6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

Blog View Home Subscribe Contact Us About

100
Shares

BLOG INVESTORS BORROWERS MY RETURNS BEST OF INVEST

FORUM PODCAST Search this website

An Investors Due Diligence

Lessons in Marketplace
Lending
This investor shares what he has learned doing due diligence on
40 origination platforms and 50 investment vehicles.
MAY 30, 2017 BY ADMIN 13 COMMENTS

100
Shares

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 1/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

100
Shares

[Editors Note: This is a guest post from James R. (Jim) Hedges, IV. He was one of the early leaders in
the hedge fund and alternative investments industry, and is the author ofHedges on Hedge Funds. He
was the Founder and Chief Investment Officer of LJH Global Investments, LLC, an alternative investment
advisory firm which advised on over $5 billion of alternative investment allocations. In 2017, Mr. Hedges
founded HEDGES COMPANY (www.hedges.company) to provide insights on alternative investments to
entrepreneurs, investors and fund managers. The firm is especially focused on specialty finance and co-
investment opportunities. Mr. Hedges is also a partner in LJH Financial Marketing Strategies, LLC
(www.ljhfm.com). He lives in Los Angeles, California.]

When I began working in the family oce and hedge fund worlds in 1992, private investors were looking,
foremost, for return enhancement and, secondarily, for diversication. 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 1990s, 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 dierentiate fund managers and tell the dierence 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 todays marketplace lending sector, it is a similar story. There is a proliferation of funds in the space,
and assets are owing 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

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 2/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

groups. Product dierentiation is dicult, 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 eld, we have a universe of loan originator platforms. Best

100known names like Lending Club, Prosper and SoFi have dominated the press, but there are, in my
estimation, well over 100 unique specialty nance loan origination platforms, and within that group, loans
Shares
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
Factoring
Retail installment contracts (RICs)
Solar equipment nancing
Education nancing
Automotive repair nancing

Each of these segments has unique drivers impacting customer acquisition costs, underwriting
procedures, and borrower behavior. Consequently, many of the segments oer diering yields, default
rates and durations.

On the other side of the marketplace lending landscape, once the loans are originated, there are many
dierent asset management structures through which capital inows 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 SICAVs
40 Act Funds (interval funds which mostly have staggeringly high fee burdens)
Notes and Variable Life Insurance wrappers for tax eciency

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 3/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

With gross current yields ranging from high single digits to the upper 20s (and in some cases, even
higher), its easy to see the appeal for family oces, 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

100investment market, making this space the holy grail for todays investors.
Shares
Over the past year, Ive 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. Ive seen a great deal of
opportunity, but Ive 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 rst establish ones 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 eld
is populated with portfolio managers who are more likely to have worked at Capital One on a credit desk
than on the trading oor of Goldman, Sachs. The lack ofa traditional investment pedigree and track
record in this eld makes it more dicult for one to assess a managers relevant skills and experience.
Likewise, the use of leverage in this eld is not conned to swaps and broker/dealer leverage, but is more
analogous to the leverage debt fund markets (i.e. CDOs, CLOs, etc.). Moreover, these factors, when
combined, (less portfolio management expertise and unique leveraged assets) highlights a risky dynamic.
Its 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,

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 4/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

historic performance of borrowers behaviors is less understood. The result is that nancial 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

100space have lacked consistent methodologies. Managers frequently accrue for loan losses using diering
standards. The result is that performance can be overstated or that returns appear to be smoother than
Shares
they would be using dierent methodologies. For instance, I oer the following excerpt from the
performance report of a very large fund in the space.

When I rst saw these returns, I instinctively thought of Mado. 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 theyve reported is, in
my experience, unlikely indicative of a valuation methodology that accurately reects 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 oer liquidity terms which could be
inconsistent with the underlying duration of the investments in their portfolios. By example, an alarming
number of funds oered 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-ows of capital should be sucient to meet any redemption requests, one should take pause. Its
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:

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 5/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

sloppy valuation
poor liquidity management
unexperienced portfolio management
ineective use of leverage

100
Expect a rapidly changing environment. The coming years will surely see billions of dollars of investor
Shares
capital ow 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 oers some very appealing uncorrelated returns and current income
for those who execute superior due diligence.

