Crowdfunding and peer lending are quickly becoming mainstream finance and could change the CFA and Wall Street forever
Small business community Manta ran a survey last year and found that 67% of business owners felt they didn’t have enough small business funding choices. Worse still, more than two-thirds (69%) felt the funding environment had not improved or was worse over the last year.
There’s no mystery why funding for small- and medium-size enterprises (SMEs) has dried up. Regulatory requirements around Basel III and Dodd-Frank have increased lending costs and capital requirements for traditional lenders. Because of costs to make small business loans which are considered riskier, it costs just as much to make million dollar loans as it does to make a $50,000 loan.
It’s destroyed the profit motive to make loans of under $250,000 and left many business owners with no options. A 2014 survey by the Federal Reserve found that less than half of small business loan applications are approved.
Alternative Finance Becomes Mainstream
Enter crowdfunding and peer lending as alternative funding sources. The social finance phenomenon has been growing for years but banks are just starting to take notice. The group surpassed $30 billion in funding last year, topping venture capital funding for the first time, and has doubled each year since 2012.
The demand for peer loans has surged and accounts for over 70% of funding. There is actually surprisingly little different between peer lending online and the traditional bank approach. Instead of bundling and selling off their loan book to borrowers, banks have been cut out of the picture by p2p platforms like Lending Club that connects borrowers directly with investors.
Beyond the increased regulatory costs on traditional financing, peer lending platforms have another competitive advantage over banks. According to Foundation Capital, branch office costs account for more than 30% of a bank’s total operational spending and there’s a physical limit to the number of applications that loan officers can review. By reducing the physical overhead costs, peer lenders can generate cost advantages of 4% in loan origination compared to the old model of finance.
The crowdfunding industry may be a smaller part of the financial revolution but could see even stronger growth over the coming years. The Securities & Exchange Commission (SEC) finally approved regulations to allow non-accredited investors to participate in equity crowdfunding, a move that will open up crowdfunding investment to more than 58 million households in the United States alone.
The crowdfunding model has bifurcated into two worlds. In rewards-based crowdfunding, businesses and social causes raise money and give out products or services in exchange for donations. Supporters receive no ownership stake in the business.
In equity crowdfunding, business owners sell an ownership share in the company to investors. The process is similar to issuing public shares except businesses go straight to the public instead of through an investment bank.
There’s an oft-overlooked benefit to crowdfunding, both equity- and rewards-based. Supporters and investors feel a strong level of buy-in with the businesses because they feel like they helped make projects possible. Crowdfunding offers a huge opportunity for small business owners in social marketing and customer loyalty.
How Alternative Finance will Change Wall Street and the CFA
The investment opportunity in peer lending and crowdfunding hasn’t come soon enough for investors. Even as the Fed tries to end its historic low-rate program, interest rates remain stubbornly low. The yield on A-rated corporate debt is just 2.17% for the five-year maturity. Legendary investor Jack Bogle recently forecast annual returns of just 6% for stocks and 3% for bonds over the next decade.
Compare that abysmal outlook to returns of over 8.4% for loans issued on the Lending Club platform between 2013 and 2014, after adjusting for defaults. Crowdfunding returns are similar to those found in venture capital and other early-stage investments.
The lack of a liquid secondary market for peer loans and the fairly small size of the crowdfunding market means there hasn’t been much of a demand for analysts in the space. This will surely change over the coming years as the market expands and equity crowdfunding opens to the investing public.
The problem is that traditionally trained analysts may not be ready for the idiosyncracies of the alternative finance market. Within peer lending, analysts will need to integrate human factors into credit models as well as estimate a liquidity premium for the market. Analyzing crowdfunding deals will be similar to analysis of venture capital deals but will also need to include other social factors.
Here at Finquiz, we want to lead this monumental shift in finance. Over the next month, we will be posting several articles examining how to analyze investments in peer lending and crowdfunding. We’ll look at the CFA curriculum and how it can help candidates prepare for the coming wave of demand for alt-finance analysts. We’ll also look at what you can do to prepare for opportunities in this new analyst market.
Joseph Hogue, CFA