peer2peer lending fund

Investment thesIs for a P2P LendIng fund

Ian Peacock and Robert D. FergusonSloan Fellows, London Business School

January 2015

Investment thesIs for a p2p lendIng fund | 2

foreword

This paper examines the opportunity to create an alternative finance credit fund that will build and manage a portfolio of “Peer-to-Peer” (P2P) loans diversified across geog-raphies, loan durations and sectors to provide attractive risk-adjusted returns with low correlation to other asset classes. This paper is organised as follows:

• sectIon 1 provides a brief introduction to the emergence of peer-to-peer lending.

• sectIon 2 provides an overview of P2P lending and the business models of the major US and UK P2P platforms.

• In sectIon 3, we discuss the overall market size and growth opportunity for P2P lending in the US and Europe.

• In sectIon 4, we present a model to analyse whether investors can increase their risk-adjusted returns by including P2P loans in their portfolios and the correlation of P2P returns with those of other major assets classes.

• In sectIon 5, we discuss a number of key risks that we believe investors in P2P loans should be aware of before deciding to add this asset class to their portfolios.

We conclude in SECTION 6 that there is a significant opportunity to establish a fund specialising in P2P loans that will provide investors with access to an exciting new asset class and help them to enhance their risk-adjusted returns. We believe that the fund has the potential to achieve assets under management of £1 billion by 2020.

Ian Peacock robert d. ferguson

Introduction1

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overview of P2P lending

market growth potential

modelling P2P returns

Key risk considerations

Conclusion

appendix: Platform descriptions

Contents


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Banking may be on the cusp of an industrial revolu�on. This is being propelled by technology on the supply side and the financial crisis on the demand side. The upshot could be the most radical reconfigura�on of bank-ing in centuries.

andy haLdane, exeCutIve dIreCtor for fInanCIaL stabILIty at the banK of engLand

Household indebtedness is commonly de-fined as the sum of outstanding mortgag-es, home equity loans, auto loans, student loans and credit card debt. According to the IMF, in the years preceding the 2007 financial crisis household indebtedness soared to 138% of income in the world’s advanced economies. Today this ratio is still over 100% in the US, Euro core and periphery markets.

In the UK consumer debt has tripled over the last 20 years and now stands at £1.43 trillion. Mortgages represent 89% of this figure with student loans accounting for £54.4 billion and credit card debt £57 billion, growing at 5% annually.

In the US, consumer indebtedness stands at $11.63 trillion, 8% below its 2003 peak. Mortgage balances account for $8.1 trillion with student loans accounting for $1.12 trillion as of June 2014. Credit card balanc-es at the same date stood at $700 billion and auto loans at $930 billion.

Today banks have not only paused to repair their balance sheets, they are also taking a much more conservative approach to lending activities. Banks are essentially changing their business models in re-sponse to stricter regulation and political pressure.

In response to this we are seeing the birth of a new entrant, the P2P lender. These platforms use Internet technology to con-nect borrowers directly to the lenders thus disintermediating banks from the lending process. The emergence of P2P platforms marks the simultaneous alignment of multiple disruptive forces: technology,

regulation and social behaviour to provide scalable platforms that are able to operate within the banking spread.

To date, four broad categories of P2P plat-forms have emerged: consumer, student, real estate and business lending aimed at small and medium sized enterprises (SMEs). Unlike traditional direct lending, all categories of platform allow each lender to invest in partial loans. This creates a new opportunity for an investor to access a very large number of business and real estate loans in “consumer size” amounts. As additional platforms enter the market, we expect that they will specialise in spe-cific sectors, risk profiles and geographies creating a greatly diversifiable asset class.

Figure A. Cumulative lending by the top five US and UK platforms (GBP billion) representing a CAGR of 136%.

Although the outstanding volume of P2P loans remains small at this stage, P2P lending has huge growth potential. So far traction is greatest in the US, UK and China1 with platforms targeting consum-ers and small businesses. Cumulative P2P

1 Note that while the Chinese P2P market has significant scale, due to exchange controls and uncertainties regard-ing the ability to enforce P2P contracts in Chinese courts we do not believe that the Chinese P2P market currently offers attractive opportunities for international investors. Accordingly, an analysis of the Chinese P2P industry is outside the scope of this report.

1. Introduction

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lending to date is approximately $3 billion in the UK and $6 billion in the US however the industry is set for explosive growth.

As with any new credit market place, the critical success factor will be the ability to match lenders with borrowers. As plat-forms grow they will face an imbalance in

supply and demand that can be smoothed with institutional liquidity. The deploy-ment of institutional capital can not only dynamically increase matching rates, it can also underwrite whole categories of loans allowing platforms to scale much more quickly.

P2P Lending fund | Introduction

2. overview of P2P lending

Since Zopa pioneered P2P lending in 2005 most of the growth in the industry has taken place in the US and the UK. Currently the majority of P2P lending has been facili-tated by the following five platforms:

• LendingClub, the largest US platform, has facilitated over $5 billion in loans since it was launched in 2007. Lend-ingClub focuses primarily on consumer loans but also offers small business loans, education loans and patient finance loans.

• Prosper, the second largest US platform, has facilitated over $1.6 billion in loans since it was launched in 2006. Prosper focuses exclusively on consumer loans.

• Zopa, the largest UK platform, has facil-itated over £650 million in loans since it was launched in 2005. Zopa focuses primarily on consumer loans but also offers loans to businesses run by sole traders.

• Funding Circle, the second largest UK platform, has facilitated over £400 million in loans since it was launched in 2010. In 2013 Funding Circle also entered the US market. Funding Circle focuses exclusively on business loans.

• RateSetter, the third largest UK plat-form, has facilitated over £380 million in loans since it was launched in 2010.

All of these platforms operate under broadly similar business models. How-ever, investors should be aware of some important differences among platforms

particularly in their sector focus, loan term, revenue model, pricing model, lending mechanics, underwriting stan-dards and approach to risk management. These differences have arisen for a variety of reasons, including regulatory factors and a desire on the part of new entrants to differentiate themselves from existing platforms.

All of the major platforms allow both individuals and institutional investors to lend via their platforms, but for regulatory reasons some assets may be restricted to institutional or high net worth investors. In particular, while most platforms offer all in-vestors the opportunity to invest in partial loans, the option to invest in whole loans is typically restricted to institutional or high net worth investors.

sector focus

P2P lending was originally focussed on facilitating unsecured loans to consumers, and this remains by far the largest class of loans made by LendingClub, Prosper, Zopa and RateSetter. Other platforms such as Funding Circle focus on facilitating loans to businesses. More recently, other asset classes have emerged and there are now P2P lending platforms that specialise in mortgages, student loans, short-term re-ceivables financing and patient finance.

Loan term

Most platforms require lenders to com-mit their capital for periods ranging from one to five years, although RateSetter and Funding Circle also offer shorter durations.


Borrowers, on the other hand, are typically able to prepay their loans at any time with-out any penalties. P2P loans are usually amortising loans in which lenders receive a fixed monthly payment consisting of a blend of interest and principal repayments, so lenders are repaid a portion of their principal every month.

revenue model

P2P lending platforms typically generate revenue from two sources: origination fees charged to borrowers (which range from 1 to 5% of the loan amount) and servicing fees charged to lenders (usually 1%). Some platforms, such as LendingClub, charge the servicing fee as a percentage of payments received. Others such as Prosper and Zopa charge an on-going servicing fee on the outstanding principal amount, which can result in a higher level of overall fees paid by the lender. RateSetter does not charge any fees to lenders.

These fee structures mean that the plat-forms can only increase revenues by origi-nating and servicing higher loan volumes.

Pricing models

Two main loan-pricing models have de-veloped. The original model (still followed by Zopa, RateSetter and Funding Circle) is for interest rates to be set dynamically by the market. In this model, borrowers post loan requests on the platform and lenders make bids to fund a portion of the loan at a specified interest rate. Lender bids are ranked from the lowest rate to the highest until the loan is fully funded. The borrower is provided with a weighted average inter-est rate across all of the lenders that have bid and can then either accept the bids offered or wait to see if additional lenders bid at lower rates. If the borrower accepts the bids, each lender receives the interest rate offered for his portion of the loan and not the average interest rate the borrower pays.

The second model, which is followed by LendingClub and Prosper, is for the lending platform to set interest rates for each loan according to the platform’s assessment of the borrower’s risk based on propri-etary algorithms. In this model, lenders simply select a fixed interest rate that corresponds to their risk tolerance and all lenders to borrowers in that risk category receive the same interest rate.

Lending mechanics

Two very different models for matching borrowers with lenders of partial loans have developed as a direct consequence of the different regulatory requirements in the US and the UK.1 In the UK lenders have a direct contractual relationship with each borrower and the platform is in no way liable under the agreement. In the US, in order to comply with applicable SEC regulations, the legal lender of every loan funded by retail investors is technically the platform, which in turn issues securities to investors that are backed by the underlying cash flows. The securities are structured so that the platform is only required to make payments to investors to the extent that it receives payments from the relevant bor-rower. While the differences between the two models may appear to be more form over substance, a bankruptcy of the plat-form will have very different consequences under each model as described under “Key risk considerations” below.

underwriting standards

Some P2P lending platforms differentiate themselves based on their underwriting standards. For example, in the US Lend-ingClub is focussed on making loans to “prime” borrowers with a minimum FICO score of 660 whereas Prosper will consid-er lenders with minimum FICO scores of

1 Note that these considerations are not applicable to investments in whole loans. In those circumstances, the investor holds the loan on its balance sheet and has a direct contractual relationship with the borrower.

P2P Lending fund | overview of p2p lending


640. Neither of these platforms verifies employment and income information for every borrower; instead they rely primarily on credit bureau data and their proprietary algorithms to assess borrower risk. These platforms offer investors a wide range of potential risk/return profiles and generally higher interest rates than the UK plat-forms. The UK platforms such as Zopa and RateSetter have much stricter underwrit-ing standards and significantly lower yields than the US platforms: each application is assessed for risk both by proprietary algorithms and manually by the platform’s underwriting staff. RateSetter for example claims that 85% of all loan applications do not meet their strict underwriters criteria.

risk management

Most P2P platforms, including Lending-Club, Prosper and Zopa, help lenders to manage risk by automatically diversifying their loans across a very large number of borrowers in each risk band and in rela-tively small increments (typically $25 for US platforms and £10 for UK platforms). Zopa has further mitigated lender risk by establishing a safeguard fund, funded from the origination fees paid by the borrow-ers. The fund is specifically to compensate lenders in the event that a borrower miss-es a payment or defaults. Zopa’s safeguard fund has been designed to cover approx-imately 120% of Zopa’s estimate of the amount the fund will need to cover, which in turn is above current default rates.

