There’s been much collective gnashing of teeth over the last few months at the evolution of peer to peer lending, as practised by Zopa, Ratesetter and most latterly Funding Circle. The big bone of contention has been a shift amongst all three – with FC falling into line just a matter of days ago – to a pooled lending model. This means that lenders on said platforms now lend passively to a full slice of borrowers rather than pick their borrowers individually. To the critics this implies that the traditional peer to peer (P2P) model is slowly dying out. If you’re not lending to your peers, don’t you just sound like any other finance business such as a bank?
I’m not convinced by this criticism. Collectively a crowd – many peers – are still lending to another crowd, but just in a format that looks closer to a pooled, collective fund basis rather than one on one. There is no bank balance sheet lurking around and the ‘crowd’ still sets the rate at which its happy to lend. Credit scoring has always been a feature of all the platforms, whether they be ‘pure’ P2P or pooled P2P. Someone, somewhere at the centre of the online marketplace needs to set the lending criteria and make decisions about who to lend to.
Crucially this move to a pooled lending model puts individual retail investors on the same basis as most institutional investors – they can’t cherry pick the best clients, and must be willing to take what the platform gives in terms of risk allocation.
Crucially I’d argue that this is the right decision. The cynic might suggest that these changes are in fact an attempt a pre-empt any increase in defaults i.e steering lenders away from the riskiest borrowers with the highest yields. I’d argue more optimistically that this pooled approach is just plain old fashioned common sense – and backed up by behavioural economics. A good analogy is the world of individual stock picking versus managed, pooled equity funds (collective investments).
Enthusiastic equity investor’s love to boast about their stock picking prowess – a sin which I am certainly guilty of. We all love to boast about our successes and hide our failures. But academic evidence suggests that most investors, make bad investment decisions, most of the time. Stockpicking, even by professionals, is largely (though not always) an exercise in futility. If an investor is willing to be systematic about their picks using tested fundamental variables, they could perhaps reap an extra reward but we all know that most investing is driven by emotion and newsflow i.e our greed leads us to bet on the biggest potential upside bets and the newsflow steers us towards us towards the latest shiny marketing offers. Many years of experience has taught me that picking stocks is largely a mugs game and that most of us are better of using collective, pooled funds to do our investing. Even more importantly I have also realised that even active fund managers face an uphill struggle to out perform the wider benchmark index – which thus makes passive, benchmark hugging investments a good core option. Sure, by all means do some stockpicking at the fringes, but don’t be fooled into stock picking is a core portfolio strategy for long term wealth preservation and capital gains. Fun, yes, foolish, quite possibly.
I think this argument is even stronger when it comes the credit based investments offered by P2P platforms, where arguably our ability to make an informed judgement about a single loan is incredibly limited. Our natural temptation is to buy into those borrowers with the highest yields. I’m sure, as with equities, there are some very talented individuals out there, who can perform the necessary due diligence on risk and return looking at said borrowers and thus boost risk adjusted returns – but I think they are a distinct and very small minority, and best of luck to them! Most investor’s by contrast really only want a core, passive return from an asset class with as little fuss as possible. Remember that the crowd though exciting, does not always have to be active! The crowd will happily let an expert decide for them – right or wrong, smart or dumb.
Thus, the switch to a pooled approach is a simple recognition of investor reality, born from experience as the platforms mature. It’s also, very simply, the most sensible thing to do for the investor and the platform. Crucially I think we might see more experienced investors peel off from these big platforms and migrate to more niche platforms which might continue to allow investors to pick their own loans – most of the mainstream will be happy to stick with either pooled investing or using secondary financial instruments such as retail bonds (Lendinvest) and investment trusts (Funding Circle’s SME Loan income fund) which also pool risks and returns.
But this change also highlights another possible twist. Why shouldn’t this model be applied to equity crowdfunding? I’ve long wondered whether any of us are frankly capable of making an informed decision about any business looking for equity via the crowd. The big platforms have massively improved their due diligence process (though there will always be critics) but I’m not too sure if any level of advanced fact finding and analysis would help us filter the duds from the tenbaggers. I’ve many years of experience of investing (badly) in micro caps and I can say with absolute confidence that I believe small cap stock picking strikes me as a form of intellectually reasoned gambling.
If that’s true for stockmarket listed small caps (with all their accompanying data and reporting) ,I’m doubly certain its true for unlisted private businesses listed on crowd funding platforms. I would take this argument and suggest that thus it makes much more sense to adopt a passive approach – buy all the businesses that make it on to a crowd funding platform after the aforementioned due diligence process. If an individual investor wants to load up on extra individual exposure to Acme Ltd, great – let them top up. But for the core portfolio, just invest in everything that is deemed worthy enough to put in front of the crowd. Syndicate Room – and Crowdcube in the past – have tacitly accepted this logic by launching their own funds, which cherry pick the best campaigns. Why not go one further and just say anything that passes the platforms diligence process, gets invested in by all investors? Either your due diligence process is really first rate and screens out all the duds – in which case everyone should be happy – or that due diligence process isn’t what’s cracked up to be and you have businesses on your platform that your core investment fund wouldn’t touch with a long bargepole? In sum, let’s make equity crowdfunding into a passive funding tool for all high quality SMEs in the UK.