Peer-to-Peer Lending: A Complete Guide

Loan-based crowdfunding, or peer-to-peer ("P2P") lending, involves people and institutions using platforms to lend money directly to consumers or businesses, to make a financial return from interest payments and the repayment of capital over time.

In the P2P sector, a variety of loans are facilitated. SME finance, consumer credit and property finance (including property development finance) are prevalent categories. A significant proportion of consumer finance is unsecured and for consumables.

Unlike equity crowdfunding, P2P lending tends to be more complex, with platforms often taking a more active role in pricing loans and managing investor portfolios.

P2P lending, also known as loan-based crowdinvesting, involves the crowd lending money to a borrower with the expectation of repayment, including interest, over a specified period. Instead of seeking debt financing from traditional financial institutions like banks, individuals seek loans directly from smaller private lenders through online platforms.

The Legal Structure

P2P investors are lenders under bilateral loan agreements—each investor has an individual contract to provide credit to each borrower. They enter into a contractual relationship with the underlying borrower, and the platform provides a service in relation to this contract, usually to both parties.

The contracts between borrower and lender are often called "Article 36H agreements", as this type of contract falls within the relevant section of The Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) (No.2) Order 2013.

Loan Characteristics

Various asset classes can underpin a P2P loan: - SME finance: Business loans to small and medium enterprises - Consumer credit: Personal loans, often unsecured - Property finance: Including property development finance

Loans may be secured or unsecured. In the case of a secured loan, the investor (often through a security agent) has recourse to underlying assets, which could include real estate, other tangible assets, or company shares.

A distinguishing feature of P2P loans is the interest payment mechanism and term structure.

Interest Payment Timing

Interest may be paid: - Regularly: Monthly, quarterly, or annually - At maturity: Capitalised or "bullet" interest paid at the loan's end

Interest Calculation Methods

Various methods exist for calculating interest payments: - Simple vs compounded interest - Fixed vs floating rates - Different calculation methodologies (360 or 365 days) can impact returns

Loan Terms

Loan terms can vary widely, ranging from a few months to several years. In instances of extended maturity, platforms may offer a secondary market as an exit strategy.

However, the lack of liquidity and a clear price mechanism in these markets doesn't guarantee the sale of an investment, potentially leaving investors unable to exit their position before maturity.

Repayment Structures

• **Bullet loans**: A large part of the loan is repaid in a single payment, normally near the end of the term
• **Amortising structures**: Payments of capital are spread over the life of the loan

The P2P lending sector has always been diverse, but platforms have developed an even wider range of business models, with some taking a more active role in investment decisions and providing ancillary services.

Pricing Platforms

These platforms advertise investment opportunities and facilitate investments, but are also involved in setting the price. The platform: - Conducts due diligence on loans - Sets the interest rate the borrower must pay - Determines the rate received by the investor - Often benefits from the spread between borrower and lender rates

Investors need to rely on the platform's ability in assessing risk and appropriate returns. Investments are commonly offered on a deal-by-deal basis.

Discretionary Platforms

The most complex business model, now very prevalent in P2P lending. These platforms not only set the price but also choose the investor's portfolio of loans. The platform: - Advertises a target rate of return - Strategically invests capital in a customised portfolio - Functions like a discretionary manager - Uses automated processes to select loans based on predefined risk criteria

Some platforms allow investors to choose their preferred level of risk or investment duration, but this is not universal.

Portfolio Management Approaches

Some platforms invest money once received and hold loans to maturity. Others adjust portfolios over time, replacing matured loans with new ones. In this case, the platform also determines transfer prices for loans moving in or out of portfolios.

While loan-based crowdfunding platforms generally carry less risk than equity investments, it is still possible to suffer capital loss.

Borrower Default Risk

Investment risk depends on: - What kind of underlying financing a platform facilitates (consumer loans vs property development) - The type of investment and its security - The creditworthiness of borrowers

Platform Risk

Where P2P platforms price loans or choose loans on behalf of investors, investment performance depends significantly on: - The sophistication of the platform - Quality of risk methodologies - Adequacy of systems and controls

If a platform operates a complex business model without appropriate systems and controls, the likelihood of losses is much higher. Investors are exposed not only to underlying loan performance but also to how well the platform prices loans or manages portfolios.

Adverse Selection Bias

Crowdinvesting platforms typically face challenges in offering borrowers funding certainty until funds are raised through the crowd. Consequently, loan sizes are often kept small. This may discourage high-quality borrowers and hinder funding of institutional-type loans.

Some platforms have adopted innovative measures, securing fronting or bridging funds to finance entire loans before presenting them to investors.

Platform Continuity Risk

The continued operation of a P2P platform is particularly important for returns to be realised. A platform structures loans by splitting them across multiple lenders, meaning multiple bilateral contracts underpin one loan.

An investor may only be exposed to small individual amounts, making standalone contract administration impractical. Platform continuity is critical to investor outcomes.

Nominee and Security Agent Roles

Platforms often act as nominee, agent and/or security agent, exercising rights like voting or accessing security on behalf of investors. Decisions made by the platform can be crucial to investment outcomes.

Because of this impact, the FCA imposed rules on P2P platform wind-down plans, ensuring arrangements for continued functioning of complex IT infrastructure.

Private debt, defined as credit provision by non-bank institutions, has experienced significant growth since the Global Financial Crisis, with recent acceleration due to the changing interest rate environment.

The Private Debt Market

The primary route to invest in private debt is via unlisted private debt funds. These differ in investment strategies, ranging from lower-risk senior lending to advanced strategies like distressed debt. Private debt is widely regarded as a lower-risk alternative investment compared to other alternative asset classes.

Unfortunately, most private debt funds are not accessible to retail investors and require large minimum investments. Few publicly listed funds mirror private debt strategies, and new unlisted retail fund structures are only slowly emerging.

P2P's Role in Private Debt

In light of limited choices for retail investors, P2P lending has been one of the leading ways to gain exposure to private debt.

Market Size Comparison: - Global private debt market: ~$1.2 trillion - UK P2P lending sector: <£2 billion

Despite its small size, P2P lending occupies a crucial space. While most private credit funds focus on high-value deals worth £5m or more, P2P lenders frequently lend much less, giving small and medium-sized borrowers access to credit.

Research from the Deutsche Bundesbank shows that P2P loans supplement the institutional market, with volumes rising when traditional banks are unable or unwilling to supply the market.

Returns Comparison

Loans channelled via P2P platforms involve higher interest rates than traditional banking, but on a risk-adjusted basis they are comparable, as the loans are riskier. P2P loans tend to be higher risk than institutional credit.

Advantages of P2P Lending

• **Diversification**: Diverse loan types and low minimums allow broad diversification
• **Control**: Investors retain greater control over investment choices
• **Customisation**: Decisions based on individual risk tolerance and return expectations

Overall Assessment

P2P lending appears to be a valid way to access alternatives, despite its risks. It offers hands-on investors the ability to build portfolios from a wide choice of platforms and loan types.

However, investors should be diligent in platform selection and pay attention to differences in risk profiles versus other private debt strategies. Diversification both within P2P (platforms and loans) and outside (institutional private debt) is advisable.