Last Updated on December 15, 2020 by Oddmund Groette
Crowdfunding/p2p is a relatively new asset class and has increased in popularity over the last five years. To my knowledge, the biggest market, UK, at one point had 12% (?) of the lending market served by crowdfunding. But before you dip your toe in the crowdfunding water you should carefully evaluate if this is for you. My advice: be very, very careful.
It is very tempting to make 10% (and more) on your capital, but let me assure you 10% does not come without risk: I would say it comes with substantially more risk than you realize. The pitfalls are many, and for most people, I would say the “old and boring” stock and real estate market is a much safer bet. In this article, I bring forward some arguments against crowdfunding after having invested in eight different pan-European platforms, although I will not get into any specifics about each platform. My “wisdom” comes from common sense and many years of handling risk in the stock market.
First off, read the contract
Before you do anything, you MUST read the contract to understand how the platform operates. Do you understand the business? How does the platform make money? Will the platform make money in an economic recession? When a loan defaults, who gets paid first, you or the platform? This is just examples, but important issues. The devil is in the details.
No alignment of interest
When I make an investment in stocks I prefer to invest alongside owner-operators who has skin in the game. If the manager makes a mistake he suffers just as much as I do. Most platforms make their money by allocating loans and perhaps take a cut of the interests paid by the borrower. But they share no risk in the principal. Thus their interests are not the same as yours. The platform makes most of their money by providing loans, and quantity over quality might be their preferred action. Successful lending requires discipline because this is a very cyclical business..
The biggest risk is platform risk. What happens if the platform goes belly up? I can assure you it will take a long time until you get your money back, and you will get back much less capital than the face value of the loans. Platforms are required to have a backup of all their data, and in theory, another provider can just take over the business and continue managing the loans on your behalf. However, there will be a long liquidation process and no one works for free. Lawyers are not cheap, and the administration costs will be substantial as they need to get to know the loan book while at the same time having no incentives to save money (they are paid by the hour). Any winding down of a platform will most likely take years and in the meantime, lawyers have a feast on your capital.
On some platforms, you have additional risk toward the loan originator. How is this possible? One of the biggest European platforms is basically just a “broker” and provides investments into loan originators from all over the world. That means you have two platform risks. If the loan originator goes belly up, you will face losses as if the platform itself went bankrupt.
Platform risk is for real. At least three UK platforms have either gone bankrupt or winding down voluntarily. The platforms will consolidate and just a few will survive as independent platforms.
Crowdfunding means investing in assets that are very hard to dispose of. If you for example invest in a consumer loan with five years of payback time, you have to wait for the loan to mature or to sell on the secondary market. Several platforms have secondary markets, but they are illiquid unless you sell at a discount (loss). You are basically stuck for five years waiting for the borrower to pay back the principal.
Somehow my return does not correspond to the return advertised on the platforms. In some of the platforms, my return was substantially lower than claimed as average for the platform, even though I diversified to hundreds of loans. In other words, there is reason to believe the expected return is exaggerated.
Crowdfunding is a new business and has until now never experienced a serious economic recession. To my knowledge, only one platform (UK) was operating before and during 2008/09. If we hit a crisis you will suffer losses on loans (defaults) and I suspect several platforms will go belly-up. Lending is very much a boom-bust business.
Brexit is thus far the closest we have come to a recession, and it is not pretty. After Brexit, several UK platforms experienced a substantial increase in defaults, and one of the biggest went bankrupt. Recently another platform decided to wind down, albeit in an orderly fashion.
Lending is a commodity and is highly competitive. Managers need to be prudent, and business cycles last for many years, perhaps making managers blind for the risk. There is a strong reason to be skeptical about a new business like p2p lending because it attracts many “fortune seekers”.
Security risk (LTV risk)
In asset-backed lending you put your trust in the valuer. Real estate is a very fragmented market where each property is unique and valuation is sometimes very difficult to estimate, especially when the loan is aimed at developing a property. Even worse, without a strong surveyor with a mandate from the platform, there is no guarantee that the funds will be spent according to the plan. In addition, there is a huge risk in lack of proper due diligence by the platform as the interests of the platform and the investor/lender are not aligned.
