Jerome Le Luel
London-based Funding Circle is a direct lending platform for business loans, where investors lend directly to creditworthy small businesses. Launched in 2010, the firm has facilitated £2.7 billion (€3.2 billion, $3.4 billion) of loans to over 30,000 businesses in the UK, US, Germany and the Netherlands.
PDI met the firm’s chief capital officer, Sachin Patel, and chief risk officer, Jerome Le Luel, to find out more about the firm’s approach to direct lending and how it differs from the banks’ approach.
How was Funding Circle founded?
Sachin Patel: We grew out of the ashes of the credit crisis. While working for a private equity company seeking to acquire Northern Rock, our CEO and co-founder, Samir Desai, looked at the bank’s small business lending division and was shocked to see just how antiquated it was. He researched the market further and found SMEs were, in fact, served poorly by all banks. He determined that there was a much better way of doing things – and here we are, seven years later.
The banks were offering a very poor service. It took two to three months to get rejected for a loan, never mind accepted, and there were so many manual processes. You had to be interviewed in the branch, documents were sent by fax and there were no ‘out of hours’ services.
In the UK, the SME loans we intermediate average approximately £70,000 in size. Banks have never found a good solution for this market because it falls between their two main priorities of consumer loans and large corporate loans, where they have cross-selling opportunities. Small business loans fall through the gap. We can do a very high level of credit assessment without banks’ expensive infrastructure.
Although we’re disruptive, we now work closely with the banks. The likes of RBS and Santander are happy to refer businesses they are not able to help because the regulatory environment means that the capital requirements on holding small SME loans are too high – it make no economic sense from their point of view. A referral arrangement allows banks to retain or even win over new customers.
How are marketplace lenders regulated?
SP: We’re not a bank so we are not regulated under domestic bank regulations or subject to Basel III. Instead, we’re regulated to varying degrees in the local markets where we operate, for example in the UK under the Financial Conduct Authority’s debt-based crowdfunding regulations. The FCA has been a very forward-thinking regulator; it has spent time getting to know the industry well and the regulations reflect that. It’s a relatively new industry, but we are required to have many of the basic elements of risk infrastructure that other regulated businesses such as banks and asset managers have.
How does that risk infrastructure at a direct lending platform like Funding Circle compare with what you’d find at traditional lenders?
Jerome Le Luel: What surprises me is how different the allocation of resources is in different businesses. A big bank puts a lot of management attention and resources into investment banking and certain retail operations because they are very profitable, and the technology and methods applied are quite good. But small business lending is not prioritised because it’s not a particularly profitable or sexy business for them. We have re-engineered the origination, credit assessment and servicing model to service small business borrowers and the technology we have developed is entirely bespoke.
We are addressing the same issues as the banks: making sure that we work with the right borrowers; that processes are performed in a well-designed manner with good controls, that data is used well and that we leverage the expertise of our people. The banks do all this for credit cards and mortgages, but we apply it to small businesses. Small business lending is difficult for banks because the expense of the requisite infrastructure and people is very high. It’s not their priority. Many have legacy systems going back 20-30 years and a large and disparate branch network which is hard to move away from.
What are the implications of direct lending platforms not having a balance sheet to use in lending?
JLL: Sometimes people ask whether we have enough skin in the game. My answer would be that if a loan fails we get less revenue. We receive an origination fee and a servicing fee and, if the loan fails, we lose the latter. We’ve made a commitment to deliver and if we don’t, then investors will put their money somewhere else and our ability to earn fees on originating and servicing loans will deteriorate. In the UK, we also publish details of every single loan ever originated on our website alongside cohort data and stress testing findings which enables a fast feedback loop in terms of credit performance. The immediacy of information and institutional scrutiny supports a robust alignment of interests.
How engaged have institutional investors been with the asset class?
SP: A few years ago, some ‘early adopters’ took a leap of faith. The investor base has evolved from hedge funds to banks and will likely continue to expand to insurance companies – in other words, towards lower and lower cost of capital. With our track record, we are no longer capital-constrained, it’s more about where we want to take the capital from and our most important priority is to diversify our funding sources. A number of domestic and supranational development banks have invested directly or indirectly in SME loans through our platform, including the European Investment Bank and the British Business Bank. The due diligence from institutional investors can be exhaustive, but other investors have taken comfort from the scrutiny that they apply.
Investors lending through our platform pay only a servicing fee. There are no management fees and our institutional investors get beta access to a granular pool of short duration, high yielding loans.
How will loan books like yours fare in a less benign credit or macroeconomic environment?
JLL: The book we have now was started in 2010 and we’ve not had a recession with this business model. But we have to be prepared. You need to understand the correlation between macro factors and their influence on the market. We compile forward-looking scenarios and do stress testing and we can make adjustments if the market starts moving.
We had a comprehensive stress test conducted by a large UK-based actuarial firm to see how they would impact the net yield. In good times, the stress test results suggested that the UK net yield would be approximately 7 percent and, in the worst-case scenario, this went down to approximately 3-4 percent. The stress test was based on a scenario which saw negative GDP growth and house prices falling 30 percent. The stress test results suggested the loan book would still be seeing a positive yield even in terrible times. Tested against a 2008-type recession, the stress test results suggested the net yield was about 5 percent.
This article is sponsored by Funding Circle. It was published in the May 2017 issue of Private Debt Investor