A new form of broker is emerging that combines the distribution power of the internet with the wisdom of crowds: the crowdfunding platforms or peer-to-peer (P2P) lending websites.
Zopa was the first P2P lending site; it started in 2005, with individuals lending small amounts to other individuals. Since then, the concept has expanded to embrace peer-to-business (P2B) lending and equity investment.
The concept is simple. A small business wanting to raise, say, £100,000 of funding to scale up its operations advertises its need on a crowdfunding website. It provides a basic business description, the purpose for which the funds will be used and some outline historical accounts. The site itself may generate some sort of credit score for the business. Individuals with money to invest select the businesses they favour and bid to lend an amount and at a minimum rate. Once the offer period is over, the site will set a strike rate, which is the lowest rate for funding the entire £100,000, and the lenders bidding at rates below this will be successful. An individual with, say, £1,000 to invest will probably spread it among 10 to 20 businesses, meaning that investment amounts can be quite modest, often in the range of £25 to £100.
Dealing with thousands of lenders is only possible if the crowdfunding site has sufficiently robust systems to run the auctions effectively and to record the interest and capital repayments and allocate them correctly across the wide investor base. In theory, it is a win-win situation, with businesses getting the funding they need without having to remunerate an intermediary bank. But businesses have to pay a platform fee and an arrangement fee, while the investor gets what looks like a massively higher yield than those provided by conventional bank and building society deposits. Recent data from leading P2B crowdfunding website Funding Circle implies that rates for investors average 9.1%pa and tend to be in the range of 7% to 11%.
The issues of risk and return are key for investors, but, realistically, how many of them will be able to analyse risk and assess whether the return justifies that risk? The presumption and hope must be that by spreading your investment, you will never lose too much. The actual default experience at Funding Circle to date runs at 1.1%pa, but it advises investors to expect 2%pa overall, subject, of course, to the mix of high- and low-risk loans. For borrowers, crowdfunding is a viable alternative if you can present an attractive case, have a track record in business and generate turnover above a minimum size, but some form of security or personal guarantees might well be expected. Depending on which site is used, loans from six months to five years are possible, normally at fixed rates, with amortising capital repayments for the longer terms. Most crowdfunding sites are, by definition, themselves fairly recent start-ups, but their track record is growing all the time; Funding Circle has lent £57m to date.
Dealing with thousands of lenders is only possible if the crowdfunding site has sufficiently robust systems to run the auctions
Other platforms exist, including ThinCats.com, which started in January 2011 and has since made £10m of loans using a model that involves a network of ‘sponsors’ who assess borrowers in person. Relendex takes bids from individuals to lend via secured loans against properties that generate commercial income. Other crowdfunders that cater for businesses include Squirrl (a platform for funding assets that are provided by suppliers to customers, for example, vending machines) and personal loan providers Encash and Wonga.
The provision of funding via the internet is, in many ways, a by-product of the financial crisis. A shortage of bank funding has acted as a spur to innovation, and the artificially low interest rates that investors earn through conventional channels has encouraged them to seek higher yields elsewhere. Although it is encouraging that individuals have been prepared to embrace innovation, there could be an accident waiting to happen, with a potential mis-buying scandal.
Recent data from leading P2B crowdfunding website Funding Circle implies that rates for investors average 9.1%pa and tend to be in the range of 7% to 11%
Regulation of the P2P lending sector in the UK is light and somewhat confusing. Meanwhile, the Financial Services Compensation Scheme does not cover any investments made by individuals through crowdfunding platforms. Some sites fall outside the remit of regulation because they themselves are not selling securities or taking deposits; instead it is the investors who are making loans. Other sites require investors to self-certify that they are sophisticated investors or high-net-worth individuals. But Relendex is subject to oversight by the Financial Services Authority because it is actually offering transferable securities in a fund.
This article is based on the research report Seeds of Change: Emerging sources of non-bank funding for Britain’s SMEs, produced by the Centre for the Study of Financial Innovation and sponsored by the ACT. The article mentions certain platforms to indicate the kinds of services that are available. No recommendation or endorsement by the ACT is implied.
Martin O’Donovan is deputy policy and technical director at the ACT
