Bank stress tests herald an opportunity for P2P sector

Author

Date

7th December 2016

The 2016 stress tests conducted by the Bank of England’s Prudential Regulation Authority (PRA) revealed that three of our major banks would not to be able to withstand another financial crisis on the scale of 2008. RBS, Barclays and Standard Chartered were all found to be vulnerable while the remaining four – HSBC, Lloyds Banking Group, Nationwide and Santander – were judged to be sufficiently robust.

However, the reality is that, although the tests replicate the Armageddon scenario of another synchronised global recession (which includes, for example, the prospect of UK residential property prices falling by 30%), there is no real chance that the Bank of England would ever allow any of them to go bust. In the meantime, the three banks that failed the tests are being granted leave to boost their financial resilience as a precaution.

Some commentators have been quick to suggest that perhaps the P2P lending industry should undergo similar stress testing on the basis that the vast majority of the operators have never experienced an economic recession. While this argument may have some headline appeal, it ignores the fact that banks are balance sheet lenders whereas P2P lenders are not – they simply match borrowers with lenders via internet trading platforms and the terms and interest rates applicable to both parties are fixed throughout the lifetime of the arrangement. Loans can still go bad, of course, but that outcome should not have a direct impact on the solvency of the platform operator. It is a non-argument.

One useful reminder from history is that the last time we had a recession the first instinct of the banks was to draw in their horns and stop lending, especially to the hard-pressed SME sector which, according to the FSB, provides 60% of private sector jobs and accounts for nearly half of private sector turnover. It was against this economic backdrop that the P2P lending industry was born in the first place. Difficult conditions represent opportunity.

Of more concern, perhaps, was the recent announcement by Zopa – the one company that was created pre-recession in 2005 – that it is to stop taking in funds from investors without there being sufficient loans in which to put their money.

Zopa, which had accumulated losses of £20m over 11 years of operations, specialises in consumer loans, but there is evidence to suggest that SMEs, too, are not so eager to borrow money as they once were. Commenting on Q3 this year, Mike Conroy, the British Banking Association’s MD for Business Finance, stated that: “…there is clearly lower demand for finance for businesses overall than in the same quarter a year ago. This subdued demand reflects reduced or postponed investment plans and confirmed deposit holding, particularly by smaller firms, as they operate within an uncertain trading environment.”

In the circumstances, it seems the arrival of the Government’s new Bank Referral Scheme, which officially went live on November 1, could not be more timely. Growth-minded SMEs and interest-starved lenders could both find what they are looking for through a vibrant P2P business lending sector.

Jargon Busting

Author

Angus Dent

Date

1st December 2016

The varied funding structures used by new companies can be a bewildering topic for the uninitiated, not least because they are mired in financial jargon.

How many non-financial people could explain how seed funding differs from mezzanine finance for example? Or who supplies these different types of funding?

Let’s cut through the jargon and take a look at the key concepts.

When any company is created, or in its early stages, it is described as a startup. They are often not profitable or even generating revenue.

Thus, they desperately require a financial lifeline to help navigate through this formative period. This seed capital, as it is known, is usually equity rather than debt and allows startups to invest in areas such as product development and general operations to get them on their feet.

So where do they look to obtain it? It is hard to come by from traditional financers such as banks, or venture capitalists, as it considered a very high risk investment, so startup directors must often look to friends, family and their own savings for this initial cash. It is also likely that some angel investors (like TV’s dragons) will be interested in investing at this very early stage. These are often wealthy veteran entrepreneurs who invest their own money and can offer advice based on experiences.

Latterly, of course, crowdfunding platforms have also offered equity-based funding.

If the startup moves forward, the business may then be in a position to launch a new round of funding and attract new investment when the initial funding runs out. This is likely be referred to as a Series A funding round and may be followed by a Series B, C, D and so on. These are sometimes termed alphabet rounds.

These will usually be for an equity stake in the business, though some businesses may offer debt instead if their balance sheets are robust and directors do not want to dilute their ownership.

Unlike the initial round, however, the business will now likely be able to attract institutional investment from venture capitalists to stabilise them over the medium-term.

Venture capitalists invest through a business, rather than as individuals or part of a syndicate as angel investors do, and also tend to offer larger amounts than angels. They will likewise offer a growing business support and contacts to help them, but will generally take a more active role in its running and require a seat on the board.

All these companies will now have traded for at least a few years, acquiring a financial track record and hopefully a steady customer base. This increased business maturity and stability tends to translate into lower risk (and lower reward) for potential investors, something that changes the nature of the available sources of finance.

Some companies with more robust balance sheets will now be in a position to seek out senior debt in the form of loans secured against assets of the business.

Senior debtholders are those that are most likely to be repaid in the event that a business gets into financial difficulty. Gaining a loan from a bank at this this stage of development is notoriously difficult however. As such, businesses are increasingly turning to newer sources of finance, such as peer-to-peer lending platforms, to provide them with the credit lines they need.

Others businesses that lack assets against which to secure debt, or the stable cash flows to service it, may look to invoice financing to improve their cash flow.

Invoice financing can be split into discounting and factoring, both of which involve the third party finance provider advancing the money owed to a business by its customers, minus a service fee. With factoring, the finance provider takes control of the debtor book, while with discounting the relationship between a business and its customers is left untouched.

