Morgan Stanley
  • Investment Management
  • Oct 19, 2018

Investing in the Fintech-Enabled Lending Boom

Born out of peer-to-peer lending, online alternative lending has gone mainstream, presenting new opportunities for small businesses, consumers and investors.

Over the past decade, fintech innovations spearheaded by alternative-lending platforms have disintermediated traditional lenders, significantly shifting the landscape for consumer and small-business loans. 

Millennials grew up with technology and are comfortable managing their finances on smartphones.

Where once a loan was a slow-moving manual review of credit criteria, alternative-lending platforms use “Big Data” to automate most of the underwriting process and provide rapid credit decisions via a smartphone app or website for everything from a $10,000 credit card refinancing to a $100,000 loan to expand a small business.

For fixed-income investors, the convergence of technology and finance on these platforms has opened opportunities in a new asset class: alternative lending.

The Evolution of Alternative Lending

What began as “peer-to-peer” marketplaces bringing together borrowers and lenders has evolved considerably in recent years. Alternative-lending platforms now span many categories, including unsecured consumer, small-business and other forms of specialty financing.

Most loans underwritten by alternative lending platforms are now funded by institutional investors,1 and the largest platforms are disrupting the classic neighborhood-bank-lending model by playing to the strengths of fintech: low operating costs, user-friendly websites or mobile apps and innovative underwriting models that harness Big Data and better reflect the realities of today’s mobile-first consumers.2

“Millennials represent the largest generation in American history. They grew up with technology and are comfortable managing their finances on their smartphones rather than through a traditional bank,"3 says Ken Michlitsch, Morgan Stanley Investment Management's lead portfolio manager for its AIP Alternative Lending Group.  Similar dynamics are playing out among true small businesses, where faster loan processing speeds and innovative credit models are helping win business for alternative lenders.

“Banks tend to have higher cost structures and regulatory capital pressures that can sometimes limit their ability to serve the needs and expectations of borrowers today," Michlitsch adds. “For these and other reasons, alternative lending represents a secular shift in the way consumers and small businesses seek to efficiently access capital."

An Emerging Asset Class

While alternative lending is currently gaining traction among borrowers, it's also becoming a formidable asset class in its own right, with the U.S. market now accounting for an estimated $50 billion of annual origination.4

As investors grapple with the portfolio implications of a rising interest-rate environment alongside a continuing search for yield, alternative loans may offer attractive absolute and risk-adjusted return characteristics. Such loans tend to have less duration risk and interest-rate sensitivity, compared to longer duration traditional fixed-income securities; they also have lower correlation to other assets, including traditional fixed income and equities.

Low unemployment rates, rising real wages and declining consumer debt as a percentage of gross domestic product are also part of the appeal of the differentiated, consumer-oriented fixed-income exposure that alternative lending can provide. This is especially true in light of expanding corporate balance sheets and relatively thin corporate credit spreads.

Credit Cycle Might Be Late Stage, but the U.S. Economic
Backdrop Currently Appears Supportive of the Consumer

Source: Federal Reserve, https://www.federalreserve.gov/releases/housedebt/ and Bureau of Labor Statistics, https://data.bls.gov/timeseries/LNS14000000, as of December 31, 2017. *See footnotes for additional disclosures.

A Portfolio Approach

As alternative lending comes to the fore, it offers investors an opportunity to fine-tune their strategies—i.e., yield, credit risk and duration—just as they do with traditional fixed-income asset categories.

Even so, successful outcomes require expertise in fixed-income investing, insight into macroeconomic trends, as well as operational knowledge to analyze the strengths and weaknesses of diverse lending marketplaces.

Rather than invest in single loans on standalone platforms—as is the case for individuals investing directly via a peer-to-peer platform—certain investors now have access to alternative-lending funds, such as Morgan Stanley Investment Management’s AIP Alternative Lending Fund.

Instead of investing in the companies that manage the platforms as a primary strategy, these funds offer investors diversified exposure to loans underwritten across multiple alternative-lending platforms, loan types and geographies. In many cases, investors can gain access to segments previously available only to banks and credit-card companies.

