Biiiiig Growth Street Update On Bad Debts, Reserve Fund And Super-Large Loans
My main research focus over the past few weeks has been on re-interviewing Growth Street*, probing for more details, and pushing it for better quality data. This article covers all that, with my usually candid opinions thrown in.
Check out my three-minute summary and, if you are really interested in Growth Street, slog through the detail below it!
All lenders have earned between 5% and 6.5% interest, with bad debts fully covered by the reserve fund at the point at which the loan goes bad.
Loan improvements, bad debts and the reserve fund
Growth Street has improved anti-fraud measures and abolished a type of loan that was unsuccessful.
If we exclude the results from loans it will no longer approve, its overall bad-debt rate, after recoveries, looks to be on track at around 1.3% of outstanding loan amounts – provided Growth Street's recoveries continue to pick up through 2019 and 2020, matching their expectations. I find their expectations to be very plausible.
Its reserve fund, at 3.5% of outstanding loans, is substantial in comparison to those bad debts.
Can its reserve fund withstand large loans going bad?
Growth Street has several large or very large loans that could wipe out the reserve fund and eat into lenders returns.
Large loans are sub-optimal when relying on a reserve fund, but Growth Street does have a rather unusual set of tools to defend lenders from the reserve fund going under. Growth Street argues these tools are powerful. Again, while Growth Street needs more time to prove it, its claims are very plausible.
The tools to defend against large-loan trouble include:
- A technical interface, whereby Growth Street receives large business borrowers' accounting data, so that it can immediately spot a deterioration in a borrower's financial situation.
- Growth Street's ability and legal right to manage the size of the loan rapidly downwards before the financial situation at the borrower deteriorates too far; the borrower is obliged to repay more rapidly while it still has the financial ability to do so.
- The right to have a large business borrower's customer payments paid directly to Growth Street in the event that the borrower's situation starts turning for the worse.
In addition, Growth Street only accepts very large loans from highly profitable businesses, where it finds that the risk of those loans going bad are lower than the other loans it approves.
The reserve fund is probably sensibly sized for the overall risks involved, even with large loans, and the risk of lenders losing money overall remains low.
Offshore tax havens
One of our readers was interested in the legal structure of Growth Street, which includes holding companies in Guernsey and British Virgin Islands.
These are used by Growth Street's founding shareholder Thomas Høegh of Art Alliance, and his shipping family, for the tax advantages they afford.
New key person
Growth Street's risk director has left and the key person right now is currently Mark Chamings, who joined some weeks ago. No 4thWay expert has yet had a chance to interview him or conduct research into his background, but we'll attempt to do so after he has settled in.
While its large loans do niggle, Growth Street remains strong, with the top, a highly credible proposition and good prospects for lenders.
My full report
There's a lot to report on for those of you who want a deep, deep look into Growth Street's current status In this article, I'm going to thread together a variety of very important themes that I have dug into.
Lenders using Growth Street or interested in doing so need to take the time to read this and get updated.
Fraudulent loans and Growth Street's new checks
Growth Street has suffered relatively few loans that have gone bad compared to similar business lending. Its reserve fund has had to pay out on just 10 out of nearly 300 loans, so far.
Of those 10 loans, four of them are worth mentioning in more detail.
Two of those four loans were the subject of fraud and should not have happened.
In response, Growth Street did what I always look for: it admitted the errors publicly and took steps to ensure it didn't happen again. This is not a given in P2P lending, as there can be psychological and business pressure to bury the evidence, refuse to admit blame, pass the buck onto others, and fail to learn from mistakes.
Growth Street now uses a tried-and-tested fraud database from Cifas. It re-checked all existing loans and found that no other loans appeared fraudulent, while it also found that Cifas would have identified those two fraudulent loans for them. For many types of lending in the UK, Cifas really is an essential tool.
In addition, Growth Street started to integrate with the Open Banking system, which hooks up other banks' data on borrowers, so that it can increasingly see their financial and borrowing activity, including spotting fraud.
Growth Street also offered extra training to its sales and lending personnel.
Unsuccessful loan product is no more
I mentioned four loans out of 10 bad debts that are worth going into. Two of those were the fraud cases I mentioned above.
