An Overview of Marketplace Lending and the Best Practices for Investing in the Asset Class

The number of institutional investors investing in marketplace lending assets has increased substantially over the last two years.We at Orchard see four main types of institutional investors as having driven the majority of this growth to date: (1) traditional asset managers purchasing these assets for their existing managed accounts and –40 Act funds, (2) Business Development Companies, (3) large hedge fund managers purchasing these assets within their existing hedge funds, and (4) startup hedge fund managers creating funds dedicated to investing in marketplace lending assets.However, as marketplace lending becomes better known to the broader investment community, we believe that it can be leveraged by fixed income investors of almost any type or level of risk tolerance.

This article will provide an overview of marketplace lending, including some of the potential benefits and challenges to investing in this asset class.It will also provide a set of best practices for the institutional investor considering an exposure to the asset class.

Overview

Marketplace lending has come to encompass a number of different business models, but at its most basic involves the investment of capital via online platforms to lend directly and indirectly to consumers and small businesses.A marketplace lending loan is generally a short duration, high yielding, fixed income instrument.The types of marketplace lending loans available today are predominantly unsecured personal loans and secured and unsecured small business loans.Specialty marketplace lenders are also entering the space, including those dedicated to student loans, mortgages, auto loans, and even invoice factoring loans.

Benefits

We continue to see significant growth in the volume of loans (about $2 billion monthly) that are originated by marketplace lending platforms and in the number of institutional investors that are starting to invest in this new asset class. The following summarizes the three primary benefits that we and many of our clients have identified: short duration, high yields and low volatility.

Short Duration

The majority of marketplace lending assets have shorter maturity terms compared to those of traditional fixed income assets like government or corporate bonds, which typically have between five and thirty years terms.The typical marketplace lending consumer loans have terms between two and five years.The typical small business loans have terms between a few months and a few years. Interestingly, the effective duration of the loans are generally much less than the stated terms as a result of prepayments.

High Yields

The typical yields on marketplace loans are higher than those on government and corporate bonds.After taking defaults into consideration, consumer loans are returning on average between 4% and 9%.Small business loans on average are returning between 8% and 12%.Student loans are returning on average 3% and 5%.Mortgage loan returns vary depending on the type of property.Yields have come down slightly over the last few quarters, which can be attributed to lower cost of capital available to the platforms and competition for borrowers.

Low Volatility

Marketplace loans can be purchased directly from origination platforms, or exposure to the space can be obtained by purchasing a securitized bond backed by marketplace loan assets.The majority of the marketplace loan supply is purchased directly from origination platforms.The loan value of marketplace lending assets that are purchased directly from origination platforms will not fluctuate in short periods of time because there is no active secondary market to re-sell the loans and therefore the loan value will have lower volatility. Securitized bonds, on the other hand, do have an active secondary market, allowing bonds to be re-sold and purchased at market prices that are determined by supply and demand. The loans purchased directly from origination platforms are less liquid than the securitized bonds, but the trade-off is lower volatility in the loan value since it is not directly influenced by other external market factors like current interest rates.

Challenges

Institutional investors quickly realize that investing in marketplace lending assets requires new research tools, technology, and operational processes.The existing execution or data analytics infrastructure for fixed income strategies (e.g., Bloomberg) will not work for marketplace loans because the market information is largely fragmented (with the exception of Lending Club and Prosper, who publish full loan-level details online).Existing order management systems cannot handle execution in this asset class, because the origination platforms are not yet integrated with these systems and do not use FIX protocol or any other widely recognized standard for trading.Consequently, managers have several challenges scaling their investments within the asset class.There are three main challenges that institutional investors continue to experience and attempt to find solutions for:

1. Accessing comprehensive data for loan analysis across origination platforms
2. Finding and accessing marketplace lending origination platforms
3. Developing a robust operational infrastructure to monitor, value, and benchmark investments.

Accessing Comprehensive Data for Loan Analysis Across Origination Platforms

Many institutional investors review multiple origination platforms for different marketplace loans in order to better diversify their investments. However, it is quite challenging to efficiently access and analyze loan tapes across multiple origination platforms.The loan tapes are typically provided in Excel and have different data points and sometime different calculations for the same data points (e.g., DTI ratios).As one can imagine, trying to combine and standardize hundreds of different data points from multiple Excel files is challenging without the appropriate infrastructure and technology. Investors would prefer to have a system that can easily aggregate the historical loan information in a unified format to allow investment teams to easily filter and analyze historical loan information.

Finding and Accessing Marketplace Lending Origination Platforms

The current demand far outweighs the available supply of marketplace loans.Therefore, it is important to be able to find and access the many origination platforms globally to secure supply that meets one’s objectives.Most investors do not have the resources to efficiently source the supply needed to scale their investments within marketplace lending.With hundreds of marketplace lending platforms in the U.S. and thousands of platforms globally, many investors find it challenging to marshal the internal resources necessary to effectively find platforms that meet their objectives, evaluate them, and then access and successfully purchase from them.

Developing a Robust Operational Infrastructure to Monitor, Value and Benchmark Investments

While marketplace lending platforms became available in the U.S. nearly ten years ago, the loans originated on these platforms are still considered a relatively new asset class for institutional investors.Investors are finding that they cannot utilize their current technology and operational infrastructure to manage their existing strategies for marketplace loans. As previously discussed, the traditional execution or order management systems currently do not provide execution services, portfolio management, risk analytics and comprehensive reporting systems on marketplace loans. As a result, investors will need to implement additional technology and operational infrastructure in order to support the full lifecycle of processing these loans.

