Imagine you’d loaned money to a company via a debt-based crowdfunding platform. The term of the loan was 10 years, but after five, despite earning a decent return on it, you decide you want the original loan amount back. This is where a secondary market comes in, allowing you to sell your previously issued security to a willing buyer.
There is quite a bit of buzz around secondary markets in crowdfunding and P2P at the moment. Many see the growing numbers popping up as a sign of things to come – as the industry has become more sophisticated, secondary “exchanges” have become increasingly common. But while creating secondary markets for debt is reasonably straightforward, the story isn’t the same for equity. Besides, even the existence of secondary markets within the industry has prompted something of a battle.
That’s because within debt (and I will be dealing with these two sides of alternative finance separately) the mindset up until fairly recently has been pretty traditional: that P2P offers a more human way of lending and borrowing, and loan parts should only be exchangeable at 100p in the pound (i.e. someone can’t sell at a discount or premium).
But the ability to trade securities is a hallmark of any sophisticated market – or, indeed, a market full stop. “Liquidity is key to the future of P2P lending,” says Andy Sweeney, head of fixed income at Ablrate. His platform, unlike others in the debt space, allows lenders to buy or sell loans at any price. “This works fantastically in cases where you are marketing longer-dated loans as investors often don’t want to invest for five years. And if they know that they can sell out easily and get their money back, they will participate,” he says.
The argument of innovators in the industry is simple: why shouldn’t an investor be able to sell a loan part with an interest rate of 2 or 3 per cent? After all, if a company has borrowed money, it may well have done so to aid a transformation, meaning its value has gone up since the loan was first issued. The Financial Conduct Authority already requires debt and equity-based platforms to give investors a 14-day cooling off period, where they have the right to cancel the purchase of an investment without penalty or reason, and many see secondary markets as a key development for investor protection.
Of course, creating a secondary market is not so difficult if you’re dealing with loans – because doing credit analysis is relatively straightforward. As in mainstream markets, “it’s very easy to benchmark the credit worthiness of a business and, therefore, an appropriate yield on a loan, if you have access to how a company is performing, specifically profitability,” says James Codling, co-founder of VentureFounders. You can price risk quite easily according to certain defined tests and ratios – and the same is true of property, which is why these types of crowdfunding platforms often have secondary markets.
Implications for debt investors
Sweeney says that many critics of debt crowdfunding avoid the product because of the “lack of liquidity” cited by their financial advisers. “In my experience, though, that’s exaggerated. Is it as liquid as the FTSE 100? No. However, could you exit the bulk of your investment within a few days? Yes.” He points out that P2P isn’t the place for the portion of your money which you need instant access to anyway. Moreover, the higher yields “more than compensate” for the slightly lower liquidity.
It’s also important to think about transparency. Not all platforms will operate in a way which allows you to see the underlying asset you’re invested in. While this needn’t be a problem per se, it does mean that getting out early could be expensive – because the platform has more freedom to choose the charges it wants to levy. Also look at whether you get paid accrued interest right up until the investment is passed on. Not all platforms will operate like this, so you could end up losing a chunk of payments if you sell early.
Also bear in mind that, in order to effectively price risk, investors need to have access to information about a business. That means platforms playing an enhanced role in ensuring that financials and performance information are available to lenders.
The equity story
This brings us nicely to equity – a completely different kettle of fish. “It’s notoriously difficult to find liquidity in equity crowdfunding,” says Codling – VentureFounders is an equity-based platform – “and I really don’t see secondary markets evolving until the market is much more mature and there is the associated liquidity”. This is because crowdfunding platforms deal invariably with very early-stage companies that don’t have much of a track record. “It’s quite difficult to price equities anyway. You’ve got relatively little information flow – given the private nature of the market – and, as a buyer, you don’t necessarily know how the company has performed since close, or what’s happening in the wider market,” he adds.
Moreover, early-stage businesses can be sensitive about pouring their closely guarded financials into the public domain, making the job of pricing shares extremely hard for platforms and investors. Just shunting investors together on a platform is unlikely to be effective. Banks get round the challenge via secondary desks, but that requires full-time, specialist employees who really understand what’s been going on in a company: is the management still the same? What about the business plan? What has performance been like? No mean feat – and beyond direct matching (where a platform pairs a current holder with buyer), it’s difficult to comprehend how platforms, without industry-level collaboration, could manage it.
And there’s a further reason secondary markets aren’t coming naturally to equity crowdfunding: tax breaks. The government’s generous Enterprise Investment Scheme (EIS) means investors can put up to £1m into qualifying investments every year, and receive income tax relief at 30 per cent of the cost of the shares upon exit. But investors must hold their shares for three years before they can sell out without losing the benefit. “EIS is driving the market. Because of the attractive reliefs, a lot of money flows around primary issuances,” says Codling.
It’s also worth remembering that many investors buy into (often extremely) early stage businesses, which arguably gives a sense of being in it for the long haul. And more crucially, an investor selling will be doing so for a reason, so the security could well be distressed. If you’re an EIS investor now, the question is, “why are you selling?” says Codling – “probably because you need to”. Because of the 30 per cent relief, anyone looking to buy would immediately factor that in and be doing so at 70p in the pound – and then you’ve got the challenge of pricing the stock. Think about the buyer, too: if you buy in a secondary market, you won’t get the benefit of EIS, including future capital gains tax or inheritance tax relief, so you’d have to see a material uptick in a company’s performance to sensibly go near the stock in the first place.
Some are trying to solve the dilemma. Platforms InvestDen and Crowd2Fund have recently unveiled secondary markets open to any crowdfunded security from any platform. Direct matching is a possible way forward for the time being, but it’s a big job for platforms, who have to justify the potential sale to buyers. “Unless the whole market suddenly wants a greater level of transparency, it’s difficult to see it happening,” says Codling. There would need to be far more liquidity than there is now, but he suggests that, further down the line, we could potentially see some form of Alt Fi Crowd index. And there’s also the argument that institutions – and there is an increasing volume of institutional money piling into the P2P market – may see buying in a secondary market as attractive.