The basic rule of investing is simple - the greater the potential reward the greater the risk. So it must be clear as day that when crowdlending platforms boast returns in the excess of 10%, there must be great risk present. Stock market's historical average return is around 7%, which is traditionally considered as the best performing asset class.
How can it be then, that peer to peer lending platforms can state much higher returns? And it's not just marketing bullshit. I am personally getting absolutely stunning returns on many platforms, much higher than 7% on most of them.
| Platform | returns |
|---|---|
| Bondora | 17% |
| Crowdestor | 17% |
| Swaper | 16% |
| Bulkestate | 15% |
| Robocash | 13% |
| Mintos | 12% |
| Peerberry | 13% |
| Estateguru | 10% |
| Viainvest | 10% |
| Crowdestate | 10% |
So many platforms with 10% or higher return? How can that be?
The truth is complicated, but I'm going to do my best to clarify. It's a long post, but it's worth the read if you are considering investing in peer lending or already have.
9 risks of peer to peer lending
1. Issuing a loan or refinancing it
In the consumer lending space, the first crowdlending platforms made money by issuing loans directly to borrowers and asking investors to finance them. The beauty of this is that there are no middle men and the platform has all the control. Interests tend to be high, too. In the case of Bondora, which operates with this model, some interest rates are over 270% annually.
These platforms commonly make their profits through fees of organizing the loan, billing and a small percentage of the interest. The problem for the investor was though that the risk was all on the investor. If the payments were late, it was mostly your problem. Sure, they'd do the debt collection for you, but it would take years to recover all the principal. The platform therefore doesn't have much to gain from a high quality risk profiling.
Other platforms refinance existing loans by other loan originators they partner with. The beauty of these platforms is that while they too tend to get their profits from organizing the refinancing, the loan has originally been issued by someone who took on risk. The loan originator would have had to keep the loan in their balance sheet, if it would not be refinanced. This usually means they will have applied much stricter risk profiling to the loans.
Business loan platforms operate in very similar fashion: some finance their projects directly, others refinance existing loans and some have agreed on a third party to fill in missing gaps.
Point 1: Look for risk dynamics, who is taking the risk? If you as the investor take on all the risk, ask for higher interest.
2. Skin in the game
It is extremely important to understand the mechanism of how the platform makes money itself. As mentioned, some platforms make their profits mostly through fees. In that case, the higher the volume the better. In the ever increasing competition for private investors' money, platforms that have a skewed interest for quantity over quality and no risk will probably not care as much about how well the bad debt will be collected.
Some lending platforms (e.g. Crowdestor) put always their own "skin in the game" as well. This means they will always finance part of the loan with their own money. If the loan would fail, it needs to hurt the platform for this to have an impact. If the fees etc. are enough to cover for this, then it probably will not function as it should.
When a platform puts their own money in the loans they provide to investors, it aligns their financial interests with yours. This is extremely important. Platforms do this, since they want to scale up. They won't have the balance sheet to invest in all the projects they find, so they use private investors to leverage their project portfolio. As long as your financial interests are aligned, it's good. But watch out for too grandiose plans.
Point 2: Make sure your interests are not misaligned with the platform / loan originator.
3. Aftermarket and loan duration
What if the stock market plummets and you know in your guts it's time to buy? What if you find the house of your dreams and you're short in down payment, but don't want let it slip through your hands? What if you wreck your car and need to replace or repair it quickly?
Things happen - things that suddenly increase our need for cash. When they do, liquidity becomes very valuable to you. Sure, if you have no plans to touch your investments for years, then more power to you! When we do give up liquidity altogether though, we need to be damn sure the opportunity cost will not come back to haunt us.
How will the principal you've invested return back to you?
Each loan will have a duration. The shortest ones are even just 30 days, like on Robocash and Swaper. Some platforms will let you invest in loans with up to 60 months duration, such as Bondora and Mintos.
A lot of the larger platforms that have been around longer provide an aftermarket. The loan aftermarket will provide liquidity in case you need to turn your loans into cash. Selling loans on the more efficient aftermarkets, such as on Mintos, will have negligible impact to you financially. On less efficient aftermarkets, you will need to give a proper discount for someone to take the loan off your hands.
The longer the duration of the loans you're investing in, the more valuable an aftermarket becomes. Keep in mind though that although there might be buyers today eager to take your well-performing loans off your hands, things can change.
Point 3: If you value liquidity, ensure it by short duration loans or an efficient aftermarket.
4. Balance sheets and buyback guarantees
It has become increasingly popular to provide buyback guarantees for loans. A buyback guarantee means that if the borrower is unable to pay back the debt in the agreed schedule, the loan will be bought back from the investor - usually within 60 days from missed payments. Loans that have a buyback guarantee usually have much lower interest (except perhaps on Crowdestor). When you don't have buyback guarantee, you should definitely expect higher interest, unless the project is very low risk.
