Investing In Peer-to-peer Loans

There are many peer-to-peer lending models, which makes it difficult to compare an investment in the R&M Income Fund with a peer-to-peer loan. I have nevertheless set out some commentary below that might be useful in this regard.

The standard peer-to-peer model is one where the investor simply purchases or otherwise provides the funding for a loan to an individual or to a business.  The downside to this model is the lack of diversification. The investor is exposed to a higher risk than he/she would be exposed to when investing in a well-diversified portfolio of loans, leases, etc.

Consider this example: One invests $100,000 in 5 loans of $20,000 each to borrowers of prime credit standing, each paying 10% pa in interest and having a portfolio bad debt risk of 1%.  If one of the 5 loans was written off as a bad debt, the investor will suffer a $12,000 loss of capital.  If on the other hand one had invested $100,000 in a fund with $10 million in funds under management and 1% was written off as bad debts, one would have made a profit of $9,700.

Peer-to-peer models have generally endeavoured to overcome this disadvantage. In some cases, they have created a ‘reserve account’ against which bad debts are first written off.  These reserve funds are created by siphoning off a portion of the return payable on each loan.  One of the problems with this approach is that the investors buying loans of lower risk (and therefore getting lower returns) are in effect subsidizing those buying higher risk loans paying higher interest rates. If all investors then prefer purchasing higher risk loans, the risk across the portfolio will blow out resulting in more and more money needing to be siphoned off returns in order to sustain the reserve account.

Another disadvantage of peer-to-peer lending is the time and effort it takes to select, assess, price and bid for loans to purchase.  An easier and lower risk approach is to invest in a managed fund that in turn invests in a portfolio of loans, leases and other financial products.

Prepared by: Mark Morris