RateSetter has adopted a different ap-proach to risk management. Under the RateSetter model, lenders choose to lend based purely on duration without regard to the risk of the underlying borrower. Instead, RateSetter has established a much larger safeguard fund (which it calls the “Provision Fund”) funded again by borrow-ers according to RateSetter’s assessment of the risk of the loan. As a result, RateSet-ter claims that there is no need to diversify across multiple borrowers because the risk of default is already diversified across all borrowers and accumulated in the Provi-sion Fund. The Provision Fund currently covers approximately 223.2% (as of Octo-ber 27, 2014) of RateSetter’s estimate of potential claims against the fund.

These consumer-focussed protection funds are determined by the platform and held as segregated cash. They are not contrac-tual percentages.

More detailed summaries of the five major P2P platforms and their business models are provided in the Appendix.

secondary market liquidity

All of the major platforms provide a facility for secondary trading of loans. Fees are applicable and liquidity is platform de-pendent. We anticipate the low levels of liquidity available today will improve as the industry grows and central markets develop.

P2P Lending fund | overview of p2p lending

In this section we examine the main driv-ers of growth and the potential size of the market opportunity in each of the UK, the rest of Europe and the US

uK

The P2P lending industry in the UK today is a dynamic market with over 30 platforms focussed on consumer and SME lend-ing. Cumulative lending by UK platforms reached £1.89 billion in 2014 with £900 million lent in the first nine months of the year.

Figure B. Cumulative consumer lending in the UK.1

Although the majority of platforms by number (80%) focus on business lending, consumer and SME lending are similar in size based on volume of cumulative lending. In the first nine months of 2014 lending to SMEs was approximately £900 million and to the more mature consumer market was approximately £1 billion.

A significant development in the UK has been the recent announcement that the government is planning to include P2P products within ISA eligible investments

1 Peer-to-Peer Finance Association, Q3 2014 market data.

3. market growth potential

from April 2015. UK consumers have £470 billion invested in ISAs, of which £228.5 billion is held in cash or money market deposits.2 This represents a huge growth opportunity for P2P lending and a unique opportunity to create strategic part-nerships by ‘wrapping’ an ISA structure around our fund.

Consumer lending

At the end of September 2013 outstanding personal borrowing in the UK was £1.43 trillion,3 a figure that has tripled over the last 20 years and is currently increasing by approximately £90 million per day. Mort-gages represent £1.29 trillion, or 89% of the total, and outstanding consumer credit at the end of September stood at £165 billion and was growing by 6.1% per year.4

Credit card debt represents £58.5 billion of the total outstanding personal borrow-ing with current average interest rates

2 UK Government Office of National Statistics (www.gov.uk).3 The Money Statistics November 2014, (www.themoney-charity.org.uk).4 Bank of England annual growth rate estimate August 2014.

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“ “ We predict that by 2020 cumula ve lending by UK pla�orms will exceed £60 billion.

Sum of our predic�ons for the UK consumer, business and factoring markets.


of 18.06%, or 17.56% above the UK base rate. The average APR on a £5,000 person-al loan stands at 9.2%, while the average rate for an overdraft, an £8 billion market, is 19.67% according to the Bank of En-gland. These rates are significantly higher than those available from P2P platforms. For example, one year loans are currently available from Zopa at 6.9% APR.

To date Zopa borrowers have mainly used the loans to consolidate debt (21%), for auto loans (43%), and for home improve-ment (21%).

Focussing on these forms of debt we can make a rough estimate of the potential demand for loans through P2P platforms in the medium term.

Approximately 50% of UK consumers have no savings or savings of less than £1,500 per household. Conservatively, to remain comfortably in the prime borrower market we estimate that if P2P platforms were to achieve a 10% market share in credit card debt via debt consolidation, 20% of the personal loan market and 5% of the overdraft market this would equate to £26 billion in consumer lending via P2P platforms (a 26-fold increase) saving bor-rowers over £1.5 billion in annual interest payments. This impressive figure does not even take into account the potential for P2P platforms to capture a significant part of the UK mortgage market.

The CAGR of P2P loans originated by the top five US and UK platforms combined is 136% with the UK platforms alone growing at a CAGR of 104%. Applying these growth rates as upper and lower growth bands we expect the UK consumer P2P market size to reach our estimate of £26 billion in between four and five years.

This level of growth can only be achieved if the demand from borrowers can be matched by the supply of willing lenders. However, on the supply side we see a po-tential imbalance. We estimate that there are currently 75,000 consumer lenders on UK P2P platforms each lending an average of £16,000. Consumer lender numbers are growing at a CAGR of 46%, which means that at current growth rates there will be a shortfall in supply of between £10-20 billion by the time our medium term esti-mates are reached.

Even assuming higher rates of consumer lender growth on P2P platforms due to greater consumer awareness, ISA eligibil-ity for P2P loans and continued lacklustre returns from other asset classes (for ex-ample, the average annual interest rate on cash ISAs is currently 0.82%5), we foresee a significant need for institutional investors to provide liquidity to the consumer P2P market to meet expected demand from borrowers and smooth growth.

Further opportunities are also likely to arise as P2P platforms move up the value chain and challenge the mortgage lending market6 and the broken business models of payday lenders result in some pivoting into sub-prime P2P lending.

business lending

A large proportion of the outstanding debt issued by European SMEs between 2004 and 2007 is due to be refinanced by 2017.

5 The Money Statistics November 2014, (www.themoney-charity.org.uk).6 Mortgages account for 89% of outstanding consumer debt in the UK with average interest rates of 3.2% (al-though sub-prime borrowers pay much higher rates). This presents an enormous market opportunity where to date there have been limited P2P entrants. Lendinvest, a P2P platform that specialises in financing for residential and commercial property, has lent a total of £166 million and folk2folk, a specialist platform focussed on the financing of residential property in the South West of England, has lent £37 million.

P2P Lending fund | growth potential


However, many of the markets in which these loans were originally made are ei-ther closed or are operating at significantly reduced capacity. In 2012 a UK govern-ment backed taskforce estimated that domestic small businesses could face a funding gap of up to £190 billion by 2016. This presents a very attractive opportunity for P2P platforms and other alternative capital providers to fill the gap left by the banks.

Just four banks control 80% of UK SMEs’ primary banking relationships and 92% of SME lending comes from the traditional banking system. The chart below shows the decreasing trend in bank lending since the 2007 financial crisis and specifically the continued decline (4% per year) in bank lending to the SME sector.

Figure C. Bank of England: Lending to UK business-es.7

(B) Lending to UK SMEs with annual debit account turnover less than £25 million.

(C) Lending by a British Bankers’ Association panel of lenders to SMEs in Great Britain. SMEs are defined as businesses with turnover of up to £25 million. Data are to March 2014.

7 Bank of England trends on credit, July 2014.

In an effort to further boost SME lending, in 2013 the UK government formed the British Business Bank (BBB) with an initial public funding commitment of £3 billion. The BBB’s mandate is to support SMEs via established and newly emerging finance providers. To date, the BBB has lent over £800 million to UK SMEs. In 2014 the BBB began matching money lent via P2P platforms. The BBB has already committed £40 million to Funding Circle, £10 million to Zopa aimed at UK small businesses and sole traders, and £5 million to MarketIn-voice. We believe that this explicit govern-ment support for P2P lending to SMEs will drive significant growth in the market.

Based on our discussions with UK bank-ers we believe that SMEs will increasingly need to turn to alternative finance sources for their funding needs. Banks are continu-ing to jettison unprofitable banking rela-tionships and lending to small businesses is particularly capital intensive.

Aside from the people and processing cost, we estimate that the bank’s tier 1 capital requirement resulting from an average SME loan across Europe is 10 to 14% of the loan value. This is a requirement the P2P lenders do not have and as such is a sustainable competitive advantage.

We further predict that more and more SMEs will turn to P2P platforms for their borrowing needs as they become frustrat-ed by the banks’ increased due diligence processes and bureaucracy and the asso-ciated delays in making lending decisions. For many SMEs, the primary attraction of P2P platforms is the relative speed at which loans can be funded when com-pared to the high street banks.

Another promising trend is for UK banks to enter into formal partnerships in which they refer some of their SME customers to P2P platforms for their borrowing needs. For example, Santander announced a for-mal referral agreement with Funding Circle

(A) NON-FINANCIAL BUSINESSES (C) BBA SMES

(D) LARGE BUSINESSES(B) BANK OF ENGLAND SMES

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in June 2014 and RBS announced their intent to enter into a similar arrangement with an unnamed platform in October. We are aware of at least two other UK lenders that are exploring similar opportunities. The UK government has also recently indi-cated that it may require UK banks to refer declined SME loan requests to alternative lenders, which could further boost P2P SME loan origination.

To date, cumulative business lending by UK P2P platforms is approximately £900 million and this figure is growing at a CAGR of 340%. This rate of growth cannot be sustained by retail lenders alone. We be-lieve that P2P platforms are best viewed as highly efficient loan originators that create a central market in which loans are funded by a combination of retail and institutional investors.

The average size of an SME loan funded by UK P2P platforms is £70,000, the average tenor is 45 months and net returns to lenders range from 7-12%. P2P platforms anticipate that SME default rates will be between 1-2% but this has not yet been tested through a downturn. Investors should not exclusively rely on the credit analysis of the platforms in this sector; detailed judgmental analysis should be undertaken by investors to supplement the credit assessment undertaken by the platforms.

Funding Circle, the largest originator of UK P2P loans for SMEs, is growing at a CAGR of 150% with cumulative lending to date of £426 million. Considering the rate of growth to date, the announced partner-ships with banks, and government pres-sures and incentives to boost SME lending, we anticipate that the UK P2P business market could reach £20 billion in the next five years.

Factoring (invoice financing for short term funding needs) is another sector in which UK P2P platforms have become increasing-ly active. We have witnessed the creation of a tradable invoice market that offers net returns to investors of 8-12%. We believe that there is tremendous scope for P2P platforms to expand in this area. The Asset-Based Finance Association (ABFA) estimates that there are 250,000 small businesses in the UK that operate in markets suitable for invoice discounting and factoring. ABFA further estimates that the financing requirements of this market currently stand at over £300 billion and are growing at over 170% per year, of which less than 1% is currently funded via P2P platforms. Extrapolating growth and assuming a relatively modest market share of 5%, this suggests that the P2P invoice trading market could be as large as £15 billion in five years.

This market, now technologically enabled, allows efficient access to very short-term lending. We consider this an excellent vehicle to dynamically manage cash flows of the fund and reinvestment risk.

europe

P2P lending in Europe is much less mature than in the US and the UK with generally only one or two platforms operating in each market.

Europe’s P2P platforms are regulated at a national level creating as many as 28 regulatory regimes, with regulators in each country operating at their own speed and in their own national interests. The plat-forms we have polled in France, Germany, Italy took an average of two years to gain regulatory approval and generally were required to adhere to the same regulatory standards as traditional banks.



We believe that the slowness of European regulators to embrace the opportunity offered by P2P platforms, plus bureaucracy at the EU level should they try to imple-ment a harmonised approach, will supress growth and consumer confidence in the industry in the short to medium term both for domestic and cross border P2P lending in Europe.