A loan to asset value of for example 70%, may in reality be 80%. As an example I give you one from the UK: I participated in one loan where 1.2 million GBP was lent, and the security was valued at about 1.8 million. The borrower defaulted, and the security was sold at auction for 900 000, just half of the value given by a certified 3rd party property valuer. It gets worse, just 500 000 was paid back to lenders as 400 000 was paid out in fees to handle the sale.
Power of attorney and subsequently litigation risk
Most people do not consider that they hand over their money to the agent (platform) with basically a carte blanche to operate on your behalf. If your agent (crowdfunding/platform operator) is a fraud and doing a lousy job, the borrower can go after you (however, the law is different from country to country). This happened in the UK where a borrower threatened to sue all 4 000 borrowers in an £8 million loan where the agent called in the loan prematurely. The UK High Court ruled that the claimant was right to go after the lenders because the platform is just an agent working on behalf of the lenders. This means lenders might be at risk to be “jointly and severally liable” for claimed losses. In this particular case, the agent called in the loan just a few days too early according to the contract (they should have sought legal advice on the exact day to call in the loan) and created the claimant’s legitimate grievances even though the borrower clearly defaulted on many points. This is a mistake by the platform/agent, but you have unfortunately given them carte blanche for the loan particulars. Eventually, the case was called off because The Judge required the claimants to pay collateral/security (in case they were to lose the case), but the claimant never put up the money and thus the case was dismissed.
In asset-back security, lending conflicts happen all the time, and litigation is the name of the game in certain countries. Real estate is a professional market where you as a lender have limited knowledge of the borrower. Caution is required before lending any money.
Difficult to compound
Albert Einstein once said compounding is the eighth wonder of the world. He is of course right. Unfortunately, it’s very difficult to compound in crowdfunding. Let me give you an example: Assume you have 25 000 EUR to invest. If you let it compound at 10% for 20 years, it’s worth 168 000 EUR. It’s completely unlikely you can do this on a crowdfunding platform. Why? First, most platforms are not able to reinvest such large sums of money, and second, you have to pay taxes annually:
Most likely you will have to pay taxes on the annual interest income. Taxes have a huge impact on your ability to compound. If interest income is 10% you might just end up with a 7.5% yield after taxes. The less you can reinvest, the less you can compound. For most people, a 2.5% difference does not sound much, but over 20 years a 10 000 investment is worth 67 000 with 10% and just 42 000 with 7.5%. And of course, after defaults, you will make less than 10%.
Many countries do not allow defaults/losses to be offset against interest income, Norway for example (only corporations can), and many countries require to classify loan losses against capital gains. If your interest income is 5 000 and loan losses 1 000, your effective income is obviously just 4 000. But not necessarily for the taxman, who will base your income on 5 000, not 4 000!
10% upside and 100% downside (perhaps more than 100% due to litigation)
You have a capped upside. You can’t make more than the interest rate, but you face a 100% downside (of course, we can argue this is very unlikely). Considering litigation risk, you actually risk losing more than your original investment.
Is it relevant to believe banks will enter the market? At some point in the future, I believe banks will expand to niches of the p2p market. In Norway, we see this already happening where banks have invested in start-ups and dipped their toe in the water.
How can you make crowdfunding successful?
You must carefully read the contract with the platform and fully understand the risks involved. Pay special attention to the arguments brought forward in this article, and choose the platforms with the longest track record. As far as I can see, the best option is asset-backed real estate loans with low LTV. However, be careful with development loans as they are the riskiest. Real estate bridge loans with LTVs lower than 60% should be the safest.
What can you expect in return for crowdfunding?
Remember to discount taxes on your income. Moreover, you must expect losses when the next recession comes. If gross income is 10%, I believe you should be happy with a 6% real return after taxes and losses.
In my opinion, the disadvantages outweigh the advantages. I advise you to step back and assess the pros and cons before investing in p2p/crowdfunding. There are many pitfalls in a new business and in any start-up phase there are many bad business plans. I expect the market to consolidate, and I suspect many more platforms to go belly-up. Personally, I’m conservative and like to stick to the proven asset classes: stocks and real estate. I believe most investors should do themselves a favor and do the same.
Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.