31st July 2014

Intelligent Partnership: IFA’s and Crowdfunding: What you need to know

It’s likely you’ve already come across the term crowdfunding. This explosive new form of finance, which grew to a £1bn+ industry in the UK in 2013, is set to grow by over 60% this year. Household names, such as Hugh Fearnley-Whittingstall, are turning to this form of alternative finance to raise capital to fund their businesses and ideas - Hugh recently raised over £1m for his River Cottage business.

The success of the industry can be heavily attributed to two main trends: Disintermediation, whereby industry cuts out the “middle man” (or in many cases a chain of middle men), benefitting both parties as the middle man is no longer taking his cut. This is evident in industries such as music with popularity of online streaming and digital downloads, or publishing with more and more people turning to tablet reading devices and e-books.

The second trend is that banks are reluctant to lend due to increased regulation, more risk adverse business models and apparent distain for the people they were set up to serve.

The advising community, whether intentionally or not, appears reluctant to grasp the crowdfunding concept. There are many reasons for this: comments I often hear is that it is “too risky”, that “the FCA will pull us over the coals” if something goes wrong, that “there is no FSCS” or even “it isn’t regulated”.

Whilst some of these concerns are of valid merit, more often than not they are surface judgements without “getting under the bonnet” – this is what due diligence is for, and IFA’s have a requirement (and duty) to explore these opportunities for their clients.

In terms of risk, yes, there are some risky forms of crowdfunding, but to call crowdfunding “risky” per se is a sweeping generalisation. There are 5 different forms of crowdfunding recognised by the FCA: Equity, Debt, Reward, Donation and Exempt. The latter 3 forms are not regulated by the FCA, and are less likely to require advice – these will mainly be used for philanthropic reasons or to meet clients’ ethical or social preferences.

The first two forms of crowdfunding are the ones where advisers are likely to see interest from clients. Equity crowdfunding is the purchase of shares in new start-ups or young businesses. More often than not (and increasingly), purchasing equity in these firms comes with SEIS or EIS tax relief. Furthermore, should the shares be held for 2 years or more they may qualify for business property relief.

Of course, these investments carry quite a large amount of risk due to the high rate of start-up failures, and whilst the tax breaks are great they should not drive the investment decision. Note that these investments are often illiquid, and recent FCA regulation restricts ordinary retail investors to only 10% of their net investable portfolio in this form of crowdfunding.

Debt (loan) based crowdfunding perhaps makes a more solid case for inclusion within an investment portfolio. Loan based can be split into 2 further sub categories: Peer-to-peer (P2P) or peer–to-business (P2B). The interest paid is usually determined by a bidding system, so the individual or business, after passing credit checks, raises funds via an online platform. More often than not, individuals set what interest they would like to pay, for how much and how long, and then individuals (investors) bid how much they want to lend and at what rate. All bids that fit the criteria are matched. Most platforms are all or nothing (if the order isn’t filled 100%, the rest of the matching orders are void), though some will allow loans to be part filled.

The downside of P2P is that it isn’t easy to provide collateral as security against the loan. Some P2P platforms set up protection funds (provision, contingency or slush funds) with money kept aside to repay lenders should the borrower default. With P2B, loans can be secured against an asset: it should be emphasised that not all P2B loans are secured against an asset (these are unsecured loans), but should risk mitigation be one of your primary reservations, then security is a good idea. Security can be against invoices, or tangible assets such as equipment, machinery or property. In the event of default, the lenders can take ownership of the asset which can be sold to recoup their money. Interest rate returns are attractive, varying from 4% to anything up to 15% per year - obviously the higher the rate, the higher the deemed risk of the loan. These loans are not covered by the Financial Services Compensation Scheme (FSCS), but as mentioned, some platforms have contingency funds, and the key to compensate for risk is diversification - spreading funds across several loans reduces the risk of loss through default, with the higher returns available compensating for default.

The argument that the regulators will penalise advisers for recommending crowdfunding products is again invalid. As of the 1^st of April 2014, debt and equity based crowdfunding come under the remit of the FCA. If IFA’s want to keep their “independent” tag they need to consider the whole of the market, crowdfunding is now part of this. Given the current market environment of low interest rates, stock markets near historical highs and low bond yields, the current traditional investing space looks unattractive. Plus, let us not forget – the world economy has just experience the largest money printing exercise in its history. How this will unravel is not known. To think everything is now all rosy is perhaps complacent at the very least.

The simplicity of crowdfunding is one of its key attractions: of course, most platforms have different angles, but the overarching principle is the same - channelling funds from an entity that has them to someone/thing that needs them, all via an online platform.

One key consideration for IFA’s is how they can undertake the correct due diligence. As crowdfunding is a young industry, it is not always easy to gain data on the various platforms, though this is starting to improve with the likes of AltFi and P2PMoney.

You must assess the suitability of crowdfunding as you would any other product. Diversified portfolio construction is at the heart of good investment: crowdfunding offers attractive returns, diversification from traditional asset classes, it is now regulated and the market is growing at pace. For the wise adviser, this is an opportunity to pick up new clients and strengthen relationships. For those who don’t, you may well be missing a trick.

Should you be interested in more information on crowdfunding, Intelligent Partnership has a number of useful resources. Please go to:

https://intelligent-partnership.com/research-format/article/?filter=alternative-finance-investments

Investments, Regulation