Part 3: Best-practices for a reliable crowdfunding investment platform

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This is the last part of our three-part blog post series about best practices for crowdfunding and P2P platforms. In the first blog post, we talked about the platform’s company structure and management.

Read ‘Part 1a: Platform operator’ here.

Read ‘Part 1b: Management and key people’ here.

In the second part, we focused on due diligence, transparency and complete information, deposits and withdrawals.

Read ‘Part 2: Processes’ here.

And in the last section, we will give an overview of the investment opportunities analysis and legal structures.

a. Contracts

There are secured or unsecured loans and even equity investments on the market. So, here is a short recap of what each of these means for the investor:

Secured loans (also known as “senior loans”) are usually the safest and thus the least profitable type of capital. The loan is secured against the collateral, which is usually a mortgage on the property, pledge on the assets of the company or some other type of collateral. With this type of loan investor is the first in line to receive their payout, and in case of any problems the collateral can be liquidated to minimize losses. However, the existence of collateral means that the risk (and therefore the yield) is lower and one should definitely investigate the asset that is offered as collateral. At the same time, investors should acknowledge that the collateral is the last resort for repayments and good projects should generate enough cash flow to repay the attracted capital without a need to liquidate the collateral. Here is an example of a secured loan.

An unsecured loan is a layer of capital between equity and secured loans. They are riskier than secured loans, but also more profitable. While mortgage holders are usually first in line to receive repayments, an unsecured lender will receive repayments only when all secured lenders are fully paid off. To offset the fact of “being the second in line” means that unsecured debt should have a higher interest rate than the secured debt. While the unsecured loan is still more secure than the preferred or common equity, the project’s large scale failure could result in a situation where there would be no funds to repay unsecured creditors after the secured creditors have been paid off. In the case of unsecured loans, one should pay attention to the Sponsor they are trusting their funds and the platform’s problematic loan collection process. Here is an example of an unsecured loan. 

Mezzanine investment is a hybrid capital (either subordinated loan or preferred equity) that lies between equity and loans. It has still lower risk than equity – mezzanine financing is repaid before equity, but after all more senior obligations have been fulfilled. Additionally to the usual interest, bonuses that depend on the profitability of the project may be added to the mezzanine capital. Here is a mezzanine loan example.

Equity is the capital placed in the company by its owners. Equity investments have both the highest risk as well as the potentially highest return. With this type of investment one should note the structure of a company’s liabilities – the company will pay debts to employees and creditors first and only then the equity investors may receive their payments from the remaining assets of the company. In case of failure, there is a real possibility that the earnings of the investor are reduced to zero, and in worst cases, the equity holders may lose all of their investment. When the project succeeds, however, employees and creditors usually receive a fixed interest rate while the equity investor takes all the remaining profit. So, in this case, one should make sure that they assess the probability of failure. Is the project understandable? Are the numbers presented in the project realistic? Here is an equity project example.

As a rule of thumb, it is good for an investor to remember – the lower the risk of the project, the lower the expected yield.

The main thing to keep in mind: Take time to read loan contracts beforehand and make sure you understand the legal structure of an investment opportunity. 

 b. Guarantees

While the guarantee or the collateral should not be the primary source of repayment, the availability of collateral or guarantee would reduce the investment’s risk level (and expected return as well). At the same time, the availability of collateral or guarantee does not ensure that the project will be successful. The aim of the collateral or guarantee is to ensure the Sponsor is properly motivated to make the interest and loan repayments as agreed in the contract.

Let’s take an example:

Lender issues a loan of EUR 100 to finance the construction of an apartment. The loan will be secured by the first lien mortgage set on the property. Borrower’s goal is to sell the apartment at EUR 150, once completed.  

The mortgage does not guarantee that the Borrower will be able to sell the apartment for EUR 150 as planned. If the Borrower’s market analysis was wrong, the real estate market goes down or the Borrower can not complete the construction (for whatever reason), the property could be worth much less than EUR 100, in the most extreme case it could be worth almost nothing and consequently, the value of the mortgage will be less than 100 EUR or close to nothing.

The mortgage, therefore, guarantees me that the debtor will have the highest interest in repaying the loan as agreed because otherwise the guarantee will not be released. Thanks to the guarantees, the lender will have stronger means of recourse against the borrower and will be able to repay the loan more quickly. 

Main things to keep in mind:

  1. Always check which collaterals and guarantees are given by the Sponsor before making an investment. 
  2. The collaterals and guarantees must be specified and clearly identifiable in the investment description. 
  3. While unsecured projects would have higher expected returns, they are also riskier.

Guarantees will be essential in case of delayed payments or unexpected events, and unexpected events in real estate are quite common. 

Crowdestate approach:

Crowdestate is a full capital stack provider, meaning that we aim to provide the real estate companies with different types of capital, including secured mortgage loans, mezzanine or equity capital. The need for the specific type of the capital will arise from the project itself and it will depend on the Sponsor’s equity and target leverage. From an investor’s perspective, a properly structured capital stack would mean that there is enough equity in the project and that all capital layers are priced properly.

From the practical point of view, Crowdestate is always aiming to secure the investments with collaterals or guarantees, if they are available. Most of our investment opportunities offer guarantees to investors,  and they are stated in a clear and visible section. Collaterals and guarantees are usually are represented by:

  • Mortgages;
  • Pledges on company shares;
  • Personal guarantees;
  • Credit assignments. 

c.  “Buyback guarantee”

The “buyback guarantee” is a marketing trick used by several crowdfunding platforms, especially in the P2P unsecured consumer lending market. It promises the investor an automatic repayment of his loans in case the loan interest or repayments are delayed.

The promise of the “guarantee” sounds so sweet that lots of investors will not pay attention to the fact that the “buyback guarantee” is granted by the borrower to himself (and not by a fund or a third party institution).

When the loan originator is no longer able to service their contractual obligations to investors, they cease doing interest and principal repayments, and no “buyback guarantee” can force them to make payments.

P2P investors already having experiences of “buyback guarantees” being completely worthless. The first (and maybe already forgotten) lesson comes from the Polish consumer lending company Eurocent in 2017 (please see the detailed article here), which became insolvent and ceased making payments to its lenders in spite of promising the “buyback guarantee”. More recent examples are the scam crowdfunding platforms Envestio and Kuetzal, where nonexistent projects were guaranteeing their own repayments.

In the current economic turmoil, there is a high chance that some borrowers’ or loan originators’ repayment capability will be adversely affected, and their “buyback guarantees” will turn out to be worthless, just like in the case of Eurocent.

Our recommendation is to be very sceptical about “buyback guarantees” unless the guarantees are offered by the capable third party, for instance, a bank or an insurance company. We also recommend being sceptical about the social media influencers using the availability of “buyback guarantee” as one of the “signs of quality” when evaluating crowdfunding platforms.

Conclusion

Following the advice in this article will not guarantee the success of your investments, but it will probably help you to keep away from shady, untransparent platforms and unsuitable investment opportunities.

The above listed most important factors to consider when selecting the crowdfunding platform is subjective and definitely not comprehensive. Did we miss something important? Let us know by sending us your thoughts to [email protected]. Thank you!

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