mai 20, 2020
An Introduction to Alternative Lending
An Introduction to Alternative Lending
mai 20, 2020
As investors grapple with the portfolio implications of a global pandemic, 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?
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 underserved by traditional lending institutions with loan investors seeking attractive yield-generating investments. The lending model grew out of small balance, peer-to-peer unsecured consumer loans financed by retail investors.
The types of credit risk underwritten by alternative lenders have expanded over time beyond unsecured consumer to include small business lending, student loans, auto finance and other forms of specialty finance.
As volumes ramped and the asset class matured, alternative lending evolved such that most loans are funded today by institutional investors, a group that counterintuitively includes even banks.1 Recognizing their technological and geographic constraints, community banks may focus on their core competency of deposit gathering while outsourcing credit underwriting and servicing to alternative lending platforms.
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 borrowers and loan investors together, and by using technology-enabled models to rapidly underwrite borrower credit risk to determine appropriate loan pricing, terms and amounts offered to 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 servicing fees. 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 platforms may maintain an economic interest in loans sold to investors.
The loans themselves generally have relatively low initial balances, and terms of 3-5 years are typical. Today, the most common consumer unsecured alternative loan in AIP’s Fund is fully amortizing, with a weighted average term3 of roughly 3.6 years and an average balance of roughly $10,000.4
The Evolution of Alternative Lending
Alternative lending grew rapidly in the decade following the first peer-to- peer online loans underwritten in the U.K. in 2005 and in the U.S. in 2006, gathering 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 original peer-to-peer format to institutional buyers serving as the predominant loan investors, purchasing portfolios of loans in bulk. Hedge funds were early buyers, actively selecting individual loans that they expected would outperform the platforms’ average underwriting. As the platform underwriting models matured and the opportunities for hedge fund alpha5 generation declined, institutional buyers largely migrated to passive pro rata purchases of loans within each buyer’s defined credit box.
Passive pro rata allocations moved the diligence burden for loan purchasers from the individual small ticket loans to all the loans underwritten by a platform within a purchaser’s defined credit box, as well as to the platforms themselves. Passive allocations also facilitated deeper integration with the capital markets. The first securitization backed by unsecured consumer alternative loans occurred in 2013, and the first rated securitization of those loans 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 2019, Morgan Stanley Research estimated nearly $18 billion of asset-backed security issuance by the marketplace lending sector, implying that roughly 40% of unsecured consumer marketplace loans originated in the U.S. that year were securitized.6
* “The Hourglass Effect: A Decade of Displacement”, QED Investors, Frank Rotman, April 13, 2015; AIP Alternative Lending Group research.
** “Marketplace Lending Securitization Tracker”, PeerIQ, Q2 2018.
*** AIP Alternative Lending Group. 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.
**** Source: https://www.transunion.com/blog/consumer-credit-origination-balance-and-delinquency-trends-q4-2019 and https://onlinexperiences.com/scripts/Server.nxp?LASCmd=AI:4;F:QS!10100&ShowUUID=DBABE960-72C0-4091-99F3-EBFE91B81159&AffiliateData=HomepageBanner&Referrer=https%3A%2F%2Fwww.transunion.com%2Fbusiness; market share data as of 3Q19
As illustrated in Display 3, the market share of fintech alternative lenders has grown in recent years, mirroring trends in consumer preference for transacting online. A recent study by TransUnion found that over the past six years, banks, credit unions and traditional finance companies have ceded market share.
Source: https://www.transunion.com/blog/consumer-credit-origination-balance-and-delinquency-trends-q4-2019 and https://onlinexperiences.com/scripts/Server.nxp?LASCmd=AI:4;F:QS!10100&ShowUUID=DBABE960-72C0-4091-99F3-EBFE91B81159&AffiliateData=HomepageBanner&Referrer=https%3A%2F%2Fwww.transunion.com%2Fbusiness; market share data as of 3q19
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 attractive yield and low duration that stands in sharp contrast to the traditional fixed income universe. Alternative lending’s relatively low duration may reduce sensitivity to changes in benchmark interest rates. One contributor to low duration is the amortizing structure typical of alternative loans, which may facilitate vintage diversification7 that may be challenging to achieve with traditional fixed income that only repays principal at maturity. Furthermore, alternative lending may offer outsized credit spreads,8 gross of any defaults and recoveries. While alternative loans often are unsecured, meaning defaults typically will be higher and recoveries lower than with traditional fixed income, we believe that alternative lending’s outsized credit spreads may provide a cushion against realized principal loss when investors encounter adverse economic environments, such as those caused by the COVID-19 pandemic or experienced during the global financial crisis.
Gross coupon is the annual interest rate paid on a bond/loan before accounting for prepayments, defaults and/or recoveries.
Past performance is no guarantee of future results. Source: US High Yield=Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD; US Inv. Grade=Bloomberg Barclays US Corporate Total Return Value Unhedged USD; US Treasuries = Bloomberg Barclays US Treasury Total Return Unhedged USD. Data as of May 15, 2020.
2. Unsecured consumer alternative lending may be diversifying versus other major asset classes, including traditional fixed income. Alternative lending’s underlying credit exposure stems primarily from the consumer, rather than from corporate or government credit exposure that generally dominates traditional fixed income allocations.
Past performance is not indicative of future loss. Diversification does not eliminate the risk of loss. For illustrative purposes only. The darkest blue color indicates asset classes that are most correlated to one another, while light blue represents asset classes that are least correlated.
* Source: Bloomberg and AIP Alternative Lending Group. Data as of May 15, 2020. Equities are represented by S&P 500 Total Return Index, Real Estate by MSCI US REIT Index, US Treasuries by Bloomberg Barclays US Treasury Total Return Unhedged USD, US IG by Bloomberg Barclays US Corporate Total Return Value Unhedged USD, and US HY by Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD.. Correlations are calculated based on a track record starting with the Fund’s inception on October 1, 2018 through March 31, 2020.
3. Unsecured consumer alternative lending has exhibited attractive absolute and risk-adjusted returns. Since the AIP Alternative Lending Fund’s inception in October 2018, it has weathered market volatility in October 2018, December 2018, May 2019, August 2019, and the COVID-19 pandemic that gripped markets starting in February 2020. While the Fund’s unrealized losses in March 2020 were below those of both high yield and investment grade corporate credit indices, they highlight that alternative lending might exhibit greater correlation with economic volatility than with market volatility.
Source: Bloomberg and AIP Alternative Lending Group. Data as of May 15, 2020. Based on actual performance data of an initial investment of $1,000 made on October 1, 2018. There is no guarantee that any investment will achieve similar results and actual results may vary significantly.
Source: Bloomberg and AIP Alternative Lending Group. Data as of May 15, 2020; Fund’s inception on October 1, 2018 through March 31, 2020.
4. Alternative lending reflects a 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, geography, security interest, ticket size and duration).
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.
While alternative lending has not been immune to the COVID-19 global pandemic, we believe that alternative loans continue to offer potential benefits 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.