The pros and cons of alternative finance
Martin Morris assesses the meteoric rise of the alternative finance sector and what makes non-traditional options so appealing.
New business sectors can claim to have more than doubled by value in consecutive 12-month periods, but the alternative finance sector looks set to do just that by the end of this year.
The claim comes in a report from innovation charity Nesta and the University of Cambridge, Understanding Alternative Finance: The UK Alternative Finance Industry Report 2014 (published November 2014). The study predicted that the market, estimated at £1.74bn by end-2014 (2013: £666m), could jump to as much as £4.4bn by end-2015.
The sector is dominated by peer-to-peer (P2P) lending, followed by invoice trading and equity crowdfunding. The balance comes from community shares; rewards crowdfunding; pension-led funding; debt-based securities and donation crowdfunding.
LendingCrowd is Scotland's first and only dedicated peer-to-business crowdlending specialist. Launched in late 2014 and still awaiting full Financial Conduct Authority (FCA) approval, it has more than 900 investors on its platform. It has made 27 loans in the region of £1.5m (predominantly to sole traders and limited companies) to date.
Fraser Lusty, head of business development at LendingCrowd, says that from the borrower's perspective crowdlending is increasingly attractive – not least due to strained relationships many small business owners currently have with their banks.
Reaction to P2P lending has been strong, at least in the experience of Neil Davidson, MD of Alderburn Finance, who has presented to more than 30 accountancy firms across Scotland. He says many have been surprised at the number of P2P platforms offering finance to SMEs and many could think of several clients that could benefit from such funding. The result has been a steady increase in Scottish P2P loan applications and some very happy SMEs, he says.
Alternative finance is all about flipping this on its head and putting the borrower in charge.
Neil Davidson views P2P SME lending risk assessment as at least as rigorous, if not more so, than that carried out by the banks, although he advises shopping around. "Platforms vary in respect of the types of loans they are most comfortable with (e.g. quantum, sector, types of security), and from time to time platforms can have liquidity challenges themselves," he says.
He adds: "For every £1 lent over the platform there must be £1 invested on the platform, a hurdle the banks don't have but perhaps should. Accordingly, it can be a challenge to identify which platforms to approach. This is where the knowledge of a specialist intermediary can be worth its weight in gold."
Neil Davidson's experience is that the banks have welcomed P2P lending, referring their customers to such platforms when their own ability to lend is constrained. One in three borrowers surveyed by Nesta said it was "unlikely" or "very unlikely" they would have been able to secure funding with other sources.
Default rates for business loans have varied with some platforms showing default rates of less than 1 per cent, while others – some of which have now closed to new business – have seen rates significantly higher.
Transparency remains a key issue – a point that has been taken up by the FCA, which took over regulation of the industry in April 2014.
Paul Crayston, head of communications at online invoice platform MarketInvoice, notes that his company, along with players such as Funding Circle, has published its entire loan book online. He says: "As a business looking for finance, you will have come to expect slow, process-driven applications, expensive, opaque terms and long contracts you can't break. Alternative finance is all about flipping this on its head and putting the borrower in charge."
Christine Farnish, chair of the Peer-to-Peer Finance Association (P2PFA), whose members represent around 90 per cent of the UK industry, is also mindful when it comes to transparency and credibility. Over the past 10 years P2PFA members have provided ordinary loans or invoice finance to creditworthy customers only and have succeeded in doing so with low default rates (less than 2 per cent per annum, on average).
Christine Farnish says: "We employ strict credit controls, which are as robust, if not more so, as the banks', and we lend only to businesses with an established track record, not start-ups."
The mini-bond route
Mini-bonds have become an increasingly popular financing route for businesses. Ostensibly a type of debt security, they typically run for around three to five years, offering an interest rate of 6 to 8 per cent per annum. The now closed Innis & Gunn Beer Bond, for example, successfully raised £3m to fund the creation of a state-of-the-art brewery, via a four-year, initial fixed-term mini-bond carrying an interest rate of 7.25 per cent gross per annum for investments from £500.