Consumer lending

Although total real outstanding household debt has been declining steadily since the financial crisis, European households have not de-levered in a uniform way. Outstand-ing European unsecured consumer debt is currently approximately €1.1 trillion, most of which has been financed by banks.

We are seeing slow and steady growth in lending via European P2P platforms with cumulative euro area consumer lending of approximately €500 million to date. The largest European platforms are current-ly Prêt d’Union in France (€120 million), Auxmoney in Germany (€120 million), Trustbuddy in Sweden (€100 million) and Prestiamoci in Italy (€20 million).

Domestic markets are evolving at varying speeds, creating domestic opportunities of different sizes. We see this as the first stage in the evolution of P2P lending but anticipate a rapid evolution to a second stage with fierce cross border competition.

This ambition of growth beyond national boundaries will facilitate the need for insti-tutional capital to achieve critical scale for the platforms to reach escape velocity.

business lending

Despite the gradual recovery in demand for credit, European regulators continue to press banks to de-lever their balance sheets making it harder for them to lend. Local policy initiatives aimed at stimulating lending (such as the European equivalents of the British Business Bank) may not be sufficient to overcome these factors and help banks to satisfy credit demand.

According to the ECB, access to finance is an issue cited by 60% of SMEs as one of the most pressing challenges they face. In general, the ECB finds euro area SMEs require more bank loans and overdrafts than are available from banks, and almost 40% of loan applications made by euro zone SMEs were refused or only partially granted over the period.

Demand for credit will receive an addition-al boost in 2017 as many of the SME loans written before the financial crisis will fall due for refinancing.

As the chart below shows, growth in bank loans has been flat to negative in recent years, which has created a clear funding gap for European businesses.

Figure D. Loan growth (% YOY) in Euro zone non-fi-nancial business sector. Source: European Central Bank, Pictet Asset Management.

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We predict that even-tually Con�nental Europe will become a larger P2P market than the UK but explosive growth will re-quire a more suppor�ve regulatory framework.


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We believe that in the longer term P2P lending has massive potential in Europe, a market where 80% of financing to the real economy currently comes from banks. However, significant growth in Europe will only come once P2P platforms are able to operate in a more flexible regulatory environment similar to that in the UK. If a favourable regulatory environment can be established, P2P platforms will be able to compete for the €2.4 trillion in non-core loans sitting on the balance sheets of Europe’s traditional banks.

us

Two platforms, Lending Club and Prosper, currently dominate the US P2P lending market. To date they have lent $6.2 billion and $2 billion, respectively, with lend-ing volumes growing exponentially since 2009.8

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Other P2P platforms account collectively for less than $250 million in consumer lending but growth is doubling every six months with returns ranging from 7% to 25% depending on the risk profile of the borrower.

The US P2P business lending market is much less mature than the consumer mar-ket. Of the two major platforms, Prosper does not currently facilitate business loans and LendingClub only recently entered the business loan market. In addition to LendingClub, Funding Circle entered the US market in 2014 and OnDeck recently

8 Lending Academy 2014.

began offering lenders the opportunity to purchase loans via its online marketplace. All three of these platforms only make business loans available to institutional lenders.

Student loans and mortgage lending are low yielding assets that some P2P plat-forms have started to securitise. The concept is to create a low yielding portion of “rated” prime debt to place with asset managers, and a higher yielding equity component for retail and other institution-al investors. P2P student loan platform SoFi has securitised over $400m in “A” rated debt in the last twelve months.

US P2P lending has so far grown without widespread publicity and marketing. How-ever, we believe that the proposed IPOs of LendingClub and Prosper in the consumer space, SoFi in student loans and OnDeck in business lending will add further momen-tum to this rapidly growing sector over the next twelve months.

Consumer lending

According to the NY Fed, US consumer indebtedness now stands at $11.62 trillion, 8% below its 2003 peak.9 Of this amount, mortgage balances account for $8.1 trillion, student loans account for $1.12 trillion, credit card balances account for $700 billion and auto loans account for $930 billion.

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9 NY Fed Quarterly Report on Household Debt and Credit August 2014.



Lending for consumer loans, credit card and other revolving consumer credit are all facilitated via P2P lending. Gross interest rates on platforms range from 6 to 35% with charge off rates ranging from 1.9% for a grade A 36 month loan to 21.2% for a 60 month G rated loan. The average net return to investors on US platforms is approximately 200-300 bps higher than on UK platforms, possibly due to the higher risk tolerance of US investors.

At its current growth rate the US P2P con-sumer credit market is expected to surpass $300 billion by 2020.

business lending

The US has a much more advanced capital market than Europe with banks accounting for just 20% of business financing needs. This diversified source of funds has led to faster adoption of business lending through P2P platforms than in the UK and Europe as the default option for borrowers in the US is no longer the traditional banks.

In the US, public assistance to support the growth of small business is provided by the US Small Business Administration (SBA). In 2013 the SBA supported $29 billion in lending to small businesses, an increase of 10% on 2012. This growth is in direct response to the decrease in availability of bank lending.

There are 28 million SMEs in the US. In the non-farm commercial and industrial sector, loans to small businesses of $1 million or less stood at $299 billion as of June 2014, down 12% on pre-crisis levels. Of that amount, $130 billion in loans were in amounts less than $100,000, $48 billion in loans were in amounts between $100,000 and $250,000 and $120 billion in loans were in amounts between $250,000 and $1 million. If P2P platforms, whose aver-age business loan size is $130,000, were to capture 15% of the market, this would equate to $45 billion of lending.

rest of the world

This report focusses on the development of P2P lending in the UK, Europe and the US. However, it should be noted that P2P lending platforms are emerging in many other countries around the world.

Today the only significant market outside of the US and UK is China where there are over 1,000 P2P platforms operating within

a shadow banking market with assets of between $3-6 trillion. Only a small propor-tion of these companies operate online and they face a number of restrictions that limit their growth. For example, there are limits on the maximum number of times a loan can be “sliced” into smaller portions and retail borrowers may only be matched with retail lenders.

We believe that in the medium term there is massive potential for P2P lending to become a global phenomenon. Investors that are interested in investing in P2P loans in new markets will need to undertake detailed analysis of the relevant political, legal and regulatory frameworks as well as the cultural backdrop and individual credit risk regimes in each country. We are already seeing interesting developments in Australasia, Canada, South Africa, Latin America and across Asia. We intend to monitor developments in these and other jurisdictions closely so that we can identify the platforms with the greatest potential to succeed in each market and that have management teams able to execute within our investment tolerances.

“ “ The US P2P market could account for $400 billion in lending by the end of the decade.


4. modelling P2P returns

P2P lending is a new asset class that offers attractive risk-adjusted returns both in the US and the UK with low to negative cor-relation with traditional equity and fixed income markets.

Our P2P portfolio will comprise consum-er loans and ‘consumer sized’ SME loans allowing very broad diversification across the US and European debt markets. Cash management and reinvestment risk will be managed by the dynamic investment into P2P invoice financing platforms.

The loan books of the biggest platforms since the third quarter of 2010 consistently generated attractive monthly returns while also maintaining extremely low month-to-month volatility.

We were able to analyse the loan books of LendingClub and Prosper in the US and Funding Circle in the UK. We were also able to backward induce performance for the loan book of RateSetter.1

return profiles

To compile monthly returns, we priced each loan book entry as an annuity with monthly income equivalent to the amor-tized monthly loan payment. Although interest rates were determined by a combination of fixed and auction pricing, we assumed both market mechanisms accurately priced loan risk and thus set the discount factor equal to the interest rate net of fees.

1 Returns modelled do not incorporate any outperfor-mance in picking loans or allocating among loan classes. We anticipate improved performance through better than average selection.

Monthly returns were calculated by sum-ming the annuity payment and the capital gain or loss. Prepayments were treated as redemptions at par value while defaults were reflected as a near total loss of capital. Capital loss in cases of default was reduced to 95%2 to reflect the average 5% recovery of principal through collections.

The model portfolios summarised below, invested in every possible loan available on each platform, and returns are compiled on a value-weighted basis assuming no re-investment risk and no holdings of excess capital.

The risk free rate used to calculate excess return is an equally weighted average of 1, 3, and 5-year yields on US Treasuries.3 Given the brief track record and the finan-cial environment since 2010, the portfolios produced extremely high Sharpe ratios.

The Sharpe ratio has been provided for illustrative purposes only since we remain wary of drawing any definitive conclusions while the asset class is still maturing. On a monthly basis, we have only observed 47 periods during which the economy has been growing steadily and interest rates have remained persistently low. No annu-alized Sharpe ratio is provided since such a figure would only be based on four obser-vations that all occurred during a time of historically low volatility. We do however expect the Sharpe ratio to stabilise at a

2 Because of low default rates, recovery percentages be-tween 0% and 20% did not materially alter returns.3 US Treasuries were chosen rather than the Fed Funds rate to more closely reflect P2P loan characteristics.


level higher than other asset classes in the long run because of the nature of the asset.

us consumer P2P

Prosper’s loan book of approximately 100,000 loans over 47 months returned 1.17% monthly (15.0% annually) on average with a low of 1.04% and a high of 1.24%. Month-to-month volatility was 0.06% corresponding to a Sharpe ratio of 18.3.

LendingClub’s loan book consists of ap-proximately 350,000 individual loans over the same period, and a random sample of 50,000 loans produced monthly returns averaging 0.99% (12.5% annually) with a high of 1.23% and low of 0.84%. Monthly volatility averaged 0.11% to produce a Sharpe ratio of 8.6.

uK consumer P2P

RateSetter does not disclose its loan book, but provides average returns for 1, 3, and 5 year loans on a monthly basis. An equally term weighted portfolio of loans produced monthly returns of 0.39% (4.8% annually) with a standard deviation of 0.07% yielding a Sharpe ratio of 4.7.

uK business P2P

Funding Circle’s loan book consists of approximately 9,000 SME loans across the UK. The portfolio returned 0.60% per month on average (7.4% annually) with a high of 0.64% and low of 0.56% corre-sponding to a monthly volatility of 0.02% and a Sharpe ratio of 23.3.

DJIA SP 500

10 yr Bond

NAS-DAQ

FTSE Pros-per

Fund-ing

Circle

Rate-Set-ter

Lend-ing

Club

Avg Mon Return 1.13% 1.37% 0.19% 1.64% 0.60% 1.17% 0.60% 0.39% 0.99%

Risk-Adj Return 1.13% 1.37% 0.19% 1.64% 0.60% 1.11% 0.54% 0.33% 0.93%

Risk (Mon St Dev)

3.28% 3.50% 1.98% 4.10% 3.47% 0.06% 0.02% 0.07% 0.11%

Sharpe 0.34 0.39 0.10 0.40 0.17 18.29 23.34 4.65 8.59

Figure G. Monthly returns and STD by asset portfolio.

asset correlations

As an asset class, P2P loans are attractive not only due to high risk-adjusted returns, but also because of their low or negative correlations to other asset classes (see Figure H below). None of the platforms (UK or US) show any correlation with equities, and furthermore, all but RateSetter show no correlation with US Treasuries.

