All the truth on the Provision Fund
Having decided back in 2014 to offer to investors in credit a lower risk investment option, in mid-2015 the employees of AB NEO Finance (hereinafter – NEO), and in particular me, Evaldas Remeikis and our in-house lawyers, were thinking really hard how the construct a legitimate and easily understandable instrument that:
- is compliant with the requirements of legal acts without, however, us being perceived as engaged in deposit gathering or insurance business;
- would provide investors with significantly greater secure investment facility by assuming only corporate rather than credit risk;
- ensure (at least in theory) for NEO, as a company, earnings during periods of strong economic growth that would outweigh any losses in times of economic decline.
The service of the Provision Fund (hereinafter – PF) from its very outset was focused on more conservative NEO investors preferring to avoid credit risk, or those looking for a safer investment option rather than refraining from investment in anticipation of a looming crisis.
So, with the assistance of our lawyers we managed to design an instrument that can mitigate investor risk. The instrument has not been modified since the beginning of NEO’s operations, and has been used for the past three years and seven months, just as it was in December 2015. The instrument was subsequently scrutinised by our supervisory authority, the Bank of Lithuania, which did not have any comments.
What is the Provision Fund?
The Provision Fund service is a chargeable surety provided by NEO to investors. A legal definition of surety is provided in Articles 6.76-6.89 of the Civil Code of the Republic of Lithuania: https://www.infolex.lt/ta/12755. For an investor who has selected to invest in credit with the service, this means that:
a) if the credit recipient delays payments, NEO will instead pay the instalments strictly according to the credit repayment schedule;
b) in case of contract termination, NEO will repay to the investor the entire credit balance, and the outstanding interest accrued pending the termination of the credit agreement.
In this way, NEO enters into a transaction with an investor, and in consideration for the PF fee payable immediately the investor is granted a contractual obligation on the part of NEO (a contract is drawn up at every instance of electronic investment) to properly fulfil the obligations under the above items. It is important to note that a PF fee paid by the investor is included in NEO’s balance sheet as income from which NEO calculates provisions according to the Fund’s operation mechanism. Thus investors contribute the funds not with a chance to claim them in the future, but rather to pay NEO as a fee for the Fund's service. This, however, does not mean that the funds in full or partly belong or will belong to us in the future. In the event that NEO is unable to fulfil its surety obligations, or is bankrupt, the company's operations would be taken over by a receiver, and the investors, being the creditors, would retain all the rights to the granted credits, however only to the extent that NEO has failed to fulfil its surety obligations. In that case the investors would be placed in the general line of creditors after the State and the employees.
What is the Provision Fund account needed for, and why was it created?
In the process of designing the service, i.e. even before the beginning of NEO activities, we were asking ourselves how to present this relatively sophisticated product (as peer-to-peer lending was in general a novelty in Lithuania) to investors, especially as many of them do not read contracts, and nevertheless have to be as comprehensively informed as possible about the activities and the services provided by NEO. We had way more than one idea. As Deividas Tumas, a member of the Board, mentioned on the ‘P2P Lietuva’ Facebook group, among the acceptable options was to show the authorised capital, equity, the company's assets, all the funds in the account, etc. Another puzzle for us was how to call the service – the Guarantee Fund or the Provision Fund or any other name. Obviously, we decided that the service was to be called the Provision Fund. While programming the NEO information system, we created a new account, would accept the PF fees and cover the delayed contributions and the value of the terminated contracts.
While thinking how to demonstrate to investors that the fund also held specific assets, we concluded that investors always best understand the concept of money, as everyone knows what money is. Just as a starting point we contributed to the Fund, i.e. to a separate account EUR 75,000, and then would make a ‘print screen’ picture every day, and later on a weekly basis, to demonstrate that the money was present in the account.
So our decision to show the account balance was in fact partly a marketing solution that did not contradict the logic or the essence of a PF, because while providing surety with all of its assets the fund shows only its smaller part, i.e. we show only one account used to ‘move’ the funds.
Internally at NEO we compute and demonstrate to investors the redemption ratio, the amount that we are required to hold in the account, so that we are able to discharge our obligations to the investors. The ratio is computed as a ratio of the obligations assumed as related to the PF service to the amount accumulated in a separate account. The ratio value normally ranges between 10 and 13 per cent. We compute the ratio every month on the level of the credits active at that respective moment (i.e. with a high level of accuracy), and in case it appears that the balance in the account exceeds the amounts necessary to compensate any estimated loss, we transfer the excess to another NEO account, or, conversely, supplement the PF account from other accounts in case of a shortage. The estimation of the redemption ratio is the responsibility of Marius Navickas, a member of the NEO Board, and whose expertise in the area is priceless to us. The mathematical calculations are carried out taking into account the projected default rate on the part of the credit recipients, also considering selected assumptions, in this way producing the amount in the funds required to be able to compensate any future loss on the part of the investors. Additionally, we use a ‘buffer’, i.e. a coefficient indicating that in the event the assumptions are not realised and appear worse than projected, the additional reserve will be used to ‘absorb’ the unforeseen loss. It is specifically because of the coefficient that we can conclude that provided no economic downturn is expected investing in credits with the PF is less profitable than investing without it. In other words, some slowdown in economic development, or benefits to investors that are larger than estimated according to the PF model computations have already been included in the PF fee. Therefore, at our seminars we consistently suggest that investing with a PF service is most profitable when anticipating a certain economic downturn.
