Where Does P2P Lending Fit in a Family Office Portfolio?

[Editor’s note: This post originally appeared on the LendIt Conference blog.]

Where does P2P lending fit in a family office portfolio? This is the question that was posed to me by a very prominent family office who was kind enough to share their asset allocation plans with me:

2013 2014e 2015e Long Term
Cash 8% 3% 3% 3%
Fixed Income 33% 39% 33% 20%
Public Equities 31% 23% 23% 20%
Alternative Investments 7% 5% 5% 9%
Real Assets 9% 14% 17% 20%
Private Investments 12% 17% 20% 29%
Total 100% 100% 100% 100%

 

Just taking a close look at this chart, P2P could fit in many places, but where should it fit? 

Should P2P fit into the fixed income bucket?

P2P lending is obviously a fixed income product, but it doesn’t share the same characteristics as a traditional family office fixed income portfolio, which is typically comprised of government treasuries and tax-free municipal bonds. P2P yields are much higher, the asset class is not liquid, the borrowers are vastly different, durations are shorter, and there is no independent ratings system like a traditional public bond. P2P is an awkward fit for the fixed income portfolio, it should probably be allocated to another bucket.

Should P2P fit into the public equities bucket?

P2P lending is clearly not a public equity, but the notes share some characteristics with public equities. Namely, the 7-9% target returns (in the US) match the long term trends of the public markets. Plus, the P2P lending platforms are mostly early stage businesses that carry operational risk similar to an equity investment (yes, the risk is minimized through bankruptcy remote structures). Overall, there is probably a better bucket for P2P lending.

Should P2P fit into the alternative investments bucket?

This category is a potential fit. P2P lending is high yielding, short duration, uncorrelated investing. The Alternative Investment bucket often is the bucket for things that are uncorrelated to the markets and are difficult to benchmark, which sounds a lot like P2P lending. Alternative Investments typically include long/short hedge funds, macro funds, and liquid credit funds. These strategies are typically very scalable and relatively liquid, which differs from P2P lending. You could probably include P2P in this category but there still may be a better fit elsewhere.

Should P2P fit into the real assets bucket?

Maybe we are thinking about P2P lending wrong since marketplace lending is just a methodology for allocating capital and not really an asset class. The three broad categories for P2P lending are consumer, small business, and real estate. Real estate crowdfunding is a real asset and should be allocated to the Real Assets bucket. It makes sense to split up P2P lending into its asset classes and allocate real estate to the real assets bucket. 

Should P2P fit into the private investments bucket?

What is this category private investments? It includes private equity, venture capital, and direct private investing. This category probably makes the most sense for consumer and small business P2P lending. In the consumer space, this is a market that has been monopolized by banks for 30 years through credit cards. Now that marketplace technology has cracked it open for everyone else, it is a newly investible asset class of private debt. In the small business space, this is a market that has been overlooked because of the structural and regulatory issues faced by banks. While the banks cannot economically originate and underwrite small loans for small businesses, P2P technology platforms are able to proceed efficiently without competition creating financing where no market existed previously. Again, this is a newly investible asset class of private debt. Private debt seems like a close cousin of private equity. The private investment bucket is probably a nice home for consumer and small business P2P lending.

P2P Lending is Catching a Rising Tide

It is interesting that this family office had decided to reduce exposure to Fixed Income and Public Equities and increase exposure to Real Assets and Private Investments. P2P lending fits nicely into this shifting allocation. I suspect that many family offices are going through a similar allocation shift just as P2P lending is rising in prominence. This allocation shift is evidence that P2P lending is catching a rising tide.

For those family offices that are ahead of the curve, LendIt Europe will the place to go to network with Europe’s top P2P platforms and the industry’s most important investment managers. Perhaps you will leave with a better understanding of where to put P2P lending in your portfolio.

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Edward
Edward
Nov. 11, 2014 9:24 am

Thanks, Peter, for sharing this. I enjoyed your “which bucket” analysis. I was also surprised by some of the large shifts among the various asset classes for this one family. Good food for thought as we all consider our own individual asset allocations in the upcoming years based on our own unique view of the risks, rewards, historical returns, fundamental economic shifts, gut feelings, risk tolerance, etc.

Brendan Ross
Nov. 11, 2014 10:04 am

Hi Jason, I respectfully disagree with some of your assessments, and this is important enough that I will weigh in at length.

