||High yields: A review of companies in the Fincorp space
By Scott Francis
|PORTFOLIO POINT: Investors tempted by promises of high returns should remember they can be riddled with risk.|
How can we avoid another Fincorp? More to the point, how can investors sidestep the sort of stress and financial loss thousands are now facing with the $150 million collapse of another so-called property investment company?
When Westpoint collapsed last year much of the finger pointing was done at financial planners who had been lured by high commissions. This time financial planners don't seem to be the culprits; in Fincorp's case aggressive advertising has cut out financial planners able to be swayed by high commissions, and targeted consumers directly.
It is worth pausing and thinking about the economic conditions surrounding these two collapses. Economic growth is strong, property markets - while not as spectacular as a few years ago - are solid, unemployment is low, inflation is steady and interest rates are moderate. These are good economic times, and yet we have two significant collapses that have destroyed the retirement prospects of about 12,000 Australians.
The collateral damage of these collapses is spreading, yet they can be avoided.
Here's a two-point guide you should follow if you're ever tempted by funds offering high-yielding debentures, unsecured notes, promissory notes or high yielding mortgage funds - or any combination from those four investment categories.
1. These investments should not be a core part of your portfolio; they fit among "alternate assets" and might make up a maximum of 5-10% of a portfolio.
2. Investing in mortgages related to property construction is RISKY. Risks include both the construction risks and the marketing risk of actually selling the property.
If the mortgages securing such an investment fail, it is almost certain your investment will fail. Ignore such grandiose statements as "secured against real property" or "secured against the assets of the company". If the mortgages fail, your investment will fail.
But to really avoid the worst excesses in this area you have to first understand what's under the bonnet when it comes to many high-yield funds.
The absence of financial advisers (so far) from the Fincorp scandal revealed another danger. With many high-yield schemes that use cleverly designed targeted marketing, investors are very much on their own. In the case of Fincorp, a substantial number of investors were listeners to one single radio station in Sydney: 2GB.
Moreover, a worrying dimension of the Fincorp collapse is that even investors who took the time to read the details of the company prospectus (the group's key sales document) were duped. One investor who recently wrote to Eureka Report extracted the single clause in the prospectus that convinced him his money was safe.
3.12 Security for First Ranking Note Holders
The Company has charged all of its assets in favour of the Trustee to secure the punctual payment of all monies due to the holders of the First Ranking Notes. The Charge is a first ranking charge and currently there are no securities or other liabilities ranking in priority to or equally with this Charge.
On first reading almost any investor might take the clause above to imply the money was secure. But the investor was unaware that:
The assets of the company were not the actual properties themselves; they existed in another company. The assets of the company were the loans themselves.
Where it says that "currently there are no securities . ranking in priority to or equally with this charge", the word currently clearly had a temporary meaning.
Overall, the combination of fine print and slick marketing at Fincorp created a perception that investments were secured by real property, not just property loans. However, the reality is that most lending was simply for second mortgages, which are lower quality than first mortgages. What's more, Fincorp's method of paying regular interest payments, structured like bank account investments but with higher interest rates, hid the real investment risk
How can investors read the sales documents from an investment company. City Pacific is a mortgage company that has nothing to do with Fincorp or Westpoint, but it has come to the attention of the chief market regulator, the Australian Securities & Investments Commission (ASIC).
In 2005, ASIC challenged the claims that City Pacific had made about investors' ability to withdraw money. City Pacific had described accounts as being "at call", whereas they actually required a 90-day redemption period and were never "at call" as represented.
City Pacific has moved on since that intervention by the regulatory authorities. The company's current prospectus reveals a string of factors that have been central to the problems eventually faced by high-yield companies in the recent past.
Related Party Loans. The prospectus shows that 19% of the fund assets are loaned to related parties. This, in my mind, is a significant conflict of interest. How can you say to investors that you are getting them a fair rate of interest when you are lending to related parties?
Fees. City Pacific is able to charge fees of up to 3.65% of the gross assets of the mortgage trust. This is potentially twice the fee of the average managed fund, and I would argue that their fees are too high.
Capitalisation of Interest. This has been a significant problem in the high-yield sector. Interest is not paid back on the loan but capitalised (added back to the loan). City Pacific has 90% of the loans where interest is capitalised (page 9 of the PDS). Most City Pacific loans are medium-term - up to 18 months - which mitigates some of this risk.
