The rise of peer-to-peer lending sites was borne out of the aftermath of the Great Recession financial crisis, as banks tightened their standards and consumers sought liquidity in a floundering economy.
But since the sites first emerged as aggregators of consumer microloans, many of them have evolved to also include institutional investors seeking yield.
One such firm is Whitefish Bay-based Looking Glass Investments, which bases its investment strategy on buying loans on these sites, in what is known as marketplace lending.
The idea for Looking Glass came out of a conversation between friends. Matt O’Malley and Chad Cotti both had young children and wanted to make sure they were saving enough for their kids’ education. They had dabbled in peer-to-peer lending before and saw the potential in it. In 2012, they cashed out their children’s college funds and made their first joint investment in a loan on lending site Prosper.
O’Malley, who was then a procurement and sourcing manager at Journal Communications Inc., and Cotti, an associate economics professor at University of Wisconsin-Oshkosh, wondered how to most efficiently determine whether a loan would default before making an investment.
From there, they began to build algorithmic models to analyze and underwrite a loan in as little as five seconds using custom software that analyzes hundreds of factors related to investment performance.
LGI’s economists use econometric and machine learning models that incorporate as much information as it has available about the borrower, the characteristics of the loan itself and the context, said Nathan Tefft, Ph.D., executive vice president and chief economist at LGI.
“We use all that data to then build predictive models which try to model as accurately as possible the direct effects of all those underlying variables, how those variables interact,” Tefft said.
Once they had a proprietary system in place, the founders gathered $5.5 million in seed capital from general partnership investors. Looking Glass Investments officially launched its fund in January 2014.
“People might argue that we had a disadvantage coming into this because we were not money managers. We weren’t brought up in that world,” said O’Malley, now president and chief operating officer at LGI.
The firm focuses on four lending platforms: Funding Circle, Lending Club, Peerform and Prosper.
Prosper introduced its institutional investing channel in April 2013 and has since seen significant interest from a broad swath of institutional investors, including banks and firms like Looking Glass, said Eric Thaller, executive vice president of capital markets at Prosper. Its balance shifted to majority institutional investors and its loan origination surpassed $1 billion as a result.
“For institutionals such as Looking Glass, it is a first come-first serve market,” Thaller said. “To the extent that they have the ability to process information quickly and make a decision about funding a consumer, they can effectively purchase those loans in very short order.”
“We know that there are others out there working on similar approaches,” Tefft said. “We know there’s competition because we end up competing for loans on the online marketplaces.”
The competition and simplified application process on marketplace lending sites can make the experience easier for the consumer, Thaller said.
“They can get the money in one to three days,” he said. “That really separates marketplace lending from the traditional process by which people would get a consumer loan. You don’t fill out a long paper application, wait two to three weeks for an answer and then get your funds.”
Using its custom predictive analytics software, LGI evaluated $6.2 billion in potential loans and invested about $21 million in about 10,000 loans in 2015. The model Looking Glass developed evaluates the likelihood of default on a particular loan. Most of the loans the firm invests in are above the average fixed interest rate.
“We know everything about a potential borrower—except their name,” and personal details, O’Malley said. “We just allow the numbers to tell the story.”
Marketplace lending is attractive to borrowers who want to improve their credit or get an easy loan, O’Malley said. It has become more competitive as an alternative, and banks are starting to partner with accredited investors like Looking Glass to underwrite the non-traditional loans rather than taking on the risk themselves.
Most loans go bad between eight and 13 months into repayment, O’Malley said. So far, the firm’s default rate is about 3.4 percent since it launched the fund. If a loan defaults, LGI charges it off immediately, and the platform manages the collection.
O’Malley cautions investors that marketplace lending is a new asset class, so the numbers could change.
“The return number could end up being higher…and the same with the default. The default could end up being lower,” O’Malley said. “Duration matters.”
Lending platforms like Prosper service the loans and assure repayments are distributed among the multiple investors that may be part of a single loan.
“We make sure that each investor is distributed appropriately the amount of principal and interest due to them,” Thaller said. “We take care of all the operational burden of the fractionalized loan.”
O’Malley described marketplace lending as a new, explosive asset class for investors. LGI can invest up to $35,000 in a loan. Its largest lender is Capital One, which supports a separate managed account, followed by GCI, a Waukesha-based private equity firm started by the children of Lands’ End founder Gary Comer. It now has 84 investors, many of them local, and $18 million in assets under management.
“(LGI’s model) translates into excellent returns for our investors,” Tefft said. “Somewhere around 10 percent is what we have been doing in actuals in past returns and we hope to continue that.”
As a high-yield, low duration loan, a marketplace loan can prove worthwhile for a variety of investors, Thaller said.
“We’ve demonstrated through our track record very good performance. But I think in addition to that, these assets are high yielding, short duration, monthly paying assets, which I think is very attractive relative to other opportunities in the market,” he said.