A MONEYWEEK SPECIAL REPORT: DAY 2

MoneyWeek
Unconventional
income masterclass
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Risk Warnings
Before investing you should consider carefully the risks involved, including those described below. If you have any doubt as to
suitability or taxation implications, seek independent financial advice.

General - Your capital is at risk when you invest. Never risk more than you can afford to lose. Bid/offer spreads, commissions, fees
and other charges can reduce returns from investments.

Deposits made using peer to peer lending are not covered by the Financial Service Compensation Scheme (FSCS). This means
that you will not be entitled to FSCS compensation should the borrower default.

Taxation - Profits from investing, including both capital gains and dividends, are subject to capital gains tax and income tax
respectively. Tax treatment depends on individual circumstances and may be subject to change in the future.

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Day Two: Three key strategies for

succeeding in the world of P2P
Welcome back!

Yesterday, we took our first in-depth look at the fast-growing world of

alternative finance, exploring the three main platforms (Zopa, RateSetter
and Funding Circle), all of which offer yield-starved investors the chance to
boost their income by lending either to small businesses (Funding Circle), or
to (largely) other consumers (Zopa and RateSetter).

It’s exciting stuff, and I’m sure you’ll agree that the income on offer is a lot more tempting
than anything you’ll find going down similar, more mainstream routes.

So what’s the best way to take advantage? Today our unconventional income expert
David C Stevenson explains his approach to the sector, and explains why you need to
think like an investor, rather than a saver.

By the end of this lesson, you should have a much better feel for how this sector fits into
your overall financial plan – and how you can make the most of the returns on offer.

Good investing,

John Stepek, Editor, MoneyWeek

How peer-to-peer fits into your financial plan

Hello again! I’d like to return to a point I made in the first part of our unconventional
income course. I said that if you’re going to put money to work in this fast-
growing space, you need to think like an investor – not a saver. Today, I’d like
to explain why that is, and show you how to do it.

When I say you should think like an investor, it’s because I’m aware that
much of the peer-to-peer (P2P) lending sector likes to use the language of
saving. That makes me very uncomfortable. In each and every case you are
lending to borrowers who aren’t covered by the government’s Financial
Services Compensation Scheme. So if the borrower defaults, you may lose all of your
money.

Although risk levels are incredibly low – with RateSetter and Zopa also offering
protection funds – the best attitude is to think like an investor and assume that the worst
will happen. Don’t put rainy-day ‘emergency’ cash to work on these platforms.

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That said, thinking like an investor doesn’t mean you have to be quite as fearless as
investors in equities (shares). P2P lending is closer in style to what bond investors call
‘credit’ – corporate and consumer debt. It’s riskier than government bonds, but arguably
less risky than equities.

That makes these products ideal for what I like to call my ‘middle pot of capital’. You
see, at one extreme I need risk-free cash for day-to-day stuff. At the other extreme, my
equity risk capital is tied up for decades, with the understanding that it will endure the
inevitable ups and downs of the market cycle.

P2P lending can be made to work in a middle pot of capital where I’m trying to make cash
work harder over the next one to five years – a time frame that is not ideal for equity
investing.

But thinking like an investor also requires you to think long and hard about the risk/
reward trade-off. Anything that yields above 10% in this economic climate needs to
be treated with some considerable caution, whereas anything yielding below 3% is
unattractive unless there’s a chance of a big capital uplift.

So how do we manage the risk/return trade-off on P2P platforms? I’d suggest using three
different, but interrelated, strategies.

Platform risk – don’t put all your eggs in one basket

The first is to look at platform risk, which in my book means proper diversification across
platforms and within platforms. That means you should put money to work on at least
two to three platforms, and within each platform make sure you are diversified at the
borrower level.

My own A-list of platforms would include Zopa and RateSetter for consumer loans,
Funding Circle, ThinCats, and Assetz for business loans, Wellesley & Co and LendInvest
for property, and lastly MarketInvoice and Platform Black for lending to businesses
based on their invoices (a specialist niche aimed largely at bigger institutional investors,
although as we’ll discuss later in the series, it is starting to open up to smaller investors).

