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

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

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.

Peter Hunt

The author is a partner at the consulting
and services firm Invigors.