The AIP Alternative Lending Fund is registered under the Investment Company Act of 1940 as a non-diversified, closed-end management investment company and only available to accredited investors.  An investment in the AIP Alternative Lending Fund should be considered speculative and involving a high degree of risk, including substantial loss of investment. Key risks include credit risk, risk of unsecured loans and platform risk. The fund does not operate as a mutual fund and it is expected that it will offer to repurchase shares quarterly via a tender offer. A broader description of the fund’s investment risks is provided at the end of this article.

Updated Approach to Assessing Risk

The final aspect of alternative-lending funds is the consideration of risk. Alternative-lender underwriting models leverage data and technology to improve underwriting iteratively, while seeking to be more effective at sizing up whether borrowers will make good on their debt.

“Traditional consumer underwriting models rely heavily on credit scores, which are backward-looking and focused on willingness to pay," Michlitsch explains, adding: “When extending credit, you need to understand both willingness and ability to pay.”

To address these issues, managers of alternative-lending funds consider a broad array of data sources on borrower spending habits and personal history to augment traditional credit scores.

The popularity and growth of alternative-lending platforms suggests that fintech-enabled alternative lending is here to stay. Positioning investors at the intersection of technology and finance, alternative lending may provide diversified exposure to a continued shift in the way that consumers and small businesses access capital.

For more information on the AIP Alternative Lending Fund, ask your Morgan Stanley representative or Financial Advisor or visit the Morgan Stanley Investment Management website.  

Plus, more ideas from Morgan Stanley’s thought leaders.

Footnotes

* Past performance is not indicative of future results. For illustrative purposes only. There is no guarantee that the market trend above will continue. The statements above reflect the opinions and views of AIP Alternative Lending Group as of the date hereof and not as of any future date and will not be updated or supplemented. Please reference the glossary below for the definition of household debt service ratio.

1  Source: AIP Alternative Lending Group. Data as March 31, 2018.

2 Source: American Banker, February 8, 2018.

3 Source: American Bankers Association, June 20, 2018.

4 Source: AIP Alternative Lending Group research, based on 2017 volume growth reported by Kroll.

GLOSSARY

Credit Spread: The difference in yield between a US Treasury security and a non-Treasury security.

Duration: Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates.

DISCLAIMERS

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the firm offers.

This general communication, which is not impartial, is for informational and educational purposes only and not a recommendation. Information does not address financial objectives, situation or specific needs of individual investors.

Any charts and graphs provided are for illustrative purposes only. Any performance quoted represents past performance. Past performance does not guarantee future results. All investments involve risks, including the possible loss of principal.

ADDITIONAL RISKS

Loans May Carry Risk and be Speculative. Loans are risky and speculative investments. If a borrower fails to make any payments, the amount of interest payments received by the alternative lending platform will be reduced. Many of the loans in which the alternative lending platform will invest will be unsecured personal loans. However, the alternative lending platform may invest in business and specialty finance, including secured loans. If borrowers do not make timely payments of the interest due on their loans, the yield on the alternative lending platform’s investments will decrease. Uncertainty and negative trends in general economic conditions in the United States and abroad, including significant tightening of credit markets, historically have created a difficult environment for companies in the lending industry. Many factors may have a detrimental impact on the Platforms’ operating performance and the ability of borrowers to pay principal and interest on loans. These factors include general economic conditions, unemployment levels, energy costs and interest rates, as well as events such as natural disasters, acts of war, terrorism and catastrophes.

Prepayment Risk. Borrowers may have the option to prepay all or a portion of the remaining principal amount due under a borrower loan at any time without penalty. In the event of a prepayment of all (or a portion of) the remaining unpaid principal amount of a borrower loan in which alternative lending platform invests, the alternative lending platform will receive such prepayment but further interest will not accrue on such loan (or the prepaid portion, as applicable) after the date of the prepayment. When interest rates fall, the rate of prepayments tends to increase (as does price fluctuation).

Default Risk. Loans have substantial vulnerability to default in payment of interest and/or repayment of principal. In addition, at times the repayment of principal or interest may be delayed. Certain of the loans in which the alternative lending platform may invest have large uncertainties or major risk exposures to adverse conditions, and should be considered to be predominantly speculative. Loan default rates may be significantly affected by economic downturns or general economic conditions beyond the alternative lending platform’s control. Any future downturns in the economy may result in high or increased loan default rates, including with respect to consumer credit card debt. The default history for loans may differ from that of the alternative lending platform’s investments. However, the default history for loans sourced via Platforms is limited, actual defaults may be greater than indicated by historical data and the timing of defaults may vary significantly from historical observations. The Platforms make payments ratably on an investor’s investment only if they receive the borrower’s payments on the corresponding loan. Further, investors may have to pay a Platform an additional servicing fee for any amount recovered on a delinquent loan and/or by the Platform’s third-party collection agencies assigned to collect on the loan.

