This post first appeared on AltFi.com, where you can read my monthly posts on the Alternative Finance landscape globally.
It is one of the paradoxes of the alternative finance market that, in a yield hungry world an asset class providing a risk adjusted return beyond all but the most outlandish investment strategies has yet to attract significant amounts of mainstream institutional capital. Talk to institutional investors and the answer is always that this is an untested asset class and so it is too early to invest. These same investors will eagerly buy the first Government bond from a small emerging market, or back a leveraged buyout of a company.
So what is happening here? To my mind “to early to invest” or “not been tested in a downturn”, both of which will could also be true for the other examples above, is in the case of the AltFi industry code for “no idea whether I can really trust these guys”. This is due to the fact that there is significant scope for platforms to develop without rigorous processes and procedures, and there are no real industry standards. In the absence of these, the bigger platforms get bigger simply by virtue of the lemming principle – no one is going to criticise if you head in the same direction as everyone else.
What the industry needs to do is to face up to the fact that, in the finance sector, you have to apply standards that are equivalent to other areas of the industry (and even beyond at an early stage) or you will never be taken seriously by other participants. If this can happen then some of that capital that would have ended up in the coffers of a Government of somewhere you couldn’t find on a map or the pockets of the ex-shareholders of an overleveraged cyclical company could be heading instead into loans originated by the AltFi sector.
Above and beyond the benefit in terms of opening up institutional interest in the AltFi sector, the application of common standards would allow the various aggregators that have started to appear in the AltFi space to genuinely compare like with like, and would also start to build a secondary market in loans, which given the amount now outstanding starts to make a great deal of sense.
So what sort of standards need to be set? I would group them into six areas: underwriting, technology, reporting, documentation, regulation, and business model.
Firstly on underwriting, those that know me or have heard me speak at conferences will know that this is a real bugbear of mine. These platforms are not technology companies first and foremost, they are finance companies. They need rigorous written processes and procedures for underwriting from day one. It is no good going out with a minimum viable product and iterating thereafter, if you expect other people to fund the loan book. The expected default rate needs to be forecast, modelled, stress-tested and continually reported in a full and transparent fashion (see below). “We’ve built a clever algorithm which will learn as it goes along” is not good enough.
In technology, as with underwriting, the requirements of a grown up finance business worthy of investment by an institution are significantly beyond that of an early stage technology company. Platforms need to be aiming to be far more resilient to hacking than a regular website and should be using someone certified in ethical hacking to break in on a regular basis and give a report of vulnerabilities. This report needs to be acting upon. Someone who knows what they are doing will get into every site, the issue is how much damage they can do. “We’ve done pen testing and we’re fine” is not an acceptable answer. Secondly there need to be internal protections against the actions of rogue employees, as this becomes a significant risk once businesses start to grow up and employ beyond the core founding team. Thirdly the entire code needs to be regularly reviewed, because as the platforms grow and bits bolted there is a risk that it ends up a bit of a mess.
The third key area is reporting, and again this has been another bugbear of mine for years. Previously I was involved in the US syndicated loan market, as an investor and an analyst. In this market “default” was just that, a loan that had missed a payment (of any kind), or tripped a covenant. The same is true in the bond market. On the other side the “recovery rate” was the amount recovered on average from these defaults. The net of the two was the actual loss of return netted off against interest received to give you what investors receive. In normal market conditions for 1st lien senior secured loans the defaults ran at around 1-2% and the recovery rate was 70%+. Compare this to the alternative finance market, where a loan is not regarded as “non performing” until at least 45 days behind in payments and “defaults” are only really those loans that are irrecoverable, and thus there is no recovery rate. To my mind the nomenclature needs to be aligned with other fixed income asset classes. A “default” is something that has missed a payment; if that default is not rectified within 45 days it becomes “non performing” and if it is written off it is described as just that. This will also generate a recovery rate, which I suspect will be high, but so will the default rate. The other area of reporting which should be covered is restructuring. If a repayment comes through a restructuring of a company’s finances that may be good news, but a platform that has a consistently high rate of restructuring may indicate a systemic risk in the book, which would not be apparent from other figures.
The industry does not want to head down this route for fear of frightening off investors, and will only change if everyone else does, because no one wants to report a default rate a multiple of the competition, because they haven’t changed their definition of a default. I would argue that the lack of comparable data with other asset classes is actually holding back investors and giving more realistic numbers will go a long way to this being accepted as a true asset class in its own right. As for the competition issue, if there are agreed standards implemented universally there will be no competitive issue.
The remaining three areas for standards are relatively self explanatory, but nevertheless are worthy of laying out. Fourth on my list was documentation, and here again I would turn to the syndicated loan market – the reason it is a trillion dollar, liquid market in the US is that documents are written based on a standard form of documents. The AltFi industry needs to agree common standards and apply them across platforms, and then investors can compare apples with apples. Fifth on the list is regulation, and this really shouldn’t be necessary, but given that many platforms have tried to skip between the raindrops of regulation in the past, all platforms need to publicly commit to applying all regulation and cooperating with regulators in every jurisdiction in which they operate in an open and transparent manner. Finally, in respect of business models, all platforms need to be able to demonstrate that they have a business model which will allow them to demonstrate their strategy for achieving consistent profitability without heroic assumptions either as to further equity investment or growth in the business.
The final question would be who should set these standards and police them. I don’t believe that the P2PFA is the right body, since it represents the interests of the largest platforms, whose interests are least served by establishing common standards, since the status quo works very well for them. Instead I would suggest that the providers of capital, the funders of loans, need to get together to create a “Funders Forum” if you like. With input from the platforms this body would need to come up with common standards and provide certification that platforms meet the standards. Many people in the industry will roll their eyes at the idea of more bureaucracy and paperwork, but if you want to attract institutional investment, this is what you need to do.