Even within the P2P space, platforms targeting different borrowers, consumer (RateSetter) versus SME (Funding Circle), are negatively correlated with each other. Together the P2P return profiles present compelling opportunities for diversifica-tion.

DJIA SP 500

10 yr Bond

NAS-DAQ

FTSE Pros-per

Fund-ing

Circle

Rate-Set-ter

Lend-ing

Club

DJIA 1.00

SP500 0.97 1.00

10 yr Bond -0.51 -0.54 1.00

NASDAQ 0.87 0.94 -0.49 1.00

FTSE 0.85 0.87 -0.44 0.79 1.00

Prosper -0.09 -0.09 0.04 -0.12 -0.03 1.00

Funding Circle -0.07 -0.04 -0.04 -0.07 0.04 0.37 1.00

RateSet-ter -0.06 -0.10 0.23 -0.12 -0.09 -0.26 -0.73 1.00

Lending Club -0.06 -0.02 -0.06 -0.02 0.02 0.13 0.77 -0.72 1.00

Figure H. Correlation of asset portfolios standard deviation.

Due to the limited operational history of platforms, we observe outliers in certain correlations. Over time we expect these to stabilise at weak positive values among P2P platforms while maintaining almost no correlation to other asset classes.

Portfolio diversification

P2P return characteristics make it an attractive asset class to incorporate in a di-versified portfolio. Although the P2P track record only spans 47 months, P2P assets significantly expand the efficient portfolio frontier when included in an optimally diversified portfolio.

P2P Lending fund | modelling p2p returns


Based on all monthly returns since the third quarter of 2010, as seen in Figure I, the minimum variance portfolio with P2P assets included achieves a return of 0.6% monthly with an average volatility of only 0.01%. The minimum variance portfolio without P2P loans generates 0.8% month-ly, but is subject to volatility of 1.5%.

By including P2P assets in the minimum variance equity portfolio, we can increase returns by up to 70bps per month for the same risk appetite. This can be seen from the blue dotted line on the efficient frontier graph below. For the same amount of volatility, the P2P optimized portfolio returns up to 1.34%.

These figures are all without leverage.

Figure I. Efficient portfolio frontier.

Leveraged returns

Average P2P asset returns are below that of US equities historically, but due to their low volatility, leverage is a viable strate-gy for generating attractive risk-adjusted returns. As shown below, conservative amounts of leverage based on a monthly risk free rate of 0.16% (2% annually) can significantly boost returns while holding risk relatively unchanged.

% Leverage Monthly Return Monthly Risk Annual Return

0% 0.60% 0.01% 7.44%

5% 0.62% 0.01% 7.72%

10% 0.64% 0.01% 8.01%

20% 0.69% 0.02% 8.58%

25% 0.71% 0.02% 8.86%

30% 0.73% 0.02% 9.15%

40% 0.78% 0.02% 9.72%

50% 0.82% 0.02% 10.30%

60% 0.86% 0.02% 10.88%

70% 0.91% 0.02% 11.46%

80% 0.95% 0.02% 12.04%

90% 1.00% 0.02% 12.63%

100% 1.04% 0.03% 13.22%

Figure J. Optimised portfolio employing leverage.

For example, an optimised portfolio em-ploying a conservative 30% leverage ratio enhances monthly returns from 0.60% to 0.73% (7.44% to 9.15% annually) with a monthly volatility of 0.02%.

Caveats

Our modelling shows that the P2P asset class presents tremendous opportunities, but with some caveats.

• Returns modelled do not incorporate any outperformance in picking loans or allocating among loan classes. We an-ticipate improved performance through better than average selection.

• All the historical returns discussed above assume no unallocated capital while actual investment returns face prepayment and reinvestment risk. This can be mitigated to an extent by redirecting excess capital into other short term asset classes such as invoice financing, which have yielded net dou-ble digit annualized returns.4

• No platform had a losing month during the entire 47-month time frame. Until the asset class goes through a full eco-nomic cycle, the performance data is limited.

4 For example, MarketInvoice, a leading trade financing platform in the UK, returned 18.8%, 14.51%, 12.70%, and 11.69% net of fees in 2011-2014 respectively.

MO

NT

HLY

RE

TU

RN

S

RISK

2.0%

2.0%

1.5%

1.5%

1.0%

1.0%0.0%

0.0%

0.5%

0.5% 4.0%3.5%3.0%2.5%

With P2P Tangent

Without P2P

P2P assets

Traditional assets

X

X

X

X

X

X

X

X

P2P Lending fund | modelling p2p returns

We believe that the global P2P lending market is at an inflection point and ex-pect that it will grow increasingly rapidly over the medium term. The growth in this exciting new asset class offers investors a tremendous opportunity to achieve attrac-tive risk-adjusted returns with low volatility that are relatively uncorrelated with other asset classes. However, the P2P lending industry is still in its infancy and investors in P2P loans face a number of important risks and uncertainties. We believe it is crucial that investors be fully aware of the following risks when deciding whether to participate in this market.

the platforms have a limited oper-ating history and default rates could be much higher than expected in a downturn

Zopa, the first P2P lending platform, was only launched in 2005 and most of the growth in the P2P industry has occurred after the 2007-2008 global financial crisis. As a result, most of the P2P platforms have a relatively limited operating history, par-ticularly at their current scale, and do not know what their long-term loss experience may be. To date, P2P lending platforms have been able to fairly accurately predict default rates and have generated attractive returns to investors after taking defaults into account. However, it is unclear how default rates would be affected by a future major downturn and investors should not rely on historical default rates as an indication of future default rates. If default rates were to increase significantly (as they

did during the most recent downturn), investor returns could be much lower than expected and they may even occur losses.

the platforms’ revenue models pro-vides them with incentives that may not be aligned with investors’ inter-ests

P2P lending operates as an origi-nate-to-distribute model where the plat-forms have no “skin in the game” and lend-ers bear all of the losses in the event of a default.1 Under this model, P2P platforms generate revenue from origination fees on new loans and servicing fees on existing loans. Accordingly, the more loans they originate and the larger their loan books the more money the platforms will make. This provides the platforms with a clear in-centive to originate as many new loans as possible regardless of quality. To date, the platforms have maintained high underwrit-ing standards and some platforms distin-guish themselves from their competitors on the basis of their rigorous underwriting standards. In the current environment in which P2P loan volumes are increasing exponentially the platforms have no incen-tive to lower their underwriting standards. Because the industry is relatively new it is also important for reputational reasons for the platforms to maintain high under-writing standards. However, if in the future origination volumes start to decrease then the platforms may have an incentive

1 Other than a reduction in servicing fees to the extent that loans are charged off.

5. Key risk considerations


to lower their underwriting standards to maintain revenues despite any reputation-al consequences this might have.

because P2P borrowers have the right to prepay their loans at any time investors may face significant reinvestment risk

All P2P loans originated by the major US and UK platforms bear a fixed rate of inter-est for the entire term of the loan. These platforms also allow borrowers to prepay their loans at any time without penalty, whereas lenders must commit their funds for the duration of their loans.2 This means that in an increasing interest rate environ-ment lenders will not have the opportunity to take advantage of the higher interest rates, whereas in a decreasing interest rate environment borrowers will have an incentive to refinance their loans at a lower rate. If this happens then investors face the risk that they will not be able to reinvest their money for a similar rate of return. Investors should be mindful of the risk of prepayment when projecting future returns based on current loan yields.

It is notoriously difficult to assess sme credit risk. P2P platforms may not be able to assess sme credit risk as well as banks, which could result in higher default rates and losses for sme loans originated by P2P plat-forms.

All lending decisions require high quality credit information so the lender can accu-rately assess the risk and required return for a given loan. However, high quality data is often not available for SMEs, particularly smaller SMEs that are not required to pro-duce audited financial information. Banks are able to rely on their analysis of past loan performance, personal relationships

2 Note that while most platforms provide a facility for lenders to resell their loans in a secondary market these markets have limited liquidity.

with the borrower, their ability to monitor ongoing creditworthiness using current account activity and their knowledge of the local business environment when assessing credit risk to make up for the lack of reliable historical financial data. P2P platforms, which have centralized credit underwriting teams that rely primarily on algorithmic credit scoring models, are therefore at a significant disadvantage to banks when assessing SME credit risk.

Over time, the algorithmic credit scoring models used by P2P platforms may result in increasingly reliable credit assessments as more and more historical default infor-mation for borrowers with similar charac-teristics are added to the models.

Investors should not place undue reliance on Zopa’s safeguard fund or ratesetter’s Provision fund

To date, Zopa’s Safeguard Fund and RateSetter’s Provision Fund have done an excellent job at protecting investors against 100% of losses resulting from defaulting borrowers. Both funds current-ly provide a significant cushion over and above the amounts that the platforms expect they will need to pay out (120% in the case of Zopa’s Safeguard Fund and 223% in the case of RateSetter). However, Zopa’s Safeguard Fund represents less than 1% of its total loan book and RateSetter’s Provision Fund represents less than 2.5% of its loan book. This means that a relative-ly small increase in nominal default rates above those expected by these platforms could easily exhaust these funds and leave lenders exposed to the full impact of borrower defaults. Neither platform discloses estimates of the probability that defaults could exceed the levels provided for by these funds. While both Zopa and RateSetter do warn lenders of this possibil-ity their marketing materials place a lot of

P2P Lending fund | Key risks considerations


emphasis on their historical track record of covering 100% of defaulted loans, which may give lenders a false sense of security.

Investors in fractional loans origi-nated by LendingClub and Prosper are significantly exposed to the risk that the platform becomes bankrupt, which undermines the diversification benefits from lending to a large num-ber of borrowers

In order to comply with SEC regulations, investors in fractional loans originated by LendingClub and Prosper do not have di-rect contractual relationships with borrow-ers. Instead, they hold SEC-registered debt securities issued by the platforms that are backed by cash flows from the underlying loans. Because these securities are debt obligations of the platforms, lenders are exposed to both the risk of default on the part of the borrowers and also the risk that the platform becomes bankrupt. In particular, borrowers may stop making payments on their loans, the platform may be restricted from making payments on the notes, interest may no longer accrue on the notes, and noteholders may not have any priority over other creditors of the platform. It appears that Prosper lenders may be in a better position than LendingClub lenders since it has designed its corporate structure to reduce the risk of a bankruptcy of the issuer of the notes to investors, but there is significant uncer-tainty regarding the effectiveness of these measures.

a large number of LendingClub and Prosper borrowers appear to have provided false employment or income information on their loan applications, which raises legitimate questions regarding the integrity of the borrowers on those platforms

LendingClub and Proper do not verify employment or income information for all prospective borrowers. Instead, the platforms rely on their proprietary algo-rithms to select a sample of borrowers to verify. According to their SEC filings, a very significant proportion of borrowers selected for verification are unable or un-willing to provide satisfactory evidence to confirm this information (up to 40% in the case of LendingClub and 15% in the case of Prosper). While both platforms warn inves-tors not to rely on unverified information provided by borrowers investors should maintain a healthy degree of scepticism regarding whether borrowers that provide false information on their loan applications should be trusted to repay their loans.

