It’s obviously not for widows and orphans, but the risks aren’t as straightforward as you might think, says David C Stevenson.
Over the last few years the alternative finance sector – which incorporates everything from ‘equity crowdfunding’ through to peer-to-peer loans( P2P) – has had a fantastic press. Literally thousands of articles have extolled the virtues of the sector as a disruptive challenger to the ‘broken’ conventional finance sector.
Many of these articles have very sensibly mentioned the obvious risks involved with this kind of investing. In particular, that these investments aren’t protected by the government’s Financial Services Compensation Scheme (FSCS). However, I think it’s fair to say that the discussion on risk hasn’t been quite as detailed as I think it needs to be.
In this article, I’m going to focus on risk in the largest part of the alternative finance sector – P2P lending. (As a reminder, this is where individuals lend to other individuals or businesses on a P2P website, such as Zopa or Funding Circle.)
The reality is that lending to consumers can be risky. And when you look at lending to businesses, I suspect there’s a damned good reason why many high street banks have chosen to scale back their lending programmes to smaller companies.
Despite what the government might say in public, in private the regulators believe that the risk to capital from this sort of lending is just too great.
So it’s essential that you understand the complex nature of the risk here. Consider the challenges now faced by investors who have used Assetz Capital’s P2P platform to lend money to a Belfast business called the Belfast Furniture Mall, at Balmoral Plaza.
On initial inspection the situation looks fairly worrying. The business has shut down and Assetz Capital investors could potentially face a six-number shortfall. That could be a bit of a shock for investors in a platform that prides itself on secured lending against real assets.
That said, you need to be a bit careful with the term ‘default’. It doesn’t necessarily mean that investors will lose all their money. Indeed Assetz is now busily trying to find out what went wrong and what security their investors may or may not have. Could the investors have lost all their money? Maybe. But there also seems a decent chance that there may be some meaningful level of recovery. This inherent uncertainty reminds us that defaults can be slippery beasts.
But even if you do get all your money back, you still face another risk which is the ‘opportunity cost’. You might get your money back eventually, but in the meantime you could have lent that money out to someone or something else. And those borrowers might have paid a decent whack of income. Then there’s the issue of arrears where a borrower might be running behind on repayments.
In many cases arrears never turn into defaults, but there are also many cases where arrears prove to be a leading indicator for eventual defaults. Crucially you need to see data on those arrears and understand what impact they’re making on your income.
The next big issue is ageing. This doesn’t refer to the average age of lender or indeed the borrower. Rather it’s the average age of the loans on a platform’s books. Because the whole alternative finance sector is so young, the average age of a loan across all platforms is very low.
Most loans have been issued in the last one to three years. Existing statistics refer to backward-looking numbers from this constantly evolving book of loans. Yet every study of bonds – the nearest parallel to P2P loans – reminds us that as debts get older, the chances of defaults and arrears grow over time.
So, numbers that you see quoted now may not be remotely accurate in, say, two years time, as the sector carries on growing at breakneck speed.
Platforms such as Funding Circle, who put transparency at the heart of what they do, show fascinating graphs which compare different ‘vintages’ of loans (years) against both their expected default rate and their actual default rate.
Unsurprisingly, some years have had much worse default rates than others and most ‘young’ loans tend not to default. However, that can change markedly over time. The true test will come in two to three years time, especially as interest rates slowly start to creep up again.
Our next way of looking at risk is to see it dynamically, as something that constantly evolves at every stage of the business cycle. It’s a dynamic relationship because the business cycle will, in turn, be impacted by those changing interest rates.
The issue here is that with the honourable exception of Zopa and Funding Circle, we’ve not really had platforms that are old enough to sensibly show us how defaults will wax and wane according to the flow of the wider economy.
Most default rates on the biggest platforms (Zopa, RateSetter and Funding Circle) may currently be running at very low levels (between 0.3 and 1.5% pa) but we would expect those numbers to radically change as a future recession kicks in. What matters here is the likely ‘pace of change’ of default increases.
The best way of understanding this is to ask exactly how big an increase in default rates should we expect, as borrowers start to first go into arrears and then slip into default?
It’s hard to get proper data analysis of business loans but we can use some numbers for corporate bonds that are tracked by Moody’s. Using that data, we can see a consistent pattern which suggests that the peak-to-trough change in recent cycles has been about five times the initial level of bad debt. So bad debt increases by roughly 400% over a business cycle.
If you look at numbers for consumer loans in the US, you’ll see a similar story. The data suggest a four-fold increase to the peak is possible (although that data is weighted towards safer mortgages). So, I think it’s fair to say an increase of three to six times, from peak to trough, is possible on current low default levels.
In other words, if the current default rate is 0.5%, it might rise as high as 3%. That’s a change that needs to be factored into your own investment assumptions.
But even here we run into a complication: protection funds, operated by Ratesetter and Zopa. With these schemes, when a borrower makes an interest payment, a portion of that payment is diverted into a protection fund. Then if a borrower defaults, lenders can receive compensation from the fund.
Both Zopa and RateSetter lend to consumers and have very low default levels (currently) but they acknowledge that could change as the economy evolves. Ratesetter suggests that bad debt levels could at some point go as high as 1.5%, and its protection fund currently has £6.1m in reserve to protect investors.
This is actually more than they need in cash if bad debt levels did hit that 1.5% mark, but if Ratesetter was hit by a tsunami of claims, it might not be enough. That said, both RateSetter and Zopa would argue that their tough credit scoring procedures will also help avert that kind of meltdown.
It’s also worth noting that you can’t offset any losses from loans against any tax on the income, although that’ll hopefully change in the not too distant future.
• You can find news about alternative finance as well as key statistics for the sector at Altfi.com.
It’s been a busy month in the fast-expanding world of alternative finance. Perhaps the biggest innovation has come from business P2P lender ThinCats, which has just announced its very own self-invested personal plan in collaboration with the Sipp Club.
This makes a huge amount of sense for wealthier adventurous types with a decent pot of capital. Remember, you can have multiple Sipps, so you could put a small proportion of your pension savings into high yielding loans on ThinCats and shelter any income from tax. Hopefully most of the other platforms will be introducing rival products soon, with Isas not far behind.
We’ve also seen the emergence of a new mini-bonds platform courtesy of the equity crowdfunding site, Crowdcube. Mini-bonds are similar to corporate bonds except they’re not tradeable on the stock market, so they’re illiquid assets. Typically they’re issued by smaller companies.
Now I’ll be honest and admit that I’m no fan of mini-bonds. I think that bonds as an asset class look overvalued, retail bonds even more so, and many existing mini-bond issues look especially risky to me.
In simple terms, I think you are taking equity-style risk but with only relatively low levels of income in return (less than double digits), backed up by relatively poor security.
But mini-bonds issued by Chilango and River Cottage on the Crowdcube platform have been snapped up by investors obviously happy with the risk/reward trade-off. The positive point here has to be that a leading platform is looking to run a pipeline of these mini-bonds, with loads of risk warnings blasted at customers. This should allow investors to sensibly compare like with like.
Crowdcube’s big rival, Seedrs, has also been busy innovating – it’s just launched the first ‘convertible equity issue’, in a relatively new ad tech business, Future Ad Labs.
I’ve been underwhelmed by some early-stage businesses highlighted on equity crowdfunding platforms – but we’re now seeing smart businesses coming through, with decent VC funding, and investing structures that are the norm in Silicon Valley.
Convertible equity effectively allows you to buy shares at a discount to later prices as fund raising progresses – it’s normal practice out in California and is a sign of the whole
crowdfunding space maturing at breakneck speed.