Sunday, August 14, 2016

P2P Selection - How We Choose our Borrowers

"Any one can make loans!  Takes no talent, takes no guts.  Making good that's a whole 'nother story..."  Michael Sonenshine, CEO SymCredit

It's been nearly two years since I laid out the business plan for the SymCredit platform, raised some equity financing and set to work.  The first year was all about building a foundation - designing the website, hiring some managers, firing some managers, writing policies and procedures and re-writing policies and procedures.

Nearly nine months ago we on-boarded our first borrower and now we are on-boarding new loans monthly.  We are still growing at a snail's pace, much to the dismay of our investors, who would like to see us moving at lightning speed.

There are a number of reasons for the slow start out of the box, which I won't detail here.  I had the experience many years ago of pushing a services organisation onto the fast track opening the door to far too many error and far too many corrections and spending time and money cleaning up the mess and worse, having to re-earn the trust and confidence of customers.

I'm often asked the question about how I benchmark SymCredit, not only in terms of its development, but in terms of installing good practice.  In terms of development, I look at the biggest platforms in the sector today, where they were five years ago and what was their trajectory since.

A few names that stand out in my mind are Funding Circle (UK), LinkedFinance (Ireland), Bondora (Estonia) and Zltymelon (Slovakia).  At the end of 2010 Funding Circle based in the UK had placed GBP 2.2 mln worth of loans.  Six years on they have surpassed GBP 1.2 billion.  Linked Finance opened its doors in 2013.  During the first six months they loaned about EUR 1 mln and today, about 3 years later they have grown to EUR 18 mn. Bondora launched in 2009.  Volumes were small in the early years.  By 2014 nearly five years after establishing operations they had grown to EUR 22 mn and now they are close to EUR 60 mn.    Zltymelon, based in Slovakia launched operations in 2013.  It took them nearly a year and a half to surpass EUR 1 mn in loan volume.  Three years down the road they have lend more than EUR 4mn.

Looked at in this context, we are about where we should be.  We've got our first borrowers.  We've got our first investors.  Momentum is picking up.  From here on it's all about execution and smart marketing. Like every new P2P Platform we expect to grow slowly in the initial years and then accelerate rapidly. Why?  Because it takes time to educate the market and earn the trust of investors.

In terms of installing good practice, I look most closely at Funding Circle.  This is not to say others are not good.  Rather this is say I truly respect and admire the way Funding Circle runs its business and this is why I invest part of the Symfonie Lending Fund via the Funding Circle Platform.  If you ever have the chance to meet Funding Circle founder Samir Desai you will find the conversation a learning experience.

When I invest via a peer to peer lending platform I am putting my faith mainly in the ability of the platform to evaluate borrowers.  I expect that the overall pool of borrowers will deliver a total return consistent with the risk level they represent.  At funding circle the overall pool of loans delivers about a 7% annual return.  The most stable and consistent returns come from the highest rated A borrowers.  The riskier rated C and now D borrowers have gross yields of between 11% and 18% but after defaults are factored in the returns are within the expectation.

Platform statistics tell the story of how a peer to peer lender selects borrowers classifieds them and manages them after the deal is done. Funding Circle stands out for the depth and transparency of its statistical presentation and the consistency of its returns.

What Funding Circle also does well is recover bad debt.  To date I've received back nearly 25% of defaulted debt. That's far more than I have received from any other platform I have invested through.  Moreover, when loans go bad, Funding Circle is clear and transparent about what went wrong with the loan and what Funding Circle is doing to recover the loan.  What's also nice is that Funding Circle doesn't charge high fees for recovering the loans.  The platform has a mechanically clear and economically efficient set of processes.  It implements the recovery process and reports the results back to investors. 

Too often in the investment banking industry bad or distressed debt is looked on as trash that when hauled away nets the trash hauler a hefty return on capital.  This is not to say that distressed debt traders don't take risk and shouldn't be compensated for it. But the business model of buying a loan at 10 cents on the dollar and collecting 20 cents on the dollar by doing nothing more than giving the borrower an easy way out is a deadweight loss for the investors who took significant risk to begin with.  Many peer to peer platforms create this cheap ride simply because trash smells and they somehow feel they don't get compensated for having to deal with rot and filth.

Funding Circle takes recovery and its responsibility to its investors seriously.  True, they are in business to broker loans.  But once the loan is brokered, the interests of their investors are their highest priority.

This leads me away from this unpaid, uncompensated plug for Funding Circle and back to the subject of this article - How We Choose our Borrowers.

In a nutshell, the answer is carefully.  Here are the some of the key principles of our credit policy:
1. Less is More. We'd rather have fewer borrowers on our platform that we can be confident in than have many borrowers that don't perform as they should.

2. Credit is about willingness to pay as much if not more than it is about ability to pay. We review the personal credit histories of the owners and directors of the borrowers on our platform.

3. Credit is about assessing the strength of the entrepreneur and management team running the company.  We assess the quality, knowledge and experience of the management at each borrower who seeks a loan from our platform.

4. We put little faith in the business plans of the future and a lot of faith in the ability of management.  Banks ask borrowers for detailed forward going business plans and projections.  What often comes out of of the process is spreadsheets with geometric extrapolations of the present based on assumptions that don't necessarily reflect anything more than the desire of the business owner to get a loan.  This is not to say banks are stupid or filled with paper pushers.  Rather, this is to say that we find that asking a business owner important and serious questions about they way he or she runs the business and where he or she wants to take the business is a better approach to the problem.

5. Our business is business loans.  At the end of the day, people run those businesses and people invest in those loans.  We select entrepreneurs who we feel demonstrate a certain personal honesty and integrity.  They understand well that people are putting their hard earned money to work with them and they understand the seriousness of the trust relationship that creates.

6. Cash flow and borrowing go hand in hand.  We'd much rather lend money to a business with a steady client base and predictable earnings that has no equity than to a cash poor business with equity on the balance sheet.  Our experience tells us that equity and assets have strange way of disappearing at the worst imaginable moment.

7. The bottom line is not as important as how the numbers add up.  Many small and medium sized business provide a stream of cash to the owners that works its way out through wages, directors fees and services fees.  This is why the balance sheet of successful wholesale or retail business can look lousy while the owner has over the years come to own 3 houses and put 4 kids through expensive universities.  When times are good the business PnL may worsen.  When times are bad there is more cash in the business, and a leaner expense base.  Moreover, from year to year tax management and tax optimisation strategies may influence the expense base.

 At the end of the day, credit is as much an art as a science. 
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