I have written eight articles in my AltFi News series on Risk in Alternative Finance (“AltFin”).
In the first part of rounding up the main take-aways I focused on the four key points that AltFin must learn from FS risk disasters of the past 30yrs: Hubris. Complexity. Risk “Measurement” and Regulation of Minutiae.
In this second and final part in the series I will summarise the key points from the last five more specifically AltFin Risk articles.
1) Overall Theme – Caveat Emptor
Sometimes it’s only at the end of a long journey that you see the pattern emerging.
Across the whole of AltFin – from equity through to debt – the common weakness is not on the “origination side” (ie getting assets/deals) but rather on the “sell side” (lender/investor side).
I suppose we shouldn’t be surprised (even if the “democratising of finance” PR BS gets wearing at times). All AltFin firms’ revenues are a function of origination and in a world with excess funds coming in there is no apparent great need to better inform investors.
By far the worst offending subsector is Equity Crowdfunding. Most such platforms don’t even tell you how many deals they have done or what percentage of listed deals were successfully raised, let alone how many have subsequently failed as firms.
In “Risk in Equity Crowdfunding – Oh Dear What Can The Matter Be?” I write about what can euphemistically be described as “varying standards of professionalism”. Key weaknesses are the well-discussed but ever-present practice of selling B shares [“not very equitable equity”], unclear-to-poor standards of due-diligence, and company-set offer-prices.
I think the only consolation in this sector is that privately most players agree with me. The more professional end tries to mitigate these issues [but let’s face it, more grown-up markets such as AIM have had plenty of issues]. As to the other end, it’s a relatively open secret that it’s a greed-fest of shipping deals and pocketing the dough.
We have already had one case [Camden Brewery q.v. [A Bitter Taste for Camden Town Brewery Crowdfunders?] where the crowd got one deal only for a large investor to later get a better deal. Expect more in that vein.
2) Communicating Risk
Equity crowdfunding risk warnings that you may lose all of your money are a somewhat fatuous. Little more than a derriere-covering exercise. After all you rather want to know how far the platform is going to prevent that happening don’t you?
The P2Ps as a whole are by contrast more conscientious perhaps in their underwriting standards. Not least of which because returns are rather more immediate and poor underwriting will cripple a P2P far faster than poor listing will cripple an equity crowdfunder.
However whilst arguably lenders are better cared for they are still, in an #oldFS fashion perhaps, kept rather in the dark.
In the P2P space the main problem for lenders is that they have no clear quantitative information as to what their risk is.
By which I mean if you go and stick £1k in the main platforms tomorrow, none of them will inform you of the likely range of returns you will get over the next say 3yrs.
Is it say £1299-£1300? £1100-1300? £0-1300?
For those platforms that grade assets in risk bands – do they tell you how well they do it? Really well? Pretty well? Poorly?
After all you are rather relying on their grading process aren’t you…
What is the chance of that provision fund failing?
1 in a thousand? 1 in a million?
What would that mean anyway in a world where “black swans” fly past all the time, where (as per Part 1 of this article) “risk arithmetic” has proved wrong time and time and time again?
Especially in a climate within which there are increasing flows of “institutional money”, there is a pressing need to address these issues. Not least of which because much of the “institutional money” is charging a pretty penny (and more) to its investors for – what’s that phrase beloved of the sempiternally-underperforming fund management sector?
Ah yes… “adding value”. Superior asset selection and all that. Trouble is if you ain’t got any info on how risky the investments are it’s rather hard to see how that’s done at all.
More caveat emptor?
3) Emerging Theme – Sectoral Growth
The past is less of a guide to the future when the future differs from the past.
One meta-theme which has emerged in 2015 is “growth”.
P2P in the UK currently lives in what can only be described as a “post Lending Club IPO” climate. A combination of a dash for assets and a clamour to escape a burning building stuffed with over 150 P2Ps where few will make the exit (ha!) and they alone will achieve fabulous wealth.
“Fintech is not tech” is a favourite mantra of mine. Growing a tech company fast has one set of challenges – but at least you find out that your new chat app that will take the world by storm is having issues pretty soon.
