Just how dangerous is it in the new world of crowdfunding?

By David Stevenson on 10th September 2014

Over the last few years the alternative finance sector - which incorporates everything from crowdfunding of equity through to P2P loans - has had a fantastic press. Literally thousands of articles here in the UK have extolled the virtues of the sector as a disruptive challenger to the 'broken' conventional finance sector. Many of these articles have very sensibly mentioned the obvious risks involved with this kind of investing but I think it's also fair to say that this discussion hasn't been   quite as detailed as I think it needs to be. Of course lending to consumers can be risky and it goes without saying that there's probably a damned good reason why many high street banks have chosen to scale back their lending programmes to small and medium sized enterprises - despite what the government might say in public, in private the regulators believe that the risk to capital from this sort of activity is just too great.

Just how dangerous is it in the new world of crowdfunding?

If you want to invest in the alternative finance space I think you need to have a proper understanding of the complex and slippery nature of risk, especially as applied to the biggest part of the AltFi sector, P2P lending - crowdfunding I think has always been regarded as much riskier largely because it is a form of unsecured equity funding.

To understand this complexity consider the challenges now faced by investors who've used  Assetz Capital's secured lending platform to invest  money to a Belfast based businesses called the Belfast Furniture Mall at Balmoral Plaza. On initial inspection it looks fairly worrying  - the business has shut down and Assetz Capital investors could potentially face a six number shortfall  for what seems like a default, which could be a bit of a shock for investors in a platform that prides itself on secured lending against real assets. Now that term default is the obvious bogey man of 'debt/loan' based investors i.e you invest and do not receive any money back at all. But default is itself not quite black and white as newspaper headlines assume - Assetz are now busy at work attempting to find out what went wrong and what security their investors may or may not have. Could the investors have lost all their money ? Maybe but there also seems a decent chance that there may be some meaningful level  of recovery. This inherent uncertainty reminds us that defaults can be slippery beasts  - ask any investor in Argentinean debt where many hedge funds are still fighting to get their money back in full a mere 12 years later !

But even if you do get all your money back you still face another risk which is what I suppose we could call an opportunity cost from this uncertainty  - you might be recompensed eventually but actually in the meantime you could have lent that money out to someone or something else that would have paid a decent whack of income. This prompts us to look at the issue of arrears where a borrower might be running behind on repayments. In many cases arrears never turn into defaults but there are also many cases where arrears turn into a leading indicator for eventual defaults. Crucially you need to see data on those arrears and understand what impact its having on your flow of income.

The next big issue is aging. This doesn't refer to the average age of lender rather to the average age of the loans on a platforms books.  The whole altfi sector is so young that the average age of a loan is probably in the lower double digits in terms of months across all platforms i.e most loans have been issued in the last 1 to 3 years and are still very young. Existing statistics refer to back ward looking numbers from this constantly evolving book of loans. Yet every study of bonds - the nearest parallel to P2P loans - reminds us that as debts get older the chances of defaults and arrears grows over time. So numbers that you see quoted now may not be remotely accurate in say two years time as the sector carries on growing at breakneck speed. Platforms such as Funding Circle who put transparency at the heart of what they do show fascinating graphs which compare different 'vintages' of loans (years) against both their expected default rate and the actual default rate. Unsurprisingly some years have much worse rates of defaults  than others and most 'young' loans tend not to default but that can change markedly over time. The true test will be 2 to 3 years hence, especially as interest rates start to slowly creep up again.

Our next way of looking at risk is to see it dynamically, as something that constantly evolves alongside the business cycle - which will in turn be impacted by those changing interest rates. The issue here is that with the honourable exception of Zopa and Funding Circle we've not really had platforms that are old enough to sensibly show us how defaults will wax and wane according to the flow of the wider economy. Most default rates on the very biggest platforms (Zopa, Ratesetter and Funding Circle) may currently being running at very low levels (between 0.3 and 1.5% pa) but we would expect those numbers to radically change as a future recession kicks in. What matters here is the likely 'pace of change' (or dynamic) of default increases.

The best way of understanding this is to ask how big an increase should we expect as borrowers start to first head into arrears and then slip into default ? It's hard to get proper data analysis of business loans for instance but if we look at numbers for corporate bonds (tracked by Moodys) we see a consistent pattern which suggests that the peak to trough change from previous cycles in the last twenty years has been about 5 times the initial level of bad debt. Analysis by S&P and Experian in the US of consumer loans space also suggests a 4 fold increase to the peak  is possible (although that data is weighted towards safer mortgages). I think it's fair to say assume an increase of between 3 and 6 times from peak to trough is possible on current low default levels - a change that needs to be factored into your own investment assumptions.

But even here we run into a complication - protection funds, operated by Ratesetter and Zopa. These platforms lend to consumers and have very low default levels (currently) but they acknowledge that that could change as the economy evolves. In Ratesetter's case they suggest that a bad debt  could hit at some stage go as high as 1.5%. To help with this they've set up a protection fund that currently has £6.1m in reserve to protect investors. This is actually more than they need in cash if bad debt levels hit that 1.5% mark (it's actually covered 2.3 times) but if Ratesetter was hit by a tsunami of claims it might not be enough although both Ratesetter and Zopa would argue that their tough credit scoring procedures will also help avert that kind of meltdown !

And of course all this discussion of risk needs to be tempered by the realisation that you can't offset any losses from loans against any tax on the income, although that'll hopefully change in the not too distant future.

