Innovation in financial technology has led to the emergence of crowdfunding as a separate investment class over the past ten years or so. Investors have become increasingly aware of the ‘interesting’ opportunities available in the peer-to-peer lending sector and are investing in ever greater numbers.
These opportunities are broadly split between investment-based crowdfunding and loan-based crowdfunding. The latter is also known as peer-to-peer lending (P2P) and it may be useful to explore the pros and cons of investing in this activity.
What’s the appeal of investing in peer-to-peer lending?
Better returns:
Investors are continually looking for alternatives to leaving their money on deposit at banks where interest rates have been falling for years.
The principles of peer-to-peer lending are very similar to the activities of high street banks. Investors are familiar with the business model and are attracted by the potential for higher returns; notwithstanding that UK savings accounts are considered risk free whereas lending is not.
Regulated activity:
Loan-based crowdfunding is regulated by the Financial Conduct Authority (FCA) so the online platforms need to be authorised and approved to conduct business. The fact that there is a regulatory framework which must be followed by P2P lenders offers reassurance to investors.
Innovative Finance (IF ISA) ISA eligible:
Formal FCA authorisation means the P2P lenders can structure their lending products within a P2P ISA wrapper also known as an Innovative Finance ISA. This means investors can invest up to their maximum allowance of £20,000 (for 2019/20) and the income and capital returns generated are tax-free.
Diversification:
For some investors, rather than simply allocating their capital to shares, bonds and property; peer-to-peer lending offers an opportunity to spread their investment risk across another asset class.
What are the risks associated with peer-to-peer lending?
Capital loss:
Peer-to-peer lending is NOT a savings product. Loan-based crowdfunding is higher risk than holding money on deposit. There is a risk of borrower defaulting on their loans and there is a strong possibility that any collateral pledged as security for the loan will be sold for less than the redemption value of the loan.
Risk profile of borrowers:
Loans are usually offered to entrepreneurs or companies that cannot secure borrowings through conventional lenders (like banks). The typical borrowers will include start-up businesses with a higher risk of cashflow problems and eventual failure. There is a greater possibility of the interest coupon not being paid or capital not being returned.
No compensation:
Where a P2P lender handles clients’ (investors) money without FCA authorisation and it fails or becomes insolvent, then there is no protection in place for investors.
In addition, peer-to-peer lending is not covered by the Financial Services Compensation Scheme (FSCS). So, in the event of the underlying borrower failing to repay its debt, resulting in a capital loss, you will not have access to this Scheme.
Lack of liquidity:
Liquidity is the ability to be able to turn your investment into cash as quickly as possible. While some P2P lenders allow you to cash in or redeem your investment through what is known as the secondary market – selling to other investors – there may be an exit fee for doing so or your share of the loan portfolio may be sold at a discount.
Even if permission to redeem is available there is no guarantee that the sale will go through as quickly as you would like (it could take several days, or longer). If too many investors try to cash out at the same time, the P2P platform may suspend redemptions until an orderly exit position can be established.
Some P2P lenders actually prohibit the sale, transfer or assignment of your investment to another investor so you are locked in until the agreed maturity date expires.
Which P2P platform should you invest in?
There are so many P2P platforms to choose from that evaluating what each has to offer and then rating them has almost become an industry in its own right.
I believe the biggest player in the sector is Funding Circle which focuses on lending to small businesses rather than individuals, and generally offers higher returns, but with arguably more risk.
Another P2P platform is folk2folk, who lend to SMEs for business purposes and take property or land as security against the loan at a maximum loan-to-value of 60%.
Before you decide which P2P lending platform to invest in, I recommend you read as many reviews as you can, to gain a better understanding of the risks involved.
One blogger has charted his own experiences of the sector over the last five years and has reviewed a number of providers, so that may be a good, practical starting point.
Alternatively, Which? magazine also carries out in-depth reviews of leading peer-to-peer lenders such as RateSetter, Zopa and Funding Circle and these are definitely worth a read, before making an investment decision.
Investor restrictions: Are you eligible to invest in a P2P lender?
With effect from the 9th December 2019, the FCA introduced new rules and guidelines for all authorised P2P lending platforms. The objectives of the new rules are to improve protection for retail investors and allow them to reduce their exposure to risk.
P2P lenders who promote “direct offer” financial promotions need to ensure that these offers are communicated to investors (retail customers) who meet the following criteria:
- Investors must be certified or self-certified as ‘sophisticated investors’ or are certified as a ‘high net worth individual’
- New investors will be certified as ‘restricted investors’; which means that with effect from 9th December 2019, they are limited to investing no more than 10% of their net investable assets in P2P loans
- The 10% limit will not apply to investors who confirm that they have receive regulated investment advice from an authorised person in respect of the promoted investment
- However, investors who are initially categorised as ‘restricted’ can be re-classified as certified sophisticated investors (and the 10% investment limit removed) if they have made two or more P2P investments in the previous two years.
Making an investment decision
Before making a decision to invest in peer-to-peer lending, retail investors should conduct their own due diligence. To see a checklist of the issues you should consider, please click here.
