[Editor’s note: This is a blog post from Jeremy Todd, Head of Capital Markets at Prime Meridian Capital Management. Prime Meridian Capital Management is a bronze sponsor at LendIt Fintech USA 2018, which will take place on April 9-11, 2018 in San Francisco.]
The marketplace lending sector is growing up – quickly.
The types of institutional investors allocating to the marketplace lending asset class has changed dramatically, from mostly family offices and fund of funds about five years ago to institutional investors such as pensions, endowments and sovereign wealth funds today. That is good news of course, and a sign this asset class is evolving and growing.
It also means there is greater overall understanding of the asset class, the fund product offerings, and an increasing institutionalization of the industry. That step up in sophistication and broader market preferences, is changing the way that fund managers, allocators and investors are analyzing and investing in the space.
It is a big shift from what the typical fund used to look like just a few years ago, which:
- only purchased loans from origination platforms
- invested only in consumer loans
- invested in loans only from the largest platforms such as Prosper and Lending Club
- used a credit model to purchase only select loans from the platforms (active buying versus passively buying)
- offered only one fund to allocators
Unfortunately for allocators, these types of funds have not necessarily met the investment objectives for a variety of reasons including: declining yields on consumer loans, sub-asset/vertical portfolio diversification, platform diversification, leverage utilization and a differentiated portfolio construction methodology (e.g, not just purchasing whole loans).
The expansion of institutional investors has ushered in higher investment standards for this asset class which now require a very high level of portfolio management expertise, risk management oversight and robust operational infrastructure before making an allocation.
As a result, these allocators and investors have generally shifted investment activity towards the top five trends:
- investing through a combination of loans, securitizations and warehouse lines of credit
- investing in multiple sub-asset classes
- using both well established and newer origination platforms
- investing both actively and passively from platform
- investing through multiple sub-asset class funds
Let’s take a closer look.
1-Institutional allocators investing through a combination of loans, securitizations and warehouse lines of credit
Many allocators are starting to realize there are several investment options of investing in the marketplace lending fixed income asset class other than just purchasing whole loans. There are now two other additional methods that offer meaningful benefits. One is through bonds that have securitized whole loans in the asset class. Bonds have both advantages and disadvantages, and one unique plus is gaining access to certain platform loans that may only be available through securitizations.
Another option is through offering warehouse lines of credit to lending platforms, typically through banks and now some managers. The main advantage is that a manager offering a line of credit to an origination platform, versus purchasing whole loans, may not necessarily be exposed to individual default risk on the specific loans the platform underwrites. The manager can still likely receive similar returns yields though from the origination platform while reducing credit risk. There are other potential advantages in terms of tax considerations to the fund’s investors. Today, most allocators prefer that their investments in the asset class use the full spectrum of investment options to maximize returns.
2-Institutional allocators investing in multiple sub-asset classes
Initially, pooled funds only invested in consumer loans because that is all the early origination platforms offered. Today, there are many other verticals such as: small business, mortgages, trade financing and student loans to name a few. Each may have quite different risk return profiles based upon factors such as average yields, collateralized/non-collateralized, personal/business loans, etc. Accordingly, many allocators now prefer managers’ who have expanded their investments in the marketplace lending asset class to these different verticals to achieve different targeted returns, diversify their investments, and better manage their risk exposure.
3-Institutional allocators using both well established and newer origination platforms
In the early years, hedge funds would generally only invest in larger well-established origination platforms such as Lending Club and Prosper. But today, many allocators prefer funds that invest in both well-established and newer origination platforms, which may offer outsized relative returns to larger platforms and overall portfolio diversification. There are limitations, however, as newer origination platforms generally have smaller overall loan volumes and therefore will only accept a limited number of third-party investors. Accordingly, allocators realize the increasing importance of: a manager’s ability to leverage their overall size and reputation, a proven track record of establishing mutually beneficial strategic origination partnerships for research and securing additional impactful relationships with newer origination platforms for the institutional allocator’s benefit.
4-Institutional allocators investing in asset class both actively and passively from platforms
The larger platforms such as Lending Club, Prosper, and Funding Circle still offer active buying using an auction-based system. But the vast majority of platforms only allow investors to purchase all the loans they originate passively. This provides two types of value-added benefits a manager can offer an institutional allocator. For one, a manager may create alpha on active platforms by investing in loans with a lower default rate based upon other platform loans with similar credit grades and loan terms.
Secondly, as mentioned above, is the manager’s ability to establish partnerships with newer origination platforms with limited supply and possibly higher risk-adjusted returns even if the manager is investing passively on the platform. As a result, most allocators prefer that marketplace lending money managers have the ability to offer both types of investments in their funds.
5-Institutional investors investing through multiple sub-asset class funds
Allocators typically prefer to establish relationships with fund managers that offer multiple differentiated sub-strategies within an asset class. This allows the investor to allocate to either one or more multiple funds to meet investment objectives. This is not surprising since allocators typically spend significant time performing due diligence on a new manager before making an investment. To highlight this point, allocators typically prefer to invest in traditional fixed income through money managers that offer multiple separate strategies such as high grade, high yield, municipal, and treasury bond funds. This can make it easier to select different strategies by one firm to meet their investment objectives. Comparatively, most allocators prefer now to invest in marketplace lending managers with a menu approach as well as multiple funds offering different verticals/sub-asset classes.
These five trends illustrate how the marketplace lending space is becoming more institutionalized across every facet including the asset management side. As a result, allocators are holding asset managers to the same institutional standards and due diligence requirements as other asset classes. These trends also highlight the evolution of the institutionalization that allocators are driving in this asset class and that is a positive catalyst for the continued growth of capital into the marketplace lending industry.
About the author: Jeremy Todd, Head of Capital Markets, at Prime Meridian has assisted many allocators in both research in the marketplace lending asset class and helped find quality managers while working for two of the leading data and technology providers in the industry. He has also written two widely distributed white papers on best practices for both domestic and offshore allocators in performing due diligence in marketplace lending. He has invested in three of the four investment options available for investors: 1) personal accounts on the retail platforms, 2) investments in third party hedge fund managers, and 3) investments in funds offered by certain lending origination platforms, but not 4) MPL bonds, but indirectly invested in bonds through third party managers.