Investment Insight
An Introduction to Alternative Lending
 
 

Investment Insight

An Introduction to Alternative Lending

 

As investors grapple with the portfolio implications of a rising interest rate environment alongside a continuing search for yield, alternative lending may offer attractive absolute and risk-adjusted return characteristics. An allocation to alternative lending may provide investors with exposure to a secular shift in the way consumers and small businesses access capital. In this paper, we provide insights on this nascent asset class.

 

What Is Alternative Lending?

Alternative lending is an asset class borne of bank disintermediation and technological innovation. Alternately referred to as marketplace lending, peer-to-peer lending and P2P lending, alternative lending takes place through online platforms that use technology to bring together borrowers who are underserved by traditional lending institutions, with loan investors, who are seeking attractive yield-generating investments. The lending model grew out of small balance, peer-to-peer unsecured consumer loans financed by retail investors. As volumes ramped and the asset class matured, alternative lending evolved such that most loans are funded today by institutional investors.1 At the same time, the types of credit risk underwritten by alternative lenders have expanded beyond unsecured consumer to include small business lending, student loans, auto finance and other forms of specialty finance.

Display 1: Alternative Lending Model
 
 
 
 

How Does it Work?

Borrowers may seek alternative loans for a variety of reasons, including for debt consolidation or to pay down revolving credit card balances. By moving from a revolving structure to an amortizing installment structure, borrowers may benefit from a lower interest rate than would be charged on a comparable revolving balance, such as from a credit card. Alternative lending platforms seek to streamline the traditional lending process by bringing together the borrowers with loan investors and by using technology-enabled models to rapidly underwrite borrower credit risk to determine appropriate loan pricing, terms and amounts offered to the borrowers.

When borrowers accept loan offers, investors may purchase the loans post-issuance, either by actively selecting loans that they wish to purchase or by taking passive pro rata2 allocations of loans that meet pre-specified criteria with respect to loan type, size, term, duration, credit risk, geographic concentration, etc. Investors largely obtain the potential economic benefits and risks stemming from the loans, but the platforms typically maintain the customer relationship with end-borrowers and act as servicers for the loans, sending cash flows from the borrowers to the investors net of a servicing fee. The platforms also may charge loan origination fees, typically to the borrowers.

Platforms may use partner banks to formally originate the loans that they underwrite. The partner banks typically conduct oversight on the platforms’ underwriting models and ensure that underwritten loans and servicing procedures comply with applicable laws. In some cases, the partner banks or the platforms may maintain a continuing economic interest in loans sold to investors.

The loans themselves generally have relatively low initial balances, on the order of $1,000-$50,000. Today, the most common consumer unsecured alternative loan is fully amortizing, with a weighted average term2 of 45 months, a duration2 of roughly 1.1 years and an average size of $13,000.3

Display 2: Traditional Banking Model
 
 
 
 

The Evolution of Alternative Lending4

Alternative lending grew rapidly in the decade following the first “peer-to-peer” online loans underwritten in the U.K. in 2005, and the U.S. in 2006, and gathered pace in the wake of the Global Financial Crisis. These small volume credit experiments leveraged marketplace models alongside technology-enabled customer acquisition, underwriting and loan servicing geared to borrowers that had grown comfortable with online services. Alternative lending volumes scaled as the credit crisis drove bank retrenchment from consumer and small business lending, and as new regulations increased the cost of capital for traditional banks, stressing the traditional banking model.

To facilitate burgeoning loan volumes, alternative lending platforms evolved their funding models from the “peer-to-peer” format to predominantly institutional buyers purchasing portfolios of loans in bulk. Hedge funds were early buyers, actively selecting individual loans that they expected would outperform the platform’s average underwriting. As the platform underwriting models matured and the opportunities for hedge fund “alpha”5 generation declined, institutional buyers largely migrated to passive pro rata purchases of loans within each buyer’s credit box.

