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Is crowdfunding dangerous

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Since recession took hold, lending to small businesses has reduced significantly as banks look to boost balance sheets to meet stringent capital adequacy requirements. And so enter, crowdfunding or peer-to peer-lending which threatens to fill this void.

From the borrower perspective, there are certainly a string of benefits to be had; speed of decision for one after all, banks are bound by process and may take months to make lending decisions, but a crowdfunder could make an advance in half the time.

Then you have choice of investment; owners feel their investors are genuine enthusiasts and endorsers of their business idea. And of course you have the spread of invested funds across multiple opportunities (often hundreds) so any individual failure has an insignificant effect on return.

What could possibly go wrong Ill tell you.

While the quality of accepted loans and equity sourced via crowdfunding has typically been good in the past, it’s likely that as the market grows, a more diverse set of applicants will use this route to gain funding. Simultaneously investors will become more willing to move down the risk curve in search of higher returns.

That in itself is fine; however, growing larger and more diverse requires a significant improvement in the quality of the analysis available to investors; ideally, to mitigate the information asymmetry between traditional lenders and retail investors using crowdfunding sites.

Credit risk is not child’s play and pricing correctly for the long term has taxed experts minds and has yielded only limited success. Crowdfunded lending is by its very nature a market; markets are good at discovering the price of commodity items which are easily transferable, be that company shares or bushels of corn.

Loans to individuals and small companies are not in themselves a commodity, the loans are provided to individuals and small companies that differ widely in their ability to repay and how they might react in an economic downturn.

Large financial institutions can treat pools of loans as a commodity but only with the backing of robust and comprehensive data and analysis. Sloppy underwriting and inaccurate information can quickly catch even relatively large well-capitalised investors out.

To expect individuals to compete with volume players is unrealistic; they will more likely get their fingers burned to the detriment of the industry and possibly the economy.

The other danger of crowdfunding is that business ideas that would ordinarily fail the rigour and scrutiny of the traditional bank loan would nevertheless gain funding approval through less-rigorous channels, whether they are particularly good or innovative ideas or not, resulting in a market akin to the dotcom boom in the late nineties. One has to question if you you can’t convince educated, savvy backers to invest in a business perhaps the idea isnt so good after-all

From an investor perspective, whilst funds are spread thinly and widely across multiple investments, there remains the possibility that the crowd-funding company itself will fail, resulting in total loss being incurred.

Investor check-list

To avoid the potential of total loss, would-be investors need to understand the risks via:

1) Publishing detailed tracking information. This should include expected and measured performance of risk grades for similar assets lent to in the past as well as the performance of the debt collection function on debts that have defaulted.

2) Providing the underlying anonymised facility level data so independent parties can verify that performance and check model assumptions

3) Providing a flexible online tool to make it easy for prospective investors to understand the potential losses of their portfolio under different stressed economic conditions.

Closing this information gap would be a big step forward in countering potential regulatory concerns of the downsides of crowdfunding that are not fully apparent to investors.

The key question for investors is do crowdfunding and peer-to-peer lending sites offer better returns because they cut out the middle man and provide a more efficient market, or are the improved returns a financial slight of hand borne out of regulatory arbitrage that hides risk in the system

At present the answer is both until crowdfunders can demonstrate the same rigour as their regulated cousins in banks then they dont yet deserve to be a mass-market phenomenon.

Mark Sisson is the MD of 4most Europe.

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