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Nothing ventured, nothing gained… but how risky are they?

by | Aug 11, 2014 | Investment News

Peer-to-peer lending and Crowdfunding have been getting a lot of coverage recently. That’s not surprising given the low interest rate / low return environment we’re in currently.

They have also attracted interest from the Financial Conduct Authority and on 1 April they became regulated investments.

Being regulated means more scrutiny which is a good thing. It does not mean that the FCA endorses them as an investment.

Risk = return?

It also does very little to make them less risky. Investment is all to do with risk.

Yes you could make more than having your money on deposit.

In return you are taking on a lot of risk much of which can’t be seen or quantified.

What is crowdfunding?

It is internet-based lending that matches people who need to borrow with people who want to lend.

It is for anyone who needs to raise money but does not want to rely on banks or others: this is investment-based crowdfunding.

It is also for those willing to lend: this is peer-to-peer lending (or loan-based crowdfunding).

The mechanics

Money loaned is pooled through a website, which is also known as a platform.

Equity investment crowdfunding: typically used for start-up businesses, offering investors shares or a stake in the business in exchange for sufficient cash to give the business a head start.

Peer-to-peer lending: between individuals, allows money to be loaned and borrowed with the website as the middleman holding the ‘IOU’. Returns for lenders can vary with some interest rates as high as 7%.

How much is being raised?

Looking only at the serious capital raising exercises £939 million was raised in funding to individuals and businesses in 2013, up by 91% on 2012. That’s according to national innovation charity and think tank, Nesta (formerly NESTA: National Endowment for Science, Technology and the Arts).

Nesta predicts this figure will grow to £1.6 billion this year, 2014, providing £840 million worth of business finance for start-ups and SMEs.

The Financial Conduct Authority

Inevitably, such figures and rate of growth have attracted the attention of the City watchdog.

Some commentators have described this as unwelcome attention (a reason to be wary if ever there was one!), arguing that fiscal regulation will slow the spontaneous free-flow of funds that is the defining characteristic of crowdfunding.

The fact is that very few crowdfunding platforms are covered by the Financial Services Compensation Scheme (FSCS), which pays money back to consumers if a regulated company goes bust.

The first lesson

Be absolutely clear on this point: whether authorized or not, if your platform fails you are not protected by the FSCS.

You stand a very high chance of losing your investment if things go wrong.

The second lesson

Do the research.

Be certain you feel comfortable with where your money is going – do you know enough about the particular start-up you’re attracted to?

There are no standard rules on the information that platforms have to provide on the companies they promote.

Also the FCA has said it will not dictate how start-up companies should disclose the risks inherent in investing in them.

Do not expect regular reports either on how the company you have invested in is performing – for the detail, you will have to do the spadework.

In the same vein, for peer-to-peer lending there is no requirement for those platforms to chase borrowers who fail to make loan repayments – though some do guarantee payments should a borrower default.

What are the FCA’s new rules and regulations?

For peer-to-peer lending the new rules stipulate the level of reserves lending platforms must have supporting their business – at least 0.2% of the monies they lend out, up to the first £50 million of loans.

Operators will also be obliged to provide for investors demonstrably robust plans for collecting loan repayments should their platform fail. There will be failures.

FCA-authorised platforms will be required to have a minimum of £20,000 in capital, rising to £50,000 in 2017.

However, and crucially, for investment crowdfunding, the FCA has decided to keep platforms out with the remit of the FSCS if they are not already covered by it.

It has committed to reviewing crowdfunding again in 2016 together with its position on the FSCS.

Our view

This is not an alternative to having money on deposit. Money on deposit is safe (up to the FSCS limit) this is not.

This is simply an alternative investment and should be reviewed as such.

  • Until there’s a good solid, long term track record of performance we will remain critical observers.
  • Without standardised risk or information disclosure it’s next to impossible to compare one opportunity to another.
  • With very little in the way of regular reporting you will struggle to keep tabs on what is going on.
  • Lack of transparency is never, ever a good thing and is a reason on its own to run for the hills.
  • If  it all goes wrong there’s very little in the way of recourse open to you.

If you want to get involved be prepared to take a loss and only commit what you are prepared to lose completely. Two-thirds of start-ups fail within the first three years.

You will be giving money to a business that has a very high chance of failing.

There will be failures and those failures will cost a lot of money. We would rather it wasn’t our clients who suffer.

In summary

  • There is, and never has been, a free investment lunch.
  • Higher returns = higher risk. Simple.
  • Don’t chase returns.
  • We’re worried that investors are chasing return at the expense of taking on extra risk.
  • Worse still much of that risk is hidden, obscure, not reported and therefore can’t be quantified.
  • We don’t believe in fads or fashions and crowdfunding and peer-to-peer lending certainly qualifies as such at the moment.
  • All in all that’s not the way we recommend clients invest their money.

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