The process of investing in small business loans via the Funding Circle marketplace is about to change.
Co-Founder and CEO Samir Desai has written to the platform’s investors this morning to inform them that Funding Circle will be moving away from the auction based approach to pricing credit. The platform will transition to a fixed interest rate model within the month. It’s a substantial change to the mechanics of the platform, and one that’s likely to meet with a fair amount of controversy amongst Funding Circle’s private investors.
Historically, those investors have undertaken lending opportunities by bidding to invest at a certain interest rate. Every Funding Circle loan is assigned a risk band, from A+ to E, each of which carries a minimum interest rate. The ultimate cost of finance will be at least equal to that lower limit, but borrowers might also end up paying significantly more, depending on investor demand. The auctions operate on a first-come, first-served basis, but investors have the ability to undercut one another by out-bidding on interest rate. In other words, the more investors that compete to lend money to a business, the more the interest rate is driven down.
It’s a system that has allowed many of Funding Circle’s most active and enthusiastic private investors to earn better-than-average returns. But it's also a system that, by Mr. Desai’s own admission, comes with significant drawbacks.
Criticism from Without and Within
The Funding Circle boss outlined those disadvantages in his letter to the platform’s lenders. The first was that the auction process is time-consuming, and there is no guarantee that investor money will be successfully deployed at the end of it. That means that investors will often have money invested in the platform that isn’t earning interest. Second, while the peer-to-peer purists may love the auction model, many investors have told Funding Circle that they’d prefer a simpler means of investing through the site, as the complexity of the auction model puts them off. And finally, the lack of upfront certainty about cost-of-funding has been a recurring point of concern for prospective borrowers.
External criticism has also been leveled at the auction-based approach. Some argue that it can lead to the mispricing of risk. Others have openly doubted the logic of having multiple groups of investors receiving different interest rates for taking the same level of credit risk.
The combination of these factors has caused the platform to turn to a model that is more akin to the those employed by the big US marketplace lenders, like Lending Club and Prosper. Loans may still be hand-selected by the investor, but the interest rates attached to those loans will be determined by the platform. Funding Circle already operates a fixed pricing model for its property and asset finance loans. The fundamental distinction, as Desai puts it, is that the key factor in determining interest rates will be “the risk of the loan, rather than the availability of investor funds”.
We wonder if Funding Circle’s soon-to-launch fund could have played a part in the restructuring. The Funding Circle SME Income Fund will provide investors with passive exposure to the platform’s small business loans. But determining the interest rate that this fund will achieve will be difficult if every loan listing is subject to an auction process.
Fund aside, Desai outlined the key benefits of the new, fixed interest rate model, as he sees them. He suggests that the process will now be simpler to understand for investors. Money will be made to work more efficiently thanks to certainty of cost, which Desai believes will cause businesses to accept loans more rapidly than they currently do. And finally, the Funding Circle boss is of the opinion that the shift in process will bring more borrowers into the platform, creating a broader range of lending opportunities for investors.
But in spite of the well-made arguments of the Funding Circle management team, an investor backlash (of at least some degree) is inevitable. The platform believes that 71% of its investors will achieve a higher expected return as a result of the advent of fixed interest loans, but that of course leaves 29% of the site’s 40,000+ individual investors who will not.
Online Commenters are Not Happy...
Funding Circle will be accepting feedback via several mediums, including an investor evening, webinars, and by email. But a number of passionate investors have already taken to the UK peer-to-peer sector’s independent forum to voice their thoughts.
One commenter who goes by the handle “stevet," has declared that the advent of fixed interest rates will end his interest in the platform. Another finds the news “very disappointing”, adding that his effective interest rate “is probably going to fall off a cliff”. We must remember of course that the people that fuel discussion on the P2P Independent Forum are exactly the sorts of sophisticated investors that would have likely turned the auction model to their advantage over the past five years.
Funding Circle has lent just shy of £800m in the UK to date, and has achieved annualised year-to-date growth of 113.88% in 2015. As the platform continues to scale, and increasing numbers of rookie investors pour in, a structure which produces more consistent returns across the board – irrespective of the investment nous of each individual lender – has clearly been identified as the most sustainable method of moving forward.
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