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Investing in the Fintech-Enabled Lending Boom

Born out of peer-to-peer lending, online alternative lending has gone mainstream, presenting new opportunities for small businesses, consumers and investors.

Over the past decade, fintech innovations spearheaded by alternative-lending platforms have disintermediated traditional lenders, significantly shifting the landscape for consumer and small-business loans. 

Millennials grew up with technology and are comfortable managing their finances on smartphones.

Where once a loan was a slow-moving manual review of credit criteria, alternative-lending platforms use “Big Data” to automate most of the underwriting process and provide rapid credit decisions via a smartphone app or website for everything from a $10,000 credit card refinancing to a $100,000 loan to expand a small business.

For fixed-income investors, the convergence of technology and finance on these platforms has opened opportunities in a new asset class: alternative lending.

The Evolution of Alternative Lending

What began as “peer-to-peer” marketplaces bringing together borrowers and lenders has evolved considerably in recent years. Alternative-lending platforms now span many categories, including unsecured consumer, small-business and other forms of specialty financing.

Most loans underwritten by alternative lending platforms are now funded by institutional investors,1 and the largest platforms are disrupting the classic neighborhood-bank-lending model by playing to the strengths of fintech: low operating costs, user-friendly websites or mobile apps and innovative underwriting models that harness Big Data and better reflect the realities of today’s mobile-first consumers.2

Millennials represent the largest generation in American history. They grew up with technology and are comfortable managing their finances on their smartphones rather than through a traditional bank,"3 says Ken Michlitsch, Morgan Stanley Investment Management's lead portfolio manager for its AIP Alternative Lending Group.  Similar dynamics are playing out among true small businesses, where faster loan processing speeds and innovative credit models are helping win business for alternative lenders.

“Banks tend to have higher cost structures and regulatory capital pressures that can sometimes limit their ability to serve the needs and expectations of borrowers today," Michlitsch adds. “For these and other reasons, alternative lending represents a secular shift in the way consumers and small businesses seek to efficiently access capital."

An Emerging Asset Class

While alternative lending is currently gaining traction among borrowers, it's also becoming a formidable asset class in its own right, with the U.S. market now accounting for an estimated $50 billion of annual origination.4

As investors grapple with the portfolio implications of a rising interest-rate environment alongside a continuing search for yield, alternative loans may offer attractive absolute and risk-adjusted return characteristics. Such loans tend to have less duration risk and interest-rate sensitivity, compared to longer duration traditional fixed-income securities; they also have lower correlation to other assets, including traditional fixed income and equities.

Low unemployment rates, rising real wages and declining consumer debt as a percentage of gross domestic product are also part of the appeal of the differentiated, consumer-oriented fixed-income exposure that alternative lending can provide. This is especially true in light of expanding corporate balance sheets and relatively thin corporate credit spreads.

Credit Cycle Might Be Late Stage, but the U.S. Economic
Backdrop Currently Appears Supportive of the Consumer

Source: Federal Reserve, https://www.federalreserve.gov/releases/housedebt/ and Bureau of Labor Statistics, https://data.bls.gov/timeseries/LNS14000000, as of December 31, 2017. *See footnotes for additional disclosures.

A Portfolio Approach

As alternative lending comes to the fore, it offers investors an opportunity to fine-tune their strategies—i.e., yield, credit risk and duration—just as they do with traditional fixed-income asset categories.

Even so, successful outcomes require expertise in fixed-income investing, insight into macroeconomic trends, as well as operational knowledge to analyze the strengths and weaknesses of diverse lending marketplaces.

Rather than invest in single loans on standalone platforms—as is the case for individuals investing directly via a peer-to-peer platform—certain investors now have access to alternative-lending funds, such as Morgan Stanley Investment Management’s AIP Alternative Lending Fund.

Instead of investing in the companies that manage the platforms as a primary strategy, these funds offer investors diversified exposure to loans underwritten across multiple alternative-lending platforms, loan types and geographies. In many cases, investors can gain access to segments previously available only to banks and credit-card companies.

The AIP Alternative Lending Fund is registered under the Investment Company Act of 1940 as a non-diversified, closed-end management investment company and only available to accredited investors.  An investment in the AIP Alternative Lending Fund should be considered speculative and involving a high degree of risk, including substantial loss of investment. Key risks include credit risk, risk of unsecured loans and platform risk. The fund does not operate as a mutual fund and it is expected that it will offer to repurchase shares quarterly via a tender offer. A broader description of the fund’s investment risks is provided at the end of this article.

Updated Approach to Assessing Risk

The final aspect of alternative-lending funds is the consideration of risk. Alternative-lender underwriting models leverage data and technology to improve underwriting iteratively, while seeking to be more effective at sizing up whether borrowers will make good on their debt.

“Traditional consumer underwriting models rely heavily on credit scores, which are backward-looking and focused on willingness to pay," Michlitsch explains, adding: “When extending credit, you need to understand both willingness and ability to pay.”

To address these issues, managers of alternative-lending funds consider a broad array of data sources on borrower spending habits and personal history to augment traditional credit scores.

The popularity and growth of alternative-lending platforms suggests that fintech-enabled alternative lending is here to stay. Positioning investors at the intersection of technology and finance, alternative lending may provide diversified exposure to a continued shift in the way that consumers and small businesses access capital.

For more information on the AIP Alternative Lending Fund, ask your Morgan Stanley representative or Financial Advisor or visit the Morgan Stanley Investment Management website.  

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