The marketplace lending industry has experienced tremendous growth in recent years, with loan originations on the rise and numerous new entrants, including some banks that are starting their own platforms or teaming up with fintech companies.
The industry’s growth has been fueled by demand for loans from consumers and businesses that have been underserved by traditional lenders, as well as a desire for higher yields among investors with capital to lend. Any outside observer might conclude that this growth coincides with a high level of secondary market trading activity for marketplace loans (MPLs), but that is not the reality, according to an industry consultant.
“To date, there has not been much of a secondary market for these loans,” said Christopher Kennedy, a managing director at MountainView Financial Solutions, a Situs company. For several years, Kennedy has been leading the development of MountainView’s MPL valuation business, which includes work with some of the largest marketplace lending platforms. He also works on MountainView’s loan sale advisory team.
One fundamental reason for the low level of trading activity is that the loans have a short life, with pools typically consisting of 36-month term loans and typically just 12 to 24 months of duration after considering amortization and prepayments. But a larger reason is that the secondary market hasn’t evolved to the point of having a deep pool of buyers and solid mix of flow and bulk trades.
“Most of the major marketplace lending platforms and investors have become comfortable with specific buyers in a forward-flow agreement, where a pre-determined number of loans are delivered on a specified frequency,” said Kennedy. “In these flow relationships, the buyers have thoroughly vetted the lending platform and thoroughly reviewed the loan underwriting guidelines as well as prepayments and other aspects of loan performance. The flow segment is where the majority of deal activity exists today in the secondary market.”
The bulk segment, however, is very thin, according to Kennedy.
“It’s not a deep, 30-40 group of buyers or even a 10-15 buyer pool showing up for these auctions,” said Kennedy. “It’s less than a handful.”
He explained that in the bulk segment of the secondary market, the buyers typically don’t have a chance to thoroughly review the platform or the seller, while the sellers just want to get the trade done for one reason or another – perhaps their fund is closing or they’re leaving the investment strategy altogether. In this scenario, an investor may have a loan portfolio with $100-200 million of unpaid principal balance, but the investors’ expectations don’t match what buyers are willing to pay; most buyers want to buy the loans at a discount to par. For this reason, Kennedy says, many trades blow up.
To avoid this outcome and have more successful trades, Kennedy said frequent loan valuations are essential.
“MPLs are deep level 3 assets,” said Kennedy. “Investors should be getting multiple independent valuations on their portfolios, and there should be a level of understanding regarding the potentially large range of fair value estimates to help set their expectations about pricing levels should they decide to sell. The reason a lot of these trades don’t get done is because these investors don’t really understand where the market is … because they’re not getting the asset marked by a third party that is in touch with a variety of market participants.”
From the sellers’ perspective, they think they can get a premium price in their sale, because they have been achieving returns ranging from 8-9% to the low teens, according to Kennedy. But buyers don’t see it that way; they usually see the assumptions as aggressive, especially now, when we may be at the top of a credit cycle and could be going into a recession in the near future. In addition, a buyer may see significant counterparty risk if the seller’s fund isn’t going to exist in the near future.
Another issue for potential buyers is loan servicing. If buyers don’t have a loan servicing operation, they need to find a sub-servicer. Some sub-servicers specialize in MPLs, according to Kennedy, but this is just another issue that needs to be addressed prior to engaging with the secondary market, and an expense that may reduce returns.
“In short, it’s a complex process to trade these assets,” said Kennedy.
So what are the elements of successful trades of MPLs? Kennedy is part of diverse panel that will answer this question in a session at the Marketplace Lending & Alternative Financing Summit in Dana Point, CA. The session, Debt Sale Trends in the Marketplace/Alt Lending Sector, takes place Nov. 29 and includes panelists spanning across asset managers, loan sale advisors, loan auction platforms and loan valuation providers