Portfolio management tools are critical for any asset class, including marketplace lending instruments.Investors must track and value the hundreds and thousands of loans that they will have across multiple lending platforms. This requires the ability to easily aggregate and standardize data across multiple origination platforms.Additionally, institutional allocators will require independent third parties to calculate and value the portfolios in order to ensure that accurate management fees and performance fees are being charged by the funds.

Marketplace lending investors must be able to benchmark their investments and show performance attribution in order to demonstrate whether and how alpha is generated in their portfolios.Determining the appropriate benchmarks and analyzing attribution in marketplace lending loans is a difficult task that requires sophisticated technology given the many different calculations that must be performed. To determine the appropriate benchmarks, investors must analyze the vintage, grade, terms and portfolio weightings of the loans, and in order to calculate these different variables, investors must have access to extensive historical data and analytic tools.

Best Practices to Investing in Marketplace Lending Assets

The following is a summary of a white paper called, “The Essential 8 Best Practices to Marketplace Lending” released by Orchard Platform earlier this year (see www.orchardplatform.com/research).The paper provides more detail on these key considerations for investors in marketplace lending assets, but I will provide a summary of the best practices here.

1. Alpha vs. Beta Determination
   The first best practice is to determine whether a strategy is actively attempting to generate alpha or passively buying beta.In order to generate alpha, investors must implement credit models to determine the best loans and then actively select those loans.Passive investors are not selecting specific loans and are effectively buying an index of loans, which is considered buying beta.
2. Direct Platform vs. Securitization Investing
   The second best practice is to determine the appropriate method of investing in marketplace lending loans, whether it is purchasing the loans directly on the platforms or getting exposure through securitized bonds backed by marketplace lending assets. There are different benefits to each method.Investing directly on the platforms allows for more transparency, higher level of portfolio customization and potentially higher yields and less volatility compared to investing in securitized bonds.On the other hand, securitized bonds provides an easier way to purchase a portfolio of loans, the potential ability to short, and offers greater liquidity and lower cost to use leverage as compared to investing directly on the platforms.
3. Leverage Utilization
   The third best practice is to determine the leverage utilization. Investors must decide whether leverage will be used on the marketplace lending portfolio.If leverage is being used, investors must examine how much leverage and examine the cost of the leverage in order to ensure financing expenses are minimized.Investors will be able to better analyze and benchmark a portfolio of marketplace lending assets after understanding the leverage utilization.
4. Supply, Supply, Supply…Finding, Accessing and Acquiring
   The fourth best practice for investors is to understand the supply sources of marketplace loans. In order for investors to successfully invest in marketplace lending assets, they must be effective in finding, accessing and acquiring supply, which is currently very limited. In order to access supply, investors will be required to negotiate terms and documentation for rights to acquire the loans.The process of acquiring or purchasing the loans is especially important for active strategies because it will require a robust order management system.
5. Multi-platform Diversification
   The fifth best practice for investors is to diversify the origination platforms that they have exposure to.Diversification helps minimize counterparty risk by having exposure to multiple sub-asset classes across multiple platforms within marketplace lending.Counterparty risk within marketplace lending is the possibility of an origination platform becoming insolvent.
6. Portfolio Valuation
   The sixth best practice for investors is to properly value a portfolio.As mentioned earlier, it is important to value marketplace lending portfolios appropriately so that management fees and performance fees can be calculated and charged to clients correctly.To value a securitized marketplace lending bond is relatively straightforward because securitized assets are actively traded and have market prices.To value a portfolio of loans that are purchased directly from origination platforms has many challenges, including no real-time price discovery, changing estimated default rates within and across platforms, and even the process to standardize and aggregate information from multiple origination platforms can be complex.Investors must have a well-documented and objective portfolio valuation process for their end clients.
7. Portfolio Benchmarking
   The seventh best practice is to select an appropriate benchmark for the portfolio.Choosing the appropriate benchmark is critical in order for investors to determine whether and how alpha is being generated in the portfolio. There are two levels of benchmarking available for marketplace lending strategies.The first is to compare the overall portfolio returns to a public marketplace lending index. The second is to compare the portfolio with a customized benchmark using portfolio attribution.The second level of benchmarking is required in order for actively managed strategies to calculate alpha.
8. Robust Infrastructure
   The eighth and final best practice is to have a robust operational infrastructure to manage marketplace lending assets.Other studies have highlighted the importance of having a robust infrastructure, and institutional allocators view it as a major requirement for making an allocation to a fund. A robust infrastructure requires implementing the right technological tools to address and minimize the operational risk in managing marketplace lending assets.

Conclusion

The level of assets under management in marketplace loans is expected to continue to grow significantly over the next five years. The majority of the growth is expected to come from institutional investors as they continue to discover the benefits of investing in marketplace lending assets. However, investors will need to address the many challenges of investing in this asset class.Understanding the best practices and key considerations can help address many of these challenges and offer investors the opportunity for exposure to this new and exciting asset class.

About Orchard

Orchard is a technology and infrastructure provider for marketplace lending.

Bio

Jeremy Todd is the Head of West Coast and Asia sales at Orchard Platform. He has over 18 years of financial services experience in sales, marketing, and business development covering asset managers, hedge funds, institutional investors, broker-dealers and registered investment advisors. He was previously at Barclays, where he managed the west coast prime brokerage business. He has also been a director at The Bank of New York Mellon, where he started the Pershing Prime Services business and managed the sales team, and a managing director at Bear Stearns in global clearing sales. Jeremy earned a B.A. in philosophy from the University of California, Berkeley.