P2P Lending fund | Key risks considerations

“ “

A key component of our value proposi�on is our ability to compre-hensively assess and manage these risks.

P2P platforms are in the early stages of harnessing network effects to disrupt traditional lending models just as Amazon has disrupted the retailing industry. For the first time, investors have the ability to gain direct exposure to SME loans in “con-sumer sizes” allowing them to spread their investments across a very large number of consumer and business borrowers further diversifying risk.

We believe that P2P platforms have a sustainable competitive advantage over banks due to their superior, low cost oper-ating model. They can function within the bank bid offer spread, delivering superior returns to lenders and improved rates to borrowers.

These driving forces, if supported by pragmatic regulation, should propel this industry to facilitate half a trillion pounds of lending globally by 2010 of which over £100 billion will be in the UK and Europe.

Consumer lending

Net returns on P2P consumer loans in the US are approximately 2-3% higher than in Europe due to the much lower appetite for risk in Europe and specifically the UK P2P market where platforms are currently targeting savers. This is a key cultural dif-ference, but we believe that it will change as platforms have to grow origination vol-umes in order to increase their revenues.

The next evolution will be for UK platforms to move further up the risk curve in the consumer market delivering greater risk

adjusted returns. This is a segment in which institutional liquidity will play a key role, allowing platforms to experiment without affecting performance on their retail funded super prime loans. It will be crucial to develop strong partnerships with the platforms in advance of this evolution to jointly develop new classes of loans that offer different risk/return profiles. First movers will seize these opportunities and create an edge that will enhance value and raise barriers to entry.

The same is true of European platforms, not only to smooth and boost growth domestically as they broaden risk appetite, but also critically to provide essential li-quidity when they commence cross border activity.

Due to the diversification achievable in the consumer sector significant due diligence is required on each platform and its underwriting process in order to build confidence in the quality of the underlying borrowers.

As we will be closely analysing each plat-form, the respective underwriting stan-dards, management team and competitive environment we will be in a strong position to identify interesting private equity invest-ment opportunities. We envisage using up to 5% of the AUM of the fund to invest in P2P equity, in the process strengthening key business partnerships.

6. Conclusion


P2P SME platforms bring scale of origi-nation through a technology model that democratises the origination process. The average borrower is seeking less than £100,000 and we will generally take just a small proportion of each loan.

In Europe (as with much of the rest of the world), SMEs represent 99% of all private businesses and account for a very sub-stantial percentage of new jobs that are created. SMEs currently have very limited alternatives to the banking sector when it comes to their financing needs, and politicians are acutely aware of the risks associated with the oligopoly that is bank lending to this sector. New capital require-ments for banks will only serve to choke the availability of capital to a significant engine of growth.

The platform’s own credit analysis will be done primarily on a ‘scored’ basis that em-phasises individual credit quality, sector/industry analysis and a review of available financial information. The data-driven process does not allow for much, if any, subjective analysis. This centralised scored approach, plus platforms having ‘no skin in the game‘, presents a clear misalignment of interests. This credit analysis risk is mit-igated by us holding a diversified portfolio of consumer-sized loans.

An added benefit of the scale of loans in which we will invest is the ability to increase the size of an individual SME loan at our discretion.

In this case, a key component of our alpha generation will be in the ‘judgemental’ de-cisions we will make around larger lending to specific sectors, geographies and indi-vidual businesses. We will analyse the key factors such as macro and micro business environment, team quality and execution ability, competitive forces as well as finan-cials to create a diversified portfolio of

business loans. We will not rely exclusively on the P2P platform’s assessment of credit risk in this notoriously difficult sector.

Invoice financing will be a key component of our portfolio as it provides not only shorter term investments but it will also fa-cilitate the management of cash flows and reinvestment risk. We believe there will be an opportunity to dynamically manage this asset class with the use of bank revolving credit lines to augment the fund’s capital base and improve performance.

Over time the algorithmic credit scoring models used by P2P platforms should result in increasingly reliable credit assess-ments as more and more historical default information for borrowers with similar characteristics are added to the models. As these models continue to develop, P2P platforms have the potential to be able to make more sophisticated and reliable SME credit assessments than banks that rely primarily on subjective factors. A key factor of our success is our ability to dynamically manage our portfolio and P2P partner-ships in line with this evolution. There will be many entrants to this market and it is key to partner with or invest through the platforms that will succeed.

The P2P asset class as it exists today has yet to endure an economic downturn, but evidence suggests returns are robust. Using historical consumer and SME default rates during the financial crisis as a proxy, we would expect returns to significantly outpace defaults.

For the US unsecured consumer loan mar-ket charge-offs reached a high of 6.71% in the second quarter of 2010. For the same market in the UK, write-offs reached a high of 1.94% of the total outstanding loan amount in the second quarter of 2009. The US SME loan market is segmented into Real Estate Commercial and Commercial/

P2P Lending fund | conclusion


Industrial loans, which experienced charge off rates of 2.94% and 2.56% respectively. Detailed data on UK SMEs is only available from 2011, but as a proxy, the SME failure rate was only 2.84% in 2009.

We aim to prove concept and returns with a strategic seed investor throughout 2015 and then quickly raise external assets tar-geting the wealth management and family office community.

At inception of the fund the team will ac-tively manage all rela-tionships with the plat-forms and regulators and closely monitor the industry’s develop-ment. Partnerships will be formed with existing and emerging platforms creating important bar-riers to entry. The fund structure provides a necessary conduit to the market through-out this early cycle. As winners emerge and the market scales we expect that there will be an evolution towards some direct insti-tutional investment, from some of the larg-er asset managers, into loans originated by established and proven platforms. They will of course receive only the average returns of the platform, trailing the evolution of the market and therefore performance as this sector continues to scale and innovate.

We expect that the fund will begin as an active manager taking an economic share of performance as well as assets under management. As the winning P2P plat-

forms emerge and strong partnerships are formed an element of deployment will become passive focussing on capital reinvestment with the very active focus on new platforms, initiatives and regions.

Our investment value is built on our ability to better segment the market and to access loans in those specific sub-grades that we believe offer the greatest risk-ad-justed returns. Because of our proximity to management at the largest platforms

and our ability to find and evaluate emerg-ing ones, we have the scale necessary to economically allocate across the P2P spec-trum in terms of SME and consumers. Within each segment, our diversification reduc-

es the modelling risk that direct lending would otherwise face, which allows us to achieve lower volatility for the same return. Furthermore, our strategy manages reinvestment risk much more aggressively through short term invoice financing and by utilising diversification to ensure greater liquidity. Together, our tactical allocation offers more attractive returns for the risk we take.

By taking just 1% of the forecast Europe-an P2P market we are confident we can achieve assets under management of £1 billion by 2020.

P2P Lending fund | conclusion

“ “

A por�olio with default rates of up to 8% in SME, 16% in US consumer, and 5% in UK consumer loans—2.5 �mes crises levels—would s�ll suffer zero losses.

The following are general description of the five major P2P lending platforms: LendingClub and Prosper (which operate solely in the US), Zopa and RateSetter (which operate solely in the UK ) and Fund-ing Circle (which operates in both the US and the UK).

In order to comply with US federal secu-rities laws, LendingClub and Prosper are required to publish detailed prospectuses that contain far more information than is currently disclosed by the UK platforms. We have therefore been able to provide significantly more information regarding LendingClub and Prosper than for the oth-er major platforms.

overview

LendingClub1 is the largest P2P lending platform in the US. Since it was launched in 2007, LendingClub has facilitated over $5 billion in loans.

LendingClub offers investors the opportu-nity to participate in either its standard or its custom loan programs. The standard program loans are three- to five-year per-sonal loans made to individual borrowers with a FICO score of at least 660 (among other criteria). Standard program loans are issued in amounts ranging from $1,000

1 Unless otherwise specified, information in this section has been sourced from LendingClub’s Registration Statements on Form S-1 filed with the US Securities and Exchange Commission on July 23, 2014 and October 20, 2014.

to $35,000. Standard program loans are offered publicly to all investors via Lend-ingClub’s website or privately to qualified investors (essentially wealthy individuals or institutions) in private transactions. Cus-tom program loans include small business loans in amounts ranging from $15,000 to $100,000 with various maturities between one and five years, education and patient finance loans in amounts ranging from $499 to $40,000 and other loans that do not meet the requirements of the stan-dard loan program. Custom program loans are available only to qualified investors in private transactions.

All of LendingClub’s loans have fixed inter-est rates, are amortizing, are unsecured and may be prepaid in whole or in part by the borrower without penalty at any time. Borrowers are therefore protected against rises in interest rates and have the option to refinance at a lower rate if interest rates fall, exposing lenders to reinvestment risk. LendingClub does not restrict borrowers from incurring additional future debt and its loans do not contain cross-default provisions.

Investors that are not qualified investors may only invest in standard program loans via SEC-registered “borrower payment dependent notes” issued by LendingClub that correspond to payments received on underlying loans selected by the investor. Qualified investors may invest in standard program loans or custom loans via trust certificates or interests in limited part-nerships that purchase trust certificates.

appendix: Platform descriptions


These trust certificates also correspond to cash flows from underlying loans chosen by the investors. In both cases it is import-ant to note that the investor does not have a direct contractual relationship with the borrower: LendingClub issues investors with securities backed by cash flows from the underlying loans. In addition, banks and other financial institutions that wish to hold the actual loans on their balance sheet can purchase whole loans, but are prohibited from contacting the borrowers directly.

LendingClub charges borrowers a fee of between 1-6% of the amount borrowed depending on the term of the loan and its credit grade. Investors that invest via notes typically pay a servicing fee of 1% of each payment (principal and interest) received from the borrower. Investors that invest via trust certificates can instead choose to pay a management fee of up to 1.3% per year.

Qualified investors and institutions cur-rently provide the majority of Lending-Club’s financing. As of June 30, 2014, there were $3.3 billion of LendingClub loans out-standing, of which $1.5 billion (44%) were financed by trust certificates, $981 million (29%) were financed by trust certificates and $881 million (26%) were financed by notes.

underwriting process

To be eligible for a standard program loan LendingClub requires borrowers to have a minimum FICO score of 660, a debt to income ratio (excluding the borrower’s mortgage) below 35%, an “acceptable” debt-to-income ratio (including both the borrower’s mortgage and requested LendingClub loan), and a credit report that reflects at least two revolving accounts currently open, six or few credit inquiries in the last six months, and a minimum credit history of 36 months.

