By Rupert Taylor on Friday 22 January 2016
Wellesley Finance Plc has closed Series 1 of its corporate mini-bond – the Wellesley Mini-Bond – which is one of the largest ever on the UK market, having raised £25m since its launch in July 2014. The Series 1 Wellesley Mini-Bond was not expected to close until Q1 of 2016, but has proven exceptionally popular with investors.
As a result, Wellesley has now opened Series 2, which aims to raise up to a further £50m. The terms remain identical with the bonds offering interest rates of 7%, 7.5% and 8% (gross) per annum, paid twice a year, for a fixed term of 5, 6 and 7 years respectively. The minimum investment is set at just £100, and thereafter rises in multiples of £10.
It is interesting to consider how an investment in the Wellesley mini-bond differs from an investment on the Wellesley platform itself. I.e. how does lending on the platform differ from lending to the company?
Let’s start with lending on the platform. According to the Wellesley site ‘Peer-to-peer’ lending for a 5 year term (i.e. comparable term to the shortest duration mini-bond) on the Wellesley platform yields a return of 6.32%. Lending this way comes with a number of protections. Firstly all loans are secured against tangible assets. Indeed, it is disclosed on the investor statistics page of the website that the current loan book is backed by a ‘weighted average loan to value of 69%’. Secondly, the platform offers an ‘auto-matching’ tool that maximizes diversification by updating the investors’ exposure on a weekly basis, such that they are continually exposed to the entire loan book, including the most recently made loans. Thirdly, the book of loans is afforded a certain amount of protection by a provision fund. At the time of writing this is disclosed as amounting to £2,826,657 versus a ‘lender total which is eligible for the provision fund of £129,093,990’. Just like all provision funds this sum could be dwarfed in a downturn but nonetheless it provides a significant buffer against losses. There is a fourth and final reassurance - Wellesley itself lends alongside you. In fact they take the first loss. In their words:
‘Our own investment is always the first to be used in the event of any loss.’
The amount that Wellesley invests is not disclosed, so the amount of first loss buffer that they will cover is not known. And interestingly there is an element of discretion at play. The website also reveals that:
‘If there are losses in excess of the published balance of the Provision Fund, there may be insufficient funds to cover all claims made by customers of Wellesley & Co. the Directors of Wellesley & Co would consider at their discretion to use the company’s capital to settle any further claims.’
Nonetheless this real ‘skin in the game’ is almost unique in the P2P market and should provide significant reassurance. Effectively an on-platform investor is trusting Wellesley to be motivated to maintain their strong track record of preserving investor capital. In their words:
‘We take great pride in the fact that no customer has ever lost a penny investing in Wellesley.’
Wellesley’s motivation to sustain this will be high albeit their appetite, and indeed ability, to make good losses in a stressed credit environment are un-tested. But so far so good.
Now lets look at the mini-bond. The mini-bond investor is lending to Wellesley Finance PLC i.e. the company. In the words of Wellesley:
‘We use your investment in order to expand our business and lending capability, including our Peer-to-Peer lending platform’
It is important to recognize that this bond is not secured against the security that underpins the loan assets that are being matched on the platform. However, as explained above, we know that Wellesley as a firm is lending alongside P2P on-platform investors. As such the mini-bond investors’ capital is also at risk on the platform but without the associated protection that an ‘on-platform’ lender would enjoy. First there is no explicit security. And second Wellesley’s capital is subordinate to P2P lenders’ capital – it is committed to take some proportion of the first loss. So effectively investors in the mini-bond are taking loan risk that is subordinate to on-platform lenders. There is, however, a premium on offer for this extra risk – the 5 year mini-bond would yield 7% p.a. versus 6.32% on the platform.
Aside from considering the risks inherent in subordinated on-platform lending activity, a prospective mini-bond investor also needs to consider the wider risks inherent in lending to Wellelsley Finance PLC as a company. Conventional measures of appraising the risks inherent in this exposure are hard to discern. There is an unhelpful lack of financial disclosure relating to the company in the prospectus. Basic details are missing – for example there is no P&L or balance sheet. As such identifying the key metrics used to guide an investment of this sort such as leverage ratios and the like is impossible. Looking at the filings on Companies House doesn’t shed much light either – the company has extended its accounting period for 6 months. As a result the most up top date financials available are stale by some 18 months, covering the period up to June 2014. Operating profit in that period was approximately £1m. Whilst this number has almost certainly grown significantly, inline with the impressive origination growth of the platform, investors cannot accurately appraise the risks inherent in lending to Wellesley Finance PLC without an updated number. Additionally, it is unclear where Wellesley Finance PLC sits in a corporate structure with many different entities. (We counted 13 entities listed on Companies House). What we do know is that the entity that is issuing the mini-bond, Wellesley Finance PLC, is not the entity authorised and regulated by the FCA to carry out peer to peer lending. Furthermore there is no detail provided to mini-bond investors on any guarantees between these two entities if they exist.
It therefore appears to me that lending on the Wellesley platform may be a better opportunity than investing in the mini-bond. Certainly the associated risks can be more easily appraised. The return for a 5 year term would be 6.32%, which, whilst less than the 7% earned in the equivalent term mini-bond, comes with security, and the comfort provided by both the provision fund and the senior status versus Wellesley PLC’s own capital. The difficult to answer question is whether or not the small return premium afforded by the mini-bond is sufficient to compensate for the additional risk. This uncertainty reveals, to some extent, an issue that observers of Wellesley have struggled with – namely a lack of disclosure. And the subject of disclosure goes to the very essence of the model of P2P lending.
All P2P models are vulnerable to a similar criticism. Critics want to see an alignment of interests between the platform and the lender whereby the platform is incentivised to perform sufficient due diligence on originated loans to ensure a sensible appraisal of risk. Most platforms, and certainly most of the market leaders, have confronted this criticism using extensive disclosure. By transparently revealing the performance of their loans they allow the market to appraise their due diligence using their lending track record.
Wellesley take a different approach. Arguably the real ‘skin in the game’ provided by the platform operators’ own capital should ensure the ultimate alignment of interest thereby rebutting all critics. The trouble is that market commentators still demand more disclosure. This could be in part down to the fact that we do not have enough visibility over the financials to know how much of the company’s capital base is still made up of the founders’ equity. It could easily be that the bulk of the capital at risk is now that of the series 1 mini-bond holders, soon to be joined by series 2, mini-bond holders. Real skin in the game doesn’t count for quite as much when it is someone else’s skin!
The reality is that only a full credit cycle will prove which model is better. A stressed environment will demonstrate how different credit processes perform in difficult times. But importantly, in the case of Wellesley, it would also demonstrate the inclination, and indeed ability, of Wellesley Finance PLC to cover the losses of on platform lenders. Just how much of the losses would they, or indeed could they, stomach to ensure that on-platform investor capital is preserved? And of course this question is critical to the investor in the mini-bond who would have rather different interests to the ‘on-platform’ investor. As such it would present Wellesley with an interesting dilemma. At what point would their underlying ‘on-platform’ investors share the pain with the mini-bond holders? More disclosure around exactly how much first loss the company would take would allow for a better appraisal of the relative risks inherent in each instrument.
In the meantime, before a tougher credit environment inevitably arrives, prospective investors can weigh up how they would like to take their Wellesley exposure. My hunch is that 6.32% with security and seniority is a better bet than 7% without. That said, without knowing what proportion of first loss Wellesley PLC will take, and without more visibility over the loan book, and the financials underpinning Wellesley PLC, I am far from sure!