Why crowdfunding may not be for everyone

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
Why crowdfunding may not be for everyone

Coinciding with the technological development of online platforms, and the increasing reliance on the internet for many more aspects of our daily lives, the peer-to-peer (P2P) finance and crowdfunding sector has exploded, offering a much more tempting place for one's money.

Many crowdfunding or P2P platforms offer returns of at least 4 per cent, sometimes going considerably higher - but investing via one of these platforms is not nearly as straightforward as putting one's money into a savings account, and they can come with considerable risks.

This guide attempts to explore how P2P finance works, some of the risks, and how to go about selecting the right platform.

The sector started in the UK with Zopa, when it launched its peer-to-peer lending platform in 2005, and is divided into two: peer-to-peer lending to small businesses and individuals, and crowdfunding investment through equity and debt.

I wouldn't say that you shouldn't touch it. You just shouldn't be comparing apples with pears, and making them all apples.Anna Bowes

The sector finally got the official seal of approval in 2014 when it became regulated and in 2015 it was announced that savers could access this form of financing through an Isa, the Innovative Finance Isa - the returns and interest one makes on peer-to-peer loans and crowdfunding debt could be tax free, with a maximum investment for this year of £20,000. 

Treading carefully

However, many in the financial adviser community are wary of suggesting people should invest via these platforms, especially the P2P platforms which receive much more capital, because the concept can seem like an alternative to cash savings, whereas in fact they are much more risky than a cash deposit.

Kay Ingram, director of public policy at LEBC, says: "One of my concerns in these adverts for these Innovative Finance Isas, are that the comparisons are often made with cash deposit rates but it's a totally unequivalent comparison. It doesn't take account of the fact that a P2P lending platform is much more risky than a cash deposit."

Returns on P2P platforms being promised range from about 3 per cent to 7 per cent, which is a clearly a lot more than a typical cash Isa of just above 1 per cent at the top of the 'best buy' tables.

Anna Bowes, director at SavingsChampion, says: "I wouldn't say that you shouldn't touch it. You just shouldn't be comparing apples with pears, and making them all apples.

"You get some providers making it clear that this is not a savings account. The difficulty is that the concept is the same - you put your money in and you lend it to somebody else, and you get an interest rate, but the mechanics of it are different and the risk profile is different.

"A lot of people have done very well with P2P. What I think people should be aware of, effectively it's more akin to an investment because you're lending your money to somebody else.

"It could be that you're scaling that up and lending it to lots of different people, or to one person; the latter is a much higher risk."

She notes: "When you do that with a bank, the risk is with the bank or building society, they are providing a fixed rate savings rate, and in the worst case scenario the bank goes bust you're protected by the FSCS [Financial Services Compensation Scheme]."

With P2P finance, if the borrower goes bust, or the platform cannot meet its liabilities, you have no FSCS compensation.

In 2016, the most recent data available, £4.6bn was invested in the alternative finance sector, up from £3.2bn the previous year, and £300m in 2011, according to the Cambridge Centre for Alternative Finance.

A VCT has many more controls and they all give you 30 per cent tax relief up front. If it turns out to be a complete loss, you can claim back relief on the loss.Kay Ingram

With peer-to-peer lending, retail investors - and increasingly institutional investors - lend their money for a certain period of time to other individuals or businesses; investment crowdfunding is considered more of an investment in small businesses, either via debt or equity.

P2P business lending is the most popular sector, with £1.23bn being lent in 2016; P2P consumer lending was £1.17bn and P2P property lending was £1.14bn. 

Crowdfunding sees much less money - equity-based crowdfunding received £272m, while debt-based crowdfunding received £79m in 2016.

Alternative finance

But the alternative finance sector has become an increasingly important feature of small business financing. In 2016, 32,800 small and medium-sized enterprises (SMEs) used it, amounting to £3.3bn, and 17 per cent of seed and venture stage equity investment came from equity-based crowdfunding.

The basic principle is that an investor firstly picks the most appropriate platform - deciding whether to opt for lending to businesses, individuals, or becoming a small business investor.

The lender chooses how much he or she wants to invest and how long he or she wants to tie the money up for, as well as an indicative rate.

The platform then attempts to match that up with suitable borrowers, who are looking to pay a certain percentage over a certain period of time, with an appropriate risk profile. Typically, a platform will put together a portfolio of loans based on the profile you have invested, so that, ostensibly, the loan is 'diversified'.

Investment-based crowdfunding puts investors and small businesses together, allowing the investor to buy equity or debt so that they have a stake in the business. This model is viewed by the regulator as much simpler than the P2P model.

Platforms now have to be authorised via the Financial Conduct Authority (FCA), and many of them allow their products to be put into an Isa, but the investments are not backed by the FSCS.

The danger is the possibility of the company or individual you have lent to goes bust, and there is no guarantee that you will get your money back. 

Ms Bowes says: "An Innovative Finance Isa should be seen alongside a Stocks and Shares Isa, and you can have a very, very high risk Stocks and Shares Isa.

"Is it wrong to have a stocks and shares Isa?"

Ms Ingram disagrees and says anyone considering this type of investment would be better off looking at other regulated investments. She says: "If someone has capacity for loss and can take a lot of risk, I think they can use EIS [enterprise investment scheme] and VCT [venture capital trust]. 

"A VCT has many more controls and they all give you 30 per cent tax relief up front. If it turns out to be a complete loss, you can claim back relief on the loss.

"With Innovative Finance Isas, you only get tax relief on the gains."

Rate rise risks

Despite some misgivings, the sector has been so popular with investors that there is a wall of money waiting to invest in suitable investments, and not enough candidates wanting the money, especially on the investment crowdfunding side.

Another challenge on the horizon is rising interest rates. The platforms have benefited from a very low interest rate environment, but with the rate rise earlier this month, the consensus is that rates are only going in one direction.

Ms Bowes says: "What happens if interest rates rise and people can no longer pay back their debt? You might start to see more and more defaults.

"It's my concern that this industry has exploded in a low interest rate environment. While we won't see rates rising to the levels of 10 years ago, I still think it's a potential issue.

"People could suddenly find themselves in trouble because debt has become more expensive; if they have a mortgage and they have business based on borrowing, it's more expensive to pay back their debt."

The FCA is also getting involved, clamping down on some aspects of what it deems to be poor practice, and lack of clarity over the risks people are taking.

The following articles will show in more detail how alternative finance works, what the risks are and how to pick the most suitable platform.

melanie.tringham@ft.com