Many call it Prosper “2.0.” But it’s hard to pinpoint exactly when or how the next-generation format of the peer-to-peer lending site began.
Some might point to the company’s emergence from a high-profile legal scrap with the Securities and Exchange Commission in 2008, when it lost a battle against having to register its loan offerings as securities. Or to its 2010 changeover from an eBay-style auction site, where interest rates were set by lenders’ bids rather than by a borrower’s credit score (as they are now currently set).
A new management team installed at the start of 2013 was also a signature event distancing the firm from the old Prosper.com. So was the subsequent move to a new downtown San Francisco headquarters last year although Prosper president Aaron Vermut chalks that up to coincidence, not symbolism. “It was more of a factor the old lease was up more than really anything else,” he admitted.
Whatever the turning point(s), Prosper today is miles from its roots of matching borrowers with individual mom-and-pop lenders. So is much of the rest of the peer-to-peer or direct-online lending industry, dominated by Prosper and market-leader Lending Club but now being slowly populated by other upstart social lending sites serving niche areas like microfinance and small business lending.
What was once an experiment in financial democratization aimed at supplanting mainstream banks and lenders has evolved into a fast-growing loan market that’s embracing the traditional players of finance as both investors and partners in their loan products. There are even the first signs of a fledgling securitization market for secondary market investors to pool and collateralize portfolios of P2P loans, even though they are still a microscopic part of the estimated $11 trillion consumer lending market (including $800 billion in credit card company portfolios).
“We see interesting opportunities for partnerships,” said Lending Club chief operating officer Scott Sanborn. “When Lending Club started, people viewed us as kind of an anti-bank. But banks have ceased offering personal loans, for a lot of reasons so many of them have recognized they can’t do it all that effectively.”
Observers point to a wealth of reasons why peer-to-peer lending has growing appeal for institutional investors. The size of the market is expected to continue to grow quickly, as consumers with recovering credit profiles start using Prosper and Lending Club to pare down their revolving credit debt. “I don’t think I’m getting any Christmas cards from credit card companies this year,” said Ron Suber, head of global sales for Prosper, in a Dember interview. “While this is still small, it’s meaningful, it’s taking their best borrowers, the cream of the crop, from some of their portfolios.
Prosper, which began operating in 2006, last year surpassed the $1 billion mark in total loan issuance. The company is expected to loan out that much alone in 2014, according to Suber. The firm had $9 million a month in monthly originations at the beginning of 2013, “but now is doing $50 million” a month, he said. “We expect to do $70 million in January alone.”
Appealing to Big Investors
Lending Club, launched in mid-2007 with $3.5 million in first-year originations, has since issued more than $3 billion in loans with $2 billion of that in 2013. December was another record month, with $240 million issued through more than 17,000 personal loans. “Essentially we’ve doubled [in loan volume] every year since inception,” said Sanborn. “We believe now we’re one of the top five issuers of personal loans in the U.S.”
With the economy recovering, the sites are attracting consumers who are improving their credit scores enough to qualify for credit-card debt consolidation loans, which are the primary driver of loan activity through Prosper and Lending Club. Applicants with high-end FICO scores (as assessed by credit-risk analysis by both companies) can apply for a maximum of $35,000, with average loan sizes of $13,625 through Lending Club and $6,830 through Prosper. (For Prosper’s highest rated “AA” borrowers, the average is $10,092).
Peter Renton, a peer-to-peer industry observer from the blog LendingAcademy.com, also says small business owners are increasingly turning to peer-to-peer social lending sites as a way to obtain credit that isn’t available from banks, or is less onerous than other asset-backed or factor-type lending. That sector’s demand is fueling startups like Funding Circle USA, Quarterspot, and Fundation that concentrate on the peer-to-peer model for businesses. Lending Club itself plans to launch a small-business lending platform next year.
“Some of these newer online lenders are providing lower interest rates than most cash-advance people, and providing same speed, and that’s what I consider very interesting,” says Renton. “If you can pay 18%t APR on loan, and have it in two days, that’s a very attractive proposition for a lot of small business owners.”
But what’s been truly driving the market this year, said Renton, is the interest from the institutional investors like hedge funds, insurance companies and private equity looking to buy up loan offerings on Prosper and Lending Club sites to add to their portfolio mix.
According to Sanborn, more investors are now coming to Lending Club’s market to shop for loans to add to portfolios, in search of high yields and low duration from products derived from low-risk borrowers. “Over the last two-to-three years, we’ve seen a broad diversification on who’s investing,” he said. Instead of smaller investors placing opening lender accounts of $10,000-$20,000, “we’ve moved into higher net worth individuals, and increased dealings with those individuals through registered investment advisors, family offices, and broker-dealers like Morgan Stanley.”
