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Is Institutional Lending In Peer-To-Peer Good For You?
“Financial institutions” have increasingly been lending through peer-to-peer lending websites. But what is peer-to-peer institutional lending, how widespread is it, and, the key question:
Is institutional lending a good or bad sign for individual lenders doing P2P?
I'll get to that. I must warn you that this is a very big topic. So make sure you're sitting comfortably. Firstly, you need some background.
What is institutional lending in peer-to-peer lending?
Institutional lending means lending from banks, investment funds (such as hedge funds and pension funds), insurance companies and other financial-services businesses.
It can also mean government-tied institutions, such as government-funded banks, but those are outside the scope of this article. I'll write about that later this month.
Specifically, on the 4thWay website, we're talking about the lending that institutions do through peer-to-peer lending companies or working closely with them to provide borrowers with funds.
The institutional lending might take place by signing up online and lending in the same way as everyone else, or the P2P lending company might offer the institution a separate solution.
Some P2P lending sites include institutional lending in all their online statistics or in the complete historical loan books that they provide to 4thWay or publicly. Others strip institutional data out of their reports.
Why lenders have mixed views about institutional lending
Recently, a 4thWay user told us she looks to institutional lending as one of her lending criterion; she prefer to lend to P2P lending sites that are being trusted by large financial businesses that, like 4thWay, have deeper access to assess all aspects of their business, as well as greater capability to do so.
Other 4thWay users are sceptical: if institutions are lending large sums of money through these P2P lending sites, does this mean that they get to take the best loans for themselves? Might not the P2P lending site end up favouring institutions, allowing them to cherry pick loans, for example? And can we really trust just any old anonymous institution to know what it's doing – and to have interests aligned with ours?
Everyone is making good points. If you want to understand institutional lending and use that as a factor in your lending decisions, you need to try to dig deeper to see how it works in practice:
The different ways institutional P2P lending can affect you
I'm going to list for you the 12 different ways peer-to-peer institutional lending can work, because this should impact how favourable you consider it to be.
Sometimes, institutional lending involves a combination of the following 12 items.
1. Underwritten loans
Especially in property lending (but also occasionally in business lending) loans can be underwritten by an institution.
This means that the institution arranges the loan and lends the full amount to the borrower first. Then, individual lenders buy loan parts off them through the P2P lending site.
At the moment, institutions doing this in peer-to-peer lending are typically non-bank lending companies, such as successful family firms, larger lending businesses, or some kind of smaller investment fund.
The mere fact of a loan being underwritten in this way doesn't usually present any extra risk to lenders. The benefit is that it smooths the process so that borrowers can borrow more quickly, and lenders can lend more quickly, without waiting for a P2P loan auction to end.
Sometimes, the institution holds onto part of the same loan and therefore keeps a modest amount of skin in the game. A backer of Octopus Choice, for example, holds on to 5% (more on that later). Institutions may even take first loss, meaning that they lose money on their loan parts before anyone else. Again, Octopus Choice offers that.
2. The institution takes extra risks
This is when an institution will lend alongside you, but will take a junior position.
That means you'll get your money back first in the event that the borrower suffers issues and the P2P lending site needs to take legal action for you to recover the bad debt. The institution can only get some or all of its money back after you have got all of yours.
This arrangement is almost always legally backed by a first charge for you and a second charge for the institution.
That's a bit like homeowners getting a mortgage on a house with Halifax and then getting a second loan on the house with Royal Bank of Scotland. If the homeowners were unable to pay their debts and the home was repossessed, Halifax would get its money back before RBS saw anything. In this example, you are Halifax.
With this arrangement, you aren't actually lending in the same loan as the institution. Instead, you're lending in different loans, ranked differently, so the institution is not really doing the same thing as you.
In other words, the institution is not really doing institutional lending through the P2P lending site, but rather partnering with the P2P site and passing off the safest slice of debt to individual lenders.
It might be reassuring for some lenders to know if an experienced institution is willing to take a riskier chunk of debt than you and it loses money before you. It certainly reassures me and the results so far in P2P lending back this up.
The institution gets to earn higher interest rates on the riskier slice that it keeps, and individual P2P lenders get better safety, and lower rates.
3. The institution takes fewer risks
The reverse can also be true: the institution takes the safest slice and lower interest rates, and individual lenders at the P2P lending site get the higher interest rates and riskier lending position.
This time, you have what's called the junior debt and they have the senior debt.
An example of this is P2P lending site Property Partner, which partners with Proseed Capital. Proseed Capital offers to share the higher interest-rate slice of debt in this way with lenders using Property Partner. Property Partner accepts around one in five of these loans.
A risk here is that the institution passes off a riskier chunk of lending that it actually thinks is a step too far. An institution in this senior position, then, can be less reliable for lenders than one taking the risky slice – at least until the P2P lending site has a long track record.
To try to compensate for this, Property Partner asks Proseed to at least take the first loss of 5% on all lending to ensure that it has some skin in the game that is ahead of individual lenders.
Visit Property Partner.