By contrast growing a Fintech company fast is orders of magnitude more challenging – many of the problems only emerge years after bonuses have been pocketed.
I find it very hard to think of one example in FS where a rapid increase in quantity hasn't been accompanied by a deterioration in quality.
4) “Risk Debt in P2P”
In “Risk Debt in P2P – Overview” I extended the well-known concept of “tech debt” in startups/scaleups to cover “risk debt”. Situations where the company’s growth has outstripped it’s controls and understanding.
A little like being a teenager perhaps – suddenly you inherit all these hormones and freedom and strength and believe you are on the case and in control only to find out a decade later that – erm – you weren’t entirely as wise as you thought you were ;-)
In “Risk Debt In P2P – Examples” I covered eight key areas right now that P2Ps would be well advised to be looking to tighten up on:
Liquidity is so important in FS.
The tide always comes in and always goes out (or with the soon-to-be ISA the tsunami comes in once a year).
And as King Canute showed there ain’t nothing you can do about that no matter who you are.
All platforms rely on there being an incoming tide for anyone that needs to exit. However the irony of liquidity is that it isn’t there when it’s needed most.
Plus without some central clearing/marketplace/standard for P2P assets you are forced to sell your asset back to one player. Not the best way to get a competitive price perhaps.
All of which rather reminds me of the old days of life insurance policies and swaps before ISDA agreements.
ii) Principal vs Agent Risk
Not as black and white as it looks ;-)
iii) Provision Funds and the Art of Self-Insurance
I raised the question above about what’s the risk of your provision fund failing?
There’s another question. Who audited that? You? Or an independent authority?
As we know there is a whole world of actuaries and insurance capital directives to ensure that insurance companies have enough funds to cover claims. And it ain’t simple.
iv) Yield-Driven Marketing – Oooh, Ouch
P2Ps “headline numbers” are often/generally a complex model something like current yield minus fees minus projected losses [plus payments from provision fund].
Plenty of scope there for over-enthusiastic (or over-cautious) under-estimating of losses. Especially given this pernicious “single number” approach to estimates of loan losses.
Imagine if the Bank of England just published a number not a cone for its inflation forecast. Just like budget numbers they would always be high or low and scot-free. Compare this to the grown-up habit of providing a range – then you know how often they fell in or out of their expected envelope.
It’s all relative – and utterly meaningless without any stats about how many data points are released about a loan.
vi) Cherry Picking
In a world of retail and institutional money “standards vary” as to how pari passu platforms treat the two categories and how disclosed it all is.
vii) Legal Debt
Just like Tech Debt and Risk Debt, startups/scaleups incur legal debt.
Plenty of lawyers have given me plenty of examples where the ship’s hull isn’t sealed as well as it might be. A little stormy sea and soon one will find new leaks in many ships.
viii) Cyber Risk, Fraud et al
It’s a worry for everyone.
Of course everyone does something about it. However when the Chairman of HSBC says it’s one of the major risks a bank faces you can be sure the #newFS crowd (ha!) aren’t immune.
As poacher, gamekeeper and consultant in an ever-changing FS world over thirty years I have time and time again seen the pattern of over-confident growth. Of risk appetites slowly increasing day by day. Of hubris slowly increasing day by day. Of one in a million events arriving seemingly every other year.
The “proven structural answer” to FS risk crises is narrow, simple, siloed activities, clearly and simply regulated.
Inside FS firms - and I have seen more than a few - large and small, old and new, I have lived through many ways of “cutting the cake”.
The only thing you can do in an uncertain world is to stay on the case.
P2Ps need a process for ongoing capture, tracking, and management of ALL risks that might derail them and their lenders/investors.
Having been in FS before CROs existed, I have lived and breathed a world where there is no-one whose sole task it is to keep track of EVERYTHING firmwide that can derail the firm.
If we are to avoid “Deja-Vu All Over Again” P2Ps should learn from the mistakes of #oldFS and get a firmwide CRO not just the silo-ed credit and compliance functions (“necessary but not sufficient”).