I’ve always been a tad curious about why some stockmarket listed lending funds seem to trade at a decent premium – Honeycomb, and the Funding Circle SME Income fund – whilst others (actually, most) trade at a whopping discount. On a simple level, there really only be two drivers for the share price IMHO, one of which is more obvious than the other. The first is that the funds hit their dividend targets. On this basis, one can see why the likes of P2PGI and VPC initially disappointed while Funding Circle’s turned into a market darling.

The second driver has to be defaults – credit losses inevitably eat into returns. But I’m a little more cautious of this latter driver as we are still relatively early into a default cycle and so we shouldn’t really expect to see any variations in the default rates, and if they do start to appear we know there are some very idiosyncratic lending policies lurking in the background. I would argue that the true test of a lenders risk analysis will only probably float to the surface during the next recession, when we should expect to see a quantum increase in default rates, both in consumer lending and for SMEs. My rough and ready reckoner is that we should expect anything between a 2 to 3 fold quantum increase for consumer lending and a five-fold increase for SME lending.

So, in simple terms, the real difference at this stage in the business cycle should be that dividend payout.  Honeycomb has ticked all the boxes, but Funding Circle’s fund is a more questionable case. It did hit its initial targets but then announced that it would be reducing the dividend after the initial period – a reversion of the normal practice in funds land, where the dividend usually starts off low and then builds.  I applaud the fund for its crystal clear investor relations and transparent market signaling – no mean feat – but I’m not sure why we should cut it any slack for reducing the dividend.

I’d also note that the recent numbers from FC SME show that the net asset value has been reduced quite substantially – by 1.9%  in the first seven months of the current financial year. I think we can safely say that was a tad unexpected. Alan Brierley at Canaccord has observed that portfolio impairments amount to a loss of 3.6% (total portfolio impairments in the full financial year ending March 2018 were just -1.9%). Dollar hedging costs also helped ate into returns, as it has in P2PGI and VPC. The chart below from Canaccord breaks out those losses. It’s also worth noting that some losses came from the (now legacy) property book – the fund and the platform has exited this competitive niche – but we’ve also seen losses increase on US loans and a moderate increase in UK SME delinquencies. The quantum is still very small and probably nothing to worry about – in previous years Funding Circle has seen idiosyncratic upticks in losses which have resulted in tighter lending policies – but one is nevertheless left wondering what might happen in a really nasty recession.

I have to say that I think Brierley is right when he says that the current yield doesn’t really “adequately reflect the risks”. According to Brierley, “for the reduced dividend to give a dividend yield of 6%, which was the lower end of the original target range and the minimum level that we believe is more commensurate with the risk profile and recent experience, the share price would have to be 87½p.”

To be fair, the share price has come down a fair bit in the last few days and is currently hovering around 96p, but I think I agree with the Brierley – Funding Circle’s fund has got away lightly with its share price. I wouldn’t quite as low as 87.5p but I think a level of around 90 to 95p seems eminently more realistic. By contrast, it strikes me that a more positive convergence trade might be to reinvest some money into P2PGI which after its recent change of management looks to be getting its mojo back again. I’m not sure a historic 17% discount adequately reflects the signs of solid progress – and especially when you consider that its loan book is looking ever more like Honeycomb which still trades at a whopping premium. Alan Brierley at Canaccord also notes that the managers of P2PGI have made significant personal investment recently, which is another potential positive. Overall I’d be quite attracted to a double pairs trade – sell Honeycomb (clearly regarded by the market as a quality fund but in my view patently overpriced) as well as Funding Circle SME while I would consider buying P2PGI and VPC (which has been steadily hitting its dividend targets after an equally rocky few years).

One last thought – with an obvious declaration up front. I am a NED of SQN Secured Income (SSIF) but I would observe that the much bigger sibling, SQN Asset-Backed fund, is now trading back around par while its smaller direct lending sibling (SSIF) still languishes on a 7% plus discount even though its INCREASED its dividend payout in the last year.