When I began working in the family office and hedge fund worlds in 1992, private investors were looking, foremost, for return enhancement and, secondarily, for diversification. Fast forward 25 years, investors are still looking for return enhancement, but less on the equity side, and rather more for current income. In the early 1990’s, hedge funds were a secretive, largely unregulated landscape with virtually no disclosure and very little educational information available for those looking to allocate capital to the space. As a result, investors often did not know how to differentiate fund managers and tell the difference between an A- player and a C- player. There was a profound lack of thought leadership, and those charged with advising new entrants in the market had to do a great deal of educational missionary work and lay out a thoughtful path of insights.
In today’s marketplace lending sector, it is a similar story. There is a proliferation of funds in the space, and assets are flowing in to funds to the tune of hundreds of millions of dollars per quarter. There are ample industry-focused conferences and e-publications, but there remains precious little in the way of independent research and insight for private investors, institutions and the consultants who serve both groups. Product differentiation is difficult, and there is still not a robust set of data analytic tools or benchmarking indices.
In terms of the landscape, on one side of the field, we have a universe of loan originator platforms. Best known names like Lending Club, Prosper and SoFi have dominated the press, but there are, in my estimation, well over 100 unique specialty finance loan origination platforms, and within that group, loans are being originated in an ever-increasingly diverse set of sectors, such as:
- Unsecured consumer credit for debt consolidation and emergency expenditures
- Real estate lending (often secured by real property)
- Small business credit
- Merchant Cash Advance
- Equipment Financing
- Retail installment contracts (RIC’s)
- Solar equipment financing
- Education financing
- Automotive repair financing
Each of these segments has unique drivers impacting customer acquisition costs, underwriting procedures, and borrower behavior. Consequently, many of the segments offer differing yields, default rates and durations.
On the other side of the marketplace lending landscape, once the loans are originated, there are many different asset management structures through which capital inflows are being allocated, including:
- Managed Accounts for institutional investors
- Hedge Fund Vehicles (i.e. private partnerships: funded all at once with shorter lock-ups)
- Private Equity Vehicles (i.e. private partnerships with investment drawdown periods and long-term lock-ups)
- Fund of Funds investing across a spectrum of originator strategies
- UK-listed Funds (i.e. closed end funds, most of which trade at meaningful discounts to their NAV)
- Luxembourg SICAV’s
- 40 Act Funds (interval funds which mostly have staggeringly high fee burdens)
- Notes and Variable Life Insurance wrappers for tax efficiency
With gross current yields ranging from high single digits to the upper 20’s (and in some cases, even higher), it’s easy to see the appeal for family offices, under-funded pensions and insurance companies. Even with potentially high default rates, these loans can provide a very strong current income stream, and with average loan durations typically under 2.5 years, there is very little comparable in the traditional investment market, making this space the holy grail for today’s investors.
Over the past year, I’ve had the opportunity to engage in diligence discussions and meetings with approximately 40 origination platforms which have originated over $18 billion of new debt in 2016 and 50 investment vehicles, managing in aggregate over $10 billion of capital. I’ve seen a great deal of opportunity, but I’ve also found numerous reasons for investors to have great concern and proceed with great care.
Once prepared to allocate capital to the space, an investor in this space must first establish one’s point of view on:
- Segment (-s)
- Duration of assets
- Rate thresholds
- True Lender requirements
- Appropriate entity structure
- Tax implications of entity structure
- Allocation size (multi-manager or single focus)
Establishing these sorts of goals and parameters is the fundamental bedrock of beginning an investment allocation process.
As ever in the alternative investment landscape, manager due diligence is paramount, and this new field is populated with portfolio managers who are more likely to have worked at Capital One on a credit desk than on the trading floor of Goldman, Sachs. The lack of a traditional investment pedigree and track record in this field makes it more difficult for one to assess a manager’s relevant skills and experience. Likewise, the use of leverage in this field is not confined to swaps and broker/dealer leverage, but is more analogous to the leverage debt fund markets (i.e. CDO’s, CLO’s, etc.). Moreover, these factors, when combined, (less portfolio management expertise and unique leveraged assets) highlights a risky dynamic. It’s also true to state that many funds in the space have added little value or even created their own problems through portfolio management errors and mistakes on deploying leverage. To wit, many of the niche segments in the marketplace lending landscape are somewhat new to direct lending, and as such, historic performance of borrowers’ behaviors is less understood. The result is that financial modeling and risk management at many funds has been reliant on incomplete data.
I want to shine a light on something we should all be terribly concerned about. Valuation practices in this space have lacked consistent methodologies. Managers frequently accrue for loan losses using differing standards. The result is that performance can be overstated or that returns appear to be smoother than they would be using different methodologies. For instance, I offer the following excerpt from the performance report of a very large fund in the space.
When I first saw these returns, I instinctively thought of Madoff. The narrow band of returns is, in my experience, highly unusual and inconsistent with the returns of investments being marked-to-market. To be clear, I am not saying that this fund is a fraud. I am stating that the performance they’ve reported is, in my experience, unlikely indicative of a valuation methodology that accurately reflects the month-to-month performance of the underlying assets. What this could mean is that investors could be disadvantaged when they come in or leave the fund.
As stated earlier, there is a wide spectrum of investment vehicle structures with varied liquidity terms. What is abundantly clear is that the majority of funds appear to offer liquidity terms which could be inconsistent with the underlying duration of the investments in their portfolios. By example, an alarming number of funds offered annual liquidity (some with gates, others not) where the underlying assets were 36 and 60 month stated duration. When a manager tells you that current income and all the new investor in-flows of capital should be sufficient to meet any redemption requests, one should take pause. It’s critical to keep in mind that the instruments in these funds are not liquid. There is no formalized primary securities market or secondary trading platform with any establish volume.
Given the current rate environment and lack of performance in mainstream alternatives, there is no doubt that the landscape of direct lending is entering an explosive growth phase. However, there are many factors that could derail its progress:
- Increased bank regulation
- Shocks to the consumer credit cycle and rate environment
- Fund blow ups due to:
- sloppy valuation
- poor liquidity management
- unexperienced portfolio management
- ineffective use of leverage
Expect a rapidly changing environment. The coming years will surely see billions of dollars of investor capital flow into this asset class, and there will be a wave of new products, intermediaries and experts. My experience evaluating a broad array of originator platforms and investment vehicles has only highlighted the increasing complexity and systematic risks. In spite of a cautionary message to move carefully into these waters, the sector offers some very appealing uncorrelated returns and current income for those who execute superior due diligence.