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Stranger Things Are Happening in Lending
There is a preconception that debt finance deals are the adventures of corporate juggernauts or multi-national behemoths. That couldn’t be further from the truth. In reality there are a host of options being explored by our client base which comprises start-up companies, established trading SMEs, listed companies and family offices looking for investment opportunities. Whilst the funding options on offer can be vast, the risk is the same in every case – likelihood of ‘exit’. In other words, as an investor, how do I get my money back? As a borrower, can I afford this?
It would seem that even after conducting intensive due diligence on a prospective borrower to the extent they are holding a financial floor plan, even high street lenders have concerns they may not find an exit. There has, in the UK at least, been a tightening of the lending criteria that the traditional high street banks use, meaning approvals for debt products, whether that is a working capital facility, expansion funds or a safety buffer going into 31 October 2019, are becoming more remote. Start-up companies and even 3-5 year trading businesses that are showing incredible resilience, will almost always be asked to drop the corporate veil and hand over personal guarantees from key business owners.
As a result, business owners and directors are turning towards alternative forms of debt funding in search of investors.
In times of low interests rates, bonds have traditionally been the go-to debt instrument of choice due to their comparatively higher rates of return for investors and the lower cost of borrowing for those issuing companies. However, the risks tied to a bond relate, understandably, not just to the health of the issuing company and its underlying assets but also to external market factors. At the time of writing, the United States Federal Reserve Bank is expected to cut interest rates by a quarter-point in an effort to prop up record US economic expansion. Where the rate of returns for investors could fall as a result of this cut, they will generally look for higher returns elsewhere in bonds from companies of lower asset quality. With this higher reward, comes higher risk. The Bank of England, by contrast, is forecasting several interest rate rises over the next few years but that does not mean UK bondholders would be immune from risk; for fixed rate bonds, interest rate rises will generally mean a drop in value of that bond. As always, the composition and quality of the bond must be assessed but market and economic forces must also be factored in when considering where (and when) the future exit may be.
Therefore, for some, a simpler route to finance (or investment) can be found in the peer-to-peer (P2P) lending market. P2P provides an easy means of matching willing investors with businesses in need of cash and with that ease of access. The area has seen significant development over the last 7 years, especially with the popularity of companies such as RateSetter and Funding Circle (who last year received a £150m cash injection from the British Government). However, as with any industry that moves faster than those who are meant to regulate it, the risks have not always been apparent. The Financial Services Compensation Scheme does not apply to P2P lending and notwithstanding the requirement to have at least £50,000 worth of capital in reserves to act as a buffer against financial difficulty, money invested with firms who have not been tested in an economically turbulent environment such as the one which may be upon us come 1 November 2019, risk having unknown prospects of exit. Traditionally P2P platforms facilitated exit by pairing existing loans with new investors but, if the Bank of England’s interest rate rise goes ahead as planned, assessments will need to be made on how those exits will be impacted if new investors with ambitions of higher interest rates cannot be paired with existing investors on lower positions; existing, lower yield investors, need to ensure they still have a clear route to exit. In an attempt to mitigate some of the risks posed in the P2P market the Financial Conduct Authority (FCA) released its policy statement on P2P lending on 4 June 2019 (PS19/14) which, amongst other things, seeks to i) implement limitations on how much new investors who have not received financial advice can put into peer-to-peer lending by capping the level at 10% of your investable assets, unless you’ve received regulated financial advice) and ii) compel companies to be pro-active in ensuring investors have the requisite knowledge about their business including, crucially, information about the risks should a P2P platform become insolvent. These protections have been codified as part of the FCA’s powers under the Financial Services and Markets Act 2000 and will come into force on 9 December 2019.
Of course for those with a sufficient support network another great alternative route to funding is through friends and family. This has always been regarded as a ‘safe’ way to borrow but equally that attitude can lead to relaxed formalities (unwritten agreements, or written agreements but vague terms) which can be problematic if things do not go to plan. Just as risky is the general assumption that as an acquaintance of the borrower or lender, there are no rules governing the relationship. It is crucial to at least consider whether the relationship between the parties could be such as to trigger regulation by the FCA which, is a significant risk if there are clear commercial or business-like terms to the arrangement. If lending to an individual but also taking security over residential property in the European Economic Area, you need to consider whether this could be a Regulated Mortgage Contract. If there are several loans being made to a company, with shares allotted as part of the arrangement, consider whether you participating in or establishing an open-ended investment company or collective investment scheme without sufficient authority. Each of these carry severe (sometimes criminal) consequences and again, impact the likelihood of establishing an exit.
In summary, the traditional lending avenues still remain, but the roads are narrower than before. Borrowers and investors are increasingly heading off the beaten track in search of alternative routes to finance. There are however pitfalls to these options and when they approach, mind the gap.
Having completed his training with Bishop & Sewell LLP, Andrew qualified as a Solicitor in October 2015.
Andrew works on a wide range of corporate matters including acquisitions, sales and re-finances. Andrew’s regularly advises clients on loan facilities and debentures as well as operational contracts for the services sector.