Guest Post by David Drake.

David Drake is the founder and chairman of LDJ Capital, a New York City private equity firm, and The Soho Loft, a global event-driven financial media company helping funds advertise for investors. You can reach him directly at David@LDJCapital.com. 

David Drake

Institutional investors are taking over the nascent peer-to-peer lending industry, and in doing so, taking the “peer” out of the equation. For their part, “peer-to-peer” lending platforms likeLending Club, Prosper,FundingCircle, Zopa, Peerform, and Ratesetter are embracing the shift.

With deep pockets, institutional investors – hedge funds, asset managers, pensions, endowments, and foundations – bring growth, stability, and legitimacy to these online loan marketplaces. Lending Club alone is expecting to fund $1.5 billion in loans in 2013 (see “Crowdfunding Will Make 2013 the Year of the Gold Rush”), largely due to the availability of capital from institutional investors.

Given their high current and historical risk-adjusted returns, online lending marketplaces are becoming extremely attractive for yield-starved investors. Several hedge funds are beginning to exploit the greater transparency and the ability to customize a portfolio that quantitative, cross-platform trading models bring.

Prosper’s head of global institutional sales Ron Suber notes that “maintaining a diversified inventory (quantity, term and quality) of loans for retail and institutional lenders is key.”

Some, like Lending Club through LC Advisors, are even creating their own hedge-fund-like vehicles.

From the “peer’s” perspective, however, this shift may not be as beneficial.

“Individual investors are going to be left with the scraps,” says Michael King, a former investment banker in the technology and asset management industries, now an MBA student at Cornell. “To a lesser extent, the loss of the social mission of peers helping out peers will also turn off some investors and borrowers.”

Still, it’s not like social-mission-driven investors won’t have an opportunity to lend. Sites like SoMoLend, Kiva Zip, and many more fulfill this objective.

In any case, these reservations are unlikely to stem the tide toward an institution-dominated lending marketplace.

“With new peer-lending sites being created weekly, and funded loans growing exponentially, the industry has passed the tipping point,” says King, who is also a senior associate at the Johnson Graduate School of Management’s student-run Big Red Venture Fund. “Institutions will go where the money is.”

This doesn’t mean that lending platforms don’t need to proceed with caution.

“The more reliant online lending marketplaces are on institutions, the more power institutions have to influence underwriting,” King says.

As institutions seek more and more loans to deploy capital, some believe there is a risk that lending platforms will loosen borrower standards and misprice loans. Some have even equated this to the credit conditions leading up to the subprime lending crisis, with negative implications for both investors and borrowers over the long run.

If this were to happen, the consequences could be dire.

There is also the possibility that investors will see these loans as low-risk, when they are anything but. Though sites like Lending Club and Prosper maintained low default rates during the financial crisis, the bulk of loans are still high-risk uncollateralized personal loans to pay off credit card debt, and are highly susceptible to changing economic conditions.

Mitigating these risks is increasingly drawing the attention of industry regulators.

“The regulators follow the institutions, which has both positive and negative consequences,” King says. “While regulators will impose reporting and governance burdens on online lending marketplaces, they also bring credibility to the sites, giving investors more comfort.”

For the time being, institutional investors are helping the industry grow as it operates in regulatory limbo. Because these investors are accredited, regulators give them more leeway as to how and where they invest. But there is still a great deal of uncertainty about the extent to which unaccredited investors can participate.