Pricey Funding Circle too risky

Funding Circle was launched in the UK in 2010 and has since expanded into the US, Germany and the Netherlands, providing a source of lending to SMEs underserved by mainstream banks since the financial crisis. Borrowers can apply online for a loan of up to £1m – although the average was £70,000 during the first half of the year – and are matched with investors. At the time of the IPO, the interest rate on the average loan was about 11 per cent. The group generates revenue via an initial transaction fee, ranging between 1 and 7 per cent of the amount lent (deducted from the loan proceeds paid to the borrower), and an ongoing annual servicing fee of 1 per cent. The group is targeting adjusted cash profit margins of 35 per cent over the longer term, as it exploits economies of scale.

Loans under management have been growing rapidly during recent years, more than doubling between 2015 and 2017 from £860m to £2.1bn. That had risen to £2.8bn by the end of September last year. Fast-rising new loans meant transaction fee revenue grew at a compound annual rate of 78 per cent between 2015 and 2017, and 59 per cent during the first half of 2018. However, that new lending has been achieved via costly marketing activity to attract borrowers and investors, and a rapidly rising wage bill. While marketing costs as a proportion of revenue have declined in recent years, up 57 per cent in the first half at £24.7m, these costs were equivalent to 39 per cent. Meanwhile, first-half staff costs rose 54 per cent to £38.3m (which excludes £4.7m of capitalised spending on development staff) representing 68 per cent of revenue. Overall, first-half operating expenses rose 50 per cent. The heavy spending means the group has yet to turn a profit. In fact, analysts at house broker Numis do not expect profitability until 2021.

Given transaction fees typically represent around 80 per cent of annual revenue, achieving those forecasts will depend on the group’s ability to attract funding and SMEs continuing to take out new loans – neither of which has been tested through a full economic cycle. While the group does not fund the loans, which reduces balance sheet risk in the event of loan impairments, it does not charge fees on impaired loans, which could eat into revenue if defaults rise. More significantly, a worsening economic outlook could make investors less willing to put up capital to fund new lending and SMEs less likely to seek funding to expand their businesses. Admittedly, the group has been growing its less flighty institutional investor base – which represent 51 per cent of overall investors – with asset manager Waterfall agreeing in December to invest £1bn in lending over two years. Its coffers were also topped up by the £300m in gross proceeds raised at IPO.