Investors could also opt for the BeerBucks BeerBond, which offered an equivalent 9 per cent per annum gross, with the return taken in the form of "BeerBucks" to be redeemed against Innis & Gunn products.
As with any new industry, some investors may still have concerns about participating in crowdfunding, especially when you consider the mini-bonds themselves are usually unsecured.
The FCA warns that mini-bonds are illiquid and can be high risk. Moreover, there is no protection from the Financial Services Compensation Scheme should an issuer fail. Some firms have previously failed to make clear that investors' capital is at risk and mini-bonds are not capital-protected products. Unlike listed corporate bonds, mini-bonds are generally not traded, so investors' money is effectively locked in until maturity.
As Ayan Mitra, founder and CEO of crowdfunding platform CrowdBnk, puts it: "As with any new industry, some investors may still have concerns about participating in crowdfunding, especially when you consider the mini-bonds themselves are usually unsecured. These concerns have likely been heightened when mini-bonds run into difficulties. Recently, one product was forced to suspend interest payments, for example, but this is why it is crucial that investors do not view every mini-bond as identical."
Ayan Mitra adds that each should be judged on its own merits as there can be huge differences between products. Moreover, there needs to be more education about the way they're structured. He says: "It is not just the products that are different of course. There are a number of crowdfunding platforms and they all operate in different ways. In our view, best practice is to be totally transparent and clear with investors."
Ayan says CrowdBnk believes it's crucial to only offer products that it, as a business, also feels comfortable investing in.
"We participate in every product we offer to customers, ensuring our interests and those of the end investors are aligned. That is also the reason why we reject 90 per cent of companies that approach us, as we only want to promote products which are created with the end investors' best interests at their core," he says.
Crowdfunding under scrutiny
Like mini-bonds, equity crowdfunding has come under increased regulatory scrutiny. When the FCA reviewed 25 websites (including loan-based and investment-based platforms), it identified a number of problems, such as a lack of balance, with many benefits emphasised without a prominent indication of the risks.
It also found insufficient, omitted or "cherry-picked" information, leading to a potentially misleading impression of the investment. For example, "risk warnings being diminished by claims that no capital had been lost or the relevant risk warnings being less prominent than performance information."
The FCA was also concerned about misleading claims appearing to place retail investors on an equal footing with venture capitalists. The regulator noted: "This becomes significant if venture capitalists are able to profit from successful investment opportunities but crowdfunding investors find, when an investment succeeds, that equity dilution means they do not share in the profits to the same extent."
Although the FCA is keeping the crowdfunding arena under close scrutiny, they are intending to foster further innovation in the market rather than planning to further tighten the rules.
The Nesta survey found that 38 per cent of investors described themselves as professional or high net worth individuals, but the balance was made up with retail investors, with no previous investment experience of early stage or venture capital investment.
Despite such concerns, the sector continues to grow. Seedrs, the largest crowdfunding platform in Europe to focus solely on equity investments, confirmed in July 2015 that venture capital firm Venrex had chosen to host its new £1m fundraising on the platform.
The idea is to open up equity investment in early-stage businesses to more investors, "effectively democratising the traditional venture capital business by making it possible for more investors to take part in the potential success of start-ups raising VC investment," Seedrs says.
Havard Hughes, head of public and regulatory affairs at PR firm MRM Communications, and a former regulator, argues that some of the UK's greatest financial institutions were formed through what would now be considered crowdfunding, with individuals banding together to fund insurance or housebuilding. "Many of these arrangements would now be impossible because of the burden of regulation," he says.
Yet he adds: "It is good to see that, although the FCA is keeping the crowdfunding arena under close scrutiny, they are intending to foster further innovation in the market rather than planning to further tighten the rules."
Going forward, the key issue will be maintaining the correct balance between industry oversight and regulation while not stifling innovation. Knowing that the FCA is watching should concentrate the minds of all concerned.
Martin Morris is a freelance business journalist. This article first appeared in the October 2015 edition of CA magazine.