A MONEYWEEK SPECIAL REPORT: DAY 1

MoneyWeek
Unconventional
income masterclass
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Risk Warnings
Before investing you should consider carefully the risks involved, including those described below. If you have any doubt as to
suitability or taxation implications, seek independent financial advice.

General - Your capital is at risk when you invest. Never risk more than you can afford to lose. Bid/offer spreads, commissions, fees
and other charges can reduce returns from investments.

Deposits made using peer to peer lending are not covered by the Financial Service Compensation Scheme (FSCS). This means
that you will not be entitled to FSCS compensation should the borrower default.

Taxation - Profits from investing, including both capital gains and dividends, are subject to capital gains tax and income tax
respectively. Tax treatment depends on individual circumstances and may be subject to change in the future.

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© 2015 MoneyWeek Ltd.

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Day One: Getting started in the world

of P2P
It sucks to be a saver.

Near-zero interest rates are a conscious effort by central bankers to force

savers to become investors (to take more risk) and to effect an inter-
generational wealth transfer (most young people can’t really afford to save
– but they do need to borrow).

Just consider a comment allegedly made by ex-Federal Reserve chief Ben Bernanke to
hedge fund supremo David Einhorn. Bernanke supposedly said: “if you raise interest
rates for savers, somebody has to pay that interest. So you don’t create any value in the
economy, because for every saver, there has to be a borrower.”

As Société Générale analyst Andrew Lapthorne notes, this suggests “Bernanke is against
lenders receiving higher rates of return (ie, higher interest rates) as it is a drain on
economic growth”.

I don’t think Bernanke’s right. I think this is more a central banker’s excuse to justify
‘financial repression’ - artificially keeping rates low in order to help inflate away the
economy’s debt burden. This has been going on for some time. But the good news is that
financial innovation might just rescue the humble saver and the even braver investor
from central banker repression.

Whilst savers have been getting stuffed by low interest rates and falling yields all over the
world over the last five or six years, there have been some interesting innovations in the
financial markets that could help bridge the gap.

All of them involve interesting and unconventional methods of collecting more income –
and from sources you’ve probably never considered or even heard of. Over the next five
days, our ‘unconventional income’ expert, David C Stevenson, will be introducing you to
a whole series of ways of pocketing a bigger income. We’ll cover everything – from what
you need to know to get started to the risks involved.

We call it our ‘Unconventional Income Masterclass’.

Let’s jump right in – I’ll hand you over to David, who’s going to introduce you to one of
the most promising areas in alternative finance today: peer-to-peer lending.

Good investing,

John Stepek, Editor, MoneyWeek

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The Alt-Fi Revolution

Hello, and welcome to the unconventional income masterclass!

The financial crisis of 2008 was pretty awful for most parts of the banking
sector. But it was good news for one part of the finance industry –
‘alternative finance’.

This catch-all term covers activities such as ‘peer-to-peer (P2P) lending’ and
‘crowdfunding’ – in short, companies that enable individuals and firms to raise money
while cutting out banks. While the likes of P2P pioneer Zopa already existed before
the financial crisis, widespread disenchantment with traditional banks, and the low
interest rates on offer, brought a surge of interest in Zopa and rivals such as RateSetter
and Funding Circle. These companies used the internet to establish marketplaces where
savers looking for higher returns on their money could lend it to borrowers looking for
loans at a better rate than banks were offering. Even the government could get behind
this vision – the Treasury has consistently helped the sector along, especially platforms
that target the small business (SME) sector, such as Funding Circle.

It’s all very exciting. And I for one think any serious investor or saver should pay
attention to the rise of P2P finance. But there are a few things to get clear before you
go bounding in. Firstly, despite all the press coverage, the sector is still relatively small,
compared not only to the big high-street banks, but also to the impact of ‘new’ banks,
such as Handelsbanken (consistently voted the best consumer service bank in the UK)
and upstart Metro Bank. If small businesses are looking for ‘alternative’ sources of
finance they are still more likely to approach these “new banks”, or specialist asset
finance businesses that already exist.

Secondly, while they are often pitched as alternatives to banks, these are definitely not
banks we’re dealing with. The likes of Zopa and RateSetter offer better rates of return
than their high-street peers. But there is a reason for this – they are not deposit-taking
institutions. There is no backing by the Financial Services Compensation Scheme (FSCS),
which protects savings in a high street bank up to a level of £85,000 (£75,000 from 2016).
Instead, any money you invest via P2P lenders is theoretically entirely at risk - you could
lose it all. These are online exchanges that allow you to borrow from, or lend money to,
other individuals, but unlike banks, they do not guarantee your money in any way.

