Major P2P Founder Warns: “Our Industry May Never Be Profitable”

Cliff is an experienced journalist hired in as 4thWay's “Chief P2P Cynic” to give you the alternative view. Read about Cliff.

A couple of months ago, towards the end of March, I had a one-to-one meeting with a leading light of the peer-to-peer (P2P) lending industry. This well-known and globally respected individual co-founded one of the UK's largest P2P lending websites.

During our chat, which lasted less than 40 minutes, we discussed a wide range of issues affecting his business and the wider P2P lending market. However, as our talk progressed, my host began to wax lyrical, opening up in a more off-guard, stream-of-consciousness manner.

In fairly quick succession, this P2P VIP made these three surprising and stimulating statements:

1. “I'm not convinced that the P2P lending industry can ever be sustainably profitable.” What is being said here is that, as a whole and in the round, marketplace lending may never achieve the sustainable, lasting profits enjoyed by mainstream lenders (such as the UK's leading banks and building societies).

2. “Our current business model is not suited to ongoing profits. It may need to change.” I took this to mean that, despite growing revenues, rising costs (notably, the steep cost of marketing for growth) were impacting on the firm's ongoing profitability.

3. “The next six months will likely determine our platform's future.” What is being hinted at here, and within a half-year at most, is the possibility of adjustments to the existing business plan. What wasn't said was whether this would be evolution (small steps) or a revolution (a major transformation – or abandonment – of today's model).

What wasn't clear at the time was whether this P2P grandee – speaking offhand and with no self-editing – was suffering from a personal and philosophical crisis, or whether he was legitimately worried at an industry level. Either way, the message from this soliloquy was clear: it's entirely possible that P2P lending might never be profitable to a worthwhile degree.

What if these predictions prove correct?

For the record, these revelations are not quite as apocalyptic as they first appear. Zopa (the granddaddy of P2P lending and the world's first P2P lending website since its launch in March 2005) has never made a bean in more than 10 years. Thus, Zopa's strategy has repeatedly evolved over its 12-year life. This year, Zopa recently applied for a banking licence so that it can take deposits from individuals and just yesterday announced it will stop offering SafeGuard, its reserve fund to cover expected bad debts.

If this leading expert is later proved correct, it indicates that the P2P lending market we know today could well be in for a period of sustained upheaval in the years to come. Consequently, the business models of some – or perhaps even all – P2P lending websites might have to change, possibly even radically.

If marketplace lending does have to undergo enforced change, what might happen as a result?

P2P sites might merge or close

If profits do prove frustratingly tough to maintain, lessons from other struggling industries suggest that P2P lending is likely to enter a period of enforced and intensified competition. As competition for lenders and borrowers heats up, this could lead to several rounds of market consolidation, such as mega-mergers between big players, takeovers of weaker performers by stronger rivals, and closures among weak and underperforming providers.

Growing into other kinds of lending…

The major players may decide to throw their nets wider by branching out into new forms of lending away from unsecured personal loans and/or business lending and into new realms or niche markets.

For example, RateSetter has expanded into property-development and business loans over the past few years and has started recruiting regional managers in order to acquire more borrowers.

…Or reducing complexity

On the other hand, moving into new sectors or markets can be risky, as heavy upfront costs and ongoing investment can easily generate substantial losses for P2P sites in the early years. What's more, entering a market dominated by large and skilled operators can be a hiding to nothing.

Hence, some P2P lending sites might well decide to stick to their knitting by pushing on with their existing strategies, in the hopeful belief that future profitability will finally arrive. For instance, Funding Circle has just decided to move away from property-development lending in order to stick with its core market of business loans.

P2P sites might charge lenders more

In order to reach for profits, some P2P lending websites might be tempted to increase their “spreads” – the cut they take for themselves that creates a difference between (higher) borrower rates and (lower) lender rates. This would lead to ‘rate compression' for individual lenders, which conceivably could mean permanently lower returns. Similarly, it might mean higher rates being demanded of borrowers, making P2P loans less attractive in comparison with those on offer from traditional lenders.

Fewer opportunities for individual lenders

If ongoing returns to lenders do come under downward pressure, it will likely discourage some individual P2P lenders from risking their spare cash in return for reduced rates. Were this to happen, we might see even less individual lending and more lending from institutions (e.g. investment funds).

Taken together, these possible future events and outcomes would most probably lead to lower potential returns for lenders and other investors – including the likes of star fund manager Neil Woodford, whose growth fund has invested around £20 million into Ratesetter.

Four ways to protect your lending against potential disruptions

If the P2P lending market does endure an ‘existential crisis' in future, with players shifting about to try to find out what proves profitable, what can individual lenders do to offset or reduce these risks?

Of course, none of us can control what happens to the overall P2P lending market. Therefore, what is most important is that we focus clearly on our own primary risk control. It's our responsibility when lending our own money – and no-one else's – to ensure that our loans are sufficiently strong to survive unanticipated changes that will arise from time to time.

In short, how can we lessen the effects of potentially negative market movements? As with any investment portfolio, the key is careful risk management and control, underpinned largely by proper diversification. This diversification should include most, if not all, of the following safeguards:

1. Asset allocation, which means how your total wealth is divided up between different asset classes (different types of investment). Personally, I would argue that UK investors with established and diversified investments should assign perhaps 5% and certainly no more than 10% of their total wealth to P2P lending.

2. Platform diversification, which means spreading your P2P lending across multiple P2P lending websites – or “platforms”. By not keeping too many eggs in a single basket, you are less vulnerable to any P2P website going bust. To be clear, that doesn’t mean you lose all or even any of your money, and history so far shows otherwise, as we explained in The 13 Key Peer-To-Peer Lending Risks Risks. But a bust P2P lending site can, at the very least, mean lots of worry and delays in you getting your money back.

3. In addition, for P2P lenders genuinely worried about their exposure, it makes sense to seek out the operators that have either received a lot of money from start-up investors or are already profitable (as well as players that could be profitable were they to choose to stop investing for growth).

4. Lastly, for extra reassurance, UK investors might stick to lending through websites authorised by the UK’s own regulator, the Financial Conduct Authority. These are required to have clear and specific plans for an orderly wind-down in the event they go bust (including setting aside a minimum £50,000 to collect and chase existing loans until individual lenders have been repaid).