Investing Guide at Deep Blue Group

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Guide to Peer-to-Peer Investing

The Internet is doing away with banks as intermediaries, bringing pools of
borrowers together with individual investors



Lending between individuals has been around since the beginning of
human civilization. It may be the worlds second-oldest profession.

But in the modern era, there is little person-to-person about it.; borrowers
work with institutions who have all the power; terms can sometimes be
oppressive.

The Internet is leveling the playing field. Online peer-to-peer (P2P) lending
platforms are doing away with the banks that act as slow-moving, costly
intermediaries, bringing pools of borrowers together with individual
investors. For professional investment managers, the result is an
alternativeand attractiveincome asset class. (Why do I say attractive?
See my personal experience and returns with one such platform below.)

Tom Myers, a San Francisco-based principal at the wealth advisory firm
Brownson, Rehmus & Foxworth, was an early adopter of P2P lending. With
one of his clients on the board of Lending Club, the largest of the P2P
platforms, Myers opened up a personal account. The more he looked under
the hood, the more he liked what he saw as an option for some of his high-
net-worth clients. Five years later, Myers now has about $75 million of
client funds invested in the LC Advisors Fund, a professionally managed
pool. Theres decent return for some modest risk for the kind of clientele
[average investable assets of $20 million] we serve, he says.

Chris Spence of Picayune, Miss.-based Diligentia LLC is such a champion of
P2P lending that he established his investment firm partly to exploit the
advantages of investing in it, as well as other nontraditional asset classes.
The value proposition Diligentia offers clients is also nontraditional: Clients
receive a guaranteed rate of return. Diligentia profits represent the spread
between its net annualized returns and the guaranteed payments to clients.
Spences firm reserves the right to invest clients funds in a variety of asset
classes including, but not limited to, equity instruments, debt instruments,
ETFs, real estate and, increasingly, P2P lending.

Spence started using Lending Club on a personal level in 2010 and quickly
became a power user. Once I got comfortable enough with P2P lending, I
took an incremental approach in bringing in Diligentia assets, he says.
Ive been pleased by the net annualized returns. Both (Lending Club and
Prosper) do a good job pricing their loans, he adds, and the platforms
backtested results show accurate estimations of defaults.

Marketplace Lending

Indeed, so popular is P2P lending among the professional investment
classes that some of the peerness is coming out of the process. The influx of
funds is less from individuals and more from hedge funds, family offices
and other institutions seeking to park private capital. Although Ill continue
to refer to it as P2P lending, perhaps marketplace lending better reflects
the emerging reality.

Regardless, for investors, the best thing about P2P investing is how easy it
is. There are few barriers to entry; you can get started for as little as $25.
The platforms offer wide options for investors wherever they are on the
risk-aversity curve. For conservative investors who want to supplement
their CDs, the least risky notes on the platforms offer substantially better
returns than bank certificates for modestly higher risk. For investors who
want to complement their junk-bond portfolio, there are notes with
correspondingly higher risk profiles. Ive never felt more confident in the
stability of the asset class, Spence says. P2P is coming into the
mainstream. Lending Club has filed with the SEC to go public later this
year.

Jeffrey S. Buck, an Atlanta-based principal and member of the investment
team at Diversified Trust, thinks of P2P investing as an alternative to
traditional fixed income. For receptive clients, he typically targets 5 to 8
percent of a clients portfolio, often shifting money from lower-return,
credit-sensitive bonds. While liquidity exists, Buck nevertheless counsels
his clients to think of these assets as a five-year hold. A key benefit offered
by P2P diversification is that it has a low correlation to other asset classes
in their portfolios, he says.

Buck and the investment team at Diversified Trust analyzed P2P strategy
until they had a good understanding of the expected risks and returns.
Reaction from our clients has been positive; some clients who had been
receiving monthly distributions have recently elected to reinvest instead,
Buck says. With rates low and expected to go sideways or higher, P2P is an
attractive income alternative and diversifier to traditional bond strategies.

In the spring of 2013, Lending Club began experiencing a huge surge in
investor interest from a diverse group, says Bo Brustkern, co-founder of
Lend Academy Investments, a service established specifically to help
advisors and family offices invest in established and emerging P2P
platforms. Since then, Lending Club has been oversubscribed, and as a
result it has restricted allocations to virtually everyone, including many
family offices and advisors. While Lending Club attempts to catch up with
demand, the situation today is that many large investors are still
significantly delayed in putting their money to work. Eventually, we believe
the marketplace will re-establish equilibrium, he says.

