17 May, 2017

Peer-to-Peer-Lending: Bigger Than the EIS/VCT Market Combined

Industry commentators within the financial advice market often draw comparisons between peer-to-peer Lending (P2P) and tax efficient investments. Yes, it is true that both are non-standard alternative investments which have grown substantially over the past 20 years. However, this is almost the extent of their similarities with investors exposed to a completely different underlying asset and profile of risk. Financial advisers have fuelled the growth of the tax efficient market while direct retail investors are the driving force behind P2P’s rise.

There are three tax efficient venture capital schemes open to UK investors: Enterprise Investment Scheme (EIS), Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trust (VCT). Investors benefit from a substantial tax benefit for investing in these schemes and providing the underlying assets perform, also a financial gain. A fourth tax efficient category does exist, Business Property Relief (BPR), which provides inheritance tax relief. These tax advantages have been put in place to encourage investors to invest in smaller, riskier, high growth businesses.

Similarly, to the government establishing a framework for the tax efficient market to grow, the use of technology has allowed for P2P to be established. Peer-to-peer lending allows investors, or lenders, to connect directly with borrowers on online platforms. This creates efficiencies in the market, providing investors with a reasonable risk-adjusted return and borrowers with quick access to capital. Although the HMRC has not directed significant tax benefits to P2P, they have introduced a new form of the ISA account, the Innovate Finance ISA (IFISA).

Table 1: EIS, BPR, VCT, P2P History and Principal Players
Name Founded Founder Principal Players
Business Property Relief (BPR) 1974 Government Scheme Octopus Investments, Downing, Deepbridge, Oxford
Enterprise Investment Scheme (EIS) 1994 Government Scheme Calculus, Triple Point, BlackFinch
Venture Capital Trust (VCT) 1995 Government Scheme Octopus Investments, Downing, Pembroke
Peer to peer lending 2005 Zopa (UK based business) Zopa, Octopus Choice, RateSetter, Funding Circle

Growth of Peer-to-Peer and Tax Efficient Market – Comparisons

Figure 1: VCT, S/EIS and P2P Market Growth. Source: Tax Efficient Review, Intelligent Partnership, Orca Analytics, HMRC

Both the S/EIS and P2P market have grown substantially over the past 10 years. The VCT market appears to have stagnated with investors favouring S/EIS over VCT investments for two reasons: a greater investment cap; £1m vs. £200k; and a wider range of tax reliefs.

The P2P market in the tax year 2015/2016 was just larger than the combined S/EIS and VCT market (£2.52 billion vs £2.53 billion). During the 2016/2017 tax year the P2P market has continued to grow, equating to total volumes of £3.65 billion. Although we will have to wait for the HMRC to release the 2016/2017 S/EIS and VCT industry figures, it’s likely that the P2P market is now considerably larger.

Although exact figures for the size of the BPR market are hard to determine, research agency Intelligent Partnership suggests that the UK could have saved around £595 million in tax through estate planning in 2015/16. This gives an indication of the total addressable BPR market. It’s therefore likely that the P2P market is bigger than the entire tax efficient investment market.

Differences in Investor Base

Despite both tax efficient investments and P2P growing in prominence, the source of capital has been quite different. Direct retail investors, or “peers”, have fuelled the growth of P2P. Until 2014, all investors in P2P were self-directed investors, investing directly online. In 2016 the market was still predominately retail investor focused, however an influx of capital has come from institutional investors making up roughly 30% of the market. To-date, appetite from financial advisers has been limited.

In comparison, financial advisers have driven growth in the tax efficient investment market. Research by Intelligent Partnership demonstrates that 82% of advisers recommend VCTs while 88% recommend S/EIS investments. Although retail investors can invest directly in tax efficient products, they need to have a deep understanding of their personal tax position which may overcomplicate the investment decision. That said, direct S/EIS investing does happen predominately in the form of angel investing either through crowdfunding sites or private arrangements.

Octopus Investments the largest EIS manager announced in May 2016 that it would not raise money through EIS schemes. Although they stated this was due to a change in focus towards their VCTs, in the same year Octopus Investments launched it’s own P2P platform, Octopus Choice. An interesting market shift.

With such a strong demand from direct retail investors for peer-to-peer investments, we may see growth within the adviser channel, particularly if clients start requesting P2P.

Reasons for Investing

The benefits of P2P investing differ drastically when compared to tax efficient investing. Although the investment case for tax efficient products is important, the tax benefits associated with these products are often the main trigger for investing. In contrast, P2P investors are seeking a stable, risk-adjusted return which is not correlated to the stock market.

Equity or debt Debt Equity Equity Equity
Exposure Consumer, SME and property loans SMEs including AIM listed companies SMEs not including AIM listed companies SMEs including AIM listed companies
Financial benefit Fixed income Capital preservation, capital growth & dividend Capital growth & dividend Capita growth & dividend
Minimum holding period No minimum 2 years 3 years 5 years
Capital Gains Tax No capital gains Taxable 100% relief 100% relief
Income Tax Taxable (unless held within IF ISA) Taxable 30% relief 30% relief
Inheritance Tax Taxable 100% relief 100% relief Taxable

Investors in P2P are typically exposed to a diversified pool of either consumer, business or property loans. In contrast, S/EIS, BPR and VCT investments expose investors to equity positions in small businesses seeking to grow.

With P2P lending it’s possible to review the underlying loan book performance of the assets and now with 12 years’ worth of data, the returns are fairly predictable. This level of transparency and predictability cannot be achieved when investing in equity positions held within tax efficient products.

So Why are They Compared?

In general, peer-to-peer lending, VCTs, BPRs and S/EISs investments are considered non-standard, alternative investments with a potential for capital losses. Suitable investors are likely to already have a well-diversified portfolio, looking for either tax efficiencies or a stable yield.

With the exception of some AIM listed businesses, which can be accessed through specialist BPRs or VCTs, the majority of the underlying assets of tax efficient products are unlisted. The non-listed nature of the ultimate exposure also holds true for peer-to-peer lending investments. The outcome of this is that both tax efficient investments and P2P investments are relatively illiquid asset classes. It is possible to get your money back when investing in P2P, providing there are new lenders willing to substitute your loan commitments. Fortunately, with an abundance of demand for borrowers, it’s very quick for investors to access their funds early when withdrawing from the major P2P providers. With VCTs and EISs investors are able to exit early, but the HMRC will claw back any tax incentives gained. In both circumstances investors should be prepared to commit for the long term.

The government created sufficient tax breaks which formed the BPR, S/EIS and VCT markets. The purpose of this was to help foster the growth of early stage businesses through the provision of equity capital. In 2016, 36% of the P2P market related to SME debt financing. In effect, P2P lending could be seen as the debt equivalent of the equity EIS/ VCT market. This leads to a final question: is it unrealistic to expect the HMRC to extend tax breaks to the P2P business market?

Probably not, as growth has occurred naturally with the benefits of peer-to-peer being strong enough for investors to get on board without the tax benefit.

Unlike Tax Efficient Investments which can benefit people of a certain wealth bracket, P2P investments attract investors from all wealth brackets. The principal restricting factor for the growth of the P2P sector is not investor demand but how effective the P2P platforms are at originating creditworthy borrowers. If the platforms can crack this nut, there will be little to stop the growth of the P2P market.

The provision of high quality data and research is likely to provide comfort to financial advisers as they consider further alternatives beyond tax efficient products.

If you have any comments on this article please email CEO of Orca, Iain Niblock on [email protected].