What’s the Alternative?
A quick guide to Alternative Finance Structures
22 March 2018
What is alternative finance (“AF”)?
AF is effectively “non-bank lending" or "private debt". The concept can usefully be separated into:
- Alternative funding providers; and
- Alternative finance products – such as high yield bonds, retail bonds and loans where the terms may vary from those usually encountered in traditional debt structures.
Why have we seen an increase in alternative finance?
Following the financial crisis, conditions have been fertile for borrowers, thanks to a historically low interest rate. Although the official bank interest rate was raised from 0.25% to 0.5% in November 2017, we are a long way from the ten per cent-plus interest rates common during the early- and mid-eighties.
Notwithstanding favourable borrower conditions, traditional banks are mindful of the lessons of the past and this has been reflected in recent lending practices, which some may deem “conservative”. Banks have also been driven by a need to deleverage following the recession and by increased regulatory capital controls (such as Basel III and CRD IV).
AF providers have moved to plug the resulting perceived gap between bank-supply and borrower-demand. Alternative finance may be more prevalent in certain sectors or in respect of certain assets where the absence of bank lenders reflects a longer-term shift in credit policy. The evolution of the AF has also been very much motivated by the technological innovations of peer-to-peer lending and crowdfunding platforms.
High-profile crowdfunding platforms include Seedr, Kickstarter and Indiegogo.
Crowdfunding is a way in which people, businesses and other organisations can raise money through the use of online platforms.
- It’s regulated by the Financial Conduct Authority (“FCA”).
- The party seeking investment will pitch an idea online and request funding in return for a one-off reward (such as a discount card), an interest-yielding return or an equity stake.
- Typically, funding is raised from a large number of people each contributing relatively small amounts.
- The most successful pitches tend to be brands or concepts that investors can identify with, such as food and drink brands or local enterprises.
Peer to Peer Lending (“P2P”)
Recent P2P entrants to the local market include, amongst others, Assetz Capital, Thincats and Funding Circle.
P2P is a process of lending money to individuals or businesses through online services matching lenders to borrowers.
- It’s frequently used by small to medium enterprises seeking funding but not exclusively.
- In theory, P2P lending can be used to finance a wide range of business needs but it’s typically used for project-specific property development.
- It’s regulated by the FCA, like crowd-funding.
- On P2P platforms, investors typically obtain a return based on the level of interest the borrower pays and the platform collects the repayments of interest and capital from each borrower and passes them to the investors.
- Borrowers are subjected to credit checks and rated according to risk, by most P2P lenders using a star-rating which signifies the assessed likelihood of the company going into default (and therefore the potential risk exposure for investors).
- At present, interest payments on P2P loans are not subject to withholding tax making them an attractive prospect for potential investors.
Business angels or “angel investors” are private individuals who invest their personal capital in start-up companies, usually in return for an equity stake.
- This is an age-old lending model– the term “business angel” was coined in the 1970s but the practice of a benefactor investing in an enterprising individual or start-up has been in existence for centuries (think Dickens’ Great Expectations).
- Private investors continue to account for £800 million to £1 billion of early stage investment each year in the UK - their position has not been usurped by trendier and more high-profile AF structures.
- Investment is not limited to funding – angels usually have experience with other businesses or their own, knowledge and useful contacts.
- In consideration of their investment of finance, resources and expertise, angels will usually require an equity stake and some degree of control over the investment or investment company (usually through advisory or non-executive director roles).
Challenger banks are ever-growing - amongst the most popular are Atom Bank, Metro Bank, Monzo and Starling Bank.
Challenger banks are small, recently-created retail banks in the UK, sometimes specialising in areas under-served or unexplored by traditional banks.
- Challenger banks are not a source of alternative funding in the strict sense however they are new entrants to the lending sector and are looking for a market share.
- They are also distinguished by their progressive use of information technology, such as online-only operations and apps that avoid the costs and perceived complexities of traditional banking.
- These banks have introduced innovative processes to address the fact that it will rarely (if ever) deal with customers in person - such as recording videos of customers in order to satisfy AML requirements. They may also offer features that particularly appeal to a younger demographic such as auto-budgeting, in order to assist customers in managing their finances.