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Funding Circle wriggling free of the grip of short sellers

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Funding Circle's shares ... not exactly on a tear

After a disastrous start to life on the London Stock Exchange, the shares of Funding Circle Holdings PLC (LON:FCH) are starting to look less shop-worn.

At one point in the first week of trading, the shares had lost a quarter of their value, a level of ignominy only surpassed in the history of the London Stock Exchange by such “where are they now?” horror stories as Estonian Telecom (down 91% in its first week of trading) and Prodesse Investments (down 88% in its first week).

READ Funding Circle almost back to float price after reassuring trading

Following the flop that was its initial public offering (IPO), the stock quickly became a favourite of those who like to sell short – the practice of borrowing stock from an institutional investor and then selling it in the hope of buying it back at a cheaper price later.

According to IHS Markit, at one point 1.8% of the peer-to-peer lender’s shares were out on loan to investors.

The recent recovery may have been due to short sellers closing their positions; the shares are now only 4.5% below their flotation price but before anyone gets too excited about this, let us not forget that the company set an IPO range of 420-530p before reality set in and amended it to 440-460p – and even then it had to bang it out at the very bottom of the range.

That was even with committed backers such as Danish fashion tycoon, Anders Povlsen, who sold £113mln worth of shares in stock market star ASOS to help finance a £150mln investment in Funding Circle that garnered him a 10% stake, and asset managers Old Mutual and Invesco who grabbed stakes of 7.5% and 5.2% respectively.

To be fair, the current market capitalisation of around £1.4bn is impressive for a company that was only founded in 2010 but until fairly recently there was talk of a valuation of around £1.75bn.

Friends, Romans, countrymen! Lend me a fiver

After emerging as “the next big thing” after the world’s banking system seized up in the wake of the Lehman Brothers crash, the peer-to-peer (P2P) lending model appears to be the subject of much more sceptical scrutiny of late.

For those of you unfamiliar with the model, the basic idea is that Funding Circle acts as a marketplace where borrowers – typically small-to-medium enterprises (SMEs) in Funding Circle’s case rather than individuals – can solicit loans from Funding Circle’s members – typically institutions but also individual lenders.

Funding Circle has been quoted as claiming that its investors lent almost as much to small and medium-sized companies as the entire UK banking system in 2017.

It has facilitated more than £5 billion in loans to more than 50,000 SMEs, with more than £2.5 billion under management as at 30 June 2018. In 2017 alone, loans facilitated through Funding Circle’s platform contributed to £3.9 billion of gross value added to the UK’s gross domestic product and enabled more than 75,000 jobs, it trumpeted in its prospectus.

In 2017 and the first half of 2018, 85% of its loan book funding came from repeat investors and it claimed that the 2017 cohort of loans is projected to deliver returns ranging from 4.6% to 7.6% across the different geographies in which it operates (UK, USA, Germany and the Netherlands).

Attracting new lenders comes at a price​

Revenue is rising fast but at a price. In 2015, revenue was £32mln; it rose to £50.9mln in 2016 and £94.5mln in 2017. Over the same period, marketing spend as a percentage of revenue declined from 64% to 41%.

Critics say that is still a staggeringly high level of marketing spend to garner new customers and could account for why the company has never come close to a profit in its existence.

In 2017, the adjusted underlying loss (EBITDA) was £25.1mln and free cash flow was also negative, at £35.3mln.

All of this in a lending environment that is just about the most benign there has been since the Bank of England set up in business.

Many investors want to see how the P2P lenders will cope with a good … er … bad old-fashioned recession before they consider backing a P2P lender.

Some already suggest that the halcyon days are over and that P2P lenders are finding it harder to attract lenders.

The value of US operators has fallen through the floor​

Five years ago, the first P2P lender to float in the US, LendingClub, had a share price of US$25; it is now trading at US$3.64 after a scandal in which it was found to have sold US$22mln of loans in 2016 to an institutional investor that did not fit the criteria of the investor.

That sapped some of the confidence in the P2P model. Another listed US operator, On Deck Capital Inc, has seen its share price fall from US$24 five years ago to US$7.16.

P2P platform operators have taken to offering incentives to institutions to cough up money. US operator, Prosper Marketplace, has offered warrants at cut-price exercise levels to institutions to encourage them to get on board.

Funding Circle itself agreed last year when it launched in the Netherlands and Germany to cover any loan losses experienced by a cornerstone institutional lender.

The company said it was normal practice to offer such incentives when it launched in new areas and not symptomatic of increased difficulty in getting investors to lend to SMEs through its platform.

With a market capitalisation of £1.4bn, the company is valued at almost 15 times last year’s revenue. US peers On Deck (market cap of US$534mln) and LendingClub (market cap of US$1.55bn) both trade on a multiple of 2.7 times annual revenues.

The true worth of a P2P lender may be somewhere in the middle but either way, it is hard to argue that the short-sellers have got it wrong with Funding Circle.

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