P2P lending: an un-Christmassy story

accapr —  24 December 2013 — Leave a comment

Emmanouil (Manos) Schizas

In our last blogpost for 2013, ACCA’s senior economic analyst, Manos Schizas, talks about trying his hand at lending directly to SMEs – and watches one of his borrowers fail.

I was extremely pleased to host ACCA’s Alternative Finance conference back in March 2013. It was an opportunity to showcase some of the most innovative finance providers in the UK, and it was exciting to see professional accountants work out the implications of their offering for themselves and the businesses they worked for.

But here at ACCA’s SME Unit we’d like to think we’re not all talk, so I have since opened accounts with a number of peer-to-peer consumer and business lending platforms, and have recently started to invest in the latter in earnest. As part of a wider portfolio of loans, I recently bought sixty pounds’ worth of the debt of a company that I shall call Space Odyssey Ltd (not their actual name of course). This may not sound like much but P2P platforms and elementary finance textbooks both stress that it’s important to diversify when investing, and I sure am glad I did in this case.

Looks good to me!

Seen from a policy wonk’s or a journalist’s perspective, Space Odyssey was precisely the kind of salt-of-the-earth business the banks ought to be lending to. It was a manufacturer with well-known big clients. At five years of age, Space Odyssey had managed to not only trade throughout the recession, but also grow by an average of 20% per year and consistently turn a profit. Now it needed to finance its working capital in order to continue growing. Its credit score was better than average for its sector, and indeed exceeded any other relevant benchmark. On top of that, the directors were willing to personally guarantee the loan and were prepared to pay more than the 6.8% average recorded by the SME Finance Monitor for fixed-rate loans of less than 100k. What’s not to like, right?

At first glance, a couple of things were troubling. My own concerns centred on a directors’ loan that was larger than the loan Space Odyssey were seeking from the platform (why were these guys unwilling to put their own money into their own company as equity? Were we investors expected to bail the directors out?) Yet I also knew that this was a common arrangement among growing firms: back in 2009, when I modelled the UK SME population for the purposes of ACCA’s response to the Rowlands Review, I was surprised then to find that directors’ loans were five times more common among the businesses the Review was hoping to increase lending to than among other SMEs – 57% of consistently-profitable, fast-growing and cash-positive businesses were using them.

Other investors on the platform were also concerned about the directors’ insistence on anonymity, the pace at which they responded to questions on the platform, and most importantly their claim (probably in error) that the company had ‘no debt’, when in fact it had a bank loan and overdraft facility in place, and owed substantial amounts to directors and even more to trade creditors. Overall, however, investors welcomed Space Odyssey’s bid, and their loan was not particularly expensive by the platform’s standards.

The other side of the story

What I now know, but couldn’t have known at the time, was that Space Odyssey was already failing, despite what seemed like decent efforts by its management. Two of its major customers had gone bust, one in 2010, then another in 2012, pushing liquidity to the limit. Then earlier in 2013, a major supplier had halved Space Odyssey’s credit limit, pushing them properly over the edge. Yes, Space Odyssey’s top line was growing, and yes, it needed money to finance working capital; nobody had lied to investors. Nor were we bailing out the directors, who kept lending more of their own money to the company throughout the last year. But there was, clearly, more to the story than that. The P2P loan covered less than half of the liquidity shortfall; and even a larger loan, I now think, would have done little to help.

This is because loss of liquidity does not remain an abstract problem for long – it spreads throughout the business’ operations quickly and messily. When a business is unable to pay on time, suppliers don’t just sit there and take it. Space Odyssey’s suppliers refused to complete pending work and orders, derailing projects already in the pipeline. Similarly, clients withheld payments as projects were delivered late or to a less than satisfactory standard. The final blow came from Space Odyssey’s suppliers who secured County Court Judgements (CCJs) against the company. Who could blame them? Except the County Court had handed down a death sentence, making it nearly impossible for Space Odyssey to borrow formally or to secure credit from suppliers. By the time it was agreed the company was to be wound down, the cash shortfall had grown eight-fold.

Meanwhile, directors were scrambling to save a dying company. Just dealing with creditors must have been a nightmare; its own owners aside, Space Odyssey had nearly 70 creditors outstanding when it went out of business, including HMRC, their landlord, and their own staff. And here I was wondering, along with my fellow investors, why they weren’t responding to our questions in time.

Curtain call

Then on 15 November 2013, ironically one day before ACCA’s recent debate on Zombie Companies, I received notice that Space Odyssey was going into Creditors’ Voluntary Liquidation. While this process is decidedly an offline, face-to-face affair, it was related to me in the spirit of peer due diligence that is common in the p2p finance sector: I was invited, along with all other investors, to submit questions for the first creditors’ meeting, where the p2p platform would also be represented. I did, and my question was, in fact, asked on the day. My subsequent questions to the platform were answered promptly by their Head of Insolvency, who also forwarded the directors’ report to creditors as well as an attendance note from their own representative. It is from these documents that I pieced together the story of Space Odyssey, although even that is unlikely to be the whole truth.

And what about my money? It looks like the directors are going to honour their guarantees, keeping investors’ losses very low. They claim they will not go back into business together, or separately.

It’s not a good outcome of course, but it’s been reasonable and professionally managed. Space Odyssey’s failure is no doubt a personal tragedy for a number of people and I’m not entertained by it. I didn’t sign up to lend just so I could watch businesses being wound up or so I could help myself to guarantors’ hard-earned savings, but I always knew this was a possibility. More to the point, without a solid regime for business recovery and dealing with insolvent borrowers, I would not have had the confidence to invest in the first place.

This is not to say that I, or anyone else, should only lend if we can be assured we won’t lose money. They call it providing ‘credit’, for a reason. The P2P investor’s first and best line of defence is diversification, not recovery, and the sector’s strength is that it makes diversification possible even for small individual investors.

Lessons learned

As the p2p lending sector matures, stories such as Space Odyssey’s will naturally become more common. Major platforms also know this and are already citing estimated default rates much higher than their actual historical figures, precisely in order to avoid misleading investors.  Both the platforms and the Financial Conduct Authority (FCA) are stressing that p2p loans to businesses are not savings accounts and are not guaranteed by the government. Perhaps some investors still refuse to believe their borrowers can fail, but I suspect these are a minority.

Still, I think one group of people could do with a crash course in P2P default risk: us small business lobbyists. Until recently, newspaper headlines were screaming for governments around the world to force banks to lend based on politicised ‘common sense’ criteria. In the UK, the British Business Bank is still being urged to do the same. Wouldn’t it be nice if everyone making the case for such supposedly ‘common sense’ lending were also willing to try their hand at lending their own money? They might do no better than I did on this occasion, but at least it would be their own money they’d be losing instead of the taxpayer’s.

Reflecting further on Space Odyssey’s story, I can see one way in which the p2p sector needs to mature further. My father was a bank manager before he retired, and his stories, dating back to 1960s-70s Greece, all seem to revolve around tragic heroes like Space Odyssey’s directors. When their companies were in trouble, the market knew. The bank manager often dealt with their suppliers and their customers, and couldn’t help but notice a pattern.

On the one hand, I hope that one day the p2p sector will be able to reproduce this advantage of old-fashioned relationship banking. On the other hand, I think back to Space Odyssey’s early efforts to maintain anonymity and wonder whether they would ever have bothered with a close-knit p2p lender community like that. Even perfectly creditworthy businesses aren’t whiter-than-white, after all. Balancing crowd due diligence against inclusion will be a challenge for p2p lending platforms, and I look forward to seeing how they reconcile the two.

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