New opportunities ?

It's been a busy month in the fast expanding world of alternative finance- perhaps  the biggest innovation has come from business P2P lender ThinCats which has just announced its very own self invested personal plan in collaboration with the Sipp Club - details are at http://www.sippclub.com/thincats-sipp-ssas/.

This makes a huge amount of sense for wealthier adventurous types with a decent pot of capital - you can have multiple SIPPs so you could put a small proportion of your money into these currently high yielding loans and shelter any income from tax. Hopefully most of the other platforms will be introducing rival products soon with ISAs not far behind!

We've also seen the emergence of a new mini bonds platform courtesy of crowdfunding leader Crowdcube.

Now I'll be honest and admit that I'm no fan of mini-bonds. I think that bonds as an asset class look over valued, retail bonds even more so and many existing mini bond issues  look especially risky to me. In simple terms I think you are taking equity style risk but with only relatively low levels of income in return (less than double digits), backed up by relatively poor security.

But mini bonds issued by Chilango and River Cottage on the Crowdcube platform have been snapped up by investors obviously happy with the risk/reward trade off. The big positive has to be that a respected crowdfunding platform is now looking to run a pipeline of these mini bonds, with loads of risk warnings blasted at customers - forcing this flow through just a few platforms like Crowdcube should also allow investors to sensibly compare like with like.

Crowdcube's big rival Seedrs has also been very busy innovating - it's just launched the first convertible equity issue in relatively new ad tech business AdLabs. Being honest I've frequently been more than a little underwhelmed by some early stage businesses highlighted on crowd funding equity platforms - more than a few outfits looking to raise money are much  too risky for your switched on venture capital types. But we're now seeing smart businesses coming through, with decent VC backing and investing structures that are the norm in Silicon valley. Convertible equity effectively allows you to buy shares at a discount to later prices as fund raising progresses - its normal practice out in California and is a sign of the whole crowdfunding space maturing at breakneck speed.

Key Facts : Consumer platforms

                   
 

Zopa

RateSetter

First loan

2005

September 2010

Cumulative Volume Lent (As of 19th May 2014)

 574,000,000

277,268,264

Principal Oustanding

NA

176,100,263

AltFi Market Share (last 3 months)

18.32%

19.29%

Number of investors

52,000+

 13,908

Number of loans made since launch

 100,000+

45,946

Type of borrowers

Individuals

Individuals

Current Rates

3yr

5yr

Monthly Access

1yr Bond

3yr Income

5yr Income

High

4.0%

5.2%

3.4%

4.0%

5.3%

6.2%

Average

4.0%

5.1%

2.6%

3.5%

4.8%

6.1%

Low

4.0%

5.0%

1.8%

2.9%

4.6%

5.6%

Term

3yr, 5yr

Monthly, 1yr, 3yr, 5yr

Provision Fund?

Yes - 'Safeguard'

Yes

Provision fund coverage (multiple of estimated bad debt)

1.21x

2.3x

Default Rate for loans originated by year

2014*

2013*

2012*

2011*

2010*

2014*

2013*

2012*

2011*

2010*

P2PFA Actual Default Rate

0.00%

0.23%

0.64%

1.01%

2.42%

0.11%

0.73%

0.97%

0.70%

2.09%

P2PFA Anticpated Default Rate

1.98%

1.41%

1.50%

2.01%

2.59%

1.49%

1.54%

1.40%

1.40%

1.40%

Secondary market/Mechanism to get money back early?

Yes - 'Rapid Return'

Yes

Secondary Market Fee

1% plus any difference between loan rate and current market rate

0.25% plus any difference between loan rate and current market rate

Secondary market transactions as % of Cumulative volume lent

N/A

3.77%

Lending Fees

1% pa (included in rates shown above)

Included in lending rate

Minimum Investment

£10

£10

                     

*Loans originated in this year

                   

Data correct as at 14th July 2014 Source: AltFi Data

                   
                     

Key Facts : Business platforms

                   
 

Funding Circle

         

First loan

August 2010

         

Cumulative Volume Lent (As of 19th May 2014)

312,784,940

         

Principal Oustanding

222,928,504

         

AltFi Market Share (last 3 months)

15.37%

         

Number of investors

 30,518

         

Number of loans made since launch

5,533

         

Type of borrowers

SMEs

         

Current Rates

A+

A

B

C

C-

         

High

12.9%

14.3%

13.9%

14.3%

14.5%

         

Average

7.7%

9.1%

10.2%

11.1%

12.7%

         

Low

6.0%

8.0%

9.0%

10.0%

11.7%

         

Term

1yr, 2yr, 3yr, 4yr, 5yr

         

Provision Fund?

No

         

Provision fund coverage (multiple of estimated bad debt)

N/A

         

Default Rate for loans originated by year

2014*

2013*

2012*

2011*

2010*

         

P2PFA Actual Default Rate

0.00%

1.10%

3.70%

6.30%

4.10%

         

P2PFA Anticpated Default Rate

4.60%

4.70%

4.30%

3.30%

3.00%

         

Secondary market/Mechanism to get money back early?

Yes

         

Secondary Market Fee

0.25%

         

Secondary market transactions as % of Cumulative volume lent

21.18%

         

Lending Fees

1% pa

         

Minimum Investment

£20

         
                     

Data correct as at 14th July 2014 Source: AltFi Data

                 

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