Funding Circle Income Fund

[Walkeia]

I am pasting some analysis I posted on ADVFN in case anyone is in this. I did this in early April. Please note, I bought but have subsequently sold this fund for a small loss as my concern about the health of the SME sector increases after recent Funding Circle and RBS statements. So here is my best shot at a deep dive into this one.

My conclusions are twofold.

1. FCIF has limited downside from here unless the UK economy really craters, it's purely a play that the fund wind up will be >86.6p.

2. Stay away from P2P lending - I believe their implied default rates are far far too low and their incentive structure is wrong --> i think this is the reason the institutional investors want this fund unwound - they want out of this sector and I wholeheartedly agree.

So using recent fact sheets and last year's annual report I get the below

Net assets 315
Cash 22.05 (7% of the fund is in cash from end Feb)
Loans 292.95
Income 28.41615 (9.7% avg int rate 2016+; matches '18 fin statement)
Costs 4.743 (from '18 fin statement, excludes FX charge and NPLs)
I-C 23.67315 (Income - costs = NPL capacity)

Below is the capacity for non-performing loan write downs for respective recovery rates just using the income generated by the loan interest less costs. Googling recovery rates I have found figures between 30-40% for Italian banks. However to be conservative I used the 10 & 20% recovery rates for my investment decision.

NPL implied @ 0% R 8.08%
NPL implied @ 10% R 8.89%
NPL implied @ 20% R 9.70%
NPL implied @ 30% R 10.51%
NPL implied @ 40% R 11.31%

To me, these default rates look quite realistic for UK SME lending. If anyone can find a good data series on this I would be interested. All I found was a European report - UK SME default rate in 2015 at ~11%, add in the 30% recovery rate commonly cited and this fund is returning negligible NAV gain. This view is corroborated by FC's own statistics: (cannot post link - on their website) where '16 & '17 NPLs are developing on significantly steeper gradients. To be fair to FC this assumes zero recovery. Could I see 16, 17 and 18 defaults going 10%+ on a zero recovery? - it seems unlikely unless we get a very significant economic deterioration. Yet, nor is this fund going to organically gain significant NAV value in my opinion - which would also explain the wind down.

So why did I consider buying? I have updated the implied recovery rates above to account for the market cap of the fund as opposed to NAV. Using 86.6p / (9.1%).

Discount to NAV @ 9.1% = cash 28.66

NPL implied @ 0% 17.86%
NPL implied @ 10% 19.65%
NPL implied @ 20% 21.44%
NPL implied @ 30% 23.22%
NPL implied @ 40% 25.01%

Lending Club (US P2P lender to households and businesses NPLs in '08 was 15%). I find it difficult to see FCIFs default rate getting towards these figures. My base is defaults of ~10%, 20% recovery rate and so no organic growth but should over time realise the 9.1% discount.

Lastly, FCIF have stepped up their buybacks of their own shares since March. In Feb they bought 2.137m shares resulting in a 0.06% addition to NAV however after the fund wind up was announced they stepped this programme up and have bought 7.825m (+0.22% NAV) shares in March and in April are on course to buy 8.8m (+0.25% NAV). This appears to be the main way they can create NAV growth if the share price remains at such a discount - they will have significant incoming cash monthly from loan rolls offs to continue this. I do also take this as an indication of the boards outlook - the statement highlights they will use cash balances to correct material deviations of the share price from NAV which implies the default rate is not running away higher in my view.

The risks:

1. it's a 10% trade with potential for ~5% further upside if things go better than planned but over what time period? Rolling off the loan book we'd be talking years and that isn't a great return over that period.

2. Hidden aspects as mentioned above we just can't see. High unwind fees (even though fees should start coming down as they use less banking facilities etc).

[Walkeia]

2. Stay away from P2P lending - I believe their implied default rates are far far too low and their incentive structure is wrong --> i think this is the reason the institutional investors want this fund unwound - they want out of this sector and I wholeheartedly agree.

It's only fair I post an update to the above as I cut this holding for a small loss after taking the dividend into account. The recent failure of Lendy has sadly validated the point above - and now it looks like retail may be on the hook for 50%+ capital loses.

There's a camp of thought which says 'buyer beware - if the returns are too good to be true then your to blame' yet I feel this places an unrealistic burden of financial expertise on the average person who unlike the majority of us on this message board may not enjoy personal finance. LCF managed to advertise as FCA regulated for a short period on the Telegraph money website and Lendy changed its name to Saver Stream - both giving false pretences of authenticity and underlying business activities.

My two pence,

1. The regulator should and will take a lot of flack for this and nothing will change. Under-resourced yes; but that is not a good excuse especially in Lendy's case which has been active since 2010/11. I honestly believe the only way to change incentives here is to go US style with executives facing potential prison terms.

2. P2P - good idea runs in same old human greed; especially when the platform provider / loan salesman has little to no skin in the game.

3. 50% losses stinks .... there is development finance which is high risk yes; from albeit limited experience when I did some development loans the losses on the ones which went wrong never got anywhere near these levels of losses due to over-collateralisation etc.

[Itsallaguess]

2. P2P - good idea runs in[to] same old human greed; especially when the platform provider / loan salesman has little to no skin in the game.

Firstly, hats-off for coming back and posting an update - I'm not sure there's many that would have done given the circumstances....

Secondly, and specifically on the point above, the problem I always have when thinking about P2P is similar to the one you raise - human greed - but I think where we might differ is that you seem to be suggesting that this huge negative influence only starts at the platform provider/loan salesmen position, and works itself out from there...

I personally think that you might want to start a little bit further upstream, and consider how human greed might affect those taking and (supposedly...) paying back the P2P loans in the first place, and it's always been that consideration, as well as your own 'downstream worries' that has stopped me going anywhere near the P2P arena....

Cheers,

Itsallaguess