P2P loans are fixed income. Liquidity is a separate matter.

Fixed income is blessed with a simple definition: you lend money, you get paid back, your risks are defaults and inflation.

This exactly describes P2P loans, whether to individuals or to small businesses (as in my fund).

P2P loans are vulnerable to the macroeconomic risks of fixed income: if we have a recession, defaults will rise (and these numbers are reasonably well understood).

I have dozens of family offices and financial advisers as clients, and when P2P is added to a portfolio the losers have generally been either other fixed income, long-short equity, or both.

Whatever P2P is replacing, the fact is that P2P is classic fixed income. This is perhaps P2P’s greatest triumph: to deliver high returns with low risk within a completely standard asset class.

I am going out on a bit of a limb here, and exceptions abound within true alternatives, but returns from most other non-fixed-income investments are characterized by their relationship to the price of something: stocks, real estate, the future value of private companies, timber, commodities. While some strategies may be pure beta and others may base their value-add on alpha, there is an important element of beta which comes back to price and volatility.

Even “market neutral” strategies such as long-short equity are measured based on their ability to avoid beta.

The risks in a portfolio exposed to pricing beta are measured in terms of volatility: how much do prices of X move up and down, and how much will the portfolio move as markets move.

Expected long-term upward movement in price versus the pain of short-term volatility: that doesn’t sound much like P2P.

Let’s talk about liquidity. It is absolutely true that some P2P investments are not especially liquid. However, they are also the same in one respect: they self-liquidate. You don’t sell a P2P investment to get returns, it just melts away over time into principal and interest.

Not all fixed income strategies are liquid, because not all fixed income trades. Auto loans, structured settlements, and other fixed income strategies that have been securitized are all illiquid before (and often after) their securitizations.

LendingClub, Prosper, and the small business platforms I buy from can be conceptually understood as performing a new kind of fixed income securitization: rated loans are sold to one or more investors with an attached servicing agreement.

There are plenty of true alternative investments that operate within fixed income. Many are characterized by the purchase of non-performing loans. These investments depend on legal recoveries, not the simple, self-liquidating cash flows that you get from a portfolio of performing P2P loans, and so they are true alternative investments.

Professional investors are in the business of boxing risk, and P2P loans are clearly fixed income.

Brett Byers
Brett Byers
Nov. 11, 2014 11:21 am

Hi Jason, I think P2P is clearly fixed income (for the reasons stated by Brendan). I don’t even see it as even slightly questionable.

I am the Chairperson of the Investment Committee of Rainforest Trust, and we have moved the bulk of our fixed income over to P2P (from high-yield bonds, which now provide lower yields and carry risk of depreciation should we enter a rising interest rate environment).

Prosper and Lending Club notes (the bulk of P2P for now) are most analogous to credit card receivables, which have been packaged and sold as fixed income products for years.

Reflective-Rupee (on Prosper)
see: https://www.lendacademy.com/one-of-prospers-largest-individual-investors/

Emmanuel
Nov. 11, 2014 6:37 pm

Jason,

I also think P2P is fixed income. We compared Lending Club / Prosper performances with many different asset classes, and the highest correlation with clearly with consumer credit, itself a sub-class of fixed income.

Prescott
Nov. 11, 2014 8:02 pm

fixed income..

Andrew Johansen (Randawl)
Andrew Johansen (Randawl)
Nov. 12, 2014 2:54 pm

Jason,

While I appreciate your efforts at writing a light PR/advertising piece for the blog and detailing your thought process, I think your attempts at classification are off the mark.

Brendan clarified this well a few posts above, as he has some background in investing/advising/etc.

Either way
Either way
Nov. 12, 2014 3:40 pm

call it what you want…you will lose your money in downturn whatever it’s called. this is an industry on the cusp of carnage.

RawRaw
RawRaw
Nov. 13, 2014 9:02 am

Either way, how did consumer portfolios perform in the last crisis (the worst in some time)? Care to share your numbers from the past to give us a glimpse of the carnage to come.

Either way
Either way
Nov. 13, 2014 9:26 am

Those loan portfolios were underwritten by banks with a balance sheet and skin in the game. Not origination platforms which take a spiff then dump risk off to investors.

