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  1. Overview of risks
  2. Provision funds
  3. Skin-in-the-game

Overview of risks

If you are considering investing in peer-to-peer (‘P2P’) lending for the first time, you need to understand that P2P investment involves risk. A risk of capital loss is inevitable with any investment unless you wish to place your funds into an FSCS protected savings account (in which case your savings are currently protected up to £85,000).

However, investing in a FSCS savings account will currently produce paltry returns given the current low interest rate environment. In search of higher returns, many are choosing to invest funds into alternative investment choices such as P2P lending. It’s important that such investors do not blindly invest into P2P platforms, but first clearly understand what they are investing in, the key risks and how those risks can be partially mitigated.

There are three main ways in which P2P investment risk can be partially mitigated (by you, as opposed to the platforms themselves):

  • Due diligence – First and foremost, you need to understand what you are investing in.
    • Self-select – If you intend to invest in self-select loans, many platforms offer an abundance of information about the loans on offer (e.g. loan amount, security offered, LTV, repayment plans). You are then able to do as much or as little research as you please.
    • Auto-select – Alternatively, if you are intending to invest in auto-select loans, then you need to understand the lending criteria of the P2P platform to understand whether the level of risk being taken by the platform is acceptable for the level of expected returns. This website features a number of platform reviews which aim to provide digestible overviews, but we would always recommend doing your own research too.
  • Security
    • Different platforms accept different levels of security from borrowers. Investors must understand the level of security taken to understand the level of risk they are accepting. For instance, some platforms focus exclusively on unsecured lending with no tangible security offered by the borrower (e.g. RateSetter, Funding Circle and Zopa). These platforms focus on diversification in an attempt to mitigate risk. Other platforms focus exclusively on secured lending (e.g. Growth Street loans are secured against all business assets, whilst Kuflink loans are secured against first or second charges against UK property).
  • Diversification – The importance of diversification is best illustrated by example. Below we consider a simplified (unsecured) example of two individuals, each with £2,000 to invest.
    • Investor #1 chooses two self-select unsecured consumer loans to invest £1,000 into (£2,000 total investment). Each investment is expected to deliver 10.0% interest rate per annum, paid in full at the end of the 1 year term. At the end of the term, the first loan repays and the investor receives £1,100 back. However, the second loan defaults and the lender is required to commence recovery proceedings which can take time. The investor is now facing the possibility of a potentially large capital loss.
    • Investor #2 chooses to invest £2,000 into 100 different P2P investments (£20 per loan).  Assuming the same 10.0% interest rate overall after a 1 year term, the investor would expect to receive a payment of £2,200 back at the end of the term (£22 from each individual loan investment). In this scenario, more than nine of the 100 loans (9*£22=£198) would need to default (with no money recovered) before the investor faces the possibility of capital loss.

Aside from these three key points, a further consideration is the existence of a provision fund or the lender having ‘skin-in-the-game’.

Provision funds

A number of P2P platforms set aside a contribution from investors or borrowers to a pot called a ‘provision fund’ (sometimes also labelled as a ‘Reserve’ or ‘Safeguard’ fund). This pot exists to absorb losses in case of default. Provision funds are most popular on unsecured lending platforms as no tangible security can be seized in the event of default. If a P2P platform offering secured loans has robust security and strong credit control procedures, a provision fund should be largely unnecessary.

The existence of a provision fund is not a guarantee of safety, but should typically result in smoother returns for investors as losses may be absorbed by the fund. If the provision fund became depleted (e.g. in a significant economic downturn), the provision fund may not always be able to cover defaulted loans and investors may still suffer capital losses.

There are two types of provision funds – a fully integrated provision fund pays out immediately and automatically when an investor defaults resulting in no time-lag for investor repayments. Conversely, discretionary funds pay-out at the discretion of the directors.

The added layer of security that a provision fund offers comes at a price, with investors typically receiving slightly lower rates of return. This is because the provision fund requires cash that might have otherwise been distributed to investors via higher interest payments. Instead, this cash sits unutilised in a segregated cash account earning low interest rates for the business. 

Platforms offering a fully integrated provision fund:

Consumer lending

Platforms offering a discretionary provision fund:

Business lending

Consumer lending

  • Unbolted (secured lending)
  • We Lend Us (unsecured lending)

Property lending

  • LandBay (secured lending)
  • Just Us (mixture of secured/unsecured lending)

Skin in the game

The term ‘skin in the game’ refers to when a P2P platform/loan originator risks its own money alongside the investors in the P2P platform, often on a first loss basis. This reduces the risk that investors are exposed to if a borrower defaulted on a loan.

This is an attractive proposition for investors as not only does it reduce investment risk, it also ensures that the platforms goals are aligned with their own.

Platforms with skin in the game:

Property lending

  • Loanpad – The platforms lending partners fund a minimum 25% of any loan. The lending partners accept the junior tranche of the loan (they invest on a first-loss basis).
  • Kuflink – Invests a minimum 5.0% in all loans, on a first loss basis.
  • Octopus Choice – Invests a minimum 5.0% in all loans, on a first loss basis.
  • HNW Lending – Invests in all loans on a first loss basis (typically 10.0%)