A sense of security

Security provides reassurance for peer-to-peer platforms and investors alike that there may be a way to recover capital in the event of a defaulted loan. But is security always an effective way to mitigate risk? Marc Shoffman investigates…

FROM PROPERTY TO porches, there is a peer-to-peer lending platform for almost any sort of underlying asset. The concept sounds great on paper. A borrower gets a loan secured on an asset, while an investor has slightly more reassurance that money may be able to be recouped if things get wrong, as the platform can sell the asset. This is often promoted by secured P2P lenders as a way of mitigating risk.

But in reality, things haven’t always played out as they should. Administrators of collapsed P2P lending platform Collateral – which offered loans secured on property and personal items such as jewellery – have spotted mistakes in valuations, while others have struggled to sell the underlying asset or faced legal claims from borrowers.

“Secured lending should in theory be safer than unsecured and that is reflected in the rate, but doesn’t mean investors can be passive about it,” says Frank Wessely, partner at insolvency firm Quantuma.

“They should enquire how the value of the security is assessed and the exit strategy that shows how prepared a platform is in case the loan fails.”

So how are P2P platforms ensuring their security is secure?

The type of assets that can be used as security for P2P loans range from property to business equipment to high-net-worth items such as classic cars or art.

Platforms take a different approach to the asset depending on the type of security. For example, loans secured on an invoice or business machinery would be backed up by legal documentation or a charge taken on the firm.

In contrast, lenders who take physical items, such as HNW Lending or Lend & Borrow Trust, will usually store items in their own vaults until the loan is repaid. The idea is that these assets could be sold should a loan default, which would then repay lenders.

“It is extremely important for the P2P sector to have secured loans,” says John Butler, chief executive of Lend & Borrow Trust. “Unsecured lending is subject to potentially big swings, but secured lending helps reduce that risk.

“There are lots of different examples of assets across the risk and return spectrum.”

The underwriting process brings another facet into the underwriting process as a platform must assess the risk of both the borrower and the asset.

Ben Shaw, founder of HNW Lending, which offers loans secured on property as well as personal items such as classic cars, says it is important to get to know the borrower.

“You have got to look at the borrower and their reasons for borrowing,” he explains. “Somebody starting a technology business with no assets is higher risk than someone using a security to buy a house.”

P2P business lender Rebuildingsociety offers loans secured by a personal guarantee or business assets or property. Michael Lawther, the platform’s legal and operations manager, says the security offered in support of a loan application forms a distinct but important question in the lending decision.

“As a platform, we encourage our investors to look at security separately to the credit risk of the business,” he explains. “The overall risk of a business defaulting on a loan is not directly related to the quality of collateral offered in support of the loan.

“Investors should consider the risk of default as a separate risk to the risk of their capital being unrecoverable in default and declared as bad debt.

“The former is dependent on the credit risk of the investment and the borrower’s ability to repay, whereas the latter is dependent on the quality of the security provided.”

However, Butler argues that the credit risk of the borrower is of less importance if there is a viable underlying asset underneath.

“The loans we arrange are heavily over collateralised,” he explains. “We will only arrange loans of up to 75 per cent of the value of gold and 65 per cent of the value of silver.

“There has to be a huge decline in market value to result in the value of the collateral falling below that of the loan.

“However, we do take additional steps such as asking a borrower to put up more collateral if the value of the asset drops.”

Lend & Borrow Trust applicants must also get an accountant to verify that they are high-net-worth individuals with a minimum income of £150,000 or assets worth £500,000. Another way investors can be reassured of the underwriting process is if a platform has skin in the game. HNW Lending’s Shaw, for example, invests his own money in each loan.

“When I have 10 per cent of my own money being lost before an investor, I am suddenly more focused,” he says.

Valuations

Platforms need to consider how much money they could recoup from an asset if the loan defaults. Quantuma’s Wessely warns that in some cases the asset may need to be sold at a discounted price to its open market value if there is a rush to repay investors.

However, platforms are more bullish about valuations. Butler says there is an open market for bullion prices so you will always know the price you are going to get.

Similarly, Shaw says he would avoid getting into the loan if it looked like an asset would be hard to sell and says indices can be used to track the price of assets such as cars or fine wine.

However, there are other factors beyond valuation. Angus Dent, chief executive of business lender ArchOver, says the most important aspect of security is not value but appropriateness.

“It’s no good securing a business loan with the chief executive’s house – that tells you nothing about the health of the company or its ability to repay its debts, which is the point of security in the first place,” he explains.

“A house is hardly a mobile source of funds – if the borrower folds and you’ve got lenders rightly clamouring for repayment, the last thing you want to do is wade into the torture of house-selling chains.

“Investors should seek out loans that are secured with assets that actually relate to the business itself.”

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Type of charge

There are different ways that an asset can be secured, such as through a fixed or floating charge, with the former giving more rights to the platform should the loan default. Currently, when a business goes into administration, the first funds go to paying the administrator, followed by any fixed charge, which could be on a business asset or property.

The next preferential creditors are employees, who will get their wages paid from any funds left, followed by those with a floating charge. HMRC is currently an unsecured creditor and gets paid last, but this will change from April 2020 and it will rank just after employees as preferential creditor and ahead of those with a floating charge.

Wessely says a platform should ideally take a first charge as other forms have a higher degree of risk as you are further down the list of creditors. The type of charge the P2P platform is taking will often be disclosed in the loan documentation and you can see this reflected in the borrower’s financial details with Companies House.

This would only be accessible if it were a limited company taking a loan, as partnerships and high-net-worth individuals do not have the same reporting requirements.

Read more: The changing world of buy-to-let

Recovery

In the event of missed loan repayments, platforms will typically enter into dialogue with the borrower at first to try to establish a solution, but as a last resort they will need to take possession of and sell the underlying asset.

However, Wessely warns there is no such thing as an easy realisation.

“Recovery and realisation are never easy and straightforward, although it is implied in that way,” he says.

“It is often a slow and protracted process that creates more concern the longer it goes on.

“There are always difficulties depending on the type of asset and the market conditions prevailing at the time of recovery.

“The chances of recovery can depend to a large degree on the cooperation of the debtors, some have their own agenda and can cause difficulties and delays for the platform.”

Shaw says having an asset such as a classic car in its own storage vault makes the recovery process easier in the event of a default.

“We have the asset in our possession,” he says. “If we need to enforce our rights we don’t have to go out and find it. “If the borrower’s business fails as you have an asset to sell.”

Similarly, Butler says Lend & Borrow Trust can quickly sell the gold it has been storing as collateral.
Lawther says Rebuildingsociety works with a team of collections agents, credit control agents, solicitors and insolvency practitioners to arrange for the enforcement of the security.

“As all of our loans must be secured by a minimum of a personal guarantee from the directors or shareholders, we always have two avenues to pursue the debt – the business itself and the director,” he explains. “The latter is often more important when lending to small businesses, as many companies do not own sufficient assets to be confident of a recovery to unsecured creditors in the event of default.

“Therefore, having the extra assurance that the directors will remain personally liable for the debt even if the business is wound up or liquidated is an effective tool to obtain a positive result.”
He concedes that there will be times when the value of the security will not be sufficient to gain a full recovery of the capital and interest.

“In these situations when all available legal means have been explored, the loan is declared as bad debt or unrecoverable,” he adds.

Secured lending may appear to fall onto the safer side of P2P, but it is still an investment. There are always going to be risks in P2P lending and feeling reassured by the promise of returns from underlying assets is no substitute for due diligence.

This article first appeared in the June issue of Peer2Peer Finance News, which can be read in full here.