Some loans go beyond being just 'higher risk'
One noticeable aspect of the Kuetzal and Envestio P2P scams was that some investors were willing to buy almost any loan, as long as the interest rates were high enough. Both sites provided no useful financial information about the borrowers, and the loan descriptions often made no sense, or were implausible. Since then, many P2P investors have naturally become more cautious. For example, Wisefund was recently unable to raise €300,000 to fund a project called ‘Sea Buckthorns – berries with positive effect on body’.
Crowdestor is another site that focuses on offering higher risk loans that offer high interest rates. We are pleased to see that it has responded to past criticism. It now provides at least some financial information about its borrowers and also registry excerpts. We think there’s room for a site like Crowdestor in the P2P sector, as long as investors properly understand all the risks, and the loan underwriting is performed carefully and professionally.
However we think there are several situations where investors may be dramatically under-estimating the risks of certain loans on sites like Crowdestor and elsewhere. We highlight below some situations we have observed where loans go beyond being just higher risk, and in our opinion start becoming a little crazy.
Hidden venture capital investments (with no upside)
Crowdestor has listed a loan to a technology company. It has an interest rate of 24%, with a 12 month maturity. We have strong doubts about the likelihood of success of this company. But that’s not the main problem – the main problem is that the borrowing company has zero revenues, and does not even have a working product. The loan is being used to fund software development. Companies like this get funded all the time, but not with debt – the risk is far too high. Instead, companies get funded by issuing equity to people like angel investors and venture capitalists, so that if the company is successful, the investors will get a high return (multiples of what they invested).
Loans like this are effectively venture capital investments, but with a maximum profit of only 24%, and what seems to be a fairly high probability of zero recovery. Those are not good odds. Other examples in this category include loans taken out to fund the production of movies and electronic game development.
Loans that don't stack up
In the past we highlighted that a loan to a petrol company seemed dubious, because it had a very high interest rate, in a low margin industry. That loan turned out to be fake. Consider whether it makes sense for the borrower to take out the loan. Do the terms seem normal for companies operating in that industry? High interest rates are usually a sign that a company is facing financial distress, and lacks other options.
Crowdestor is currently raising funds for a loan to a timber supplier. We have no doubts that the loan is genuine, but we note that the timber and paper industries are notorious for being low margin, difficult businesses. In fact the financial statements show that this business operates on just 2% gross margins and has never made any more than €4,000 profit in the last 5 years. Does this seem like a company that can afford to pay 36.2% on its borrowings (the effective cost of the loan being provided)?
No realistic exit plan
One of the reasons that P2P lending has been successful in some countries is that local banks take a very conservative approach to assessing risk. It means that lenders who can be more flexible can find attractive lending opportunities with limited risk.
Too often though, we see P2P loans structured with fairly short maturities. There is no obvious way for the company to generate the cash needed to repay the loan. The assumption seems to be that the loan will either be extended, or rolled over into another loan on the P2P site. That’s a high risk plan for both the borrower and investor. In fact it means that there is no real plan.
The most reliable exits come from a planned sale of an asset (such as units in a property development), or where there is certainty that bank financing can be obtained in the future (for example once a renovation of a property is completed). If a business has strong profits, loan repayments from operating cashflows can also be a reasonable exit plan for lenders.
Collaterals that might be worth zero
We sometimes see P2P loans that are secured with collateral that could be worth zero, or much less than expected. Yes, the platform has obtained a valuation report that says the collateral is worth a specific amount. However in some situations there is a big difference between a theoretical value and what investors are actually likely to recover if a loan goes bad.
For example, we recently saw a P2P loan that was secured on a fairly small parcel of rural land in the Baltics. The stated LTV was fairly low, and many investors will therefore think that it is a low risk loan.
So what’s the problem? The problem is – who will want to buy a small parcel of rural land in the middle of nowhere, with no planning permission, if the borrower defaults on this loan? In this situation the only potential buyers tend to be owners of surrounding land. And they tend to take advantage of this situation by bidding at very, very low prices. Often, they will refuse to bid at all, due to their personal relationships with the borrower, or lack of funds.
Country risk is also a consideration. In the past Crowdestor has provided funding to a resort in Cambodia. We have not reviewed the legal documents. However we really hope that the borrower repays the loan, because we have strong doubts about the ability of an Estonian P2P site to successfully recover a loan in Cambodia. Particularly when there are rules there restricting foreign ownership of property….
Examples of other real estate collateral that can have close to zero real value include specialised commercial property (factories etc where there are no alternative uses), land parcels with no access rights (such as forest) and lower quality assets in declining sectors (such as retail shops).
No 'skin in the game'
Would you lend €200,000 to a company whose shareholders had only invested €5,000 into? That’s the credit limit set by Crowdestor for the timber supplier we mentioned earlier, for a business with only €5,000 of capital.
We see many loans to companies that have not received much investment from their shareholders. They should really be raising capital, rather than borrowing from P2P investors. By borrowing funds they avoid diluting their ownership, or putting more money in themselves. That’s good for them, but not their creditors.
If shareholders lack ‘skin in the game’, they are much more likely to write off their investment and just walk away. They have little incentive to turn around the businesses when things don’t go to plan. Under-investment by shareholders is often a sign that they lack confidence in the prospects in a business. But if they don’t believe in the future of the company, why should you?