Alternative finance is growing strongly – our latest report showed the sector grew 84% in the past year. This is great news for many of us who have been following and supporting the industry. But as any sector develops and matures, it will face challenges.
Below we set out six of the main challenges we think alternative finance will need to tackle if its current success is to continue.
1. Avoiding fraud and dealing with it when it happens
As we discuss in this year’s study the potential ‘collapse of one or more of the well-known platforms due to malpractice’ was seen as a high risk to future growth of the market by 57% of the surveyed platforms. While the UK is yet to see a high profile case of platform fraud, it seems inevitable that as the market grows, there will be some platforms not playing by the rules. Swedish platform Trustbuddy who suspended its business due to suspicion of misconduct, including misuse of client money, in 2015, is one example of this.
The challenge will be how industry associations deal with incidents of fraud and if the industry can maintain the trust of consumers as well as regulators when cases of fraud happen.
2. Getting to sufficient levels of volume
As we illustrate in this year’s study, growth of the alternative finance market is slowing down, from 161% between 2013 and 2014 to 84% between 2014 – 2015. While an 84% growth rate is impressive for any industry, it might not be sufficient for the alternative finance market, where platforms rely on facilitating very large volumes of loans, investments and donations to make a profit.
Across the Atlantic, where the market is also experiencing rapid growth, there has been some concern from investors in to some of the big P2P lenders that the platforms won’t be able to maintain growth and increase the volume of loans needed to build a profitable business. As an example, Shares in Lending Club dropped almost 50 per cent between January and October 2015 amid fears that the group cannot sustain its rapid pace of expansion without lowering underwriting standards or spending much more on marketing.
3. Managing delays and non-delivery in rewards and donation based crowdfunding
Rewards and donation based crowdfunding have grown increasingly popular as way for entrepreneurs to fund everything from community gardens to gadgets and video games (we estimate the market grew to £54 million in 2015). Getting people to back or pre-purchase a product or project can be a great way of testing whether or not there is a market for an idea before putting money and time behind making it a reality. However, realising the project often proves surprisingly difficult for successful donation and rewards based fundraisers, in many cases leading to significant delays in delivery (One study of Kickstarter campaigns estimated that 75% of all reward based projects were delayed).
As the volume of campaigns goes up, so do stories about campaigns struggling to deliver on their promises. In 2015 we saw one of the most serious incidents of this to date when the company behind the Zano drone, after successfully raising £2.3 million to deliver a mini drone to more than 12,000 supporters, collapsed.
Delays and non-delivery could have severe implications for platforms as potential backers become more sceptical about using them to support projects. As rewards and donation based crowdfunding continue to grow, the platforms will need to play an even stronger role in helping fundraisers develop realistic business and project plans before they look to the crowd for finance. Similarly, fundraisers/backers are increasingly seeing rewards based crowdfunding as a pre-purchase , where they are guaranteed a product at the end of the project, rather than backing an entrepreneur to try and realise an idea. Along with educating fundraisers, platforms will need to continue to educate backers about the risks they are taking when supporting a rewards or donation based project.
4. Finding the right balance between the crowd and the institutions
Crowdfunding and P2P lending have been much touted as a way for individuals and businesses to raise funds by attracting small amounts from a relatively large number of individuals. However, as illustrated in this year’s industry report there is a growing trend of big traditional investors finding ways of working with ‘the crowd’. This particularly true in the P2P lending market, where around 25% of all loans were funded by institutions.
In 2016 institutional involvement in the P2P market is likely to increase and will go from being the trend to the new normal. However, while 2015 saw many banks and other financial institutions form partnerships with alternative finance platforms, we still know relatively little about this market. What exactly are the benefits for institutional investors of engaging with the alternative finance market compared to more traditional methods of investment? What does it mean for the ‘crowd’ of small lenders and investors? Is alternative finance a democratisation of finance or will retail investors be squeezed out of promising deals by institutions?
5. Balancing equity crowdfunding successes versus failures
One of the biggest questions asked of the equity crowdfunding market is the ability of crowdfunded businesses to deliver a financial return to investors. With the exits of E-Car club and Camden Town Brewery in 2015 we got the first evidence that crowdfunded businesses can exit. At the same time the industry reports relatively low failure rates amongst successful fundraisers, with one study suggesting that to date only one in five of equity crowdfunded businesses have failed.
On the other end of the spectrum, last year, along with the exits, also saw a couple of high profile failures, such as Rebus Group who raised more than £800,000 in 2015. And while the failure rates to date have remained impressively low they will undoubtedly go up as equity funded start-ups age beyond year 2 and 3.
That a high proportion of startups fail, should be a surprise to none. some studies suggesting that one in ten startups survive more than a few years (other say it’s closer to one in five). The challenge for equity crowdfunding platforms over the next couple of years will be to demonstrate that successes outweigh failures and that in the long run they are able to deliver a financial return to investors, and compete with more traditional forms of startup investment. This isn’t a simple question of average IRRs (after all, the average VC fund performs terribly – good performance is concentrated in the best funds), but it does mean there needs to be some confidence that smart investors can find some good opportunities through equity crowdfunding, Building on this the equity crowdfunding market will need to maintain trust and investment appetite from investors as stories of failure become more common.
6. Getting more women involved in investing and fundraising The majority of people taking part in funding and fundraising using alternative finance platforms are men. Indeed, less than 10% of people who have used equity based crowdfunding to raise finance and only around one in five who have used P2P business lending to take out a loan are women. While this reflects a wider economic inequality, it seems like a missed opportunity for an industry that prides itself on disrupting the world of finance. Getting more women involved in funding and fundraising will be one of the main challenges for the industry going forward.
While all of the above are significant challenges, they are also a sign that what was a few years ago a market worth a mere £260 million with little attention beyond a core of early adopters, has now grown in to a vital source for personal and business finance. This has brought with it increased levels of scrutiny from policy makers, investors and users. It will be interesting to see to what extent the challenges above and how platforms address them will impact on the growth of the online alternative finance market.