According to World Bank, 200 million businesses globally are unable to get the credit they need, both for working capital and for investments. The estimated global credit gap exceeds $2 trillion. Entrepreneurs are always eager to seek capital to grow their business, but banks can’t meet their needs. Small business loans also are not as profitable for banks, because they cost the same amount to originate as larger loans. For this reason, banks tend to put less emphasis on lending in the sub-$500,000 range. This creates a large funding gap for small businesses, which tend to seek out significantly smaller loans.
Peer-to-peer (P2P) lending platforms have evolved to solve the funding gap issue for small businesses. P2P platform is an online platform to allow small businesses to borrow a loan from a pool of investors who are seeking an interest repayment with an interest rate between 9-14%.
In 2015, an estimated amount of $23 billion was lent to borrowers globally via P2P platform whereby China accounted for 85% of the loans borrowed and the UK accounted for $4.4 billion of lending. Morgan Stanley predicts the P2P loans will exceed $150 billion to $490 billion globally by 2020. Given the huge opportunity, there are 60-80 countries that now have at least one P2P platform operating or lined up to launch in 2015/16. Governments around the globe are aware of the phenomenon and have assigned their relevant agencies to regulate the alternative finance activities.
Alternative finance activities such as equity crowdfunding and peer-to-peer lending are now regulated by the Financial Conduct Authority in the United Kingdom and have been from 1 April 2014. Two years later on 13 April 2016, Securities Commission Malaysia (SC) announced the introduction of a regulatory framework to facilitate peer-to-peer financing and allow P2P platforms to be operational in early 2017. In this particular announcement, Malaysia will only plan to launch the peer-to-peer financing option to business loans instead of personal loans. To put it into perspective, a Federal Reserve (US) report states that debt consolidation loans account for more than half of all peer-to-peer loans, followed by credit card payoffs (17%) and home improvement (8%), while small business loans account for an estimated 3.5% of all funded loans.
The big players in the P2P lending industry are Funding Circle, Lending Club, Prosper and Zopa. Interestingly, the big 3 US players even formed their own alliances: Marketplace Lending Association which sounds similar to UK’s Peer-to-Peer Finance Association. Here’s a snapshot of the big 4 players:
|Funding Circle||Lending Club||Prosper||Zopa|
|Founded||2010 @ UK
2013 @ US
|2007 @ US||2005 @ US||2004 @ UK|
|Loan Funded since operational||£1.3 billion||$18.7 billion||$6 billion||£1.5 billion|
|Side Notes||Funding Circle is a pure peer-to-business lending platform and not accepting individual as borrower. UK Government putting £20m in Funding Circle to fund small businesses along with investors||Largest player with most available loans for investors at all time and rate usually better than Prosper||Prosper only allow individual as borrower and the loan limit is $35,000.||In 2013, Zopa changed its model to let consumer feels more like putting money in a fixed-saving account. Lender don’t get to choose who to lend to. More details can refer to http://www.zopa.com/lending|
Most of the P2P portals are focusing on personal loans instead of business loans. My writeup focus will be geared towards peer-to-business (P2B) portals.
Here’s the 5 key elements which businesses should know about P2B lending:
- Speed & Simplicity
On Funding Circle, the online application for loan eligibility can be completed in 10 minutes without visiting any physical office. Within two hours, the business owner should hear from a loan specialist, who will ask them to submit documents for the application verification. If approved for a loan, the business should be funded within 10 to 14 days. It shows how businesses can now bypass a much complicated bank lending process.
- Access to funding
Based on a Nesta survey, 33% of SME borrowers from P2P platforms were convinced that they would have been unlikely to get funds elsewhere. In the UK, close to 50% of the SME loan applications were rejected. P2B portals quickly become the go-to place for these SMEs.
According to Bank Negara Malaysia (BNM) statistics, non-household loans approved in 2014 and 2015 were RM 160 billion and RM 180 billion respectively, while loans outstanding in 2014 and 2015 were RM 578 billion and RM 624 billion. The BNM statistics included listed companies, large private companies and SMEs. SME Bank had provided a brief statistic for SME lending: it states that SME loans outstanding in 2013 and 2014 were RM 199.6 billion and RM 225.9 billion of which borrowed to a total of 693,115 SMEs. RM67.3 billion worth of loans were approved in 2014 to 140,815 SMEs.
