Innovative Finance Isas: don’t let rewards blind you to the risks

The eye-catching potential of Isas focused on peer-to-peer lending often obscures the risks that accompany them.

On first assessment, peer-to-peer Isas – known officially as innovative finance Isas – appear to fill a hole in the Isa market. They are hybrids that operate between the relatively high-risk/high-return sphere of the stockmarket and the lacklustre but safe zone of cash. They offer a handy route to a reliable and diversified income stream. At the same time, investors can enjoy the feeling of disintermediating those nasty banks.

The sector is maturing. During the final quarter of 2018, more than £800 million of new lending went through peer-to-peer platforms that are members of the Peer to Peer Finance Association (P2PFA) – the total figure including non-members will be higher. Some £527 million of this lending went to businesses and £282 million went to consumers. Cumulatively, the sector has now lent close to £10 billion.

Reasons to be careful

However, the maturation of the sector has brought changes: the peer-to-peer sector is broadening. While increasing choice may be welcome, it brings new risks and makes deciding where to invest more difficult. James Newbery, investment manager at British Pearl, says: “Peer to peer is seen as a single product type. The reality is different. Large swathes of consumers are being led by the headline interest rates, but that is only one side of the equation.”

The City regulator is worried. In a recent consultation paper on the sector, the Financial Conduct Authority (FCA) raised concerns that investors may not be getting the information they need to understand the risks in the peer-to-peer sector. At the same time, they may not be being adequately compensated for the risks they are taking. What’s more, fees are not always transparent. It all sounds as though the FCA is gearing up to introduce tougher regulation.

The problem is that the peer-to-peer market encompasses a broad range of investment options. The oldest and most established peer-to-peer lenders are firms such as Zopa, Funding Circle and Ratesetter, which each have around a decade of experience in the sector. Zopa provides a platform for lending from individual to individual, true peer to peer. Consumer loans are generally fairly safe. Individuals feel honour-bound to repay their loans in most cases, although prudent underwriting should be undertaken. Lending to small businesses is riskier. However, most peer-to-peer lenders are buying a basket of loans rather than loans to a single company, so they are diversified.

Some platforms don’t pick loans on behalf of investors but instead create a menu for investors, who select the loans that interest them. Andrew Lawson, chief product officer at Zopa, says: “Some platforms will automatically diversify across different borrowers. However, some allow investors to pick specific loans. This appeals to investors interested in a specific company: a local business, for example, or one on which an investor has some specific information. But the risks are different. In such cases, the investor is doing the research on the credit risk and loan pricing. It requires a bit more sophistication.”

Take care too when entering the somewhat murkier world of property peer-to-peer lending, where important distinctions between peer-to-peer providers need to be understood. In particular, investors must be alert to the difference between peer-to-peer lending on existing buildings with tenants and on more speculative ‘development finance’ peer-to-peer lending.

Hidden risk

The new Easymoney Isa is an example of the latter. It spreads investors’ money across builders and developers looking for finance for up to two years. The investor’s loan is backed by property the borrower owns. However, that ‘property’ won’t necessarily be worth very much if it is a development that hasn’t yet come to fruition.

Moreover, the risks are not necessarily discernible from the interest rates on offer, as the FCA has pointed out. Some products paying 4-5% income seem to be high-risk, but certain products paying comparable income look relatively low-risk. With other asset classes, high potential returns tend to be linked to high-risk, but this doesn’t appear to be the case in peer-to-peer lending. The onus is on the individual to take responsibility.

This makes the FCA uncomfortable. Peer-to-peer platforms have had to be authorised since 2014. However, the FCA’s recent consultation paper proposed some additional rules for peer-to-peer lenders. Among the more notable changes under consideration are measures to prevent retail investors who aren’t considered ‘sophisticated’ from investing in the sector.

Robert Pettigrew, director of the P2PFA, says its members are keen to raise minimum standards in the sector, particularly in terms of platform disclosures on performance: He says: “Platforms should be open about the risk characteristics of a loan and their fee structure, so that the exposure an investor faces is reflected in the returns they should expect to receive. Platforms should be judged against their own performance. The P2PFA requires its members to publish their expected (at outset), projected (throughout the life of the loan), and actual returns and non-performing loans, so that potential investors can measure a platform’s performance in terms of not only what it achieves but also how it measures against expectations.”

Principled position

Pettigrew’s view is that a principle-based approach is best, one that “ensures investors, particularly retail investors, are adequately protected, informed and aware of the consequences of their investment decisions – not least because of the innovative, fast-paced development in the various markets served by platforms.” Peer-to-peer lenders that are part of the P2PFA (not all are) have committed to a certain standard of governance.

Lawson points out that many peer-to-peer lenders have advocacy scores (from the likes of Trustpilot) higher than the high street banks, and that the peer-to-peer sector should play an important role in the UK economy. The banking sector is no more enthusiastic to lend to small firms than it was in the wake of the financial crisis and alternative sources of finance are needed. Moreover, peer-to-peer lenders can distribute money faster than banks can, which is important for growing firms.

Pettigrew says: “Peer-to-peer lending has introduced competition and innovation into lending markets. Platforms have stimulated change among traditional providers. Some improvements in customer experience across financial services can be attributed to innovation spurred by peer-to-peer lending.”

However, investors need to be comfortable with the risks entailed with peer-to-peer lending. Some products are marketed as ‘near cash’ and an alternative to a savings account. This is misleading. In addition, protection from the Financial Services Compensation Scheme does not apply. All peer-to-peer lending comes with the risk of default, but this risk is far higher with some peer-to-peer investments than others. Investors should look for firms that are transparent about the potential for default. The longer-standing companies generally have a handle on their default rates to date. Lawson says: “We can give investors expected default rates with some degree of confidence and set reasonable expectations for losses.”

Note also that many of these products have not been tested in a tough economic climate. Always check whether a peer-to-peer lender has a slush fund to cushion customer losses at difficult times.

Lawson suggests investors ask themselves a number of questions when selecting a peer-to-peer investment. Do I want my money to work hard for me or do I want to work hard for my money? Is it clear what loans I am going to be buying? Does the platform concentrate on a particular asset class – consumer or business lending – and do its job well? What is the platform’s track record? What is its expertise in delivering returns? What is its track record across different cycles?

Newbery suggests a similar range of questions. What is the probability of a borrower defaulting? If a borrower defaults, how safe is my loan principal? How much of the capital will remain after any default? Can I recover capital from another source, by selling some security that the borrower used as collateral, for example, or through a reserve fund offered by the investment platform?

There is much to like about peer-to-peer lending: it can provide a diversified and stable source of income that is uncorrelated with bonds or stocks . But the sector is getting messier. Investors who neglect due diligence may get burnt before the regulator steps in.

Peer-to-peer investment trust options

Another option for investors interested in peer-to-peer lending is specialised investment trusts. High-profile fund manager Neil Woodford may have just exited his holdings in the sector, but this appears to have been more to do with meeting redemptions than the sector itself.

There are three main trusts in the sector. P2P Global Investments (P2P) is valued at £700 million while Pollen Street Capital-managed Honeycomb Investment Trust (HONY) has grown in value to £400 million on the back of solid returns since its launch in 2015. It is up 38.4% over the past three years. But it now trades at an 8% premium to net asset value. P2P sits on a 10% discount but has returned just 10.3% over the same period.

The Funding Circle SME Income Fund (FCIF) was first to launch; but in the wake of disappointing performance, the board announced in April that the trust would wind up and return capital to shareholders.

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