“Only a fool learns from his own mistakes. The wise man learns from the mistakes of others.”
SMEs need finance. That’s a situation that will never change. However, precisely how SMEs are accessing finance, and indeed how they will do so in five, ten, twenty years time, is changing rapidly.
Since the financial crisis, an era of growing need for SMEs to be able to access brand new sources of finance has been ushered in. This is a situation that is now recognised globally. Borrowers can no longer simply rely on banks for funding, as banks’ ability to lend has been increasingly curbed by regulation since the economic chaos at the end of the last decade.
Irresponsible lending was mainly to blame. Banks making loans created huge sums of new money, and every time a new loan was created, a new debt to the economy opened up. Collapse was inevitable.
When borrowers were unable to repay their loans, they stopped paying them. As this happened en masse, banks found themselves in grave danger of bankruptcy. As a result, banks reduced their new lending to businesses and households, creating a slowdown, which caused market prices to drop and meant that those who had borrowed too much in order to speculate on rising prices had to sell these assets in order to repay their loans.
More panic erupted, and the banks cut their lending even further. And the rest, as they say, is history – and a lot of failing and underfunded SMEs.
What is Due Diligence?
In hindsight, it’s very easy to see where things went wrong – and it can all boil down to a lack of due diligence (DD).
But what is it exactly?
Well, put simply – DD comprises the detailed investigation of an investment opportunity, in order that an investor can make an informed decision as whether to participate or not.
Done properly, it is more than just a quick check – and it’s certainly much more than relying upon the recommendation from a ‘trusted’ individual.
In fact, detailed DD should reveal the robustness or otherwise of the investment opportunity including its legal structure. It needs to include details of the physical assets in question, how they are managed, exactly who owns them, and the circumstances under which these assets can be sold or transferred should problems occur with the repayment.
Due Diligence in Alternative Finance
The banks largely failed, in their role as protectors of the economy, by not performing adequate DD on many of those entities and individuals that sought to borrow from them. This point cannot be made too strongly – though in the spirit of fairness, the banks themselves cannot be held entirely to blame. Indeed, what is perhaps most disappointing about the financial crisis is the instrumental role that credit rating agencies (i.e. the firms which rate debt instruments and securities according to the borrower’s ability to pay back loans) – such as Moody’s – played in the downfall. In fact, it is fair to say that it could not have happened without them.
Moody’s granted AAA credit ratings to approve over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes through 2007. By 2010, hundreds of billions of dollars worth of these triple-A securities were downgraded to ‘junk’ status.
As Lawrence McDonald comments in his book A Colossal Failure of Common Sense:
“How on earth could a bond issue be AAA one day and junk the next unless something spectacularly stupid has taken place? But maybe it was something spectacularly dishonest, like taking that colossal amount of fees in return for doing what Lehman and the rest wanted.”
Put simply, Moody’s and other credit rating agencies gave the banks exactly what they wanted – the green light. And, in turn, investors the world over recklessly indulged in bonds that were backed by trillions of dollars worth of US credit card debt, student loans, and lots and lots of mortgages. Eventually, this wide-scale manipulation of the rating process turned sour, to the ultimate detriment of investors and the economy at large.
As a result, bank lending is now very closely regulated – to the point, in fact, where these regulations have become a hindrance to the economic recovery, as SMEs struggle to access the funding they need to grow.
This is where alternative finance has stepped in. Increasingly, peer-to-peer (P2P) lending and crowdfunding platforms have gained traction and popularity amongst borrowers as a viable means of accessing funds when banks have let them down.
Indeed, as the AltFi sector continues to improve and expand, more and more platforms are emerging, and the deals that are being done are aggregating to be worth billions each year.
However, the last thing that the AltFi sector should do is repeat the mistakes of the banks. There is no equivalent of a Moody’s at present in the alternative finance sector, and indeed the industry has been very much self-regulated (though not entirely) during its lifespan. As such, there exists a pressing concern that there are many alternative finance companies operating that are worryingly light on their due diligence.
John Ficenec in The Telegraph:
“The peer-to-peer lending websites are typically providing unsecured credit for car loans, home improvements and to pay off other credit card debts. There is no guarantee that the money will be repaid and any funds lent through the websites are not covered by the Government-backed Financial Services Compensation Scheme, which protects bank savers up to £75,000.”
If there is one thing that everyone in the quickly expanding finance industry should have learned is that effective due diligence is essential. Indeed, talking to Business Reporter, CEO and co-founder of InvestDen Matt Novak cites the lack of DD as being the biggest risk to alternative lenders and the sector as a whole:
“Crowdfunding by its very nature is open to everybody. It is the democratisation of finance. Mum and dad or someone who has their £50 to take a punt on something, are investing.
“But they should still be given the right opportunities and opportunities that have a higher degree of success. We have a social responsibility to give them a great deal. We are the only ones stepping up to that social responsibility.
“We examine all of the material. If they are making claims, are the claims true, verifiable and bona fide? If they are saying they have got this wand and you wave it and it will turn someone into stone, is this actually accurate?”
