New financial asset classes (Crowdfunding – Donation, Equity, Reward; P2P) are emerging fueled by investor demand for premium deal flow (Equity Crowdfunding –HealthiosXchange), lower fees (borrowers refinancing high cost consumer debt via Marketplace Lending – Prosper), philanthropic motivations (“Impact the World” via micro-finance – Kiva), desires to prepay for innovative products (Reward-Based Crowdfunding platforms – Kickstarter), and legislation (the JOBS Act). Are Marketplace Lending/Crowdfunding new asset classes? The stats say Yes! (Source: Massolution)
Growth rates accelerating
- Market grew 81% from 2011-2012 exceeding 64% growth from 2010-2011
- Funds raised via Equity Crowdfunding projected to increase from 4% (in 2013; 200MM) to 8% (in 2014; $800MM) of total capital raised in the sector
- Limited Partners going direct – Sensitivity to high fees as demonstration by Calpers recent decision to eliminate hedge funds from their portfolios and retail properties
Peer-to-Peer (P2P) lending has been an unstoppable force. Loan originations ($’s) recently surpassed $7 billion and market leading P2P online marketplace, Prosper, originated $172 million in September 2014 vs. $7 million year-over-year.
What’s behind Peer-to-Peer’s meteoric rise or what some are now calling “Marketplace Lending”?
- The emergence and adoption of FinTech. From Daniel Gorfine/Chris Brummer’s “FinTech Building a 21st Century Regulator’s Toolkit,” October, 2014 – “Online finance and investment platforms are increasingly challenging the providers of traditional financial services with efficient, low-cost, and user-friendly products and platforms”
- Investor thirst for yield. Low investment rate environment motivating investors to source deal flow from innovative online platforms including Peer-to-Peer
- “Convergence” or the adoption of online investment marketplaces by institutional investors including hedge funds, family offices, and lending institutions (traditional banks)
So will equity crowdfunding catch up to P2P lending? It’s up to institutional capital!
If YES, what similarities exist between P2P and equity crowdfunding?
Like P2P marketplaces, Equity Crowdfunding portals (AngelList, CircleUp, HealthiosXchange) are launching innovative financing vehicles repositioning the goal posts on how Accredited investors gain access to premium deal flow at lower fees (most likely correlated to/resulting in higher returns), institutional capital (venture capitalists) sources deal flow/invests in promising companies, and private companies reach the 8.7 million accredited investors in the United States. Equity Crowdfunding innovations include: investor syndicates (~online venture funds), eBack Offices (electronic documents, compliance, regulatory, payment), and crowdsourcing (scoring, “following” companies).
Like the debt/lending industries, private equity is a huge market as measured by invested capital. Over $1 trillion in capital was invested in Reg D companies in 2013. These financial marketplaces, controlled by established intermediaries (venture capitalists, broker dealers, banks), are rife with inefficiencies/high fees for participating investors including management fees/carry (“2” and “20” – venture capital) and front-end fees/loads (10-15% on non-traded REIT investments – broker dealers). But for most accredited investors the primary issue still remains access to premium deal flow. Like P2P, Equity Crowdfunding allows all investors to participate, no preferential treatment or connections required.
Convergence = Institutional Capital Sources Meet Retail
Convergence’s imprint is everywhere within Equity Crowdfunding from FundersClub’s “Partnerships” (invest alongside premier venture capitalists), to HealthiosXchange Ex.PR.E.S.S. portal (co-investments), to Limited Partner “direct investing” in AngelList syndicates (Maiden Lane), to “celebrity” investors (Gil Penchina/Tim Ferriss) leading AngelList syndicates. Like debt/lending, private equity/venture capital is migrating online. Why would it not? Technology is the ultimate leveler (“democratization” of capital), and there is immense untapped wealth available to private equity sponsors online (only 7% of the 8.7 million investors participate in private equity). As opposed to the zero-sum game mantra viewed by many incumbents, Equity Crowdfunding’s gains are institutional capital’s losses, direct investing is complimentary and additive to existing funding structures (Limited Partners funding venture capitalists). In fact, platforms like HealthiosXchange’s Champion’s Program, mimics institutional structures consolidating investors into special purpose vehicles (SPV’s) acting like Limited Partners (~Accredited LP’s), but without the management lockup restraints.
Adoption of Technology to Increase Adoption
Direct investing/crowdfunding portals are employing “Best-in-Class” social media/analytic technologies to reach investors globally. For example, incorporating many of the viral tools employed by social media giant Linkedin and Facebook to reach investors and foster engagement, portals like SilverportalXchange (real estate) create communities wherein members “friend,” “follow,” “message,” and “share” with the resulting member-generated data then personalized (match deals to investor preferences ~text analytics).
Equity Crowdfunding is also closely following P2P’s playbook by incorporating strategies for easily performing due diligence (online documents), transacting (electronic back-office), assessing risk (scoring), communicating with companies (interacting with management via online forums), and participating in investment communities (groups, follower companies).
Equity Crowdfunding Leverages Technology to Reduce Risk, Increase Investor Returns
Equity Crowdfunding portals are striving to reduce the risks associated with private equity investing by launching innovating financing platforms including Investor Syndicates. Given the risks associated with private equity investing (~illiquid, “hits” based business, high failure rate), investor syndicates were created to make it easier for investors to diversify across a number of promising companies/high-profile lead syndicators (esteemed investors with successful track records) via low investment thresholds (<$5,000 per investor per company).
Portals also aim to reduce investment risks by providing information/data online required to assess investment opportunities. Online tools include scoring (Crowdsourced, Proprietary), ability to message potential/existing investors online, and leverage events-based forums (webinars, road shows) to interact with management.
