Against the backdrop of more than $14 trillion in negative-yielding debt around the world, declining interest rates in the U.S. and clients' desire to generate income from assets beyond stocks and bonds, some advisors may be having more conversations about private lending.
A straightforward definition of private lending is an individual or organization loaning money to another person that is having difficulty getting capital from a bank. In most instances, these loans are made for business purposes, such as medical, real estate, restaurants and startups, and are made higher rates than a bank would charge. Typically, private lenders do not loan money to an individual that is looking to, say, consolidate consumer debt or invest in stocks, because there is no underlying asset or business in such loans.
For advisors with clients with sufficient net worths and robust liquidity, private lending is a conversation worth having, particularly for income-hungry clients and those familiar with real estate.
“For those with ample net worth, becoming private lenders to real estate developers and builders, and other businesses, can make for big payouts, the ability to negotiate favorable terms, meet interesting people and associates, and increase cash flow,” according to U.S. News and World Report .
Private lending is just like any other asset class where the investor expects an above-average rate of return: there are risks. Obviously, private lenders face the same primary risk that traditional banks do, that being risk of default.
No one loans money based on handshakes. Clients interested in “being the bank” must have the right legal team and have all their documents in order. Even when taking the necessary legal steps to protect themselves, lenders still face some risk.
Look at the risk of default this way. Banks that issue credit cards give cardholders an agreement and one of the cornerstones of those agreements is that the user agrees to repay the borrowed sum of money. Legally speaking, the cardholder agreement is a contract and enforceable as such. Yet, card issuers are always writing off bad loans. In fact, in the fourth quarter of 2018, some of the major credit card issuers reported increases in charge offs .
This simply translates to the world of private lending and how advisors talk to clients about the subject. When loaning money to another party, there is a real risk that some or all of loan amount will not be repaid, meaning aspiring private lenders should have strong stomachs and enough capital invested elsewhere to sustain loan losses.
With clients, advisors can explore alternatives to direct lending, such as funds or investing in loan companies. A private lending fund will pool investors' capital, similar to a mutual or private equity fund, across multiple projects, thereby mitigating risk and taking investors' off the front lines.
In this case, the risk of default remains, but it decreases and investors do not have to go through the hassle of working with lawyers, running background checks on borrowers and performing their own due diligence on projects.
Another idea, one made possible due to evolving technology with lenders such as LendingClub. Indeed, LendingClub is a public company. It trades on the New York Stock Exchange under the ticker “LC,” so to be clear, we are NOT talking about investing in LC stock here.
Rather, LendingClub allows individual investors, even those with modest amounts of capital, to purchases notes backed by consumer loans. The company even frames this asset class as a “fixed-income alternative, with historical returns of 4–7% per year.”
LendingClub's platform is potentially compelling for investors looking for that fixed income replacement with the benefits of automated investing. The company offers a “platform mix,” which is basically a portfolio of loans graded in similar fashion to corporate bonds with varying grades. Or investors can do it themselves and build their own portfolios.
Lending Club offers 25 grades, ranging from A1 to D5. Borrowers that get loans in the “A” category typically have excellent credit and thus pay lower interest rates. As the scale moves toward “D,” borrowers' rates increase.
As would be the case in the corporate bond space, investors can expect lower risk and lower returns with high-grade LendingClub loans and more risk, but potentially higher returns in the “C” and “D” loans.
Prosper, a peer-to-peer lender, offers a model similar to LendingClubs. Prosper has seven different risk categories, AA at the high end to HR, or “high risk” at the low end. AA Propser loans would return about 5% to investors while the company's riskiest borrowers could generate returns of almost 12% for investors.
StreetShares and FundingCircle allow investors to tap small business loans as the underlying asset, but StreetShares may be more approachable for many investors because it doesn't feature the $250,000 minimum investment required by FundingCircle.Related: Trade Tensions Are Back: Here’s How to Deal with It