My key concern with any of these is to pick platforms with lots of ‘volume’, ie, lots of
lenders and investors investing sizeable amounts of money. You can see this volume data
issued on a monthly basis at www.altfi.com (of which I am co-founder), as well as on the
individual platforms’ own websites.

Personally, I’d look for a platform to be generating at least £1m, if not £5m in flows a
month (although frankly I’d be happier at the £10m level). Smaller platforms can offer
great value for the adventurous, but you need a proper due-diligence checklist (I’ll talk
about the sorts of things you should look out for when considering lending to a small
company in a later report in this series, on ‘mini-bonds’).

But for now I’d look at the charges, investigate whether there’s a secondary market
being offered (this means you can get out of a loan earlier than the term date), as well as
working out what’s the minimum size for lending to an individual or business.

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I’d also hope that the platform gives you lots and lots of data and I’d be keen to see an
automatic reinvestment option, ie, when your money matures, you are automatically
reinvested back into another loan on the platform.

Interest rate risk – what happens if and when rates rise?

The next key strategy is to diversify your interest-rate risk. In other words, you need
some protection if interest rates do start to rise. I think it’s highly likely that interest rates
could start to pick up in the next year or so.

A rate rise is traditionally bad news for any fixed-income security, such as a government
bond. The impact on P2P loans might vary enormously – depending on the borrower,
whether the rate is fixed and a range of other factors – but I’d be keen to set in place a
couple of key targets.

Personally, I’d be looking for around 40% of my total pot of money to be invested in
shorter-duration products. So that would include RateSetter’s monthly and yearly
products, bridging loans offered by the likes of LendInvest, and invoice-based products
offered by Platform Black and MarketInvoice, where the average duration of a loan
(backed by an invoice) is between 60 and 90 days.

I would also look to have no more than 50% of your investments in five-year fixed loans –
these are very vulnerable if interest rates suddenly start rising.

Default risk - what if the borrower doesn’t pay up?

My last strategy is to make sure I am diversified in case of borrower risk – ie, default risk
through a business cycle. This is closely related to the interest-rate cycle and the key idea
here is to make sure that you are not solely lending to riskier small businesses.

We know from past experience that in a recession (which is usually preceded by interest-
rate hikes) the number of consumer-credit defaults can increase three-to-fivefold,
whereas businesses that default can increase by between five and seven times in
numbers. So, whatever levels of default you see now – as low as they are – could go up
drastically in a bad recession.

Another risk is arrears – these could start building up even though defaults are low.
Carefully scrutinise the statistics on this and look for trends that suggest risk levels are
increasing.

In practical terms, I’d be focused on balancing the risk levels between consumer loans
(likely to have lower default levels, but also paying out lower interest rates) and business
loans – with, say, 50% of my capital in each broad segment. By my own rough-and-ready
yardsticks, a diversified private investor running the three strategies above should expect
a blended net yield (after any costs or defaults) of between 4.5% and 6.5% per annum by
following the ideas above.

You could use a fund manager to help you run these strategies instead. For example,
there’s a London-listed closed-end fund called P2P Global Investments (LSE: P2P). You’re
charged a 1% annual management fee and a performance fee for a fund that manages
the process of putting money to work on the key UK and US platforms (Zopa, RateSetter,
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Funding Circle and, in the US, Lending Club).

The managers will run all the strategies I’ve detailed above and their aim is to pay out
85% of the total loan income received to investors on a quarterly basis. They can also
invest in specialist markets that aren’t open to private investors, but where yields are
higher. So this fund could be an interesting, lower maintenance alternative, even though
you’re paying a manager to run your investments.

Next time we’ll be looking more specifically at how to generate income from property
(something which we all know from experience is very close to British investors’ hearts) –
without actually having to go through the hassle of becoming a landlord yourself.

Until tomorrow,

David C Stevenson