P2P Guide

31 30 P2P IN ACTION: BORROWER CASE STUDIES P2P IN ACTION: BORROWER CASE STUDIES accept a loan request is based on 3,000 different data points, including but not limited to: • Affordability of the loan, including coverage ratios. • Business net worth. • Profitability. • Trends. • Age of business and management team. • Use of loan. • Credit history of directors. • Days beyond term, and vs sector average. • Cash flow indicators such as searches. For business loans, unsecured loans up to limits set by each individual platform are common, typically secured by a personal guarantee from one or more directors. Clearly, in the absence of security, the underwriting process is crucial in identifying the companies which are likely to be in a position to fully repay funds lent, and/or directors whose personal guarantees provide a real opportunity for collection of outstanding amounts. A personal guarantee puts the director’s personal assets at risk in the event of default on loan repayments, so a platform will usually undertake an examination of what those assets are, including their value and any other potential claims on them. Nevertheless, where security is available, a fixed or floating charge may be put in place over the business’ assets and it is the ownership and value of that asset that must be verified to judge the level of protection that can be provided to lenders (investors). LOANS Borrowers (small fee % of loan) Lenders (investors) Provision Fund Not making any loan interest Case Study: Loan Underwriting – A corporate borrower (SME loan) The sophistication of underwriting procedures will vary across platforms and is often aided by technology that assists with the process of checking records in relation to the potential borrower. For companies looking to borrow, there are typically some minimum initial requirements to allow the credit assessment team to begin its work. For example, Funding Circle requires the most recent filed accounts of the company and a copy of the up to date management accounts (no more than three months old). Where management accounts are not available (for instance where the borrower is a non-limited business) three months’ bank statements must be provided. Borrowers can be limited companies and non-limited companies, LLPs, sole traders or partnerships, but at a minimum Funding Circle requires an annual turnover of at least £50,000 and more than two years of filed or formally prepared accounts. Funding Circle states that the internal risk model when deciding whether, and at what risk band, to Provision funds and loan defaults 5.1 The basic premise of a provision fund is that borrowers contribute payments into a segregated fund, which pays out if a borrower defaults. There are two main types of provision fund: • FULLY INTEGRATED PROVISION FUNDS: automatically pay out when a borrower defaults and therefore there is no time lag for investor repayments. By making the return more predictable, these funds can reduce the volatility of investor returns. • DISCRETIONARY PROVISION FUNDS: pay out at the discretion of the directors of the platform. The level of provision funds, in terms of the proportion of the loan book that they cover, depends on the platform and a fairly wide range exists from less than 1% to 7%+. This figure is related to the risk profile and projected default rates of the loans issued and is decided by the platform. While it might seem that the best policy is to have a large provision fund to cover as much as possible of the value of any defaults, too much cash sitting idle in a segregated account will cause cash drag. That means it will reduce returns and cost investors money, so there is a delicate balance to be struck here. Although past performance is not an indicator of future performance, it is also useful to review the size of a reserve fund in relation to the platform’s past bad debts. The critical statistic is whether the reserve fund has easily survived any and all bad debts. Obviously, the larger the loan sizes, the more chance there is that the reserve fund could be affected or even wiped out if one or two borrowers default on most or all of their repayments. This means that platforms that approve very large individual loans put their reserve funds at higher risk than those that approve the same overall loan value across multiple borrowers. HOW A PROVISION FUND WORKS Lenders receiving full returns are more likely to reinvest Estimated Loan Defaults % OF P2P LOAN APPLICATIONS APPROVED (2016) SOURCE: CCAF PROPERTY CONSUMER BUSINESS 0% 10% 20% 30% 40% 50%