From the March 2016 issue of Research Magazine • Subscribe!

Crowdfunding and Peer Lending: Time to Swim With the Sharks?

Clients are showing interest in nontraditional funding techniques; advisors can help them understand the risks and benefits

The Great American Search for Yield has led many clients to seek investment opportunities that promise higher returns than traditional asset classes. Crowdfunding and peer-to-peer lending allow investors to provide capital directly to start-ups and individual borrowers. Who needs investment banks when I can use technology to cut out the middleman?

According to Andrew Zumwalt, a University of Missouri Extension professor and expert on online banking, many investors “have gotten caught up in the shark tank mentality. It's exciting! Who doesn't want to be a shark?” The question, of course, is who is going to be eaten?

Both peer-to-peer lending and crowdfunding get rid of the traditional financial intermediary. Peer lending allows individual investors to place dollars in the hands of borrowers without a bank taking a cut of the transaction. Equity crowdfunding allows investors to sidestep Wall Street and place dollars in the hands of entrepreneurs. Banking seems ripe for disruption, and the time may be right for individual investors to get on board.

Peer-to-Peer Lending

Peer-to-peer lending is the oldest alternative online banking platform, so it provides a useful window into the potential benefit of online investing. Prosper has been around since early 2006. On Prosper, you can join over 2 million lenders who each chip in as little as $25 per loan (or note). Credit score is used by Prosper to place borrowers into risk categories, and lenders can review borrower information to select the loans they want to make. Lending Club is now larger than Prosper (currently $13 billion lent and rising) and essentially operates the same way.

There is now ample net (after default) return information on both Prosper and Lending Club to suggest that peer lending is a solid investment. It's worth hitting Lending Club's remarkable historical loan return Web page to understand how well investors have performed on their peer loans. For example, borrowers with the highest A-credit rating have provided investors an average net return of 5.2% from an average interest rate of 7.7%. The difference represents the defaults. The lowest credit rating borrowers (F&G) have returned 9% from an average interest rate of 23.5%. Generally investors willing to accept a higher risk of default are rewarded with a higher expected net return.

According to Zumwalt, “it's better when you diversify across all the credit categories. I also only put $25 in each loan to reduce my risk with each borrower.” Because you can diversify your investments among individual loans, the only real risk of selecting borrowers with a lower credit rating is the possibility of widespread defaults during a severe recession. “If there's an economic downturn, everyone could just default. They’re unsecured loans,” notes Zumwalt. And none of the loans are FDIC insured.

It's useful then that Prosper and Lending Club were established before the financial crisis, and the returns from these years don't look as bad as you might expect. If we look only at returns on loans made from the first quarter of 2007 through the first quarter of 2010 on Lending Club, default rates are higher than on newer loans but net returns to lenders still range between 5.5% for A-rated borrowers to 5.25% for E-rated borrowers. The lowest credit borrowers returned only 2%, but the return was still positive. And even during the financial crisis, investors were rewarded for lending to higher credit risks since D-rated borrowers yielded 6.1%.

Zumwalt made 4.9% on his Prosper loans net of fees between 2009 through 2016. This is better than the five-year performance of the high-yield corporate bond category (3.24%), and represents an intriguing and legitimate portfolio category for clients. The duration of loans ranges between three and five years, and loans can be laddered to control portfolio duration. The main disadvantage is that these loans are relatively illiquid, although a secondary market does exist within the sites to dispose of loans for cash. These secondary market loans tend to sell at a deeper discount.

It can also be fun to read about the people who are borrowing your money to pay off high-interest credit card debt or start a new business. But, as Zumwalt notes (and researchers have confirmed) “if you think you can do better by reading people's stories and looking at their pictures, you don't have a chance.” A good strategy is to set lending criteria, such as a range of risk levels, and automatically fund loans that meet these requirements without spending the time reviewing individual requests. Researchers note that photos and descriptions that borrowers add to their loan requests aren't vetted by peer lenders, so you shouldn't really pay attention to them.

Of course, some still do. Younger, beautiful looking women tend to have an easier time getting funded. According to research conducted by my graduate students, it appears that photos of attractive females can be relatively easy to obtain on the Internet. So attaching them to a loan shouldn't provide much value.

