Eyes Wide Shut? – Muckler Urges Caution for P2P Investors Seeking Income

‘Investors face potential losses when the loans they have bought are down-valued’ – sound familiar?

In 1905 in The Life of Reason, George Santayana wrote ‘those who cannot remember the past are condemned to repeat it’ and certainly there have been concerns that the securitisation of the peer-to-peer (P2P) industry bears more than a passing resemblance to the market in mortgage-based securities in the lead up to the financial crisis in 2008.

For many ‘securitisation’ is one of the City’s dark arts; the sheer number of acronyms – MBS, ABS, CDS, CDO, CMO, CBO, CLO – are the blue-blood equivalent of the rhyming slang employed by their near-neighbours to the East.

However, securitisation is merely the practice of turning an illiquid asset – in this case a book of loans – into a readily tradable instrument; this attracts institutional investment and allows risk to be spread across a range of unsecured loans.

‘those who cannot remember the past are condemned to repeat it’

P2P loans are attractive in this regard because platforms control the risk profiling of their borrowers and therefore those buying the loans should be able to assess the overall risk they are exposed to with some accuracy.

Because the market there is relatively advanced, securitisation has been a feature of the P2P market in the States for some years now, with the UK tipped to grow strongly with individual investment opportunities following shortly thereafter.

However, alarm bells rang recently when CEO and kingpin of $1 billion Lending Club, Renaud Laplanche, resigned and the company announced on its website that lenders ‘may not receive the full amount of payments due or could see delayed payments if the company goes out of business’.

It emerged that Lending Club, a key player in the P2P industry sold a portfolio of $22m (£15m) to a large investor, which then discovered the loans were not quite what they were cracked up to be.

Shares in Lending Club, which listed on NYSE in December 2014 are down 60% year to date and despite the fact that they rallied on Friday (May 20^th 2016) there is still some frantic bailing going on to keep the company on an even keel.

However, because of the way in which its loans had been packaged up and sold on, collateral damage was inflicted elsewhere; P2P Global Investments, a UK investment trust that buys loans from Lending Club, saw its shares fall by 65p or 7% as well.

The trust has a current yield of 7%, and because of recent events, its shares now trade at a 13% discount to the net asset value (NAV) of the fund.

The conundrum for potential investors is to decide whether the valuation of the assets held by the trust, with the Lending Club loans, is accurate and therefore whether it really is trading at bargain basement prices.

The trust has a target dividend range for the year of between 60p – 80p, and if it were to be set at the midpoint, the discounted share price means that investors would receive an effective dividend yield of 8% – quite an attraction for income-starved investors.

The biggest unknown, and threat to the would-be investor, is just how high default rates will be in what is an industry in its infancy; the attraction of investing in a vehicle such as an investment trust is that it delivers a diversified portfolio that spreads its risk around, but it is as yet unclear how P2P will respond to difficult market conditions.

‘just how high default rates will be in what is an industry in its infancy?’

The fact that P2P Global Investments is now trading at a significant discount to NAV is in complete contrast to the way such trusts performed when they were fresh out of the traps; some consider that an inevitable readjustment to the initial euphoria that greets a disruptive technology.

So, it’s OK to plough in then and take advantage of those big discounts?

Well, there may be room for such an investment in a diversified portfolio, but it is clear that companies such as P2PGI, and indeed the entire P2P industry has some fences to mend in terms of re-establishing trust.

In order to shore things up, P2PGI stressed that it selected only loans from borrowers with good credit scores – prime loans – from the platform and not from borrowers with slightly impaired credit ratings – near prime loans.

Jason Hollands of investment manager Tilney Bestinvest believes that P2PGI, remains a well diversified investment vehicle with over 130,000 individual loans, paying an average coupon of 10%.

Because the structure of an investment trust allows its manager to leverage its assets – effectively borrow against them – it should in theory be in a position to purchase better quality loans, and thereby deliver attractive returns to the income seeker.

However, there is undoubtedly risk in investing in P2P, and Alan Brierley, Head of Investment Trust Research at Canaccord Genuity is looking for the board of P2PGI to demonstrate its confidence in the trust by buying back its own shares to bolster its share price and reduce the discount.

Brierley does not consider this the time for income seekers to ‘buy-the-dip’; he fears that poor sentiment in the P2P market could lead to further falls in its price and rates P2PGI as a ‘hold’.

It looks likely that the sector will experience ongoing volatility until markets work out how P2P loans respond to a challenging economic environment and during that period it may not be a happy hunting ground for the long-term DIY investor.

However, if companies such as Lending Club can steady the ship and employ robust risk management procedures, securitised P2P loans could appear on retail investors’ radar in the future, delivering much needed income as UK base rates head towards zero.