Are Retail Investors Really The Secret to Marketplace Lending Stability?

July 18, 2016 | By: Sean Murray

Wall Street 2015 One anecdotal lesson that marketplace lenders seem to be circulating in 2016 is that outside institutional capital alone isn’t enough to succeed long term, at least on the consumer lending side where the yield spreads are typically narrower. Retail investors are crucial, some of them say, to achieve balance. In late March for example, a group of industry captains predicted there would be a return to the industry’s peer-to-peer roots, partially because of the assumed loyalty that retail investors offered. That was before several players stumbled, reported weak loan volumes and announced layoffs. So are we now seeing a return to the retail investor?

That assumes that they were a part of the industry’s capital structure to begin with. And that’s never really been the case. For Lending Club, about 20% of their loans were funded by self-managed individual investors in 2015. 47% came from individuals through investment vehicles or managed accounts. For Prosper, individual investors only made up about 5% of loan funding. And then that’s about it. Everyone else relied on wealthy accredited investors and institutions from the start.

“Retail investors are more loyal to a specific platform,” said Fundera’s Jared Hecht during that March panel. But he probably assumed, to his credit, that the platform wouldn’t do anything to jeopardize that trust. Lending Club, of course, is a good example of what happens when that trust is violated after the CEO resigned in a scandal that included the manipulation of loan data.

And here’s how retail investors reacted, according to a Morgan Stanley report: 24% of retail investors that were aware of the scandal and DOJ investigation said they would no longer be making new investments on the platform. Another 24% said they would stop temporarily. Only 16% of those aware said they wouldn’t be changing the amount of new investments they make. But that’s for those aware. Many retail investors haven’t any idea that something happened.

“82% of investors (not primed with information about the investigation) planned to invest more or the same amount on the platform,” they reported, which may speak more to why retail investors would be a more stable capital base than anything else, the fact that they may be more likely to be blissfully unaware or detached from what’s happening to the platform they’re investing on. That’s a frightening thought but perhaps not much different than some investors who don’t pay any attention to their equity investments so long as the dividend checks keep coming.

How many people cashed out their mutual funds after Brexit, for example? I know I didn’t. It never even entered my mind despite my portfolio losing about 4% in a few days. It of course came right back up. Contrast that with Lending Club investors who haven’t lost anything as a direct result of the investigation.

And in that sense, it probably all comes down to the relationship a retail investor has with the platform. Do they feel that it’s safe enough that they can just let it roll in the background of life to generate steady returns like a mutual fund? Or do they consider it a speculative investment where they’re in today for some yield but out tomorrow at the first sign of danger? The former would indeed be the sweet spot for a platform looking for a stable capital source, but their long-term ability to tap into this group will depend on whether or not they can prove to regulators, particularly the SEC, that they will not violate the privilege bestowed on them to do this.

After all, Lending Club and Prosper for a long time were the only platforms to have obtained special SEC approval to solicit retail investors. StreetShares is another company that has recently joined them, but their ability to tap into this investor class is made possible under a different law, the JOBS Act’s Regulation A+. Under that, they can only raise a maximum of $50 Million, an amount too small for the likes of companies like SoFi or OnDeck if they were to seriously consider making retail investors part of their capital base.

Therein lies the conundrum about retail investors being a key component of long term capital sustainability, few platforms can even access them. And with regulatory skepticism starting to creep in, the window to pursue that as a realistic channel might already be closed. Which means that any platform that was totally reliant on Wall Street to begin with, might forever be stuck with them and their volatile whims.

One doesn’t need look any further than to see the consequences of that realization than the rumors that SoFi may consider becoming a bank to guarantee its long term survival, the company whose actual slogan is “Don’t Bank.” Dependent on raising evermore outside capital, the lender seems to have recently reached the ceiling of institutional investor appetite for its products, according to the WSJ. And this at a time when their loans are performing well and the economy is still expanding. The WSJ reported that SoFi CEO Mike Cagney might be seeking regulatory approval for a state banking charter in Utah and with that the ability to offer credit cards and deposit accounts. The story states that the deposits wouldn’t be used to fund the loans themselves. If true, they would still accomplish another objective by doing that, diversifying the company out of the one-dimensional rat race of having to make evermore loans even when the market can’t tolerate them anymore.

For marketplace lending, the peers in peer-to-peer may only offer stability if you can access them. For everyone else, there’s another set of retail roots that platforms could over time head towards, deposits. Banks figured that out a zillion years ago. And to that end, marketplace lending might be known by a more fitting name in the not-to-distant future, banking. That will mean tighter controls and stricter regulations but in the end ensure long term stability. And if that’s what a platform is really trying to achieve, then maybe they’re heading to an ironic end.

The industry could return to its retail roots then after all, but a retail level far more simple and basic. Stability may just mean a teller window and an ATM machine…

Last modified: July 18, 2016