Debt disruptors yet to face test from a downturn

Call it catch 22: the world is stuck with a mountain of debt that may prove impossible to repay in full, but needs more of it to try to restart economic growth.

Businesses, particularly small ones, borrow to expand, and consumers borrow to acquire, injecting demand into the economy (provided they acquire new things rather than existing assets).

Demand for loans has been subdued since the financial crisis, as both companies and individuals have endeavoured to pay down debt. But even that lower demand has provided a new investment opportunity, as so-called alternative lenders have sprung up to occupy the space vacated by banks, which were forced to cut back on lending by new regulations and constrained balance sheets.

The development has been hailed as a disruptive force, offering investors higher returns than those available on traditional savings products and borrowers' lower rates, or finance they could not otherwise have raised at all.

But, although the returns look attractive, the risks are also significantly higher.

A bank deposit or savings account is a loan to the bank, not to the bank's borrowers. The money is only at risk if the bank fails - and we already know that the top banks are too big to be allowed to fail. Deposit protection schemes offer further security.

The actual experience of investors with marketplace lenders will depend much on the accuracy of the credit assessments used to select borrowers. Rigour in credit scoring is what separates the platforms institutions select to do business with and the "wild west", according to one investor who has backed a US platform.

The sector has yet to be tested through a downturn, so whatever the claims made by platforms about the robustness of their systems and the creditworthiness of their borrowers, there are no guarantees, and no compensation schemes to bail out investors, although some platforms have escrow funds to cover defaults.

The sector is changing fast too, as institutional investors such as hedge funds muscle in. They already account for an estimated 80 per cent of the loans originated through Prosper and Lending Club, the two biggest US platforms. Banks also provide loan funding to some platforms, as do state bodies. The opportunity for retail investors to participate might well prove fleeting. Some platforms, such as Payoff in the US, exclude retail investors, dealing only with accredited investors.

Platforms have welcomed institutional investors for the volume they bring, enabling them to build scale more quickly. But retail investors are fearful that the big money will get the best deals, and could also turn tail fast in a downturn, leaving platforms high and dry.

Another development is the adoption of securitisation, bundling loans into packages and selling them to hedge funds and other investors. This widens the investor base and increases liquidity, but also raises concerns. Just as with subprime mortgages, a bundle of peer-to-peer loans could contain some at high risk of defaulting.

According to one platform operator, though, the big question for the sector is what will be the impact on returns "if too many investors start chasing this asset class and 'pushing' more debt on to an already overleveraged consumer base".

Look to the bond market for answers to that. As the hunt for yield turns to the alternative lending space, returns are likely to fall, pushing investors down the credit quality range.

According to Lendingstats.com, which crunches data from Lending Club and Prosper, historical returns to individual Prosper lenders range from the high teens downwards - all the way to the negative low teens for the worst performers. Lending Club shows average annualised returns ranging from 5 per cent for the top credit profile to 8.9 per cent for the lowest.

In the UK, Zopa, the biggest platform, is offering investors projected rates of 5 per cent over five years and 4 per cent over three years, after fees but before tax. Funding Circle, which lends to businesses rather than consumers, quotes an expected return of 6.8 per cent.

Is that really sufficient compensation for the risk investors are taking on?

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