So when RateSetter, for instance, advertises a five-year average, pre-tax return of more
than 6% for its savers (as of October 15 2015), it might be attractive, but it’s not risk-free:
as the lender, you will have to shoulder the burden of any losses (‘defaults’) out of this
income. Currently RateSetter and Zopa boast remarkably low default levels – in 2014,
RateSetter was 1.4% while Zopa was 0.6%, but that could rise substantially if there is a
recession and insolvencies shoot up. If defaults soar, you, the saver, could take a hit. Both
Zopa and RateSetter have established well-funded protection schemes financed out of
income, which means that so far no saver has lost money, and these funds would almost
certainly offer substantial respite from any wave of defaults – but you should be aware
that losing money is possible, even if it hasn’t happened as yet.

With those caveats out of the way, I’d like to emphasise that this sector has huge potential.
In America, for example, where they’ve taken a great British financial innovation and

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ran with it, the two big P2P platforms, Lending Club and Prosper, now have several
billion in cumulative deal flows between them. And over here in the UK, the sector is
now regulated by the Financial Conduct Authority (FCA), bringing it firmly into the
mainstream (though note again that this does not imply that your investments are
guaranteed in any way, as it is not covered by the FSCS). And big institutions have
realised that P2P is big news, investing money both via the platforms, and in the
platforms themselves. So who are the big players, and how can you take advantage?

The main types of alternative finance

Alternative finance companies have a few things in common. They are all internet-
based. They tend to be very social, with the crowd playing a major role in setting both
the price (interest rate) for capital, and its supply. In terms of relationships, the provider
(or platform) is just there to facilitate the exchange of capital. In other words, you have
a contractual relationship with each customer or borrower, as well as the platform.
So in theory, if the platform goes bust, your loan to an individual or business need not
necessarily be affected.

There are several areas in the sector to be aware of, and new companies are sprouting up
all the time. By far the biggest opportunity in the sector right now is in the P2P lending
area. This was pioneered by Zopa, but the two other big names now include RateSetter
and Funding Circle, while other new platforms are launching all the time. These firms
provide a route for people with savings to lend that money to individuals or businesses
looking for loans.

For the more adventurous investor, there’s the fast-growing world of online invoice
funding. This is where investors advance money to companies who are owed money via
their invoices. Sample companies include MarketInvoice and Platform Black. We’ll go
into more detail on all of these platforms shortly.

Finally, there’s the world of ‘crowdfunding’. This involves investors buying equity in
young businesses – it’s almost like a private online stock exchange. Big names in this
sector include Crowdcube and Seedrs. We won’t talk much about them in this course
(these are not income investments - companies this small rarely if ever pay dividends),
but those who are interested can learn more in the alternative finance section at
moneyweek.com.

Starting out with P2P

Most savers will probably start with the biggest P2P platforms – Zopa, RateSetter, and
Funding Circle. The following table gives a very simplified summary of the returns on
offer from the largest – just remember that these rates were advertised (on AltFi.com) as
of the middle of October 2015 and are likely to change on a regular basis.

R ATES MONTHLY 1 Y E AR 3 Y E AR 5 Y E AR

ZOPA: 3.8% . 5.0%

FUNDING CIRCLE: 7. 2% (AVER AGE NET RETURN).

R ATESET TER: MONTHLY: 3.0% 3. 4% 5. 3% 6. 2%

Zopa currently boasts the most money lent via its platform (over £1bn), but RateSetter is

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catching up fast (more than £800m), helped in part by its wider range of savings products
(it offers monthly and one-year options as well as the core three and five-year terms).
Both Zopa and RateSetter have expanded their activities, but their basic business model
has been built around providing online platforms that allow savers to lend to borrowers
(via small investments that start at £10 a go) across different risk categories and different
time periods. The platforms take a cut of each transaction.

These are far from being just ‘dumb’ platforms where you are left with all the risk
of batting off borrowers who will never repay you. Both Zopa and RateSetter have
developed remarkably robust credit scoring and analysis systems. In fact, Zopa’s chief
executive, Giles Andrews, has observed in the past that a consulting firm had once
asked him if it could white-label Zopa’s credit system to a major conventional financial
institution.

Whether these credit analysis systems (which focus on looking for customers who won’t
default) will stand the test of a recession is another thing. Zopa, for instance, did see a
noticeable uptick in defaults in the last quarter of 2008 as the last recession kicked in. But
to be fair, this upsurge didn’t even push its default rate past 1%.