Sanborn estimates that investors based on the average one-month interest rate of 14.63% charged to Lending Club borrowers since 2007, minus fees and an annual default rate of 3% are getting 6 to 10% returns on P2P loan portfolios.
For Prosper, says Vermut, one of the chief goals of new management was to make the service more friendly to institutional investors a market for which Aaron Vermut and his father Stephan (Prosper’s new CEO) along with Suber imported their experience with through the prime brokerage and hedge-fund advisor Merlin Securities. All three headed that firm before joining Wells Fargo when Merlin was sold to Wells by sponsor Sequoia Capital in 2012.
“We knew how to create an institutional structure, we knew how to explain what we’ve done [in a way] that would create confidence with institutional investors,” said Aaron Vermut. “We know who they are, how to close them, and we were able to bring on some interesting partners in pretty quickly.”
Despite the P2P market’s small size, what’s attractive to investors is the opportunity “to get access to consumer credit directly” rather than through derivatives and securitization of unsecured consumer debt, said Vermut. “But to create a bespoke portfolio that meets your own investment criteria to buy a piece of loans or whole loans, is a totally unique asset class and value proposition,” he said.
Under the new management, Prosper adopted a bankruptcy remote business model that shielded the notes held by lenders from the company’s business operations. This reassured investors that they were only exposed to the risk of the loans they held, and not any corporate misfortunes (a similar structure already existed with Lending Club). Prosper also settled a longstanding class-action lawsuit by Prosper 1.0 investors for $10 million bringing an end to the company’s problematic first stage in which defaults soared above 36%.
Also, in February Prosper dropped bid data from the site, a nod to institutional investors needed to protect proprietary data on the loans in their portfolios. “All the large investors, you could find every single one of them, every loan they had invested in, and you could piggyback on them,” said Renton. “I thought they should have shut down earlier.”
Among other changes, Prosper revamped its website to simplify the loan application process and corrected serious omissions in navigation structure such as allowing borrowers to save the progress of an application to finish in a later session. Prosper also dumped its former credit-scoring service to adopt the industry standard FICO model to improve rates assignment and approvals. Vermut said the new executives were surprised to learn that borrowers were often not given proper rate offers such as when customers who should have been receiving 10% interest rate offers were instead being quoted 18% and walking away. “Our pricing was simply not competitive and we were missing it,” said Vermut. “We needed to be more accurate, more user friendly and more simplified.”
Both Prosper and Lending Club make money from fees and interest (lacking charters themselves, both companies originate their loans through WebBank, a $138 million-asset state-chartered industrial bank in Utah). The online format allows P2P to fund loan operations at one-third the cost of a retail bank, according to Lending Club. “We don’t have branch infrastructures, and don’t have capital reserve requirements,” says Sanborn.
Lending Club, the largest P2P lending site in the industry, was on path to turn its first annual profit $100 million in 2013 and has announced plans for an initial public offering in 2014. In addition, banks are being added to the Lending Club platform as a source of leads and applications. This past summer, Lending Club inked deals with Titan Bank of Mineral Wells, Texas and Congressional Bank of Bethesda, Md., to offer personal loans through those community banks’ branch retail operations.
But those weren’t the only major headlines this past year. In May, Lending Club received a $125 million investment from Google and added another big-name board member in former U.S. Treasurer and recent Federal Reserve chairman candidate Larry Summers to join former Morgan Stanley titans John Mack and Mary Meeker.
Prosper has its own high profile board members such as former Consumer Financial Protection Bureau deputy Raj Date and received a $20 million investment from Sequoia Capital when the Vermuts and Suber were brought in. (Prosper was founded in 2005 by former E-Loan executive Chris Larsen.
The industry’s dispute with the SEC in 2008 is often the dividing line between today’s P2P market vs. the original lending models envisioned by Larsen and Lending Club founder Renaud Laplanche, when both companies were looking to erode the dependence on the traditional financial institution in the personal loan space.
But the SEC filed a cease-and-desist letter, arguing both firms were selling unregistered securities in the form of loan promissory notes. Both firms settled and went through a formal registration process, complete with a dormant quiet period in which neither sold loans to the investing public (Lending Club continued to issue loans to borrowers with its own funds).
