​Twelve percent returns on fixed income? You don’t say…

​Twelve percent returns on fixed income? You don’t say…

​Twelve percent returns on fixed income? You don’t say… The burgeoning world of online private credit represents an intriguing new development in investable assets. In an era when traditional fixed income is generating barely any return online lending to small businesses and individuals represents an intriguing new idea. 

Traditional fixed income investments, of course, are barely returning any cash to investors in this era of low interest rates. So no wonder the growing interest in what is known as peer-to-peer lending.

Since the recession of 2008 the online private credit market has emerged and evolved into what is, arguably, a brand new asset class. Brendan Ross is the president of Direct Lending Investments LLC, a company that runs a short-term, high-yield small business loan fund. "It's a rebirth of the simplest and oldest way of making money: one individual loaning money to another and getting paid back with interest," says Ross.

The idea is rather simple. Online lenders like IOU-Central and Prosper.com find prospective borrowers through their websites. These platforms automate the underwriting process, do credit checks and confirm the applicants' bank accounts as a way of vetting borrowers. The lender posts the qualifying requests on their website; private investors decide which proposals to fund, either in entirety or in part.

Think of it as a mini-bond market for retail and small-business borrowers. For instance, at Lending Club investors can choose to lend the entire amount requested by a borrower, or as little as $25 to multiple borrowers, reducing potential losses on defaults. Investors then fund these loans and make returns based on the high interest rates charged on these loans.

In an interview with Wealth Professional Ross expanded on the business plan. "For an investor this is the Holy Grail in uncorrelated returns--short-term, high-yield fixed-income."

The average loan in the portfolio is just $41,000. Loans are typically made to a small business. "These are people who can't get a loan from a bank." Twenty five percent of the portfolio is retail stores, another 20% of the portfolio are loans to doctors and dentists. According to Ross the average small business represented in the portfolio has been operating for 12 years. The average FICO score is 680. The businesses are usually worth between $500,000 and five million. "Walk down any main street and look around...these are the people borrowing," says Ross. "Everyone knows small businesses overpay for credit. It's an easy concept, and it works through advisors for conservative investor. This is like one-year paper returning 12%.  Private credit is the heart of what investors want: uncorrelated returns, high yield."

Ross explains that there is daily interaction between the fund and the account of borrowers as borrowers repay daily and weekly.  "There is no better way to know what's going on with a lender," he says. As well, there is no lock-up of funds and investors can see inside the live portfolio. The fund itself is now worth $42 million today, a respectable amount. So legitimate have these funds become that Ross' fund is available through Schwab and Fidelity in the U.S. "The fund shows up on the client's statement. There is no work for the advisor," says Ross. 
 He says turnover in the portfolio is 18-19% per month. He claims a default rate of 4-6% on an annualized basis. Though, he  goes on to add that, "These kinds of funds can have 22% default rate and still break even. I can have one out of five loans go bad and still return capital," says Ross.
So, why the rapid growth in this sector? One reason is the reduction in bank lending to small business by large banks that has occurred since 1998. According to a report from the Cleveland Fed: "Small business lending has dropped substantially since the Great Recession. While some measures of small business lending are now above their lowest levels since the economic downturn began, they remain far below their levels before it. For example, in the fourth quarter of 2012, the value of commercial and industrial loans of less than $1 million--a common proxy for small business loans--was 78.4 percent of its second-quarter 2007 level, when measured in inflation-adjusted terms." Private credit is stepping into the breach. "Banks used to make half of loans outside agricultural and retail sector to small business," says Ross.
As well, the advent of new technology making peer-to-peer lending possible another reason for the rapid growth in the sector. After the economy crashed in December 2007, nascent online peer-to-peer lending platforms quickly grew. The first platform appeared in 2008. Ross has been in the game since 2009. There is a premium available to investors exploiting previously inefficient credit markets that have lacked infrastructure. "We profit from that," says Ross. "I buy from four lending platforms. The platforms find the loans. I manage the assets of this diversified portfolio. Of the thirty platforms out there, I took the best four...Now that fixed income is not doing what it's supposed to be doing, I think funds like mine are the best alternative investment out there."

There is also a feel good story here about lending to small businesses. Though, Ross focusses on the returns. "For investors with a sense of mission, there is a story to tell. But for an investor who wants uncorrelated returns this is a fine too."

He adds that the portfolios are also "clean", that is, there are "no porn stores or drug paraphernalia stores. No loans that would embarrass an investor."  Now you know. In an era of 3% returns on a 10-year bond, the new world of retail, peer-to-peer lending is an intriguing market development.