What’s next for alternative finance?

2015 wasn't a great year for public markets, with the vast majority of equity markets chalking up big losses. Bond investors didn't do much better, with some more specialist forms of corporate credit experiencing big losses. But 2015 was a big year for the nascent but fast growing world of alternative finance.

Some simple numbers tell the story. The total loans through the big five platforms more than doubled from £2.8bn to £5.3bn, according to numbers from AltFi Data. Crucially, the average total return on these loans (tracked through something called AltFi LARI index) increased from 5.9% in January 2015 to 6.26% at the end of the year.

It's worth dwelling on that set of numbers for a moment lending volumes by the likes of Zopa, Ratesetter and Funding Circle massively increased (in fact the market share of the top three platforms actually increased in 2015) yet overall returns also went up!

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Over in the crowdfunding segment a much smaller universe, but probably growing at a faster pace total equity investments on the big platforms stormed ahead, from £124m in January 2015 to £198m by year end.

More to the point, we've seen a subtle transformation in crowdfunding. Sure, there's still a long list of very early stage start-ups being given ridiculous valuations by nave investors, but there's also a growing number of more established businesses looking to raise capital for genuine transformational growth.

One anecdote should suffice. I was recently talking to one investment expert in crowdfunding (he also invests more broadly in early stage venture capital) who told me that he could go for months back in 2014 not seeing a single sensible, well established business looking to raise equity. By early 2015 he was seeing at least one a month whilst by the end of 2015 he was seeing at least one potential candidate every couple of weeks.

2016 might be an even bigger year for alternative finance. The big change is the arrival of an Isa that will be allowed to invest in alternative finance in April. Most of the big lending platforms are already readying their Isa wrappers as we speak and I have no doubt that we'll see a fair bit of money flooding into the sector in 2016 as investors find that average return of more than 6% per annum on lending attractive.

But this tax wrapper rush may also coincide with a more worrying development platform failures. We've already had one very notable P2P lending platform go down Swedish based Trustbuddy, which I have written about in the past. A suspected fraud was uncovered at the platform and the shares were suspended investors probably won't get anything back. But I would hazard a guess that is the only beginning.

My comment towards of the beginning of this article about the top three platforms increasing their market share is crucial here. Zopa, Funding Circle and Ratesetter are all increasing their market share for a very simple reason. They've spent years building their brand and now they have the capital to properly market and then crunch the numbers on lending decisions. This means they can be competitive on loan pricing and they can also reach new pockets of investors that are denied to the smaller brands and platforms.

Yet again we're witnessing a very familiar process. Technological change comes along and disrupts a market. This disruption encourages a multitude of businesses to enter the market which in turns prompts expansion of the sector. But the early leaders are able to raise more capital, quickly. This gives them an early mover advantage especially where brand and market reach is crucial (which costs money via advertising). These major players slowly start to dominate the market, pushing aside the long tail of weaker players. These second and third tier players are forced to either find a competitive niche or they'll pulverised by scale players who force them to make poor business decisions.

My guess is that we'll see this process play out in 2016. Top tier P2P platforms will continue to devour capital and market share forcing the smaller lenders to increasingly more desperate measures. Failure then becomes a real likelihood. At which point investors need to think long and hard about the platforms they're lending money on. Questions you need to ask include:

Is this platform ever going to produce a profit?

Does it have enough advertising and marketing spend to attract new lenders and borrowers?

Are the lending rates too high because they are lending to riskier borrowers?

What is the wind up plan if the platform does go bust and as an investor I'm left with a loan and no platform?

But my guess is that over the course of the next 12 months we'll also see two other key developments emerge. The first is that that cycle of market development I traced out will move on to the next stage which is that even bigger, bank backed entities will enter the market. There's a legion of rumours swirling around that big US alternative lending platforms such as Prosper and Lending Club are about to enter the UK market. There's also much more substantial rumours that huge investment banks mostly American are about to launch their own alternative lending propositions.

If this is the case then we're about to enter a much more interesting phase in the development of the alternative finance market. Bank backed platforms will have the power backed by massive capital and copious spending on marketing to really propel the market forward into the mainstream. But at what point does alternative finance just become old finance repackaged?

But this massive change in competition might also hasten the next development, which is that more and more will be lent to the wrong kind of borrowers. The alternative finance industry has been waiting around for a Default D Day for years, ie a significant increase in bad debts and defaults on loans and equity investments. In truth within the lending space we haven't seen much change in default levels while over in the crowdfunding space, there's only been a small trickle of business falling over after initial seed investments.

As move into 2016 I think we will see a subtle transformation especially in lending to SMEs. I would hazard another guess that we'll see a sustained boom in lending to small businesses across "product sets", ie everything from invoice funding through to longer term loans. Some of this increased lending will come through established channels such as finance brokers, who will do their best to screen out the no hopers from tomorrows gazelles (growth businesses with real potential). But as the sheer scale of lending increases this filtering process won't be able to stop more and more failures cropping up everything from outright frauds through to businesses experiencing life threatening cashflow crises.

As a result, my guess is that we'll see a steady increase in defaults by business lenders in 2016. It won't be a massive tsunami of defaults, more a gentle upturn (a 25% to 50% increase from current, low, levels) which this will inevitably eat into real returns for both lenders and equity investors. This will in turn force up the expectation of investors for returns over in the lending space they'll start to demand high rates to compensate for the increase in defaults.

This article was first published on Altfi Investor