For Investors, Is Alternative Finance Collaborative or Disruptive ?

Rather than trying to supplant banking and venture capital, a collaborative model is emerging where digital platforms work side by side with traditional investors

Today we take a a look at the investor side of the alternative finance market, which is comprised of both retail and institutional investors. We foresee that equity crowdfunding, like debt-based P2P lending, will continue to evolve and attract ever more institutional investors going forward, boosting deal volumes and injecting more professionalism in the market.

The slashing of interest rates globally in the wake of the 2008 financial crisis pushed retail investors to look to non-traditional investments to boost returns. This major development boosted the popularity of the alternative finance market as an asset class. Since then, the increased access afforded by the online investment model has meant that the industry has secured its position alongside more traditional asset classes, drawing the interest of institutional investors.

As it stands, the investor side of the alternative finance market, incorporating both debt and equity, is made up of both retail and institutional investors. As the alternative finance market moves upstream, drawing larger more established SME issuers, institutions are becoming more involved. These institutions are investing in the space both through platforms and in the platforms themselves.

Retail

Retail investment into the P2P market has been primarily driven by the low interest rates available globally on bank deposits. When factoring in inflation rates, the picture for savers becomes even worse. In the UK for example, with interest rates at 0.5% after the financial crisis and inflation at around 2% up until recently, in real terms, capital deposited in banks was decreasing in value. Compared to the rates on offer from various different P2P platforms during the same period, it is easy to see why alternative lending has become so popular for consumers.

Other key drivers for P2P lending include: the diversification benefits brought about by incorporating new asset classes into a portfolio; consumers general dislike of banks as a result of their perceived role in the global recession; and the ability for investors to choose exactly where their capital goes.

The story with retail equity investment is similar – it is the outsized returns from private company investment that draws investors. But aside from this, the key driver for equity crowdfunding’s rapid growth is the increased access to a previously severely restricted asset class. For relatively small qualifying amounts, investors can now gain access to a market that has been traditionally out of the reach of most ordinary people. The low qualifying amounts also mean investors can spread their investment over a number of companies and lower overall portfolio risk.

Prior to the introduction of equity crowdfunding platforms, it was notoriously hard for individuals to invest in private companies. Legislation made it illegal for companies to advertise that they were raising funds, meaning they could not post it on a website or on social networks, making it hard for investors to identify which companies were in need of capital. Other ways were to invest were via an angel network or venture capital firm, but both are prohibitively expensive for the majority of people.

Institutional Investment

Thus far the alternative finance sector has seen a divisive split between the characteristics and development of equity versus debt-focused platforms. Debt platforms have outpaced equity offerings in the pace at which they have been adopted by institutional investors. In fact, many P2P lenders, such as Lending Club, Funding Circle, and Prosper, already have direct funding lines to banks. Arguably one of the reasons that the P2P lending market is comparatively more advanced than the equity crowdfunding market is that the offering is more advanced for institutional investors. Tools are more complete and allow institutions to more easily analyse investments, assess risk and execute deals. Platforms such as Orchard and PeerIQ, make the investment process simpler and more transparent. The short-term returns available through platform-based lending should also not be overlooked as a factor driving this trend. The ready adoption by institutional investors helps explain why debt platforms have received more media attention and outsized valuations, such as Lending Club’s $6.42Bn valuation as of June 2015. However, equity platforms now look set to catch up with debt platforms as they increasingly attract institutional investment.

When it comes to equity crowdfunding, a more complete offering that better serves the need of institutions is starting to emerge. As more data providers and marketplaces come online, allowing institutions to better source and evaluate deals, institutions are becoming more involved. Newer hybrid, co-investment models are evidence of institutional participation alongside the crowd.

One of the major trends in the financial markets has been ever-later IPOs by large, successful, young businesses. This has meant that investors, especially on the institutional side, such as those from hedge funds and mutual funds, are having to invest in companies when they are still private in order to see the outsized returns they used to earn from investing at the IPO stage. A number of developments are making such investing more viable and fluid.

Firstly, aside from the increased access that equity crowdfunding platforms afford investors, they are also able to massively reduce the time it takes for investors to make decisions. Platforms do a lot of the legwork by condensing all the investment articles into one place and save the investor the time it takes to reach out to a company themselves. They can also offer guidance in the form of pre-vetted deals and by being able to view the other investors in a deal.

Additionally, the growth of platforms like SecondMarket and Founder’s Club, makes it easier than ever for investors to commit capital comfortably, allowing investors to enter and exit positions in a similar way to what they have grown accustomed to in public markets.

All of this informs our view that equity crowdfunding, like debt-based P2P lending, is going to attract ever more institutional investment moving forward, boosting deal volumes and professionalising the market. Some institutional investors may even go a step further, investing in the space by buying the platforms themselves.

By Michelle Tang