With more investors and savers considering P2P lending products in the continued low interest rate environment, and the prospect of further rate cuts to come, it’s vital they understand the platform they are putting their money into — above all its management of risk and capital loss rate. Think of it as ‘underwriting the underwriters’, or assessing the risk assessors. Here are the 10 questions I would ask.
1. WHO’S THE PROVIDER?
Are they a familiar face in the financial services sector or a complete unknown? How long have they been operating? How well capitalised are they? What sort of systems and controls do they have in place and how experienced is the underwriting team? Have they survived any major market or economic crashes? Also, if it it exists, be sure to consult any third party due diligence into the provider, to help you better assess how robust they are.
2. DO THEY HAVE SKIN IN THE GAME?
Some P2P products include a ‘provision fund’ — a pot of money that can be used in the event of default as a sort of insurance policy. How big is it with the lender you are considering, and what level of cover does it provide? More importantly, to what extent does the P2P lending platform suffer if a loan goes bad? And are they ready to take a hit before you, the investor?
3: ARE THE LOANS SECURED?
Does the P2P platform you’re considering lend in the hope that it will get its money back, or is there a tangible security that can be called upon if a borrower were to default? Unsecured lending is worlds apart from secured lending – the latter is generally considered far less risky because if the worst case scenario did happen, the underlying asset can be sold and the lender has the opportunity to get most or all of their money back.
4: WHO ARE THE BORROWERS?
Each P2P platform tends to deal with specific types of borrower, whether individuals or businesses. These borrowers have widely varying motivations, levels of experience and associated risk profiles. It’s important to understand who the borrowers are and what they’re planning to do with the money that’s lent to them. Does the lender know? Does it know the sector the loans are being made in? And how, if at all, does it monitor the way its money is being spent?
5: WHAT’S THE TYPICAL LOAN TERM?
What’s the duration of the typical loan borrowers are seeking to take out via the P2P lending platform? The longer the average loan length, the greater the potential impact on liquidity and the ability of investors to withdraw their money. Shorter loan terms mean quicker redemptions, which boosts liquidity.
6: HOW DIVERSIFIED IS THE LOAN PORTFOLIO?
It will probably vary over time, but how many loans are investors getting exposed to, on average? Remember that risk can be significantly reduced if investor funds are spread across a broad portfolio of loans rather than a small handful.
7: HOW GOOD IS THE UNDERWRITING?
How are the borrowers assessed? What sort of credit profiling is undertaken? And if loans are secured, what assets are they secured against? How are they valued, and what level of buffer is there in case that value was to fall over the course of a loan? For example, if the loans in a portfolio are made at an average loan-to-value of 60%, that’s a 40% cushion for investors’ capital in the event of default.
8: WHAT’S THE CAPITAL LOSS RATE?
This is the essential yardstick of good underwriting. Never invest without asking the P2P lender for its historical ‘loss rate’ and be wary of lenders that don’t openly publish it. Past performance is not a reliable indicator of future success but understanding it is crucial due diligence.
9: HOW EASY IS IT TO GET OUT?
It’s all well and fine if it’s easy to invest, but how do investors access their money when they need to? Does the product carry a fixed term, or can investors choose to withdraw at any time? And are there any costs or penalties for doing so? Some products will have a secondary market, and some providers will be able to use their balance sheet to facilitate withdrawals – while others may lock investors in for the duration of loan terms.
10: WHAT’S THE RISK/REWARD TRADE OFF?
After reading the above, hopefully you won’t: but don’t, whatever you do, simply plump for the product promising the highest interest rate. Generally speaking, the higher the interest rate, the higher the level of risk investors are taking on, the less accessible their money or the greater the lock-in period. This is what professional investors call the risk/reward trade off. Or in other words, if it seems too good to be true, it probably is.