In the case a loan is bought back with a buyback guarantee, some platforms will pay for the lost interest for the time the loan was delayed, others will not. On at least Mintos, Robocash, Swaper, ViaInvest and PeerBerry, the buyback guarantee also covers for the accrued interest for the time the loan was already late.
When the accrued interest is not covered for, it means the principal in your late loans are not working for you, but laying idle. To compensate, you should ask for a higher interest.
But buyback guarantees sound great right?
They're not all great.
Someone always takes the risk. In the case of buyback guarantees, it's the company that provides the guarantee. And when that front fails, the investors will pay.
I've mentioned the case Eurocent in my Mintos review. Most of the platforms that aggregate loans from multiple loan originators do not provide the buyback guarantee themselves, but instead, the loan originator is the one who will have to buy back bad debt. This is the case for example in Mintos. Eurocent was providing buyback guaranteed loans, but got into trouble and went bust. Even though loans had a 'guarantee', investors still lost money.
A weak balance sheet and a bad risk model will produce horrible results combined with a buyback guarantee. For a while it might seem like the platform is doing great, all late loans are bought back, everything's fine and dandy. Then one day, complete radio silence, more and more loans go late without being bought back. You'll eventually read from the news that the platform has become insolvent and will not be able to buy back the bad debt.
Robocash is so far the only platform that takes on the buyback guarantee risk for them self. This would be a problem, unless Robocash was not owned by a financially very solid parent company (read more in my Robocash review). When the platform is the one taking on that risk, it's an all-or-nothing game. If the platform goes insolvent, everything on it is affected.
In the case of e.g. Mintos. the platform will not fall even though one of their loan originators go bust. This is good and bad. Good, because you can diversify across multiple loan originators and thus mitigate catastrophic failure. Bad, because you probably won't have resources to go through the balance sheets of all loan originators and you'll therefore be exposed to some bad apples. With a buyback guarantee, you don't have to be so worried about diversifying within a platform, but you do need to diversify across loan originators.
Crowdestor is collecting a separate buyback fund to be used to cover losses - for as long as there're funds in the fund. This feels smart, albeit not the best selling argument for investors who don't think too much about platform risk.
Point 4: Buyback guarantees only work if the company issuing them doesn't become insolvent. Make sure you know who is issuing the buyback guarantee and don't put all eggs in the same basket. If you invest in loans without buyback guarantees, diversification is even more important.
5. Collateral, personal guarantees and personal bankruptcy
If no individual gets any tangible shit for a loan you invest in going bad, you should really consider if the reward is worth the risk. When no individual is really accountable, but instead a company, or worse a shell corporation, how careful can you expect people to be with your money?
When investing in consumer loans, the country you invest in has tremendous impact. In Finland for example, your debt is forever yours so long as the debtee keeps formally reminding of it. Even if one fails to pay back their debt, there's a minimum interest the loan will forever accrue.
Personal accountability is a powerful motivator. If someone's personal financial life is on the line, they will stop at nothing to paying back the debt.
Some countries have mechanisms to 'reset' one's personal debt, often referred to as 'personal bankruptcy'. While I'm fully in support of this mechanism, it's not favorable if you're investing in consumer loans.
Even better than a personal guarantee is collateral. Having collateral against the loan means that if the debtor fails on payments, there's a clear legal procedure for the loan originator to seize control of the debtors possessions. Collateral works equally well with personal as well as business loans.
Even if you invest in buyback guaranteed loans it pays to pick loans with collateral. When there's collateral, failed projects will not take as large toll on the balance sheet of the platform, if any.
Point 5: Make sure it really stings the debtor if the debt isn't paid. Favor collateral even with buyback guarantees, since it eases the pressure on the platform's balance sheet.
When investing in consumer loans, the country you invest in has tremendous impact. In Finland for example, your debt is forever yours so long as the debtee keeps formally reminding of it. Even if one fails to pay back their debt, there's a minimum interest the loan will forever accrue.
Personal accountability is a powerful motivator. If someone's personal financial life is on the line, they will stop at nothing to paying back the debt.
Some countries have mechanisms to 'reset' one's personal debt, often referred to as 'personal bankruptcy'. While I'm fully in support of this mechanism, it's not favorable if you're investing in consumer loans.
Even better than a personal guarantee is collateral. Having collateral against the loan means that if the debtor fails on payments, there's a clear legal procedure for the loan originator to seize control of the debtors possessions. Collateral works equally well with personal as well as business loans.
Even if you invest in buyback guaranteed loans it pays to pick loans with collateral. When there's collateral, failed projects will not take as large toll on the balance sheet of the platform, if any.
Point 5: Make sure it really stings the debtor if the debt isn't paid. Favor collateral even with buyback guarantees, since it eases the pressure on the platform's balance sheet.
6. Risk correlation impacts your overall portfolio risk
How you relate to the risk of your peer lending investments depends on the composition of your portfolio. As explained by modern portfolio theory, when you add new assets to your portfolio, it is not only the amplitude of volatility that matters, but perhaps even more so the correlation to your other assets. If the newly added asset has volatility that is uncorrelating with your existing volatility, it can decrease your overall volatility.