Will the Real Marketplace Lender Podcast 69: Jon Barlow, The Pure Marketplace Lending
Please Stand Up? Founder of Eaglewood Capital Model is Dead, the Hybrid Takes
January 20, 2016 July 22, 2016 its Place
In "Guest Post" In "Lending and Fintech Podcast" September 26, 2016
In "Peer to Peer Lending"

FILED UNDER: GUEST POST

TAGGED WITH: DUE DILIGENCE, HEDGE FUNDS, MARKETPLACE LENDING

COMMENTS

A N says
May 30, 2017 at 3:52 pm

Just a guess, but are those returns from the Direct Lending Income Fund?

Reply

Peter Renton says

May 30, 2017 at 9:32 pm

I am sure Jim, the author, will not tell you which fund it is from but I can tell you, as an
investor in the DLI Fund, those are not the returns I have received.

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 6/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

Reply

J Baxter says
100 May 31, 2017 at 7:07 am
Shares
Yes Peter, they aredirect reproduction of the table included on all investor letters.

Reply

Peter Renton says

May 31, 2017 at 12:40 pm

Youre right. I went back and looked at the returns in the investor letter and you
are correct. My mistake.

Reply

Vidal Sassoon says

May 31, 2017 at 1:38 pm

If the guy who runs that fund is the one Im picturing, perhaps there was
just a mix-up and the pasted return chart was of instructions to be sent to
his personal hairstylist regarding exact spacing and width. Its probably just
an honest mistake. #WIGPULL

Better yeti says

May 31, 2017 at 2:46 pm

Wow. Ive never seen such a civil comment thread. Thanks for restoring my
faith in humanity.

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 7/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

Sharppencil says
June 1, 2017 at 11:47 am

Specically, they represent DLIF for Feb thru Nov of 2016, 2015, and 2014
100
Shares (Jan and Dec for each year omitted). Comparable YTD for Feb thru April
2017: 0.73, 0.81, 0.72 or consistently about a .1 lower return month by
month. This is largely (altho not exclusively) due to the Dealstruck default (in
which, alas, I was a participant in an unsecured note that was used as part
of their initial capitalization). To the authors point, this is the kind of
discrepancy due to a lack of historical data in mark to market that is going
to show up in these kinds of investments. With my Dealstruck loss I have
found that my personal returns in this space have been around 8% over a
four year period, good, but not great and probably what investors should
expect rather than double digit.

Vidal Sasson, not sure what your issue is with Brendan Ross who runs
DLIF but I have never found him to be anything other than a straight
shooter about risks and their approach.

Nietzschean Apologies says

June 1, 2017 at 1:18 pm

Even a good shepherd needs a bellwether occasionally, lest he become a

wether, himself.

There is a spirit of goodnatured rambunctiousness that ought not be

mistaken for malice.

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 8/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

Charlie Moore says

May 31, 2017 at 12:20 pm

Investors are still largely relying on the old paper loan document diligence approach to these
100
Shares assets that simply does not work. Investing in online lending requires a technology based
diligence solution of the loan data integrity, conrming with trusted external data sources the
veracity of the asset. Checking an electronic document as proof of the asset invites problems.

Reply

Randy says
June 1, 2017 at 12:35 pm

I too thought that the DLI returns were too consistent and was worried about a Mado scenario.
Before I invested in the fund in 2015, I requested and received audited nancials from DLI. I
called the audit manager at the accounting rm to conrm the nancials were legit and was
told they were. My reasoning for why the returns are so consistent is that DLI incentivizes the
originating loan platform company to collect on the loans by paying a higher fee when
collections are above benchmark and penalizing when below. The net eect results in a return
falling within a narrow band. Ive moved funds from a taxable account to an IRA account,
resulting in a total liquidation of the taxable account without penalty or reduction in returns vs
published returns. So far its working for me. Hope I havent missed something.

