7 September, 2017

5 Ways to Avoid Risk When Investing in P2P Lending Platforms

5 Ways to Avoid Risk When Investing in P2P Lending Platforms

Peer to peer lending (“P2P lending”) has emerged in recent years as an innovative form of financing. P2P lending gives retail investors the chance to earn greater returns on their investment compared to deposits in financial institutions and provides borrowers with lower interest rates. The P2P industry is filling the gap un-served by mainstream financial institutions. However, P2P investment also comes with significant risks. Investors, therefore, need to understand what P2P lending is and take precautionary measures.

First, avoid Ponzi schemes. A Ponzi scheme is an orchestrated and coordinated investment scam where investors are promised high returns when they invest their money in the system. The project generates income from new investors and uses it to pay the older investors. The scheme usually comes to a halt when it fails to attract new investments.

One of such is Ezubao, a P2P lending company incorporated in China. Ezubao promised unrealistic returns on their investment products. They promised close to seven times what the mainstream financial market was offering. They created fraudulent investment products and used the money from new investors to compensate earlier investors.

Despite the senior executives in the company knowing that the company had no financial muscles to keep all their investors happy, they continued to pay themselves hefty salaries, and when the word hit the ground that Ezubao was a fraudulent scheme, they started hiding and confiscating evidence. Some of their documents were unearthed six meters below the ground by Chinese police’s excavators. Singapore has witnessed the establishment of several P2P lending companies. While those in Singapore are unlikely outright fraudulent companies like Ezubao, it still pays to take some precautionary measures.

Here Are five ways to stay safe when investing in P2P.

1. Diversify your P2P investment

As they say, a wise man does not put all your eggs in the same basket. This should be your guiding principle as an investor. Don’t lend to only one company.

Spread your lending amongst borrowers and even over different platforms. Typically, the window for investment only lasts a short time. Certain platforms run campaigns that are so popular that within 24 hours, all available allocation for investors are taken up.

This means that investors can only do very limited due diligence before lending. It is foolish to commit a large amount of money with only limited due diligence. Therefore, spread out your investment. In this way, even if some loans turn bad, you won’t be losing too much sleep.

2. Start Small on Each P2P Platform

Every P2P platform is different. From the nature of borrowers that they on-board, the way they set interest rates, the amount of information provided to potential investors to make the decision, and most importantly, the track record of bad loans, it takes time to become comfortable with the platform.

So start small on each platform and scale up your investment only when you feel comfortable. The good thing is that most platforms in Singapore allow small minimum investment sizes of S$1000/-.

Keeping track of the bad loans ratio on the platform is also key. As definitions of bad loans differ, this is often not a transparent number. So by starting small and following individual platforms, you will be able to decide for yourself how often bad loans occur, and just as importantly, what the platform does to help investors in each of this situations.

3. Start with lower-risk options

Don’t rush to invest in high interest rate borrowers. As a general principle, the higher the interest rate offered, the higher the risks. If you are starting out in P2P investing, it make sense to go for lower interest rate lending initially, until you become more familiar with the mechanics of the investment type and are able to spot trends between specific sectors and likelihood of default.

As mentioned earlier, many platforms only allow a limited time for due diligence, this means that you would likely have to use simple heuristics to make your investment decisions. This takes practice and experience.

4. Develop your personal red flags

Since you need to rely on heuristics rather than in-depth due diligence to make lending decisions, a red-flag​ ​checklist​ is a great way to do this.

The red flag checklist could include metrics such as:

  • The industry of the borrower. For example, oil and gas companies are currently in trouble due to the low oil prices. Maybe something to avoid.
  • The age of the borrower. Newer businesses tend to be riskier.
  • The cash balance of the borrower. If there is one item in the accounts of the borrower you want to see, it is the cash balance. Clearly, the borrower is in need of cash (that is why it is borrower). Nonetheless, good borrowers tend to use the cash for growth (rather than survival) and also maintain a cash buffer to repay lenders.
  • The cash flow record of the borrower. If the cash flow record does not demonstrate great volatility, this suggests that the borrower may find difficulty in repaying
  • The profit margins of the borrower. Low margin businesses tend to operate on the precipice of viability. If any cost item unexpectedly increases, the borrower may start making losses and struggle to repay creditors.
  • The credit score of the borrower. A credit score may be provided by the P2P platform or by a third-party. This may be a good “first check”. But one should avoid relying solely on the credit score and delve deeper.

5. Understand the motivations of the P2P platform

The structure and revenue model of P2P platforms differ. Some P2P platforms receive revenue when investors make investments. Some obtain revenue from the borrowers. Some receive revenue only on repayment of the loans.

Clearly, the latter model allows P2P platforms to be better aligned with the interests of investors, who are interested in repayments. The former models begs the question what the platform will do if a borrower defaults on repayments. Pursuing bad loans is not a cheap affair, with legal and administrative costs needing to be paid. Where investors are distributed, it is not clear who should take the lead in pursuing these companies. The platform seems to have some responsibility, but in the legal documentation for P2P platforms, they typically (and understandably) disclaim such responsibility.

P2P platforms which seek to maintain a positive reputation and long-term track record will take additional steps to pursue bad loans and maybe even restructure loan payment profiles.

This article was written by RobustTechHouse and submitted to Orca