Peer lending and alternative finance offers a new world of opportunities for investment analysts but you need to know key criteria
While crowdfunding has dominated the media attention with stories like the Coolest Cooler and Oculus Rift, it’s peer lending that accounts for the majority of funding volumes. P2P loans on sites like Lending Club and Prosper reached $25 billion in 2015, 73% of the total alt-finance space.
We looked at the amazing growth in alternative finance and how it’s changing Wall Street in a prior post. With rates at historic lows and bonds paying next to nothing after inflation, peer lending investments are offering investors the chance to diversify their fixed-income portfolio and earn a higher return.
Even on the huge growth in peer lending, the $25 billion in loans is still a fraction of the total loan market. I studied just how big peer lending credit could become on my blog PeerFinance101 and found the current P2P market just 0.15% of the total $16.3 trillion loan market.
While institutional investors are already training their analysts to evaluate peer lending investments, the retail market may offer a huge opportunity to freelance analysts as well.
What is Peer Lending Investing?
Peer lending and P2P investing is really very similar to the traditional way loans have been originated and sold to investors. In the old model, a bank originates a loan and then sells its portfolio to a broker or investment firm. The broker then sells chunks of the package to investors according to different criteria like maturity and borrower risk.
P2P investing is the evolution of this model into the social space online. Borrowers apply for their business or personal loan on platforms like Lending Club. The platform checks the borrower’s credit, assigns a rating and an interest rate on the loan. Investors can then invest directly in the loan, usually from $25 and up on each loan. The platform collects monthly payments on the loan which include principal and interest and passes the money on to investors.
Peer loans are generally unsecured personal loans or small business loans and are quite a bit riskier compared to traditional fixed-income debt. Loans are usually offered on 3- to 5-year terms at a fixed rate. Borrowers pay a 5% origination fee and most sites charge investors a 1% annual fee.
Returns for investors have been very good, ranging from 5% to almost 10% for loans after accounting for defaults.
Despite the fact that p2p loans are unsecured, average credit scores for most borrowers are actually pretty good. Lending Club and Prosper only loan to borrowers with credit scores of 680 or higher (prime loans) while some sites originate loans to borrowers with a 640 credit score or higher.
Institutional investors and even banks have started to invest heavily in peer loans as a way to diversify fixed-income portfolios and provide for higher returns. Banks have also found a way to remain active in the credit market without the heavy lending regulations imposed by the government. This institutional interest is creating demand for analysts that can rate and analyze personal loans and other p2p investments.
The size and dispersion in the retail market means the demand for analysts is still fairly new but growing as well. Since individual investors don’t typically have a large chunk of their portfolio in peer loans, fees to p2p analysts would not be very large to manage single accounts. This will change as more investors put money in peer lending and firms can build larger, dedicated departments of analysts.
How to Analyze Peer Lending Investments
There are no formal rating agencies for peer loans though each lending platform employs its own methodology for assigning a rating and an interest rate. This may change eventually as the market grows and investors look for a more consistent source for ratings.
The peer lending platforms make it fairly easy to pick loans for retail investors, offering dozens of criteria on which to search loans. Some of the criteria will not mean much in creating excess returns but there are some factors that tend to result in lower defaults and higher returns. I talked to a peer lending investor last year that has averaged a 12% return over the last six years and made $10,000 on his portfolio of loans.
Within my own portfolio, I like to focus on loans with the following criteria:
- No credit inquiries in the last six months
- Home Ownership
- Debt to Income ratio of less than 20%
- Income greater than $55,000 per year
- Protected borrower occupation, someone working in education or public service is less likely to lose their job
The major peer lending platforms make all their loan data available so it would be relatively easy to create your own proprietary model for analysis, whether you built it yourself or outsourced the model. The model would allow you to pick certain criteria from the list and then back-test returns accordingly. You could then sell the model to investment firms or use it as a freelance analyst for peer lending investors.
It may take a few years of growth but the peer lending industry will eventually be a strong source of demand for financial analysts. Secondary markets where investors can buy and sell loans have just been launched, adding to the analysis need beyond the origination market. Learn how to analyze peer loans early to distinguish yourself in the market.
‘til next time, happy investing!
Joseph Hogue, CFA