If all of your portfolio is peer lending, then adding more peer lending will not help your overall risk. If most of your portfolio is stocks, it's a different story.
In an economic recession, stocks react very quickly. When the future expected profits shrink, investments can slow down, resulting in a vicious circle. But for example consumer loans are driven more by unemployment, which is traditionally considered a lagging indicator. In fact, unemployment often lags two to three quarters behind.
On top of the lag, platforms that offer buyback guarantees will have an extra cushion: their balance sheet. With slim cushions, investors will see either buyback guarantees being relaxed or lifted, or in the worst case platforms becoming insolvent - a dire result for investors. If that cushion is thick enough however, the platform could weather the full length of the storm. That would mean much lover volatility comparing to a stock portfolio.
Business loans behave in a different manner and completely depend on the industry they're in. Diversifying across more industries can potentially reduce overall volatility, but only if the risk is not too high. Peer lending, both consumer loans and company loans, are not extensively tried and tested in an depression. They seem to work well now, but it's anyone's guess what will happen in an economic depression.
Point 6: Consider the risk of your peer lending investments in the context of your overall portfolio.
7. Be nimble in your diversification and avoid cash drag
Needless to say, I've diversified my peer lending portfolio quite wide. I already track 16 platforms in my monthly updates where I have at least 1,000€ each.
I mention diversification many times in this post and it is a value in itself. If one platform goes down (turns out to be a Ponzi scheme for example), it's not catastrophic for your early retirement plans. Through diversification your portfolio has less volatility and thus risk.
However, diversification has some other added benefits as well.
The loan volume on platforms go up and down. The market is in constant flux.
You might have set your auto invest configurations on Swaper or Mintos just right, only to find out in your monthly regular check-up that thousands of euros are just sitting on your account, not working for you.
It has happened to me a few times, also on Bondora.
There are two reasons for this.
- Loan volumes fluctuate month to month
- The supply of investors' money is currently on the increase
When the supply and demand of capital fluctuates on a platform, it might happen that there is much more supply than there is demand. The capital must go somewhere though, right? Some investors will reduce their expected interest. Some will wait for better opportunities.
I withdraw my capital and put it elsewhere. I can do that, since I have lots of great platforms to choose from where I already have an account and I am familiar with how they function.
The fluctuation of the market is likely to be greater the smaller the volume on the platform. One excellent resource to check for platforms' loan volumes is on p2pmarketdata.com. It gives you a good idea of the size of the operation you're dealing with.
Point 7: Diversify across platforms, not only to reduce risk, but also for more efficient allocation of capital.
8. Politics will shape the industry greatly
In September 2019 in Finland, consumer loans were affected by a new regulation, imposing a maximum nominal interest of 20% on them, with any extra fees having a maximum of 150 euros per year. This put one platform I had 100,000 euros in effectively out of business.
In China, 90% of peer lending platform have already gone bust in 2019, due to stricter regulation and more is to come.
Luckily, Europe isn't China, but since a lot of platforms seem to be flocking to the Baltics, namely Estonia and Latvia, these countries have a critical role in determining the future of peer lending in Europe.
As long as consumer debt doesn't become a pronounced local problem in the Baltics or at least the local peer lending companies don't contribute significantly to it, there should be little political eagerness for regulating these platforms. At an EU level, it is luckily fairly complicated to drive through new directives so quickly it blindsides investors. If the EU considers that, it will take time and there will be plenty of warning.
I am certain that eventually, regulation will dramatically change the peer lending industry. In its current form with annual percentage rates in hundreds of percents, it's simply not sustainable. Personally, I welcome that regulation.
Point 8: Be ready for the inevitable regulation. Ensure you have a plan for that.
At the turn of 2020 both Envestio and Kuetzal collapsed without any communication to investors. Criminal investigations are on-going and there's no reason to think anything other than fraud at this point.
I've become much more careful after that with what kind of platforms I invest big into, and you should too.
9. Fraud
Most of these peer to peer lending platforms are not regulated. As limited companies, people are not personally accountable for bad financial choices as long as no crime has been committed.At the turn of 2020 both Envestio and Kuetzal collapsed without any communication to investors. Criminal investigations are on-going and there's no reason to think anything other than fraud at this point.
I've become much more careful after that with what kind of platforms I invest big into, and you should too.
Afterwords
It's a long list and I'm sure I've missed some points someone will find critical. You're welcome to point them out in comments.
I personally have had over 200,000 in peer lending platforms and through burning my fingers a few times I wish to think I've learned something. On the other hand though, I am exceptionally risk-seeking. Keep that in mind when making your own conclusions.
The whole peer lending industry is still figuring out its form and I'm sure there are unknown unknowns also: things that might hit us all like a meteor without us ever even considering the possibility. That doesn't mean other asset classes wouldn't have them, but peer lending is less tried and tested than e.g. stocks.