Passive pro rata allocations moved the diligence burden for loan purchasers from the individual small ticket loans to all of the loans underwritten by a platform within a purchaser’s defined credit box, as well as of the platforms themselves. Passive allocations also facilitated deeper integration with the capital markets. The first securitization backed by alternative loans occurred in 2013, and the first rated securitization followed in 2015. U.S. consumer and small business alternative lending platforms first listed their shares publicly in 2014. The first registered alternative lending fund launched in the U.S. in 2016. In 2017, Morgan Stanley estimates that $14 billion of U.S. marketplace loans were securitized, which is on the order of one third of all such loans originated in the U.S. that year.6

Display 3: Evolution of Alternative Lending
 
 
 
 

Past performance is not indicative of future results.

* “The Hourglass Effect: A Decade of Displacement”, QED Investors, Frank Rotman, April 13, 2015; AIP’ Alternative Lending Group research.

** The statements above reflect the opinions and views of AIP Alternative Lending Group as of the date hereof and not as of any future date and will not be updated or supplemented.


 

As illustrated below, the U.S. market saw nearly $35 billion of alternative loan originations in 2016, representing an increase of more than 200% from the volumes underwritten in 2014. The consumer segment represented about 70% of U.S. alternative lending, followed by roughly 21% in small business and 9% in specialty finance (a variety of smaller verticals).7 The small business segment has taken some market share from the consumer segment in recent years, a trend that may continue given the sizable market opportunity alongside banks struggling to underwrite small ticket business loans using relatively antiquated and manual processes.

Display 4: U.S. Loan Origination by Segment***
 
 
 
 

*** Cambridge Centre for Alternative Finance: Americas (June 2017); AIP Alternative Lending Group. Past performance is not indicative of future results.


 

Why Is the Opportunity Compelling Today?

In our view, there are four main reasons why alternative lending may be a compelling strategy for investors.

1. Alternative lending may provide a potential combination of better yield and low duration that stands in sharp contrast to the traditional fixed income universe today. Alternative lending’s low duration should reduce sensitivity to rising benchmark interest rates, while outsized credit spreads8 may provide a cushion against credit loss should investors encounter a less benign economic environment than we’ve experienced following the Global Financial Crisis.

Display 5: Alternative Lending vs. Traditional Fixed Income: Coupon and Duration (as of 3/31/2018)
 
 
 
 

Coupon is the annual interest rate paid on a bond/loan before accounting for pre-payments and defaults.

Past performance is no guarantee of future results. Source: Orchard (duration as of 01/2017 and coupon as of 3/2018), Barclays. US High Yield: Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged, US Investment Grade: Bloomberg Barclays US Corporate Total Return Index Value Unhedged USD, Barclays Aggregate: Bloomberg Barclays US Aggregate Bond Index, 10 Year UST: United States Treasury Note/Bond. See the end of the presentation for index descriptions.


 

2. Alternative lending historically has been diversifying versus other major asset classes, including traditional fixed income. We believe that the relatively low historical correlation of alternative lending to traditional fixed income has been supported by alternative lending’s underlying credit exposure, which stems primarily from the consumer rather than from corporate or government credit exposure that generally dominates traditional fixed income allocations. Judiciously selected alternative lending investments historically increased portfolio diversification and a portfolio’s expected return per unit of risk (Sharpe ratio).8

Display 6: Historical Correlations Through 3/31/2018
 
 
 
 

Past performance is not indicative of future loss. For illustrative purposes only. The darkest blue color indicates asset classes that are most correlated to one another; light blue represents asset classes that are least correlated.

* Equities are represented by S&P 500 Total Return Index, Fixed Income by Bloomberg Barclays U.S. Aggregate Bond Index and REITs by MSCI US REIT Index. Correlations are calculated based on a track record starting 1/1/2011 and ending 3/31/2018. See end of the presentation for index descriptions.


 

3. Alternative lending has exhibited attractive absolute and risk-adjusted returns since the inception of the Orchard US Consumer Marketplace Lending Index in January 2011. The returns from alternative lending have been slightly better than the returns generated by U.S. REITs and substantially better than the modest return of traditional fixed income over the same period. Furthermore, alternative lending posted positive returns during periods of market turmoil when other traditional asset classes struggled, including the “Double Dip” recession risk period in 2011, the “Taper Tantrum” of 2013, “Grexit” concerns in 2015, the U.S. presidential election in 2016, and the February 2018 market dip. It should be noted that since a liquid secondary market with observable prices has not yet developed, alternative lending typically uses discounted expected cash flow, mark-to-model valuation.9

Display 7: Risk-Adjusted Returns vs. Traditional Asset Classes
 
 
 
 
 
 
 

Past performance is no guarantee of future results, and we recognize that the economy has been benign in the time frame over which index-level data has been available for alternative lending. We believe that alternative lending returns, which are relatively untested in an economic downturn, may prove pro-cyclical and likely would decline during more challenging economic periods. However, we believe the significant credit spreads on offer from alternative lending may provide meaningful cushion before principal losses and may position the asset class to perform admirably over a full economic cycle.

