Crowdfunding as a form of investing is risky. But so are investing in shares and bonds – you could lose almost all your investment value if you had Lehman shares or bonds during the global financial crisis.
Crowdfunding is generally not regulated. But that does not mean that the practice is dodgy. Crowdfunding is nothing but pooling of funds from large groups of people to finance a certain project for a certain investment return. While crowdfunding concept is not new, Internet-based crowdfunding platforms are relatively recent developments, even in countries such as United States and Great Britain. Unsurprisingly, regulators are scrambling to understand crowdfunding and its implications.
So how should one approach crowdfunding as a form of investing?
Firstly, analyze the risks involved. In Singapore’s context, the main form of crowdfunding is lending to businesses. The key risks of lending-based crowdfunding are:
- Credit risk: The risk that the borrower is unable to repay its loans on time, which may result in default.
- Fraud risk: The risk that funds may be lost due to deceit by the borrower.
- Counterparty risk: The risk that funds may be lost due to failure of the crowdfunding platform.
Credit risk is an extensive topic in itself – more details next time. Basically, look for sound character from the management (are they trustworthy?), decent track record (are the operations profitable?), favorable business conditions (is the industry in a downturn?). Understand the funding needs (for capex or working capital) and how the company is going to generate returns sufficient to repay the loans.
Fraud risk. If possible, speak to the borrower to get a feel of the business and understand how its business model works. Visit the facilities and speak to its customers/suppliers/competitors to ensure that the business is real. (If you can’t understand how the company makes money, don’t invest!) Understand how the crowdfunding platform performs checks on the borrowers.
Counterparty risk. Assess the creditworthiness and business model of the crowdfunding platform. Understand how the crowdfunding platform handles funds from borrowers and lenders. To reduce counterparty risk, the investor can minimize cash accounts maintained at crowdfunding platforms.
After understanding the key risks, the investor can propose a lending rate or decide whether the promised lending rate is acceptable for the level of risk. Then, the investor decides on the size of his investment. It is very important to diversify. Because crowdfunded loans are typically unsecured and borrowers are usually unable to obtain bank financing due to weak credit, there is always a chance of default. An overly concentrated portfolio could be easily wiped out with a few defaults. On the other hand, a properly diversified portfolio can offer a higher risk-adjusted return.
Once the investor is ready, he can put up a bid for the crowdfunding loan and wait for the campaign to close. If the bid is accepted, the investor basically relies on the crowdfunding platform to follow-up on all the debt repayments. If a default situation occurs, the investor will decide whether it is worthwhile to pursue legal actions against the guarantors.