4 October, 2017

Provision Funds: Delivering Value or Marketing Message?

Provision Funds: Delivering Value or Marketing Message?

“Provision Funds” were once viewed as a reassuring security measure mitigating risk for peer-to-peer investors, however in the past year the function of the provision fund has been questioned and Zopa has removed their version of a provision fund for new lending products. We’re keen to explore the benefits and drawbacks of provision funds to establish their value for investors.  

Typically, borrowers contribute payments into a segregated fund, sometimes referred to as a Provision, Safeguard or Reserve fund, which pays out if a borrower defaults. The concept was first introduced by RateSetter and has since been adopted by a number of other large P2P providers, including Zopa, Lending Works, Landbay, Lendy, Wellesley & Co., Assetz Capital and Growth Street.

BondMason has been vocal about their views on the use of provision funds in their ‘Direct Lending Report’, published earlier this year.

‘We would like to see the end of provision funds. They are used as a tool to attract lenders but do little (nothing) to improve returns for well diversified investors.’

BondMason, 2017

Since then, Zopa has announced the closure of their safeguard fund and RateSetter’s provision fund has been scrutinised in the media; a result of rising defaults close to the level of the fund.

There are distinguishable differences between provision funds, fully integrated funds, and discretionary funds. Fully integrated provision funds automatically pay-out when a borrower defaults and therefore there is no time lag for investor repayments. They are integral to the models of RateSetter and Lending Works and investors should understand how these operate before making a decision to lend on either of these platforms.

The other category is discretionary funds, present on Lendy, Assetz Capital, Wellesley & Co. and Landbay which pay-out at the discretion of the directors. There is often a time lag between a borrower default and the funds paying out as their use is at the discretion of the directors. As a result, they are not as reliable.

Fully Integrated Provision Funds

Fully integrated provision funds reduce the volatility of investor returns, producing a more stable, predictable return. They do not however reduce the underlying risk present on the P2P platform. If we take RateSetter for example, investors are ultimately exposed to all loans in circulation on the RateSetter platform. If defaults were to rise the provision fund would be consumed and lenders’ returns would be impacted and eventually their capital would be affected. This can be seen in the RateSetter chart below, showing what happens when defaults rise on the platform.

RateSetter Provision Fund Details

Figure 1: RateSetter Default Scenario. Source: RateSetter

If we took a hypothetical scenario where there was no provision fund, we would see an increase in the ‘interest remaining’ (light grey bar) as borrowers would contribute more to interest payments as they are not contributing to the provision fund. In essence, the provision fund contribution is a reallocation away from the interest payment and not an additional payment made by the borrower. The net result of this scenario (no provision fund) is the same as if the provision fund does exist. The capital loss is felt when defaults hit 8.4%. The presence of provision funds therefore does not decrease the ultimate risk investors are exposed to.

Furthermore, it could be argued that the presence of provision funds actually reduces investor returns. As cash sits idle in a segregated account and the benefit of these funds is delayed until a borrower defaults, on an IRR basis, which takes into account the time value of money, the return an investor receives is reduced.

Acting as a high impact marketing message, provision funds may also create an illusion for investors who see them as a way of reducing risk. If usage of the provision fund reaches levels where it is close to being fully depleted this is likely to cause concerns, particularly on platforms where the provision fund is central to the proposition. A bad loan of £12 million made by a RateSetter wholesale lending partner emerged in summer 2017.  Instead of letting this bad debt engulf the RateSetter provision fund, the company itself took the hit by making repayments on behalf of the defaulted company. This decision protected the RateSetter provision fund but has been negatively reported on by the media.

For more analysis on RateSetter, read: 'RateSetter Review: Loan Book Analysis'

With no reduction in risk, a slight decrease in investor returns and the creation of a false sense of investor security, it’s understandable why BondMason has asked for the use of these funds to be ended. However, there are some advantages.

One advantage of provision funds is that they decrease the volatility of investor returns as funds which have been built up over time can be used to cover an increase in unforeseen defaults. Below we’ve calculated RateSetter’s net returns on an IRR basis across all loans in the RateSetter loan book and plotted this against the actual net returns published by RateSetter, which includes the coverage of the provision fund.

RateSetter Actual Net Returns vs Provision Fund Returns

Figure 2: Actual net returns, with and without the provision fund.

The results show that investors would have been better off without the provision fund in 2011 and 2012 when defaults were lower than expected. However, in 2014 and 2015 investors received a higher return due to the presence of the provision fund as defaults were higher than expected.

Although the overall effect is a slight decrease in investor returns, the presence of the fund has stabilised returns over the years. This reduction in volatility is important for mainstream investors.

Discretionary Managed Provision Funds

It’s a different story when considering provision funds which are managed on a discretionary basis as defaults are not automatically covered. They are not as reliable as the provision funds offered by RateSetter or Lending Works. Their presence should not be the primary driver to lend on a particular platform and should be more viewed as an additional method of recovering capital in the event of a default.

Lendy, for example, promotes a provision fund which aims to have funds set aside equal to 2% of the outstanding loan book. There is no way of verifying this figure and as pay-outs are at the discretion of the directors it is difficult to determine how it will actually function when it’s needed most - when investors are facing capital loss. Asset security underpins all loans on the Lendy platform and this is the first line of defence for investors. In the event of a default, if the asset cannot be sold or there is a shortfall in the capital recovered, the provision fund might be used, at the discretion of the directors. If the asset is sold below valuation, which has been the case with defaulted loans at Lendy, there is either an issue with valuations or the property market has taken a downturn. If the property market took a downturn and the valuations were greatly incorrect, it’s likely that the provision fund would be consumed very quickly.

P2P Provision Funds Conclusion

When the provision fund is integrated fully into a P2P platform as it is with RateSetter and Lending Works, investors are likely to receive a more predictable, stable return at the expense of a slight decrease in overall returns. For new P2P investors, the presence of provision funds may provide a deceptive comfort and when the fund is fully consumed they fully appreciate that they are exposed to the underlying loans originated by the platform. Of course, this is the true nature of peer-to-peer lending, and investors should be fully aware of this with no illusions. For discretionary managed provision funds, investors should not rely on these as a reliable method for recovering capital.

There is always a risk that a borrower will default and that is why a fully diversified portfolio is the best mitigation of risk. Investors can expect attractive returns in the peer-to-peer lending market and if they build a fully diversified portfolio they can manage the risk present. As always, we encourage investors to build portfolios across multiple P2P platforms, across different lending sectors and across a wide range of borrowers. This will allow investors to earn the attractive, stable returns that this asset class offers while managing the risk present.