In the first wave of peer-to-peer lending call it P-to-P version 1.0 the demand from investors easily outpaced the available supply of consumer borrowers.
Some U.S. households used the loans to refinance existing debt, but investors craved even more opportunities to earn the attractive returns associated with those online personal loans.
Today that imbalance between supply and demand is helping to fuel the rapid spread of peer-to-peer lending into other classes of debt. And the industry's biggest new frontier is small business lending.
"Small business lending is ripe for disruption. It's the perfect asset for peer-to-peer, and I think we're going to see a lot of growth over the next 24 months," predicts Ethan Senturia, chief executive officer of Dealstruck, an upstart peer-to-peer lender. "There's a lot of capital that needs to get to work."
The P-to-P industry's boosters argue that new loan platforms are going to permanently change how U.S. small businesses get financing. But the sector's breakneck growth is also drawing warnings from skeptics who note that the P-to-P industry brings unique risks and carries a slim track record.
"P2P lending is evolving, and it's still too early to know what the industry will look like in its more mature state," warn Standard & Poor's analysts in a recent research note, which lays out a series of reasons why the firm is refusing to rate peer-to-peer securitizations, including those composed of both consumer loans and small business loans.
"Some of these issues are P-to-P companies' lack of performance histories through full economic cycles, uncertainty about their long-term commitment to the business, and their financial stability, operational risks, servicing quality and loan credit performance in a downturn."
The peer-to-peer loan industry began as a way to match up individual borrowers with individual investors. But today the P-to-P moniker is a bit of a misnomer, because so many of the industry's loans are being funded by institutional investors, rather than individuals.
Funding Circle, a U.K.-based company that now has around 50 U.S. employees, calls itself an "online loan marketplace" for small businesses. Its U.S. loans are funded by institutions and accredited investors.
The company, which has U.S. offices in San Francisco, is targeting small businesses that are unable to qualify for bank loans and are looking for an alternative to higher-cost sources of credit, such as merchant cash advance providers.
Funding Circle's average small business loan is $150,000. The company charges annual interest rates between 9.9% and 17.5%, in addition to a 3% origination fee.
"There is this perception of a bank loan availability that just isn't there," says Alex Tonelli, managing director of Funding Circle USA. "We are looking to be what a bank should be to those customers."
Funding Circle made its first U.S. small business loans last year. This year the company expects to lend out $600 million globally, including $100 million in the United States. Funding Circle announced this week that it will move deeper into the risk pool with a new tier that will allow it to approve 25% more of its applicants.
"There's been a lot of capital raised in our industry," Tonelli says. "I expect more of the floodgates to open. So the flood of capital is coming. And how people are able to drink from the fire hose, so to speak, in a productive way, is going to be an interesting development."
Funding Circle has global ambitions, and it's not shy about sharing them. "We're transforming the financial system," Tonelli says.
Such boasts are common these days inside the P-to-P loan industry.
Speaking on a panel at an industry conference in San Francisco this week, Gary Chodes, chief executive officer of Raiseworks, a New York-based P-to-P lending platform, described the total market opportunity in P-to-P small business lending as being around $370 billion per year.
San Francisco-based Lending Club, one of the industry's leading platforms, announced in March that it is expanding into small business loans. And at this week's industry conference, Tom Green, vice president of new business initiatives at Lending Club, predicted that peer-to-peer lending will be the "predominant model" for small business loans in the future.
Gilad Golan, the CEO of LendingRobot, a Seattle company that allows P-to-P lenders to automate much of the investment process, predicts that peer-to-peer lending will continue to displace bank loans. "There's nothing to slow it down," Golan says. "Traditional banks will have a hard time competing."
Some banks are choosing to team up with P-to-P lenders. Just this week, Lending Club announced a new partnership with Union Bank. Under the deal, Union Bank will buy personal loans from the peer-to-peer platform, and the two firms will work together to create credit products for their customers.
Carlsbad, Calif.-based Dealstruck wants to become a kind of farm system for banks. Chief executive officer Senturia says he'd eventually like to see Dealstruck's small-business borrowers graduate into more affordable bank loans.
"There's a number of companies that are significantly overpaying for credit," he says, "but they can't make the jump from a 50% product to an 8% product. They need something in between."
Dealstruck's online platform facilitated its first small business loans in October. The company's two-year term loans average around $100,000 in size; they carry annual interest rates from around 10% to near 30%, plus an origination fee that's usually 3%-4% of the loan amount.
Senturia argues that the peer-to-peer structure gives companies like Dealstruck a structural advantage over traditional balance-sheet lenders.
"You're going to have investors that want prime credit at 8% or 10%, and investors that want nearer to subprime credit," he says. "And the ability to have a flexible capital structure is the power of P-to-P. You don't have that power when you are just yourself lending."
Still, there are questions about the durability of the P-to-P lending model, as well as its usefulness in the small-business loan market.
William "Denny" Dennis, a senior research fellow at the National Federation of Independent Business, a small-business trade group, questions whether P-to-P investors are likely to stick around for the long term.
"I have at least one part of me that's a little skeptical," he says. "I think there might be an initial surge of people that are not totally understanding what this is all about."
P-to-P lending relies on streamlined, heavily automated underwriting, and that's harder to accomplish with small business loans than it is with consumer loans, due to the fact that small businesses do not maintain data on their finances in a standard fashion.
Securitization offers a way to lower the P-to-P loan industry's cost of capital. Lending Club's investors and others have successfully securitized loans. But at least for now, Standard & Poor's, which has endured sharp criticism for its ratings of subprime mortgage securities prior to the financial crisis, is refusing to issue ratings on P-to-P deals.
"I would say that we're taking a cautious approach," says Michael Binz, managing director for asset-based securities and residential mortgage-backed securities at S&P Ratings. "Certainly this is a fairly untested market, a very fragmented market, one that we're just in the early stages of learning more about."
S&P points out that in many cases, the P-to-P lending platforms don't own a piece of the loans they're facilitating.
"You have that one loan, and then you may have several investors who are funding that loan," says Ildiko Szilank, an S&P credit analyst. "So the fundamental risk is also fragmented."
The recent S&P report on P-to-P lending points out that the peer-to-peer market has not weathered an entire economic cycle. It raises questions about what would happen to the P-to-P platforms during a downturn.
"Generating attractive fees based on new loan originations places an incentive for these companies to open their services to a wider base of borrowers," the report states. "Managing delinquent or defaulting loans in times of economic stress often requires more intensive effort and resources versus doing so in a benign business and economic cycle."
Corrected May 14, 2014 at 8:26AM: An earlier version of this story said Lending Club had securitized loans. It was corrected to say the company's investors have done the securitizations.