Lending to businesses
Funding Circle is perhaps the most revolutionary of the three major platforms, as it
focuses on small or medium-sized enterprises (SMEs). This is intrinsically riskier – most
of its clients are incorporated businesses, which in theory means the directors could
just walk away from their debts. But in practice, Funding Circle goes to remarkable
lengths to incorporate every scrap of data publicly (and privately) available to check
the ‘robustness’ of a business borrower. If that doesn’t do the trick, its frequent use of
personal directors’ guarantees should assist – for example, directors are required to
offer up their homes as a guarantee if necessary. The platform also recommends that you
diversify widely – across at least 100 loans (that might sound a lot, but at £20 a loan it
equates to £2,000).

Even so, it’s hard to believe that Funding Circle could ever hope to match the low level of
defaults enjoyed by its consumer peers – currently its default level is running at around
1.5%, but it’s entirely possible that that loss rate could treble, if not quadruple, during a
severe recession. For example, corporate bond default rates in the US business market
have risen as high as 10% a year in a severe recession.

So what happens if a borrower does default? Funding Circle (unlike Zopa and RateSetter)
does not have a protection fund, but it has expanded its debt recovery service, which
might help in getting some of that money back. Ultimately though, investors could suffer
losses.

Given this higher potential for losses from lending to volatile businesses, it’s little surprise
that Funding Circle tends to quote a higher net (after potential defaults and costs) return
than the consumer lenders, although that will vary based on the length of time you lend
for and the perceived ‘risk’ of the borrower. Lend to a ‘riskier’ business rated a D or E
(as opposed to a top-notch A) for over five years, and your gross return could easily hit
double digits, but clearly you also have a higher risk of default.

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What to watch out for

Given the low levels of defaults, it’s easy to understand why many investors are tempted,
especially compared to other mainstream income options. For example, most new issues
of London Stock Exchange-listed retail corporate bonds rarely boast yields of much more
than 5%-5.5% for a six-year term, whereas RateSetter offers 6.2% (before any potential
defaults) for five years. And P2P investors don’t just have to buy one bond from one
company – they can diversify across hundreds of borrowers. The big platforms also allow
investors to sell loans early via secondary markets.

All the same, before you invest, it’s worth applying the same standards to P2P lending as
you would to a conventional fixed-income security – such as a gilt or a corporate bond.
To do that, we have to look at the concept of ‘spreads’. This is the difference in interest
rates on offer over different periods of time (duration, or ‘term spread’) and different risk
levels (‘risk spread’). All things being equal, the riskier the investment, and the longer the
term, the higher the rate of return. As an investor, you have to ask yourself, is the term or
risk spread wide enough to reward you for future uncertainty?

For example, looking at those rates mentioned above, lending for five years on Zopa
rather than three gives you an extra 1.2% a year. For RateSetter, the ‘spread’ for three to
five years is roughly 1.0%. By contrast, lend to the British government – which has never
defaulted, to date – and the extra yield moving from three to five years is around 0.5%.

So a P2P investor has to consider whether these extra few fractions of a percentage point,
for example, are worth the risk of lending for an extra two years – particularly given that
default rates could soar in any future recession (so the longer you hold a loan, the riskier
it is). To get an idea of how high defaults could go, consider that US data, from credit
rating agency Standard & Poor’s and credit-rating firm Experian, suggests that defaults
across all consumer loans (including mortgages) stand at below 1% a year just now. But in
the middle of the recession, in spring 2009, that rose to 5.5%. So a severe recession could
hit P2P lenders hard. Savers should also consider the consequences of a general rise in
interest rates – there would be better returns on offer from banks, while rising rates
would put pressure on all borrowers.

But on balance, I would definitely recommend the major P2P platforms. I’m particularly
keen on the shorter-term loans – around one to three years. That’s because I don’t expect
a severe recession during that time period, so at current yields you are probably being
amply rewarded for taking on default risk.

For the more adventurous

If you’re a wealthier investor, with more of an appetite for risk, you might want to
investigate the smaller, more exotic platforms. As the bigger P2P platforms have become
more popular, some of the more experienced P2P investors have moved beyond the most
liquid exchanges towards their smaller, auction-based rivals, which can sometimes throw
up real opportunities.

ThinCats is perhaps the biggest rival to Funding Circle. It has a very different model:
borrowers partner up with existing specialist finance brokers to ‘list’ their loan
requirements to a syndicate of investors. I think you could get a net return of at least 7%
(after defaults and charges) for a five-year term on this fast-growing platform. You might

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manage even higher returns from smaller rivals, such as FundingKnight and Rebuilding
Society. You can read more about these platforms below.

