With bad debt rising in sub-£10,000 deals, is now the time to be exiting the micro-ticket market?
While economic commentators mention a path to recovery, a number of financiers in the micro-ticket market appear to be walking a tightrope between survival and unsustainable credit losses.
While margins appear fairly strong and some remedial actions have been taken to tackle defaults, high levels of realised and provisioned bad debt seem to make profitability marginal at best, with many companies likely to be making a considerable loss.
Definition and management of defaults varies considerably. Companies have subtly different definitions of when a customer is in arrears, making it difficult for companies to compare their performance with others in the same market.
One funder indicated that his company tended not to charge a fee for late payment. Another used a convoluted calculation method to determine the late payment fee, which could not be explained clearly.
“The figure is what the system chucks out,” was the explanation.
In such cases, it is questionable whether such an opaque method of calculating additional charges for the customer is best practice. Not only is it likely to lead to inefficient dealings with the customer trying to explain the logic for the additional charge, but is also unlikely to be considered as ‘treating customers fairly’ (TCF).
As a relatively high proportion of customers in a sub-£10,000 (€11,000) portfolio are likely to be individuals (possibly acting as sole traders), this should be a cause for concern for the funders in question.
Many funders serving this market do so not as a strategic choice but more as an accommodation to trading partners, either brokers or vendors.
This is especially true at the smaller end, where the total interest from a transaction is low, no matter what the interest rate. The full cost to serve often applies, which may mean touching a low-value deal several times.
“We just use our standard underwriting process,” was the response of one player in the market.
This particular funder reported getting a lot of ‘maybe’ decisions for sub-£10,000 deals through its automated underwriting process, each one requiring manual intervention.
Add the normal sales support requirements in terms of chasing accounts, getting director’s guarantees and so on, and there are a number of directly attributable costs that can be allocated to the transaction that will make it loss-making before any consideration is given to in-life costs or bad debt loading.
The response of another funder who was asked the same question was: “If we did not do that type of deal there are some brokers we would not be able to serve, as they specialise in the sub-£5,000 market.”
While the response is an extreme case, it does highlight the requirement for greater commercial awareness, notably profitability and cost-to-serve analysis in a segment where small variations in income lines or costs, multiplied across a high volume of transactions, can have a fundamental impact on bottom line profit.
While a customer orientation is admirable, it can be an expensive business when almost every deal is costing money.
Especially when working with a vendor partner, carrying out the analysis may provide a lever to negotiate some form of financial commitment, such as a loss pool for transactions under £5,000 in value, agreed changes to operating process, contribution towards operating costs or some other means of achieving a minimum return requirement.
Standard documentation for specific vendors or brokers may also need changing, as it may, for example, not include an appropriate inception fee.
In terms of income lines, there appears scope to increase both the range and penetration of insurance products. Asset cover is sporadic with seemingly similar processing approaches generating significantly different outcomes in terms of penetration rates.
Of the funders interviewed, very few sold into the sub-£10,000 market. Classically, one funder said that insurance was “in the plans to look at”, although it had no apparent urgency to develop this income line.
Again, it may come back to priorities. With sub-£10,000 business being a small part of that funder’s portfolio, especially in financial terms, it is likely to receive a relatively small amount of attention for product or service development. This may be a dangerous outlook if the deal flow represents a small but consistent outflow of profit.
In such cases, if development time cannot be allocated to ensure this business is profitable, the appropriate funder response may be to raise the minimum transaction size, focusing on those areas where the quantum of interest income is sufficient to cover costs and generate the required return.
Especially for those companies who have stumbled into the sub-£10,000 market, it appears that few companies are maximising their performance. While economic recovery may be slow, bad debts look set to continue at a high level for some time to come.
This may prove a necessary catalyst to review and improve a number of business practices, relating both to bad debt management and the broader areas of cost and income. Otherwise, despite the rise out of recession, losses could prove unsustainable for some funders in this market.
The author is a partner at the consulting and services firm Invigors.