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Cash Drag and Marketplace Lending

As institutional investors deploy more capital into marketplace lending, one issue that continues to arise for investors is cash drag. Cash drag refers to the effect of cash holdings potentially reducing the performance of an investment account. It can be computed as the difference between a fund’s investment returns without cash and the total fund returns including cash. Regardless of the asset class, cash drag is a concern for investors who are trying to maximize returns. This post will explore the reasons for cash drag when investing in marketplace lending loans, particularly for Lending Club and Prosper.

 

Cash drag can be caused by:

  1. cash sitting idle in an investor’s account
  2. cash being tied up during the funding process for loans.

 

Idle cash in account

Cash sitting idle in an investor’s account can be caused by:

  • Cash that was recently transferred into an investor’s account that is yet to be deployed.
  • The amount of time that it takes for cash to transfer over into an investor’s marketplace lending account from the investor’s bank account. This process can sometimes take a several days depending on the originator.
  • Principal and interest that has not been reinvested. Payments for Lending Club and Prosper loans are made monthly, and the inability to deploy this capital immediately can cause cash drag.
  • Early repayments. Investors will find that some borrowers may repay their loans ahead of schedule. Unlike other asset classes, which may protect investors from early prepayment, Lending Club and Prosper loans do not offer such protections. While it is possible to create models that predict the likelihood of early repayments, this would likely come at the expense of increasing the likelihood of default. A borrower who is able to prepay his or her loan is simply less likely to default. A balance would need to be struck between minimizing prepayment/cash drag as well as minimizing defaults.
  • Limited loan inventory. The demand for marketplace lending loans has greatly outpaced the supply. Depending on the platform, the type of loans that are in greater demand will vary. For example, on Lending Club and Prosper, higher yielding and lower rated loans are typically in greater demand. Investors willing to alter their strategy can diminish their cash drag, but this may also diminish their opportunity for higher yielding loans.

 

The ability to purchase loans quickly at scale is one of the ways to minimize cash drag in a high-demand environment. Orchard assists investors with minimizing cash drag by being able to quickly deploy large amounts of capital into marketplace lending platforms.

 

Idle cash during funding process

Once an investor decides to invest in a loan, it may take some time for the loan to be fully funded. During this time, the investors’ cash is locked up, which results in cash drag. Delays in the funding of the loan can be caused by:

 

  • A lengthy verification process. It may take some time for all of the borrower’s information to be verified by the online originator.
  • Withdrawals. Borrowers may decide to withdraw their application for whatever reason before the loan is fully funded. They may have found another loan elsewhere, they may no longer need a loan, but in general, the reason for their withdrawal is unclear.
  • Cancellations. The originator may decide that the loan cannot be funded due to a lack of information from the borrower or due to their inability to find enough lenders/investors to fully fund the loan.

 

To begin our analysis, we calculated the number of days it takes for a loan to originate on Lending Club or Prosper using the count of days between the loan’s listing and origination dates. In the chart below we can see that the difference in days is minimal with both platforms, averaging between four and five days to originate a loan. We can also see that the loan type, whole or fractional, has minimal impact on origination time; both fractional and whole loans on average take between four and five days to originate on either Lending Club or Prosper. The funding times for Lending Club and Prosper are also explored in a previous post.

2014_06_16_01

 

The distribution of loans by days to originate also appears to be relatively similar across whole and fractional loans. On both Lending Club and Prosper, the plurality of whole loans originate in two days. For fractional loans, the plurality originate on Lending Club in four days and on Prosper in two days.

2014_06_16_02

 

Using additional data available for Prosper, we can also calculate the percent of loans that are “Completed”, “Cancelled”, or “Withdrawn” as well as the average time it takes for a listing to reach any of these states. When calculating days to “Complete”, we again use the listing start date and loan origination date  to determine the average number of days it takes for a loan to originate. For listings that are “Cancelled” or “Withdrawn” we count the number of days between the listing start date and last updated date.

 

Prosper Listings for Q1 2014

Percent of Listings Average Days
Completed 60.58% 4.66
Cancelled 34.67% 10.11
Withdrawn 4.76% 8.82

 

One way to minimize the cash drag caused by a slow funding process is to create a model which invests in loans that are more likely to be funded, such as loans that are further along in the verification process and loans that have a high percentage of amount funded. However, this must be done in conjunction with the understanding that trying to model for loans that are more likely to fund may limit yield opportunities for other loans. Again, a balance must be struck between minimizing cash drag and maximizing returns.

Conclusion

Cash drag is a concern for any investor in any asset class. In the first quarter of 2014, the average time that it took for a loan to receive funding on Lending Club and Prosper were 4.8 days and 4.6 days respectively. This is time that an investor’s money is not being put to work. Furthermore, 34.7% of loans on Prosper were cancelled and 4.7% were withdrawn, with an average time of 10.1 days and 8.8 days before being cancelled or withdrawn causing even greater cash drag on investors’ portfolios due to their need to reinvest this cash. While it may be possible to minimize cash drag in marketplace lending by using platforms like Orchard to quickly deploy capital and by altering one’s investment strategies, one must always do so in consideration of the balance between risk, return, and volume.

 

Feel free to sound off in the comments section regarding your experiences with cash drag in marketplace lending. We’d love to hear your thoughts.