While the name might suggest something obscure, "shadow banking" is part of an increasingly visible, and vigorous, sector of funding for business growth as well as lending to individuals.
Sometimes referred to as “shadow banking” or “alternative funding”, the sector that finances business outside the traditional marbled halls of banking has become more noticeable as bank lending is squeezed by regulatory capital controls.
And for any wealth management firm wondering where its future clients are going to come from, it is essential that investment in new firms continues. If small and medium sized enterprises are starved of funding, there will be fewer liquidity events for wealth managers to tap into in the long run. Wealth managers have a very clear interest in ensuring capital finds those able to use it.
It is generally encouraging, therefore, that the non-banking sector has displayed so much entrepreneurial energy. And it is also unsurprising. Capital, like water, finds its level sooner or later, however hard regulators try to control it. If banks can’t, or won’t, fund businesses, others assuredly will. The upshot, of course, is whether alternative providers are prudent and if clients understood what’s at risk.
The non-banking sector covers a wide front: peer-to-peer lending; crowdfunding; angel investing, venture capital and pension scheme-backed financing. While there has been a media hype around areas such as crowdfunding, not all of these areas are particularly novel – often the only really new element has been the ability to harness the wonders of the Internet to put providers of capital in touch with the demand side.
According to a report by the Economist (10 May), the business of direct lending or private debt is booming; investment funds making loans in this space lent $97 billion worldwide in 2013 and are due to overtake that figure this year. Peer-to-peer lending, about which the UK authorities have sought to tighten controls recently, is a fast-growing sector. The value of loans organised by Lending Club, a large organisation in this sector, totals now over $4 billion; that organisation has been around since 2007 (source, The Economist). And let’s not forget that one of the most traditional forms of non-banking funding for a business is called the equity market.
Use a pension
Among recent developments has been the alternative funding space. The UK government, in its March budget of this year, proposed to ensure that if a request for funding by a bank is rejected by a bank, the request must be passed to an alternative funding portal.
One of the businesses operating in the “alternative funding” space is Clifton Asset Management, a founder of a UK-based network called Alternative Business Funding (now containing eight members, with more due to join). Adam Tavener, chairman, is a bullish advocate of this market and explained how small and medium-sized firms can unlock pension fund assets to fund financial needs, with a business’s intellectual property as collateral. (Under official rules, movable physical assets such as a car or piece of machinery aren’t eligible as security.)
"There is a tremendous amount [of capital] in the pensions industry - about £2 trillion ($3.34 trillion) - and about £100 billion of that is from business owners,” he said in a call to this publication.
"We fund on average around 20 to 30 businesses every month; we have funded about 2,200 so far, with a total involved of around £230 million," he said.
After the-then Labour government in the UK initiated legislation in 2004 to facilitate pension-backed company funding, the market got going in 2006 with the “A-Day” reforms of that year.
A firm such as Clifton acts as an arranger: it will calculate what a would-be client's pension fund is worth; pensions that can provide the money can include the client's private pension schemes, such as SIPPs, as well as defined benefit schemes. The affected pension money must be that of the business owner and not from others, given the obvious need to protect outside parties from misuse of such funds (as infamously happened with the disgraced media tycoon Robert Maxwell in the late 1980s).
When providing financing, Clifton will ensure that the pension fund in question holds a right to a business's intellectual property as collateral; the IP is valued independently by a third party. The financing takes the form either of a loan or a sale and leaseback agreement. Depending on the type of funding, duration can be up to 10 years.
Not all proposed funding will be accepted: much depends on the riskiness of a business. To ensure the commerciality of a transaction, Clifton will calculate what would have been the interest charge that a bank would have imposed to see if the risk is bearable or not.