The prospect of awaiting for registration approval prompted a potential third entry into the P2P field, the UK-based Zopa, to drop plans to enter the U.S. marketplace. But by 2009 Prosper and Lending Club were back selling to investors in the states they were permitted to do so.
Regulation is still a threat now that the CFPB is in place, however. Questions emerged shortly after the passage of Dodd-Frank as to what authority the consumer bureau would have over P2P and direct-online lenders, particular those already under the auspices of SEC oversight.
In 2011, the U.S. Government Accountability Office released a much-anticipated study outlining the future roadmap of regulation for the peer-to-peer market. One path would continue an SEC oversight approach where federal-level securities regulation would govern lenders while states ensure compliance to borrowers’ rights; another would be the reclassification of P2P loan investments as consumer financial products that would place the industry under the CFPB’s watch. The GAO made no recommendations for any projected option.
Upstarts Targeting Niches
The surge this year in P2P lending volumes isn’t the only evidence of the market’s rise. In the past year, several upstarts in P2P have been announced, although many are involved in niches like small business or microfinancing. Some, like Lending Club’s Sanborn, see firms launching that will bring the peer-to-peer format into auto lending and purchase finance, as well.
One firm that garnered Renton’s attention is BorrowersFirst, a fledgling lending site that as its name implies will place the emphasis for its retail business exclusively to borrowers by providing more customized features in regard to rates and maturity length. Renton said the firm won’t be offering a public marketplace for loan shopping by investors, but will instead turn to accredited investors who will have to buy whole loans rather than portions of loans as allowed by Prosper and Lending Club.
Lending Circle, a U.K. P2P lender, has opened up shop domestically with a $35 million investment in a new U.S. arm based in San Francisco. Another firm planning to launch in the first quarter of 2014 is FreedomPlus, a Freedom Financial Networks affiliate company that is headed by former Prosper and Lending Club executive Joseph Toms. Toms plans to expand the peer-to-peer universe into a mid-prime territory for consumers with scores below 660 FICO (the minimum cutoff for Prosper and Lending Club) who are emerging from crisis-era financial problems or whose scores are weighed down by excessive debt that could be alleviated through personal loans.
With Prosper’s poor experience with bad-credit borrowers, this would seem to be folly. But over the past five years, Toms said, Freedom Financial offered a debt consolidation product through debt-settlement companies that worked with consumers with average credit card balances of $16,300. Though they had an average FICO of 576, “the default running rate was under 2%,” he said. “There are a lot of people out there with large balances that have poor credit scores but have fundamentally put into place the necessary things that allow them to become better credit scores.”
The capital markets demand for P2P loans has spawned a different line of startups, as well, in the launch of new institutional analytics and automated loan-buying platforms. For example, analytics firm Orchard in New York—which recently brought in former Citigroup CEO Vikram Pandit as an investor—builds portfolio models of P2P loans on Lending Club’s market for clients based on desired yield and risk parameters and automates the loan-purchase process.
Why do hedge funds need analytics for this market, given the public availability of the loan requests and performance data? Experts point to the relative scarcity of loans to purchase, and the speed in which investors must act to find the best loans. “Allocation is difficult is in this space, so even if you wanted to put money to work you’d have to go to platform and be approved for it,” said Matt Burton, CEO and co-founder of Orchard. “Currently I think there is two to three times more demand [for loan fulfillment] than there is supply, so a lot of people are getting left on the sidelines.”
Nascent Secondary Market
There is some interest in securitizing P2P. Both Prosper and Lending Club platforms allow for the trading of existing notes, but most are only available through small, non-collateralized allotments and don’t provide updated risk parameters of borrowers, according to Burton. So In October, Eaglewood Capital Management completed the first-ever $53 million securitization of a package of consumer loans originated through Lending Club. Securitization appeals to some institutional investors that could not invest directly in through Prosper and Lending Club’s marketplace, according to Eaglewood CEO and chief investment officer Jon Barlow. “It’s a unique combination of high-yield, short duration and high credit-quality that I did not see, and continue to not see, in traditional fixed income investments,” he said.
“I think another [value proposition] is the price discovery piece of the secondary market,” said Orchard’s Burton. “That will help institutional investors value their current portfolios, which is kind of a missing piece.”
Lending Club’s Sanborn, however, doesn’t see a strong demand for securitized products just yet. “There may be some people who are buying and trying to flip at a premium to people in states where Lending Club is not available to retail investors,” he said. Expanding the secondary market “is [far from] the No. 1 request” the company receives. “The typical behavior is not to get out of their investment. It’s typically looking to get more of them.”