It will come as no surprise to most business leaders that the traditional means of financing businesses are transforming. Revolutionary changes to the global financial markets and technological advances are altering funding sources and the mechanisms for accessing them. Before 2008, the financial market was dominated by large, trusted banks that offered a traditional approach to lending and provided the majority of finance for businesses, typically backed by physical, material assets or assets tied to the business owner. The string of scandals that has plagued banks since then – from rigging inter-bank interest rates to taking high-risk approaches to lending – has led to fundamental changes in the availability of bank lending and a new dawn of banking regulation.
At the same time, technology and new business models are also shaping the types of business finance and funding available, as well as determining the ways organizations source it. Individual high-net-worth investors are more important than ever and are increasingly encouraged to invest in growing small, emerging businesses through different types of incentives and new funding models. Equally important in this paradigm shift are the opportunities afforded to average working class individuals who are now able to take part in new investment and financing opportunities. Understanding the acute but significant differences between the huge range of finance and funding options available – from bank lending to crowd-sourced funding to private equity and venture capital – is a challenge, but will be vital for business leaders as they consider the next steps for finance to suit their circumstances and needs.
Internet-based lending platforms – so-called peer-to-peer facilities – are becoming an increasingly important source of consumer credit and have the potential for continued rapid growth. These platforms may offer borrowers the opportunity to obtain credit at lower interest rates than would be available to them through banks or other traditional lenders. In addition, they offer investors the opportunity for attractive risk-adjusted rates of return. In general, the term Peer-to-Peer lending (P2P) is one where a third-party Internet-based platform acts as an intermediary between borrowers and lenders. They must not be otherwise connected to each other, or the platform, and the loan must usually be for personal, charitable or small business purposes.
In the 2012 budget, the Chancellor announced that the UK government was allocating £100 million for investment in ‘non-bank’ channels to help improve the flow of finance to growing businesses. This was the first time the UK government had directly lent money in this way, meaning that peer-to-peer lending represented increasingly fertile ground for business finance.
A key branch of this investment involved government joining with Funding Circle to lend £20 million to businesses directly through Funding Circle’s online marketplace. Beginning in 2013, the government started to lend on every loan that comes onto the Funding Circle marketplace, funding up to 20% of each loan at the average rate, with the remaining 80% of a loan funded by investors in the normal way.
The regulatory framework has been designed primarily to achieve the following key objectives:
Provide additional protection for consumers
Promote effective competition within the P2P lending industry
Allow the growth of the industry to continue in a controlled way
Ensure platforms provide clear and not misleading information and have appropriate procedures for handling client money
Ensure firms deal appropriately with customers in financial difficulties and complaints
Ensure platforms maintain a stable financial position and have contingency arrangements in place in the event of a platform failure.
There is a strong emphasis on the transparency and availability of information on platform providers’ websites, particularly relating to the risks and rewards involved in P2P lending. This should make it easier for both lenders and borrowers to make informed financial decisions.
What does this mean for the P2P lending industry?
The increased consumer awareness of this sector and additional credibility and consumer protection should give lenders more confidence in how their money is being managed and borrowers more confidence in choosing P2P platforms as their loan provider.
Investment advisers will also welcome the sector being regulated, as they can now advise and recommend to their clients a highly attractive product alongside other investment opportunities. This regulatory environment should also ensure that the exponential growth experienced by the industry during recent years can continue in a controlled manner whilst maintaining the high standards and customer focus with which the industry is associated.
It nonetheless remains the case that any prospective operator of a P2P platform must be careful to plan and operate its business in compliance with applicable regulations. Regulatory costs may prove to be a significant barrier to entry into this industry; such costs may become a significant expense for those platforms that commence operations and any failure by a platform operator to comply with applicable regulations can result in civil or criminal penalties, litigation expense, adverse publicity or, in an extreme situation, the termination of its business.
The Peer-to-Peer Market Landscape for Borrowing and Lending
A number of internet-based lenders are currently in operation in the United States and Europe. Each such site generally focuses on a single market segment; i.e., consumer loans, small business loans, student loans or microfinance (small loans directed to individual third-world entrepreneurs). The consumer sites have attracted the most media attention as these sites generally are thought to have the greatest potential to revolutionize an existing financial market. In particular, the consumer sites have created a marketplace in which consumers not only can lower their financing costs but also in some instances can obtain credit when bank financing would have been denied.
Peer-to-peer lending has a bright future as evidence by: the substantial growth in loan volumes achieved by existing platform operators; the substantial equity investments made in those operators by prominent institutions; the actual or expected commencement of operations by new P2P lenders; the increasing interest of institutional investors in P2P loans as an asset class; the completion of the first securitizations of internet-originated loans; and last, but not least, the announcement by the largest P2P operator that it expects to undertake an initial public offering in 2014.
