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Marketplace Lending Explained

Increasing longevity means clients are looking for income. After years of strong growth, marketplace lending may be the place to find it.

By Dr. Mark R. Bell

Marketplace lending has grown by nearly 150 percent on a compound annual basis for the last half-decade. Strong growth and real longevity mean that most advisors have to consider the role that marketplace lending plays in their clients' portfolios. Let’s examine what marketplace lending is, the questions of its classification as an asset class, investment risks, and the best approach to the asset.  

What is marketplace lending?

Marketplace lending began as peer-to-peer lending around 2006. The idea was that a technology-enabled platform allowed willing lenders to lend money to needy borrowers, bypassing traditional banks and credit cards, reducing barriers to transaction, and offering strong savings for borrowers and good returns for lenders. As more and more financial institutions have stepped into the lender role, the industry has transformed into a “marketplace” in which loans are created and then sent out to individuals, hedge funds, wealth advisors and banks.

Today the value is clear. Refinancing high-rate credit card debt or other hard-money-type loans among high-quality borrowers via a marketplace lender is sensible and provides good value to all parties. It remains to be seen with the large number of entrants into the field if this margin can hold up. For now, it appears attractive. This is particularly true since most of the borrowers have strong FICO scores (say 700+), and losses have been relatively low.

Is it an asset class?

If marketplace lending makes sense as an investment, what is its role in a portfolio? For the last half-decade, academics and investors have argued about whether or not marketplace lending is a new asset class that should be modeled for and allocated to separately, or part of a fixed income allocation. Many advisors saw marketplace lenders (MPLs) as akin to master-limited partner investing—in that it could be illiquid, provided yield, and was potentially not highly correlated with equities. Without reviewing the entire debate, my view is that it is best to characterize MPL as “alternative fixed income” rather than its own line-item asset class. This is because it is largely illiquid and nontraditional, but nevertheless, the risk that is being taken is credit risk. As such, as advisors allocate to MPLs they should reduce other parts of a client’s fixed income portfolio.

What are the risks?

As part of a fixed income allocation, what are the risks in marketplace loans? Many are obvious. There is the credit risk of the borrower first and foremost—here the asset can be seen as clearly pro-cyclical; in other words, as the economy improves, the asset strengthens. Correspondingly, as the economy weakens, the credit of the borrower will weaken. There are, of course, other risks, as the loans are generally illiquid. Additionally, there has recently been some weakness in consumer credit, primarily in auto loans and credit card defaults, though these have been largely limited to the subprime aspects of these loan categories. Nevertheless, the concern remains as to whether these are harbingers of more trouble with better borrowers. Finally, the spread between traditional fixed income and “alternative” fixed income such as MPLs might begin to tighten as interest rates rise and traditional fixed income instruments begin to carry some meaningful yield. 

What are the best approaches?

There are multiple ways to get exposure to marketplace loans. The most cumbersome is to buy loans directly off of a platform—for example, create a Prosper account and purchase loans on behalf of your client. This is time-intensive and concentrates in specific loans and vintages. As such, funds have been viewed as the best way to access the market. Lending Club runs a series of funds that provide this service for clients. These funds have had some return and some publicity in the past, as well as investor-relations challenges. Concurrently, new funds have emerged. A particularly interesting one is an interval mutual fund (daily pricing, quarterly liquidity) managed by longtime marketplace loan experts River North. The River North fund RMPLX has over $100 million of assets and buys loans from five different originators: three are consumer focused and make up 80 percent of the fund, and the remainder come from two commercial lenders that lend to small businesses. The worst way to get exposure is by buying the equity of publicly traded marketplace lenders, such as LendingClub, as this equity is a different bet than the loans themselves.

 

Dr. Mark R. Bell is a managing principal at Diversified Trust.

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