Funding Circle’s office on the City’s outskirts has more the appearance of an entertainment venue for the 20 to 35-year-old bracket, than a pioneering financial services business. Maybe this is exactly what you can expect of a fast-growing, fintech environment.
Funding Circle’s peer-to-peer platform for investors to back small businesses has made waves in the past two or three years, to the extent that it’s now attracting talent from the top of financial services; Eric Daniels, the former chief executive of Lloyds Banking Group, joined in September as a non-exec director. The business has also been described as the first peer-to-peer unicorn – Funding Circle – which is valued at $1bn.
The firm’s CRO Rahul Pakrashi revealed to Marcel Le Gouais how the business approaches
relationship management with its micro SME customers.
MLG: Would you describe collections as sitting in first line here?
RP: “Yes, collections sits in operations and is first line. The three lines of defence (business/ops in the first line; risk in the second and audit/QA in the third) are distinct in terms of roles and responsibilities, staff and mandates. They are integrated in their approach and goals.
So the third line audit and sample collections procedures. They listen to calls we have with our borrowers who are in trouble, to ensure policies are being followed and that there’s no digression.
“In the second line, we will devise what the criteria for defaults should be. With regards pre-delinquency. I will generate an early warning list to pass onto the pre delinquency team to help current borrowers, where something bad is about to happen, to make sure things are OK.
“As for borrowers who are already missing payments, I will generate a likelihood of payment for those borrowers. There is so much data available to me; we have a view of how much secured and unsecured each borrower has. We can harvest that for a view of the affordability of each borrower.
“Collections is very different from how banks manage it, because within the banks, there is a balance sheet to absorb any losses. For us, it’s most important that the borrower survives – because these are micro SMEs. The borrower might have only one supplier, so very small movements may make or break them. But if you work with them, understand them and support them, you can default them but have a view on how they can overcome their situation.”
MLG: So how does your approach to struggling borrowers work in practice?
RP: “Internally, there is a survival for revival methodology that we follow. It is in our interest, and our investor’s interest, that the business owner survives through a problem he or she is facing. Quite like ourselves, our borrowers are solid entrepreneurs. If they can survive a crisis, they will be able to start another business one day, and continue to make repayments to us. We will be able to make recoveries for investors.
“Like the banks do, we approach this in three ways:
“A vast proportion of our recoveries also come from personal guarantees. Each and every loan we write will have the director behind it, as a personal guarantee. Again, because these are micro SMEs, they may or may not have unencumbered assets to take security on, so we will take security on large ticket items, but our average ticket is £50,000 to £60,000. Therefore, every loan will be backed by a personal guarantee so if here the borrower does default, that’s how most of the recoveries are made. We’ve found this to be very effective.”
MLG: How would you describe a typical customer?
RP: “These businesses are typically one man shops. There's also a lot of “web tech” firms that started in around 2004 or 2005.
“These types of firms don't have many assets and they don't have many borrowings. If you look at how they borrow from the banks, they don't have classic SME loans, they don't do things like hire purchase for example. Everyone has a current account but a lot of their borrowing is on credit cards.
“If they don't have company borrowings they can't technically enter insolvency. If you look at the insolvency rates of these sorts of companies, it looks as if they're recession proof.
“However these businesses tend to close instead of entering formal insolvency. During a period of five years that I tracked, from 2006 to 2011, only 25 percent of these types of firms lasted that five-year period.
“So the closure rate is high but many of these are family-run businesses - perhaps just a husband and wife partnership. They basically do it to feed their families and they just want a stable income. They don't necessarily have big expansion dreams; they don't necessarily want to be the next Tesco.
“So typically, after a period of dwindling income, they close the business, pay creditors off and start something else.”
MLG: There's a lot of cynical industry talk about defaults and loan loss coverage at peer-to-peer lenders, can you tell me about how that works here?
RP: “We are writing new business of about £100m each month in the UK and our default rate in the UK is six percent.
“The good thing is that in terms of coverage, investors are receiving net returns of about seven percent after all fees and losses. The loss rate is about two percent. But if you look at the gross yield, it's about 10 percent minus one percent in fees, so nine percent.
“But what about Funding Circle? As we have a micro SME book, what about them? It was actually 1.5 times worse because as I said earlier, these tiny companies don't go insolvent, they just close.
“If you look at concentrations in the construction industry, as an example, it goes up to 2x. Whichever way you look at it, the last time we had a big financial crisis, things got 2x worse. If I'm running with a 4x coverage, it will get bad, but you won't lose money.”