The Performance of Crowdfunding Investors: Evidence from Random Assignment of Loans to Crowds and Institutions

Abstract

Funding small businesses used to be the exclusive domain of angel investors, venture capitalists, and banks. Crowds have only recently been recognized as an alternative source of financing. Whereas some have attributed great potential to the funding provided by crowds (crowdfunding), others have clearly been more skeptical. We join this debate by examining crowds’ performance to screen the creditworthiness of small and medium sized enterprises (SMEs) compared with the performance of institutions in the context of online peer-to-business lending markets. By exploiting the randomized assignment of originated loans to institutions and crowds in the online peer-to-business platform of Funding Circle, we report that crowds underperform institutions in screening SMEs and thus, relative to institutions, crowds miss the opportunity to lend at higher interest rates as adjusted by the likelihood of loan defaults. The interest rates set by crowds predict default 22% less accurately than those set by institutions. Moreover, the underperformance gap of crowds compared with institutions widens with risky loans, implying that crowds show limited expertise in their risk assessment. Overall, our findings highlight when crowds face limitations in evaluating SMEs.

Keywords: crowdfunding, peer-to-peer lending, institutional investors, online loan market, wisdom of the crowd

JEL Classification: G23