If a borrower meets these criteria, Lend-ingClub uses a proprietary algorithm based upon historical performance of its borrow-ers to assign an LC Score between 1 and 25 corresponding to base risk grades of A1 through E5. LendingClub uses the base risk grade to assign a final interest rate de-pending on the channel through which the borrower is sourced, the loan amount and the loan term. As of September 30, 2014, the interest rate on an A1 loan was 6.03% and on an E5 loan was 22.15%. Additional risk grades from F1-G% are modified from the E5 base grade based on channel, term and amount and had interest rates ranging from 23.43% to 26.06% as of September 30, 2014.

LendingClub screens applicants through US government sanctions lists and its own fraud detection systems and indemnifies investors for losses resulting from identity fraud. However, it is important to note that LendingClub does not verify employment or income information for all applicants and does not indemnify investors in any other cases of fraud. From October 2008 through December 2013, LendingClub reimbursed investors a total of $0.5 million in 51 cases of identity fraud.

In 2013, LendingClub verified employ-ment and income information for 79% of applicants. Of the borrowers selected for verification, only 58.6% provided Lending-Club with satisfactory evidence to verify their income, 30.5% failed to respond to the request or provide satisfactory evi-dence and therefore had their applications rejected, and 9.6% withdrew their appli-cations. This suggests that approximately 40% of all potential borrowers (including those not selected for verification) are pro-viding unreliable employment or income information during the application process. LendingClub does not guarantee that it

P2P Lending fund | platform descriptions


will continue to perform employment or income checks. Accordingly, LendingClub warns investors that information supplied by borrowers should not be relied on—they should only rely on the loan grade assigned by LendingClub.

Loan issuance process

LendingClub’s loan issuance process has been specifically designed to comply with a myriad of US federal, state and local laws, including those governing the issuance and sale of securities, lending practices and usury limitations. For exam-ple, notes are registered with the SEC to comply with US restrictions on the offer and sale of securities to the public. A key element of the loan issuance process is LendingClub’s relationship with WebBank, an FDIC-insured industrial bank chartered in Utah, which originates all of Lending-Club’s loans. By using WebBank to origi-nate its loans LendingClub believes that under federal law its loans will generally not be subject to state usury limitations

If a loan application is approved it is listed on LendingClub’s marketplace to attract in-vestor commitments. If sufficient investor commitments are received, WebBank is-sues the loan and keeps the loan on its bal-ance sheet for two business days and then sells the loan to LendingClub. LendingClub funds the loan purchase with the proceeds from the sale of notes and trust certificates to investors. All of LendingClub’s outstand-ing loans appear as assets on its balance sheet and all outstanding notes and trust certificates appear as liabilities. As a result, investors do not have a direct contractual relationship with borrowers. Investors can achieve diversification by spreading their investment across a large number of loans that meet their criteria in minimum incre-ments of $25.

Late payments and defaults

If a loan is past due, LendingClub contacts the borrower to request payment. After a 15-day grace period, LendingClub can charge a late fee of the greater of 5% of the unpaid payment or $15. Any late fees received are passed on to investors net of LendingClub’s 1% service charge. If a loan becomes 31 days overdue it is either re-ferred to an outside collection agent or to LendingClub’s own collections department. Any amounts recovered on such loans are passed on to investors net of LendingClub’s 1% service charge and a collection fee of up to 35% of the amount collected.

Investors are likely to suffer significant loss-es if a loan becomes more than 30 days overdue given the 35% collection charge and the fact that late payments are an ear-ly indicator of charge off probability.

LendingClub publishes significant amounts of data regarding historical delinquency and charge-off rates for its loan portfolio.

bankruptcy and other potential issues

Investors face a very significant risk of loss if LendingClub were to become subject to a bankruptcy proceeding for several important reasons. First, LendingClub has made arrangements for only limited backup servicing of its loans. If Lending-Club were to fail and it is not able to put adequate servicing arrangements in place then it may not be able to make payments on the notes or trust certificates. Second, because the notes and trust certificates that investors purchase are obligations of LendingClub and not the borrowers, in the event of a bankruptcy LendingClub may be prevented or delayed from making payments to investors and interest may cease to accrue on the notes and trust certificates. Since bankruptcy proceedings



can take many months or years to com-plete, this could severely impair the value of the notes and trust certificates. Finally, because the note and trust certificates are unsecured, investors may not have priority over other LendingClub creditors to pay-ment from the corresponding loans and may have to share those proceeds with all of LendingClub’s other creditors, including investors in other loans. Accordingly, even though LendingClub’s lending model al-lows investors to diversify their risk across a wide range of borrowers, all investors are very exposed to the risk of a LendingClub bankruptcy.

Another potential issue facing LendingClub relates to the fact that it is required to reg-ister notes with the SEC. Each time a loan is made and is funded with notes, Lending-Club is required to post specific informa-tion about that loan and file that informa-tion with the SEC, including employment, income and credit bureau information that may not have been verified by Lending-Club. This additional information is sub-ject to the anti fraud provisions of the US securities laws. Accordingly, LendingClub is potentially exposed to the risk of litigation from the SEC or investors who relied on false or misleading borrower information when making their investment. Although the risk may be small, it is possible that LendingClub could faces substantial dam-ages claims or penalties in respect of this information. If these damages claims or penalties were sufficiently large they could result in a bankruptcy proceeding, which would expose all LendingClub investors to the risks described above.

overview

Prosper2 is the second largest P2P lending platform in the US. Since it was launched in 2006, Prosper has facilitated over $1.6 billion in loans.

Prosper offers investors the opportunity to invest in three to five year loans to indi-viduals in amounts ranging from $2,000 to $35,000 via two channels, the Notes Chan-nel and the Whole Loan Channel. Unlike LendingClub, prosper does not currently facilitate loans to SMEs. Loans are assigned randomly to the two channels based on Prosper’s determination of the relative overall demand in each channel. Loans on the Notes Channel may be partially funded if they receive bids for at least 70% of the amount requested. Loans on the Whole Loan Channel must received bids for 100% of the amount requested. Only institu-tional investors are eligible to invest in via the Whole Loan Channel, but all loans are offered via Prosper’s website.

All of Prosper’s loans have fixed interest rates, are amortizing, are unsecured and may be prepaid in whole or in part by the borrower without penalty at any time. Borrowers are therefore protected against rises in interest rates and have the option to refinance at a lower rate if interest rates fall, exposing lenders to reinvestment risk.

2 Unless otherwise specified, information in this section has been sourced from Prosper’s Registration Statement on Form S-1 filed with the US Securities and Exchange Commission on October 3, 2014, its Annual Report on Form 10-K for the year ended December 31, 2013 and its Quarterly Report on Form 10-Q for the three months ended June 30, 2014.



Prosper does not restrict borrowers from incurring additional future debt and its loans do not contain cross-default provi-sions.

Investors that invest via the Notes Chan-nel invest in SEC-registered “borrower payment dependent notes” that corre-spond to payments received on underlying loans selected by the investor. This model operates almost identically to Lending-Club’s standard program loans and, as with LendingClub, investors via the Notes Channel do not have a direct contractual relationship with the borrower: Prosper issues investors with securities backed by cash flows from the underlying loans. Investors via the Whole Loan channel hold these loans on their balance sheet but are prohibited from contacting the borrowers directly.

Prosper charges borrowers a fee of be-tween 1-5% of the amount borrowed depending on the term of the loan and its credit grade. Lenders are charged ongoing servicing fees of 1% per annum on the outstanding principal amount of the loan. This could result in significantly higher charges to lenders over the term of the loan as compared with LendingClub, which only charges servicing fees on payments of principal and interest received by the lender.

Prosper does not separately disclose the proportion of loans funded via the Notes channel and Whole Loan channel, but it appears that as with LendingClub insti-tutions currently provide the majority of LendingClub’s financing. For example, for the quarter ended June 30, 2014 Prosper originated $370 million in new loans but the volume of loans held on Prosper’s balance sheet increased by only $8 million. This suggests that approximately $362

million of loans were purchased by inves-tors via the Whole Loan channel, or almost 98%.


Prosper’s eligibility criteria are less strin-gent than LendingClub’s. Borrowers must have a minimum FICO score of 640, fewer than seven credit bureau inquiries within the last 6 months, have a stated income greater than $0, have a debt-to-income ratio below 50%, have at least two open trades reported on their credit bureau, have no reported delinquencies of 30 or more days within the last 3 months and have not filed for bankruptcy within the last 12 months.

If a borrower meets these criteria, Prosper uses a proprietary algorithm based upon historical performance of its borrowers to assign a “Prosper Rating” between AA and HR that correspond to estimated average annualized loss rates ranging from 0%-1.99% for AA to over 15% for HR. Prosper determines estimated loss rates by using credit scores from credit reporting agen-cies and a proprietary “Prosper Score.” The Prosper Score predicts the probability of a loan going more than 60 days past due within 12 months from the application date based on historical data from Pros-per’s borrowers and a data archive from a consumer credit bureau. LendingClub uses the base risk grade to assign a final interest rate depending on the channel through which the borrower is sourced, the loan amount and the loan term. As of Octo-ber 2014, the interest rates on AA loans ranged from 3%-15% and for HR loans ranged from 25%-36%.

As with LendingClub, Prosper indemnifies investors for losses resulting from identi-ty fraud but does not verify income and employment information for all applicants or indemnify investors in any other cases



of fraud. From inception through June 30, 2014, Prosper had reimbursed investors a total of $0.75 million under its indemnifi-cation obligations.

Between July 14, 2009 and June 30, 2014, Prosper verified employment and income information for 59% of applicants and cancelled 15% of loan listings because they contained inaccurate or insufficient employment or income information. Un-like LendingClub, Prosper has undertaken to continue to provide income and verifi-cation checks consistent with its current practices going forward.


Prosper’s loan issuance process, like Lend-ingClub’s, has been specifically designed to comply with a myriad of US federal, state and local laws, including those governing the issuance and sale of securities, lending practices and usury limitations. Prosper also uses WebBank to originate all of its loans

If a loan application is approved it is listed on Prosper’s marketplace in either the Notes Channel or the Whole Loan Chan-nel in order to attract investor bids. The bidding period on the Notes Channel ends on the earlier of 14 days and the date on which it has received bids totalling the re-quested loan amount. The bidding period on the Whole Loan Channel ends on the earlier of one hour after the loan is posted and a lender committing to purchase the loan. This suggests that institutional in-vestors are very active in monitoring loans that become available on Prosper and are able to very quickly determine whether to purchase a given loan. If a Whole Loan Channel loan does not received purchase commitments then it is re-posted for

bidding in the Notes Channel and potential lenders are informed that it had previously been posted on the Whole Loan Channel.

The process for funding Notes Channel loans is identical to LendingClub’s. If suffi-cient investor commitments are received, WebBank issues the loan and then sells the loan to Prosper. Prosper funds the loan purchase with the proceeds from the sale of notes to investors. All loans funded via the Notes Channel appear as assets on its balance sheet and all outstanding notes appear as liabilities. As a result, investors do not have a direct contractual relation-ship with borrowers. Investors can achieve diversification by spreading their invest-ment across a large number of loans that meet their criteria in minimum increments of $25.