P2P in Operation

Online platforms such as Lending Club and Prosper Marketplace match
lenders with borrowers of varying credit risks, offering net annualized
returns of around 8 to 20 percent. Investors usually take fractional shares
of large numbers of notes to mitigate risk of defaults. Both platforms
provide profiles of the creditworthiness of the borrowers and the
performance characteristics over time of the notes they issue. The platforms
then offer the notes in what is essentially an auction. Once a note attracts a
sufficient number of investors, the loan is originated and serviced.
Platforms charge borrowers a one-time fee and lenders a monthly service
fee.

P2P loans are typically funded by specific individuals lending their own
money on a fractional basis at interest to specific borrowers. For example, a
note of $1,000 to a specific borrower is often funded by $25 investments
from 40 different lenders. As borrowers repay the 36- or 60-month notes,
the principal and interest payments are distributed proportionally to the
individual lenders. Lending Club loans are $1,000-$35,000; the average is
$13,913. All notes are unsecured.

Lending Club has some rigid underwriting standards. It rejects applicants
with FICO scores lower than 660 and a debt-to-income ratio below 30
percent, a set of thresholds that is said to exclude over 80 percent of
applicants.

Interest rates are a function of the calculated risk that the borrower wont
repay the loan. The higher the anticipated rate of default, the higher the
interest rate the borrower pays and the lender can expect. Lending Club
groups borrowers into seven loan grades, A through G. Within each loan
grade borrowers are further categorized into five sub-grades, 1 through 5.
The most credit-worthy borrowers are graded A1, the least worthy G5.
Where applicants fall on that risk continuum depends on Lending Clubs
assessment of their credit history. Applicants graded A1 get to borrow
money at the lowest rates, currently 6.78 percent APR for 36-month notes
and 7.3 percent for 60-month notes. For borrowers rated G5, the rates are,
respectively, 29.99 and 28.69 percent APR. Prosper charges even higher
rates for borrowers with lower credit histories.

More than three-quarters of borrowers list debt consolidation as the
purpose for their loans. So its a no-brainer for them to borrow at, say, 11
percent from a P2P lender to retire credit card debt of 21 percent or more.
Other purposes for loans include home remodeling, vehicle purchases,
medical costs and even vacations. Of course, there is no guarantee that
borrowed funds will be used for the listed purpose.

One-Year In: My Experience with Lending Club

To better understand P2P investing, I opened a Lending Club account in
April 2013. Initially, I deposited just $275 and carefully selected 11 of the
most conservative, lowest-interest-bearing A and B notes I could find. Like
most fledgling investors, I dreaded defaults. Within 45 days, I started
receiving daily interest and principal payments that totaled $8.46 per
month, which represented a net annualized return of 9 percent. After a few
months of receiving such returns, I considered that my savings accounts
paid interest of 0.25 percent and my three-year CDs paid 1.5 percent. The
more I researched this article, the more comfortable I got with P2P. In the
following months, I began transferring idle cash to my Lending Club
account, first gradually, then more aggressively.

Returns are gratifying and immediate. My Lending Club notes
outperformed not only all my other self-directed investments, but all of the
respectable returns my investment advisor harvested on my behalf in my
retirement accounts.

Spending time on the platform, I saw that most savvy investors preferred
the highest-yielding notes. In fact, theres intense competition for the most
desirable notes. Historical data seems to bear this out. The significantly
higher yields (as high as 15 to 25 percent) seem to more than compensate
for the very real increase in predicted defaults. My own tolerance for
defaults increased.

A Random Walk Through Peer-to-Peer Lending

When I started, I wanted to see if my careful selection of notes would
outperform notes selected at random. As an experiment, I created a
diversified portfolio of 250 notes I individually selected, one by one. At the
same time, I created another portfolio filled by an equal number of notes
selected at random. To this point, I can report that Ive found no significant
difference in performance.

A number of services insist they have a better way to filter out and select the
best-performing notes (see sidebar). But Renaud Laplanche, the CEO of
Lending Club, insists that no loan is better than any other. There is no
evidence that any investor has generated better-than-average returns on
the platform consistently, he says. [Advisors] can tailor their portfolios
based on their risk appetite and objectives, but that doesnt have a negative
impact on the other investors.

Fifteen months after starting this experiment, my account had slightly more
than 4,000 notes of every risk threshold (see Figure 1). Im only about
halfway through the lifecycle of the 36-month notes and even earlier for the
60-month notes. Defaults, if they happen, tend to occur later in the process.
Still, as I filed this article, I had only two notes go into default. Of course, 69
notes are in various stages of arrears and many of these will almost
certainly be charged off. Interest from P2P loans is generally taxed as
personal income instead of capital gains.