So, Farwell and adieu to the Funding Circle SME Loan Income fund. Last week it announced that it would cease investment in new loans and return capital to shareholders. Just a quick reminder. Funding Circle SME was launched in November 2015 and targeted an annual dividend of between 6pps and 7pps, and an annual total return of 8-9%. However, after a good start those returns have started to diminish and the trailing one year NAV is -0.2%, largely powered by an increase in the level of defaults.

Funding Circle has said that “A global income fund providing access to a diversified portfolio of Funding Circle small business loans was the right strategy for investors and Funding Circle in 2015. However, there are now more appropriate and varied ways for investors to participate on the platform”. On one level, I’m sure that FC is right. It is big enough now to be on the radar of huge institutional players who could easily put a few hundred million in play overnight.

But on another level, I’m not sure I entirely agree with FC that it was the right idea to launch the fund back in 2015, especially as it was always evident that FC would go for an IPO at some stage.

Here’s the nub of the issue. Once you set up a fund which invests in your core assets via origination, you let investors see into the engine room of your main operation. Now public market investors who have put money to work in the main listed origination entity are buying into a growth business which will supercharge origination from SMEs. I think there is a very sensible argument which says that FC can become the biggest global SME lender in varying geographies, and in the process open up lending markets neglected by lots of national banks. That is a worthy, global scale argument for buying the main vehicle equity.

But you also have to accept that with ramping up origination comes credit risk. Put simply, you are busy focusing on acquiring new customers and with that comes an acceptance that you’ll probably see some deterioration in the credit quality of that lending. Funding Circle will say until they are blue in the face that their models are better than everyone else, informed as they are by a better big data set. I believe them but every algo needs testing, needs to make mistakes, just as every human risk officer learns from their mistakes. So, I think it was obvious from Day One that as global scale became the key business operational strategy (and thus an IPO), we were going to see credit deterioration. Just as any other business in its niche would experience – there’s no criticism of the model here, just a statement of brutal facts of life.

Which is where the listed lending fund comes in. From the very beginning, I always thought we’d see a seasoning effect on the loan book. The first few years would be fine as those new loans worked through but by year two or three you’d start to see more problems. And hey presto, that is exactly what happened.

At which point I think it worth switching over to a note by Alan Brierley from Canaccord on the subject last week.

“On 29 August 2018, the company issued a prospectus for a share issuance programme of up to 500m shares. This incorporated a stress testing analysis under several economic scenarios, including the UK PRA 2017 variant (this comprises a set of factors which are more challenging than those seen in the global financial crisis including a fall in UK GDP of 4.7% and a rise in interest rates to 4%). The stress testing analysis found that even in this scenario, “expected returns remain attractive” ranging between 2.4% and 4.3% and that this “extreme downturn scenario illustrated the resilience of Funding Circle’s model”. Given the outcome in the past year, we have some reservations about the efficacy of this model, and the resilience of the portfolio in a more challenging environment.”

Put simply Funding Circle’s model is just like everyone else’s. It probably can price risk more efficiently in some places but with scale, it is simply training its algos and risk officers to not make the same mistakes they’ve already made as they’ve expanded.

By putting a listed fund with variable returns in the public market it opened itself up to detailed scrutiny from skeptical public market investors. Better perhaps to have copied say Lendinvest’s approach and issue a fixed rate coupon bond with less reporting behind it and make sure you have forecast cash flows to make the interest payments. Or perhaps just issue an ETF which tracked the assets and made no specific dividend target – “invest in our tracker vehicle and we’ll give you the market pricing for SME loans. In some years it’ll go down, in others especially immediately after a recession, pricing will shoot up”.

So, either list a fund or the main entity but not both. For the record, I actually buy into the Global SME scale argument for FC and think a case can be constructed for saying the shares are undervalued over the very long term but that’s a very different matter, for another time.

We are where we are though and to their credit Funding Circle have done the right thing. But investors are left wondering what might happen next.

Interestingly the shares haven’t really bounced much in price since the announcement (up a few pence). They currently trade at about 86p as I write this. I’ve maintained that the shares will only realistically price once we get to 80p. I note Canaccord’s (admittedly bearish) observation that “with a weighted average loan life of 29 months and with some loans up to five years in duration, in the absence of portfolio sales, the return of capital is likely to take some time”. There’s a decent possibility that we may move into an even trickier macro-economic environment at which point defaults could increase from the already elevated levels. Or maybe the UK will bounce post Brexit (!?). Whatever, I think the wind down will reveal a few more unfortunate errors and wouldn’t be surprised to see the eventual realization value hit the equivalent of say 90p a share i.e equivalent to a 10% haircut. At that level, I’d only be interested in buying the shares on a big discount closer to 80p.

Quick update on the Numis recommendations list

The well-respected funds’ research team at Numis have just announced that they have removed three funds from their Recommended list this quarter, primarily recognizing strong share price gains:

“Greencoat UK Wind: Greencoat UK Wind’s share price has rallied 13% in 2019 ytd, putting it on a 14% premium. This partly reflects the NAV uplift from the extension of the assumed asset life for the whole of the portfolio from 25 to 30 years. We hold management in high regard, but believe that a future capital raise may provide a more attractive entry point, and so we would look to take profits.

Blackstone/GSO Loan Financing (BGLF): We added BGLF to the Recommended List in January 2019, when it was trading on a mid-teen discount. Sentiment towards the senior loan and CLO market has improved, and the shares have risen 13.5% in Sterling. As such, we are removing it from our list, and continue to favour Fair Oaks Income as our long-term holding for exposure to CLO equity.

Regional REIT: Following the narrowing of the discount from mid-teens to 9%, we have removed Regional REIT form our Recommended List. We continue to back the management team to deliver on their active asset management plans, but believe that better value is available elsewhere in the sector.”