First in a two-part series examining destabilizing trends in the marketplace lending sector.
From humble roots, peer-to-peer lending is ballooning into a global phenomenon. Tech-focused lenders are rapidly modernizing both the experience of applying for credit and the process of approving loan applications, and forcing banks to follow suit.
But along the way, the burgeoning sector's financial structure morphed. What started as a techno-utopian dream — a decade ago, the basic premise was that the Internet's decentralized architecture would connect savers and borrowers directly — soon evolved into a decidedly less revolutionary business.
Today the top firms, known in the United States as marketplace lenders, cater largely to hedge funds, banks and other institutional investors. This change of course enabled the industry's rapid growth, but it also made the loan platforms more vulnerable to external shocks.
"Everything in finance gets pushed to the limit. It then breaks. There's a clear-out. And the people who've been prudent survive," said Rhydian Lewis, the chief executive of RateSetter, a U.K.-based peer-to-peer lender that has become an outlier by remaining heavily dependent on retail investors. "I have no doubt that the peer-to-peer lending, or marketplace lending, industry will be any different."
Entering 2016, marketplace lenders face a major challenge: can they again pivot to start relying more heavily on money from individual investors? More retail money would mean a more stable base of funding, which could prove critical in turbulent times, as many of those in the industry acknowledge.
"Retail investors have been very loyal to the platform," Lending Club CEO Renaud Laplanche said at an investor conference in September. "In aggregate, they are very predictable, very dependable."
By contrast, hedge funds have been drawn to the sector in large part because they are searching for yield at a time when interest rates are stuck at rock bottom. They could make a quick exit now that rates have started to rise.
The next spike in unemployment could also cause a shakeout among institutional investors, as more borrowers start defaulting on the unsecured personal loans offered by online platforms.
Those scenarios suggest that marketplace lenders would be prudent to pursue more retail money. However, there are structural impediments to the large-scale influx of retail cash into the sector, especially in the United States. What's more, it is not clear that the demand from everyday investors can keep pace with the industry's substantial appetite for growth.
'Cumbersome and Wasteful Process'
Between the third quarter of 2014 and the same period this year, Lending Club's loan originations grew by 92%. Yet during the same one-year period, the percentage of the San Francisco-based firm's loans that were bought by self-managed individual investors fell from 19% to 15%.
Still, Lending Club has a substantially more diversified funding base than many of its competitors, which are financing their loans with credit lines from other financial institutions.
Of the large firms in the sector, only Lending Club and Prosper Marketplace are open to the vast majority of individual savers, who don't meet the income and net-worth requirements to become accredited investors. In order to satisfy Securities and Exchange Commission rules for selling to nonaccredited investors, the two companies must register each loan as a security.
"This is a cumbersome and wasteful process that benefits nobody," Lend Academy, which educates investors about the industry, wrote earlier this year in comments to the Treasury Department. "Most platforms don't offer investing to retail customers due to regulations that make it cost-prohibitive."
Another constraint on the prevalence of retail investors involves taxes. Profits that individual investors derive from loans originated on the platforms are treated as ordinary income, while any losses are treated as capital losses.
"It's a horrible deal," Matt Burton, CEO of Orchard Platform, a technology provider, said at a recent industry conference.
Unfavorable U.S. regulations are not the only factor that is driving the shift to institutional money. The same trend is now happening in Europe, where different rules apply.
Bondora, a platform that originates consumer loans in Spain, Estonia and Finland, currently gets roughly 90% of its funding from retail investors. But CEO Pärtel Tomberg said that he expects that number to fall over time to about 20%, as the firm ramps up institutional money in an effort to get bigger faster.
The trouble with retail investors is that attracting them requires significant spending on marketing, Tomberg said. "The business model doesn't really hold up long-term."
'No One's Figuring It Out'
One additional factor is also limiting the growth of retail investment in marketplace lending: building a portfolio of loans is a time-intensive task that is better suited for hobbyists than mainstream savers.
Lending Club has recently sought to overcome that reality by allowing investment advisers and brokers to offer the platform's loans directly to clients through their websites.
But more likely to make a big impact is the long-anticipated arrival of mutual funds focused on the marketplace lending sector. Such funds could provide a large base of relatively stable funding for loan platforms that do not enjoy the benefit of federally insured deposits. They could also allow unsophisticated retail investors to access a new asset class.
"There's a whole industry of financial advisers that sell the mutual-fund products," said Jahan Sharifi, a lawyer at Richards Kibbe & Orbe. "They're easy to transact in. It's not that the Lending Club or Prosper platforms are difficult to use — in fact they're easy to use — but you have to learn how to use them."
Over the summer, applications to establish two mutual funds focused on marketplace lending were filed with the SEC. Both applications were for closed-end funds, which raise a fixed amount of capital and are not allowed to continue issuing shares to new investors.
The funds had been expected to start operating in the third quarter, but as the end of 2015 approaches, the applications have yet to be approved by the SEC. The two firms that filed the applications, RiverNorth Capital Management and Van Eck Global, declined to comment on their status.
Outside observers said that asset managers have been struggling to find the right vehicle to catalyze retail investment in the sector. Their efforts have been hampered by a lack of secondary market liquidity for marketplace loans, which makes it harder for investors to exit their positions quickly.
Bill Kassul, a partner at Ranger Capital Group, said that his firm decided to establish a London-listed marketplace lending fund because it could not figure out a structure for retail investors that made financial sense in the U.S.
"I know there are a lot of people looking at it, and no one's figuring it out, which isn't a good thing," he said. "I do think if someone finds the perfect vehicle, you'll see a flood of funds at that point."
In August, an Atlanta-based company called Groundfloor got the SEC's approval to join Lending Club and Prosper in selling marketplace loans to nonaccredited individual investors.
The firm lets middle-class investors buy slices of real estate loans that are as small as $10. For now, Groundfloor is open to investors in eight states plus the District of Columbia.
CEO Brian Dally said that he does not believe everyday savers need the help of Wall Street money managers to determine where to invest their money. "People can have their own investment thesis, and decide what the best value is for their money," he said. "We think when you give them the right tools, people are more than smart enough."
But Groundfloor appears to be swimming against the tide, as larger firms like Avant and Kabbage continue to use institutional cash to fuel rapid growth.
A similar trend has taken hold recently in the United Kingdom, despite efforts by that country's regulators to foster the involvement of everyday savers.
London-based RateSetter, which still gets about 90% of its funding from retail investors, expects that number to drop to 60%-70% in the next couple of years, CEO Lewis said at a conference in November. That would still be a much higher percentage than other large platforms, but it represents a departure from the company's original path.
In an interview, Lewis said that a diversified funding base, which includes both retail and institutional money, will provide resilience for RateSetter across economic cycles.
At the same time, Lewis lamented the recent evolution of the marketplace lending industry's financing side. He said that some lending platforms are motivated by "short-term greed" to "seek maximum investment for lending, without consideration for the long-term impact."
"Performance obviously plays out over many years," Lewis warned.
Coming in part 2: The rising use of leverage brings new risks to the online lending sector.