All of this suggests that the SEC’s adoption of final rules permitting the use of general solicitation and advertising in private placements of securities and its publication of draft crowdfunding rules have also focused attention on the potential for internet platforms to revolutionize the financial markets.
The two main peer-to-peer lending sites in the U.S. are LendingClub.com and Prosper.com. These sites are the two biggest in terms of loan volumes. There are other online lending options, such as SoFi.com, for example, which specializes in student loans from alumni, and LoanBack.com, which lets users create legally binding loan agreements to lend to friends or family. At Kiva.org, you can lend money to needy entrepreneurs in developing countries. Lending Club and Prosper.com, however, basically bring together people with money and people who need it.
Both sites look at potential borrowers’ credit histories and other factors and assign them risk scores, which are then used to decide the interest rate of the loan. On Prosper.com, someone with the best rating, AA, recently could get a three-year unsecured loan with an annual percentage rate as low as 6.73%. A lower-rated borrower could pay more than 20%.
Returns for lenders can be impressive. Both sites have been cited as saying that historic annual returns range from around 5% for the safest loans to more than 10% for riskier loans.
The loans on both Prosper and Lending Club are at fixed rates. While this will be advantageous for borrowers if interest rates start to rise over the next few years, it poses a potential risk for investors. Right now, a 5% return looks healthy compared to the much lower rates available on safer investments like certificates of deposit and money-market funds. But five years from now, that may no longer be the case.
Funding Circle wanted to establish a common marketplace for businesses seeking finance and funders seeking to invest to come together, bypassing banks to forge mutually beneficial financial terms. Since its launch in 2010, Funding Circle has been responsible for over 1,400 loans, totaling £70 million funding for 1,300 businesses.
All transactions take place on an online marketplace, where investors bid on loans in an auction-style process for up to 14 days per business which cuts out the protracted and relationship-driven nature of bank loans. Loans are available from £5,000 to £500,000 with repayments over one to three years. The platform has a high ratio of investors to businesses and provides a strong guarantee of funding for SMEs pursuing this route.
Funding Circle enables individuals to lend to a wide range of businesses and receive strong returns on investment (average growth yield 9.1%) that aren’t possible through traditional banking. Control is firmly in the hands of investors as they select which businesses they want to invest in and at what interest rate they want to receive monthly repayments.
[Funding Circle is not the only lender in the UK market; other peer-to-peer sites can be found here: http://uk.zopa.com and http://www.ratesetter.com]
While the lenders initially attracted retail investors, the returns have lured big institutions and hedge funds. Lending Club projects returns of 5.4 percent to 9.4 percent. Platforms like Lending Club, Prosper and Funding Circle are being flooded with institutional money due to advances in technology, operations and services. Newly formed peer-to-peer platforms can leverage these business models in accelerating market entry.
There will continue to be rapid growth in peer-to-peer lending, which encourages individuals to invest personal wealth in SMEs. The increasing popularity and frequency of these partnerships amid sharp withdrawal of traditional bank lending will be facilitated by technology.
Opportunities to finance growing businesses and new business ideas will originate from increasingly diverse sources over the coming years. By 2020, it will be common for businesses to connect with investors via peer-to-peer websites and market wide platforms such as the recently launched FundingStore.com, which matches SMEs to potential investors, advisers and lenders.
It is projected that by 2016, U.S. peer-to-peer lenders will be originating upwards of $20 billion in loans annually. Clearly, age-old sources of funding, though well established, are changing through innovation and technology’s influence and the nature of the economic environment itself.
[Related: “Peer-to-Peer Lending: Game-Changer or Business as Usual?”]
The likelihood of a business successfully securing financial support will rely on the business’ ability to present itself as an attractive proposition in line with the fundamental drivers for the funder or investor that takes account of these changes, rather than ignoring them.
Bank funding has been transformed and in light of new regulation it will most likely never return to the pre-2008 environment. The invoice-financing avenue may provide a more viable funding route than ever before for businesses offering goods on a non-returnable basis to a diverse client base. Technology will continue to be the ‘enabler’ by defining the types of business being created and allowing SMEs to identify new routes of financial support.
Funding via technology will be driven by social and emotional behavior to a greater extent than finance has ever experienced. Businesses seeking finance through this route will succeed if their connection with a community of supporters (eg., consumers, partners, suppliers or a combination of all) equals or exceeds their ability to create profit. This represents a revolutionary change to the nature of securing investment and is well underway.
Government’s role in business finance should be one of partnership or creating incentives to encourage other investors and funders to privately finance the growth of the SME community that is so vital to the global economic recovery. The UK government is already breaking new ground by working with new initiatives such as Funding Circle to channel money to those who present a real opportunity to impact national economic status. Private equity will become an accessible route of finance for more SMEs than ever before and new players such as the Business Growth Fund are defining a new kind of investor – part finance, part guidance.
Business finance going forward will require the ability to adapt to the changing nature of banking and tapping into powerful online communities (“the Crowd”) while taking advantage of the social aspect of finance.