Is it better to hold the funds intended to fulfil the obligations to the investors who have selected the Provision Fund service in a bank account or to invest?
In the early stages of our activities when the amounts were not so significant, we used to keep the Provision Fund’s funds in bank accounts. However, with the amounts increasing, in 2018 we started considering whether that was really the most optimal solution both for the shareholders of the company and for investors in credits. That was an issue we allocated an immense amount of time to. Ultimately, we decided to invest part of the funds held in the Provision Fund’s account in credits, while ultimately being transparent to the investors, i.e. by segregating the funds held in cash and those invested. Still, there was another important question – which credits should be invested in? Since, for the purpose of maintaining its liquidity, NEO invests in credits while borrowing funds at 7-8 per cent interest, a decision was taken not to borrow anymore, so not increasing the corporate credit risk where the funds were held in the account, but rather to invest the funds into credits which we believed would generate a return. The members of the Board understand very well that in investing the PF’s resources into credits all of the shareholders assume a certain risk, and that in the background of a crisis an investment can earn very little, or even the return may be negative. NEO has been dedicating significant attention to crisis simulation by carrying out so-called stress-tests on an annual basis. The results of the most recent test performed in March 2019 are available here: https://www.neofinance.com/en/page/12/business-continuity-plan.
So, by investing part of the funds held in the PF account, we will be able to earn additional income, thus strengthening the NEO’s equity capital, thus accumulating additional reserves that will enable us to survive any looming economic slowdown. I am personally assured that it is highly probable that even in view of an economic slowdown we will be able to generate a positive return for the following reasons:
- at least for the time being the received interest is sufficient to outweigh any loss from insolvent loans;
- by investing in credits we consistently increase income from the commission fee applied to credit recipients;
- another important factor is time: while not knowing the timing or scale of the next economic downturn, we will in the meantime be generating a sufficiently high return, so that in the early stages of a downturn our obligations to the investors will be fulfilled from the accumulated return.
Case C deserves more detailed analysis; in case the anticipated economic downturn is insignificant or is expected in the slightly more distant future, the generated return will increase the equity at NEO that will subsequently be used to cover the loss. It is also possible that the anticipated economic downturn may be so insignificant that the profit accumulated by way of investing might be sufficient enough to compensate the losses without the need to use the funds accumulated from the PF fees. Still, the economic downturn may also be quite tangible. In that case, the profit would be ‘consumed’ rather rapidly necessitating the use of the cash reserve (which is anticipated to account for approximately 30-40 per cent of the funds currently held by the PF). Under that scenario we will on a monthly basis be investing the funds and returning the credits, as well as using the funds from other assets.
Our major asset is the future commission that at the end of Q2 2019 totalled EUR 3.65 million. In case the crisis is deeper, the moment that is in my opinion most important for the investors would be triggered – how much the shareholders have invested in the capital, and to what extent they are interested in maintaining their business. Currently, our total amount invested in the capital is EUR 4.18 million, so if necessary both myself and the other shareholders could contribute to NEO’s capital, as much the most tangible loss would be suffered otherwise. Nevertheless, to require a contribution of additional funds to the capital, the crisis must be really significant. And I have reason to say this; as I have already mentioned we carry out so-called stress tests on an annual basis. The tests are instrumental in assessing potential crisis scenarios and projecting the condition of NEO’s cash flows. This only shows that we take any potential economic downturn very seriously, and we have been accumulating financial reserves from the very outset of our activities, which are increasing every quarter.
The graph below shows in clearer terms what I have in mind. It simulates an economic downturn of a level where investment in credits temporarily becomes unprofitable. We can see that the profit shown in the green area would outweigh the loss suffered in the course of the crisis (shown in the red area). In reality, quite the reverse may be the case, so for the sake of clarity the graph shows only one of the possible scenarios.
Our recent estimates show that for investors to have zero return with the interest rate remaining on a level similar to the current one, the number of insolvent credits in the platform would have to increase from two to three times.
Moreover, it is entirely unimportant where the interest will return to – to the Provision Fund or to another account, as NEO is liable to the investors who have selected to invest with the PF with its entire assets rather than with one selected account.
What assets does NEO manage and what amount does it secure that the obligations to investors will be fulfilled?
- EUR 0.35 million is held in the Provision Fund account.
- About EUR 0.5 million represents the difference between the loan portfolio held by NEO and the obligations to the creditors (about 40 per cent of the creditors are NEO's shareholders).
- EUR 3.65 million is the future commission proceeds.
- EUR 0.5 million in cash and cash equivalents is held in other accounts.
So, the assets held by NEO that would be used to fulfil the obligations to the investors account for EUR 5 million, so should NEO have to compensate 40 per cent of the credit balances invested by the PF, the amount would total EUR 1.12 million (preliminary data for the end of Q2 2019). I would still need to mention that a 40 per cent loss in the invested loans using the PF service is conceivable only under the scenario of a significant economic downturn.
So, whether or not NEO invests part of the PF’s funds held in the PF account will not essentially change very much. The NEO Board is confident that the present arrangement is a solution most beneficial for the shareholders and for the investors, as it will facilitate the strengthening of NEO’s equity.
Chairman of the Board Evaldas Remeikis