Marketplaces help define the startup zeitgeist. We’ve been pitched everything from sharing sports kit and washing clothes, to betting on football and buying art. Somewhere out there is a new business that wants to be the intermediary, the disruptive force, that profits from directly connecting consumers.
Peer-to-peer (P2P) lending is a stalwart of the class. Billions of pounds has now been lent through the 15-year-old market, which reduces costs by cutting out traditional lenders and takes a fee for creating new loans.
Half a dozen P2P platforms dominate the UK market. Even for these veterans, it's extremely tough to get the volume of loans needed to create a sustainable, profitable business. What will happen to the startups in the sector?
Bain Capital Ventures’ Matt Harris, who was chairman of P2P provider OnDeck during the market’s genesis, calls the top tier of the now-listed companies who entered the market early “Alt Lending 1.0” (thing Lending Club, SoFi and OnDeck et al.).
“I am most worried about the wave of ‘me, too’ players that came next, Alt Lending 2.0,” said Harris in an early 2016 take on the sector. “Most of them built their business plans on the now shifting sands of temporarily high valuations and cheap capital, and have insufficient differentiation to carve out a durable niche.”
We’ve now moved onto a third group that Harris says are benefiting from the lessons learnt in this nascent industry.
The rise of the new class: Alt Lending 3.0
Data shared with BusinessZone by the Financial Conduct Authority (FCA) shows that the number of peer-to-peer licences fell by 38% from 91 to 56 during 2016 (industry insiders estimate there’s only 30 currently operational).
“You have to get to a significant volume of loans to cover costs,” says Tim Slesinger, CEO of P2P investment aggregator LendingWell. “In the interim, you can be quite lean, but there are more and more regulations and pressures, which is good, but with that comes a cost.
“A lean startup in peer-to-peer looks a bit different now than five years ago. You have to get up to a couple of million quid a year to be able to start covering costs, if you work that backwards at 1 or 5% [arrangement fees] it’s a significant volume.”
Getting to that volume has bred a reliance on institutional money, essentially cutting the ‘peer’ out of peer-to-peer and allowing large funds to get in on the act.
The founder of a platform who left after the withdrawal of funding by its financial partner brought it into distress told BusinessZone startups in the sector would have to have an “incredibly strong niche” to survive without an institutional backer.
“The industry is built on volume. In order to get the volume you need to have access to a huge bank of retail investors, or institutional investors, or a mixture - and mixing the two is a tricky art.
“Another driver is the margin you have built into your business model. The P2P industry generally operates on very slim margins, which drives you to look for significant volumes. So, you can either shave costs to virtually nothing, and that means very little credit sifting, or else you need institutional money that allows you to write larger transactions.”
ArchOver is trying to carve out its niche by building insurance and marketing into its offering. It’s been trading for two years and expects to reach profitability this quarter, according to its founder Angus Dent.
“We realised we couldn't get it to the stage where it was truly customer ready without a larger partner. Hampden has put more money in to allow us to grow faster,” Dent adds.
Hampden manages insurance assets and has an underwriting capacity in excess of £4bn. Of ArchOver’s £18m outstanding loan book, £4m has been funded by them. This means the startup has access to growth capital and can boost its deal flow.
Hurdles for the class of Alt Finance 3.0
Outside of attaining volume and navigating the resultant need for institutional investment, businesses trying to enter the sector face a series of challenges:
1) Cost of customer acquisition
Key players in the P2P market have received significant capital investment, and feed the top of their funnel with TV ads and tube campaigns while often making a loss on the deals they do. They have the highest level of visibility and have made it expensive to compete.
2) The burden of regulation
Dealing with the FCA was likened by one industry luminary as being invited into a swimming pool by a group of sharks.
P2P lenders have to comply with similar standards as high-street banks. However, startups without a significant infrastructure may find it easier to make tweaks to their products.
3) An increase in the interest rate
Since the financial crisis, the UK has had historically low-interest rates, creating low returns for savers and bolstering the argument for investing on peer-to-peer platforms. Will P2P platforms have a compelling offering when they return to normal levels?
4) A downturn will test loan portfolios
There’s also the question of defaults. The majority of the P2P platforms haven’t weathered a complete credit cycle and it isn’t clear what the impact will be.
What’s in store for P2P startups?
The loan books of small P2P lenders should survive the test of a worsening economy (based on modelling by industry experts). The primary threats are the appetite of institutional investors - funding can dry up at short notice - and competition from larger peers, which can be addressed.
Bain Capital’s Harris sums it up well: “Companies seeking funding in the lending space today generally have less of the Gold Rush mentality of the Alt Lending 2.0 players, who sought to take advantage of an enthusiastic investing community. Instead, they are motivated by legitimately unmet needs and the prospect of meaningful moats. For the first time in a decade, I’m feeling like it’s a great time to be starting a lending company.”
Let’s hope he’s right. Even 15 years after the first platform launched, the P2P market is still working hard to find a sustainable business model.
Read our deep-dive article on the future success of the peer-to-peer lending market and the impact of the Innovative Finance ISA here.