A new business model for alternative finance

published 19 April 2016

Alternative finance has reached an inflexion point. One only has to look at the downbeat nature of LendIt this year compared with previously, and the performance of listed (and reportedly unlisted too) AltFi companies. Funding these businesses more challenging than ever, and I believe many mid-sized platforms need to consider a new model for a new normal.

I have always said that the natural progression for a peer-to-peer business was from a pure marketplace model where a large number of investors participate in each loan as the alternative finance platform proves its worth to a direct lending model as it scales beyond the marketplace and the capital is provided by a smaller number of institutions, and eventually to a balance sheet model once the size and track record of the platform allow it to access cheap bank funding, which allows a larger margin to be retained by the platform in exchange for taking the credit risk.

WhileI still believe that this is a path that some will follow, there is a need for others to fast-track to a model that will allow a scaling up despite the cynicism that now surrounds the industry. These businesses are about delivering products to borrowers and capital providers in an efficient manner, being complementary to the rest of the financial ecosystem rather than extravagant (and always wayward) claims that alternative finance was set to replace the banks. In fact, I see the banks as an essential part of the solution.

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So where is the problem, within the life cycle of the alternative finance business? It is an area that I have talked about often over the past couple of years and it is an area that I refer to as The Valley.

On one side, as an early stage business, funding is straightforward because amounts are modest, returns are good and founders can find funding from friends, family and their broader networks. On the other side of the valley are the large pools of institutional and banking finance, to all intents and purposes an infinitely scaleable pot of money. Between them is The Valley, into which many of the mid-sized platforms fall too big to be funded from the small pockets of money easily accessible but too small for mainstream investors.

There have been very few businesses prepared to fund in this part of the lifecycle of these platforms (hence "The Valley"), despite the platform models having been proven and value accretion can be achieved just by taking an excellent risk adjusted return on the debt originated.

The reason for the lack of interested parties is down to it being such a specialist area that requires an in depth knowledge of the sector, and a requirement to provide both growth capital to the businesses and lending capacity, which does not fit easily into many institutions" strategy. It is where I positioned my previous business when I was CEO and I am pleased to see that ESF Capital filling the gap left by the change in strategy at my former shop. I am sure that John Mould, Ravi Anand and team at ESF will do very well and I suspect their acquisition of the majority of ThinCats will be just the first of a series of deals in the space. However, there is not much competition to ESF and with a dearth of other opportunities for funding, it is time to look for platforms to look for alternative solutions.

One alternative would be to change the model of the alternative finance business soit can more easily access funding from more traditional sources. It will grate with many of the more idealogical evangelists for the sector but the fact is that looking a little more like traditional speciality finance businesses would allow access to significantly more funding. This, I would suggest, could be achieved by writing loans on balance sheet, rather than on behalf of lenders, and then bringing in external investors to the extent that demand allows. Retaining at least part of every loan on balance sheet would deal with the "skin in the game" criticism continually thrown at the sector. Why would an alternative finance business want to do this? In the short term it can solve the funding dilemma, but in the longer term may bring some interesting spin off benefits.

Funding is assisted in two ways; firstly, looking more like a speciality finance business (but one partly funded externally, and thus with an enhanced return on equity) should make access to equity capital significantly easier, and earning money on the loans retained on balance sheet should greatly accelerate profitability, making equity investors more comfortable in these more profit-focused times.

The second way in which funding is assisted is through access to bank funding. For decades the smaller specialty finance businesses have been funded by bank lines, with the banks providing the majority of the funding, whilst the equity of the business sat in a first loss position. This works well for both parties the banks make a low risk loan, the finance businesses can grow beyond their equity. There is no reason why banks would not also lend to an alternative finance platform funding against a book of lending, and again this could greatly increase profitability, albeit that it raises the risk profile of the business itself. However, better a higher performing, more risky business than a business that cannot get access to funding, I would have thought.

Finally, this new business model for the alternative finance sector could bring a secondary benefit. If alternative finance businesses look more like the speciality finance companies that the banks have dealt with for many years, they may well be much happier working closely, or even acquiring, these businesses in years to come.

This article was first published on AltFi.com