Referring to 2 tables below, it could clearly show the funding gap in Malaysia. Although the loan amount is not equivalent to the number of SMEs loans rejected, it does show how many business expansion opportunities were rejected due to loan rejection.
|Loan Applied RM mil||372,118.7||358,947.3||386,192.9||396,783.3|
|Loan Approved RM mil||186,326.9||154,814.2||160,017.1||179,865.5|
|Loan approval rate based on loan amount||50.07%||43.13%||41.43%||45.33%|
Source: Bank Negara Malaysia. Non-household loan, including listed companies, large private companies and SMEs
|Period||2012 Jan-Aug||2013 Jan-Jul||2014 Jan-Aug||2015 Jan-Aug|
|SME Loan Applied RM billion||123.8||111.1||119.9||126.6|
|SME Loan Approved RM billion||54.8||42.4||42.5||43.6|
|Loan approval rate based on loan amount||44.26%||38.16%||35.45%||34.44%|
Source: Ministry Of Finance. SME only
The SME Bank report also stated the key reasons for SME loan rejection in Malaysia were insufficient sales, income or cash flow (55.2%), too high leverage or outstanding loans (31.7%) and failure in providing sufficient documentation (31.7%)
Peer-to-business lending is suitable for established businesses which have been trading for at least a couple of years and profit generating while the business could offer a favourable interest rate to investors.
- P2B portals aren’t for large companies. Funding circle allow businesses borrow between $25,000 to $500,000 while Lending Club is between $5,000 to $300,000
- Isn’t for startup either. Lending club requires the business to be in business for more than 24 months and to have made at least $75000 in annual sales. Funding Circle requires the business to have made at least $150,000 in annual sales.
- Interest Rate
Interest rate on P2B portals are not necessary cheaper than banks. Annual Percentage Rate (APR) represents the true annual cost of borrowing, including interest and fees. The advertised APR for Lending Club business loans ranges from 8% to 32% while Funding Circle’s APR is between 8% and 33%. According to analysts, the typical APR ranges from 14% to 19% among 2 portals. Commercial bank’s SME loans are significantly cheaper with APR ranging between 6% to 8%.
Goldman Sachs reports that the average APR on loans charged by OnDeck was 51.2% in the fourth quarter of 2014. Granted, banks take a lot longer to issue loans than P2B portals, but if businesses can wait and can qualify for an SME loan, that will be the less expensive option. However, as bank credit is not available for SMEs in many cases, P2B appears to be the only option.
|12 months||5.49% – 23.29%|
|24 months||7.99% – 25.79%|
|36 months||8.99% – 26.79%|
|48 months||9.79% – 27.79%|
|60 months||10.49% – 21.29%|
Source: Funding Circle
Generally, the fees on P2B platforms can be classified into the following 4 types of fee:
- Origination Fee: Applied when the P2B loan is approved, businesses do not need to pay it if loan is disapproved and the fee is deducted from the total loan proceeds. Lending Club charge between 1% to 7% of the loan proceeds, Funding Circle is between 1% to 6%. On Lending Club, 80% of the borrowers pay 5% while 20% of the good borrowers pay only 1%.
- Late Payment Fee: Funding Circle charge 10% of missed payments.
- Non-sufficient Funds Fee: Funding Circle charge $35 when businesses don’t have sufficient funds in their account to make monthly repayment.
- Early Settlement Fee: some platforms do charge, but Funding Circle and Lending Club don’t have this fee.
P2B Lending For Investors
For the first time in history, the ordinary investor is now able to invest in the business credit market just like big banks. In 2015 alone, $23 billion was lent by thousands of investors via P2P platforms. Why were investors attracted to this new asset class? How much return and risk does this asset class consist of?
Before going into details, let’s take a look at the UK’s top 4 P2B players who had collectively lent about £1.7b since operational and it’s dominating around 80% of the entire UK P2B lending market share (excluding property financing)
|Funding Circle||ThinCats||Assetz Capital||Folk2Folk|
|Numbers||Lent £1.3 billion to 15000 businesses from 50000 lenders||Lent £175 million to 644 businesses from 5000 lenders||Lent £116 million to 200 businesses from 12500 lenders||Lent £104 million|
|Loan offering||Secured Loan between £100,000 to £5 million; Unsecured loans up to £250k||Secured Loan between £5,000 to £1 million||Secured Loan between £50,000 to £2 million||Secured Loan between £25,000 to £5 million|
Here are the 6 reasons why P2B Loan is an attractive asset class for investors:
- 7% Net Return + Cash Monthly Repayment
Funding Circle had disclosed investor’s average return after fees is 7.1% which 50% of the investors are earning 6.4% and above. ThinCats’ weighted average return after fees and before losses and tax is 11.24%. Assetz Capital’s earning gross rates of return between 3.75% – 18% per annum with an average gross interest rate of 10.6% (before fee). Folk2Folk didn’t disclose their average rate but their advertised rate of return is 6.5%. Hence, it’s safe to say that the net return is 7% and above. Investors are able to receive cash repayment on monthly basis. It empowers the investor to reinvest the cash repayment into new loans and compound it on monthly basis.
- Simple Fee: 1%
Same as mutual funds and stocks, there are fees involved when investing in P2B loans. Unlike the stock exchange, there’s no transaction fee for every purchase of a loan. P2B platforms practice a relatively simple fee structure: 1% annual servicing fee. On Funding Circle, the 1% is charged based on the amount outstanding on any loan, payable on the capital only, not interest. It is included in the interest rate payable by the business and taken directly from loan repayments. Yes, that’s only one fee: the 1% annual servicing fee, nothing more.
