By Rupert Taylor on Tuesday 26 January 2016
There is nothing wrong with mini-bonds in theory. In fact they could prove to be perfectly designed to satisfy a yawning gap in the investment landscape. At present opportunities for the retail investor to access corporate bonds are limited. Most of the corporate bond market has minimum investment requirements that are beyond the reach of retail investors. Retail bonds were designed to fill this gap, but issuance remains small, and both the number of issuers, and average issue sizes have been falling in the past couple of years. Against this backdrop, a combination of the search for yield by retail investors coupled with the reluctance of the banks to lend to SMEs has created the perfect environment for the arrival of mini-bonds. As a result the world of alternative finance, online lending, crowdfunding – call it what you like – has a fine opportunity to usefully satisfy a need of both investors and SMEs.
All of this makes for what is, in theory, an exciting financial innovation. The problem comes when we identify how mini-bonds are being used in practice. The practical reality is that the un-met need for a retail SME credit investment product offering yield has joined up with the enthusiasm of ‘the crowd’ and created a setting that is ripe for abuse. Effectively the combination of need and excitement is so great that the crowd is not sufficiently discerning. In fact the crowd is buying crap.
Any investment should offer a sensible trade off between risk and return. To ensure that this is the case a prospective investor should demand sufficient information to allow for the appraisal of the risk. In a perfect world an investment would only be made if the return on offer was sufficient to compensate for expected risks. In theory the Internet should be the perfect medium to allow information to be presented in such a way that the crowd is able to reach an informed decision. The problem with any theory however is that the reality can be quite different. And the reality that I observe at present is that the crowd is investing in mini-bonds in the absence of sufficient information to allow for an adequate appraisal of risk to be made. As a result investors are accepting a level of return that is woefully inadequate to compensate for the risk that they are taking.
But the reckless approach of the crowd is not the only issue at play here. Mini-bonds are clearly targeted at the retail investor. As such there are other actors in the process who should all recognize some responsibility. Whilst ‘caveat emptor’ has to play a role in many areas of finance, added protections are required when the retail investor is involved. In this instance, the regulator, the platforms, and the issuers themselves should all be giving careful thought to what is going on here.
So, what exactly is going on? In short the crowd is offering ridiculously generous funding rates. And the unfortunate quid pro quo of this is that the crowd’s investment returns are likely to be very poor. A number of recent mini-bond issues would make for respectable equity offerings, assuming a sensible valuation. In effect the risk profile is conducive to an equity investment but not to a loan. This reflects the extremely high risk nature of the proposal in question, which should be compensated with the possibility of significant capital appreciation, which a ‘bond’ can never provide. Some examples:
Pocket Land Bond
Since AltFi Investor covered Pocket Land in a rather damning ‘Bondwatch’, the terms of their mini-bond bond have improved. Marginally. The bond was not on track to fund within the set time horizon but the window has now been extended and the coupon has increased from 7.5% to 10%. However this mini-bond is un-secured and structurally sub-ordinate to as much as £76.4m of secured loans. To any experienced property market observer this loan looks and feels like it should be equity, i.e. the riskiest piece of the funding structure which is either funded as a very high coupon loan, or more likely as equity that shares in any capital appreciation.
The Burrito Bond
Back in late spring 2015, Mexican fast food chain Chilango followed a £3.4m crowd funded equity raise with the issue of just over £2m worth of 'burrito bond’. The loan is unsecured and was underpinned by minimal financial disclosures that were insufficient to allow for any meaningful analysis of risk. The accompanying documents provided some limited financial data up to September 2013, for a bond launched in June 2014, together with a small amount of information on current trading up to March 2014. However there were no projections and insufficient data on which to build a meaningful model. But perhaps most telling is the recent equity raise. By following their equity raise with such a low yielding unsecured debt instrument the crowd seemingly allowed them to invent an entirely new, but not entirely welcome, asset class – Venture debt.
Since July 2014 Wellesley has raised £25m through a mini-bond and has recently launched a second series targeting up to a further £50m. Yielding 7, 7.5 or 8% depending on the choice of a 5, 6 or 7 year term, the bond is not secured. Proceeds may be lent on the platform but will be subordinate to on-platform lenders. The bond is in fact a loan to Wellesley Finance PLC against which almost no financial information is provided.
All of these loans will hopefully be repaid. In all cases there is a plausible scenario that allows the companies to develop to plan and honour the advertised coupon and repay the principal at the end of the term. However in all cases the coupon alone is very small compensation for the high risk that is being taken. Effectively these instruments all offer an asymmetric return profile. If things go swimmingly the investor will receive their coupon and eventual repayment of principal. If things go badly the investor could lose everything. In all cases equity would have seemed to be a more appropriate instrument. In all of these cases the absence of any security results in the risk of a significant loss in a bad scenario, i.e. all of the principal could be lost. This would also be the case if the investment had been structured as equity. However in a good scenario equity would be by far preferable. This is because equity would allow participation in any capital appreciation if things went well. Effectively the mini-bond investor is risking everything to make 7-10% per annum. An equity investor would also be risking everything but with the compensation of a share in any capital appreciation if things went well – one would hope allowing a possible payoff amounting to some multiple of the initial stake.
So what is the solution? The most fundamental protection that is missing from any nascent asset class, particularly alternative finance, is price discovery. Without liquid markets and quoted peers it is hard to identify what a prevailing price for a comparable asset might be. Clearly the prevailing price might not be a sensible price but at least it is a start. For example, if the crowd knew that the riskiest tranche of property development finance would normally be structured as equity, or as extremely high coupon debt, would they fund Pocket at 10%? Would the crowd be interested to know that a Private Equity or Venture Capital investor would require significantly more disclosure from either Chilango or Wellesley before investing, and that any capital provided would require the promise of equity participation in any upside to compensate for the absence of security?
In the absence of a quoted market, price discovery is going to remain a challenge. In such circumstances you would expect the market to police itself. For a durable market to evolve both investor and issuer need to return time and time again. But if one group feels hard done by, longevity becomes unlikely. As such the platforms should be motivated to arm the investor with sufficient disclosure in order to allow them to arrive at a more enlightened investment decision. This disclosure should cover the financials, and any other relevant details relating to the issuing entity – P&L, cashflow, balance sheet, management forecasts, and future projections. At present this is notably absent. But the platforms also need to recognise that disclosure relating to the success of past campaigns is equally important. The investor needs to be reassured that the platform has identified sensible opportunities in the past. Finally the platforms should attempt to develop some sort of bidding process to allow the crowd to arrive at a fair required return – in this case the coupon. In an ideal world this could be set with the some use of a link to a market price, or with the assistance of the perspective of a professional investor.
At present there is a suspicion that, in many cases, mini-bonds are positioned to prey on the naivety of the retail investor to whom the word ‘bond’ seems to bring a level of comfort and a mistaken perception of reduced risk. At present they are entering into investments that involve equity type risk for only a bond like payoff. If this asymmetry remains commonplace then the regulator should step in.