Identifying the risks of crowdfunding

 
Julia Groves
Nor'Easter Bears Down On East Coast
Julia Groves shares tips on the risks and opportunities to spot before you decide to invest. (Source: Getty)

With the market recently hitting £10bn, crowdfunding is no longer a small fish in the big finance pond. But as the sector expands, it’s also becoming more complex.

Some say crowdfunding operates on the fringes of mainstream finance. The phrase “accident waiting to happen” is one I still hear regularly from the old-school finance brigade.

But in our current low interest, low growth environment, the potential returns might appeal to those that understand the risks, and can commit to tying up their money.

The new Innovative Finance Isa (IFISA) also means potential returns on peer-to-peer (P2P) loans and crowd bonds – the two types of crowdfunding available through the Isa – can now be tax free too.

Far from being on the fringes, finance doesn’t get much more mainstream than the Isa market.

Read more: Your guide to the Innovative Finance Isa

Navigating the market

As with all investments, putting your money into any type of crowdfunding entails a certain level of risk.

But the market offers a wide range of models and terms, risks, and potential returns, so you can take as much risk as you’re comfortable with.

It’s vital that you get familiar with the different areas of crowdfunding before making a decision.

Risk is your watchword throughout this process, but just how will you know whether the returns on offer make those risks worth taking?

In equity crowdfunding, for example, you may buy a small stake in an exciting new business, investing early in the hope of making maybe 10 times your money. The majority of new businesses will fail, so investors should create a broad portfolio on the assumption that over time a few big successes outweigh the failures.

In contrast, lending to more established businesses may not have the potential to make tenfold returns, but consequently the risk of losing your capital is typically lower. This is perhaps why 97 per cent of the £10bn crowdfunding market is in debt-based alternative finance.

Crowd bonds and P2P lending often get lumped together, but a closer look at some of the seemingly small nuances between these two types of crowdfunding reveals a lot about the different levels of risk involved.

Does the platform have full permission?

Although the Financial Conduct Authority (FCA) became responsible for regulating loan-based crowdfunding platforms in 2014, many of those offering investors access to P2P lending, including one of the biggest players, are not yet fully authorised.

These platforms are operating under interim permissions in the meantime because they have not yet met the standards for full authorisation.

In contrast, as the name implies, crowd bonds are a type of investment and, as such, platforms offering this type of crowdfunding have always come under the FCA’s remit.

Are the loans backed by real assets?

Find out if a loan or bond is asset-backed or secured. Secured loans are protected by assets, such as property, which can be a good way to help manage risk because it should stop the borrower taking on too much debt.

Even if the loan is not secured against the borrower’s assets, find out if there are other lenders and if your loan or bond is “senior” to theirs, which means you will be the first in line to get paid.

Look at the level of disclosure

P2P platforms carry out credit assessments on each loan, in many cases with “ratings” given based on perceived risk. But there is no obligation to disclose to consumers why, or how, this rating was given, and every platform has its own criteria.

So do some digging on what is an “A” risk and what is a “B” risk, and shop around.

Stricter regulations covering investment-based crowdfunding require platforms to ensure you have confirmed your investor type.

These platforms will ask you to complete a quick test to check you understand the key risks involved when investing in unlisted bonds so that you are only offered appropriate investment opportunities.

You should find out how a platform’s own borrowing rates compare to interest rates on offer to consumers. For example, investors might be offered a six per cent interest rate, but if the platform is lending to the underlying borrower at 15 per cent – with the difference retained by the arranger – this tells you something about the risk they believe they are taking in relative terms.

To what extent does the platform spread risk?

“Automatic bidding” processes used across many P2P platforms automatically spread lenders’ funds over multiple, smaller loans. This helps to diversify portfolios and requires little effort on your part.

But investors are at the mercy of the platform to choose for them, with little control of where their money ultimately goes.

Crowd bond platforms differ from P2P by providing a small number of larger scale, direct investments. Rather than diversifying, this carries single investment risk.

However, this can also provide financial scope for the platform to have a higher level of due diligence and disclosure.

While the crowdfunding landscape is flourishing and becoming increasingly complicated, this has simultaneously given investors far more choice – meaning you can pick a platform which is completely suited to your needs.

And with the level of risk varying considerably between crowdfunding platforms, it’s important to understand what you could stand to lose before jumping in the deep end.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

Related articles