IFISAs: Risks to Investors
Let us consider the principal risks facing would-be Innovative Finance ISA investors.
The following is a high-level guide only and is not intended to be a comprehensive explanation or recommendation to any existing or prospective peer to peer lender.
As with all lending (peer to peer lending or traditional bank lending), the largest and most significant risk faced by the lender is borrower default risk – the risk that the borrower will fail to meet their repayment obligations to the lender.
In any lending situation, the lender’s capital is at risk – though in certain circumstances it is possible to partially mitigate this risk.
Traditionally, lenders who operate in the consumer lending (personal loan) sector have provided unsecured personal loans without security. The risk can be mitigated somewhat where the lending platform requires a guarantor to underwrite the repayments, or where the individual lenders are able to spread his or her capital across hundreds, even thousands of loan applicants – the idea being that the fallout from any one individual defaulting on his or her loan obligations would be limited to the extend of the lender’s exposure to that one individual. To illustrate, if £3,000 had been lent equally across 1,000 borrowers, the lender’s maximum exposure to the bad debt is £3.
Many peer to peer platforms focus on loans to established Small and Medium Sized (SME) businesses – which are often thoroughly credit scored by the platform before their loan application is approved.
SME business lending platforms increasingly operate strict risk control methodologies. Many will only enter into asset-backed loans, i.e. lending only where the value of the loan is secured against an underlying asset within the borrower’s business – such as a freehold property. Some loan applications require the company’s shareholders and/or its directors to enter into personal guarantee agreements.
In such a situation, the lender’s risk is somewhat mitigated by the fact that, in the event of a borrower default, the lender will receive title to the secured asset, which in theory could then be sold on to recover any shortfall in the borrower’s repayments. The mechanics of this security are very similar to that of a homeowner mortgage. Where shareholder or director personal guarantees have been provided, the repayment obligations of the company are passed on to the shareholders and directors in the event that the company itself cannot meet the loan’s repayment obligations.
In both personal and SME business loans, where recovered funds are not sufficient to cover the full amount of the loan – which may be the case if the loan was secured against an illiquid asset – the peer to peer platform may choose to draw upon its own internal ‘reserve funds’ in order to meet, or at least partially offset, borrower shortfall. However, these reserve funds are not guaranteed and capital is still at risk.
Property IFISA Risks
Specifically for investment property-related peer to peer loans, there is an additional risk on the part of the borrower – the risk that the yields achievable by the property are not sufficient to meet the loan repayment obligations.
A downturn in UK property yields could make it very difficult for the borrower to meet their repayment obligations if the property is particularly highly geared and the borrower becomes unable to meet the interest and capital repayment requirements of the property purchase loan.
If funding is for a property development company, then it is worth understanding how they assess sites before commencing a project. This could involved looking at due diligence procedures and the partners involved in such a process.
Property development companies may look to reduce risk by partnering with investors who purchase a development off-plan before sales are commenced, therefore guaranteeing cashflow and also a return for existing investors.
There is therefore an incentive for the peer to peer lending platform (as with all other property lenders) to ensure that the property itself is not too highly leveraged.
Alongside borrower risk a prospective lender must also consider the operational risks inherent to the peer to peer lending platform itself.
Over £5+ billion has been lent out by the UK peer to peer lending sector to date, but – for one reason or another – a small number of peer to peer platforms have failed.
Regardless of whether that platform and/or the loans held within in it are Innovative Finance ISA eligible, for a lender who has deposited funds within a peer to peer lending platform there would be a risk to capital in the event that the platform were to fail for any reason.
It is likely, for example, that a number of that platform’s borrowers may choose to withhold capital and interest repayments on their loans – perhaps because such borrowers would not want to pay funds into a platform where they do not know for certain that their repayments will be used to pay down their loan balances.
The sector is now fully FCA-regulated however, and many of the established platforms have made inroads to ensuring that in the event of platform failure the risks to lenders’ capital would be increased no more than absolutely unavoidable. Such measures would typically include the use of segregated client (borrower/lender) money accounts, so that the borrower’s repayments (and cash owed back to the lender) are kept physically and legally separate from the operating cash held by the peer to peer platform itself (there will typically be a number of account trustees in place to ensure that cash cannot freely move between borrower, lender and platform unduly). Similarly, many platforms operate ‘reserve funds’ which are intended to make good (or at least partially offset) such failings.
Further, the FCA regulations now require that each platform has in place a contingency plan which would be initiated in the event that the platform were to fail. Such contingency measures are designed to ensure that, for example, all existing loans would continue to operate on their original terms and in accordance with their original loan agreements.
Peer to peer loans are not covered by the FSCS
This is a key consideration for any existing or would-be IFISA lender; peer to peer lending is not the same as leaving your money in a bank savings account.
Peer to peer lending is not covered by the Financial Services Compensation Scheme and lenders’ capital is therefore at risk.
Peer to peer lending is however fully regulated by the Financial Conduct Authority. Please note that IFISAs also can now include unlisted corporate bonds or loan notes that have a fixed term and are not the same risk level as a cash ISA.
Updated: Thursday, March 7th, 2019