Time to Think Again About Investing in Invoice Funding
Talk about P2P or marketplace lending to most adventurous investors and they probably very quickly mention the opportunities on offer from major term loan platforms such as Ratesetter, Zopa and Funding Circle. Mini bonds might also pop up in the conversation but it’s a fair bet that very few would even dream about mentioning invoice funding as an option. They should, because this shorter term form of lending can make a huge amount of sense for the more sophisticated investor.
The idea behind this fast growing investment category is actually deceptively simple – it is in effect a form of very short duration bond. Imagine a business whose customer is a big high street retailer. They supply the aforementioned blue-chip name with a bunch of goods and services, which are paid by issuing the customer (the supermarket for instance) with an invoice. But the big blue chip supermarkets are notorious for paying their suppliers late which leaves the smaller business on the line for much-needed cashflow.
Step forward big invoice funding platforms such as Market invoice and Platform Black. They’ll agree to fund these short term invoices – durations last between 30 and 120 days – for a fee which usually varies between 0.5% and 1.5% per month plus fees. Add up these monthly payments and it’s easy to see how annualised rates of return can easily shoot past 105 or even 15%.
Crucially the investor gets the two forms of security. First, the ultimate credit risk is the end customer – in our example the supermarket, regarded as very reliable by most bond investors. But there’s an additional security which is that invoice itself. Cash is owed on that invoice and the investor should hopefully get their cash back very quickly as the blue chip repays the debt.
There are some obvious downsides of course. One risk is that the investor has to keep reinvesting their money every time an invoice is paid back. Call this the finger fatigue challenge as they have to keep bidding on new invoices.
The other key risk is more obvious – that the invoice goes wrong and a default is triggered. This is not an uncommon problem and can be made much worse by outright fraud or businesses trading into insolvency.
A faulty lending model?
Most lenders are paranoid about default risk (and arrears) and so they should be! More cynical investor’s might even go the next step and say that marketplace lending platforms could make the default problem much worse by poor borrower selection.
The nub of this issue is that lending platforms don’t actually put their own money at risk. Thus they might not be that bothered by the potential problem that their risk models don’t work – and that might mean that defaults start popping up everywhere. To be fair to marketplace lending platforms they’d quickly shoot back that their credit risk models are hopefully every bit as robust as the big banks – and the platforms are also scrupulously transparent about both risks and returns.
But the lack of skin in the game – the platforms own money at risk from bad defaults – is a widespread criticism and it certainly worries some institutional investors especially in the invoice funding space where knowledge about this specialist form of lending is very thin on the ground.
The good news is that some of the risks surrounding invoice funding might be mitigated by an announcement this week from two invoice funding platforms that they are now going to put their own money at risk. You can see the news article HERE.
Platform Black and Investly change their business model
Here’s the main summary of what’s changed in the last few days.
Platform Black (PB) has announced this week that they’ll underwrite the first 10% of every auction on its platform, thus taking the first 10% of any capital loss suffered by an investor on their platform. According to Platform Black this move in effect means that from June 1st the lender will underwrite the first 10% of every auction on its Platform, thus taking the first capital loss from any bad debt. The platform quotes an example where a client defaults with a capital exposure of £500k, which forces PB to fund £50k to the investor’s capital loss on a % investment per investor. Platform Black concedes that this shift in strategy won’t entirely eliminate default risk but it argues that the investor can at least ‘take some comfort that Platform Black will be considered in its approach to due diligence.
In addition to this big change of strategy, the business has also announced that it will also contribute a 1% financial interest in every single invoice auctioned on their platform. According to Caroline Langrom, MD of Platform Black, the decision to put its own capital at risk is simple common sense. “I stand by my belief says Langrom “that if I wouldn’t put my own money into an auction, then I wouldn’t expect an investor to do so either, so from 1 July we will be the first to invest in every auction”.
The announcement from Platform Black was echoed by competitor Investly. The smaller platform has always observed that its employees and shareholders participate in auctions with their personal funds but from now on the platform will be making bids on invoice auctions. According to the platform “Our bids will be made with the username Investly so that they are visible and recognizable to all investors. Our bids will range from 5-33% of the invoice funding target.” Investly emphasises that it will not be prefunding invoices. It says that it “will be making bids alongside investors. To ensure a good return for investors, we will not be adjusting our rate downwards if the auction rate falls.”
The change in business model by PlatformBlack and Investly is noteworthy and arguably fairly important for the end investor. It might help to calm those worried about this most specialised form of lending – if a platform stands to lose its own money, then it’s fair to think that your own money might be less at risk?
Rival outfits such as Market Invoice – not currently open to ordinary investors – might counter that their risk models are more than robust enough to answer these concerns. The latter platform is certainly much bigger, with a huge amount of transactions on a regular basis – it’s also very open about its lending data, made available to AltFi Data for the LARI index.
But just how risky is invoice funding? One small clue might be found in the table below. It shows defaults and arrears from Platform Black since 2012. The year before last, 2014, wasn’t a great year for the platform with crystallised losses of 5.5% but so far up to the first quarter of 2016, investors using Platform Black have not seen any losses at all.
This hugely reduced level of losses is almost certainly NOT due to the platform putting its own capital at risk – the real change seems to be a tougher credit model. But hopefully the new strategy of putting its own money alongside investor’s will keep those losses at very low levels.
Investly also takes its own risk processes deadly seriously. According to the online platform investors benefit from a number of protections including:
- The credit team running checks on all companies interested in selling invoices. This involves also checking their bank statements.
- Normally the business buying the goods or services is a large company, which decreases the credit risk.
- The platform asks buyers to confirm invoices. This is to ensure the validity of the invoice.
- Investly also has the right of recourse (asking the seller to repurchase the invoice) in case of invoice disputes or repayment difficulties of the buying company.
- Lastly in order to provide invoice financing to businesses with shorter trading history, the platform might also require director’s guarantee from the seller company as an additional risk management measure.
Our sense is that the move by Investly and PlatformBlack is important and will make a real difference to investors looking for a robust, above average income. The move to put capital at risk doesn’t invalidate the MarketInvoice approach but it does give investors’ more choice. They can now decide whether they want to invest in invoices alongside a platform or simply use its credit scoring models to catch defaults.
More to the point investor’s might now warm to invoice funding as an alternative to bonds and term lending. It’s still an investment niche that needs your constant attention – and proper due diligence about who you are lending to – but there is a real chance that investors could pick up a double digit return in good years.