In essence, we all need to find at least one source of income that doesn’t require active labour or management. This is to account for various factors, such as:
- Our inability to continue working indefinitely, and reduced income as we age
- The possibility of sudden circumstances, such as disease or illness, which hinder our capability to provide for our families
- Our employer or business closing down (the current Covid-19 situation is a demonstration of how suddenly this can happen)
- A simple lack of time, as not everyone has the hours required to analyse a particular stock or track market movements
The problem is that passive income is not easily attained—and oftentimes, these income streams aren’t as hands-off as we’d like to imagine. Renting out a property can be seen as passive income, for example. But purchasing a second property is capital intensive, and thus out of reach for many. There are also factors to consider, such as time spent on property management, maintenance costs, and higher taxes for rental properties.
On the other hand, some financial instruments, such as REITs or bonds, can also provide passive income—but the returns provided may be too low to meet our financial aspirations. In addition, some bonds may have high minimum buy-ins (e.g. $250,000 or above), and there’s a risk of loss if these assets need to be liquidated on short notice.
SME lending as a form of passive income
SME lending was once the province of large financial institutions, but today the digital economy has opened it up to individual investors. Through peer-to-peer (P2P) financing platforms, private investors can now provide small loans to a diverse mix of SMEs. The interest on these loans creates a reliable source of passive income, with some notable advantages.
- The returns provided are absolute, and higher than many other forms of passive investing
- Funds are committed for a much shorter period, compared to actually financing a business in the traditional way
- Investors can diversify their passive income source
- SME loans are also a positive form of impact investing
The returns provided are absolute, and higher than many other forms of passive investing
While unit trusts or REITS provide passive income, their returns are variable. Returns may be pegged to a benchmark index and will fluctuate with market conditions. Situations such as the current Covid-19 outbreak can sometimes result in low or negative returns.
SME loans, however, are debt instruments—they provide an absolute return, as the repayment terms are stated in black and white. Borrowers are obliged to meet the repayments, irrespective of the market situation.
Other investments that provide absolute returns, such as bonds, are lower in value, and may have high minimum buy-ins. For example, at the time we’re writing this, the Singapore Savings Bond (SSB) has a 10-year return of just 1.05%, while US Treasury Bonds have seen their yields fall to 0.318% in March from above 1.5% in mid-February.
While guaranteed, returns from bonds could be too low to meet retirement targets or other financial aspirations. This is especially true for younger investors, who must contend with inflation rate risks.
SME lending, while providing an absolute return, is also more financially rewarding. For example, the P2P platform Validus Capital projects risk-adjusted returns of 8% to 12% per annum. This is much higher than many other passive income assets.
Funds are committed for a much shorter period, compared to actually financing a business in the traditional way
It’s possible to generate passive income by funding a business that—if you’re fortunate—will turn out to be successful and generate profits without requiring active and frequent contribution. Aside from the extensive risk they involve, such traditional methods also have the drawback of long-term commitments.
New businesses may take three, five, or even more years to become profitable. In that time, your money remains locked up in the business as equity, unable to be used in new opportunities.
With SME lending through P2P platforms, however, the loan tenures typically range from 30 days to 12 months. This provides greater liquidity and flexibility to access cash on hand. Shorter loans also pose lower risks to lenders.
Investors can diversify their passive income source
It can be dangerous to place all your funds into a single source of passive income—for instance, sinking most of your portfolio into a second property and then hoping all goes well. A single stroke of bad luck (e.g. new properties springing up nearby to provide rental and price competition) could wipe out years of gains.
But with SME lending, it’s easier to diversify your investment. Loans to each company can be as low as $1,000, thus allowing you to spread out your lending among diverse businesses with low correlation. This ensures that a downturn in one industry won’t overly affect your portfolio.
SME loans are also a positive form of impact investing
There are many dynamic companies out to improve the world, from fintech firms promoting financial inclusion to green companies. Along with many other small businesses, however, these entities struggle to get loans from mainstream institutions. One reason for this is that mainstream lenders dislike disbursing small loans due to the low margins and high administrative costs involved.
However, these companies provide essential services to growing economies; and you can help support them through SME lending. For example, TRIA, a company that creates eco-friendly food packaging, has been financed by loans from the P2P platform Validus.
As an individual investor, you can use SME lending to allocate your funds for positive impact, supporting businesses that can create the changes you want to see. And you don’t need to be a venture capitalist who commits huge sums for several years to do so.
So, What Now?
Above all, SME lending is becoming part of mainstream finance, and has become safe and well regulated. In Singapore, SME lending is regulated and supported by the Monetary Authority of Singapore. P2P lenders such as Validus use escrow accounts to hold funds, and never place investors’ monies in their own account. Validus even provides insurance for capital protection, and only works with accredited investors.
It’s high time that wealth managers and investors look into the emerging asset class of SME lending; both as a way to generate passive income, and to support dynamic SMEs looking to improve our world.
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