Analysis of Fund Structures for Marketplace Lending

SoFi and Realty Shares have setup captive funds to fund their origination. Independent funds have deployed capital in marketplace lending since 2008 or so. What are the pros and cons of captive vs independent funds and how are they structured ?

4 reasons to use a fund vehicle in marketplace lending

There are a few ways to get exposure to marketplace lending.

With capital starting around $500 one can buy notes on a handful of platforms directly or via managed accounts like Lending Robot. With capital around $50,000, one can buy whole loans on a larger number of platforms. With amounts of around $250k, one can invest in funds that will themselves buy whole loans. With amounts even higher, perhaps $10 million or higher, one can cut custom deals, bonds, warehouse lines, notes or equity deals with all platforms.

Among all of these methods funds stand out for 4 reasons:

1. Investing in a fund requires less work than actively managing your own investments as people are being paid to run them.
2. They offer the most liquidity as funds can put in place first-in-first-out (FIFO) structures to allow new investments to purchase the assets of investors who want to redeem.
3. All the due diligence has already been done on the whole loans within the fund, so the legwork needs to be done only once, on the fund itself.
4. The returns are generally better than those tied to whole loans because of the fund manager’s added value.

General fund structure

In a fund, a general partner is in control of the investments within the rules it itself set up for the fund.

A limited partner invests liquid assets in the fund, money which can only be used per the rules set up above. The legal entity the limited partner invests in is usually called a feeder.

A typical fund will also retain 3^rd parties like administrators, independent directors, auditors, custodians, prime and execution brokers for specific services.

Net Asset Value (NAV) determines the fund’s price per share based on the total value of assets in the fund minus any liabilities. The NAV fluctuates according to fund returns and, for some, according to offer and demand in their shares.

Funds can choose to have multiple raises (closings) or single raises. By having multiple investor  batches ones makes the fund accounting and administration much harder but also makes the capital raising much easier.

Here is a more general discussion of fund structures which applies to all industries.

There are generally two types of investments the limited partners can make:

1. They can purchase notes into the fund. These notes can have a fixed or variable interest.
2. They can purchase equity (shares) in the fund.

Fixed vs variable notes in feeder structures

In the case of alternative lending funds notes operate much like a loan. The investor in the fund will receive regular payments, which could be a fixed interest or calculated as being a variable depending on the fund’s return. For example, the fund can sell 7% notes for 5 years. If the fund then purchases whole loans who’s yield turns out to be 8%, then the fund managers, once the fund closes, retain the difference for themselves (in addition to the other fees the fund is charging to the limited partners if any).

Another note structure is to pay the limited partners a return equal to the fund’s yield minus 1% for example. This way if the fund yields a return of 7.5% the investor will receive a 6.5% (minus fees once again) vs the 7% in the structure above.

The fixed interest case is fairly risky for the manager in case the fund returns are below the promised return. They are also risky for the investor because if the yield is below the promised return it may end up in a murky mess until all is sorted out. However, it has major international tax advantages and the benefit of being predictable. The fixed interest also incentivizes the fund manager to take a lot of risks as his outcomes are relatively binary: he keeps everything above a threshold or hardly anything below it.

The variable interest structure has the advantage of aligning the interests of the manager and the limited partner. However, it makes it hard to predict the exact returns. Usually, a few years of the manager’s track records and industry data can address that. On the other side, it also makes the calculations of the returns an important and, sometimes difficult, process. And particularly if the fund allows for redemptions.

Equity in feeder structures

The most popular option is for the fund to sell equity instead of notes. Equity allows the fund manager to structure the returns in a much more flexible way. For example, it can return all profits up to some waterfall target. Then he can split the returns, for example, 10-90, up to another milestone. Then, he can split the returns 50-50, etc. It also allows the fund to operate under the securities laws from a regulatory point of view, laws which are very well known and very familiar. And last but not least it allows the application of corporate law in the interaction between the manager and the limited partners, a law which is fairly familiar to most people while being flexible enough for nearly everything.

The other aspects of funds in the marketplace lending industry are lock-in period, investment universe, leverage, and returns.

Alignment of interest between manager, investor, and platform

All participants have to wonder if there is an alignment of interest between the fund’s manager, investors, and the marketplace platforms.