4. When institutional lending isn't really P2P
Peer-to-peer lending sites and institutions can arrange loans to the same borrower. But, here, the institution is not lending through the P2P lending business or handing loan parts to the P2P business. This is not actually P2P institutional lending and therefore it's outside the scope of this article.
5. When the institution does different loans
A P2P lending site is sometimes able to get its hands on borrowers that it thinks are good prospects, but they don't fit well with the offering promised to individual lenders. In this case, they can be offered to institutions.
For example, a small P2P lending site will find it difficult to get enough people to fund a £2 million property loan. So it offers sub-£500,000 loans to individual lenders and any larger loans that it approves to institutions.
This clear distinction between the loans available to individuals and those for institutions reduces the possibility of cherry picking.
Cherry picking is when an institutional lender is allowed to pick loans first and leave their discards for individual lenders. That can lead to worse quality peer-to-peer loans. When there is no overlap in the loans available to both types of lender, this can't happen.
Octopus Choice does this. It strips away loans with riskier characteristics, such as property development loans prior to getting planning permission, and leaves those with the institution. Individual lenders get offered safer loans.
There can sometimes be a partial overlap. At Proplend, so far, institutional lending has taken all of the very large and riskier types of loans, but they are not necessarily excluded from smaller loans.
And CrowdProperty has agreed this year to take funding of £100 million from an unnamed institution in order to be able to lend to a greater number of larger projects. This means that there is potentially some overlap, but not completely.
6. The institution lends through the online P2P lending site itself
Some institutions lend like everyone else through the online P2P lending site.
In this case, their position in the loan and the risks and returns they take are identical to individual lenders. The loans they lend in are as random as anyone else in automated accounts, or the process of choosing and lending in loans is the same in accounts where lenders manually select loans.
RateSetter is like this. Growth Street – now closed to lending – was like this. All its lenders lent on the same terms, and with the same risk, regardless of whether they were private lenders or institutions.
7. The institution gets allocated loans behind individual lenders
When it comes to lending through Zopa's online service, institutions lend on all the same terms – except that they come last.
Institutions only get to lend their money after individual lenders have lent theirs. This prevents individual lenders from having to wait longer to get their money lent.
However, Zopa does offer some institutions at least one other way to lend that works differently. See securitised lending near the end of this list.
8. The institution gets to cherry pick loans ahead of individual lenders
A P2P lending site might favour an institution over its individual lenders by granting it first access to loans.
This means that the institution might be able to either manually, or automatically, analyse a loan for selection much more rapidly than individual lenders, potentially because it receives a feed of viable loans direct from the P2P lending site.
In some cases, a technical hook-up may even enable the institutional lender to make automated, instant purchases of loans before other lenders even get a chance.
All this can give an unfair advantage to institutions.
Funding Circle's offering for institutions seems to be in regular flux, but previously it has said that institutions are offered some whole loans first before anyone else. Individual lenders can only then buy parts in those loans if the institution rejects them first.
Funding Circle argues that by its own standards all its loans are all acceptable risks for all lenders. But, so long as institutions get to choose some loans first, they could potentially still pick the best of the best, perhaps weakening the overall quality of what is left. It would be useful if Funding Circle provided open data on this.
9. The institution gets allocated loans it likes ahead of individual lenders
If a P2P lending site knows an institutional lender's own lending criteria, the P2P site can offer to place new loans into the institution's P2P lending account on its behalf, before individual lenders even know the loans are available.
Assetz Capital told 4thWay this year that most institutions buy loan parts like everybody else through online lending accounts.
But there are exceptions. 4thWay has been told that one institution is “…operating their own account on the platform. But we have the criteria they are happy with and we process the investments.”
Assetz Capital also said that one institution gets up to 25% of a loan allocated to it at the start, although it is unclear if that institution is allowed to specify its own lending criteria.
Institutions in this position possibly have a speed advantage over individual lenders. The whole arrangement likely takes place through a separate fund set up by the P2P lending site, or through a bond or similar lending structure.
10. Securitised loans
Another way a P2P lending site may – or may not – favour an institution over its individual lenders is through securitisation.
This is where more than one loan is packaged together and sold off to an institution.
Funding Circle has securitised hundreds of millions of pounds worth of loans. Zopa has also taken part in this type of lending, where P2P Global Investments, a stock-market listed fund, bought a securitised package.
More P2P lending sites will follow suit with this as they grow.
These securitised packages are each set up individually on unique terms, and we don't get to see the contracts. We therefore don't usually get much information about them.
But lenders should expect that some P2P lending sites allow institutions to specify their own lending criteria, which can lead to them having better quality loans than individuals using the online P2P lending site. That can weaken individual lenders' returns.
It's not possible to know at this stage what other, more subtle impact securitisation might have on individual lenders. For example, it could potentially lead to costs being carried by individual lenders so that institutions get a lower price.
11. When the institution is a related party
A conflict of interest can arise in P2P for many reasons, but one clear candidate here is when the institutions are closely linked, either because directors or senior staff work for or own shares in both businesses, or because one business owns the other one.
Right back at the start of this list, I wrote that an institution underwrites Octopus Choice's loans. That institution is no other than Octopus Property, a decent-sized business that lends its own money and sits within the very large Octopus Group.
