While online lending markets were initially dominated by retail investors, a significant emerging trend is the increasing participation of institutional investors. This changing dynamic is catching the attention of researchers, with a desire to understand why institutional investors have decided to participate in such alternative lending markets and how their decision making compares to that of the crowd.
In a recent (freely available open access) study by Irish Institute of Digital Business members Professor Mark Cummins, Dr. Ciarán Mac an Bhaird, Dr. Pierangelo Rosati and Professor Theo Lynn, institutional investment in the Funding Circle peer-to-business lending market place is examined. Funding Circle initially launched in the UK in 2010 and subsequently set up operations in the US in 2013 and Germany and the Netherlands in 2015. While Funding Circle acquired market exposure in Spain, in addition to Germany and the Netherlands, through its acquisition of Zencap in 2015, it subsequently exited the Spanish market in 2016. In our study, we focus on the UK lending market, which consists of £5.6bn in loans advanced to 56,000 businesses worldwide between its launch in 2010 and the end of November 2018. Most loans are unsecured, although the platform facilitates secured loans, which constitutes a smaller segment of the market. The platform has a base of over 50,000 investors, consisting mostly of individuals, along with a number of institutional investors, including the European Investment Bank, the British Business Bank, as well as international asset management firms such as Aegon and KLS. Institutional investors were granted a dedicated wholesale market place on 6th May 2014.
The wholesale market is confined to institutional investors, although institutional investment in the retail market is possible. The wholesale market differs from the retail market in that for any loan financed, a single institution provides the full funding. Such loans are designated as ‘wholeloans’. By contrast, in the retail market, loans are financed by a number of, predominantly retail, investors. Such loans are designated ‘partloans’. Investment in wholeloans in the wholesale market place can be made in a number of different ways. Firstly, a direct lending route, whereby institutional investors purchase loans directly onto their own balances sheets or through special purpose vehicles. Secondly, an indirect lending route, whereby institutional investors provide funds through the Funding Circle SME Income Fund that is quoted on the London Stock Exchange, an investment company that passively invests in Funding Circle loans and pays dividends to investors. Thirdly, an further indirect lending route, whereby institutional investors provide funds through an umbrella ICAV (Irish Collective Asset Management Vehicle) that facilitates the launch of private sub-funds of Funding Circle loans.
From our empirical analysis, we make a number of observations in relation to peer-to-business lending. From a lending platform perspective, we show that:
- the platform-administered loan allocation process is not biased in favour of institutional investors;
- institutional participation in the retail marketplace is not a distorting factor in our loan performance analysis;
- the platform’s move to a fixed rate system had detrimental effects on lending outcomes for institutional investors.
We show superior performance for loans financed by institutional investors relative to retail investors (measured in terms loan screening ability and realised loan payoff), although it is found that large sized retail investor groups achieve equivalent performance. It is further observed, however, that the lending decisions of institutional investors are not default risk minimising. Substantial levels of lending inefficiencies are quantified by the authors. Furthermore, evidence is provided that the superior loan performance achieved by institutional investors is confined to the auction period, when institutional investors had autonomy over the setting of interest rates.
Our analysis complements some other studies that have recently emerged.
Vallée and Zeng (2019) use a unique investor-level data set from the Lending Club platform to investigate the performance of sophisticated investors versus unsophisticated investors in personal lending, where the former cohort comprises institutional investors and select retail investors. The authors show that sophisticated investors systematically outperform unsophisticated investors and that this is down to superior information processing.
Lin et al. (2017) investigate institutional investment performance in personal unsecured lending as well, but draw upon data from the Prosper.com platform. The authors provide evidence that contrasts with Vallée and Zeng (2019), showing that institutional investors do not outperform retail investors, despite having larger, more diverse portfolios, and avoiding home bias.
Mohammadi and Shafi (2017), in an independent work, analyse business lending on the Funding Circle platform, finding that institutional investors outperform retail investors in screening business loans, manifesting as higher ex-ante interest rates for comparable levels of ex-post default exposure. The authors furthermore show that loans rejected by institutional investors in the wholesale market and subsequently invested in by retail investors in the retail marketplace – in a process referred to as “recycling” – perform less well (i.e. achieve lower ex-ante interest rates for comparable levels of ex-post default exposure) than a matched sample of loans funded by institutional investors.
So with institutions mixing among the crowd, we need further work done to understand much more what impact such institutional investors are having on online lending markets, and what implications this has for traditional lending markets.