Others have moved out of P2P lending altogether, and are instead lending to smaller
businesses against their flow of invoices. Essentially, you are helping small companies
to manage their cash flow. Platform Black (www.platformblack.com) boasts many
experienced high net-worth investors, and it’s growing fast, with more than £100m
loaned to date, while rival MarketInvoice (www.marketinvoice.com) – which is also only
open to institutional money, or ‘sophisticated’ private investors with upwards of £50,000
to invest (although there are suggestions that it is set to expand with a ‘retail’ offering) –
has a far bigger footprint of deals, with more than £530m in total business to date.

Annualised rates of return on these platforms – where you lend against SME invoices
to big clients with typical duration of 30 to 60 days – can come in at double-digit levels.
Duration risk is low (these are short-term invoices) and default levels are too (for now),
but you will have to analyse carefully the risks involved in each deal. If you are eligible
and looking to lend, do remember that this should be part of a diversified portfolio, not a
‘bet the house’ shot.

The major P2P platforms

Getting started in the world of P2P lending is relatively simple. The first thing you need
to do as an investor is create an account with the specific site that you want to lend with.
While there may be a few restrictions, the main requirements are that you are over 18
and in possession of a British bank account. Once this is completed you simply put money
into your account, and you can start lending.

Zopa (www.zopa.com): the first, and still by far the biggest, consumer-focused P2P
lending platform.

RateSetter (www.ratesetter.com): a challenger to Zopa in the P2P consumer sector, with

a fast-growing book of business loans, and a wider range of products, including monthly
and one-year terms for savers. It also introduced the first protection fund, which was
then copied by Zopa.

Funding Circle (www.fundingcircle.com): another very successful P2P platform, but

this time focused on lending to SMEs. Over the last couple of years it has grown rapidly,
helped by government support. Rates are higher because lending to SMEs is riskier. The
SMEs, which come from a wide range of industries and in a range of sizes (and include
sole traders and partnerships as well as limited firms), indicate the amount of money that
they need, the interest rate they are willing to offer and the duration. Extra information,
such as the firm’s credit rating and the loan’s purposes, is also displayed. You are then
given a set amount of time to bid for parts of the loan.

If you have limited time for research, you can choose an autobid function, which allows
you to select the interest rate that you are seeking. The computer then seeks out loans
with those rates and spreads your investment out over them. Another interesting feature
is the ability to buy and sell loans that are already in progress on a secondary market.

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Tips for the major P2P platforms

Diversify: have a good spread of individual investments and look at diversifying between
platforms and even sectors ie, have some business and some consumer loans. For
platforms such as Zopa, you should aim to have a portfolio of anything between 25 and
200 loans (we’re talking £250 to £2,000 here). Invest slowly and aim never to put more
than 1% or 2% of your capital in one loan.

Keep reinvesting: remember the headline interest rate – say 8% – is only what you get on
the outstanding amount, but that number falls with each repayment. To get your 8%, you
need to re-invest your money as it is repaid.

Risk: investing in riskier loans can make sense if the economy is strong and defaults
low. But as one active investor I spoke to put it, “If losing £20 worries you, don’t invest
anything”.

Platforms for adventurous investors

ThinCats (www.thincats.com): focused on wealthier investors, with an auction-based
platform. The site aims to broker relatively large business loans – between £50,000 and
£3m – over periods of six months to five years, and borrowers have to provide security.
The minimum investment is £1,000. Net returns of between 7% and 10% a year are
possible, but clearly it’s risky.

FundingKnight (www.fundingknight.com): another rival to Funding Circle, offering

loans to small businesses, with around £25m loaned out so far. It’s very much aimed at
the man in the street – you can invest from as little as £25. Prospective investors bid in an
online auction to participate in a loan – there’s plenty of information about the borrowers
on the website, so investors can decide which look the safest. Those bidders offering the
lowest interest rates win a stake in the loan. Rates for lenders are typically between 9%
and 12%.

RebuildingSociety (www.rebuildingsociety.com): maverick lender to SMEs, with very

strong ideas around being as social as possible with its savers. Suggests that returns could
be into high single, or low double digits.

Relendex (www.relendex.com): this platform allows experienced investors to back

commercial property projects. with investment starting from £500. This niche has huge
potential, but it’s still very early in terms of deal flow. Secure assets with a range of
returns between 6.5% and 10% per year.

So that’s our first look at the world of alternative finance. It’s exciting, I’m sure you’ll
agree.

Tomorrow, we’re going to be looking at the techniques you can use to actually make
money from all of this. So keep an eye out for our next email!

Until tomorrow,

David C Stevenson