With a multitude of funding options in developed markets such as the UK, crowdfunding simply represents one more option for early stage investing. However, the GCC has even greater potential to take advantage of crowdfunding. While there is a burgeoning interest in creating new small and medium enterprises in the region, entrepreneurs often face financing-related hurdles because of limited venture capital in the region. Crowdfunding presents a solution where other funding sources cannot be secured.
Crowdfunding is a growing phenomenon where an online platform is used to present projects and collect funds from citizens and investors. Most projects financed through crowdfunding today do not seek profits and do not promise financial returns to investors. These are donation-based campaigns where funders (the crowd) finance social or artistic ventures. However, crowdfunding platforms are increasingly used to offer equities and debt securities to investors seeking financial returns.
Investing in these projects is not without risks for investors. CFA Institute, therefore, calls for a framework that protects them without stifling crowdfunding innovation.
What is its potential?
By channelling finance to projects that would typically not receive attention from more traditional funding sources, crowdfunding can contribute to solve the structural gap present in the financing of early-stage ventures. Some see the next pebble of popular capitalism, where small investors search for projects and distribute small amounts of their savings across several of them. Currently, however, high-net-worth individuals and professional investors remain the main funders of equity.
Some estimates indicate that crowd-sourced loans exceeded $6.2 billion globally in 2013. This is equivalent to just 0.01 per cent of the bank-originated credit to the real economy but it is growing fast, up by 145 per cent from 2012. In the United Kingdom (the most developed market to date), crowdfunding for financial returns accounted for more than £490 million in 2013, including £28 million in equity. This is equivalent to 1.8 per cent of unsecured personal loans and 1.1 per cent of assets under management.
Crowdfunding is still at an early stage in development, where most equity and debt-financed projects have not yet matured. As a result, important uncertainties as to its future remain, which will ultimately depend on its ability to channel reasonable returns to investors.
What are its risks?
For loans, default rates appear to be moderate with some platforms reporting rates of 1 per cent, although given the exponential growth in the industry, just mentioned, few loans have matured, meaning that more time is needed to get a clearer picture of actual default rates. For equity invested in early-stage ventures, the UK Financial Conduct Authority estimates that investors lose the entire principal in 50-70 per cent of ventures. Some argue, however, that these figures are overstated.
Investing in early-stage ventures carries high project-specific risks, which inexperienced investors are poorly equipped to assess. Direct contact between potential investors and entrepreneurs, and public discussions though the networking functionalities embedded in crowdfunding platforms, may reduce the risk of fraud and increase the level of investor understanding of the project by investors. Yet, the risks specific to each project will remain high.
In addition to project risks, investors also face the risks specific to the instrument of choice, whether in the form of equity, debt securities or loans. Key risks in equity-based campaigns arise from the illiquidity of the instruments, lack of secondary market and the potential for dilution of rights, absent governance protections. For loans, the key risk is the default or delay in the payment of interests and principal. In addition, investors are exposed to fraud and operational failures within platforms.
How important is regulation?
Regulation has a key role to play in allowing crowdfunding to develop and protect investors. Existing securities regulation does not reflect the specificities of crowdfunding. Instead, a specific framework is needed that ensure the integrity of platform operations, adequate due diligence to mitigate the potential for fraud and a high level of transparency towards investors. Some Western countries have opted for requiring retail investors to review educational materials before being able to invest.
Without sufficient safeguards for investors, crowdfunding will not thrive. Platforms need to ensure that investors understand the risks and potential losses, while effectively protecting them from fraud. Otherwise, investor damage will quickly turn into lost trust, missing the opportunity to invigorate entrepreneurship and innovation.
— Mirzha de Manuel Aramendía is Director Capital Markets Policy at CFA Institute, and Amer Khansaheb is president of CFA Society Emirates
