Alternative finance is the sexy, shiny new thing, the disruptive space jam packed full of peer to peer lenders and crowdfunders generating more column inches of newsprint than profits as they valiantly struggle to upend the traditional banking and asset management model. But as is always the way with all momentum based plays, investors are desperate to know what the new NEW thing might be i.e what’s lurking on the frontiers of investing that will spark yet another big transformation. At this point in the debate, talk naturally turns to what I think is whacky stuff with my own personal favourite being increasingly frenzied attempts to marry Bitcoin virtual currencies with peer to peer loan and payments systems. God alone knows what that might look like in reality but if I were an investor I’d be keeping a beady eye on three very simple concepts: lending to students, lending for working capital to businesses and the rise of secondary markets for private equity.
Although there are a few very early stage alternative finance UK businesses in the student space, the stand out success story is in the U.S. and is called SoFi. The growth of this business stateside has much to do with the peculiarities of the U.S. Graduate funding system but I confidently predict localised versions will take off here in the UK. SoFi has become a stunning success – lending to graduates pushed past $3 billion in the last few weeks – because of a very simple insight. Traditional credit scoring systems are increasingly not fit for purpose. Most of us are by now well aware that we need to keep an eye on our credit ratings via outfits such as Equifax and Experian but its also obvious that existing systems designed to track debt aren’t really capturing the whole market. In simple terms like all quantitative systems scoring systems they rely on past data and behaviour I.e the more you borrow, the more information a lender has about you.
Already many mainstream middle class borrowers have begun to notice that if they’ve never borrowed money, their credit ratings might not be top notch. Lenders like borrowers who’ve borrowed money in the past and repaid. Potential borrowers with no meaningful history presents an unquantifiable risk and thus might not be deemed as ‘reliable’. Students and recent graduates increasingly find themselves in this trap. They might be running up student loans but other forms of credit information are probably fairly meager. Yet some students represent a wonderful bet. They might be enrolled at great institutions such as Harvard and Yale, doing degrees that might land them in Wall Street or in Silicon Valley – or more likely working with a big management consulting or accounting firm. These are actually fairly low risk candidates with huge earning potential but the traditional credit scoring models – built around something called FICO scores in the U.S. – largely misses this promising demographic. SoFi doesn’t. It lends aggressively to what it thinks are sensible borrowers and is growing at an astonishing rate. In fact sums lent have now increased so rapidly that SoFi is now scrambling to meet demand from huge institutions. That's meant its pioneered structures such as securitisation where lots of individual loans are bunched together into one traceable security and then lent on to big banks and hedge funds.
My next new new thing to watch out for is based on yet another gap in the traditional banking system – working capital funding for periods of up to one year. Readers will probably have heard of the success of outfits like Funding Circle which focuses on lending to small businesses for periods that tend to cluster around the 3 year mark although an SME can borrow for up to five years through a loan. The money for these term loans – in effect capital to help grow a business over the medium term – comes from ordinary investors like you or I as well as institutions happy to lend at rates of return that might give them between 6 and 18% per annum before costs and defaults.
But many businesses – small and large – have very different funding requirements based on the short term. They might not need a loan for three or five years (although businesses can repay a Funding Circle loan early after say one year if they need to), perhaps only needing money for a few months or maybe a year at most. This gap is called the Working Capital Gap and it's a big, big hole in the balance sheet of SME UK. Banks traditionally filled this hole with overdrafts but these flexible loan structures can be expensive in terms of fees (interest rates aren’t usually that high) and banks are reluctant to offer these facilities without personal debentures or security from the business owner. Banks have also been heavily involved in the invoice discounting and factoring world where businesses effectively hand over their incoming cash flows to an outside lender who keeps advancing money.
But plenty of businesses dislike this traditional financing model and are now turning to a very diverse bunch of innovative lenders that range from Iwoca through to ArchOver, with MarketInvoice and Platform Black the biggest players. The exact details of these models vary enormously but the underlying concept is the same – borrow for anything between a few months and a year. Iwoca’s model is the more expensive, with interest rates of 14% for six months typically but it's quick, incredibly flexible and well suited to businesses that want to borrow less than £50,000. The platform attempts to de risk its investment by looking in detail at the businesses cash flow, bank accounts and balance sheet and then uses its own internal big data analysis to work out who to lend to. The ArchOver model is slightly different in that any loans for up to a year are secured against the invoices receivables account – cash coming into the business – with directors not having to offer any personal guarantee. ArchOver tends to prefer to lend bigger sums of money – over £100,000 is typical, with sums up to £1million in the works – and the interest rates are also much lower in the single digits. Crucially ArchOver also insures any risk via a Lloyds of London insurance broker, making this a relatively lower risk proposition for bigger investors on its platform. And ArchOver and Iwoco are just the tip of a burgeoning sub sector of founders in this space – if you are in business and want to explore the huge range of options for funding a business I’m running a special workshop on the sector in London on July 20th.
Details are here -http://www.altfi.com/events/Working_Capital_Bootcamp. My own sense is that this space could be absolutely huge although it might also be risky for the investor – remember that you are lending to businesses that need cash in a hurry, which can present some very obvious risks.
My last new new thing is a very simple concept. Why buy equity or shares in young, crowdfunded businesses from the likes of Crowdcude, Seedrs and Syndicate Room when you can buy into more established private businesses via what’s called a secondary market run by the likes of Asset Match?
In effect Asset Match and its rivals are stock markets for unlisted private businesses. Many of these businesses have in fact been funded by the big guns of private equity and the market allows investors to trade out positions to other insiders via an auction. But Asset Match is also expanding fast into newer areas including working capital loans and even crowdfunding. If you want to buy into ArchOver’s loans after they’ve first been first issued, Asset Match will now offer an electronic marketplace. Equally, crowdfunded businesses such as the insanely popular (and in my opinion over valued) BrewDog business - a Scottish brewer funded via its own crowdfunding raise - are now using Asset Match to run a private market in their shares. This idea of avoiding the London Stock Exchange’s AIM market for young businesses and using a private market will grow inexorably over time and we’ll start to see some real opportunities open up for the likes of you and me to invest in more established businesses. We might even see a whole generation of crowdfunded and venture capital backed businesses offer shares in later funding rounds via these platforms. And if you want a vision of the future, jump on a plane to southern China where private stock markets – which look rather like the regional stock markets of old in the UK – now host tens of thousands of businesses listing their privately held shares. Risky? Obviously, especially when you consider the relative lack of disclosure to outside investors. But I would argue that not much more than some of the crackpot penny stocks listed on our over regulated London markets or in the U.S. via what's called the pink sheet OTC markets.