If a loan is past due, Prosper contacts the borrower to request payment. After a 15-day grace period, Prosper charges a late fee of the greater of 5% of the unpaid payment or $15. Any late fees received are passed on to investors net of Prosper’s collection and servicing fees. If a loan becomes overdue it is either referred to an outside collection agent or to Prosper’s own collections department. Any amounts recovered on such loans are passed on to investors net of Prosper’s 1% service charge and a collection fee of up to 40% of the amount collected. Loans that become more than 120 days overdue are charged off.

Investors are likely to suffer significant losses if a loan becomes more than 30 days overdue given the 40% collection charge and the fact that late payments are an early indicator of charge off probability.



Prosper publishes significant amounts of data regarding historical delinquency and charge-off rates for its loan portfolio.

bankruptcy and other potential is-sues

Unlike LendingClub, Prosper has specifical-ly designed its organizational structure to minimize the likelihood that the issuer of notes will become subject to a bankruptcy proceeding. It has done this by creating a special purpose entity to make loans and issue notes that is restricted from under-taking unrelated activities and incurring lia-bilities unrelated to funding loans. Howev-er, there is no guarantee that this structure would be effective in practice and a bank-ruptcy of Prosper would raise the same issues as with LendingClub. In addition, as with LendingClub, Prosper has made arrangements for only limited backup servicing of its loans. Again, even though Prosper’s lending model allows investors to diversify their risk across a wide range of borrowers, all investors are very exposed to the risk of a Prosper bankruptcy.

Like LendingClub, Prosper is also poten-tially exposed to the risk of litigation from the SEC or investors who relied on false or misleading borrower information when making their investment.

overview

Zopa3 is currently the largest P2P lending platform in the UK. Since it was launched in 2005, Zopa has facilitated over £650 million in loans.

3 Unless otherwise specified, information in this section has been sourced from Zopa’s corporate website (www.zopa.com).

Zopa offers investors the opportunity to invest in one to five year personal loans made to individual borrowers (including businesses run by sole traders). Loans are issued in amounts ranging from £1,000 to £25,000. Institutions lending via Zopa’s platform must be authorised by the UK Financial Conduct Authority to lend to consumers.

All of Zopa’s loans have fixed interest rates, are amortizing, are unsecured and may be prepaid in whole or in part by the borrower without penalty at any time. Borrowers are therefore protected against rises in interest rates and have the option to refinance at a lower rate if interest rates fall, exposing lenders to reinvestment risk. Zopa does not restrict borrowers from in-curring additional future debt and its loans do not contain cross-default provisions. Unlike the major US platforms, Zopa lend-ers have direct contractual relationship with borrowers.

Zopa charges borrowers a fixed fee of up to £190. Lenders are charged ongoing servicing fees of 1% per annum on the out-standing principal amount of the loan.

Zopa does not publicly disclose the pro-portion of loans on its platform that are funded by institutional investors. However, Zopa officials have informed us that they expect individuals to fund the majority of Zopa’s loans.


All borrowers must be at least 20 years old, have a credit history, a good track record of repaying debt, a three year address history in the UK, an income of at least £12,000 per year and be able to afford the loan. Zopa conducts the same credit searches done by banks and other loan companies.




Zopa has established a “safeguard” fund funded from the fees that borrowers pay to Zopa. The safeguard fund offers lenders a degree of protection in the event that borrowers fail to repay their loans, includ-ing in respect of unpaid interest. The fund is held in trust by an affiliate of Zopa. As of October 2014, approximately £6 million had been set aside in the trust of which Zopa expects to have to pay up by £5 million leaving a buffer of approximately £1 million.

If a loan is past due, Zopa will refer the loan to its collection agent who may charge the borrower a fee of 22.5%-40% of the amount overdue. If the borrower misses four consecutive payments, dies or becomes bankrupt then a claim is made against the safeguard fund. If there are not sufficient funds in the safeguard fund to cover a defaulted loan then Zopa will continue to try to collect from the borrow-er and pay any recovered amounts (net of enforcement fees) to the lenders on a pro rata basis.

Zopa publishes data regarding historical actual and expected default rates for all of its loans since inception grouped by loan market and loan duration.

bankruptcy and other potential is-sues

Zopa investors do not face the same bank-ruptcy risks as investors in LendingClub or Prosper loans for the simple reason that they have direct contractual relationships with lenders. Accordingly, even if Zopa were to fail, investors would still be able to claim directly against borrowers. According to Zopa, in that situation the fees related to each loan will be sufficient to cover borrower repayments and crediting lender accounts. Furthermore, under regulations

Zopa conducts identity, fraud and cred-it checks on all borrowers but does not disclose how often it verifies employ-ment or income information. All of Zopa’s underwriting is conducted manually by its employees.


Zopa’s loan issuance process is very different to the LendingClub and Prosper model. If a loan application is approved the loan is assigned to one of the follow-ing five loan markets based on the bor-rower’s credit quality: A*, A, B, C1 and S (business). Lenders submit their lending criteria, including the amount they wish to lend, the market in which they wish to lend, the rate they are prepared to lend at and the period over which they are prepared to lend. These lending offers are then ranked first by interest rate from lowest to highest and second by the time of the offer. If offers from lenders match the borrower’s borrowing criteria then the borrower is provided with a personalised quote showing the average interest rate from all borrowers on a given day. If the borrower accepts the quote his or her loan is funded by lenders in rank order until the full amount of the loan is matched. Each lender receives the interest rate he or she requested and the borrower pays the weighted average rate across all borrow-ers.

Unlike loans funded through LendingClub and Prosper’s public platforms, Zopa’s in-vestors have a direct contractual relation-ship with borrowers. However, the identity of the borrowers is not made public to the lenders unless required as part of legal proceedings for the enforcement of the loan. Investors can achieve diversification by spreading their investment across a large number of loans that meet their cri-teria in minimum increments of £10.



adopted by the UK Financial Conduct Authority in 2014, all UK P2P lenders put in place policies to manage the continued collection of loan payments should the platform fail.

To help ensure that the platform has suffi-cient funds available in the event of future financial shocks, the FCA has also estab-lished prudential standards that require UK P2P lenders to hold the following mini-mum capital levels:

• 0.2% of the first £50 million of total loans outstanding;

• 0.15% of the next £200 million of total loans outstanding;

• 0.1% of the next £250 million of total loans outstanding; and

• 0.05% of any remaining balance of loans outstanding above £500 million.

overview

RateSetter4 is currently the third largest P2P lending platform in the UK. Since it was launched in 2010, RateSetter has facil-itated over £380 million in loans.

RateSetter offers investors the opportunity to invest funds for one month, one year, three year or five years to fund loans made to individual borrowers (including busi-nesses run by sole traders). Borrowers can borrow on terms ranging from six months to five years. Loans are issued in amounts ranging from £1,000 to £25,000. Institu-tions lending via RateSetter’s platform must be authorised by the UK Financial Conduct Authority to lend to consumers.

4 Unless otherwise specified, information in this section has been sourced from Funding Circle’s corporate website (www.fundingcircle.com).

All of RateSetter’s loans have fixed interest rates, are amortizing and may be pre-paid in whole or in part by the borrower without penalty at any time. Borrowers are therefore protected against rises in inter-est rates and have the option to refinance at a lower rate if interest rates fall, expos-ing lenders to reinvestment risk. RateSetter does not restrict borrowers from incur-ring additional future debt and its loans do not contain cross-default provisions. RateSetter lenders have direct contractual relationship with borrowers. According to RateSetter, the vast majority of its loans are unsecured.

RateSetter charges borrowers fees de-pending upon the amount borrowed, the loan term and the borrower’s personal credit profile. RateSetter does not current-ly charge any fees to lenders.

RateSetter does not publicly disclose the proportion of loans on its platform that are funded by institutional investors. However, RateSetter officials have informed us that they expect individuals to fund the majori-ty of RateSetter’s loans.


RateSetter seeks to distinguish itself from competitors by its stringent underwriting process. According to RateSetter, 85% of all loan applications are turned down.

All borrowers must be at least 21 years old, have a good credit history and an income. RateSetter uses credit bureau reports and additional information provided by the borrower to evaluate the borrower’s ability to service the loan. RateSetter then uses a risk grading structure to allocate borrowers into one of 13 credit grades. Each credit grade carries a risk fee that the borrower pays into RateSetter’s “Provision Fund” (see “Late Payments and Defaults” below).



If a borrower misses a payment RateSet-ter will make a second attempt to debit the payment from the borrower’s bank account. If the second attempt is unsuc-cessful, RateSetter will write to the bor-rower and if necessary refer the loan to an external debt collection agency. If there are sufficient funds in the Provision Fund to cover the missed payment then lenders will receive the full amount of the missed payment from the Provision Fund. Other-wise, RateSetter will declare a “resolution event” and from that point in time all loan repayments will be collected on behalf of all of RateSetter’s savers on a pro rata basis to ensure diversification of default risk. Ac-cordingly, no single lender will be exposed to any individual default.

RateSetter publishes data regarding histori-cal actual and expected default rates for all of its loans for the past five years but does not provide a breakdown by loan duration.


The position of investors in the event of a bankruptcy of RateSetter would be similar to that of Zopa investors. Like Zopa, Rate-Setter has put in place policies to manage the continued collection of loan payments should the platform fail and is subject to the FCA’s minimum capital requirements.

uK PLatform

overview

Funding Circle5 is the largest P2P lending platform in the UK. Since it was launched in 2010, Funding Circle has facilitated over £400 million in loans.



RateSetter’s loan issuance process is slightly different than Zopa’s with loans being assigned to markets based on loan term rather than borrower credit quality. Lenders and borrowers whose applications have been approved make an offer to lend or borrow and the rates at which they are prepared to lend or borrow. Borrower and lender orders are matched first by rate and then by time. Offers to borrow remain open for at least 14 days and offers to lend remain open for at least 30 days. Each lender receives the interest rate he or she requested and the borrower pays the weighted average rate across all borrow-ers.

As with Zopa, RateSetter’ investors have a direct contractual relationship with borrowers. However, the identity of the borrowers is not made public to the lenders unless required as part of legal proceedings for the enforcement of the loan. Unlike Zopa, RateSetter does not split lender’s funds across multiple borrowers instead relying on the Provision Fund to mitigate the risk of an individual borrower defaulting.


RateSetter’s Provision Fund is similar to Zopa’s safeguard fund but provides signifi-cantly greater cover over expected default rates: 223% of estimated claims as of October 27, 2014 versus Zopa’s 120%. The Provision Fund is funded from the fees that borrowers pay according to the borrow-er’s risk grading. The Provision Fund offers lenders a degree of protection in the event that borrowers fail to make loan payments. RateSetter claims that to date no lender has lost a penny by investing on its plat-form as a result of the Provision Fund. As of October 27, 2014, approximately £8.9 million had been set aside in the Provision Fund. The Provision Fund is held in trust by an affiliate of RateSetter.



