Berk Sure Has A Way

Last year was brutal for almost all assets classes across all markets.  Investors who diversified still had sizable losses.  Many investors have pulled in their horns and moved to safe assets like cash or treasuries.  Savvy investors have been trying to navigate the myriad opportunities offered in today’s markets – ideally enhancing returns without the risk of another 2008.  I attended the Finovate Startup 2009 conference in San Francisco last week and was excited and impressed by some of the companies trying to create alternative asset classes by cutting banks out of the lending loop.

Although credit markets have thawed somewhat since the deep freeze of in the Fall of 2008, it is still difficult for many people and institutions to get credit. This creates a perfect opportunity for the expansion of peer to peer (P2P) lending.  P2P lending effectively takes banks out of the lending process by allowing people to borrow directly from other individuals (or sometimes pools of borrowers from pools of lenders).  There were four companies at the Finovate Startup conference focused on this space:  Lending Club, People Capital, Pertuity Direct and Prosper.  While the borrowing side of the P2P space is fascinating, I am focusing this post on the lending side – how these services stack up as an alternative asset class.

Prosper.  Prosper pioneered this field a few years back and ran into trouble both with the SEC as well as allowing too many deadbeat borrowers.  They have recently relaunched and remain the largest player in this nascent field.  I find Prosper’s process to lend money to be time consuming and clunky.  You have to handpick all the loans you want to fund plus bid on the interest rate you are willing to accept.  That said, among the four, Prosper seems to have the most opportunity for earning the highest yields for a motivated lender.  I expect that with their relaunch, risk management will be more of a theme since the losses on the first batches of loans were quite high.   In fact, Prosper made the point that they have raised the minimum FICO score for a loan application.  Prosper says a secondary market for longs that an investor would like to sell is coming soon.

Lending Club.  Lending Club was “fast follower” in this space and learned from Prosper’s challenges.  They filed with the SEC and grew quickly.  Their historical loss rates are lower and their risk management seemed to have been more rigorous from the get go.  I also think the process for creating a loan portfolio is a bit clunky, but easier than Prosper since there is no interest rate bidding.  Interest rates are set by the risk bucket a borrower is placed in when they apply.   This simplifies the process but may reduce potential yield for lenders.   Overall, I thought Lending Club had a nice balance of risk management, ease of use and potential yield.  Their demo showed an average yield of over 9.5%.  Since launch a report on their website says that average yield earned on the site is over 9%.  Lastly, Lending Club is the further along on the liquidity front – they have created a secondary market for loans if you do not want to hold them to maturity.  The Lending Club rep said that some loans are sold for more than par, some less but overall it is likely slightly less than par.

Pertuity Direct and National Retail Fund.  Pertuity Direct launched in January of 2009 and is the simplest of the P2P concepts from an investing standpoint.  Pertuity Direct is funded by the National Retail Fund that pays the average yield to all investors in the fund after fees.  I like this model from a simplicity standpoint.  This would be the service I would recommend to someone who was not a web expert or a credit expert.  It is simple, easy to setup and easy to manage.  That said, it remains to be seen what type of yield you will get from the National Retail Fund – the site suggests in excess of 13%!   A lot more rides on Pertuity Direct’s ability to attract, screen and retain high quality borrowers.   Liquidity in the National Retail Fund is currently quarterly but their reps indicated that they are working on more frequent liquidity windows.

People Capital.  People Capital will be launching later this year with a  focus on educational loans.  I like their focus on the educational market since it distinguishes them from competitors and potentially attracts a more creditworthy borrower.  People Capital expects that they will have competitive yield with the other services.  However, their CEO indicated he expects some lenders might be generous family members (e.g. Grandma), enabling a lower blended interest rate for borrowers.   This could be a big win for borrowers and the platform by lowering the overall interest rates that people pay for education.  Lastly, their CEO informed me that student loans are not wiped out during personal bankruptcy – effectively reducing risk by putting lenders in a higher place in the borrower’s “capital structure.” Overall, People Capital is an unknown quantity since it has not launched, but I see a ton of potential here.

I like the peer to peer lending model.  While banking has a bad reputation across the globe right now, traditional banking (deposits and loans) is a wonderful business.  By cutting out the bank, P2P allows borrowers and lenders to get better interest rates and yields than they would otherwise.   Success for these services depends upon risk management – if they set the bar too low for borrowers and defaults soar, they could kill lender demand before the platforms have a chance to succeed.  That is why all of them have trumpeted their focus on high FICO, “super-prime”, creditworthy, credit-savvy borrowers.  Transparency goes a long way towards ensuring good risk management.  I think transparency has been a big positive for Prosper and Lending Club.  I hope the Pertuity Direct and People Capital both emulate that element of the pioneers’ services.

Going forward, P2P services are indicating yields of 9% or more on average (even after fees and delinquencies).  Your mileage may vary on what type of yield to expect given the deteriorating macro-economic background, but these yields are pretty juicy, even adjusting for risk.  Over time, I expect yields will come down when credit normalizes and the fees charged by these services rise (as I expect they will).

With the possible exception of People Capital, I don’t expect these to appeal to institutions (bigger fish might want to check out Second Market or The Receivables Exchange – both very promising).   I would recommend each service to different type of small lenders – people looking to lend less than $50k.  For the savvy alpha-seeker, I would recommend Prosper.  For the “set it and forget it” mainstream investor, National Retail Fund seems like the simplest option.  Personally, I liked the balance that Lending Club has struck between yield and simplicity.  If the equity markets start to get frothy again, I would probably try Lending Club first.