Zopa and Funding Circle

Peer-to-peer or social lending as it is sometimes called is similar to the bond markets. Peer-to-peer lending involves lending individuals or small businesses money. It's a growing area of investment and the returns can be quite attractive. In the UK Zopa is the leading peer-to-peer lender. As an investor you would deposit money with them and then choose at what rate you will lend out your money. At Zopa loans are either 3 years or 5 years in duration (although some borrowers will pay off the loan early). A similar provider for business loans in the UK is Funding Circle. Funding Circle is much smaller than Zopa and has only been in business since 2010. Both sites work much the same way. Individuals and businesses wishing to borrow money are given a credit check and awarded a credit rating similar to the bond market. Both of these companies use the same scale, A+ being best, A, B, and finally C. Zopa also has a Y rating for younger borrowers with limited credit history. Both companies give their estimated defaults for these ratings on their websites. The table below summarizes them:

Rating	Zopa (3 year market)	Zopa (5 year market)	Funding Circle (all markets)
A+	0.5%	0.4%	0.6%
A	1.0%	0.8%	1.5%
B	2.9%	2.3%	2.3%
C	5.2%	4.2%	3.3%
Y	5.0%	3.1%	n/a

As you can see even the A+ rated loans are risky compared to the corporate bond ratings we looked at earlier. For example to get an expected gross return of 7% in the 3 year market at Zopa you would need to charge 7.5% in A+, 8% in A, 9.9% in B and 12.2% in the C market. On top of the default rates you have to take into account the fees that the providers charge. Zopa charges 0.5% and Funding Circle 1% a year.

Valuation methods

To evaluate the attractiveness in offering a loan we have to take into account the default rate and also the providers fees. I've found that the providers are a bit too optimistic with their default rates. Clearly it is in their interests to do so. Borrowers get better rates to borrow at and lenders are willing to lend at lowers rates meaning the providers can produce a lot of business. Therefore I take their default rates with a pinch of salt. In order to give us a margin of safety I double the default rate that the provider gives. This gives us the following formula for our expected return:

R = I - 2D - F

Where: R = Expected rate of return

 I = Interest rate offered to borrower

D = Estimated default rate

 F = Providers fee

Using this method we can evaluate the current market conditions (note the figures below show the maximum accepted rate for the last 5 completed loans. This figures tend to be volatile and rates higher than these get accepted if you are patient)

Zopa (3 year market)	Rate to borrower	Default	2*Default	Fee	Net Expected Return
A+	6.5%	0.5%	1.0%	0.5%	5.0%
A	6.7%	1.0%	2.0%	0.5%	4.2%
B	7.9%	2.9%	5.8%	0.5%	1.6%
C	8.8%	5.2%	10.4%	0.5%	-2.1%
Y	8.0%	5.0%	10.0%	0.5%	-2.5%

Zopa (5 year market)	Rate to borrower	Default	2*Default	Fee	Net Expected Return
A+	8.2%	0.4%	0.8%	0.5%	6.9%
A	8.7%	0.8%	1.6%	0.5%	6.6%
B	10.0%	2.3%	4.6%	0.5%	4.9%
C	11.6%	4.2%	8.4%	0.5%	2.7%
Y	8.0%	3.1%	6.2%	0.5%	1.3%

Funding Circle (all markets)	Rate to borrower	Default	2*Default	Fee	Net Expected Return
A+	7.5%	0.6%	1.2%	1.0%	5.3%
A	9.0%	1.5%	3.0%	1.0%	5.0%
B	9.4%	2.3%	4.6%	1.0%	3.8%
C	9.2%	3.3%	6.6%	1.0%	1.6%

As you can see the expected rates currently on offer are quite low. The best rates are in the 5 year Zopa markets where 6.9% is currently available in the A+ market. As I said before these rates are volatile and change daily. Expected returns of over 8% in the Zopa markets are not uncommon if you are patient. Looking back at historical accepted loans at Funding Circle loans at 12.2% (and higher) to the borrower have been made in the A+ market, giving an estimated net return of 10.0% plus.

Dangers

Clearly the main danger is in the risk of default of the borrower, meaning the person you lend the money to doesn't pay you back. Defaults aren't as rare as you might imagine either. Expect to get them as a normal part of this type of investing. To minimize our risks we use default rates above what the providers insurance underwriters estimate. This gives us a margin of safety. If their default rates are correct then we will make more profit than we anticipated and if they are wrong then we have a layer of protection in our larger default estimates to shield us from making a bad investment. It is by no means a safe investment to make and using the about we at least minimize the risk to our capital. Another method is to simply diversify. At Zopa the minimum loan contract is £10 and at Funding Circle £20. Therefore if any loan does default it will usually only be a small proportion of our total loan book. If you want you could lend all your money to one customer, although I would advise against putting all your egg in one basket.

Another area of risk is inflation. In times of high inflation the real value of your loan is decreasing all the time. Provided we have a diversified portfolio and the expected returns on any fixed income investments (bonds and peer-to-peer lending) is high then we shouldn't need to be too concerned about the effects of inflation on our investments.

There will be times when your money is earning no return when it is waiting to be lent out at your desired rate. I find it's usually better to be patient and wait a few months to lock in a good return than be in a rush to lend out all your money at potentially unfavourable rates. Both providers will let you set up an auto relend facility whereby you set the rates you are willing to lend at in each market and they will automatically relend money you receive as payments from existing borrowers. Both of these providers let you sell your loan book should you want to cash in the money early too.