What explains the strong institutional interest we’re seeing in lending platforms at the current time?
It’s interesting that post-crisis, investors bought into the direct lending thesis about bank disintermediation and there was a structural shift from established banks to private investors. What platforms such as ours offer is access to the SME segment. Until we came along, investors had access to corporate mid-market loans but no way to get into smaller businesses. We have developed a unique origination and servicing online platform which allows them to do this.
Investors tell us they have invested heavily in the mid-market and now they want something which is complementary and offers diversification. I would never say it should be a choice of the mid-market or SMEs; the two things are highly differentiated. A mid-market direct lending portfolio may have 10 to 15 loans, whereas online lending platforms such as ourselves offer tens of thousands. The mid-market funds often have a regional or sector focus whereas we are global. They are typically long duration with bullet repayments whereas we are around a two-year duration and the principal gets paid back every month.
Are investors familiar with the characteristics you have described?
It’s a bit of an education process around the asset class itself. Small business lending has been around for ages but there has not been a risk transfer market, so institutions have not been able to get exposure. You have to spend time making sure that investors understand how the asset class works.
How do you assess the potential size of the opportunity? What’s your estimate of current and likely future size?
We are literally just scratching the surface of what is possible. Investors have lent £4.5 billion to businesses across Europe and the US, but the market could be worth an additional £500 billion. The SME space makes up 50 percent of GDP in the UK and around 80 percent in other parts of Europe, but only a small number of platforms are targeting this part of the market at a time when the banks are stepping away.
Nearly 50 percent of capital comes from investors supporting businesses across all of our markets. They met us in their domestic market and once they get to know us and understand how the platform works and the stable returns that are generated, the relationship has been extended to other geographies.
What has been the relationship between regulators and lending platforms to date? Do you expect that to change in any way in the future?
We have been very supportive of regulation and lobbied to be regulated. The Financial Conduct Authority (FCA) has taken a forward-thinking approach. It has been proportionate and effective in the UK. In the US there are several regulators and there is an opportunity for our industry to be regulated in a more optimal way and it would be good if they replicated what has happened here.
Consistent regulation is a great way to encourage cross-border lending, not just on the institutional side but also retail. You can imagine a situation where retail investors in the UK can lend to Italian businesses, for example. That could be a very useful countercyclical buffer for Eurozone countries.
Where do you think we are in the cycle and what would a downturn mean for loan books such as yours?
At Funding Circle, we have a strong track record of facilitating lending to businesses and have a very experienced team. For example, our chief risk officer, Jerome Le Luel, was the former head of risk analytics at Barclays Group during the last financial crisis.
Also, we have a lot of data and undertake regular stress-testing exercises to model what might happen to investor returns in a downturn. In a situation similar to the last recession we expect returns to remain between 3 and 5 percent due to the high loss coverage on the loans. Our belief is that a downturn will demonstrate the resilience of the asset class.
What are the keys to a good recovery process?
We have an in-house servicing, collections and recoveries team, who are dedicated to providing businesses with specialised support. The banks often have to write debt off as they are subject to year-end requirements, but we can look to the long term. Our aim is to identify problems early and reach out to help as much as possible. We want to give businesses a chance to recover and pay back in full. As a result of this approach, our recovery rate is around 40-50 percent over a five-year horizon.
Risen from the ashes
Sachin Patel tells the story of Funding Circle
Funding Circle was born from the ashes of the global financial crisis. The firm’s chief executive officer, Samir Desai, was working in a private equity firm that specialised in buying financial services companies. He was part of a group of investors that looked into buying, and performed due diligence on, Northern Rock. It was during this due diligence that he concluded the traditional model of banks providing finance to SMEs was broken and that the platform model was the right way to address the problem.
In 2010, Desai, co-founder and UK managing director James Meekings and co-founder Andrew Mullinger launched Funding Circle. Having built the retail investor side of the platform, the British Business Bank came in as the first institutional investor in 2013. I was working with pensions and insurance companies helping them to access online lending and there was a wholesale flight of fixed income into that area which appeared to be a structural shift.
When I joined Funding Circle my feeling was, “why not go to the heart of that trend and see if we can get institutions on board?”. We recently did our second securitisation of Funding Circle loans, which was bought by the German development bank KfW with a guarantee provided by the European Investment Fund, and it priced very well. This was validation of what we offer, which is low cost beta access with no fees.
Small businesses are also supported by large investors, including banks and insurance funds, who buy the loans directly. We used to be seen as a disruptor by the banks but now they buy the loans from us at a low cost. Some of these banks now refer small businesses they are unable to support to us, including Santander and RBS.
This article is sponsored by Funding Circle