Peer to Peer Lending v Balance Sheet Lending
What is the first thing that comes to your mind when you think of alternative lending? Is it the technology driven peer to peer lending platforms, or the global lending funds of Ares and Pemberton, or perhaps it’s the Wonga like payday lenders? Since the 2007/2008 financial crisis, alternative lending has risen in many forms, now covering a wide range of lending structures and purposes. The peer to peer lending market is just one piece of the jigsaw puzzle that is alternative lending.
What is Alternative Lending?
The broad term alternative lending is used to describe the vast range of loan options available to both consumers and businesses outside of a traditional bank loan.
Alternative lenders can be segmented by the two lending models which have been adopted: peer to peer lending and balance sheet lending.
The Two Lending Models
Peer to peer lending (or marketplace lending)
Peer to peer lending is a service that enables investors to lend money to borrowers directly. A platform provides the infrastructure required to facilitate the funding arrangement.
Balance sheet lending
In the balance sheet lending model, the money lent is held on a balance sheet. The money is bought or borrowed at a cost to then be lent out to customers. As the money is lent from the balance sheet, the lender takes on all the risk. As a benefit, they take all the upside from the interest payments.
Figure 1: Alternative Lending segmentation (EY – Understanding Alternative Lending)
Comparing P2P & Balance Sheet Lenders
From the borrower’s perspective, the two lending models produce a similar result, but the source of funds, costs, borrower type, default risk and the funding process differ.
Source of money
In the peer to peer lending model, investors fund loans directly and take ownership of their loans. Generally, loans are fractionalised enabling people to take small positions in loans, allowing for easier diversification. This is commonly done via an online platform where investors can choose their risk-for-reward. In the UK, there has been a tendency for peer to peer lending platforms to offer passive solutions, where the investors (or lenders) deposit funds and the funds are automatically allocated to a large number of borrowers. However, there are still platforms, roughly 20% of the market which allow people to select individual loans.
In balance sheet lending, the money comes from a wide variety of sources, including investment banks, financial markets, family offices, HNW investors and various other institutions. Depending on the type of lending, the cost of capital and the underwriting processes can be strict. Unless the institution is a listed investment vehicle, exposure to the loans is generally not made available to retail investors.
Peer to peer lending companies typically focus on near-prime unsecured consumer loans, SME business, and property related financing. Loans are often up to 5 years and, while returns vary, the large platforms offer between 4-7%.
Although the peer to peer lending market is considered diverse and fragmented, the balance sheet lender market is even more so. While there are examples of direct cross-over with the types of lending in the peer to peer lending market, balance sheet lenders also cover more specialist lending sectors, including mid-prime consumer, payday lending, invoice financing, merchant cash advances and guarantor lending. Loans can often be shorter in duration and carrying more risk/return. The large listed funds lend from their balance sheet often providing larger loans of £15 million plus.
The funding process
Peer to peer lending platforms need to constantly reach equilibrium with the supply of capital from investors and the demand of capital from borrowers. This can either lead to a mismatch of investors having to wait for their capital to be lent or for the borrowers waiting to drawdown on the capital.
With the balance sheet lender model, once a loan application is approved the funds are readily available to disburse. However, depending on the arrangement with the institutions, there might be pressure to lend the money especially if this is at a cost to the lender.
Costs & risks
In the peer to peer lending model, the capital does not have to be bought and there is no additional capital set aside to cover losses (provision fund exceptions). The investors take the risk and return, with rates often set by peer to peer platform. This generally makes peer to peer lending better value and more transparent for the investor. With the peer to peer lending model, the platform is passing the benefit across to the investor directly and the overall return is reduced by sacrificing the potential for default volatility. So, the profitability of this model is likely to be less than a balance sheet lender.
With the balance sheet lending model, the money needs to be bought in advance and they carry all the risk for losses. The lender needs to ensure they have enough of an arbitrage between the cost of capital and borrower rates to cover loan losses and operating costs. Additionally, alternative balance sheet lenders often lend to specialist, high risk segments of the market. This means the cost of capital can be high as institutions find it difficult to price the risk. In this model, the balance sheet lender collects the interest rate spread over the lifetime of the loans. This increases the return and provides cash flow, but the balance sheet lenders retain full exposure to the risks associated with loan defaults.
Ultimately, retail investors can directly invest in loans originated by peer to peer lending platforms, while loans originated by balance sheet lenders are less accessible to a retail audience. Balance sheet lenders cover a wider spectrum of loans, spanning a broader range of sectors compared to peer to peer lending, so there could be an opportunity to increase the diversification of a portfolio. Investing in these loans could provide greater choice to retail investors and it’s possible that we will see cross-overs between these two lending models in the coming years.