The idea of holding back some of the profits in debt-based securities (DBS) platforms to help combat bad debt and late payment issues, in a so called ‘retained profits reserve’ has begun to gain traction, potentially adding another layer of security for investors.
In the P2P space, the idea of a ‘provision fund’ – where a proportion of investments is set aside in a pool to help investors retain capital if anything goes wrong – is a long-established idea, however until recently such a scheme was generally only found in the P2P space.
The idea of the retained profits reserve has been pushed by Roger Blears, senior partner of RW Blears, who compares the current situation of bond selling platforms with the Italian Banks of Renaissance Italy. Both, he says, were often very thinly capitalised when they first launched. Whereas the Italian banks would go on to have centuries dominating the European financial markets, these new money lending companies are still in their infancy, and many have yet to build a comparable financial buffer in a similar way to the traditional banks.
Speaking to Intelligent Partnership for an upcoming Report on Alternative Finance, Blears provided an example of how a fund might work: “A ‘retained profits reserve’ restriction could operate so as to:
- Restrict fees payable to the operators of money lending companies to a per annum fee of 2% of the total amount subscribed for bonds, with which to cover all operational costs; and
- Restrict distributions to shareholders so that they are only payable from: (A) Interest Income equal to 30% of the marginal difference between interest received from SME borrowers and interest due to bond holders, after deducting the 2% per annum fee; and (B) Remaining Interest Income but only after a reserve has been built up which, when added to shareholder capital, is equal to: (C) 5% of the outstanding bond capital; plus (D) Accrued but unpaid interest due to bond holders; plus (E) Any provision for non-payment of capital by SME borrowers.”
Different platforms may have different amounts, but the core idea is the creation of a reserve to act as a buffer against potential losses from the retention of a set amount of profits.
Such a measure would offer a measure of security for investors as well as help reduce risk – potentially allowing platforms to reduce interest charges and costs.
Blears added that a number of platforms were looking to, or had implemented a retained profits reserve, including Amberside ALP and Cogress.
Platforms will have to be careful, however. In its recent regulatory changes on the P2P market, the FCA introduced a series of measures aimed specifically at ensuring investors understand the limitations of any provision fund their chosen platform may have. In the same way, a retained profits reserve will not provide a guarantee for investors, and platforms will need to be clear on this fact in their marketing.
That said, assuming platforms are open about how a reserve is operated and its size, such a fund could provide a useful tool for DBS platforms looking to stand out in an increasingly crowded Alt Fi crowd. It would also help them stand out against individual corporate bond issuers, issuing bonds directly to an investor with no intermediary platform.