The other two were from a discontinued loan product that Growth Street trialled in 2015 and part of 2017: invoice finance. Growth Street found that it was not cost-effective arranging these loans. They were also too short lived, typically being repaid within one month. That's no good for lenders.
On top of that, Growth Street was disturbed by getting two invoice finance loans turning bad and being paid for by the reserve fund. By 4thWay's count, another three could technically have been called bad debts, although these were paid off almost immediately. That means that five invoice-finance loans turned bad out of a total of just 43 loans. At 11%, that's too many. If Growth Street had scaled that type of loan, its reserve fund could have been in trouble.
Put everything together and Growth Street must have been glad when it said goodbye to these loans. These sorts of failed loan experiments are not unusual or worrying. Funding Circle, the small business lending P2P site, abandoned property, and RateSetter has closed down six of its 15 different types of loans.
Since Growth Street* began in 2014, all lenders have received their expected interest, which has been between 5% and 6.5% .
Ten loans officially went bad – or at least 13 when we add in what 4thWay would call technical defaults. But if we strip out fraudulent loans that would now be spotted by Cifas, and strip out abandoned invoice loans, just six out of 239 loans needed saving by the reserve fund.
There might be one or two other technical defaults that we're not aware of (although Growth Street is imminently going to start providing us with more data on that), but those will have been rapidly paid off.
This means that around two-and-a-half loans out of 100 initially go bad, which is highly satisfactory for this kind of small business lending.
Total historical claims on the reserve fund, including the fraud and invoice-finance loans, adds up to £1,261,686, versus total lending of £48 million. That is the amount the reserve fund has paid out prior to recovering bad debts from borrowers through the courts and other means.
Reserve fund size
Claims on the reserve fund have risen over the years, but the borrower contributions and Growth Street contributions mean the reserve fund has still grown consistently larger every year, from its starting point of £200,000 in 2014 to stand now at £1,255,594. This means that the pot-size this year would be large enough to cover – for a second time – all the bad debts that have occurred over the past five years.
The reserve fund remains very large at nearly 3.5% of outstanding loans.
In 2019 so far, new contributions to the reserve fund that were paid for by the borrowers have added another £400,000. Plus recoveries of bad debt – which is a long-term process – has finally started bringing in, adding another £100,000 to the pot in 2019 so far.
Recovery of bad debt
The average bad debt has been going through the recovery steps for just six months, so more time is needed to claw back outstanding debt from borrowers through persistence and legal means.
Lenders can't expect the amount that is ultimately recovered to be as high as it usually is with real property lending, because businessis not as stable or reliable as bricks-and-mortar.
However, recoveries should be considerable, and better than you'd expect with unsecured business loans. Growth Street estimates that around half of a bad debt will typically be recovered, given time, and those recoveries will help prop up the reserve fund. You should know that Growth Street's recovery estimates are plausible, but not yet proven.
Therefore, we can probably expect around 1.3% of loan amounts (roughly half of bad debt) to ultimately be written off. The reserve fund at 3.5% easily covers this level of debt.
Growth Street's large loans
Growth Street has five loans that are larger than the reserve fund and other loans that are very substantial. Theoretically, if a small handful of these loans turn bad and a lot then goes wrong for Growth Street and its lenders, those bad debts could deplete the entire reserve fund in one go.
The reserve fund pays out before any serious effort to recover bad debts begin. This increases the risk of total depletion, since it will pay out on the entire bad debt first, and await recoveries later.
Again just theoretically – painting the worst case – if a second small handful of these large loans turn bad at around the same time, with the reserve fund gone, they would then eat away at the positive interest rates lenders are earning.
Lenders, particularly those who haven't been lending for many months – and have therefore not historically earned much interest – would then be vulnerable to making an overall loss.
There is a lower likelihood of large loans going bad
So that sets the scene, but how likely is it that all the above happens?
Growth Street argues that it takes on larger loans only when the borrower makes a lot of money and has a lower risk of turning bad. Growth Street targets a probability of below 1% that lenders' reserve fund will run out of money, even while taking the large loans into account.
We're not privy to all the information we need to confirm that estimate. But, based on the data and information we do have, it does seem plausible.