Higher Ranking Lenders. City Pacific has an arrangement with a bank to borrow funds on behalf of the mortgage trust. This bank has a higher claim on the assets and income of the trust than the mortgage investors (page 8 of PDS).
Lending for Property Construction. It is one thing to lend money against an existing property with a reasonably well known value and rental income. It is entirely a different thing to lend money against a property that has yet to be constructed, with the cost risk of both building the property and then the marketing risks of selling it or renting it. More than 70% of City Pacific's lending is for property construction or development (page 9 of PDS).
City Pacific has not had trouble from ASIC since the intervention two years ago.
Undisputed warnings - stop orders
Three other companies that have received at least one stop order from ASIC over the past three years are:
Australian Capital Reserve.
Hargraves Secured Investments.
Victorian Finance and Leasing.
There is no suggestion that these companies are currently facing new problems with ASIC.
Separately, there is an interesting group of high-yield companies that do not have a history of entanglement with ASIC.
However, I have examined the prospectus of each of the following companies and found issues that would stop me from recommending them to any of my own clients.
The catchline in the G2 finance marketing campaign says: "Offering 11.50% pa return on secured debentures".
But what is the money used for? Lending for consumer debt.
The key risk? This is a relatively new company. Lending for consumer debt is lending against assets that depreciate in value (such as televisions and whitegoods). The company made a loss of about $47,000 for the year to March 2006 (although some of this was establishments costs).
Fees. Interest rates are quoted net of fees; that is, investors get paid 11.50%; the fees are what is left over.
So what is a fair price for the risk an investor is taking in a company such as G2Finance dealing in the low-quality end of the debt market?
Credit card debt (largely consumer debt) often runs at 16% and many "store specific" consumer debt has high rates of interest, often more than 20%.
The key line in the Asset Loans promotional material is "Earn 11% pa, 3 year term".
The large print tells us the product is "secured by a first-ranking fixed and floating charge .". The small print mentions "unsecured notes".
So what is the money used for? On page 2 of the most recent AGM presentation, the company itself describes the business as "Fast Short Term Finance Secured by Property".
Asset Loans receives 2.5-6% interest a month; 2.5% interest equates to more than 25% a year (at the bottom end of the range) but unsecured note holders only get 11%. Working on Alan Kohler's Rule of Risk and Return, they should be getting at least 18% for the risk they are taking.
AuSec: Australian Secured Investments Limited
Here the catchline is "Earn 9.25% pa. Security, Flexibility, Fixed Rates and Zero Fees".
The advertisement mentions "Zero Fees" but in reality the company pays investors their return, while lending the money out at nearly double the rate and keeping the difference.
According to the Product Disclosure Statement, the key purpose of the borrowing is lending to small and medium-size businesses secured against property.
Reading the PDS it is interesting to note that: 11.5% of the loans are in arrears by more than 90 days and 50% of the underlying property security is vacant land
The average loan interest rate was 17.48% (2006). This is almost twice what investors receive
First Capital Securities
The key words in the First Capital marketing campaign are "Earn 9.95% for 3 Years"
According to the promotional material: "First Capital has successfully established itself as a national financing company since commencing operations in February 2005".
This is very much an aggressive property development lending fund. It has the capacity to lend against both first and second mortgages (and other security). For second mortgages, read mezzanine finance - also known as "top up" finance.
According to the prospectus, most of the loans are second mortgage/mezzanine finance loans. More than 40% are for construction and development. Capitalising of interest "generally" applies to construction and development loans.
The documentation also reveals there is the capacity for related-party loans.
Eureka Report editor James Kirby made the point in the Sunday Age last weekend that even if these high-yield investments worked, they are not worth the risk. I want to make the same point in a different way. The following table shows the growth in income from a $10,000 investment in ASX200 Australian Shares Index (from www.rba.gov.au).
The income starts at $540 in the first year and grows over time, so that 25 years later the $10,000 investment is now producing $4530 of annual income. Contrast that with a $10,000 unsecured note investment, which would still be paying $1100 of income (assuming an 11% yield).
Now think of the value of that investment. The unsecured note would still be valued at $10,000 after 25 years; the share portfolio will now be valued at $120,000. (NB: this is with all income being spent each year; it does not rely on income being reinvested). The graph below illustrates this comparison.
I can't find any space for any high-yielding debenture/mortgage trust/unsecured note investments in my portfolio or those of my clients. And I can't see that changing any time soon.
Scott Francis is a qualified financial adviser and a regular contributor to Eureka Report.