What ultimately counts with debt funders
It has been some time since my last post. This is mostly because we’ve been lining up a debt funding facility that will carry the platform through our pilot stage from next month until April and partly because I’ve been stretched out meeting equipment suppliers and SMEs.
We’ve sat down with a variety of different actors in the asset-backed finance arena from insurance companies to family offices to even a couple of wholesale banking operations and we have learned quite a lot about how these institutions grade and rate early-stage fintech platforms.
It’s perhaps possible to boil down the needs of a debt funder to three cornerstones, these three S’s..
Security, Stature and Scale.
Yes, it is true that tech innovation, vibrant marketing and a pinch of media buzz will help initiate a conversation but if you want to get pen on paper and a deal done then its these 3 S’s that will you will need to demonstrate above anything else. Forgive the boyish analogy but in essence debt funders want to back castles not palaces. Or at least, back the foundations of castles. If you don’t believe me just google how many financial institutions have the word ‘castle’ as part of their name!
Where as the early stage equity investor is almost entirely focused on tail upside and achieving a 20x , 100x return, debt funders are very much concerned with downside, given their limited and fixed upside. Yes it is true, particularly at early stage platforms that ‘venture debt’ usually benefits from a combination of the above. However, mentality and culture are deeply embedded and downside will always be the core focus of a debt player.
Specifically, debt funders are looking at 1. Credit risk, the risk that obligors fail to repay and 2. Platform risk, the risk that the platform is either incompetent with it’s obligations, careless in its approach or commercially doomed.
Thanks to the focus of our compliance wizards, RiskSave, we have worked hard over the past couple of months to put in place everything from Proper Record Keeping, Backup Servicing Agreements, Data Management Processes to a Complaints Policy (as if.. but yes we need one!). Also, all the legal contracts that are digitally created on the platform have benefited from Trojan work by our counsel at Simmons & Simmons. Finally, we are very much fortunate to have seed investors from leading institutions in the credit investment world and benefited from their advice in how to maximise security for our debt funders.
Despite the proliferation of investment science, portfolio theory etc etc. the guts of funding pivots on confidence, peer psychology and human-to-human trust. The herd mentality in markets has been well documented by academics and this phenomena also applies in private debt.
Track record is the starting block for 95% of funders. Besides the clear practical advantage of being able to see the platform up and running and credit performance to date, people rarely get fired for being the second person to do something.
Beyond stating the obvious I would recommend that early stage platforms focus on mitigants that help them overcome their lack of stature.
Firstly, the team and their background is essential. When I discuss how our CTO came from Maersk and helped deliver solutions around ships and technology, funders see how experience will ensure robustness e. When I mention that our credit modelling colleague (our second biggest shareholder) has worked for some of the leading SME lenders in the UK market including a leasing company there is an appreciation that we aren’t fresh in the battlefield.
Secondly, it’s important to focus on existing relationships. If a funder is presented with new people pitching a new innovative route into a market that is also new, there may well be interest to explore but a low probability of execution. Time is valuable – don’t waste it! Thirdly, turn the negative of being an early stage platform on its head by offering your debt funder upside through some equity participation.
International bond markets are $82 trillion in size. A typical hedge fund manages £200m to £10 billion. A ‘real-money’ asset manager upwards of £10 billion. An insurance company.. usually many billions. You get the picture, the numbers are big. While the funders spread their wings over many strategies and products, your proposition needs to offer future scale. ‘Go big or go home’ as they say.
In fact, it needs to scale to level that most niche lending platforms don’t reach. It is certainly the case that most of the current p2p platforms in the UK fall below the bar.
So while it may instinctively feel over zealous or against the ‘lean-startup religion’, it is critical that early stage platforms have a well mapped route to scale. This can be loosely defined as the ability to originate greater than £50M per annum.
While there are many more factors a funder will look at.. net yield being of course obvious, Security, Stature and Scale are core and central.
Too many fintech entrepreneurs build exciting, viable and valuable platforms but fall into the silicon valley mindset of ignoring down-side risk. Buzz areas like machine learning and blockchain help a palace to shine but funders want to back a castle. Gilded rooms or Guerdirons just won’t be appreciated.
Build on rock not sand. Hire solid people, invest in your legal structure, don’t scrimp on compliance and ensure a culture that is aligned with your funders.
As the business grows you can add fancy design, bring in animators and hire that CMO who ‘owns the room’ but begin by focusing on the fundamentals. Some of the leading players in financial services have existed for hundreds of years. Fintech will be a marathon. Not a sprint.