4. Alternative lending reflects a highly diversified opportunity set. Indeed, the volume and variety of strategies have flourished in recent years, providing multiple axes for diversification (e.g., by loan segment, credit quality, security interest, ticket size, duration)

Display 8: Diversified Opportunity Set
 
 
 
 

For illustrative purposes only. The statements above reflect the opinions and views of AIP Alternative Lending Group as of the date hereof and not as of any future date and will not be updated or supplemented.


 

Conclusion

We believe that alternative lending is here to stay. Indeed, we expect its growth trajectory to continue, reflecting the potential benefits of the asset class to both borrowers and investors. Positioning investors at the intersection of technology and finance, alternative lending may provide diversified exposure to a secular shift in the way that consumers and small businesses access capital.

 
Executive Director
 
 

1 Source: AIP Alternative Lending Group. Data as March 31, 2018.

2 Please see Glossary for definition.

3 Orchard Quarterly Industry Report, December 31, 2017.

4 Source: “The Hourglass Effect: A Decade of Displacement”, QED Investors, Frank Rotman, April 13, 2015; AIP’ Alternative Lending Group research.

5 Please see Glossary for definitions.

6 Morgan Stanley Research: Consumer ABS 2017 Full-Year Recap and Maturing Modifications in Resi (January 19, 2018).

7 Cambridge Centre for Alternative Finance: Americas (June 2017); AIP Alternative Lending Group. Past performance is not indicative of future results.

8 Please see Glossary for definition.

9 Source: https://www.orchardindexes.com/

GLOSSARY

Alpha: The excess return of an investment relative to a benchmark; also considered to be a measure of a manager’s investment skill.

Credit Spread: The difference in yield between a US Treasury security and a non-Treasury security.

Duration: Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates.

Pro rata: A Latin term meaning in proportion.

Sharpe Ratio: The average returned in excess of the risk-free rate per unit of risk or volatility.

Weighted Average Term: The weighted average amount of time for a group of loans to mature.

INDEX DESCRIPTIONS

Orchard US Consumer Marketplace Lending Index is designed to measure the performance of direct online lending to U.S. consumers. The Index tracks the aggregate performance of loans to consumers originated and funded on eligible U.S.-based online lending platforms. To be an “Eligible Platform,” as further described below, a loan originator must have originated more than $250 million in aggregate loans, been an operating business for more than 3 years, not be subject to material legal, regulatory or accounting issues at the time of inclusion, and such other criteria as established by the Index Committee. The inception date of the Index is January 1, 2011.

S&P 500 Total Return Index is widely regarded as the standard for measuring large-cap U.S. stock market performance. This popular index includes a representative sample of 500 leading companies in leading industries.

Bloomberg Barclays US Aggregate Bond Index is a broad-based fixed income benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities.

MSCI US REIT Index is a free float-adjusted market capitalization index that is comprised of equity real estate investment trusts (REIT). With 150 constituents, it represents about 99% of the US REIT universe and securities are classified in the REIT sector according to the Global Industry Classification Standard.

Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged measures the USD-denominated high yield fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below.

Bloomberg Barclays US Corporate Total Return Index Value Unhedged measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publically issued by U.S. and non-U.S. industrial, utility and financial issuers.

United States Treasury Note/Bond: A marketable US government debt security with a fixed interest rate and a maturity between 1-10 years.

DISCLAIMERS

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

This general communication, which is not impartial, is for informational and educational purposes only and not a recommendation. Information does not address financial objectives, situation or specific needs of individual investors.

Any charts and graphs provided are for illustrative purposes only. Any performance quoted represents past performance. Past performance does not guarantee future results. All investments involve risks, including the possible loss of principal.