The P2B platforms provide the liquidity option to investors too. On the platform itself, there’s a secondary market for investors to trade loans. 0.25% sales fee is applied on Funding Circle when a loan is sold to another investor; the fee is based on the outstanding loan amount. Interestingly, investors can also add a premium or a discount to the loan which they are selling, just like a bond.
The majority of the UK P2B loans which investors lent to are secured against something solid, tangible and recoverable in the form of property, equipment, inventory, account receivables or other equivalent worth considerably more than the loan. The Big 4 UK P2B platforms practice a maximum loan to value (LTV) ratio of 60%-65%. For example, when the business borrow a £600,000 loan, the business must provide the platform a charge over asset which worth at least £1,000,000. When the loan is declared as bad debt, the P2B platforms will recover the debt by selling the assets and return the principal plus interest to investors. In some cases, the platform might not fully recover the principal due to the liquidity of the asset, the investor losses could be up to 5%. You might wonder how much is the default rate in reality.
- Low Default
Funding Circle’s current bad debt is 1.6% and expected annualised bad debt is 1.8%, ThinCats’ current bad debt is 5.02%, Assetz Capital’s current bad debt is 1.41%, Folk2Folk is still achieving a record of zero default as to-date. Let’s zoom into Funding Circle’s statistics. Since operational, there are 259 bad debts worth £21 million against a total of 19,479 loans worth £1.3 billion. In terms of percentage, 1.33% of the loans are bad debts and the monetary amount is 1.63% of all loans. To put it into local perspective, major commercial banks in Malaysia are getting a non-performing loans (NPL) rate between 0.95% and 3.15% while SME Bank once stood high at 12.3%.
- Simple Diversification Strategy
How do P2B loan investors achieve high returns while safeguarding against default? Diversification! Diversification simply means spreading the lending across hundreds of different businesses, which means investors have a small amount lent to each one (instead of a large amount to just a few). For example, investor can lend as little as £20 per business, so by lending £2,000 in total, an investor can lend to 100 businesses and be diversified. While doing that, an investor should retain a maximum of 1% of their total amount lent to any one business. This becomes important when a business is not able to fully repay its loan as the impact on overall return will be less. On Funding Circle, diversification can be done by filtering risk grade (interest rate), location, industry sector, the business’s financials, loan purposes. Here’s an example of the interface:
Different P2B lending model between the West and Singapore
The majority of the UK’s P2B platforms and the US’s largest P2P platform Lending Club operate on the auction model and the majority of the loans are secured. Every business loan will be funded through a live auction. Investors participate by placing a ‘bid’. The bid is the amount of money that the investor wants to offer the business and the interest rate he/she set for them to pay back. Just as with any auction, the bid is final and can’t be withdrawn – but other investors offering lower rates can knock it out. If this happens, the investor can bid again at a lower rate. Only lowest rates offered in the auction are accepted into the loan. If the business chooses a fixed interest rate auction, there’s no bidding needed and thus the loan is filled on a first-come-first-served basis. All platforms have the auto-bid feature hence it’s not that complicated for new investor.
You might wonder how investors are going to know how much interest rate should they bid for. It’s based on risk grade. Funding Circle’s credit assessment model consists of 2,000 variables including company performance, credit history and existing loans and debts. Every business that passes their credit assessment process is given a grade from 6 risk levels (A+ to E). Here’s the weighted average interest rate offered by investors to each risk band: A+ is 8.3%, A is 9.4%, B is 10.4%, C is 11:8%, D is 14%, E is 18%. Lending Club even provide 25 risk grade with a specific interest rate ranging between 5.32% to 30.99%.
While the majority of P2B loans are secured in the UK and US, Singapore’s P2B platforms are offering P2B lending on a no-collateral-required basis. However, the platforms do require the business’s director to be personal guarantee on the loan. The only 3 peer-to-business platforms (MoolahSense, Capital Match and Funding Societies) in Singapore have collectively raised more than S$10 million for SMEs in 2015 and a collective total of S$24 million was lent to businesses since operational. To know more about the P2B space in SG, you may read more about The Straits Times’s reporting here. It mentioned that an investor managed to earn an average return of 17%. Among the 3 platforms, MoolahSense is the leading P2B platform with S$11.42 million lent to 65 loans while Capital Match is catching up with S$9.53 million lent to businesses.
If you wish to know about a more detailed real world example of how much can you earn from a P2P portal, you can read this blog: http://www.lendacademy.com/quarterly-p2p-lending-results-q1-2016/. He shared his investment return on a quarterly basis starting from Q1 2011 until Q1 2016 for 18 quarters. His latest annual return is 9.28%.