RawRaw
RawRaw
Nov. 13, 2014 2:57 pm
Reply to  Either way

LendingClub doesn’t choose which loans I fund. So I choose the risk, just like the bank. So again, how did consumer portfolios perform?

Brett Byers
Brett Byers
Nov. 13, 2014 12:11 pm

Either Way and RawRaw,

P2P performed quite decently in the last downturn compared to other fixed income classes with high yields.

High yield bonds, on average, lost about 30% of their value from the peaks on 2007 to the depths of 2008. Junk bond defaults peaked at 10% in 2009, versus yields of about 10% on junk bonds going into the 2008/2009 downturn.

On average, LendingClub loans issued going into the 2008/2009 provided positive, low-single digit returns. The same was true of Prosper loans, except for the riskiest loans (the HR rating), which provided slightly negative returns, but primarily because of lenders bidding the interest rates down too low via the dutch auction system then in place at Prosper. This system is no longer in place at Prosper, and the interest rates on HR rates loans are now twice the level from prior to the 2008/2009 economic meltdown.

Of course, as noted above by several above, the consumer lending on LendingClub and Prosper is most similar to the credit card segment of banking. For decades, the net annual interest rates (net of defaults) for the credit card segment has been about 10%. Interest rates have tended to be in the teens, with default rates nearly always under 5%. In 2009, default rates peaked at about 10%, still under the mid-teen average credit card interest rates then prevailing. The Federal Reserve published great data on this segment.

And many banks were totally creamed in the last downturn. If you look at the equity in CitiBank or Bank of America, it was mostly wiped out in the 2008/2009 downturn and continues to traded at levels that are closer to levels from 1990 than that of 2007.

RawRaw
RawRaw
Nov. 13, 2014 3:02 pm
Reply to  Brett Byers

Thanks Brett for responding; however, I was being sarcastic as I already know the answer. To clarify your points for someone who may not be as familiar, figured I would respond:

1) I don’t agree that credit cards are the most similar to LC loans. Credit cards are revolving credit, which past dues and charge-offs are considerably different than installment credit. I’d say the average LC loans are much more similar to the consumer loan category on the Call Reports filed by US Institutions. The further down the credit spectrum you get, the more you have to filter the Call Reports for significantly higher than peer yields to find banks that served this segment.

2) Banks weren’t creamed from their consumer portfolios in most situations. It was real estate backed assets. The consumer portfolios risk did spike, but were not the leading cause for banks having trouble.

3) The market value of junk bonds have much different credit risk profile than the average LC consumer.

Brett Byers
Brett Byers
Nov. 13, 2014 3:21 pm

Raw Raw,

I disagree on your points 1 and 3. Credit card accounts that carry balances are, in fact, very similar to term loans, as those that carry balances generally cannot pay them off (without a refinancing). Junks bonds are relatively high yield and high default rate debt like P2P.

On point 2, I only pointed out that banks were creamed, not which portfolio caused the problem. In fact, I pointed out that credit card portfolios did well (like P2P, other than Prosper HR rated loans) in the downturn – and for good reason, as P2P is mostly credit card refinancing, so it is very similar.

RawRaw
RawRaw
Nov. 13, 2014 3:35 pm
Reply to  Brett Byers

Brett, #1 is simply not true. The definition of default is different. The expectations of payments to be current is different. You state that those carrying balances cannot pay them off without refinancing, but reference that the interest rates are similar? You seem to be contradicting yourself.

Do you have data to prove that the average LC borrower with a 699 FICO Score and $73M income has the same risk profile as junk bonds? For one, you are comparing market values of junk bonds to LC (for which we have no market values). Unless the 30% was not important and you are focusing on 10%?

Just based off of the totals from LC website, you’d be correct in saying the average is similar to 10% as its currently 7.8%. However, this is a skewed data set. 70.9% of LC loans (A/B/C) have a weighted average charge off rate of just 3.9%

I was very purposeful to indicate average LC borrower. I probably should have been more specific. I do not consider E/F/G loans indicative of the average LC borrower — but I don’t have the data to know conclusively if this is entirely correct assumption.

Brett Byers
Brett Byers
Nov. 13, 2014 3:38 pm

Raw Raw, Best wishes. I wonder who you are?

