In a more innocent time, “peer-to-peer” lenders let investors earn a return by lending out their money and exposing themselves to risk. But on Tuesday, one of the UK’s largest such lenders told investors it would protect them from losses by paying out on a bad loan directly from its own coffers.

At first sight, the move by Ratesetter, which is backed by fund manager Neil Woodford, looks like generosity. But it also helps the eight-year-old lender avoid a serious reputational hit.

As we’ve written before, Ratesetter has probably the most complicated business model of the three big P2P lenders in the UK — something that might explain the fact it’s the only one of the three not yet fully authorised by Financial Conduct Authority.

While Funding Circle (and Zopa, for the most part) allow the losses from loans to fall onto lenders, Ratesetter has built a loss reserve to protect investors from bad debts. This “Provision Fund” is funded by taking a fee when a loan is extended and, in times of stress, can be topped up by diverting interest payments and capital away from investors. This means lenders on Ratesetter need to pay attention to the risk in the overall loan book, rather than any individual borrower.

At the moment, the Provision Fund has a 119 per cent coverage ratio, so there is enough money in the fund — if you include expected future fees — to cover losses 1.19 times higher than currently expected. Ratesetter’s target ratio is 125 per cent to 150 per cent.

On Tuesday, co-founder and chief operating officer Peter Behrens wrote to investors detailing three occasions when Ratesetter had intervened directly with borrowers, including one recent occasion when it took on £12m of bad debts instead of letting it hit the Provision Fund:

Adpod Limited, an advertising company: In 2015, Vehicle Trading Group used £12m of wholesale lending from RateSetter to lend to Adpod Limited. Adpod was poorly managed and got into financial difficulty. As lending this amount to a single business was outside RateSetter’s credit policy and was an exceptional case, we believed it was right for RateSetter as a company to intervene and absorb any losses from this loan, as opposed to the Provision Fund doing so. RateSetter is doing this by standing behind Adpod’s monthly loan repayments until the money is fully repaid. The amount outstanding is now £8.5m. Adpod is now fully owned by RateSetter.

There’s something very 2017 about the disclosure that “Adpod is now fully owned by RateSetter”. In this year, of all years, it’s totally normal that a finance business chaired by Prudential chairman Paul Manduca now owns a company that ran digital advertising screens in golf clubs and Toni & Guy hair salons.

According to a Ratesetter spokesperson, it “agreed with AdPod’s directors to take the company over, to better manage [the] exposure.” They also said AdPod is the business referenced in its annual accounts as the recipient of a £2m loan intended to fund its working capital

The important thing here is that the Provision Fund currently has £12.9m in cash and £8.9m of expected future income, versus £18.2m of expected losses. If Ratesetter had let £12m of bad debts suddenly wash into the fund, it would have resulted in a big knock to its coverage ratio. We don’t know what that would do to investor confidence, but it’s fair to say it wouldn’t have helped.

Vehicle Trading Group itself is another occasion Ratesetter intervened:

Vehicle Trading Group Limited, a motor finance holding company: this company went into administration because it had taken on too much debt. RateSetter bought the two operating subsidiaries in order to best protect our lenders’ interests. They are Vehicle Credit Limited (which makes loans to consumers to buy cars) and Vehicle Stocking Limited (which makes loans to motor dealerships to buy cars). We intend to expand our motor finance lending capabilities by integrating the two businesses into RateSetter product lines, with lenders matched directly to the end borrowers. The businesses are repaying their existing wholesale loans of £24m (VCL) and £12m (VSL) as their end borrowers repay in line with the loan schedules. The loans are secured on the underlying loan portfolios of these two businesses which total £31m. These portfolios are expected to generate sufficient interest throughout their lifetime to repay these wholesale loans in full.

Much of it is straightforward: Ratesetter was lending to a car financing business, which became over-indebted and went bust with £36.7m outstanding to Ratesetter. Now the lender hopes to get the money back by running off the underlying portfolios. The slightly weird thing here is that Vehicle Trading Group was a 50 per cent shareholder in Adpod and, obviously, loans to advertising businesses doesn’t really seem like the day-to-day business of a motor finance company.

The third occasion is this:

George Banco Limited, a consumer guarantor loan specialist: RateSetter obtained a minority equity share of this business, with the intention of changing the wholesale lending arrangement into one where RateSetter investors would lend directly to George Banco borrowers. However, after further examination, we concluded that we would not continue with this strategy. RateSetter will remain a supportive but passive shareholder in the business. George Banco is repaying its existing loans of £32m as its end borrowers repay in line with the loan schedules.

The announcement about the George Banco investment came on May 2. The change of heart was just a few weeks later, which raises some questions about why the investment was made in the first place.

Underlying all of this is the FCA’s ban on P2P wholesale lending, which is loaning money to other lending businesses, and its efforts to force lenders in the space to tell investors when losses occur. The regulator’s decision to stop wholesale lending by P2P lenders contributed to the demise of Vehicle Trading Group, according to the administrator’s report, as it forced Ratesetter to turn off the tap. And Ratesetter’s email to investors laying out these events should be read in the context of the FCA’s criticism in December 2016 that some, unnamed, P2P lenders were not being upfront about losses. From the FT report at the time:

“Peer-to-peer” lenders have at times masked the true performance of their loans from investors, the British market watchdog said on Friday as it signalled plans to impose tougher rules on the sector.

The Financial Conduct Authority said firms had occasionally acted in a “non-transparent manner” by using their own money to make payments on the debt without telling investors the borrower was in arrears.

“There’s been a few firms where they’ve done something in addition to what’s been promised. They’ve intervened directly in the market to avoid losses crystallising,” said Jason Pope, a technical specialist at the FCA.

You can see this push for greater transparency in other businesses too. Lendy, which does property development loans, was recently forced to end its practice of covering all interest payments for the first 90 days after default, which meant investors did not previously feel the pain of missed payments immediately.

In the email sent to RateSetter investors, Behrens said all three interventions “stem from RateSetter’s wholesale lending which we discontinued in December 2016” and added “we do not intend to intervene like this again,” which will hopefully re-assure equity holders in the lender, who probably didn’t expect to find this sort of intervention in an asset-light, platform business model.

Related links:
Peer-to-peer may have changed banking, but banking still won — FT Alphaville
Wake me up when online lenders are done turning into banks — FT Alphaville
P2P lending rediscovers balance sheet magic — FT Alphaville
Re-setting Ratesetter’s provision fund — FT Alphaville
Re-setting Ratesetter’s default ratings — FT Alphaville
Ratesetter’s provision fund “is going to be pushed to the limit” – FT Alphaville
Peer-to-peer maturity transformation – FT Alphaville
The curious state of UK “peer-to-peer” lending – FT Alphaville
It’s lenders all the way down – FT Alphaville
Lifting the bonnet on an online lending business – FT Alphaville
An end to the nascent P2P wholesale lending market — FT Alphaville

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