It's not all statistics. From a quality point of view, the picture Growth Street is painting also seems to fit what they are saying about the probability of default.
For example, the two largest loans are for over £1.8 million each and combined they are three times the size of the reserve fund. Yet these are straightforward businesses that are easier to value, being a manufacturer and a plant-hire business. (Not daffodils, but as in “plant and machinery”. “Plant” here means heavy machinery used in industry.)
Earning lenders' trust with over-sized loans
So Growth Street* talks a good game on its large loans, but lenders should only sparingly offer trust to P2P lending sites when it comes to over-sized loans that rely to a significant extent on reserve-fund protection.
Because other P2P lending sites have regretted doing that. From Wellesley (which no longer does P2P lending) to RateSetter and Assetz Capital, each have had shocks, even if lenders have still come out with positive returns.
Growth Street is making the case that a reserve fund of £1.2 million is sufficient to cover bad debts, even though 12 loans are what I'd call “large” or “very large”, as each of them are over 60% of the size of the reserve fund.
If reserve funds and automatic diversification are a major part of a P2P lending site's offering, in most cases I would expect them to restrict their lending to sensibly sized loans when compared to the size of the reserve fund.
So Growth Street has to earn lenders' trust. And I think that it does do this in some interesting and unique ways:
“Managing out” the borrowers
A big part of Growth Street's plan for its large loans is through managing the size of them downwards quickly as a borrower's financial situation starts to deteriorate. Such deterioration could be in terms of the money the business borrower makes; the value of its property, possessions and cash; and the size of its other debts.
Any such substantially worsening condition could lead to Growth Street taking action.
In such situations, Growth Street can flexibly reduce the maximum limit on its overdraft-like loans to manage the borrower down to a lower figure – even zero.
This is an option not available to most P2P lending sites, because they typically agree fixed terms with their borrowers. They might only have the nuclear option of calling in an entire debt at once, which is not so easy for any borrower to do, even if it was flourishing.
Managing borrowers out is helped in five ways
Yet in order to manage down the size of the loan, Growth Street needs tools and processes to act quickly. It has to get the size of the loan to a reasonable level before the borrower's troubles become too severe. What Growth Street does in this regard can be categorised into five parts:
1. Moody's RiskCalc
Moody's popular RiskCalc tool helps Growth Street to change interest rates and calculate the risk of a debt turning bad. Growth Street says that looking back at the previous recession, it believes this tool gives it the ability to see trouble half a year ahead, long before the Office for National Statistics.
Growth Street* can change its portfolio of loans with just 30-days' notice, so it can react quickly.
I've already introduced Cifas to you, but in addition to checking borrowers prior to approval, Growth Street monitors them regularly for fraud, so that it can take swift action.
3. Accounting and banking data
For all of its overdraft-like loan facilities where the borrower can draw down over £150,000, the borrower's accounting data is hooked up to Growth Street, which receives it on a monthly basis. Growth Street therefore knows how the borrower is performing almost as quickly as the borrower's own management.
(If you're wondering, the data hook-up is also used with some smaller loans, but Growth Street prioritises it for the big loans. Smaller loans without the data hook-up still get annual reviews.)
Its Open Banking connection can add to its safety checks.
4. Closer communication
Growth Street has a team to communicate especially with the larger borrowers, so that they can learn about issues and work together to resolve them. This is a lesser point, since it really is the least they can do, but it's good to see that Growth Street follows best practice.
5. Direct payments and site visits
If a large borrower's financial situation starts to worsen, Growth Street can require the borrower to divert all its customers' payments directly to Growth Street, on behalf of lenders.
Growth Street also does regular site audits to check collateral on loans, which is mostly money owed by customers, but it is also stock.
All of the above is “to perfect our”, Growth Street's CEO, a former risk specialist, explained to me.
Growth Street's CEO on its large loans: “We apply the same standards of monitoring that we do to all loans plus extra monitoring. I’m confident of the level of monitoring we have for those and the team and processes in place to handle them.”
The worst-case scenario
Growth Street's claims that its loans are not too large seem plausible. It is due to a combination of Growth Street's low bad debts, its extra caution in approving larger borrowers, and the five ways it is able to quickly spot issues and manage down the size of the loan.
