Institutions Bank On Peer-to-Peer Lending, but for How Long?

Although online credit marketplaces can offer attractive returns, institutional investors may not stick around when interest rates rise elsewhere.

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When Ranger Capital Group set out to develop a fixed-income fund for its institutional clients two years ago, low interest rates made typical bond investments unappealing for the $3 billion asset manager.

But in early 2013 the Ranger fund’s directors took a close look at online peer-to-peer lending, a decade-old model that lets people lend directly to individuals and businesses through websites such as Lending Club and Prosper Marketplace in the U.S., and Zopa in the U.K. The burgeoning space and its healthy potential returns excited Dallas-based Ranger’s portfolio managers in a way that old-fashioned bonds couldn’t.

“We believe that technology will change the lending environment and that investors are going to get a unique opportunity to participate,” says Bill Kassul, a partner in what is now called the Ranger Specialty Income Fund.

As yield-hungry institutions help transform peer-to-peer lending from a fringe service into one that is getting the banks’ attention, it could be a blessing for U.S. small businesses and consumers, whose borrowing power has shriveled since the 2008 credit crunch. But some market participants fear that retail investors may find themselves displaced from these ostensibly populist platforms. Another question is how soon institutional investors will leave the peer-to-peer party for better opportunities.

Launched in November 2013, the Ranger Specialty Income Fund invests mainly in consumer and small-business loans through Lending Club and Prosper, the two largest peer-to-peer lending platforms. The marketplace still isn’t big enough to serve a substantial institutional investor base: Lending Club and Prosper, both based in San Francisco, have provided a total of about $6.5 billion in loans to date.

Kassul bets that will soon change. By the first quarter of next year, he hopes, the Specialty Income Fund will be allocated across seven subclasses, including real estate, auto and traditional hard-money loans, through 12 or 13 online platforms in the U.S. and abroad. So far, the fund has invested about $25 million; for 2015 it’s banking on an additional $150 million to $250 million in commitments from institutions.

“Over the last four months, this has almost shifted 180 degrees, from smaller family offices to large institutional investors calling us about investing,” explains Kassul, who says the fund is expecting returns in the low double digits. “For a lot of these guys, their minimum is $25 million to $50 million.”

That’s a far cry from the early days of peer-to-peer lending. Prosper opened its doors in 2005 with plenty of the “Occupy Wall Street ethos of retail-to-retail,” CEO Aaron Vermut says. Vermut missed that heady start, joining last year when Sequoia Capital, a Menlo Park, California–based venture capital firm, invested $20 million and took over management of the online lender.

Institutional capital largely avoided peer-to-peer lending until the downturn following the financial crisis, when interest rates plunged and professional investors began hunting for higher yields, explains Navjot Athwal, co-founder and CEO of RealtyShares, a San Francisco–based lending platform for property investments.

Athwal, who launched RealtyShares last year, believes big investors have changed the space so much that it needs a new name. “You can’t call it peer-to-peer lending anymore because that’s a misnomer and that’s misleading,” he says. “What you can say is we’re creating a much more efficient alternative to banks.”

Has institutional money dashed lending platforms’ dream of disrupting the credit landscape? Athwal doesn’t think so. Borrowers have only benefited, he argues, though he laments that it may get tougher for retail investors to participate.

No matter who the creditors are, people and small businesses can expect a friendlier lending environment thanks to peer-to-peer platforms, says Karen Mills, a senior fellow at Harvard Business School and the university’s John F. Kennedy School of Government. They sorely need it: Bank loans to U.S. small businesses have fallen about 20 percent since 2008, while those to bigger companies are up about 4 percent, according to a July working paper co-authored by Mills.

Small-dollar loans simply aren’t profitable for banks, explains Mills, who is former head of the U.S. Small Business Administration. “It costs just as much to make a $1 million loan as it does to make a $100,000 loan,” she says. “So there’s definitely a gap in this lower segment.”

Online direct lending platforms are flattening many of the costs that have kept banks from going after small loans. For example, Prosper lets prospective borrowers and lenders complete their paperwork in about half an hour via Web-based forms.

Perhaps even more important, whereas banks have long relied heavily on credit scores, the online innovators are feeding a wider variety of borrower information into algorithms that gauge creditworthiness. “That will transform how traditional banks as well as these new players look at creditworthiness — for the better,” Mills says.

Ranger’s Kassul says his firm has fielded calls from banks interested in investing in direct loans or integrating some of the offerings developed by online players. In early October, Ranger joined forces with BankCap Partners, a Dallas-based private equity firm that helps small banks grow into midsize institutions. As they build relationships with Lending Club, London-based Funding Circle and others, both parties will consult banks that wish to give clients the option of soliciting loans on those platforms.

Even if banks do adopt peer-to-peer lending practices, institutional investors will only support the market while interest rates stay low elsewhere, Harvard’s Mills reckons. “One doesn’t want a marketplace that is here today but gone tomorrow,” she says. “Small-business owners, once again, would be left with frozen credit.”

Prosper’s Vermut says his platform aims for a diversity of lenders. For him, the ideal mix is one third retail, one third high-net-worth and one third institutional investors. But the latter — a key funding source as Prosper built the business — still account for about 50 percent of its total capital.

That must change, Vermut says. “Retail [capital] is stickier in a downturn,” he contends. “Retail is what you need in order to build a 100-year company.”

RealtyShares’ Athwal hopes to see his platform steer clear of institutional capital for the next few years. Acknowledging that it’s much younger than Lending Club and Prosper, he expects that it will end up admitting big investors. “You’re trying to run a business on one hand and build a vision on the other hand,” Athwal says. “Sometimes those things align, and sometimes they don’t.”

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