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Alternative Finance Platforms
As featured on Investopedia.com
Similarly, the financial services industry is transforming in an attempt to replace banks with platforms that provide better financing terms for those who need capital by connecting them to other people who want to deploy it. Players in this new space, commonly referred to as online alternative finance, try to act as more efficient intermediaries in the supply and demand of capital, leveraging technology to operate online.
According to a recent report, online alternative finance in the U.S. alone generated $36 billion in 2015, up from just $4 billion in 2013. Many of the major early players like Prosper and Kickstarter, launched in 2006 and 2009 respectively, have become household names while pioneering this evolving industry.
But with such huge growth comes a more crowded playing field as more and more platforms emerge. Need help navigating your way through it? Here is a rundown of what you should know about some of the more popular types of online alternative finance platforms. (For related reading, see: 5 Steps to Getting Started in Investing.)
Crowdfunding vs. Marketplace Lending
First, you'll need to understand some basic terminology:
- Crowdfunding includes all funding that is non-debt. This can include donations, reward-based contributions and equity that gives an investor an ownership stake in an enterprise.
- Marketplace lending includes all funding in the form of debt, or a loan. Online platforms can use their own capital to fund the loan (balance sheet marketplace lending) or act as intermediaries between borrowers and investors (P2P marketplace lending).
The 2012 passage of The Jumpstart Our Business Startups (JOBS) Act eased securities regulations to encourage the private funding of U.S. small businesses. The JOBS act made the process of raising capital simpler, cheaper and faster (for some companies), and eventually made this space possible. As the Act continued to evolve, it allowed more investors to participate in capital contribution to private companies. What was historically only accessible to wealthy, accredited investors is slowly becoming available to more and more investors—accredited or not.
Reward based Campaigns
Rewards-based campaigns, used by crowdfunding sites like Kickstarter, allow individuals to support projects they want to see come to fruition by essentially donating funds as working capital for entrepreneurs, startups and even artists. Supporters provide funds at a specified level and, in return, receive a gift or reward. The most successful projects are all-or-nothing campaigns, where the entrepreneur doesn’t receive any money unless the full fundraising goal is met. Note that this is not considered a true investment because you would only receive the product or service associated with your donation level.
The upside to rewards-based campaigns is that you get to put money into a project you believe in, which otherwise might not exist. Fans of Veronica Mars, for example, shelled out close to $6 million to enable the making of a movie version of the cult classic television show. On the other hand, those who raised $2.4 million to fund Oculus Rift in 2012 only received a VR headset, even after Facebook bought the company for $2 billion just 18 months later. With rewards-based crowdfunding, there’s simply no guarantee of a return even if the product is a wild success. (For related reading, see: Where Do Investment Returns Come From?)
Equity crowdfunding platforms like Crowdfunder and AngelList allow investors to acquire actual equity in a company and to act as venture capitalists. Unlike rewards-based crowdfunding, the recipient’s responsibility is to try to create long-term value for his or her investors, which means there should not only be a product, but there must also be a viable business plan and strategy for achieving eventual returns. As is the case when investing in any startup, the risks are high, but there could be potential for higher returns. Many crowdfunding platforms warn investors not to invest more money than they’re willing to lose.
With Title III of the JOBS Act opening up opportunities to non-accredited investors, this market is expected to expand at a rapid pace. In fact, equity crowdfunding platforms alone were estimated to raise $2.5 billion in 2015—nearly the same as the total amount of all types of crowdfunding in 2012.
Real Estate Crowdfunding
With the advent of commercial real estate platforms, more investors now have access to commercial real estate investment opportunities fully online with relatively low minimum investment amounts. Investors can gain entry into multi-million-dollar projects with the potential to receive recurring cash distributions and a gain when the property is sold. They also get to pick and choose which investments make the most sense to them based on the property type, real estate company, location and size. Most platforms give investors the tools to perform their own due diligence, sharing underwriting materials and third-party reports.
Equity-based real estate crowdfunding allows you to participate in real estate projects such as multifamily housing units, retail centers, office buildings, self-storage facilities and warehouses. You decide what percentage of equity you’d like and how you want to diversify your portfolio.
