Analyses
Analyses d’investissement
An Introduction to Alternative Lending
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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.
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
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
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.
*** 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.
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
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
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)
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.