Luxury items for lending
At what perhaps might be the other end of the spectrum, where individual cash needs are involved, are a clutch of firms offering collateralised finance where valuables such as jewellery, art, classic cars and other items are put up on a loan. This has sometimes been described, with typical media cheeky play on words, as “posh pawn” – referring to the traditional pawnbroking industry practice of providing hard-up people with small sums of cash in return for holding jewellery. The collateralised lenders whom this publication spoke to argue they are very different animals and reject the “pawnbroker” tag completely.
One example of a new firm operating in the collateralised lending space is HNW Lending, a UK-based business founded several months ago by Ben Shaw.
A press release from the firm gives some flavour of how it intends to operate: “A new alternative lender is launching that will provide individual loans of between £60,000 and £1million to clients against their valuable assets such as classic cars, fine wines, jewellery, yachts, private jets, art and property. HNW Lending is using funds provided by its founder Ben Shaw, as well as those of over 10 high net worth backers. The company is looking for more wealthy partners to provide further funding to grow the business. The minimum requirement for this investment is £60,000.”
The statement continues: “HNW Lending has been piloting its proposition over the last few months and to date has been involved in arranging over £500,000 of loans against valuable assets. Following its launch, the company plans to arrange up to 20 loans a month, collectively valued at between £2 million and £5 million each month. The service is highly discreet, no credit checks are undertaken and funds are usually released within a week. Also, because the proposition is based around peer-to-peer lending, interest rates are very competitive.”
This publication decided to find out more. Shaw explained that he sees his firm’s role as that of a matchmaker between owners of specific assets and borrowers who would otherwise struggle to obtain equivalent bank financing.
The assets, for collateral purposes, are valued at the price the goods would sell for, such as a 90-auction value.
Shaw is after three types of client: Individuals going through some sort of cash crisis, such as at a divorce; clients in a drawn-out financial transaction where they need some kind of gap financing, and introducers such as lawyers and accountants working for people with financial demands.
There are some firms operating in a slightly similar space, such as borro, although Shaw says his firm’s loan terms, such as duration and costs, are different. “We generally do loans with a minimum duration of 6 months, with interest rates ranging from around 7 per cent for low LTV [loan-to-value] first charges on property to around 15 per cent for high LTV second charges on property and more unusual assets (eg classic cars, fine wine)," he said.
To compare, a spokesperson for borro, elaborating on its charges, said the current rates are as follows: "Monthly interest is from 2.49 per cent up to 5.99 per cent per month; fees range from 2 per cent up to 12 per cent (depending on the asset), although a typical fee is 5 per cent. Insurance and storage costs are included here but are factored in depending on the asset type. For example, supercars, wine and fine art even some antiques will need to be stored in de-humidified storage."
So how does all this differ from pawnbroking?
“Pawnbroking, in many minds, is about going into a shop with a gold watch or something similar that is worth a few hundred quid and getting some money in return for later getting the watch back, but usually in the knowledge that you probably won’t be able to get the watch back,” Shaw said. “I do not, by contrast, expect borrowers [using the service] to foreclose,” he continued. “In my experience we have never had to need to call in a personal guarantee.”
“We speak to them [borrowers] a month before a loan will mature to see if they are struggling but we have never had a situation where it goes wrong,” he said.
“It is not unknown for some pawnbrokers to expect as many as half of their borrowers to never come back to repay their loans and claim back their goods," he said. On the other hand, Shaw said his business is not really like that of a private bank where existing clients will use some of their assets as collateral to finance specific transactions, such as art. However we often step in where private banks won't lend to their existing client base.
His firm got its consumer credit licence from the Office of Fair Trading last November and like all similar firms now has an interim licence from the Financial Conduct Authority, the UK regulator.
In a funny sort of way, Shaw, reflecting on the proliferation of such businesses, says it is a sad commentary on the banking sector’s position that this is happening.
“The fact that I exist in this area is a real shame because my rates are higher than those of banks in the past…it is not subsidised by the government through artificially low interest rates. This is a bespoke business. We aim to pool lenders in low double-digit [percentages] and borrowers can borrow in mid-double digits,” he added.