Yet any good lender should still think about worst-case scenarios, so what does that look like?
How many large loans need to go bad to exhaust the reserve fund?
Let's, for a moment, assume Growth Street's efforts to manage out large loans are not very successful.
It would probably take two to four of its 12 larger loans to go bad before the reserve fund either needs propping up or lenders will need to earn a little less interest.
Yet the risk of two or more of them going bad is is likely to be under 2.3% – and quite possibly closer to 0.5%-1.5%, since Growth Street is being especially strict on approving larger loans. (I can't be more precise than that with the data we have.)
The risk of four going bad is probably a small fraction of 1%.
A single one of the two largest loans going bad could theoretically wipe out the reserve fund by itself, but a fair bit would have to go wrong. The borrowers have to be considerably worse than Growth Street realised, despite hooking up to their actual management accounts. And the ability to manage out the borrower probably needs to be a lot more difficult than Growth Street claims.
This means that the odds of all that happening are likely to be very low – although again it is not yet proven.
What happens if the reserve fund is depleted?
Growth Street* expects to recover around half of any bad debt, but this takes time and the reserve fund pays out first.
So if the above two to four large bad debts occur, they might deplete the reserve fund before Growth Street is able to recover any of it. Here is what would happen then, in Growth Street's own words:
“In the event of a default or series of defaults that is larger than the value of the provision fund, and the losses cannot be recovered within 45 days, then the fund would be exhausted and unable to pay out against further claims.
There are two options that the board of Growth Street could consider at that point. The first option is to add additional contributions from the Growth Street group to repay any further claims.
The second option is to call aand begin a managed wind down of the loan portfolio.
The Growth Street board does not have a position today on what action it would take in this situation in the future, and would consider the circumstances at the time when making a decision.”
Growth Street itself received £17.5 million from investors in its own business this year, and it tells me that some of that money is allowed to be paid into the reserve fund.
How many large loans need to go bad for lenders to lose money?
Of greater interest to lenders is what it takes to go beyond depleting the reserve fund to actually losing money from large loans.
For this to happen, a huge amount has to go wrong for lenders if they lend through Growth Street* for at least two years or until the last bad debt has been recovered or written off.
It could take four to six of the 12 large loans to go bad, on top of regular bad debts. Probability shows that, even in a recession, where the number of bad debts is higher and recoveries are worse, the odds are strongly in lenders' favour.
Offshore tax havens
The last two sections of this Growth Street update are completely different and unrelated to the above.
First, and least exciting, taxes.
Growth Street is not just one company, but several interconnected ones. This is normal in P2P lending, but it still pays to understand the motivation for that to be able to assess the likelihood that something dodgy is going on.
Of particular interest is its company and shareholder structure that includes the British Virgin Islands and Guernsey holding companies.
Growth Street was founded by Arts Alliance Ventures, itself founded by Thomas Høegh. Høegh has been the largest investor in Lastminute.com and has invested in Transferwise.
Høegh is from a shipping family, with half his business in private equity (i.e. it invests in small businesses and startups, like Growth Street).
The Høeghs are an international family living in the UK. They have structured their investments tax efficiently, which leads to a small enterprise being held by a British Virgin Islands company that is investing in Growth Street, and a similar setup in Guernsey.
Growth Street was quick to say that the Financial Conduct Authority is completely aware of this. One of Growth Street's non-executive directors is Victoria Raffé, who was director of authorisations at the Financial Conduct. This means she was overseeing the department in charge of giving the green or red light to prospective financial businesses.
New key rainmaker
The CEO has a background in risk, so that helps in hiring, and he has done so already when he hired former RateSetter employee Mark Williams to be Risk Director. Williams was there for about a year and left a few weeks ago.
The new most senior member on the team is currently Mark Chamings. None of us has had an opportunity to interview him and check out his background yet, so we'll keep you posted.
Suggested further reading
Independent opinion: the opinions expressed are those of the author and not held by 4thWay. 4thWay is not regulated by the ESMA or the FCA, and does not provide personalised advice. The material is for general information and education purposes only and not intended to incite you to lend.
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