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Do alternative finance platforms have an incentive problem?




By Ryan Weeks on 4th June 2015

Cristian V., https://goo.gl/mr1ubx

One of the most frequently tabled criticisms of the alternative finance space is that there is a fundamental misalignment of incentives between the platforms and their investors.

 

The argument hinges on the fact that the vast majority of the platforms extract a success fee (some platforms will also charge running fees, rather than taking the entirety of their fee up front). This means, in über-simplistic terms, that the more deals that are approved/funded, the more revenue a platform accrues. It also means that, in theory, the revenues of a platform accumulate irrespective of the performance of the deals that they facilitate. Therein lies the supposed disconnect: a platform’s private investors are reliant on the long-term performance of a successfully funded deal in order to recover their principle and earn a return, the platform itself is not.

 

Is there weight to this argument? Let’s listen to both sides, starting with the prosecution.

 

The Prosecution

 

The bulk of the prosecution’s argument hinges upon the point made in the introduction: that alternative finance platforms are essentially “volume businesses”. That, as fee-charging intermediaries, their primary concern is to ship as much business through the doors as possible – with little regard for quality underwriting.

 

The swelling of revenues aside, what other reasons might we identify that cement the notion of a disconnect between platform and private investor?

 

We’re all pretty well accustomed now to the fact there is a towering wall of venture capital money crashing into the alternative finance sector. Within the past month or so, private companies in the space have taken bordering on a billion dollars in equity funding.

 

Let’s take two contemporary examples. Funding Circle hauled in $150m in April, within just a couple of days of Lufax having raised $485m. Both platforms are market leaders within their respective territories. And for both platforms, the major point of interest surrounding these funding rounds was the attached valuation. Lufax was valued at a staggering $10 billion. Experts speculated that Funding Circle’s valuation had topped the $1 billion mark – making it a “Unicorn”, in the language of Silicon Valley (a private tech startup with a valuation upwards of $1bn).

 

Priority number one for the increasingly decorated list of VCs involved with both platforms has to be to continue to drive those already gaudy valuations through the roof. And what’s the most commonly turned to metric in valuing an alternative finance provider? Transaction volumes, which of course have a direct relationship with cumulative revenues. The concern is, with so many venture capitalists taking seats on directorial boards, that the platforms will be pressured into loosening their credit criteria in pursuit of ramping up funding volumes.

 

Funding Circle’s latest fundraise was a Round E. The platform raised $65m in a Series D roughly 10 months beforehand. With each successive round the reported valuation creeps higher and higher – although exact metrics are being kept quiet for the time being. Funding Circle has raised $273m in equity funding to date. That firepower has seen the platform expanding rapidly on multiple fronts. Transactional volumes are hurtling upwards. Funding Circle US is coming on strong. The platform operates within multiple verticals (secured and unsecured SME lending, and various types of property finance). There’s a bulging matrix of strategic partnerships, from RBS, Santander and PwC on the origination side, to the British Business Bank, KLS Diversified Asset Management and Victory Park Capital on the lending side.

 

All of these activities grow the business, build the brand, and boost the value of the company. And this steep upward trajectory is not uncommon within the alternative finance space. But the question being posed by the skeptics is this: is such multi-directional and dizzying growth coming at the expense of sourcing high quality investment opportunities?

 

Of course, the other priority of these VC firms it to push the companies that they’re invested in to market. Lending Club-like IPO valuations – at many tens of times current and projected annual revenues – can’t last forever. At some stage the platforms will begin to be valued with less of an emphasis on the future and a greater emphasis on present and historical performance. It’s easy to see why shareholders might look to exit before that shift takes place. 

 

But perhaps I am being rather unfair here. Many VCs will of course have longer term investment horizons, and will strive to ensure that their investee platforms act responsibly.

 

Finally, I suspect the prosecution would point to the fact that transactional flows currently stand as the most commonly referred to success criteria (not for, say, institutional investors, but certainly among many media outlets and industry observers). But as Hendrik Brackmann of MarketInvoice pointed out in an AltFi guest column: “giving money out is relatively easy, getting it back is much trickier.” If a misalignment of incentives truly exists, then the platforms won’t be especially bothered about being repaid anyway.

 

The Defence

 

Taken in isolation, the above argument might sound at least mildly cogent. And it tends to be delivered in isolation, by commentators who don’t fully understand how the alternative finance space operates.

 

To de-bunk the notion that a fracture exists between the platforms’ interests and their lenders’, we must try to ascertain whether or not the platforms have any kind of skin-in-the-game. Let us, for the sake of argument, forget that some providers (such as Wellesley & Co. and Mintos) have monetary skin-in-the-game. Most of the equity crowdfunders and marketplace lenders do not, and we’re looking at the space as a whole here. So in what other ways is a platform tied to the long-term performance of its portfolio?

 

If a marketplace lending platform, for instance, experiences a rash of defaults (however you define “defaults”), its private investors will take notice. Consider the successes to date of the UK’s alternative consumer lenders. Zopa, the largest peer-to-peer lender, has lent £880m to date. Zopa also has a reputation for having historically been extremely conservative around credit (although admittedly the platform’s risk appetite has been expanding of late). RateSetter is the second largest consumer lender with a cumulative lending volume of £646m. RateSetter proudly reference the fact that no saver has ever lost a penny by investing through the platform.