For businesses in certain sectors, manufacturing particularly, there is an increasing availability of supply chain finance (SCF). SCF links buyer, seller and financier, providing short-term credit to optimise working capital for both buyer and seller. More simply put the buyer uses the financiers money to pay the suppliers invoices, with the financier taking title to the raw materials provided and the goods that the buyers manufactures from them. SCF is available from both banks and P2P business lenders.

For those businesses that seek to expand aggressively though, either of these forms of financing alone may not be enough, leading them to seek out mezzanine finance to help them achieve their goals.

Mezzanine finance is usually unsecured and sits behind senior debt in terms of repayment priority. Because of this increased risk for the lender, it carries a much higher interest rate and often a clause that converts the debt into equity in the company if the loan is not repaid.

These types of funding will suffice to meet the business requirements of many companies, allowing for growth while keeping ownership in private hands. The next step, if the company chooses, is to go public with an IPO (Initial Public Offering).

There are a number of reasons why a company might consider going public, such as reducing the burden of interest payments or generating publicity. Over and above any of these considerations though is the ability that being publically listed brings to raise large amounts of capital on a consistent basis.

That said, firms must take into account the significant costs of the listing process, as well as the increased regulatory requirements.

Disintermediation

Author

Angus Dent

Date

22nd November 2016

There has been much speculation about the potential impact of the IFA and wealth manager communities eventually throwing their weight behind the P2P sector. Why they haven’t done so up until now hinges on the argument that without FCA approval they have not felt able or willing to recommend P2P products to their clients. The FCA’s lengthy deliberations regarding which P2P platforms are granted full authorisation – a process that is still ongoing for most of the major platforms, including ArchOver – have obviously not helped the cause.

Crucially, authorised status will dictate which platforms will be able to offer an Innovative Finance ISA product. It is widely anticipated that, for those who pass the FCA test, this could act as the trigger that will prompt IFAs/wealth managers to give their active endorsement to P2P through IF ISAs. The hope is that, once the regulatory shackles come off, the floodgates will open as lenders/investors pile in to take advantage of tax free returns on P2P loans (obviously within annual ISA limits), which we know would generate far more attractive returns than those based on bank or building society deposits.

It all sounds great. My only question is: why do we need the wealth managers and IFAs now? Surely disintermediation lies at the very heart of the whole P2P lending project – a process by which the investor receives a greater share of the return because the middle man has been removed from the equation.

This can be easily demonstrated in the world of investment management where investors are forced to give up part of their gain in the form of fees. An investment of, say, £100,000 may produce an annual return of 7%, or £7,000. A return reduced to 6%, of £6,000, by fees would mean a reduction of £1,000 in one year alone. Over a period of five years, arithmetic shows that the cumulative loss would be £17,797, assuming annual returns are reinvested. Removing the middle man may involve slightly more effort on the part of the investor – virtually none if you are being charged fees to invest in a tracker fund – but the savings can be considerable. And it makes still less sense to be charged fees in the years when investments fall in value.

And the same applies to the world of debt finance where the banks are a classic case to point. For decades, they have enjoyed low cost of capital which, when combined with the low returns offered to depositors, explains how they can afford to maintain a presence in the High Street.

The internet has been one of the driving forces behind disintermediation – it allows the dissemination of information to large numbers of people at low cost. And the process has only just begun.

To ‘re-intermediate’ by inserting a layer of fee-charging organisations between the client and the product provider – IFAs, wealth managers and P2P aggregators, to name a few – represents an unnecessary step backwards. Those who take the risk should keep the gain

Skin in the Game

Author

Angus Dent

Date

17th November 2016

The term ‘skin the game’ is a fairly recent addition to the P2P business lending sector’s collection of ‘cool’ phrases. An import from the equity finance side of the fence, it is meant to comfort lenders/investors with the thought that, if they lose their money, others – particularly the borrowers, but also other lenders – will lose theirs, too. But apart from sounding modern and slick, does it send a message that typical lenders necessarily want to hear? And does it have any real value anyway?

‘Skin in the game’ has crept into the picture because a few P2P lenders have taken the step of putting money from their own balance sheets into selected projects. The motive for taking this kind of risk appears to be to help certain borrowers raise the cash they need because (a) some loans do not meet the usual lending criteria and (b) in the platform’s estimation, the borrower company nevertheless deserves support. Their action bears all the hallmarks of bank lending, which is why some commentators are beginning to ask whether this is the first step towards achieving that ultimate ambition. It suggests that everyone in the P2P sector secretly wants to trade their original disrupter ticket in order to become a bank.

We can’t possibly comment on the corporate plans of our competitors, but ArchOver’s position on this is quite clear: we are not a bank and neither do we have any ambitions in that direction. We are not a venture capital company, either. We provide a matching service between borrowers and lenders, using a unique business model designed to protect the interests of all parties, but especially lenders.

Furthermore, it is our contention that having the right business model – in our case we use credit insurance to protect assets valued at 125% of the loan – offers far better lender protection than having a borrower prepared to risk their own money to the tune of, say, 5% of the total as a gesture towards the ‘skin in the game’ culture.

On the issue of fairness, surely it is far better to treat all lenders the same, irrespective of whether they are individuals, family office or small institutions; there should be no special deals for anyone. And we would also argue that it is better to conduct rigorous due diligence in the first place, and to stick to the criteria rather than try to justify special cases. We do not subscribe to the notion that borrowers and lenders want to see platforms putting their own solvency at risk through approving poor loans. That’s something the banks do!