Funding Circle offers investors the oppor-tunity to invest in loans made to business borrowers (defined as any partnership, limited company or non-limited company with a minimum turnover of £50,000). Loans are issued in amounts ranging from £5,000 to £1,000,000.

All of Funding Circle’s loans have fixed interest rates, are typically amortizing and may be prepaid in full by the borrower without penalty at any time. Borrowers are therefore protected against rises in inter-est rates and have the option to refinance at a lower rate if interest rates fall, expos-ing lenders to reinvestment risk. Funding Circle offers both secured and unsecured loans and may require personal guarantees from company directors. Funding Circle also offers a range of loans for the purpos-es of residential and commercial property development finance, property investment finance, buy-to-let finance, commercial mortgages and commercial investment finance. The payment structure on prop-erty loans may differ from other loans (for example, be interest only in the case of property development loans). Funding Circle does not restrict borrowers from in-curring additional future debt and its loans do not contain cross-default provisions. As with Zopa and RateSetter, Funding Circle lenders have a direct contractual relation-ship with borrowers.

Funding Circle charges borrowers a fee of between 2%-5% depending on the size and duration of the loan. Lenders are charged ongoing servicing fees of 1% per annum on the outstanding principal amount of the loan.

Funding Circle does not publicly disclose the proportion of loans on its platform that are funded by institutional investors. However, Funding Circle has stated that it wants to create a diverse range of inves-tors including individuals, government,

councils and other organisations in order to ensure the stability of its marketplace for the long term.

Funding Circle currently only allows investors to invest in partial loans. How-ever, Funding Circle intends to introduce a “whole loan” option that will operate in a very similar manner to Prosper’s Whole Loan Channel where some loans are ran-domly allocated to the whole loan market and listed for a fixed amount of time after which (if they are not funded) they will be made available on a partial loan basis.

Funding Circle has also announced that it will allow investors to access its market-place on an automated basis through an API (application Programming Interface). The API will be available to both individ-ual and institutional investors, although we expect that the vast majority of users of the API interface will be professional investors. In order to ensure that API users are not favoured, API will introduce “speed bumps” and other measures to restrict bidding frequency and other behaviour.


Funding Circle undertakes a rigorous credit assessment process and will only lend to established and creditworthy businesses. All borrowers must have a minimum two-year trading history, minimum turnover of £50,000 and majority UK ownership and UK resident directors. Borrowers must provide the following information as part of the application process:

• company details;

• income statement and balance sheet for the last financial year;

• names of shareholders with a greater than 20% shareholding in the company; and

• details of all current outstanding loans and overdrafts.



Funding Circle may also request manage-ment accounts, bank statements and a recent tax return. If the loan is being used to purchase a specific asset then details of that asset must also be provided. Funding Circle then uses a proprietary model that considers over 2,000 variables, including company performance, credit history and existing debt to assess risk. Finally, a member of Funding Circle’s credit as-sessment team reviews every application and decides whether to list the loan on its marketplace. Funding Circle attempts to make decisions on applications within two working days of receiving a complete application.

Funding Circle uses data from Experian (including historical amounts of bad debt experienced in similar businesses) and the professional expertise of its credit analytics team to assign loans to risk bands based on their best estimate of the likely levels of bad debt that will be experienced in each risk band. The risk bands range from A+ (corresponding to an estimated annu-alised bad debt rate of 0.6%) to C- (corre-sponding to an estimated annualised bad debt rate of 5%). Funding Circle imposes minimum bid rates for each band to help its investors manage the risk of loss from bad debt.

Funding Circle conducts identity and fraud checks on company directors and will fully refund any amounts lent to borrowers that have committed fraud.

Funding Circle makes detailed information regarding its historical default rate pub-lic and allows all registered investors to download data regarding its entire loan book.


Lenders can invest in new loans either by individually selecting loan requests that have not yet been fully funded or by using

Funding Circle’s Autobid tool to automati-cally match loan requests with the lender’s selected criteria. For individually selected loans, lenders indicate the amount they wish to lend and the annual interest rate they wish to charge. As with Zopa and Ra-teSetter these lending bids are then ranked first by interest rate from lowest to highest and second by the time of the offer. If the borrower accepts the offers his or her loan is funded by lenders in rank order until the full amount of the loan is matched. Alternatively, the borrower can wait to see whether additional lenders bid the aver-age interest rate down. The borrower will have up to seven days to accept the loan or wait until new lenders bid the interest rate down. Once the borrower accepts, each lender receives the interest rate he or she requested and the borrower pays the weighted average rate across all borrow-ers. For lending via the Autobid function, lenders choose the average offer rate they want and then Funding Circle will auto-matically bid on all available loan requests that match the lender’s criteria with the rate offered for each risk band adjusted for the expected loss percentage for each risk band. Autobid will not bid more than 1% of the lender’s total funds to any one business.

As with Zopa and RateSetter, investors have a direct contractual relationship with borrowers. The identity of the borrowers is not made public to the lenders unless required as part of legal proceedings for the enforcement of the loan. Investors can achieve diversification by spreading their investment across a large number of loans that meet their criteria in minimum incre-ments of £20.


If a borrower misses a payment, Funding Circle will contact the borrower and reat-tempt to collect the outstanding payment.



If this second attempt fails, the loan will be treated as overdue and Funding Circle will continue to attempt to collect the funds and may refer the missed payment to a third party debt collection agency. Fees charged by the collection agency will be added to the outstanding loan amount and will not reduce the amount available for distribution to lenders. If the borrower fails either to make three or more consecutive monthly payments or four out of six con-secutive monthly payments then the loan will be placed into default and Funding Circle’s agents will attempt to collect the amount outstanding. The field agent may deduct up to 40% of the amount recov-ered from the borrower and the remaining proceeds will be distributed to the lenders. If the loan is secured then Funding Circle’s security agent will attempt to enforce the security with any proceeds (less the costs of enforcement) distributed pro rata to the lenders.

If Funding Circle believes that it will be in the interests of lenders to restructure a borrower’s loan then it may amend a lend-er’s loan contract in the following ways:

• increase the term by one year, with a corresponding increase in interest rate to the higher of 13.5% or 4% above the lender’s interest rate;

• increase the term by two years, with a corresponding increase in interest rate to the higher of 15.5% or 5.5% above the lender’s interest rate; or

• increase the term by three years or more, with a corresponding increase in interest rate to the higher of 17.5% or 7% above the lender’s interest rate.


The position of investors in the event of a bankruptcy of Funding Circle would be similar to that of Zopa and RateSetter in-

vestors. RateSetter has put in place policies to manage the continued collection of loan payments should the platform fail and is subject to the FCA’s minimum capital requirements.

us PLatform

overview

Funding Circle6 has operated in the US since it acquired Endurance Lending Net-work in 2013.

In the US, Funding Circle offers investors the opportunity to invest in loans made to business borrowers (other than sole proprietorships) issued in amounts ranging from $25,000 to $500,000 with two to five year terms. Funding Circle’s US platform is currently only available to institutional in-vestors and qualified (i.e., high net worth) individuals.

All of Funding Circle’s loans have fixed interest rates, are amortizing and may be prepaid by the borrower without penal-ty at any time. Borrowers are therefore protected against rises in interest rates and have the option to refinance at a lower rate if interest rates fall, exposing lenders to reinvestment risk. Funding Circle offers only secured loans and also requires a per-sonal guarantee from the business owner.

Funding Circle charges borrowers a 2.99% origination fee. Lenders are charged ongo-ing servicing fees of 0.83% per annum on the outstanding principal amount of the loan.

Funding Circle currently only allows investments to be made by institutions in its whole loan marketplace with a rec-ommended minimum investment of $5 million or by institutions and qualified




individuals via limited partnership inter-ests in an investment fund structure with a recommended minimum investment of $250,000. However, Funding Circle also intends to introduce a fractional loan marketplace that will allow institutions and qualified individuals to purchase fractional portions of loans via borrower dependent notes with a recommended minimum investment of $50,000.


Funding Circle undertakes a rigorous credit assessment process and will only lend to established and creditworthy businesses. According to Funding Circle, the medi-an values for all US loans underwritten through June 10, 2014 were a primary ap-plicant FICO score of 716, annual revenue of $758,000, debt service coverage ratio of 2.05x and asset coverage ratio of 5.7x. For loans under $200,000 borrowers must provide the following information as part of the application process:

• 3 years of business tax returns;

• 1 year of personal tax returns; and

• 6 months of business bank statements.

For loans over $200,000, the following additional documents are required:

• year to date balance sheet and income statement; and

• completed outstanding business loans and credit worksheet.

Funding Circle uses a proprietary scoring model and human expertise to assess applications and considers a range of factors including credit scores, real-time cash flows and online customer reviews. Funding Circle attempts to make decisions on applications within 14 days of receiving a complete application.

Funding Circle assigns loans to risk bands based on their best estimate of the likely levels of bad debt that will be experienced in each risk band. The risk bands range from A+ to C, with expected interest rates ranging from 8.99%-20.99% depending on the length of the loan and the borrower’s credit profile.

Funding Circle does not make information regarding historical or expected loan rates available on its public website.


Funding Circle does not make information regarding the loan issuance process pub-licly available on its website. However, we expect that the whole loan marketplace functions in a similar manner to Prosper’s, with lenders given the opportunity to bid on whole loans and the loan transferred to the lender’s balance sheet upon clos-ing of the loan so that lenders have direct contractual relationships with borrowers. Similarly, we expect that when it becomes operational the fractional loan market-place will operate in a similar manner to LendingClub and Prosper’s fractional loan markets so that investors in borrower de-pendent notes do not have direct contrac-tual relationships with borrowers.


If a borrower misses a payment, Funding Circle will contact the borrower and reat-tempt to collect the outstanding payment. If this second attempt fails, the loan will be treated as overdue and Funding Circle will continue to attempt to collect the funds and may refer the missed payment to a third party debt collection agency. Fees charged by the collection agency will be added to the outstanding loan amount and will not reduce the amount available for distribution to lenders. If the borrower fails either to make three or more consecutive



monthly payments or four out of six con-secutive monthly payments then the loan will be placed into default and Funding Circle’s agents will attempt to collect the amount outstanding. The field agent may deduct up to 40% of the amount recov-ered from the borrower and the remaining proceeds will be distributed to the lenders. If the loan is secured then Funding Circle’s security agent will attempt to enforce the security with any proceeds (less the costs of enforcement) distributed pro rata to the lenders.


Funding Circle does not publish sufficient information regarding its US lending plat-form to assess bankruptcy risks. However, we would expect that investors in the fractional loan marketplace would be ex-posed to the same bankruptcy risks of the issuers of the borrower dependent notes as investors in LendingClub and Prosper’s fractional loans. On the other hand, we would expect that investors in the whole loan marketplace would only be subject to the risk of a bankruptcy of the borrower.


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