This fund manager weighs up P2P and direct lending funds

Ben Conway (pictured), senior fund manager at Hawksmoor Fund Managers, examines the risks and rewards of the alternative finance sector…

A mixture of more conservative bank management teams retrenching to lower risk business after the financial crisis and more onerous regulations have seen banks curtail lending activity in many areas, opening up large gaps for other parts of the private sector to take advantage.

GCP, a provider of asset-backed finance, estimates that the ‘big four’ – RBS, Lloyds, Barclays and HSBC – reduced their net exposure to loans on their balance sheet by around £500bn between 2011 and 2015. Thus a large number of alternative finance vehicles have sprung up purporting to take advantage of this dynamic. As investors, it is our job to judge whether these vehicles represent good potential investments or not.

Read more: How P2P funds have fared over the past year

Peer-to-peer lenders have raised a great deal of capital via initial public offerings during this period, while direct lending funds have also been established, albeit at a slower rate. P2P providers of finance aim to lend to a constituency of borrower, mainly consumers, who have been poorly served by banks in the past. Credit card loans, as we know, are horrifically expensive and banks fail to distinguish between borrowers of different credit-worthiness.

P2P lenders aim to provide finance to consumers at cheaper rates than banks are willing (or able) to, by using technology to estimate credit-worthiness better. Direct lenders, by contrast, typically lend to small businesses, often demand security and actively choose who they lend to.

Read more: Alternative finance funds beat the sector average for dividend yield

P2P lenders offer access to their market via platforms, which package up large groups of smaller loans and investors must accept passive exposure – the lenders cannot distinguish between every single borrower, but they can use technology to rule out those they view as most at risk of default.

At Hawksmoor Fund Managers, we believe a very discerning approach to both of these sectors is necessary. Firstly, P2P lenders are addressing a market failure that pre-dates the GFC. Banks have always offered expensive borrowing via credit card loans. By contrast, direct lenders are exploiting an opportunity that would not be nearly so large or profitable were it not for the huge reduction in the size of bank balance sheets.

Secondly, direct lenders can be far more selective in who they lend to – their individual transactions are far larger and they can tailor the lending agreement to suit the lender, demanding high levels of security and tight covenants. P2P loans are unsecured and it is much harder to accurately predict default rates when the loans are to a large disparate group of people.

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Direct lenders can specify that the assets backing the loan be placed into separate special purpose vehicles and can even control the bank account into which interest payments flow. This is a level of comfort that P2P lending cannot possibly provide.

Finally, many direct lenders have been involved in this type of lending for many years and have simply sensibly moved to exploit the big banks’ reticence to compete. The P2P lending space is new and multiple business models abound.

Each of the many funds in the P2P sector have their own distinguishing features, often with entrepreneurial management teams that might be new to the market themselves. While I am sure that some of these funds will be a success and provide excellent returns for investors, equally I am sure others will lose money.

The P2P sector is undoubtedly illustrating how a capitalist society can increase social welfare, via the provision of cheaper credit to those who need it, but for now, we have no edge over anybody else in determining which business model is the most robust and we have yet to see them tested during a downturn. Direct lenders offer a similar return profile but usually for lower risk.