How The Route – Finance Carries Out its Due Diligence
The Route – Finance conducts due diligence with the meticulousness of a surgeon before performing an open-heart operation. Investments – like surgeries – inevitably come with risks. There is never an absolute guarantee that a borrower will be able to pay back a loan on time. Therefore, when investors decide to make any sort of incision into their capital for the purposes of another’s business venture, they need to be sure that this is merely a temporary wound that repayments will eventually sew back up, with long-lived health benefits to their net worth– and no lasting scars.
Ensuring that this level of assurance is provided to investors is what DD is all about. How financially sound is the borrower in the first instance? How credible is the business plan? What happens if the borrowing business flat-lines, before the loan is repaid? These are all questions that need to be thoroughly investigated with satisfactory answers before a project is approved for funding. This, and more besides, is DD. And below is how The Route – Finance conducts this necessary endeavour.
#1. Confirm the Identity of the Borrower and all other Parties
No stone should be left unturned when conducting a DD assessment and The Route – Finance takes this approach from the outset. Confirming the identity of the borrower is first and foremost. It is imperative that details of the borrowing company is established – that is to say, not just the company itself, but who controls it, who is associated with it, who its investors are, if the company has previously existed under any other name or incarnation, who is the project principal, and if any other company or investor is to be involved with the project. If the borrower cannot be established as a sound bona fide individual or group of individuals, then the loan application should proceed no further
#2. Assess the Credibility of the Project
With the identity of the borrower (and any other relevant individuals) confirmed, The Route – Finance can then take steps to assess the credibility of the proposed project. Via scrutiny of the business plan, it is imperative that it is established to where and to whom the proposed investment is going, what exactly the money will be used for, and how the borrower intends to make money on the asset(s) being funded.
It is in this instance that an evaluation of the transparency of the borrower can be taken (does everything add up, and do the costs make sense? If not, why not?).
Furthermore, the business plan should include information on the track record of the borrowing business, the previous experience of the borrower, whether the venture is something that is tried and tested or radical and unproven. Success in one market sector does not necessarily guarantee success in another new sector.
What are the marketing projections? Are they realistic? Does the documentation provided represent the risks fairly? What is the motivation for the project? Is there a market for the endeavour, and by what evidence can this all be confirmed?
#3. Assess the Exit
How will the borrower repay the loan? Does the borrower plan to refinance the project through other means at a later date in order to make the repayment, will the company be sold, or is the investment to enable growth in revenue out of which repayments will be made? In all circumstances, the business plan should be assessed to establish if the proposed exit is realistic and probable within the term of the loan.
#4. What is the Security?
Even with the most convincing, realistic and probable business plans, there is always the potential for things to go wrong. If this happens, what is the security pledged for the investment? What assets are available that can be mandated as security – i.e. they can be sold to repay the loan if the business fails to repay the loan within the term? Are there debentures over the company that can be used as security? Exactly who is giving these guarantees and how are they documented? Has it been confirmed that the legal jurisdiction is robust and that the security is enforceable?
The true value of the asset must also be provided by a valuer that is independent of the borrower, specialises in the assets pledged and that is able to support the valuation with Professional Indemnity Insurance for further security. The Route – Finance will always appoint an independent valuer to act on its behalf.
For example, a property or land transaction must include a valuation provided by a member of the Royal Institution of Chartered Surveyors (RICS), on a Red Book basis. Valuations will often be supplied by a national firm of surveyors, such as CBRE or Savills, who have the required level of Professional Indemnity Insurance.
#5. The Legal Documents
Of course, the due diligence counts for nothing if the agreed terms and security are not reflected correctly in the legal documentation.
To ensure this occurs, The Route – Finance appoints its own firm of lawyers to draft bespoke documentation in respect of each transaction. The principal reasons behind this are:
- The lawyers act for, and are appointed by, The Route – Finance and not for the borrower. Therefore The Route – Finance can be confident that its interests are the priority, not the borrowers’.
- It is not possible to perfect the security documents for different transactions, using the same set of documents. Bespoke ones will therefore always be superior to template documents.
- Sufficient time is spent drafting documents to ensure that, if it is required, these documents allow for an orderly enforcement of the security in the manner that is anticipated. Therefore The Route Investors have absolute certainty that the security for each loan is correctly documented and available.
In addition, the lawyers can provide an additional layer of due diligence where required.
For example, a property development loan will require various contractors to complete the build on the site that forms the security for the loan. The lawyers will review all the contracts, insurances, collateral warranties and any other supporting documentation to ensure that they are correct and provide sufficient security for The Route – Finance and The Route Investors in the form of recourse to the contractors, retentions or any other term that may be required.
The banks’ glory days of being the sole, mainstream providers of finance are over. Their downfall can be put down to irresponsible lending, brought on by a catastrophic lack of DD.
Into the void step AltFi providers – the P2P lenders, the crowdfunding platforms and sophisticated investor to business lending schemes. These now make up a booming sector that is gathering momentum and attention from the press and from governments all the time. But, unlike the banks, the alternative lending industry has yet to be granted the dubious acclaim of being ‘too big to fail’ – and therefore it is imperative that all providers in the sector take serious consideration over their due diligence endeavours. For it is with rigorous self-regulation and control that the platforms, individuals, borrowers and lenders will be able to protect themselves, the AltFi sector and the recovering economy at large from making the same mistakes as the banks, and ending up inducing the same distaste and distrust from the businesses and individuals that seek to use them.