ThinCats Newsletter August 2017 08/08/2017
It’s possible that Edmund Hilary and Tenzing Norgay weren’t the first people to make it to the top of Everest. When George Mallory’s body was discovered on the slopes of the mountain 75 years after he disappeared in 1924, it was apparent he was descending, having been last seen 800 vertical feet from the summit, on the ascent.
We will never know. But what we do know is that, like with Mallory, 85% of fatalities on Everest happen in the descent, not the ascent. It’s a similar story when it comes to pensions: the hazards are not so much with the accumulation phase – real and present though they are – but when you are drawing on that pension pot: or decumulation, as it’s rather clunkily called.
There are two fundamental reasons for this: the often invisible effects of inflation, and when people ‘optimistically’ underestimate their life spans. The latter is a far from trivial point. Average male life expectancy, once you reach 65, is 84 years old; the average for women being 86. That means you have a 50% chance of living beyond this date – sometimes by a significant amount. Unless you plan to occupy yourself in retirement by binge-drinking, chain-smoking and free-climbing, it may be wise to allow for this. So your portfolio needs to deliver for you over 20, 30 or even 40 years. Over such a time-frame, the stability of a portfolio is extremely sensitive to what may seem like small changes in behaviour, or relatively minor fluctuations in the inflation rate.
Impact of 2.3% inflation on purchasing power of £1
Source: UK inflation Calculator, whatsthecost.com, as of August 2017
UK Consumer Prices Index, 1990 – 2017 (average 2.3%)
Source: Office of National Statistics, as of July 2017
Inflation has been off the radar for many over the past decade. But even with the modest levels we have experienced in recent years, cumulative effects have been significant: as can be seen in the graph above, the value of £1 in 1991 had fallen to 54p by 2015. If we were to look at the impact of inflation before that in the 1970s and 1980s, the situation would have been far worse.
Since the Brexit vote, we’ve seen inflation increase. Whether this is a short-lived currency effect, or set to become a structural trend is unclear, but one should not ignore the heightened potential danger this poses to your savings. You therefore need enough growth in your portfolio to at least partially compensate for this. While not many can inflation-proof completely, as this means taking a much lower income, conversely one must be careful not to take too much, as this risks depleting one’s savings very quickly.
One rule of thumb used to be not to take more than 4% on a balanced equity/bond portfolio. However, investment information provider Morningstar has warned that “financial advisers and retirees in the United Kingdom should use lower initial safe withdrawal rates… towards 2.5% or 3.0% and not the previous 4.0%.” Lower yields, in other words, mean a lower withdrawal rate. However, being this defensive is challenging when you need to take a decent income to fund the retirement that you want. This is why institutional pension funds are increasingly looking to alternative assets such as private debt for enhanced yields – which is the solution offered to individuals by ThinCats and other alternative lending platforms. Investors receive an enhanced yield through what’s known as the ‘liquidity premium’ – the price of having one’s money tied up for longer.
Diversification is an indispensable tool in the investor’s kit. Having equities alongside fixed income in the portfolio, for instance, allows the potential for growth that bonds and the like cannot provide. So why not fill your boots with equities? Capital growth, plus dividends, seem an attractive option. The first problem is that is you are likely to have to sell assets to fund withdrawals as equities are unlikely to generate sufficient dividend income for you after taking account of fund, platform and adviser charges. Secondly, equities can go down in the short term even if they typically grow in value in the longer term – they can be volatile. When you are saving, a dip in the market just means that your next purchase of equity is cheaper. The problem with taking income however is that you are likely to have to sell equities in the dips to fund your withdrawals and so you never get a chance to recover the lost value.
Global equity markets fell by about 40% during the financial crisis (similarly with the 2000 dotcom bust), while developed market government debt rallied. Such equity volatility has important implications for those drawing income: fund performance tables are based on accumulation for savers. The top performing funds for savers may not be good for income takers, if better total returns have been achieved at the expense of lots of volatility which is deadly for income takers.
Ah, some might say, but equity markets bounced sharply within two years of the crash, and made the ground back shortly after. While that’s true, a market that falls 50% and then rises 50% is not back where it was, but at 75% of its original value. What’s more, you still need the same income while the invisible hand of the market does the (hoped for) repair work. The bigger the drop, the proportionally more your portfolio needs to grow after (see graph).
Source: OMGI, as at May 2016
Needing to withdraw income from a portfolio, a corner stone of whose value is in freefall, will empty like a bath empties after dropping a wrecking ball through it, rather than using the plug. Not many people can afford maximum inflation protection by taking very low income levels, so it is quite likely that high amounts of equity in the portfolio will mean selling down assets to fund withdrawals. This addresses one problem at the expense of creating a potentially worse one.
With inflation on the increase, holding cash functions poorly as a buffer, as the real value of this will be increasingly eroded over time.
Broadly speaking, your need for income is fixed to a far greater degree than the value of the basket of assets you draw that income from. So, while it’s prudent to have growth potential within your portfolio, it’s even more important to have a diversified basket of assets to mitigate losses, while paying a level of income compatible with your needs. The most reliable way of achieving this is to generate income from income received, not selling down capital.
