Alternative Finance - Four questions to ask yourself when making the decision whether to invest direct or via a fund

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The availability of investment opportunities within the SME alternative finance (AltFi) asset space has exploded over the last six years, since I became involved in GLI Finance and started our journey towards becoming a globally leading player in alternative SME finance.  So much so, that we recently announced that we have received regulatory approval for our own asset management business, and are launching our flagship closed end fund presently. As it is already possible to invest in the AltFi sector directly, you may wonder what benefits investing in a fund may bring.

So, what are the advantages and disadvantages of a fund versus direct investment through an alternative finance platform?  Here are four key questions that you’ll need to ponder.

Q1. Can the fund do anything for me that I can’t do for myself?

The first obvious question is what benefit the management of a fund brings to the investor. In the stock market there is a buyer for every seller and thus, in aggregate, active management cannot add any value, since for every outperformer there must be an underperformer and vice versa. The AltFi market is different, since there are not ‘sellers’ per se but borrowers. Thus there is the true opportunity for managers to add value.

However, that value can only be created through the platforms with which the manager has a relationship. We are in the fortunate position that we are the principal (and in many cases only) external investor in 19 different AltFi platforms globally, and so can access deal flow from all 19, plus a wide variety of other platforms with which we have good relationships. As a result, we can access platforms on behalf of our funds that are not available to any other funds, and that gives us, as an asset management company, our raison d'être. When looking at potential investment in a fund, ask yourself whether the manager can do anything that you as an individual cannot. If the answer is no, then I would suggest that it might be worth questioning what value the manager brings to the table.

Q2. Can I build a better diversified portfolio than a fund?

The next issue that must be considered is one of diversification. It is essential, when building exposure to the AltFi lending sector, that an investor has a widely diversified exposure. Too great an exposure to any one type of credit and you could blow a hole in your performance very quickly. Within our fund we are looking to cap exposure at 1% of the net asset value of the fund, and those would be the very lowest risk assets. As an individual, you might choose slightly more concentration than that, but remember no loan is 100% safe, and if a single exposure is more than your weighted average yield on your portfolio, you could lose money overall through just one credit going under.

Q3.  Does it work out cheaper to do it for myself?

The third point to consider is the cost. Needless to say, if you invest directly, the only costs you’ll incur are your time and the fees charged by the platforms.  If you’re considering investing via a fund, there are a couple of very important points to consider…

All fund managers will charge for managing the fund and that will normally break down between a base fee, based on the assets under management, and perhaps a performance fee. On the base fee, the thing to watch out for is whether the fee is just on the net assets, which in my view it should be, or includes a fee on borrowings (directly in the company or in a special purpose vehicle), which creates an incentive for the manager to add borrowings regardless of risk/return for the investor. I would also suggest that investors be wary of performance fees. These can be extremely damaging to an investor’s overall return and investors need to be confident that those additional fees genuinely reflect value added by the manager. 

Q4.  Do I want to be able to get my money out?

The final point to consider is one of liquidity. Although there are secondary markets in loans operating on a number of platforms, these are relatively illiquid and it has to be assumed that once loans have been bought directly by an investor through a platform then they have to be held to maturity. By contrast, a fund will provide liquidity on an ongoing basis, allowing investors to sell - although the price may be affected by supply and demand.

Whatever you do, do your homework

The big advantage for an individual investor in buying loans directly through an AltFi platform is one of control. You’re making the decisions, you can decide exactly where to invest and you can see in real time the performance of all of your holdings. There are sites now cropping up that will allow you to consolidate your holdings in one site, so you don’t have manage your assets across multiple sites. However, it will nevertheless mean a great deal of legwork. For some investors that’s half the fun. I myself invest across a number of sites, as I like the idea of directly lending to specific companies, although, going forward, the vast bulk of my investment in the sector will be in the GLI fund.

There are pros and cons to investment through funds or going directly to platforms in the AltFi world, and for different investors there will be different answers.  You may decide to do a bit of both, as I do, but whatever your choice I can’t stress enough that you need to do your homework first, because this is a highly complex sector and it’s not always immediately obvious what the best course of action might be.

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