Dear "marketplace" lemmings
Dear "marketplace" lemmings
Nov. 14, 2014 7:15 am

https://www.pehub.com/2014/11/lendingclub-with-plans-to-go-public-also-seeks-a-buyer/

Looks like your guru Renauld, and his VC backers, are trying to head for the hills. Get rich and punch out before the world (and their models) melt. If you think LendingClub is trying to change the world and the banking system, you are fooling yourself. This is about growth at all costs and selling out while the going is good. All of it wrapped in Silicon Valley jargon.

Peter Renton
Admin
Peter Renton(@peter)
Nov. 14, 2014 8:16 am

I published a short post about this rumor:
https://www.lendacademy.com/lending-club-seeking-buyer/

I have no idea who you are and I do not appreciate the fact that you never use a real name and you always register your comments with a fake email address. While I am happy to welcome dissenting opinions it makes me wonder what you are hiding and what your real motivation is here.

Brett Byers
Brett Byers
Nov. 14, 2014 1:18 pm

I second Peter’s comment.

I note that nearly every company going public also considers selling itself at the same time (unless it is really huge such, such as Alibaba, Facebook, or Google, such that finding a buyer is not so practical). Indeed, some companies file to go public to put themselves into play to be sold. Sale of a company in fact is the most common outcome for a venture backed company.

While there will be ups and downs in the P2P industry, the industry is still early stage and has very far to grow. With its huge cost advantage over the banks (and nimble ways and better credit underwriting in many cases), it is destined to be a huge chunk of debt issuance system, up from a still tiny piece of the financial industry.

I note several commentators above that use pseudonyms, which causes me to question their motives . . .

Jason Jones
Nov. 15, 2014 1:03 pm

All,

Thank you for your thoughtful comments.

This a hot topic and deserves much more rigorous analysis by someone much smarter than me. Our industry lacks authoritative research pieces on P2P risk and P2P asset allocation.

I have additional thoughts on both:

1) P2P Risk: credit card defaults doubled in our last recession, do we know how consumer installment loans performed? Logically, it would seem like in times of stress, people will pay their credit card minimums since they plan to continue to dip in those revolving balances for life expenses whereas the installment loan will be a lower payment priority. So it is quite possible that installment loans perform significantly worse that cc defaults. In 2009 three of the largest personal installment loan companies exited the industry: CapitalOne, Bank of America, and GE Capital. In aggregate their loans books were over $30 billion. Just how bad was it for them? What were their peak default rates? Is their combined performance in 2008/9 representative of potential peak default rates for prime grade Lending Club and Prosper borrowers? Again, rigorous analysis is needed here, preferably an academic study.

2) P2P Asset Allocation: isn’t it ridiculous that the largest fund managers in our industry show their performance compared to the Barclays AGG index and the S&P 500 index? Consumer P2P loans just have no correlation to either of those indexes so it is silly to benchmark them as such. Our process for asset allocation it is about putting investment products into a box and then using a benchmark against that box. This methodology is old and crusty.

Brendan, I like your last comment, “professional investors are in the business of boxing risk.” Unfortunately, our current asset allocation framework is about boxing investment products, not risk.

Check out this white paper from Cambridge Associates, which proposes to scrap Asset Allocation and switch to Risk Allocation: https://www.cambridgeassociates.com/our-insights/research/from-asset-allocation-to-risk-allocation-the-risk-allocation-framework/.

I love this Risk Allocation approach. It doesn’t really matter what bucket P2P goes into. If someone takes money out of L/S Equity in Alternative Investments and adds it to P2P Lending in Fixed Income, who cares how the ratios of Alternative Investments to Fixed Income shift? What matters is how has the risk shifted in the portfolio and what is the resulting return.

So the bottom line is that in order to think about portfolio management, we should first figure out how to quantify P2P risk and then figure out how that risk variable interacts with the other risk variables that exist within a diversified portfolio.

One last thing, contrary popular opinion, if I had to drop P2P into an asset allocation bucket, I would still chose Private Investments. We will have to disagree on that one 🙂

Jason Jones
Feb. 11, 2015 3:18 pm

Here is an interesting white paper entitled “Investment Consultants in Private Debt” written by Preqin. Fig 7 on page 4 shows where consultants are allocating private debt. Interestingly, 20% put it in Alternative Assets, 20% put it in the Private Equity, and 17% put it in Fixed Income. https://www.preqin.com/docs/reports/Preqin-Special-Report-Private-Debt-Investment-Consultants-February-2015.pdf