Help on the way up

With banks still restrictive on lending and interest rates wallowing at all time lows, it"s no surprise that businesses and savers are turning to their peers. David Craik examines the boom in P2P lending

The financial crisis has led to major changes in UK banking culture - and one of the most significant is a boom in alternative lending. Businesses have sought to find new avenues of funding as the banks, cautious about the economy and facing stricter capital regulations from the UK and EU, have largely turned off the taps.

One of the most prominent forms of alternative lending is peer-to-peer, or P2P, with firms Zopa, RateSetter and Funding Circle the ones grabbing most of the attention. Typically P2P lending involves an individual lending money to another person or a business through an online platform that facilitates and manages the process for a fee. Instead of banks lending a depositor"s savings to whoever they choose, P2P allows its users to lend direct.

Investors say how much they want to lend and for how long and the interest rate they are happy to receive. Borrowers say how much money they need and the rate they are happy to pay. The platform matches the two and usually spreads an investor"s money around a range of borrowers to reduce risk. It is attractive to both parties as the interest rates are higher than those paid by a bank and lower than most borrowers are offered.

In 2013, £480 million was lent to both individuals and businesses in the UK through P2P - 150 per cent more than 2012. The overall UK alternative finance market saw £1bn funded in 2013, up from £309 million in 2011. It is expected the figure will reach £1.6bn in 2014, with 50 per cent of that going to UK businesses.

David De Koning, Head of Communications at Funding Circle, which lends to businesses, says the company has had a stellar three years. It loaned around £130 million in 2013, taking its total lifetime figure to almost £250 million.

He says there are two main drivers. “Investors affected by low interest rates are coming to us for higher returns, and small businesses are looking for funds from us to grow. That"s because the fundamentally broken banking system has not been fixed.”

P2P is also benefiting from government backing. In total it has invested £60 million in Funding Circle through its British Business Bank. Business secretary Vince Cable is on record as saying: “Too much business lending is concentrated in the big banks - they need to be challenged.”

Changing the landscape

The sector"s public image has been helped further, since 1 April, when it fell under the regulation of the Financial Conduct Authority, a City watchdog. This will ensure that consumers will have access to fair, clear information that"s not misleading when using P2P platforms, so they can fully assess risk. The platforms will have to have plans in place so that loan repayments continue to be collected - even if they get into financial difficulty or go bust. Over time they will also be required to have enough capital in place to help them withstand financial shocks. Although consumers will still not be covered by the Financial Services Compensation Scheme, the P2P platforms have their own provision funds, which they are building as they grow. They claim these shield savers from the risk of bad debt.

“The FCA change gives the sector greater credibility and should lead to further growth,” says De Koning. “Investors who have taken a "wait and see" approach will now take it more seriously. The recent Budget announcement extending ISA eligibility to P2P loans is also a seminal moment. Again it helps us become more mainstream.”

Funding Circle primarily lends money to established UK businesses with an average age of 10 years and a turnover of between £100,000 and £1 million. “This isn"t your "Dragon"s Den" type start-ups or super fast growing firms like the next Facebook” explains De Koning. “These are core British businesses that need working or expansion capital.”

To date Funding Circle has helped 4,000 businesses access finance, with loans averaging around £60,000 but with some extending up to £1 million. An internal team of assessors evaluate applications and use a series of credit algorithms to determine risk of default.

So, who are the investors?

“Investors are the everyday man on the street. They will look to lend small amounts to hundreds of businesses, say £20 each to 100 firms. This reduces risk as some firms will go out of business and not be able to repay the loan. High-net-worth individuals though will look to invest up to £1 million. We see a mix of investors,” De Koning states.

An average net return, he claims, is 6.5 per cent - “much better than any savings account and less volatile than the stock exchange”. Another platform, RateSetter, which lends to individuals, says an average 36-month loan will return 7.9 per cent to savers.

Of course, lending platforms charge fees, which need to be factored in. Funding Circle fees are one per cent annually on the amount lent and 0.25 per cent if investors want to sell their loan on to others. Borrowers" interest rates range from 7.1 per cent to 9.4 per cent with fees varying from two to five per cent.

It might sound all too good to be true. But the fact that P2P lending is gathering steam only shows that it provides a serious option. Ben Thomason, Director of Jersey"s Asset Leverage Consultants, says: “If you understand the underlying risks then, yes, you can make a good return. In property development, for instance, you could be getting a nine per cent return after fees.”

Jersey has recently got its own P2P lender in the form of Sancus. Launched in January, most of the loans come from its existing capital pot of around £23 million, but it works with co-lenders and has ambitions to launch its own lending platform in the future. Its goal is to lend to entrepreneurs and businesses creating local jobs.

“There"s enough demand in the Channel Islands, and I can"t see that changing,” says Chief Executive Andrew Whelan. “Businesses need funding and don"t want the banks" "tick-box" approach, with decisions made by junior staff. We put a lot of our own skin in the game, in that we put our own capital into every loan.”

Sancus recently made its first loan of £2.5 million to an entrepreneur carrying out a shareholder restructuring. “They need us for a particular reason. It"s not long-term lending,” Whelan says. “There is risk. With the loans there could be a default and that risk will pick up as the loan book increases. But it is secured and we see no downside.”

So what of the future? EY Item Club expects P2P to be lending £1bn in the UK by 2016. When you consider figures from P2P lender Assetz Capital showing that although 82 per cent of HNWIs knew what the sector did but 53 per cent of the ordinary public didn"t, there is scope there to grow.

Funding Circle"s De Koning sees hedge and pension funds getting into this space and lending. Banks may also come in. “We are already talking to a number of them about how to work together,” he says. “I don"t think we"ll see them setting up their own platform. They may partner with an existing platform to help fund businesses. In the next year or so you may see such a link up with us and a bank.”

Whelan also expects more fund manager interest. “We recently held a meeting on this topic. Thirty-two fund managers turned up. Eighteen months ago no one would have been there. Clients are talking to their managers and saying "why are we not doing this?"”

Will the number of banks departing Jersey and Guernsey recently, such as Clydesdale International and the Co-op, also help growth as businesses turn more to alternative lending? “Yes,” Whelan answers. “This is low-cost technology and the banks will be hunted down. It is a problem for them. They still have large defaults on their books they have to deal with, and with legislation such as Basel III they face constraints on their balance sheet.”

Whelan says a UK bank will definitely buy a P2P lender. “It"s an important part of the economy, and it"s removing cost and generating wealth. Potentially we may see longer-term loans emerge with rates coming down as a result. But it will still generate wealth.”

Ben Thomason is cautious. “It"s a new market, and it hasn"t gone through a big downturn. Property is where the banks got burned, and the majority of these P2P players are lending on property. You are exposed to that volatility. Do people properly understand who they are lending to? Do you properly understand the liquidity risk?” he says.

Other risks could be rising interest rates as the economy picks up pace, and the quality of borrower declining as the industry grows. In the UK we"ve already seen one P2P lender, Quakle, collapse in 2011. Its demise was blamed on poor credit-rating systems.

But Thomason stresses that, as part of a balanced portfolio, P2P can work. “Potentially it can be very good for high-net-worth and smaller investors to get their surplus cash in the bank earning. But do your research on where your money will be going,” he says.