling up.
230 loans is a very modest improvement still, but 250 is no longer really very different.
Again though, more is always going to be better.
How can I spread my money across enough loans?
To reach 180, 210 or even 230 loans, you sometimes need to work at it, because you might not instantly be able to split your money between so many loans.
Use these steps to work towards – and beyond – those targets:
- Drip your money in over several months to increase the chances that you're allocated to more loans.
- Re-lend your money as your repayments and interest comes in. This doesn't just increase your number of loans, but it means that you're lending to businesses gradually during different economic conditions, so that average performance of your loans reflects the overwhelmingly positive economic effects of business and trade.
- If you're married, you might split your business lending pot in two. Set up two separate, individual accounts in each of your names. Start lending in each account in different months to try to spread across a wider variety of loans.
- Try to split the money you've set aside for small business lending into more than one P2P lending company.
- If you're unable to reach the number of loans you want, lend less of your money in each loan and put more into other P2P lending accounts.
- Once you've satisfied yourself that a P2P lending company offers high quality loans, it's important to remember that and not judge harshly if one of your accounts goes through a bad patch for a year or two, as you're likely to sell your good loans and perform even worse. And you'll end up leaving perfectly good P2P lending companies forever. (Compare this with stock-market funds and pension funds, which invariably have periods of loss that get quite substantial.)
- Related to that last point, consider the overall return across all the loans from all your P2P lending accounts, not for each one individually. That's very important, because you might be tempted to be disappointed in one half and overly pleased in the other. It's the total performance that matters.
More tips to lower the risks even further
It's not just about holding your loans to the end and diversifying. You can further, substantially reduce your risks:
- Look to lend in more prime business loans if you're able to do so, and preferably only prime. Lending rates are lower, but so is the likelihood that random chance will leave you with losses.
- It hasn't really been an issue yet in standard, unsecured business P2P lending, but keep an eye out to see if a P2P lending company starts to frequently agree to lend to the same borrowers more than once at the same time. When you're spreading across lots of loans, those loans need to be with different borrowers!
- Look for opportunities to focus on loans from experienced teams that have a lot of credit-risk and underwriting experience, and that use a lot of technology to help them properly assess applications, as well as providing enough data to fully assess how each and every one of their individual loans are doing.
Unfortunately, I can currently find no P2P business lending accounts open to lenders that fit every one of those criteria! But they are to be grasped whenever you can, so keep your eyes open – perhaps with the help of a free subscription to 4thWay News & Tips.
What are your unsecured business lending choices right now?
When my team and I enthusiastically decided to tackle this subject again this month, we failed to think about the fact that it's not the best climate at the moment for unsecured business lending in the UK. We have timed this research badly, because your choices are very limited right now:
Funding Circle, by far the largest, is currently not open to P2P lending. It switched to offering government-backed pandemic loans, which are non-P2P only and it's uncertain when – or even if, in my opinion – it will ever re-open as P2P lending. When it is offering P2P loans, Funding Circle ticks lots of boxes. But it stopped providing all the data needed to fully assess how each individual loan is doing in mid-2018. That level of data is more or less required to ascertain the spread of risks when lending in a few hundred loans.
I could write exactly the same about LendingCrowd* as I just have done for Funding Circle, with the only deviation being that it is much smaller and has completed far fewer loans.
To put any more on the list, I now need to stretch and bend the definition of these loans that I gave near the start to near bursting point. But here goes:
Rebuildingsociety* is less automated than usual for business loans. It is also nominally secured business lending, but we treat its loans as unsecured, because the security is not proven and recoveries have been far lower than we'd expect even for unsecured lending. Although Rebuildingsociety lists loans with a wide range of borrower grades, all the loans are among the very riskiest end of creditworthy, with a remarkable 20-30 loans out of 100 turning bad at some point, and paying higher interest rates.
Crowd2Fund is also less automated than usual for these loans and, like Rebuildingsociety, it has not clearly demonstrated that any security it takes is solid, so again we treat it as unsecured. Like Funding Circle and LendingCrowd – it doesn't provide detailed data of each loan, making it impossible to assess the spread of risks for borrowers.
There are quite a few other business lending P2P companies, but they are so far from my initial definition of the loans I'm covering today that I can't wedge them into this list.
A final message
Please don't let the seeming accuracy of the numbers in this article – especially diversifying across 180 to 230 loans – make you think that you can simply spread your money across that number and then you're safe.
It depends on the quality of the platform, the exact shape of any recession that occurs, when in the life of the loans that they will typically turn bad, actual repayment speed of your borrowers, and so on.
However, if you lend across this sort of number of loans, and then lend across five or more other P2P lending accounts and/or IFISAs, you're well on the way to a sensibly diversified portfolio that can take very big economic shocks.
Independent opinion: 4thWay will help you to identify your options and narrow down your choices. We suggest what you could do, but we won't tell you what to do or where to lend; the decision is yours. We are responsible for the accuracy and quality of the information we provide, but not for any decision you make based on it. The material is for general information and education purposes only.
We are not financial, legal or tax advisors, which means that we don't offer advice or recommendations based on your circumstances and goals.
The opinions expressed are those of the author(s) and not held by 4thWay. 4thWay is not regulated by ESMA or the FCA. All the specialists and researchers who conduct research and write articles for 4thWay are subject to 4thWay's Editorial Code of Practice. For more, please see 4thWay's terms and conditions.
*Commission, fees and impartial research: our service is free to you. 4thWay shows dozens of P2P lending accounts in our accurate comparison tables and we add new ones as they make it through our listing process. We receive compensation from Rebuildingsociety, and other P2P lending companies not mentioned above either when you click through from our website and open accounts with them, or to cover the costs of conducting our calculated stress tests and ratings assessments. We vigorously ensure that this doesn't affect our editorial independence. Read How we earn money fairly with your help.