If something seems too good to be true…

If something seems too good to be true…

Image from Hartmut Stein on Pixabay

Some years ago at a previous firm, on what must have been a slow day, a colleague and I came up with the characteristics that the ideal financial product would have to appeal to just about everyone.

It would have low risk, high returns, flexibility, tax freedom, low costs, high liquidity and high diversification.

Unfortunately, such a product is a chimera. There are no low risk high return investments because if they existed, nobody (including the institutions who are the largest investors in the economy) would bother to invest in anything with high risk. There would be no point. In order to compensate anyone for taking more risk, there has to be a higher expected return. Highly diversified investments do not produce the highest returns because the principle of diversification is to limit the impact on the portfolio of how any of the individual investments performs– not enough to make a killing but also not enough to get killed.

The collapse earlier this year of another supposedly low risk investment as London & Capital Finance (LCF) went into administration  with £236m of investors’ money serves as yet another illustration of this core principle. LCF apparently created a bond (a form of fixed interest investment which is theoretically less risky than shares) which would invest in loans to several hundred companies and so would actually be fairly well diversified.

Unfortunately, it seems that reality was slightly different. The loans were actually to a dozen companies, of which four have never filed annual accounts and nine are under three years old. Of the £236m invested with LCF, over half was lent to one company, which then lent those funds to other businesses. While not helping those investors who fell victim of this offering, there were other factors at play which provide a useful checklist for future investors tempted by what is a depressingly familiar story.

Glossy marketing campaigns

If a product is good, then it is not necessary to spend huge amounts (£60m in this case) promoting it to potential investors. Someone is paying for the campaign and if you are one of the investors, it will ultimately be you. In LCF’s case, a marketing company was apparently paid up to 25% of the money raised. This, the appointed administrator reports, required that the one-year bond produced a return of 44% for the investors to receive their promised returns. The five-year version required an annual return of around 19% over the period to deliver the promised annual 8%. To put this in context, the UK equity market (and shares are a much more volatile investment than bonds) has managed to exceed 18% twice in the 50 calendar years since 1970 . Even the most optimistic investors might regard that figure as unlikely to be achieved from lending, although of course this fact would not have been revealed to them at the time.

High returns on offer

A good starting point when considering what is a reasonable low risk return is to look at the redemption yield on UK government bonds with a similar timeframe. The UK government is an issuer with a low credit risk (like all governments, it can print money to meet its liabilities, albeit at the expense of rising inflation which then reduces the value of the bond anyway) and no currency risk. An internet search for ‘uk gilt redemption yield’ brings up several sites with that information and it can be seen that it is currently necessary to invest for more than eight years to earn an annual return of more than 1%. Any investment that offers a higher return than that is going to be higher risk by definition. Something offering three times that rate is likely to be roughly three times as risky. With bonds, such risk is manifest in the possibility of future promised income and/or capital payments not arriving in full on the promised dates.

Conflicts of interest

A significant proportion of financial scandals involve businesses where the directors are involved in the counterparties to an extent that makes their independence questionable. In the case of LCF, it appears that a number of investors were led to it via one of the price comparison websites that have proliferated in recent years. However, while many are entirely legitimate, this particular site was apparently run by a director of the same marketing company which was paid up to 25% of the funds raised by LCF . So absolutely no doubt about the independence of those comparisons then….

The nature of the investment product

The LCF investors invested in ‘mini-bonds’. However, as the FCA points out on its website, “Mini-bonds can be attractive to investors because of the interest rates on offer. However, prospective investors need to understand the associated risks. Mini-bonds are usually illiquid as they are not transferable, unlike listed retail bonds, which they are often compared to. They can also be high risk, as the failure rate of small businesses can be high. Additionally, as with the issue of other non-transferable corporate bonds, there is no Financial Services Compensation Scheme (FSCS) protection if the issuer fails.”

This is not the case with a regulated fund (quite apart from the fact that it is subject to the scrutiny of an authorised corporate director or trustee) so represents a risk which many of the investors did not appreciate. In particular, as bonds are securities (like shares), issuing them per se is not an activity regulated by the FCA. Promoting them to investors does require authorisation and the risks must be clearly communicated in such materials but evidently the standard of these fell short of the FCA’s requirements as it ordered LCF to stop this activity late in 2018.

Investing in loans to third parties where those assets are not easily realisable (the borrower may need to refinance their loan in order to repay the original lender and this may not be possible at a reasonable cost), may entail a delay in securing repayment of the capital. Alternatively, the administrator may be forced to accept only a proportion of the funds lent in early settlement on the basis that it is better than waiting longer for a future return which may be no better.

The underlying assets

The investors in LCF were told that their money was being lent to a number of small and medium sized enterprises. While this was probably the only – although admittedly still slim – hope that there was of delivering the returns required to meet its promises to investors (small companies are more likely not to meet their obligations than large ones, so their cost of borrowing is higher), the risks of lending to such businesses tend to be similar to those in buying their shares. When a small business fails, there is often no difference between the amount recovered by its bondholders and equity investors so the trade-off between risk and return breaks down somewhat.

Some of those companies have complex transaction histories, with frequent name and accounting date changes and the same directors appearing at new entities after previous ones have been struck off the register.

Compliance with tax rules

LCF claimed that its bonds would qualify for individual savings account (ISA) status, affording them tax advantages. It must therefore be particularly galling to investors to learn that this may not be the case. While something of an academic issue given that the will likely not be generating any returns to be tax-advantaged, investors who used their ISA subscription to invest have missed the opportunity to invest in other ISAs for that tax year.

The target market

LCF’s website  described its products as “….. aimed at retail clients who are UK taxpayers and who fall in the category of either High Net Worth Individual, Sophisticated, Self Certified Sophisticated or Restricted Investor.” Such investors are regarded as being able to evaluate complex financial instruments and to understand the need for diversification so that their future security would not be seriously compromised by the failure of one of their investments. From the stories which have appeared in the press, it appears that the target was missed quite substantially, as many investors (based on the published data, the average investment was around £20,000 per investor) appear to be inexperienced ordinary people who sunk a substantial part of their life savings into the bonds. One of the requirements of the 2018 MiFID II regulations is for firms to report the extent to which the distribution of a product or service is being matched to its target market and if nothing else, situations such as this explain why such a requirement was introduced.

Interestingly, one of the people quoted in relation to the whole sorry mess was an independent adviser, who heard about the bond when a client asked him about it back in 2015 . His firm’s investigation revealed disturbing links between those behind LCF and the organisations to which it was lending and as well as warning off the client, it notified the regulator of its concerns. While unfortunately this appears not to have protected any other investors before the FCA ordered LCF to suspend its activities late last year, it does at least highlight the merits of working with an adviser who is the agent of the client rather than of a product provider. Hopefully that particular client appreciates the value of that good piece of advice.

The old adage clearly still applies – if something looks too good to be true, it probably is.