However, Octopus Choice offsets this conflict of interest by taking the first 5% loss. It does this through another business in its group that was set up solely for this purpose: Octopus First Loss. It also restricts lending through its P2P lending site to the safest loans, keeping the riskier ones for Octopus Property.
P2P lending site Propio has a harder time proving it manages conflicts of interest. Some of its shareholders are shareholders in the two institutions that supply it with loans, Pivot and Fruition. And the key person on Propio's lending team has a similar role at Pivot.
To cap it off, individual lenders in Propio are also given the riskier, junior slice, with the closely-linked institution taking the senior, safer one.
That all sounds seedy, but I have no reason to believe it is. Propio comes across to our experts as authentic, and individual lenders earn higher rates to offset the risks. Still, it's an example of a clear potential conflict of interest with institutions.
Like Octopus Choice, Propio tries to offset this potential problem by having the institutions take a first loss of 5%. This means if a loan turns bad and not all of it can be recovered, the institution would lose 5% of the total lent first. Then individual lenders would lose their money. Finally, the institution would lose any of the rest – if it ever got that far.
Propio goes one-step further to reduce conflict of interest: it doesn't accept loans that the key person has been involved with at Pivot.
12. The institution is the brains for the P2P lending site
In property lending, it's not too unusual for the institutional lender to do the heavy lifting in terms of assessing borrowers and properties. These institutions are typically called “originating partners”, since the loans originate from them. They find and assess the borrowers before the P2P lending site got involved.
In this case, the P2P lending site needs one of two things.
A) The in-house ability to assess loans too, so that it can reject unsuitable loans offered to it by the institutional lender.
B) Or, and it's a subtle but real difference, it needs to have the experience dealing with these sorts of transactions and types of originating businesses, so that it can assess the likelihood that the institution is trustworthy and able to reliably provide quality loans. A good example of that is Loanpad, which has a large amount of legal experience in dealing with the specific types of loans and personalities that it deals with on behalf of the lenders through its P2P site.
Sometimes, a P2P lending site has a bit of a mix from A) and B).
The less that a P2P lending site is able to assess individual loans itself, the tougher it can be for lenders, 4thWay and others to assess the underlying quality of the loans it accepts, at least until there is a track record. Because access to partnering institutions is invariably much more restricted. In these cases, look for strong experience from B) and other defences on top, such as very strict lending criteria.
Growth pressure and interest-rate contraction
Some peer-to-peer lending sites feel pressure to grow, and getting a quick injection of funding from institutions is often going to be the easiest way to achieve this.
But the P2P site can suddenly find it needs to approve more borrowers in order to get a sudden influx of institutional money lent out. This can impact loan quality. It can also push interest rates down when a lot more money becomes available to lend to a group of borrowers.
To an extent, a levelling off of quality and interest rates is to be expected in peer-to-peer lending, regardless of whether there are institutional lenders or not. When many P2P lending sites start, they are so small that they can accept the very best borrowers. And, from among them, they can pick the borrowers who are least bothered about shopping around for better interest rates. So often the risk-reward balance is far too generous to the lenders to begin with, before coming down to something more sensible.
But, as P2P lending sites grow in size – whether it is due to institutional lenders or individual lenders – something to watch carefully is that standards remain high enough compared to the interest rates on offer.
The type of institution could also matter
Something I'll be trying to watch out for is whether the type of institution doing the lending can have a different impact on individual lenders' lending results.
Consider, for example, that a private lending business lending through a P2P site might expect high standards, because it is the business owners' own money at stake. These institutions might keep P2P sites on their toes and ensure that rates stay sensible.
However, if the institution is a pension fund, the managers of that fund are much less impacted by the results they produce. They are likely to be at least partly driven by the strong need to get cash earning interest somewhere. So they won't necessarily be as bothered about the interest rates, provided they beat pitiful bond interest rates. This lack of due concern could put downward pressure on interest rates at a P2P lending site.
The institution's experience matters
The experience of the institutional manager in dealing with travelling salespeople might also be a factor. An aggressive, determined salesperson from a P2P lending site is quite likely to find buyers somewhere. The buyers might not be as attuned to the nuances of P2P lending as they think.
Investment funds are supposed to be able to analyse investment opportunities wisely, but they don't always know better. Some have already been known to make investment decisions they regretted in the P2P lending space.
The flipside could be true, too, whereby the institution has the advantage. An institution used to negotiating complex securitised products might get one-up on a young, impressionable P2P lending company. Or a desperate P2P salesperson might be quick to shake hands on a big deal that is a poor deal for individual lenders.
Nothing stays the same
We all – 4thWay and you lenders – need to keep a close eye on lending results. Keep questioning and digging for details about institutional lending, to see what is going on and how their relationships with a P2P lending site might have changed.
Is institutional lending good or bad?
What do the results show us so far?
4thWay's experts tell me institutional money is probably more attracted, on average, to better quality P2P lending sites, and early results seem to indicate they choose well, on average.
Lending exclusively through P2P lending sites with institutional lending is likely to have a positive impact on your results, on average.
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.
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