But the rumblings from the enemy have started, and over the next year to 18 months I’d confidently expect that drum beat of criticism and pointed analysis will just get inexorably louder and louder – especially as the high street banks watch in horror as their hard win reputations are shredded (even more than they already have been) by the wave of marketing spend likely to come from the AltFinance space.S
One good friend working on a major newspaper has already had the experience – lunch with a major high street bank boss who pointedly took aim at the sector for a good 30 minutes.
I can also confidently predict that the number of critical articles will only increase here on in. Dan Hyde’s excellent article for the Telegraph back on August 16th – you can see it here at http://www.telegraph.co.uk/finance/personalfinance/savings/10245839/Savers-risk-big-losses-at-peer-to-peer-start-ups.html – will only be the first of many, especially as the Big Bank PR departments grind into action and corporate/consumer defaults inevitably start to pick up speed in the coming years!
How to fight back? More on that subject in future columns and articles, but I’d first start with understanding the exact nature of the attack – read and understand the playbook and then work out the response.
But where to start?
Helpfully an excellent primer on the risks faced by the AlternativeFinance sector is already available courtesy of an Edison Investment Research from 31st July 2013 for GLI Finance, written by Mark Thomas and Martyn King. What’s so fascinating is that the research note in question was actually for GLIF’s purchase of a stake in Funding Knight, a rival to Funding Circle – so full marks to GLIF and Edison for being so honest!
As is the way for investment research, the authors of the report decided to explore the risks in some detail – and in the process provided quite the best summary of risks I’ve seen. Obviously some of what follows below is only relevant to Funding Knight (an excellent platform by the way, with GLIF clearly looking to build it up a big rival to Funding Circle) but I’ve underlined the comments that I think are relevant to the sector.
The good news is that unlike many risk summaries contained in IPO sheets, this playbook against the P2P sector only runs to a few sides – many epic US risk sheets run into a dozen pages. Then again who’d really want to have bought shares in Facebook!
Anyway here’s the Edison playbook against P2P.
I’ll be following up next week with my own point by point examination of how to rebut these charges – but in the meantime expect to hear these accusations levelled by plenty of other PRs and lobbyists:
Adverse selection: It is a common feature for new lenders that they attract business declined by existing players. For Funding Knight the issue is twofold – borrowers who may have been turned down by their bank are also likely to have considered its competitor Funding Circle.
The market leader is strongly positioned: Funding Circle has a proven track record, and has raised nearly 130x as much money through 80x the numbers of investors as FK. It also has government-matched funding. Why would a borrower or lender approach FK when they have a more comprehensive option available in Funding Circle?
Crowd behaviour: One danger is that in good times rates get bid down to uneconomic levels by investors who do not understand credit risk. It also means that at the bad times too many investors will try and exit simultaneously, making the loan marketplace unworkable. We suspect that many investors take comfort from say Funding Circle highlighting that on average it takes just two days for a sale to be completed and if this then takes two weeks the outcry could make the model unworkable.
Credit collections. Managing collections is critically important to any SME lender returns. Banks have specialist departments to identify problems early, manage those problems early and then manage the collections as appropriate. The crowd-lenders do not have this infrastructure in place and do not have the business levels yet to support it.
Sensitivity to rising rates/alternative investments: A significant part of the appeal to lenders is that they are unable to earn acceptable returns from other investments. When this changes (whether it be from higher interest rates or say greater confidence in equity markets) there could be a lot of sellers and few buyers on the loan exchange. Both better returns elsewhere and an illiquid market to sell into could deter potential lenders.
Customer reaction to credit losses: By far the biggest issue is how investors will react when credit losses start to materialise in significant numbers. While impairments are clearly highlighted as an issue on the websites, and investor returns adjusted to reflect expected losses, to date experience has been good. We note management and peer comment that the investors are sophisticated (and evidenced by well spread portfolios with NESTA reporting an average portfolio of £8,000 spread across 67 positions), but we question this. For example, credit losses increase materially with the duration of lending and yet the spread investors demand on Funding Circle does not. We considered the average rate on the auction section of the Funding Circle website for A* loans with 10-12 months, 22-24 months, 34-36 months, 46-48 month and 58-60 months maturity (to get a better sample we actually took a wider range than simply the year end). …the gap between one- and five-year money is just 35bp at the low end of the offers and just 16bp for two-year vs five-year money on the high end of the offers. This is insufficient bearing in mind that Funding Circle indicates an expected lifetime loss for this category of around 1.1% (current experience since launch 60bp).
Regulatory risk: With an average investment of £8k a typical crowd lender is firmly in the space of retail investor. Regulations are expected in 2014 but how the regulator will react if there are significant losses is unclear. Buyer be compensated has become the norm for financial services. Should crowd lending become very successful regulation will no doubt increase materially. Banks lending again: The appetite of the retail banks to lend to SMEs is important. Given the political pressure they are currently under, we believe that SME lending will be an area to which banks will make a relatively early return to lending. The areas they may avoid (perhaps commercial property) will be the highest risk ones, raising the issue of adverse selection.