How are P2P lending and equity-based crowdfunding different?
Earlier this month, the Financial Conduct Authority (FCA) announced it would be conducting a review on the rules surrounding loan-based and investment-based crowdfunding, with all relevant stakeholders encouraged to provide their input before the deadline of 8 September 2016.
Certainly, from the point of view of peer-to-peer lending (P2P) platforms, this review has been welcomed, and we’re big proponents of regulation keeping pace with market development. Yet a major bugbear for the P2P lending industry, which falls under the umbrella of ‘loan-based crowdfunding’, has been the fact that consumers, members of the media and experts have frequently discussed it in the same breath as investment-based crowdfunding, and at times even drawn direct comparisons between the two.
The issue with this is that the differences between the two are stark, particularly in terms of risk profile. Here we look to make clear the distinctions, and establish why this issue has been such an albatross for the P2P sector.
What is investment-based crowdfunding?
Investment-based crowdfunding, or ‘equity-based crowdfunding’, is not all that different in principle from making an investment in the stock market. When an entrepreneur or a startup company in its early stage needs to raise capital to get their enterprise off the ground, they offer shares to potential backers in exchange for much-needed funds.
Should the business be successful, the investors will then garner their returns through the increase in value of these shares, and can potentially profit handsomely. However, if the company were to fail, then the investors’ shares would likely become worthless, while the company itself would have nothing to repay.
The risks regarding the above are obvious. A recent ONS study showed that just 45 per cent of startups in the UK make it past the five-year mark, so there is always a high degree of risk that a business will fail, and as an investor you are directly exposed to this risk.
The other downside to equity-based crowdfunding is that such investments are generally quite illiquid, and can be difficult to shift should you wish to sell up and get your money back – especially in the early stages.
So how does P2P lending differ?
Peer-to-peer lending, or ‘loan-based crowdfunding’ as it is also known, does not offer shares (and the potential appreciation in value thereof) as compensation for the money lent by the investor. Instead, the reward comes in the form of interest on the loan.
Sometimes confusion can be created in that some P2P platforms offer consumers the opportunity to lend to businesses. But again, rather than being rewarded in shares, the consumer lender benefits by way of the interest paid by the business on the loan provided.
So, does this necessarily make loan-based crowdfunding a safer investment?
First of all, linking returns to a fixed interest rate on a loan is inherently more likely to produce a stable return compared with the variables involved with share valuations. In addition, while investors in either asset class are not protected by the Financial Services Compensation Scheme, P2P lending offers important safeguards.
Platforms have strict vetting procedures with respect to borrowers, and who is approved for a loan and who isn’t. Segregated reserve funds to cover losses are now also common amongst many platforms, while at Lending Works there is the additional safety net of an insurance against a number of causes of borrower default. The proof is in the pudding too. No lender with Lending Works has lost a penny, and this is true of many other UK P2P platforms. In fact, over more than a decade, the industry has delivered predictable and stable returns – even during the recent global economic downturn.
Tax and the IFISA
The reason the review is particularly pertinent is in light of the Innovative Finance ISA. We often hear people refer to it as a ‘Peer-to-Peer ISA’, which is understandable given that, at this stage, only loan-based crowdfunding platforms (with full FCA permissions and ISA Manager approval) are entitled to offer them to consumer investors.
However, the launch of this third-way ISA was done with a view to potentially extending the privilege to investment-based crowdfunders too, and this remains under ongoing consideration. We’ve already had experts weigh in on the matter, and our concerns about shoe-horning dissimilar investment types with dissimilar risk profiles into the same wrapper endure. It is also worth noting that equity-based crowdfunding is taxed differently to P2P lending anyway.
Assessing P2P lending and equity crowdfunding in light of the review
The review itself will focus largely on whether existing rules for financial promotions, due diligence and prudential standards are still appropriate in light of the industry’s rapid development, and we look forward to contributing positively to the discussion with the FCA. We have, and always will, embrace regulation and continue to be proactive in our quest to clearly communicate the risks involved with P2P lending so that all our investors can make a thoroughly informed decision as they part ways with their hard-earned money.
However, in order for this to happen, it’s equally important that the merits of loan-based crowdfunding are fully understood too, and this can become tougher for the individual when the lines are continually blurred with equity-based crowdfunding. We hope that the above will clarify any ambiguities, and allow these two types of investment to be assessed in isolation – both by consumers and the various powers that be.
- The latest on the Lending Works ISA
- Quick guide to the Lending Works Reserve Fund
- Your updated guide to Innovative Finance ISAs
Get email updates for future blogs: