Crowdfunded or over-crowded funding?
Are the large number of competing alternative finance lenders courting the kind of risk the financial services industry is trying to move away from?
In 2010 TradeRiver was just starting its journey into the UK Alternative Finance (altfi) market. At that time there were a mere handful of platform start-ups, founded by entrepreneurs with a sense of vision and a desire to change the landscape of SME lending. This was at a time when the then Business Secretary, Vince Cable, was threatening to tax the high street banks for their lack of SME lending.
Fast forward to 2016! There are roughly 275 altfi platforms operating in Europe. In 2015 the UK altfi sector grew 84%, with £3.2 billion lending into business. Funding Circle has undoubtedly become the doyenne of the UK sector with a valuation at over $1 billion. Barely a day goes by without a story about the growth of an alternative finance market driven by disruption. Surveying the market now, I wonder how sustainable is this growth going forward and more importantly, given the number of new entrants into the market, is credit quality being compromised to achieve growth and scalability?
For all parties (banks and alternative providers) providing growth working capital into SMEs is both challenging and time consuming from a credit perspective, setting aside the capital adequacy/ring fencing provisions from a bank’s perspective. This is why many high street banks withdrew from the market following the 2008 financial crisis.
SMEs tend to be focused on sales and revenue generation, sometimes to the extent that financial information, forecasts and modelling can take a backseat and placed in the ‘not urgent’ pile. Even when businesses have up to date financial information any sudden change in circumstances can have a significant impact on cash flow and trading - and may even threaten insolvency. The challenge to altfi providers is being able to identify those SMEs with viable and sustainable credit who are not already being serviced by the main banks, but at a price point that makes the provider’s business model viable.
The range of altfi platforms provide a myriad of choice and a variety of products including; term loans, invoice trading, property finance, bridging and equity via crowdfunding - to the SME market. A number of providers have invested heavily in the technological aspects of their product to provide a technical advantage over their peers. All however have one thing in common. Without growth and sustainable scalability they will never drive sufficient revenues into their pipeline to achieve profitability.
Here lies my concern.
With so many platforms now competing around a similar credit universe, the potential lies for ‘adverse selection’. In other words SMEs with lower/poorer quality credit being offered loans they cannot ultimately support, a space where the higher yield and revenue growth can lie for the providers.
In November 2016 the Bank Referral Scheme was launched to help businesses who’ve been unsuccessful with the major banks find finance elsewhere. These platforms can then help the referred business find another source of business finance. This is a fantastic initiative that many dedicated lobbyists have worked very hard for. I do hope though that the quality of the businesses being referred by the banks into this scheme is of such a nature that it fits inside the sustainable and viable credit universe. Of course the Bank Referral Scheme comes at a cost to the SMEs, in terms of additional fees.
Since 2012 TradeRiver has provided well over £100 million in working capital to the SME market in over 1,700 separate short term revolving credit loans. As an on-balance sheet lender who underwrites our client credit capacity through trade credit, the evaluation of ‘new risk’ and ‘on risk’ is critical to preserving the integrity of our relationship with our insurance providers. Towards the tail end of 2016 we are now starting to witness credit restrictions from the credit insurance providers entering the market due to high default levels within this altfi lending sector. In some cases cover is being withdrawn completely. Whilst the 2015 NESTA report on the alternative finance industry highlighted the biggest risk to the sector being fraud or malpractice, surely the collapse of the credit market due to unqualified lending to poor quality credits is of equal concern? We echo Lord Turner’s recent comments at the LendIt conference that solid credit analysis must remain paramount.
With the inception of the Bank Referral Scheme I hope that direct lenders like us can continue to support growing UK businesses, without being held back by the decisions of a few affecting the perception of the industry as a whole.