Defaults and Bad Debts

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Kylie Greeff
28th July 2017

Save money and finance for banking conceptAs a lender on rebuildingsociety.com, you are lending to UK-based small- and medium-sized businesses. SMEs are vulnerable to many influences that can put a strain on their business and affect their ability to meet financial obligations, such as repaying a loan.

No matter how seasoned an investor you are or what your level of professional experience is, you are likely to incur a default within your portfolio at some point in time. If you are new to P2P lending, your first default is likely to come as a shock, and may tarnish your impression of P2P lending. However, you shouldn’t panic, as defaults are not unexpected and can be managed.

We’ve put together this blog to help you understand more about what a default is, why it may occur, how you can manage your risks, and how we work to protect you so that when a default does occur, you know what to expect.

What is a default?

A default occurs when a borrowing business fails to meet the terms of their loan agreement, the most common of which is failing to make a series of repayments as and when they fall due, or if the business becomes insolvent. When this happens, we will ‘call in the loan’ and security from the business and its guarantors. This demands that the full remaining debt becomes due immediately.

Prior to being called a ‘default’, a loan that has missed repayments is likely to be referred to as an ‘under-performing loan’. If a loan has missed a repayment, our collections process will kick into action from day one of the missed payment. Read more about this process here. You can also familiarise yourself with many of the other reasons a business might find themselves in default and view the standard loan conditions here.

Sometimes, if we believe that doing so will be in the best interest of the lenders, it may be necessary for us to call in a loan before the business breaches one of the terms. In order to do this, a default event must have occurred (as defined in the Loan Agreement). This power will only be used in special circumstances.

Why might a default happen?

You’re lending to small businesses, which are often run by only one or two directors and have a small staff of typically fewer than 10 people. Some small businesses may rely on a small number of clients that make up the majority of their income; if one of these major clients is late in paying, fails to pay or changes providers, this could have a serious effect on the business’s ability to service its debts. These businesses are also highly susceptible to economic and political changes that can have a knock-on effect on their industry and therefore business.

The saying ‘cash is king’ stands very true to small businesses: if cashflow is affected even slightly, the ripple effect can be long lasting, and one of the potential consequences may be that the business is unable to repay you as a lender.

Close up of fountain pen on a balance sheet

How can you reduce the impact of a default on your portfolio?

It is important for lenders to understand that they will almost certainly experience defaults in their portfolio.

In understanding that you will inevitably incur a bad debt at some point through your activity, you will naturally want to take steps to try and ensure that the overall impact on your portfolio and gains is minimised as much as possible.

Here are a few actions you might take to mitigate:

Price the risk

On rebuildingsociety.com, you are able to decide on the interest rate at which you want to lend. Loans are listed as A, B and C: A-rated loans being lower risk and C-rates loans being high risk. Preparing884x330

You should review each loan application and choose the rate you want to lend at. If you believe a loan to be particularly risky, you might choose to lend at the highest possible rate for that risk rating, or inversely, you might choose to lend at a much lower rate.

When lending, keep in mind the default rates for the various risk ratings, which can be found on the stats page. Also bear in mind that the more you charge, the more the business will need to pay. The higher the outgoings for a business each month, the larger the impact on their cashflow.

Diversify

Diversification is a key way to reduce your exposure. You can diversify your portfolio by trying to lend to a number of different risk ratings, to businesses in different sectors and to businesses of different sizes, and so on. It is a high-risk strategy to put a large percentage of your investment funds into a single business, regardless of the interest rate you are receiving. If this business fails, you could lose all your capital in that business in a single sweep.

Monitor

rebsocseparator2As a platform, we undertake a certain level of monitoring, and where possible, provide updates about the business on the ‘Updates tab’ on each loan profile. These updates are also visible to you from your investment dashboard if you are invested in that particular loan.

In addition, it is worth logging into your account on a regular basis to monitor the repayment performance of your portfolio and manage this against your risk appetite. If a business is frequently late making a repayment, you may want to consider divesting from the loan through the secondary market.

Trade

We provide a secondary market whereby you are able to both purchase and sell loan parts with other investors. Selling loan parts on the secondary market will allow you to reduce your exposure on a particular loan or increase your investment in a business and divest your portfolio.

It is important to remember that the secondary market is a real marketplace and is driven by supply and demand; therefore it may take a while for you to be able to sell a micro loan and in some cases, it may not be possible at all. You can increase the likelihood of another lender buying your loan part by pricing the loan part suitably. Our secondary market allows you to apply a mark-up or discount to the loan part.

Similarly, purchasing loan parts might allow you to build a diverse portfolio, and purchase from businesses that have already built up a repayment history on the platform. Before purchasing a loan part, you should always ensure that you review the repayment history of the business on the Repayments tab, and review the other information provided about the business.

For more on lending strategies, you may be interested in our previous blog post, 10 Tips for P2P Lending.

Recovery Process

What happens if a business is in default?

As discussed above, when a loan has been classified as a default, this means that the business has breached a major term of its loan agreement and legal recovery action will now commence. Prior to the legal recovery process, we will have attempted to get the business back on a repayment plan.

As soon as the loan is classified as a default, our recovery department will determine the most appropriate action of recovery, taking into account the security on the loan, the circumstances surrounding the default, and so on. We will engage our external professional debt recovery agents who will then begin the formal process of recovering the debt.

All loans on rebuildingsociety.com are covered by a personal guarantee, usually given by the directors and shareholders of the business. A personal guarantee allows our team to attempt to recover the debt not only from the borrowing business, but also from the guarantors personally. Our team will take legal recovery action on every defaulted loan in an attempt to recover your debt. This does not, however, guarantee that you will get a recovery.

The recovery process, depending on the avenue of recovery, may be a drawn-out process that could potentially take a number of years. Throughout the recovery process, our team will send you regular updates, keeping you informed about the progress and likelihood of a successful recovery.

When a loan is classified as a default, it will be visible on your dashboard under ‘Estimate Loss’ and you will no longer be able to trade the loan parts for that loan on the secondary market. As the recovery process progresses, we will assign a recovery probability percentage, which will be updated regularly. This figure will give you our best estimate on the percentage of your capital debt that we believe can be realistically recovered. With new defaults, we will normally set the probability to our average success rate, and then adjust it as we learn more from the solicitors enforcing the security on the debt.

We anticipate an overall recovery rate across all defaulted loans of over 40%; to date, we have achieved some level of recovery on over 50% of the loans that have fallen into default. If you want to read more about our recovery process you can do so here.

What is ‘bad debt’?

Whilst we make every effort to recover your debt, this is sometimes not possible. Where we believe we have exhausted all reasonable avenues for recovery, we will reclassify the loan as a ‘bad debt’. This means that there is no prospect of recovering the debt and as such those funds are now ‘lost’. Should this occur, the loan will be shown on your dashboard under ‘Deductions’ and will be taken into account in determining your net return.

Keep Calm

Now that you understand what a default and bad debt are and have learnt more about our recovery process, we hope that if and when you encounter your first or next default, you are better equipped to understand what is happening and also better equipped to reduce the impact a default may have on your portfolio.

Remember, if it is your first default, your net return will initially be adversely affected. However, any level of recovery and further repayments received from a diverse portfolio may see your return improve over time. P2P lending should not be viewed as a short-term, high-yield investment; loan terms range between six months and five years, and as such, it may take a while for you to build a mature and diverse portfolio. Do always keep in mind that your capital and unpaid interest is at risk and that past gains are no indication of future gains.

If you are still unsure about any aspect of the above, please do not hesitate to get in touch with one of our team members either by phone on 0113 8150 244 or via email, at support@rebuildingsociety.com.

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