HCG Funds founder Hadi Habal speaks to Marc Shoffman about the alternative investment manager’s allocation strategy…
Institutional interest in fintech lenders – including peer-to-peer lending platforms – is on the rise.
One player in this growing market is HCG Funds, an alternative investment manager that specialises in backing private credit originated through fintech platforms. It was set up in 2010 by Hadi Habal and Jose Penabad, who used to work together at investment bank JP Morgan.
The fund doesn’t publicly comment on the platforms it invests through, but is reported to have backed loans through LendingClub and Climb Credit in the US.
Habal (pictured) explains the fund’s approach to Peer2Peer Finance News, when they may be ready to invest in UK platforms and his number one rule.
Marc Shoffman: Which regional markets are you focused on?
Hadi Habal: Everything we have done so far has been in the US. The risk-adjusted returns continue to be superior in US dollar terms compared with everywhere else. The only other market that made sense was the UK but we hit the pause button after the Brexit vote. There was too much currency risk as we are dollar denominated.
We decided not to proceed until there was more clarity and four years later, we still haven’t made any investments. We need to be comfortable with the volatility in the UK first before investing. Other than the US, the UK is the only other market that provides depth, a common scoring standard for consumer credit, a legal framework and societal respect for contract law. Both legal systems are rooted in the same legal code.
The UK has a distinct advantage in business lending which is why Funding Circle came out of the UK and not the US. We don’t have a Companies House equivalent. Small business lending in the US didn’t take off in a comprehensive manner until you had payment system companies provide their own solution, outside of that there is no common data.
MS: Are there not opportunities in Europe?
HH: Europe sounds interesting but when you look at implementation, the attractiveness comes down. First there are the risk-adjusted returns, which are meagre. We are in a world where returns are low, but they are depressed even further in Europe as the region’s governments are stepping in to buy collateral. There is this conceivable large market that should be attractive on paper but the returns are way below the hurdle rate.
The European Union also has operational challenges and roadblocks, with lots of bureaucracy that you don’t get in the US or UK when setting up a business. Looking at capital allocation, am I better off investing in a small opportunity in France or something potentially bigger in the US? Ireland is culturally the most similar, the problem is depth.
Read more: Northern Ireland fintech sector “thriving”
Would HCG set up an entity to purchase loans that originate in Ireland on a standalone basis? That wouldn’t be the best use of capital.
MS: How do you decide where to invest?
HH: Every time we look at an opportunity we have to assess it in its own micro market which limits choice. There is a cultural parallel that’s important. There has to be an acceptance that someone is going to borrow and pay back credit without somebody needing a stick to chase them. That social contract is really important and is often found in a country’s DNA. If you look at India, which is a huge market with a robust banking system used to microcredit, you would think this would be a great place to go.
The loss experience has been higher in India though as there is a perception that they can get away with not paying money back. The Africa experience has been the same. Platforms have taken the model to go to large emerging markets and leapfrog the banking system with noble intentions to take credit to the masses. But the reality is that these assets have underperformed.
MS: How do you decide what to invest in?
HH: My number one rule is you have to grow slower than the growth in that market. You are always tempted, when you see something new, to grow as fast as you can.
The problem is you may end up with more capital than the opportunity. In that situation your inclination as an asset manager is to deploy the capital, so you end up doing stupid things and make sub-optimal decisions because you grew too fast. That’s painful at first but it gives you flexibility, it forces you to be disciplined.
In the early days we invested in consumer loans as there wasn’t anything else. In the US the next largest market was state-backed student loans. The pricing on these didn’t work for us as it was too long-dated and the risk-adjusted return didn’t fit. The next vertical is small businesses but this is limited because of the lack of centralised scoring systems.
Our view early on was that allocating to small businesses in the US was tricky as there isn’t a dataset to train a platform for credit underwriting. It is much easier to underwrite consumer loans. The market we looked at after consumer was fix-and-flip real estate mortgages, which is similar to the work LendInvest does in the UK. We think LendInvest is an attractive platform.
Read more: LendInvest CFO passes away
There is lots of residential data in the US as there are many people buying homes, rehabilitating them and then flipping them for profit. It also has the security of the property. It’s a great business to be in coming out of a recession but it is cyclical and we stopped buying those mortgages two years ago. On a risk-adjusted return basis there are plenty of opportunities elsewhere in other sectors. We are active in skill-based education and payment systems around small businesses.
MS: What is the biggest challenge for an institutional investor?
HH: The biggest challenge we have is educating investors about the asset class, particularly around losses. At a basic level we invest in loans. Those loans look like many loans that have been around for hundreds of years. Losses are going to happen.
Some investors come in and say I can buy this consumer credit yielding 13 per cent, they buy a pool of loans and find their net return is five per cent and they cannot reconcile why. Investors also don’t understand the nuances around prepayment.
In the US and the UK, the majority of loans can be repaid early with no penalty but then there is less interest paid to the investor. One has to underwrite that loss expectation from the beginning. My sales team is talking to asset managers and family offices. Often, they will just say it must be too risky for such high rates of return.
But then you point out how much they are paying on their credit card and they are shocked to see it is a lot more. These are conversations with professional investors so you can imagine what it is like with retail investors.