Saturday, December 19, 2015

P2P Investing - Lessons Learned from Our Loan Book

We present some of the lessons we've learned about investing in P2P loans based on our experience investing in the Funding Circle Platform. The key takeaway for investors is that it is important to select loans carefully, build a diversified portfolio and take into account the relationship between risk and return and how the trade-off varies among the rating categories.

One of the platforms we invest on is FundingCircle (UK).  We've been investing there for two years with our Symfonie Lending Fund.  Our loan book has more than 500 loans.  This represents about 4% of the loans outstanding on Funding Circle's platform.

We don't use auto filtering mechanisms.  We choose each loan by hand. We make credit decisions based mainly on the information we get from the Funding Circle website, combined with some fact and reality checks we do on our own.

We're particularly interested in our Funding Circle loans because like the SymCredit platform we operate, Funding Circle focuses on loans to small and medium sized businesses.

Lesson 1:  Be diversified but selective

Being diversified is important.  In P2P lending especially a bad outcome can result in total loss of capital invested.  Diversification spreads the risk among many loans, so the chance that one particular loan will cause a large loss are reduced.  A well diversified portfolio should achieve a return consistent with the overall risk level.

For example, if on average a portfolio of loans offers gross return of 13% and the overall portfolio loses 5% due to defaults, the investor will generate 8%.  A well diversified portfolio will be a subset of the overall loan and should have performance similar to the overall loan pool, on average.

A good credit manager can outperform the overall loan pool by using sound judgement and avoiding loans that are likely to run into trouble.

This is the point where I get to brag a little!  Apparently, we are Symfonie are doing a decent job in the selection department.  Our default rates are generally better than those of the overall Funding Circle pool.  Either we are lucky or smart.
Default Rates
Risk BandFC All LoansSymLend Portfolio
A (Low risk)2.8%0.0%
A+ (Very low risk)0.9%0.0%
B (Below average risk)4.6%5.8%
C (Average risk)5.1%4.4%

Lesson 2:  Take Risk Class with a Grain of Salt


This was my philosophy from the day I began investing in P2P loans and it remains my philosophy to date.  Many class A loans are riskier than they might seem at first glance.  Many class C and D loans are less risky than they might otherwise seem.  Why?

The secret is in the scoring model the platform uses.  Scoring models are numbers driven and don't speak to fundamental issues underlying the business. In the land of the micro economy the health of any small or medium sized enterprise can change in a matter of weeks of months.  The catalyst is almost invariably a change in the top line.  Market conditions change, sales decline, fixed costs remain and the entrpreneur doesn't have enough cash to whether the storm.

Very often credit models are sensitive to balance sheet figures, especially equity value, short and short term debt. These are not always so meaningful however. I've seen businesses that have millions of dollars in sales and millions in profits and are wonderfully stable but have no retained earnings, perhaps even negative earnings. These businsess are C and D rated.  Peel the onion however, and you realise these businesses will be solid year in and year out.

In my view the risk/reward trade-off favors loans in class B/C/D and consequently my portfolio is varies significantly from the overall population of Funding Circle's loan pool.

Breakdown by Number of Loans
Risk BandFC All LoansSymLend Portfolio
A (Low risk)28.6%6.7%
A+ (Very low risk)22.0%3.1%
B (Below average risk)23.0%14.8%
C (Average risk)17.6%43.4%

Lesson 3:  Risk Adjusted Returns Matter!

Risk and return generally go hand in hand.  The art in credit management is to identify loans that offer relatively high risk adjust returns.  Successful P2P investing means peeling the onion of credit quality and looking past the cover of the book.

Look at the Funding Circle Class A and and B average returns and average default rates.  A funny thing happens when you cross from A loans to B loans.  The average interest rate climbs by 1%.  But the default rate in the B class - that increases by 1.8%. Class B loans don't look like such a great deal!

Cross into the Class C loans and look - magic!!!! Class C loans have 1.3% higher return on average than class B loans but only 0.5% higher average loss rates. The difference is even more striking when we compare Class D to Class A.  We pick up 3.6% in gross yield but we only give up about 2.3% in loss rate.  That's a good deal any day of the week.

Loss Adjusted Returns
FC All Loans - Gross ReturnBad DebtAdjusted Return*SymLend PortfolioAdjusted Return*
A+ (Very low risk)8.2%0.9%7.3%
A (Low risk)9.5%2.8%6.7%
B (Below average risk)10.5%4.6%5.9%
C (Average risk)11.8%5.1%6.7%

* The data above are purely illustrative. Funding Circle gross returns and bad debt are based on statistics supplied by Funding circle.  Adjusted returns refelect the simply substraction of gross return and default rate. Default data for Symfonie Lend are based on actual portfolio results.  SymLend adjusted returns are the simply subtraction of gross return and the actual bad debt.  Past performance is no guarantee of future success.  Investing in P2P loans involves risks that investors should consider carefully prior to investing. 

Lesson 4:  Getting Good Performance is Labor Intensive!

Investors can take comfort in the thought that if they select a sufficiently diversified portfolio (Funding Circle reccomends at least 100 loans) they will be about the average return for the overall risk category or for the platform as a whole.  In principle there is nothing wrong with adopting this strategy and Funding Circle provides a set of automated investment tools.

For the investor who wants to try for something better there is no substitute for hard work.  You have to review each loan, and do a bit of homework.   That takes time a modest amount of credit expertise and probably a greater amount of credit instinct.

A good alternative might be hire a professional advisor to manage your Funding Circle Portfolio or to invest in one or more the increasingly available P2P loan funds.

I won't pass judgment on the others funds.  But the fund I manage I most certainly can vouch for.
For a comprehensive view of Funding Circle's performance statistics click here.

For more information about the Symfonie Lending Fund, click here.

Special credit for this post goes to Evgeny Ishchenko, our Symfonie Capital P2P loan portfolio analyst.  Thanks, Evgeny,  for building our portfolio statistics engine.

Breakdown by Number of Loans
Risk Band FC All Loans SymLend Portfolio
A (Low risk) 28.6% 6.7%
A+ (Very low risk) 22.0% 3.1%
B (Below average risk) 23.0% 14.8%
C (Average risk) 17.6% 43.4%
D 7.6% 32.0%
E 1.1% 0.0%

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