Both Prosper and Lending Club allow borrowers to invest in loans through a tax-sheltered account. Investing in peer-to-peer loans through an IRA makes a lot of sense as a way to add yield to a bond portfolio since much of the bonus in returns above other high-yield bonds appears to come from illiquidity. And since most investors won't be touching assets held in IRAs for a while, why not stash your illiquid (and high yielding, tax-disadvantaged) peer-to-peer loans in a retirement account?

You might ask why more investors aren't entering the market seeking a higher-yielding investment opportunity if returns have been so much higher than traditional high-yield asset classes? A concern some investors have is that financial institutions are moving into some of these marketplaces. If enough pension funds realize they can boost returns by buying up consumer loans, then returns will converge to a level that is appropriate for the level of risk. This means that past outperformance isn't a sure bet as more money enters the peer lending marketplace.

Equity Crowdfunding

On Oct. 30, 2015, the SEC began letting non-accredited investors participate in equity crowdfunding. Allowing individual investors to bypass investment companies, and giving them access to early-stage venture capital (VC) financing could be a revolution in what has previously been a significant speedbump in the way good ideas are turned into new businesses. You can get in on the ground floor by providing investment capital to a new firm.

Crowdfunding may sound like a revolutionary concept, but individual equity investing in start-up companies has been around since a couple of MIT and Harvard professors opened American Research and Development as a closed-end fund in 1946. The idea was that there was a gap in equity funding for firms that had a good but risky idea that limited their ability to obtain funding from a bank or on the public equity markets.

The closed-end fund structure eventually fizzled in favor of institutional investments in professional venture capital firms. One reason was that investors, particularly older ones who wanted investment income, became impatient waiting for long-term capital gains to materialize. Institutional investors could maintain a longer time horizon, and may do a better job of overseeing the venture capital managers.

Illiquidity is the first important unknown of equity crowdfunding. In the absence of exchanges to trade shares in new startups, how will individual investors be able to cash out? A couple new exchanges have popped up that feature a limited number of traded startups, but most established equity startup companies warn investors that it may take years before they get any return on their initial investment. Clients need to understand that they won't get rich overnight, and they shouldn't invest any money they might need in the near future.

Oversight is the second possible problem with equity crowdfunding. It has been argued that the biggest source of value provided by professional venture capital firms is their ability to maintain careful oversight of the start-up firm during its incubation stage. In addition to helping a new firm select board members, compensation structure, and corporate strategy, the VC is also able to award new capital through stages as the start-up either shows promise or is identified as a dud. This ability to award new capital to move an early-stage company along prods managers to work hard and doles out investor capital where expected returns are the highest.

What does this have to do with crowdfunding? One of the biggest inefficiencies of early-stage funding for firms that don't trade on traditional stock exchanges (I’m looking at you, non-traded REITs) is that investors are “dispersed,” especially if they’ve done a good job of diversifying their investment among a number of different startups. This dispersed ownership reduces the incentive to keep a close eye on managers.

Insufficient oversight might also attract bad actors to the equity crowdfunding marketplace, and even the ones with best intentions might not have the skills needed to build a new company. A recent article on penny stock IPOs published in Financial Management found that tiny companies see high initial returns but long-term underperformance, especially those led by underwriters who appeared to manipulate the market. Many state regulators have expressed concern that equity crowdfunding presents remarkable new opportunities for the more ethically challenged financial actors.

Supporters of equity crowdfunding point to the new possibilities provided by the Internet to crowd-regulate new firms. Kickstarter forums allow individuals to identify the bad actors so they don't receive additional funding. The same could happen with equity crowdfunding if individual investors were committed to weeding out fraud and if new investors actually paid attention. I’m a little skeptical.

The more established equity crowdfunding sites like SeedInvest promise to vet startups that seek capital through their platform. This may ultimately be the safest way for new equity crowdfunding investors to dip their toe into the market. They can scroll through projects on the site without worrying about whether the projects actually exist. And some of the projects on the site look like great ideas — wouldn't it be fun to support them?

So who is getting eaten in the exciting market for crowdfunding and peer lending? Peer lending seems to do a good job of using the Internet to edge out big banks in the highly inefficient consumers lending market. Investors have logged solid returns that seem to consistently beat out traditional investments. Equity crowdfunding holds significant promise if the market can find a way to limit fraud and give investors an exit strategy. But I have no doubt that there will be plenty of sharks on both sides.

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