Plus ça change

Plus ça change

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Yet again, it appears that an issuer of mini bonds has failed, leaving its investors with little or no prospect of recovering their investment.  In this instance it is a firm, Wellesley, whose TV advertisements I had actually seen myself.  I happened across the story when it appeared as an item on the BBC Radio 4 programme ‘Money box’ a couple of weeks ago.

Wellesley cites three reasons why the company collapsed.  First, in common with many other businesses, the impact of the coronavirus pandemic caused work on its developments to be suspended and this therefore impacted on its ability to generate the necessary cash flow from sales to meet its obligations.  Second, it proved hard to raise capital from other sources to support its loans to property developers.  Finally, the ban on marketing mini bonds imposed by the FCA effectively closed off the avenue of raising capital from retail investors.

While the issue of mini bonds has been covered here (and here) before, on this occasion I thought it would be interesting to consider them here from the perspective of their issuer.  This is not to excuse the way in which these products were marketed to potential investors but it may provide an insight into why it is that the Financial Conduct Authority banned their marketing to retail investors in June this year.

It is a function of any business that it requires capital to fund its operations.  There are two fundamental forms in which this may be provided – as equity or as debt.  The former should be reasonably familiar, in that the investor owns a share of the enterprise and accordingly participates in its success or otherwise.  For any business, but particularly a small one, there is a not insignificant risk that the investor will lose their capital.  For every successful story that we hear or read about, there will be many which sink into obscurity when they run out of cash.  Most investors therefore appreciate that owning a part of a small business is a risky proposition suited only to those who understand them and the enterprise in itself.

The other way of funding a business, which is not mutually exclusive from the first, is to borrow money from investors and then to repay them according to an agreement so that over time, they receive their original stake plus some interest to compensate them for being deprived of its use for a period.  The obvious starting point for most businesses seeking to raise money in this way is a commercial bank.  Lending money to businesses is a core activity of most banks and they are equipped to evaluate the viability of proposals made to them in order to assess the likelihood of their capital being returned.  Banks typically lend money either as an overdraft (more flexible but repayable on demand) or a loan (over a fixed period and with fixed repayments so providing greater certainty).  In both cases, the business and the bank reach an agreement between themselves as to the precise terms of the borrowing.  These are based on both the bank’s perception of the risk and the business’s needs.  Following this route requires a good credit history (which is not always available), and also collateral to secure the debt.

In some cases, the amount of capital required (or other circumstances) may make it impractical or undesirable to borrow from a bank.  There may be any number of reasons for this.  It may be, for example, that the terms available are insufficiently flexible for the borrower or because the potential lender does not see the risk/reward potential as attractive to it.  However there may be external professional investors a bank loan are willing to step in and provide suitable finance, in exchange for a suitable return.

In order to provide such investors with an exit route, and to avoid the business having to find the capital to repay them prior to the end of the loan term, companies are seeking to raise capital through this route may opt to issue bonds.  These are similar to a bank loan in that they have a fixed term and interest rate but they differ in that investment that can buy and sell them before the end of that fixed term without necessarily involving the issuing company in the transaction.

It is always worth considering whether, if an investment ‘opportunity’ is being avoided by a category of investor which does this on a full time basis, it is something in which a retail investor should really be investing.  Those who invest for a living generally possess the analytical capabilities to dig into the background of any potential deal and the experience to assess its potential to go either right or wrong.

This does not imply that professional investors always make better decisions or that the sort of assets in which they invest are necessarily those in which the rest of us should too.  As I pointed out recently, even the large US endowment funds have not seen particularly impressive long-term returns from their holdings in less widely accessible asset classes.  Still, if such a group is choosing to eschew a particular investment, there is probably a good reason for this.

One impact on the absence of institutions as potential investors is that the likelihood of an effective secondary market existing is reduced.  A secondary market is one in which investors can trade with other investors rather than having to do so with the original issuer.  A functioning secondary market is a key part of ensuring that assets are priced correctly.  It allows them to be set by the process of finding a willing buyer and willing seller for each transaction.  It also affords investors the opportunity to exit prior to the maturity date of the bond, for example should their circumstances change and they require access to the capital.  Even if a bond is theoretically tradeable, without an established secondary market an investor must find a buyer themselves, which is likely to prove difficult.

Wellesley lent to property developers working in the ‘affordable housing’ sector.  For some reason (probably related to the perceived risk/return characteristics but possibly the size of the issues), there is less interest from institutions and professional or sophisticated investors in this sector so the company targeted private (‘retail’) investors.  The route to this was issuing bonds, by which the investors would lend to Wellesley and it would then lend the funds to developers.  Those investors thus depended on both Wellesley and the developers for their future returns – they were not lending to people buying complete and habitable properties.

One of the victims was interviewed and, despite describing himself as ‘an informed investor’, had not taken advice (so has no redress route, as the bonds themselves are unregulated) and believed that he was investing in ‘bricks and mortar’.  It seems to be a relatively common fallacy to believe that lending money to a business involved in property development is somehow akin to what a building society does with a mortgage customer. The fact that there is some relationship to property in both instances does not mean that the two are equivalent.

The latter is relatively straightforward in that as long as the borrower continues to make the necessary payments, the lender will receive its return and over the typical 25-year term of a residential mortgage, it is likely that the property value will grow to exceed that of the loan.  Most lenders look relatively leniently on borrowers who are in temporary financial difficulties.  In the worst case, you when the property needs to be repossessed and sold, it is at least a habitable dwelling and therefore has a market value which would be expected to cover the majority of the outstanding loan.  However, the former entails lending to a trading company and the investor’s return will be dependent on the success of that company’s activities.  The available collateral is likely to be in the form of a building site which would require further investment of time and capital for it to be saleable at its maximum value.  There are also a considerably more variables which affect the profitability of a business than there are with an individual borrower so lending to a business should be approached in the same way as if considering purchasing shares in it.  Clearly, particularly where considering investing in smaller businesses, this implies a skill set which most retail investors do not possess.

It is fortunate that only a relatively small number of investors has been affected by this latest failure and the FCA’s ban on their marketing to retail investors should avoid any further new ones sucking in the inexperienced with a seemingly attractive offering which subsequently turns out to be less than it promised.  Hopefully there are no more existing issues that remain to blow up and inflict financial damage on people ill-equipped to weather it.  As always though, much of the damage could have been avoided by taking professional advice from a regulated adviser and hopefully that lesson will eventually be learned.