Alternative Investments can provide lucrative returns that are unavailable by investing in the stock or bond market. In earlier posts, we discussed alternative investments in farmland, rooftop solar system, private equity, collectibles, real estate, and gold. In this article we discuss investing in another form of alternative investment – Peer-to-Peer Lending, or P2P Lending or Crowd Lending as it is more commonly known. P2P Lending has gained plenty of momentum in the recent years as the hunt for alternative sources of investment and higher returns are pursued by investors, especially in this low interest rate environment.
Alternative Investments – Peer-to-Peer Lending
Peer-to-Peer Lending is the practice of lending money to unrelated individuals, or “peers”, without going through a traditional financial intermediary such as a bank or other traditional financial institution. The lending takes place online on peer-to-peer lending companies’ websites using various different lending platforms and credit checking tools. It is important to realize that these are unsecured personal loans – either to an individual or a small business.
The exact details may vary between platform to platform, but at a high level, the workings have three parties involved: borrower, lender, and the intermediary platform connecting the borrowers with lenders. The borrowers are willing to pay a high interest rate on the borrowed money which is passed onto the lenders, while the intermediary platform takes a cut for the service provided.
Each country has its own laws on whether P2P Lending is allowed and/or regulated. This wiki page lists some details for a few countries. One of the most popular platforms available to US citizens is Lending Club. Until very recently, Canada did not allow P2P lending unless the lender was an accredited investor but some new startups have started opening shop that individuals can participate in – such as Group Lend, and Lending Loop.
Investors can expect high returns between 5% and 15%.
While the investment returns seem lucrative at 5-15%, the investment comes with immense amounts of risks. Let me count the ways.
- You are lending money to an individual simply based on minimal amount of data – chances of default are very high!
- Same goes for small businesses. Some websites simply present data posted by the marketing department which presents you with a very filtered view of the data.
- If you are lending this to a small business – one has to ask the question why this business has had resort to this marketplace. Clearly the business has failed in raising money from traditional financial institutions such as banks or Business Development Companies (BDCs), who have more data on the business than you, as a private lender, do. Do you – as an individual investor have better evaluation of risk on these private closed-book businesses than banks or BDCs?
Im sure there are circumstances where such an investment would pay off, but the amount of risk is extremely high and potential investors should be willing to write off that investment if need be.
The big winner in this arrangement , of course, is the P2P Lending platform. The platform does not provide the funds risking capital and simply provides the service connecting lenders to borrowers and taking a cut.
So, am I saying that there is no way to get those kinds of returns? No. You can still invest in small businesses and get great returns in the range of 7-12%. And we simply turn back to our old friend – the stock market. Simply invest in the Business Development Companies. That’s what I did by investing in Main Street Capital (MAIN). BDCs are companies that have better view of the small businesses that are looking to raise cash and are better at evaluating the risk-reward profile than you, as an individual investor do. Couple of other huge advantages you can get by going this route – capital appreciation in addition to the dividends; and liquidity that you get from the stock market – you can simply liquidate your shares to get access to your cash if you change your mind about this investment. I shared some more of my thoughts on Private Equity and BDCs in this post here.
What are your thoughts on using P2P Lending platforms? Do you use it? Share your experience below.
Full Disclosure: Long MAIN. My full list of holdings is available here.