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Investing in sub-prime credit: worth the risk?

Non-standard finance companies have been growing their customer numbers and loan books, but how long will this last?
September 23, 2016

Sub-prime became a dirty word when the financial crisis hit. Many of the largest, branch-based lenders in the UK, including CitiFinancial and HSBC-purchased Household Finance, were shut down or sold off, while industry giant Provident Financial (PFG) has been steadily reducing its doorstep lending operations. Consultancy L.E.K estimates that those consumers deemed 'non-standard' by mainstream banks run into the millions. This has resulted in a fragmented market, with smaller - and often controversial - payday lenders trying to take advantage of the gap in the market.

Until recently, this left just two large non-standard credit companies - Provident and its former overseas business International Personal Finance (IPF), which was spun out in 2007. However, during the past two years two larger players have entered the UK market - Non-Standard Finance (NSF) and, more recently, Morses Club (MCL). The one thing these companies have in common is that they lend to consumers with poor credit records, who are unable to obtain finance from the big banks. Non-Standard Finance listed in February 2015 as a cash shell, with former Provident Financial chief John van Kuffeler at the helm. Its aim is to take advantage of the fragmented nature of the market, primarily snapping up branch-based and home credit businesses. Morses Club came to market after private equity group R Capital offloaded the stake it acquired in 2009 as part of an IPO earlier this year.

UK lenders have done very well operating within the sub-prime market. In the two years to the end of 2015 Provident Financial grew its pre-tax profits by half to £274m, as customer account numbers for its sub-prime credit card business, Vanquis Bank, rocketed. In the short time they've been trading, Morses Club and Non-Standard Finance have gained good traction in the market, too. The latter has succeeded in increasing active customers at Loans at Home, which grew 13 per cent to 98,000 during the six months to the end of June, while total credit issued by Morses Club increased by 16 per cent to £66m during the six months to the end of August. But what is behind the rise in sub-prime credit within the UK and to what extent is it sustainable? What's more, what are the risks involved in investing in sub-prime lenders?

 

 

A Goldilocks consumer credit market

Demand for consumer credit across the market has remained high. According to data from trade body The Finance and Leasing Association, which includes Money Barn and Every Day Loans among its constituents, its members wrote new consumer finance business worth almost £81bn in 2015, up 8 per cent on the previous year. Demand has been fuelled by continued low interest rates, making it a good time to borrow. This is slightly less relevant within the sub-prime market, since the much higher interest rates charged on sub-prime lending are not linked to the base rate.

However, conditions have also been favourable for sub-prime lenders. In recent years, while employment has held up, wages have been squeezed as productivity has stagnated. The IC's economist, Chris Dillow, says this is the ideal environment for sub-prime lenders: "Sustained low wages mean that people need a loan, but high employment means the risk of mass defaults hasn't materialised," he says.

Larger lenders also stand to benefit from regulatory change. Since 2014 responsibility for regulating consumer finance providers has switched to the Financial Conduct Authority (FCA) from the Office of Fair Trading. As well as complying with the Consumer Finance Act, companies must now also abide by certain principles for businesses lending to consumers as set out by the FCA. These include paying due regard to a client's information needs and maintaining adequate financial resources.

Around 50,000 consumer credit companies were transferred over to the FCA with interim permission to trade, with 30,000 so far becoming fully authorised. This could lead to further consolidation within the sub-prime credit market, as smaller lenders find it harder to leap the higher bar put in place by the FCA and gain full authorisation. Mr Van Kuffeler certainly hopes so. "This is one of the main reasons why we appeared on the scene and are able to raise capital - to be a consolidator in the sector," he says.

 

 

From doorstep to digital

The use of technology to issue and service loans has been one of the most marked changes within the industry in recent years. Home credit agents are increasingly being equipped with tablet computers to record their debt collections, doing away with paper-based systems. However, UK-listed providers are divided over the extent to which they plan to digitise their operations.

Provident Financial has been investing in digital lender Satsuma and guarantor-backed lender glo. The former was launched in 2013 as an antidote to online payday lenders and offers weekly-repaid loans averaging around £300, although management plans to offer a monthly-repaid product before the end of the year. Between 2010 and the end of June 2016 home credit receivables at Provident fell by 43 per cent to £490m. Morses Club is similarly digitally-minded, allowing customers to apply for loans online as well as an app offering supplementary store vouchers for customers of its club card. International Personal Finance is rolling out an app across its European markets, which allows customers to apply for loans on the go. These lenders all stress only 'higher-quality' - and therefore lower-risk - customers will have their loan approved. However, management at Non-Standard Finance is firmly against issuing loans online, deeming it too risky given the poor credit ratings of customers.

 

When will momentum slow?

Those running non-standard finance companies cite the continued need for credit as the reason why customer numbers keep rising. Whether or not loans will be approved or repaid is another matter. In the near term, we could see a further squeeze on wages as inflation rises. For customers at the bottom end of the sub-prime demographic, inflation is the main risk to their ability to pay back loans. For those with greater household income unemployment typically becomes more of a risk. Mr Dillow points out that if job churn increases, more people could lose their jobs even if aggregate unemployment stays flat. Secondly, aggregate unemployment might rise. This could be because of an economic downturn. A wider economic downturn could also result in funding drying up for these lenders. Admittedly, these are risks for many other companies in similar conditions too.

 

IC VIEW:

Non-standard finance companies are highly cyclical and operate in higher-risk environments. But with UK employment figures stable and inflation in check for now, the conditions are favourable for these lenders to keep growing their loan books. However, we prefer the likes of more established plays such as Provident Financial and await further evidence of progress from newer entrants to the market before turning bullish on them.

 

Favourites

Recent buy tip Provident Financial has a good track record of growing customer numbers and its receivables book. Vanquis bank is a good growth driver for the company and Provident is diversifying its home credit business, with a mix of digital and doorstep lending. The group sold off some delinquent home credit loans during the first half of the year to third-party debt purchasers, yet the division's receivables still increased as it focused on better-quality customers eligible to borrow larger amounts over a longer period. Provident trades at a premium to the sector, but it has the most established track record of running a very profitable loan book, reporting a first-half return on assets of 16 per cent. Solid cash generation also allows the lender to maintain an impressive dividend payout, with a healthy prospective yield of almost 5 per cent planned for 2017.

Outsiders

Sell tip International Personal Finance has been clobbered by regulation across its European markets. The group shut its Slovakian business last year after the government introduced a cap on interest charges on consumer loans. A cap on all non-interest costs associated with consumer credit also came into effect in Poland at the end of March. Its Poland-Lithuania and Czech Republic businesses have also faced pressure from increasing competition from payday lenders. To add to its woes, sales at its Mexican business were harmed by less productive agents during the first half of the year. Management is reintroducing senior leadership to the most affected areas and increasing monitoring of agents to rectify the problem. However, we think there are too many obstacles for the lender to jump at the moment to warrant owning the shares.