David Stevenson explains the potential impact of IFRS on alternative credit funds.
The financial services industry already has a horrible record when it comes to acronyms but over the last year the jargonese has reached new heights with a gaggle of regulatory acronyms lying in wait to mug the professional investor. GDPR and MiFiD2 will soon be joined by the wonderful IFRS 9. The natural reaction of most investors is to shrug their shoulders and profess ignorance but IFRS 9 really is one to watch – its impact on the P2P and direct lending funds could be substantial, all with very unfortunate timing.
To recap, most listed lending funds have had a pretty horrid year or so, with discounts turning positively cavernous as investors grow suspicious about the reliability of cashflows and the threat of defaults. A few of the listed funds trade at a small premium – most notably the Funding Circle SME fund – but confidence is fairly fragile and IFRS 9 could be a nasty jolt. In simple terms, IFRS 9 was designed for banks, requiring them to be transparent about the provision for potential losses. Unfortunately, many direct lenders have been caught in the net largely because they deal in underlying debt based assets that can’t easily be valued using a market metric – unlike say securities which can be immediately valued at market.
For private lenders the preferred system until now has been an amortisation based methodology. The fund issues the loan, tracks cashflows, and then slowly amortises down the loan over time with repayments and interest received. Any losses are taken on the chin straight away which allows the lender to value the asset at cost.
IFRS 9 forces a different way of valuing loan assets. Lending funds will be forced to provision for losses on a forward 12 month basis. On paper this means that the fund simply sets aside what they think is a fairly standard percentage for losses on an annual basis and then makes the accounting charge – IFRS 9 has no impact on cashflows and thus shouldn’t follow through to dividend cuts. But the accounting standard does require the lender to show some external validation for those loss provisions. As I understand it, lenders will be required to point to macro economic indicators and industry stats to give some context to their provisions.
Also, the accounting provisions will have to be taken as one hit at some stage in the fund's accounting period. According to fund analysts at Numis: “the changes will be implemented for financial years beginning on 1 January 2018 and thereafter. As a result, funds with 31 December 2018 year-ends will be the first to have to implement the changes (early adoption is permitted), and we expect the approach will be reflected in monthly NAVs from January 2018. Funds with accounting periods later in the year, will be able to delay implementation.” In effect this means that outfits such as P2PGI will need to report this loss provision from as early as February 2018, in one publicly announced move. This will have a direct impact on the fund's NAV in that month.
Obviously this is all just an accounting exercise but I worry that investors won’t react rationally – the sudden appearance of a loss in one could reinforce an existing narrative about impending default losses. This reaction could in turn force the share price down sharply as investors react to the losses.
But I have another worry. As I understand it the requirement for some form of benchmarking against external metrics could also set off a race to be the most conservative fund in terms of provisioning for losses. A fund with say a high income payout level – above 8% or even 10% – might be tempted by its higher risk levels to kitchen sink its provisioning and allow a reserve of say 2 to 4%. Investors might then turn around and say to funds that only provision to say 1% that they aren’t being cautious enough, marking down their share price.
These funds might fire back a solid defence such as the fact that they have a more secured lending model – say with property as collateral – but cynics will still doubt their provisioning. Crucially we won’t see a consistent, benchmarked set of metrics to measure this provisioning – funds' accounting standards for provisioning will vary enormously. This will in turn introduce more uncertainty into the valuation models used by investors looking to allocate capital to the alternative finance space.