If NO, what will prevent equity crowdfunding from matching P2P’s performance?
P2P Investor Onboarding Easier
The nuances of loaning money is well understood by investors given the prevalence of/familiarity with the banking industry and lending activity between friends and families. Debt is attractive to investors given it provides current income (yield) while protecting principal (return of capital at loan maturity). The financial markets have fed the market appetite for yield/protection of principal by providing robust analytics, reporting, ratings, and transparency contributing to the prevalence of debt (bonds) in most investor portfolios.
Given P2P loans are not classified as securities nor the organizations facilitating the lending activities identified as brokers or RIA’s, P2P platforms can more easily source deal flow (members fund loans directly from bank accounts). Ease of use and understanding/familiarity of debt has correlated to high rates of investor adoption similarly to those associated with eCommerce (~Amazon).
Investor onboarding via Equity Crowdfunding is more difficult. Investors are required to review and sign (electronic signatures available) term sheets/offering memorandums, and wire capital into escrow. As a result, many investors do not understand the process and/or given the number of additional steps (vs. P2P), do not complete the investment process.
P2P – Stimulates Institutional Adoption
Institutional capital is embracing marketplace lending platforms (about 66% of all Prosper loans in 2014 were sold to institutional investors). Peter Renton – Lend Academy, mentions in “Orchard Lands a $12 million investment from some of the industry’s biggest names,” October 21, 2014, the advent of the third lending model, “Historically, there have been two different business models in the lending industry: balance sheet and securitizations. What Lending Club (~Prosper) has proven is a third model is possible: the marketplace lending model.” Equity Crowdfunding is still pursuing institutional adoption.
P2P – Easier to Build Diversified Portfolios, Assess Risk
The P2P industry provides easy-to-use analytical tools assisting lenders with selecting and diversifying loan portfolios effectively smoothing returns. Prosper provides members value added tools on their website. Equity Crowdfunding still strives to be understood.
P2P – Establishing Liquid Markets
Secondary markets stimulate institutional engagement by providing a marketplace for liquidity; an exchange where positions can be built or liquidated in real-time. Equity crowdfunding is still focused on building its primary market.
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If there is one industry that has successfully resisted change, it is Venture Capital. There is no doubt Venture Capitalists (VCs) play a vital role in the capital markets assisting companies raise seed/growth capital to advance development programs. Major VCs devote significant amounts of capital from their Limited Partners (pension funds, endowments, foundations) investing in emerging growth companies following extensive due diligence by seasoned industry veterans, introduce valued networks assisting portfolio companies with operations, and facilitate successful exits (IPOs, M&A) given strong relationships with bankers and strategic buyers. For these services they are well compensated.
This sounds impressive. So what is the problem? Over the past 10 years VCs struggled to provide alpha (premium to established benchmark returns like the S&P 500) to reward investors for participation in a risky asset class. Though the recent IPO window and robust M&A activity will surely improve these metrics moving forward, many still feel the incumbent fee structures (“2” and “20”), long-term lock-up’s (~10 years), and reluctance to invest in early-stage opportunities and those companies located outside of San Francisco/Boston, is forcing companies to seek capital from alternative sources (accredited investors, family offices, limited partners direct).
Enter online venture capital
Fueled by advancements in social media (~Linkedin), passage of the JOBS Act (expanded shareholder cap and approval of general solicitation), and increased adoption of direct investing by alternative investors (i.e., Peer-to-Peer lending ~Prosper), the funding landscape is drastically changing! Whether in the consumer goods industry (CircleUp), technology (FundersClub and AngelList), healthcare (HealthiosXchange, Poliwogg) or real estate (Reality Mogul, SilverportalXchange) industries, investors are increasingly sourcing and investing in deal flow (private equity) directly. As with the discount brokerage revolution (rise of online public equity trading platforms including Schwab and TD Ameritrade), technology is altering the landscape of how investors participate in private equity.
One area where technology is reshaping the investment landscape is what many are calling “Convergence.” This term describes the merging of retail and institutional pools of capital resulting from the proliferation of online platforms including Peer-to-Peer Lending (P2P), and equity crowdfunding/direct investing (AngelList, Fundrise, Mosaic).
A recent article, “Has Peer-to-Peer Lending Turned Into Hedge Fund-to-Consumer Lending?” by JD Alois, Crowdfund Insider, highlights convergence:
- “While P2P lending started out by matching an individual borrower with an individual investor things have rapidly changed. The outsized returns generated by the various P2P platforms have not been missed by institutions and hedge funds.”
- “During the last quarter, almost 60% of the $1.1 billion in loans originated on California-based Lending Club – the largest P2P lender in the US – were snapped up by asset managers, banks, hedge funds, insurance companies, pension funds and other institutions. At Lending Club’s main competitor, Prosper Marketplace, 66% of loans went to these same types of investors.”
Though the merits of institutional capital’s involvement in the P2P industry can be questioned (hedge funds have acquired large portfolios of P2P loans and securitizing them to attain leverage), there is no denying the evidence supporting how technology is facilitating convergence between retail platforms and institutional investors.
It is just a matter of time until blue-chip venture capitalists launch their own investor syndicates. Why make this bold statement? Because the value propositions associated with leading investor syndicates are too compelling for Fund managers and professionals start-up investors to ignore including:
• Online presence to build a following
• Turnkey fund management tools to run venture funds (i.e. HealthiosXchange’s Reserve system)
• Access to a marketplace of tens of thousands of accredited investors
Convergence is on the move. Institutional capital is “crowding out” retail capital (Peer-to-Peer), strategic buyers are moving online to meet promising emerging growth companies, and venture capital firms are launching investor syndicates to tap into additional sources of capital. Catch the wave!
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