As a platform executive, you need to worry about both the capital supply and the borrowers supply. Platforms seek certainty in their capital supply. Platforms, for example, will lend in instruments for up to 5 years. In that case, the platform needs capital that is locked-in for the same 5-year duration.

Platforms also have a good estimate of the amount of capital they will loan in each quarter. Therefore, ideally, each platform would like for each vintage to have access to exactly the amount of capital needed to fund the vintage with the same tenor as the vintage.

Platforms have 2 options: either build their own funds they control, so-called captive funds, or to compete in the capital markets to attract investments.

Captive funds vs independent funds

Captive funds will have in their rules that they can only invest in 1 platform. And on the contrary, independent funds will typically re-evaluate which platform they invest in periodically. This re-evaluation can be scheduled or can happen each time the fund has new capital to invest or as the capital is returned in principal and interest payments. Independent funds will sometimes add new platforms and sometimes stop investing in some as Blue Elephant did with Prosper at times.

Generally, marketplace lending platforms offer in-house funds as they can rely on deals that have been vetted by their in-house team of underwriting already. Examples of platforms with in-house funds include LendInvest Capital, SoFi, RealtyShares, DirectMoney, and LendingClub LC Advisors.

SoFi specializes in student loans. But they’ve discovered that some investors don’t want to invest in whole loans. To meet a growing need in the marketplace, they’ve introduced a hedge fund to allow those investors to spread their risk around.

SoFi has hired a trustee with a banking background to manage the fund and to ensure no conflicts of interest arise, which could compromise the success of the fund in the same way that the recent forced resignation of LendingClub’s CEO Renaud LaPlanche has. If consumers can’t trust the platform, that will place major stress on the marketplace leading to fewer investors and higher fees.

Independent funds want the best possible return on capital and they want to have visibility and control of the platform’s behavior. Examples include Blue Elephant Capital Management, Prime Meridian Capital Management, and Nexlend Capital Partners.

Conflict of interest or skin in the game?

Investors often claim that marketplace lenders do not have skin in the game because once they sell their loans they will not be hurt if the yield turns out to be worse than expected. This is not true because you can fool 1 person once, but in today’s internet age you will not be able to fool even a 2^nd person once.

Investors are also often concerned that captive funds will continue buying the loans from the underlying platform no matter their quality. This is a more valid concern if the funds are locked in for 5 years. In this case, even if the platform yield is extremely bad there isn’t much the investor can do. And yes, the platform is doomed at the end of the 5 years lock-in period, but the last thing a fixed income investor wants is a loss of principal.

Lock-in period pros and cons

Captive funds usually get into long-term agreements with a single platform, usually losing freedom in exchange of privileged financial, inventory and other terms.  Captive funds usually require less effort from the fund managers. They usually have lower fees, typically management fees around 0.65% to 0.75% and no incentive fee. They usually are locked in for the same tenor as the underlying loans which avoids any need for net asset value calculations for redeeming. They, therefore, save a lot of auditor and administrator fees.

Independent funds tend to have only 1-year lock-in period. They tend to require much more active management with teams of 10 to 20 people at times. Their numerous teams have to build their own in-house technology, run the day to day of a company and continually scrutinize the platforms while optimizing their investment strategy continuously. Their fees tend to be much higher, usually 2% management fee and 20% incentive fee. Some of them allow investors to redeem even quarterly which leads to better investor liquidity. And as they permanently re-evaluate their investment decisions they keep the origination platforms on their toes.

And what about the returns in all this?

We do not have enough data to compare the returns of captive vs independent funds in detail. Some general rules do appear: independent funds need to justify their high fees and therefore strive for much higher returns. Despite risks, some of them have leveraged funds. The author has studied some documents of US funds which claim to achieve returns as high as 15% per annum when the underlying note yield is only in the 7% range.

On the other side, the captive fund’s returns are directly correlated with the platform’s returns.

Conclusion

Capital markets function the same way as manufacturing or any other industry. The pros and cons of a 5-year contract vs a yearly contract are the same.

The difference between a captive fund and an independent fund is similar to a manufacturer controlling its distributor or not.

As an investor, perhaps the question you want to ask yourself is: would you rather be married in a 5-year contract you cannot break or would you rather be dating and re-evaluate your relationship any time you wish?

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