Analyses
Analyses d’investissement
An Introduction to Alternative Lending
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Investment Insight
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mai 2019
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An Introduction to Alternative Lending
An Introduction to Alternative Lending |
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As investors grapple with the portfolio implications of a low 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, and loan investors, who seek 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 expanded beyond unsecured consumer to include small business lending, student loans, auto finance and other forms of specialty finance.
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 prespecified 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, on the order of $1,000-$40,000. Today, the most common consumer unsecured alternative loan is fully amortizing, with a weighted average term2 of 48 months and an average original principal of roughly $15,000.3
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 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 platform’s 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 2018, Morgan Stanley estimated $17.7 billion of asset-backed security issuance by the marketplace lending sector, which implied that roughly one third of marketplace loans originated in the U.S. that year were securitized.6
As illustrated below, the U.S. market saw U.S. alternative lending volumes increase by roughly 4x from 2014 to 2017.7 In 2017, the consumer segment represented about 70% of U.S. alternative lending, followed by roughly 19% in small business and 11% in specialty finance, a variety of smaller verticals.7 The small business segment took some market share from the consumer segment between 2014 and 2017, a trend that may continue given the sizable small business market opportunity, as well as banks struggling to underwrite small ticket business loans using processes that often are relatively antiquated and manual.
Source: “Reaching New Heights: The 3rd Americas Alternative Finance Industry Report.” Cambridge Centre for Alternative Finance. December 2018.
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 rising benchmark interest rates. One contributor to low duration is the amortizing structure typical of alternative loans, which may facilitate vintage diversification 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 principal loss, should investors encounter a less benign economic environment than that experienced following 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: Orchard (duration as of 1/2017 and coupon as of 3/2018), U.S. High Yield: Bloomberg Barclays U.S. Corporate High Yield Total Return Index Value Unhedged, U.S. Investment Grade: Bloomberg Barclays U.S. Corporate Total Return Index Value Unhedged USD, Barclays Aggregate: Bloomberg Barclays U.S. Aggregate Bond Index, 10 Year UST: United States Treasury Note/Bond. Please note: Orchard was acquired by Kabbage, Inc. in April 2018. Orchard ceased publishing index returns after March 2018. Therefore, no alternative lending proxy data is available after that date. See the end of the presentation for index descriptions.
2. Unsecured consumer alternative lending historically has been diversifying versus other major asset classes, including traditional fixed income. We believe that the relatively low historical correlation of unsecured consumer alternative lending to traditional fixed income has been supported by the 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 unsecured consumer alternative lending investments historically would have increased portfolio diversification and a portfolio’s expected return per unit of risk (Sharpe ratio).8
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. Please note: Orchard was acquired by Kabbage, Inc. in April 2018. Orchard ceased publishing index returns after March 2018. Therefore, no alternative lending proxy data is available after that date. See the end of the presentation for index descriptions.
3. Unsecured consumer alternative lending exhibited attractive absolute and risk-adjusted returns over the life of the Orchard U.S. Consumer Marketplace Lending Index from January 2011 to March 2018. The returns from unsecured consumer alternative lending were 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, unsecured consumer 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 mark-to-model valuation based on discounted expected cash flows, which could dampen return volatility.9
Equities are represented by S&P 500 Total Return Index, Fixed Income by Bloomberg Barclays U.S. Aggregate Bond Index and REITs by MSCI U.S. REIT Index. Alternative Lending (Unsecured Consumer) is represented by Orchard U.S. Marketplace Lending Index. Please note: Orchard was acquired by Kabbage in April 2018. Orchard ceased publishing index returns after March 2018. Therefore, no alternative lending proxy data is available after that date. See the end of the presentation for index descriptions.
Past performance is no guarantee of future results, and we recognize that the economy was relatively benign in the time frame over which index-level data was available for alternative lending. We believe that alternative lending returns, which are relatively untested in an economic downturn, may prove procyclical and would likely decline during more challenging economic periods. However, we believe the significant credit spreads on offer from alternative lending may provide a 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, 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.
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.
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