Choices, choices, choices! When alternative finance providers such as Zopa first emerged at the tail end of the last decade the business model was a simple choice based market place approach. As an investor you put your money online, and then chose who to borrow to, at what interest rate and involving a specified level of risk.
In the last few years that model has completely changed. Investors within alternative finance are now faced by a dizzying range of investment options, all designed to provide you with a return well in excess of the rates on offer on the high street. The SME focused lender Funding Circle – more on their latest move in a mo – have stuck closest to this market place model (think Ebay but for investing) but Zopa and Ratesetter have moved closer to a pooled investment fund approach. Gone are the days when you selected the kind of risk categories you want to invest in, their focus these days is not on investors hunting down individual lenders, more on selecting from a limited number of options based on how many months or years you want to lend for.
But in the last two years another option has stormed into town, the listed investment trust or fund. The first and probably still the best is Marshall Wace backed outfit Eaglewood via its UK investment trust P2P Global investments which is now valued at over £900m making it one of the biggest alternative investment trusts in the UK. Like its main rival Victory Park Capital this fund takes a much more diversified route to investing, putting money to work in a range of platforms including the likes of Zopa, and Funding Circle as well as the big US consumer based platforms (Lending Club and Prosper) plus a longer tail of smaller platforms including Funding Circle in the US, student lender SoFi and UK platforms like Lendinvest and Assetz. The advantage of this fund based approach is that you buy into a really diversified range of underlying assets including consumer loans and SME loans.
But a new option is about to emerge in the UK, the platform fund. In incredibly simple terms, this brand new option doesn’t look terrifically different from says Zopa’s pooled investment option i.e you’re buying into a diversified range of loans from just one platform with varying durations. But the resulting fund is listed on the London Stock exchange rather than sold on line direct to investors.
The race to build the first platform listed fund is now well and truly on and there are two main contenders, Funding Circle and GLIF. The biggest player is likely to be Funding Circle which has just announced that it’s planning to raise £150m by launching the SME Income Fund which will invest solely in loans originated through the Funding circle platforms (both in the UK and US). The fund is looking to return an annualised dividend of between 6% and 7% per annum to investors – the platforms average net of defaults return is in that same range if you went direct. Crucially the fund will be passively run – it’ll buy across the range of SME loans on its platform – and will feature no fund management charge. This last feature is a big bonus if only because it’s actively managed rivals – P2P GI and Victory Park Capital – both charge a management fee of 1% per annum plus a performance fee. But Funding Circle isn’t the only platform looking to build its own fund though. GLI Finance a major player in the alternative finance space with platforms from all around the world is also looking to launch its own fund which will invest in its portfolio of platforms with a yield likely to be in excess of 8% per annum [ for full disclosure I may be a non-executive director on this fund if it lists).
The idea of platform based fund is I think highly appealing for the more sophisticated investor as it opens up real meaningful choice i.e you get to decide what exactly it is you want to own. At P2PGI and VPC the fund managers get paid to make those risk based decisions which means you might have a big old slug of US loans, especially to consumers, featuring prominently in your portfolio. That may or may not be exactly what you want but with platform funds you get to decide – in the case of both Funding Circle and GLI that means you are lending mostly to small and medium sized enterprises. For many big institutions such as pension funds and insurance companies that’s a real plus as they’re sometimes reluctant to pay an active manager to make these decisions. I also think adventurous types might like this real focus – you can build your own portfolio of end borrowers, with small businesses likely to pay a higher yield.
I’d expect quite a few more of these platform funds to emerge on the UK market in the next few years, possibly pushing us towards a more established model already in the US called the Business Development companies or BDC Fund. These listed funds first emerged in the 1990s as a tax efficient way of investing in and lending money to SME businesses in the US. The idea was and still is simple – investors would help businesses by putting money to work in a closed end structure listed on the stockmarket that dictated that nearly all the income received is paid out direct as dividends to the end investors. Think real estate investment trusts except for SME loans with at least 85% of all income passed on tax free to investors through a dividend.
There are now around 50 of these business development companies with big banks like Goldman Sachs boasting their own BDCs. A handful of these listed funds are actually publicly listed tech venture capitalists (a bit like our VCTs) but the vast majority are making loans to businesses, small and large. The quality of these loans varies significantly – with private equity firms and venture capitalists making the decisions instead of alternative finance platforms – and the share price of the funds is usually below the combined value of all the loans (the net asset value). In fact the average BDC trades are at around 93% of book value with yields close to 10.30% for the sector – UK alternative finance platforms by contrast are usually trading at a premium with much lower dividend yields. Most US funds can just about cover their dividends from cash while some juice up returns by using debt to leverage income. According to one seasoned BDC observer Gary Chodes – he’s long invested in the sector and also runs his own US based alternative finance platform called Raiseworks - UK based investors in platform funds have much to learn from these US funds.
According to Gary “One of the risks facing BDC investors is that BDC management, in their attempt to maintain underlying loan yields in a highly competitive market, might shift the loan asset mix with a bias toward lower quality assets, in two primary ways: firstly they increase the proportion of loans that are mezzanine or subordinated in nature, or that rely on “equity kickers”, versus more senior and secured loans. Another risk is increasing the proportion of loans to smaller and less established SME’s, which can be riskier, often exhibited by smaller median loan sizes”.
I think the risks noted for BDCs are very relevant for UK investors in alternative finance funds. My suspicion is that as platform funds proliferate we’ll see the emergence of our own alternative BDC niche with yields starting to approach the 10% on offer in the US. Platform based loan funds are potentially a great addition to your portfolio, especially if you want those higher yields (they should start to move towards double digits), but in the case of the putative Funding Circle fund remember that there is no active manager sitting at the centre making credit risk decisions as in P2P GI.
One final observation. Some of the best income yields on offer within the alternative finance space currently come from shorter term lending for invoices. At the moment these platforms – Market Invoice is the biggest followed by rival Platform Black - are really only orientated at institutions and very wealthy investors. But my suspicion is that we’ll soon see funds targeting this space emerge very soon. If they do yields could be much higher if a recent analysis by my colleagues at AltFi Data are right. They’ve been crunching the numbers for all the loans on the market leading platform Market Invoice. You can see the full article at http://www.altfi.com/article/1227_digging_into_marketinvoices_loanbook.
It’s fascinating stuff and helps explain why so many investors want to back short term lending to businesses. Because the average duration of a loan to fund an invoice is so short – around 42 days – MarketInvoice has almost 4 times the number of completed transactions as Funding Circle. In fact Market Invoice has the biggest number of successfully completed P2P business loans anywhere in the UK (and probably the world). In fact Market Invoice is so short term in its loans that the platform recycles investor’s capital around 8 times a year!
The mean loan size on the platform is just over £51,000 and although the average yield has been trending downwards from near 20%, the income is still averaging 10% pa. Crucially losses remain low. There have been several quarters with no losses at all while the overall crystallised loss rate life to date is 0.11% with another 2.87% of outstanding loans in arrears – although it is worth noting that more than 95% of these late loans have ended up returning money. The one fly in the ointment is that there is a bit of cash drag as you wait to be reinvested – AltFi Data reports that on average between 75% and 85% of money deposited on the platform is deployed at any one time.
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