Why I Don’t Recommend P2P And Crowdfunding

Crowdfunding/P2P is a relatively new asset class and has increased in popularity over the last five years. To my knowledge the biggest market, UK, at one point had 15% of the lending market served by crowdfunding. But before you dip your toe in the crowdfunding water you should carefully evaluate if this is for you. My advice: be very, very careful. The risk is a lot bigger than you realize.

It is very tempting to make 10% (and more) on your capital, but let me assure you 10% does not come without risk: I would say it comes with substantially more risk than you realize. The pitfalls are many, and for most people I would say the “old and boring” stock market (and real estate market) is a much safer bet. In this article I bring forward some arguments against crowdfunding after having invested in eight different pan-European platforms, although I will not get into any specifics about each platform. My “wisdom” comes from common sense and many years of handling risk in the stock market.

If anything is wrong please let me know by commenting.

First off, read the contract

Before you do anything, you MUST read the contract to understand how the platform operates. Do you understand the business? How does the platform make money? Will the platform make money in an economic recession? When a loan defaults, who gets paid first, you or the platform? This is just examples, but important issues.

Platform risk

The biggest risk is platform risk. What happens if the platform goes belly up? Well, I can assure you it will take a long time until you get your money back, and you will get back much less capital than face value of the loans. Platforms are required to have a backup of all their data, and in theory another provider can just take over the business and continue managing the loans on your behalf. However, there will be a long liquidation process and no one works for free. Lawyers are not cheap, and the administration cost will be substantial. Any winding down of a platform will most likely take years and in the meantime lawyers have a feast on your capital.

On some platforms you have additional risk toward the loan originator. How is this possible? One of the biggest European platforms is basically just a “broker” and provide investments into loan originators from all over world. That means you have platform risks from both. If the loan originator goes belly up, you will face losses as if the platform itself went bankrupt. It happened in the spring of 2018 when a Polish loan originator went bankrupt. To my knowledge the investors are still awaiting what is left over from the bankruptcy.

Platform risk is for real. As an example I can inform you that the auditors of one of the platforms in Eastern/Northern Europe is questioning the business as a going concern due to negative equity. Their European expansion has not ended well.

Liquidity risk

Crowdfunding means investing in assets which is very hard to dispose. If you for example invest in a consumer loan with five years payback time, you have to wait for the loan to mature or to sell on the secondary market. Several platforms have secondary markets, but I would not count on that to be very liquid unless you sell at a discount (loss).

Return Risk

Somehow my return does not correspond to the return advertised by the platforms. In some of the platforms my return was substantially lower than claimed as average for the platform, even though I diversified to hundreds of loans. In other words, there is reason to believe expected return is exaggerated, or even very misleading.

Recession risk

Crowdfunding is a new business and has until now never experienced a serious economic recession. To my knowledge only one platform (UK) was operating before and during 2008/09. If we hit a crisis you will suffer losses on loans (defaults) and I suspect several platforms will go belly-up.

Brexit is thus far the closest we have come to a recession, and it is not pretty. After Brexit several UK platforms experienced a lot more defaults, and one of the biggest currently has about 60% of its security backed assets in defaults (my own calculations). Real estate prices have suffered and so has lenders,  and real return is a lot less than the nominal rates, even negative.

Security risk (LTV risk)

In asset backed lending you put your trust in the valuer. Real estate is a very fragmented market where each property is unique and valuation is sometimes very difficult to estimate, especially when the loan is aimed at developing a property. Even worse, without a strong surveyor with a mandate from the platform, there is no guarantee that the funds will be spent according to the plan. In addition, there is huge risk in lack of proper due diligence by the platform as the interests of the platform and the investor/lender are not aligned.

A loan to asset value of for example 70%, may in reality be 80%. As an example I give you one from the UK: I participated in one loan where 1.2 million GBP was lent and the security was valued at about 1.8 million. The borrower defaulted, and the security was sold at auction for 900 000, just half of the value given by a certified 3rd party property valuer. It gets worse, just 500 000 was paid back to lenders as 400 000 was paid out in fees to handle the sale.

Power of attorney and subsequently litigation risk

Most people do not consider that they hand over their money to the agent (platform) with basically a carte blanche to operate on your behalf. If your agent (crowdfunding/platform operator) is a fraud and doing a lousy job, the borrower can go after you (however, the law is different from country to country). This has happened in the UK where a borrower is threatening to sue all 4000 borrowers in a £8 million loan where the agent called in the loan prematurely. The UK High Court has already ruled that the claimant is right to go after the lenders because the platform is just an agent working on behalf of the lenders. This means lenders might be at risk to be “jointly and severally liable” for the claimed losses. In this particular case the agent called in the loan just a few days too early according to the contract (they should have sought legal advice on the exact day to call in the loan), and created the claimants legitimate grievances even though the borrower clearly defaulted on many points. This is a mistake by the platform/agent, but you have unfortunately given them carte blanche for the loan particulars. If the lenders lose the Court case, only then can they seek recovering losses against the platform/agent. And everybody knows this is futile as they will take necessary steps to take out capital.

In asset back security lending conflicts happen all the time. Litigation is the name of the game in certain countries. Real estate is a professional market where you as a lender have limited knowledge of the borrower. I believe you should be very cautious before lending any money.

Difficult to compound

Albert Einstein once said compounding is the eight wonder of the world. He is of course right. Unfortunately, it’s very difficult to compound in crowdfunding. Let me give you an example: assume you have 25 000 EUR to invest. If you let it compound at 10% for 20 years, it’s worth 168 000 EUR. It’s completely unlikely you can do this on a crowdfunding platform. Why? Firstly, most platforms are not able to reinvest such large sums of money. Secondly, you have to pay taxes annually:

Taxes

Most likely you will have to pay taxes on the annual interest income. Taxes have a huge impact on your ability to compound. If interest income is 10% you might just end up with 7.5% yield after taxes. The less you can reinvest, the less you can compound. For most people 2.5% difference does not sound much, but over 20 years a 10 000 investment is worth 67 000 with 10% and just 42 000 with 7.5%. And of course, after defaults you will make less than 10%.

Many countries do not allow defaults/losses to be offset against interest income, Norway for example (only corporations can). If your interest income is for example 5 000 and loan losses 1 000, your effective income is obviously just 4 000. But not for the taxman, who will base your income on 5 000, not 4 000!

10% upside and 100% downside (perhaps more than 100% due to litigation)

You have a capped upside. You can’t make more than for example 10%, but you face a 100% downside (of course, we can argue this is very unlikely). Considering litigation risk, you actually risk losing more than your original investment.

Conclusion

I advice to step back and asses pros and cons before investing in p2p/crowdfunding. There are many pitfalls in a new business and in any start-up phase there are many bad business plans. I expect the market to consolidate, and I suspect several will go belly-up. Personally, I’m conservative and like to stick to the proven asset classes: the stock market and real estate. I believe most investors should do themselves a favor and do the same.

After all these negative arguments, I still have some money in three different platforms (I won’t name them). They are profitable and I have talked to the management, and I feel somewhat sure of their operational risks, so I have deposited a small amount.