 

It is no coincidence that both platforms are leading the way in terms of investor protections as well as in terms of lending volumes. Nor is it a coincidence that platforms that have been less careful around credit (without naming any names) have often seen their growth rates splutter.

 

To summarise, the long-term success of a platform depends on its ability to originate high quality investment opportunities. Its reputation – its ability to make good on its advertised services (namely, a good return!) – is the skin-in-the-game.

 

Now that may all sound a little wishy-washy. But consider for a moment that we are dealing with a famously transparent industry.

 

Reputation serves as an entirely useless aligner of incentives if private investors have no method of gauging the performance of a particular platform. That’s why there’s such concern within the P2P space about the “black box” approach. When a platform is guarded about its performance data, or about its processes, or only chooses to reveal a fraction of important information, alarm bells are set ringing for investors. In the equity crowdfunding space, there’s a total lack of public performance data available – largely due to the fact that many of the companies that have taken on equity funding are yet to either fail or stage an exit.  

 

There are, however, heartening examples of unprecedented transparency within the sector. The P2PFA requires that its members adhere to a standardised method of reporting default information. Check out Lending Works’ statistics, for example. Member platforms are required to provide actual arrears, actual defaults and expected defaults data for each year of their operation – giving lenders a fair degree of clarity as to the performance of each provider. In short, a P2PFA lending platform which is incentivised at odds with its lenders – and so which is concerned more with origination volume and than with origination quality – will very quickly reveal itself.

 

And of course some platforms have gone above and beyond P2PFA requirement, by publishing their complete loan portfolios online. The UK’s largest peer-to-peer lenders – Zopa, RateSetter and Funding Circle – have each made their full loan books available to download via the AltFi Data site. Funding Circle has provided this unprecedented level of transparency for a while. Zopa and RateSetter joined in on the act as part of their entry into the Liberum AltFi Returns Index. The available information allows investors to track exactly the lifecycle of every loan ever originated by any of the platforms. That level of transparency in financial services is unheard of.

 

In the past, Funding Circle has suggested that total transparency in fact acts as a kind skin-in-the-game. I agree. The fact that customers are so readily able to scrutinise platform performance transforms reputational risk from something rather vague and fluffy, into the pool within which a platform sinks or swims.

 

Nick Harding, Founder and CEO of Lending Works, certainly seems to agree:

 

"We strongly believe that peer-to-peer lending platforms have more “skin in the game” than traditional lenders, irrespective of the fact we do not lend our own money. This statement appears to be a contradiction, however one factor makes it true - transparency. Unlike traditional financial services providers our data is available on our website for all to see, which means that prospective customers have far more information available to them when making a decision on which platform to use. Would savvy savers have put their retirement pot in Northern Rock if they knew their LTV and arrears data? My instinct says no. At Lending Works, we believe that our performance against our anticipated default rate is one of the key measures our industry should be judged upon, and it is this that aligns our company’s interests exactly with those of our lenders.”

 

Of course, even a supreme level of transparency is useless if investors are not discerning. But if they are, one has to assume that demonstrably low quality loan originators will quickly be rooted out and avoided.

 

The crowdfunding space is different. Given the long term horizons of equity crowdfunding investments, and the relative youth of the industry, performance data just isn’t available at the moment. And it will likely be a few years before it is. But there are some telltale signs (the timing of fee taking, the placing of a platform representative on the board of a fundraising company, an insistence on appropriate pre-emption rights, etc.) that help to shed light on whether a platform is as determined that fundraising companies achieve long term success as its private investors are.

 

One might be able to get away with running an alternative finance “volume business” – with little or no regard for quality origination – for a while. But a misalignment of incentives between a platform and its private investor base cannot be hidden for long. Transparency – in terms of process and in terms of performance data – is the key.

 

Comments

Steve Hayes

09 Jun 2015 10:58am

I point you to Unilend in France, sme loans. My take is that their investors are losing money and that they are growing. Reputation isn't doing what it should.

Andrew Rolfe

05 Jun 2015 03:54pm

The move towards greater transparency is commendable, but to argue that that is "skin in the game" is really stretching it. Even more so to argue that this constitutes more risk than traditional lenders take. They are principals and have to show losses in their books, although obviously many sell down or syndicate their positions. Over time, it will be interesting to see if the present model, where some promoters have no financial exposure save for start-up and admin costs, will survive. Even if it does, I would expect that the current levels of return to "no-risk" promoters will drop considerably. The market is still immature.

Tom Mitchell

05 Jun 2015 01:52pm

Good article. An additional point you could have considered is the impact of loan size on incentives. Platforms tendering fewer, larger loans in the P2P market would surely suffer reputational damage that would outweigh short-term financial gains if these large loans went awry. This perhaps is another point to the defence of platforms with a large average loan size in terms of alignment of interests. As you say, though, this point only holds if total transparency on the performance of loans is a precondition.


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