Reply

John Player says

June 18, 2017 at 10:02 am

You may have missed some things to consider:

3 dierent auditors in 3 years

Senior employees known to be involved in fraudulent schemes in the past
Regulatory violations for breaching investor limits while not being properly registered with
the SEC

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 9/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

No existing/awed internal risk models and analytics years into the operation of the fund
Unparalleled liquidity mismatch
Huge concentration risk at times having allocated 30% of capital to two platforms only
SPEs bankruptcy remote and not bankruptcy safe
No cash loan loss reserves
100
Shares Questionable guarantees
Underlying platforms with no relevant history, no funding next to DLIF or principals with
interesting backgrounds before turning to underwriting loans (ie, comedian agent and
poultry supply).
Gimmicky performance accounting with fee rebates into the fund to keep returns steady
And: not a single relevant institutional investor despite the size

Good luck!

Reply

Sharppencil says
June 18, 2017 at 4:46 pm

Quite a list, and would imply you have some avenues of inside information that are
not readily available. Could you share sources? SEC lings?

Reply

John Player says

June 20, 2017 at 4:12 am

You would expect every investor to know this. Absolutely no rocket science
here. Every information listed is readily available to anyone with access to
Google, common sense and a marketing presentation of the fund.

If you dont know maybe its time to rethink your due diligence process as the
article suggests.

If you know and decide to invest nevertheless you may have a dierent risk
appetite than others.

Reply
http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 10/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

100
Shares

LEAVE A REPLY

Your email address will not be published. Required elds are marked *

Comment

Name *

Email *

Website

Notify me of followup comments via e-mail. You can also subscribe without commenting.

POST COMMENT

Notify me of follow-up comments by email.

Notify me of new posts by email.

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 11/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

100
Shares

NEXT LENDIT EVENT

INVEST WITH LEND ACADEMY

REVIEWS FOR INVESTORS

Lending Club Review

Prosper Review

RECOMMENDED READING

The Pure Marketplace Lending Model is Dead, the

Hybrid Takes its Place

The 2016 Lending Club and Prosper Tax Guide

My Returns at Lending Club and Prosper

Map of Available States for Lending Club and

Prosper Investors

Banks and Marketplace Lending Platforms: Ideal

Partners?

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ THE LEND ACADEMY PODCAST 12/14

6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

THE LEND ACADEMY PODCAST

100
Shares

List of Podcast Episodes

ARCHIVES

Archives
Select Month

Follow @LendAcademy 10.3K followers

ABOUT LEND ACADEMY

Lend Academy has been bringing you all the news

and information about peer to peer lending since
2010. Founded by Peter Renton, Lend Academy not
only has the most active news site, but also the
largest online forum and the rst and most popular
podcast in the industry.

The Lend Academy team loves peer to peer lending

and our sta have all invested their own personal
money in one or more of the platforms. Lend
Academy Media is part of Cardinal Rose Group
which also owns LendIt, the leading industry
conference, and has a majority interest in NSR
Invest.

RECENT POSTS TAGS

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 13/14
6/24/2017 An Investor's Due Diligence Lessons in Marketplace Lending - Lend Academy

Marketplace Lending News Roundup June 24 accredited investors banking Banks borrowing China
Conference credit risk crowdfunding diversication Earnings
Podcast 106: Tim Ranney of Clarity Services
ntech FOLIOfn Funding Circle institutional investing

100Banks Going Digital Transforming Branches, Apps interest rates investing IPO IRA lending Lending
and a Focus on Customer Experience
Shares
Club LendIt lendstats loan lters marketplace
The Current State of Marketplace Lending in Japan
lending monthly charts Net Annualized Return p2p
Marketplace Lending News Roundup June 17
lending Prosper Quarterly Results real estate
regulation ROI sec securitization SLN News small
business loans SoFi statistics student loans taxes UK
underwriting venture capital video XIRR

Copyright 2017 Lend Academy Privacy Policy Terms Disclaimer

http://www.lendacademy.com/investors-due-diligence-marketplace-lending/ 14/14