SHOW ME THE MONEY
First and foremost, take a serious look at how a platform handles a loan, says Emanuela Vartolomei, founder and chief executive of All Street, the independent alternative finance analyst. As more platforms and products offer investors different types of fixed income exposure, they are also playing a greater role in assessing the credit worthiness of applicants on both sides of a platform, and in providing investors with access to a firm’s financials and business plan. “This means that doing due diligence on platforms, their processes and financial position, is arguably as important – if not more – than the underlying assets,” she adds.
When it comes to the loans themselves, the key, says Rob Wardrop, executive director of the Cambridge Centre for Alternative Finance at Cambridge University, is for an investor to really understand the difference between the instruments on offer. As with mainstream lending, that difference comes down to whether the instrument is based on cash flow lending, like an unsecured loan, or asset-backed lending.
There is an increasingly wide variety of platforms offering some form of asset-backed lending. Big players like Funding Circle offer both unsecured and secured loans, and platforms like Money&Co, ThinCats and ArchOver also offer secured loans to SMEs. Then there is a growing number of property crowdfunding platforms – like Property Partner, Property Crowd and LendInvest – where the collateral is property. And there is a handful of other specialist firms which offer secured lending opportunities. Ablrate, for example, gives investors access to the lucrative aircraft leasing space – deals in capital equipment, property and other secured transactions.
Wardrop stresses that the mechanism is the only difference between asset-backed lending on a crowdfunding platform and doing the same offline. The assets generate the cash flow and that cash is used to repay the debt obligation. If the lender defaults on their loan, the assets can be sold and the proceeds will be returned to investors. With secure debt, investors will need to know if the value of the security could change.
But if a loan is not asset-backed, you need to consider what the company’s revenue streams are: how will it be funding repayments? There is a reason for stressing this when it comes to crowdfunding: the companies you’re dealing with are far smaller than those which issue, say, a corporate bond. “Investors really do need to look at the source of cash that will repay the debt obligation – and, unfortunately, they don’t do that enough right now. It is the critical question,” says Wardrop. As an investor, it’s key that you have assessed whether they will be able to pay back the loan, and whether their business model is viable. Granted, businesses that turn to debt-based crowdfunding are usually older and more established than their equity crowdfunding counterparts, and firms may well be taking out a loan for a specific project, but all investments come with risks.
David Walker, partner at law firm Memery Crystal and alternative finance specialist, points out that there’s currently no FCA requirement to suggest how the loan is going to be repaid in an invitation document. “If we’re thinking about responsible crowdfunding, then there’s a case for having an additional section: evidence that the issuing company has given some thought as to how it’ll repay at the end of the term.”
The term of the loan is the next question, and minibonds are a case in point. They are a debt product issued by companies, can be secured or unsecured, are often convertible into equity when the loan matures, and are increasingly being offered by platforms. “The reason minibonds are tricky is that they are longer duration loans, and cash flow-based lending,” says Wardrop. With maturity periods typically of four of five years (notably longer than the three-year period typical to a banking loan), the investor needs to remember, he adds, that “a lot can happen in that time, particularly with SMEs”.
Walker says the term of loans on crowdfunding platforms has gradually increased, as has the commonness of bullet payments (where the issuer cannot redeem the loan before the agreed term is up). But he doesn’t see that as something to worry about – minibonds are “generally successful”, and consumers’ willingness to invest in longer-term investments is a positive development. “It’s just vital that the investor understands the reasons for the length of the term. I can see issuers in the future starting to roll up interest [packaging up several instalments into one], for example,” he says. Walker adds that he’s personally “not a fan” of doing this, because of the huge risk increase. Of course, there may well be valid reasons for doing so – an R&D-heavy firm that needs a final push to go commercial, say – “it’s just about being transparent with investors”.
But while investors can address many of these issues before they put money in, other concerns are less easily dealt with. Wardrop stresses that unless loan documents prohibit a firm from additional borrowing in the future that rank senior to minibonds – or other debentures offered on platforms – there is a strong likelihood that the firm will go and take on bank lending afterwards. “If that is the case, the bank will get the first claim on the assets and subordinated lenders will get nothing.” Wardrop believes that, “particularly in the minibonds market, there is a need for higher, more consistent standards of disclosure. There is a pre-emptive opportunity to raise the standard of documentation. If platforms pull together and improve product standards, the regulator is far less likely to be aggressive.”
Drawing direct comparisons between asset classes is not a particularly fruitful exercise, but Wardrop points out that there is “a reason family offices are turning to invoice trading platforms. It is attractive. The interest rate might be lower, but so is the risk profile.” Investors on platforms like Market Invoice and Platform Black are invariably institutions and high net worths. Because these platforms deal with invoices and receivables, they offer a “safer bet” to investors – secured and shortterm loans.
But there are a growing number of entry points for retail investors. GLI Finance, for example, invests in Platform Black and 18 other P2P business lending platforms via an investment trust which is open to ordinary investors. At the beginning of the month, sector giant Assetz Capital launched an SME income account, targeting a 7 per cent gross per annum capped return. And Funding Circle is currently raising £150m for the launch of an investment trust this year. “There’s an interesting future tension between institutional investors and crowdfunding platforms,” says Wardrop. Currently, you either act as a DIY investor, use auto-select and set your risk profile, or invest in a fund vehicle. But crowdfunding is blurring that line. Funding Circle, for instance, doesn’t charge a management fee on its fund because lenders and borrowers are already paying at other points – “the asset management industry is going to have to look at it at some point,” says Wardrop.
And the rise of debt lending in the renewables market is another interesting development. Debenture providers like Trillion Fund and Abundance Generation frequently attract those who are looking to make an ethical investment. But they can also offer confidence in the cash flow streams servicing the debt obligations – because they are underpinned by government intervention.
“You need to ask yourself whether you’re taking on government risk,” says Wardrop. “But really, the risk is that they’ll change the rules further down the road on certain projects.” But he adds that it’s hardly reckless to assume that the government would be very unlikely to cause disruption or instability within a market that it’s grandfathering: “my view is that these are very stable markets; that’s one of the reasons investors can include these investments in their pension pots.”
What kinds of debt-based crowdfunding are there?
P2P business lending allows (usually) SMEs to procure working capital direct from a group of online investors – both individual and institutional – circumventing the bank lending process. Its average growth rate across Europe of 272 per cent makes it the fastest-growing subsector of alternative lending. Many platforms don’t penalise for early repayments, and transparency and ease of use have made it a viable funding alternative for many small firms.
A much smaller market, invoice trading enables SMEs to sell, via a platform, their invoices or receivables to individuals or institutional investors at a discount, in return for working capital. According to Judge Business School’s 2014 Moving Mainstream report, although burgeoning in the UK, the European market is still largely underdeveloped.
This subsector covers models that provide long-term investments (usually 10 to 25 years). Largely the preserve of renewable energy companies, it has been growing fast, with an average growth rate of 171 per cent over the last three years, and volumes reaching £2.7m across Europe.