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The adviser’s guide to P2P due diligence

The peer-to-peer (P2P) market offers some excellent investment opportunities but before diving in, says Jane Dumeresque, advisers need to do thorough research and ensure they and their clients pick a quality provider.

For many, the fast-growing peer-to-peer sector offers a welcome alternative source of investment and borrowing to traditional banks. Although seen initially as quite a niche player, P2P is becoming increasingly mainstream and, as of 6 April 2016, lenders are able to enjoy tax-free interest courtesy of the new Innovative Finance ISA (IFISA).

The rapid growth of the industry has not, however, been without controversy and, as the regulator grapples with the number of new firms on the block and their range of offerings, some commentators have expressed unease and concern that a new wave of investors in the government’s IFISA may not fully understand the risks of P2P.

Lord Adair Turner kicked up a hornets’ nest with his comments earlier this year that, over the next five to ten years, P2P loans could be the source of losses that would “make the worst bankers look like absolute lending geniuses”.

To lump all P2Ps together and suggest they take a laissez-faire approach to risk is, however, grossly inaccurate and shows a lack of understanding of the broad nature of the P2P sector.

It is certainly correct that P2P investments are not protected by the Financial Services Compensation Scheme and there is no safety net other than your own risk assessment. Investor and their advisers should, therefore, find out everything they can about the people who manage the platforms and the loans and investments that are listed on them.

When advising clients to invest in a P2P lender, there are some key due diligence points to analyse and carry out to ensure you have separated the wheat from the chaff so your client can invest in a quality P2P provider and, in turn, gain access to a good return on their investment.

Dipping A Toe In The Water
Investing in the alternative finance world can be likened to a visit to a swimming pool. If you wanted to learn to dive, you would start on the three-metre springboard before moving up to ten metres. You can do the same in alternative finance because it is relatively easy to categorise them into risk groups.

You might start with the three-metre springboard, where you would find loans that offer lower interest rates, but are secured by property. Moving up to the five-metre board you might find loans with a lower quality of security, but a higher return. The seven-metre board is for the more experienced investor and would include unsecured debt.

If you are very experienced – and know the depth of water below – there is the ten-metre board where you can invest into the equity offering of a start-up business, which could result in you earning a multiple of your money, as in E Car Club. Or it could end in disaster and total loss, as in Rebus, the claims management company that went into administration after raising more than £800,000 through crowdfunding.

Taking The Plunge – Which Platform To Choose?
Once the decision to invest in P2P has been taken, there are a whole host of criteria lenders and advisers should look for to evaluate which P2P provider to use. For starters, it is important to know who owns the business and whether they are looking to build a sustainable business or to quickly build market share and then exit before the loan book has gone through an economic cycle.

Does the business have the financial expertise to assess the loan risk and is this done by people or using algorithms? What percentage of the platform’s loans have defaulted and does it have a compensation fund? Is the business making a profit that enables it to be sustainable or is it relying on raising additional capital to enable it to continue paying the overheads of the business?

These are the types of questions that should be answered before your client makes the decision to invest in a platform and some companies will be better equipped to answer them than others. The level of transparency given is often a good guide to the confidence that management have in their business and the product on offer.

The Bigger The Wave, The Bigger The Danger
For years now we have all known there is no such thing as a free lunch and, not surprisingly, there is a correlation between risk and reward – invariably, if it looks too good to be true, then it probably is.

Throughout the industry, there is a wide range of interest rate levels, but the rate you secure will depend on the risk grade of the business. Investors should also consider concentrating risk and whether they prefer to spread their money over a large number of loans where they may not be able to assess each one individually, or whether they prefer to invest in a smaller number of loans but do their own additional investigation work on each one.

It is important for an investor to understand how long their money will be tied up, what return they are getting, when they are getting it and what security they have in the event the borrower is unable to pay? What processes are in place?

What will the business do to try to recover their money? How long will this take and what are the costs of recovery? At Folk2Folk, for example, in the event a borrower became unable to service its loan the risk of loss would be significantly reduced due to the high level of security on each loan and lenders can gain confidence knowing their charge over the property is registered with the Land Registry.

Finding The Right Balance
These are some of the key checks advisers should go through before advising their clients. Ultimately it is about doing thorough research and ensuring they invest with a quality provider.

For those prepared to invest the time, there are some excellent investment opportunities in the peer-to-peer market, where investors can not only earn an attractive return with good security but can also help businesses gain access to capital they would otherwise not have.

[This article appeared in Professional Advisor in August, 2016.]

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