Let’s recall the example from the last blog. Our client MaVi, a young company producing marketing videos, delivers a clip to its customer Chem ltd. They issue an invoice of £10,000 to Chem Ltd which is due to be paid after the duration of 40 days. MaVi, however, needs to pay its bills and comes to MarketInvoice to receive funds for the invoice earlier. However, instead of the full £10,000, MaVi only receives £8,000 in return for the invoice. These funds are called the advance. After 40 days, MarketInvoice receives the customer payment £10,000 from Chem Ltd, out of which £8,000 and the accrued discount fee is distributed among the investors who fund this invoice. The remaining amount is transferred to the client. Within a 40-day period we have completed the loan, from advancing funds to complete repayment. MarketInvoice has completed over 5,000 such transactions.
This blog aims to explain how such a short duration is an important feature of invoice discounting and the implications of the duration on our learning cycles and advance rates.
Of course 40 days is just an example, the duration of individual loans varies between 30 and 120 days. With such short duration, the portfolio is being rolled over quite often. Since MarketInvoice launched four years ago, more than 5,500 transactions have been performed. The short duration of our lending is a significant asset for two key reasons; investors get far greater liquidity than with other peer-to-peer finance models, and we learn about the success of our risk model much more quickly than other peer-to-peer lenders.
Duration and data
Data is central to our understanding of risk. We can all make subjective judgements about the merits of an individual business plan or the likelihood an invoice will be paid, but it is far superior to base judgements on hard, objective data. Most other peer-to-peer platforms are involved in long-term lending. For example Funding Circle offers loans up to five years. That means to fully evaluate the performance of their risk model; they have to wait up to five years. Because we have seen so many loans through to completion (more than any other peer-to-peer finance platform in the world), we can learn much faster. Since inception, we iterated through four versions of our risk model, each of which we could fully evaluate. This means we could build an unparalleled understanding of risk.
Duration and advance rates
The duration of any given loan period also affects the proportion of the invoice face value we advance to the borrowing business. Typically we advance between 75% and 90% of the invoice’s value, the reason for this is two-fold:
It’s important the borrowing business, such as MaVi, has ‘skin in the game’ regarding payment of the invoice – this helps provide investor confidence and reduces the need for collateral.
As investors will be repaid directly from the invoice payment, it’s important that the payment covers the money lent to the borrowing business AND accrued fees/interest.
Thinking of the MaVi example, should the advance be higher or lower if instead of 40 days, Chem Ltd pays in 140 days? The answer is a lower advance rate should be offered. There are two reasons for this, a simple risk-based one and a more subtle accounting driven one. The risk based view is that in 140 days more things can go wrong than in 40 days. The accounting driven view points out that MaVi not only owes the £8,000, but also the accrued interest and the advance has to be set such that the invoice payment covers both. Let’s illustrate this idea with a very extreme example: Assume MaVi pays 3.75% of the customer payment per 30 days. After the 40 day duration, £500 in interest would have been accrued and out of the £10,000 customer payment, £8,500 would belong to the investors while £ 2,500 is transferred to MaVi. Now consider the duration of 280 days. In this case £3,500 interest would have accrued. This means that the investors are owed £ 10.500, but the customer payment only covers £10,000, a shortfall of £500. Therefore even before considering the risk perspective the advance should be set lower for longer duration loans.
Duration is only one factor when thinking about the advance rate. Clearly risk based factors also have a major influence in setting the advance rate. A well set advance rate ensures the business gets the working capital it needs, and that investors have the protection they need. Our method allows us to assess the risks involved more accurately than traditional invoice finance providers to make sure that borrowers get as much money as needed without posing additional risks to investors.
Our expertise in short duration lending is an important feature of MarketInvoice. Unlike other fast-growing peer-to-peer lenders we know precisely the performance of our loan book last year. This helps us improve but also gives investors confidence in our ability to price risk appropriately.