There are many benefits to investing in real estate: it can potentially generate cash flow, provide tax benefits, hedge against inflation and be used as an effective diversification tool. Successful platforms help you reap these benefits by making the investment experience easy. In just a few clicks, investors can browse investments, review research materials and sign documents. After investing, they can track the performance of their investment 24/7 from their computer, phone or tablet. With all this in mind, investors should still understand that real estate investing, like all investments, does carry risks and does not guarantee a return of any sort. (For related reading, see: The Advantages of Automating Your Financial Life.)
Rather than offering investors equity in a company seeking capital, peer-to-peer lending platforms allow investors to essentially serve as lenders and to profit from interest payments. Loan applicants receive a risk/reward rating based on their credit score and other metrics. The higher the risk, the higher the interest rate on the loan. Investors typically either handpick the loans in their portfolio or set automatic parameters that diversify their holdings based how many assets of each risk grade they’d like.
According to Investopedia, “the advantage to the lenders is that the loans generate income in the form of interest, which can often exceed the amount interest that can be earned by traditional means (such as from saving accounts and CDs). Plus, P2P loans give borrowers access to financing that they may not have otherwise gotten approval for by standard financial intermediaries.”
Many platforms, like Prosper, offer a variety of consumer loans that can be used for anything from debt consolidation to home renovations.
Niche sites have also popped up all over the Internet targeting different segments of the lending market. Student loan refinancing platforms are exploding to take advantage of the $1.2 trillion in debt currently held by American students. Similarly, alternative home mortgage and refinance lenders are becoming increasingly popular as the real estate market continues to grow. In fact, SoFi, which started strictly as a student loan refinance company, has grown to include all of these market segments.
One of the advantages to investing with some of these debt-based platforms is that you can get extremely granular with your portfolio diversification. Because each individual loan receives its own risk rating, and often times a description of what the funds will be used for, you can use your own metrics to pick and choose the exact loans that suit your expertise and risk tolerance. (For related reading, see: Student Loan Debt: What Every Borrower Should Know.)
Small Business Loans
The recession caused traditional banks to greatly unwind their lending programs, which restricted access to credit for many small business owners. In fact, small business lending from the ten largest banks decreased 38% between 2006 and 2014. As a result, online lenders have created their own lending standards to compensate for this need in the market. Along with traditional credit-based metrics, many also use more holistic standards such as vendor payments. However, most platforms require that a business has been in existence for at least a year to qualify. This gives investors a better indication of the company’s future trajectory.
The largest player in this space is OnDeck, which went public in 2014, but there are many other private players out there. StreetShares, for example, boasts 5% returns and allows investors to bid against each on funding specific loans. Other platforms fulfill specific business needs rather than simple working capital through traditional loans. Most platforms allow you, as an investor, to receive potential monthly returns on the principal you invested if borrowers meet their obligations.
NerdWallet explained how P2P lending to businesses works: “Third-party investors can invest in the loans on online P2P marketplaces, and they take on the investment risk, not the P2P lenders. As a borrower, you’ll only interact with the P2P lender. After investors agree to fund the loan, the P2P lender will transfer the total loan amount into your bank account. You’ll repay the P2P lender, and they’ll deal with repaying the investors.” (For related reading, see: The Hidden Costs of Hedge Funds.)
Real Estate Loans
Unlike most other P2P loans, your money in a real estate platform is tied directly or indirectly to a physical property, rather than a non-physical asset in a small business or consumer loan portfolio. This can potentially allow investors access to the underlying property in case a loan defaults, which is extremely important. It’s critical to know whether your loan’s lien is in first position or second position because it indicates the order in which you’ll be paid in case the property underperforms or if the loan defaults, leading to a foreclosure.
These types of investments typically deliver distributions on a monthly or quarterly basis, and could be a good source of regular income for investors who believe in the real estate market.
The Bottom Line
Online alternative finance platforms can offer both new and sophisticated investors the opportunity to participate in markets to which they previously had no access. With all the platforms and products available, investors now have more opportunities than ever to find investments that match their risk/return appetite. As all investments carry risks and there is never a guarantee of returns or preservation of capital, make sure to do your homework before you make an investment decision. (For related reading, see: Bundle Up? Not When It Comes to Financial Services.)