Credit Risk. Credit risk is the risk that a borrower or an issuer of a debt security or preferred stock, or the counterparty to a derivatives contract, will be unable to make interest, principal, dividend or other payments when due. In general, lower rated securities carry a greater degree of credit risk. If rating agencies lower their ratings of securities in the alternative lending platform’s portfolio or if the credit standing of borrowers of loans in the alternative lending platform’s portfolio decline, the value of those obligations could decline. In addition, the underlying revenue source for a debt security, a preferred stock or a derivatives contract may be insufficient to pay interest, principal, dividends or other required payments in a timely manner. Even if the borrower or issuer does not actually default, adverse changes in the borrower’s or issuer’s financial condition may negatively affect the borrower’s or issuer’s credit ratings or presumed creditworthiness.

Limited Secondary Market and Liquidity of Alternative Lending Securities. Alternative lending securities generally have a maturity between one to seven years. Investors acquiring alternative lending securities directly through Platforms and hoping to recoup their entire principal must generally hold their loans through maturity. There is also currently no active secondary trading market for loans, and there can be no assurance that such a market will develop in the future.

High-Yield Instruments and Unrated Debt Securities Risk. The loans purchased by the alternative lending platform are not rated by an NRSRO. In evaluating the creditworthiness of borrowers, the Adviser relies on the ratings ascribed to such borrowers by the relevant Platform or otherwise determined by the Adviser. The analysis of the creditworthiness of borrowers of loans may be a lot less reliable than for loans originated through more conventional means. The market for high-yield instruments may be smaller and less active than those that are higher rated, which may adversely affect the prices at which the alternative lending platform’s investments can be sold.

DISTRIBUTION

This communication is only intended for and will be only distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s/product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

United Kingdom: Morgan Stanley Investment Management Limited is authorized and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA. Dubai: Morgan Stanley Investment Management Limited (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). Germany: Morgan Stanley Investment Management Limited Niederlassung Deutschland Junghofstrasse 13-15 60311 Frankfurt Deutschland (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Italy: Morgan Stanley Investment Management Limited, Milan Branch (Sede Secondaria di Milano) is a branch of Morgan Stanley Investment Management Limited, a company registered in the U.K., authorised and regulated by the Financial Conduct Authority (FCA), and whose registered office is at 25 Cabot Square, Canary Wharf, London, E14 4QA. Morgan Stanley Investment Management Limited Milan Branch (Sede Secondaria di Milano) with seat in Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy, is registered in Italy with company number and VAT number 08829360968. The Netherlands: Morgan Stanley Investment Management, Rembrandt Tower, 11th Floor

Amstelplein 1 1096HA, Netherlands. Telephone: 31 2-0462-1300. Morgan Stanley Investment Management is a branch office of Morgan Stanley Investment Management Limited. Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: Morgan Stanley & Co. International plc, London, Zurich BranchI Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-115.415.770. Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland, Telephone +41 (0) 44 588 1000. Facsimile: +41 (0) 44 588 1074.

Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

Japan: For professional investors, this document is circulated or distributed for informational purposes only. For those who are not professional investors, this document is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory  agreements (“IAA”).

This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions.

All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.16% per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This document is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

U.S.: A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

Please consider the investment objective, risks, charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the fund. To obtain a prospectus, download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley funds.

NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT IMPORTANT INFORMATION

EMEA: This communication has been issued by Morgan Stanley Investment Management Limited (“MSIM”). Authorised and regulated by the Financial Conduct Authority. Registered in England No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.

The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

MSIM has not authorised financial intermediaries to use and to  distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.

This document may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this document in another language, the English version shall prevail.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent.

Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

All information contained herein is proprietary and is protected under copyright law.

CRC 2270812  (10/2018)

View disclosures

Learn More About Investment Management

Find Out More