Additional Risks

REITs. A security that is usually traded like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. The risks of investing in Real Estate Investment Trusts (REITs) are similar to those associated with direct investments in real estate: lack of liquidity, limited diversification, ad sensitivity to economic factors such as interest rate changes and market recessions.

Loans May Carry Risk and be Speculative. Loans are risky and speculative investments. If a borrower fails to make any payments, the amount of interest payments received by the alternative lending platform will be reduced. Many of the loans in which the alternative lending platform will invest will be unsecured personal loans. However, the alternative lending platform may invest in business and specialty finance, including secured loans. If borrowers do not make timely payments of the interest due on their loans, the yield on the alternative lending platform’s investments will decrease. Uncertainty and negative trends in general economic conditions in the United States and abroad, including significant tightening of credit markets, historically have created a difficult environment for companies in the lending industry. Many factors may have a detrimental impact on the Platforms’ operating performance and the ability of borrowers to pay principal and interest on loans. These factors include general economic conditions, unemployment levels, energy costs and interest rates, as well as events such as natural disasters, acts of war, terrorism and catastrophes.

Prepayment Risk. Borrowers may have the option to prepay all or a portion of the remaining principal amount due under a borrower loan at any time without penalty. In the event of a prepayment of all (or a portion of) the remaining unpaid principal amount of a borrower loan in which alternative lending platform invests, the alternative lending platform will receive such prepayment but further interest will not accrue on such loan (or the prepaid portion, as applicable) after the date of the prepayment. When interest rates fall, the rate of prepayments tends to increase (as does price fluctuation).

Default Risk. Loans have substantial vulnerability to default in payment of interest and/or repayment of principal. In addition, at times the repayment of principal or interest may be delayed. Certain of the loans in which the alternative lending platform may invest have large uncertainties or major risk exposures to adverse conditions, and should be considered to be predominantly speculative. Loan default rates may be significantly affected by economic downturns or general economic conditions beyond the alternative lending platform’s control. Any future downturns in the economy may result in high or increased loan default rates, including with respect to consumer credit card debt. The default history for loans may differ from that of the alternative lending platform’s investments. However, the default history for loans sourced via Platforms is limited, actual defaults may be greater than indicated by historical data and the timing of defaults may vary significantly from historical observations. The Platforms make payments ratably on an investor’s investment only if they receive the borrower’s payments on the corresponding loan. Further, investors may have to pay a Platform an additional servicing fee for any amount recovered on a delinquent loan and/or by the Platform’s third-party collection agencies assigned to collect on the loan.

Credit Risk. Credit risk is the risk that a borrower or an issuer of a debt security or preferred stock, or the counterparty to a derivatives contract, will be unable to make interest, principal, dividend or other payments when due. In general, lower rated securities carry a greater degree of credit risk. If rating agencies lower their ratings of securities in the alternative lending platform’s portfolio or if the credit standing of borrowers of loans in the alternative lending platform’s portfolio decline, the value of those obligations could decline. In addition, the underlying revenue source for a debt security, a preferred stock or a derivatives contract may be insufficient to pay interest, principal, dividends or other required payments in a timely manner. Even if the borrower or issuer does not actually default, adverse changes in the borrower’s or issuer’s financial condition may negatively affect the borrower’s or issuer’s credit ratings or presumed creditworthiness.

Limited Secondary Market and Liquidity of Alternative Lending Securities. Alternative lending securities generally have a maturity between one to seven years. Investors acquiring alternative lending securities directly through Platforms and hoping to recoup their entire principal must generally hold their loans through maturity. There is also currently no active secondary trading market for loans, and there can be no assurance that such a market will develop in the future.

High-Yield Instruments and Unrated Debt Securities Risk. The loans purchased by the alternative lending platform are not rated by an NRSRO. In evaluating the creditworthiness of borrowers, the Adviser relies on the ratings ascribed to such borrowers by the relevant Platform or otherwise determined by the Adviser. The analysis of the creditworthiness of borrowers of loans may be a lot less reliable than for loans originated through more conventional means. The market for high-yield instruments may be smaller and less active than those that are higher rated, which may adversely affect the prices at which the alternative lending platform’s investments can be sold.

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