With stricter banking regulations since 2008, Brexit uncertainty and sparse data available on small-medium enterprises (SMEs1), mainstream lending sources are not sufficiently servicing the credit appetite of UK businesses. The size of this ‘SME funding gap’ is estimated to increase to £22 billion by 20172. This is a major factor in the growth of the alternative finance (alt-fi) industry, with many alternative business funders focusing specifically on SMEs.
At this nascent stage in the industry’s development, it is vital for these lenders to develop healthy portfolios, not just for their investors, but to build the reputation of the alt-fi industry as a whole. Peer-to-peer lending accounted for 13.9% of new bank loans to SMEs in 20153. This leaves plenty of room for further growth; however, without reliable data, it will be a difficult trajectory.
Without the resources and name recognition of the leading banks, alt-fi lenders are continuously innovating to gain market share – there has been an explosion of credit risk modelling innovation in the SME finance market segment. To complement this, Commercial Credit Data Sharing (CCDS) is expected to kick off later this year; which will require nine major banks to share credit information on all their (willing) SME clients. This influx of new current account and credit information will help the alt-fi industry to continue serving a host of currently overlooked smaller businesses.
It is, of course, the SMEs with good prospects and in urgent need of finance to whom we most want to provide lending capital. Data scientists can identify and further refine this segment of SMEs, to pinpoint those that are currently overlooked by the banking industry. ThinCats is launching its first targeting model, whose algorithm is aimed at identifying these UK SMEs. By focusing origination efforts on this segment, ThinCats can grow many more mutually beneficial arrangements with SMEs.
The algorithm is an ensemble of two models: one that assesses a company’s need for borrowing, the other assessing their risk profile. Combining these ensures origination effort is focused on appropriate companies. The algorithm is trained, using publicly available data, on a UK SME ‘universe’ of borrowing and non-borrowing enterprises. The borrowing model considers a firm’s past behaviour and access to other funding sources to predict their desire to borrow over the next 12 months.
The risk model initially examines balance sheet characteristics but, crucially, ThinCats differentiates itself by including proprietary risk metrics that are not used by other lenders. These can enhance the view of firms undervalued by mainstream banking. For example, our model will highlight the rating of firms that demonstrate adaptability to market fluctuations. The intended result is a cohort of healthy SMEs that are poised for successful growth, yet still might not tick the boxes of a banking credit model.
This comprehensive modelling approach is part of ThinCats’ effort to provide the UK’s best SMEs with the finance they need to flourish. Since 2008, banking finance has been difficult to obtain and often slow. ThinCats offers an open door and faster service to firms that don’t ‘fit the mould’ of mainstream banking, by thinking laterally and picking up the SME vibrations that no one else is hearing.
The upshot of this for investors is that the ThinCats team is now in a great position to target a diverse range of funding opportunities, and this information will boost the pipeline prospects over the next weeks and months, to provide our investors with a choice of promising loans in which to invest their money.
 SMEs are defined by the National Audit Office as businesses with fewer than 250 employees and an annual turnover of less than £50 million https://www.nao.org.uk/wp-content/uploads/2013/10/10274-001-SMEs-access-to-finance.pdf
 National Audit Office – Improving access to finance for small and medium-sized enterprises, page 4, 2013 https://www.nao.org.uk/wp-content/uploads/2013/10/10274-001-SMEs-access-to-finance.pdf
 University of Cambridge – THE 2015 UK ALTERNATIVE FINANCE INDUSTRY REPORT, page 21, 2016 https://www.jbs.cam.ac.uk/fileadmin/user_upload/research/centres/alternative-finance/downloads/2015-uk-alternative-finance-industry-report.pdf
Twenty-first century businesses are dependent on their IT systems to no lesser degree than 18th century flour mills were dependent on water: no water, no business.
This has been well illustrated recently by the IT debacle at BA. For BA, what has been described as a “staff blunder” led to an uncontrolled reboot at one data centre, which in turn crashed the entire global system, causing many hundreds of flights to be cancelled over the late May weekend. The airline now faces a predicted loss of more than £158m and huge reputational damage.
The problem with networked systems such as IT is that if improperly maintained and tested, when one part goes down, it can drag everything down with it.
Having invested a considerable amount of money in our systems and supporting infrastructure over the past couple of years, we know the only sensible thing to do is to regularly try and break them. Disaster recovery plans may look good on paper but, as German military strategist Helmuth von Moltke said: “No battle plan survives the first encounter with the enemy”.
So last month we subjected our IT to an extreme test; bringing our system back online after the simulated destruction of all of our servers, and recovering all of our client data from offsite backups after deleting it from the database. And we aimed to do all of this in less than four hours.
Chief Technology Officer Nick Buller commented: “We wanted to test a real Armageddon scenario: having all of our client-facing IT and databases destroyed at the same time, and then having to rebuild the entire estate again from scratch. We have a service level target of four hours to do this – we managed to do it in five, which is good, but clearly we still have some work to do.”
The speed and efficiency with which we were able to do this is down to our investment in automated IT Development Operations (DevOps) processes – ThinCats has invested a large amount of time and money into getting thousands of manual command lines and configurations to be implemented with one click recovery. So if the worst happens we know we can recover from whatever is thrown at us, in a calm and controlled way.
This isn’t a one-off test. We will continue to develop our systems, and continue to try and regularly break them. Only in this way can we ensure that we provide you with as secure and reliable a service as is possible.