By: Craig Skauge
19.5% INTEREST PER ANNUM GUARANTEED
Given our current interest rate environment, it is hard to believe that those words were once both true and advertised by our very own government. Between November 1981 and October 1982 Canada Savings Bonds (CSBs) paid savers 19.5% interest per annum, a rate clearly in contrast to the paltry 0.5% paid today. While today’s historically low interest rates may present an unprecedented opportunity to borrow, they contrarily do little, if anything, to encourage savings.
In light of this, many Canadians, including those who historically just kept their money under a mattress, are in search of investment and savings alternatives….alternatives with yield. This environment presents an exciting opportunity for participants in the Exempt Market; be they Exempt Market Dealers (EMDs), Dealing Representatives (DRs), or prospective Investors. But like all opportunities, this unique environment comes with challenges that require everyone’s eyes to remain wide open.
There is no question that yield is in vogue these days. Investors are so desperate to earn an acceptable return, and maybe even catch up on missed earnings, that they may ignore even the most obvious warning signs of an unstable deal if a high enough coupon is thrown at them. While Investors should be asking a lot of questions about the underlying yield they are being offered, it will likely be up to both EMDs and DRs to pose tough questions, like the following, to Issuers and establish tight criteria when searching for a yield product where client’s funds may ultimately arrive.
WHERE IS THE YIELD COMING FROM ?
It is all fine and well for an Issuer to say they are offering investors debt securities carrying interest rates of 7%, 10%, 12%, or even more, per annum but the underlying number is only an obligation, not a guarantee. All parties looking at the Issuer’s securities need to ask where the cash flow to sustain the debt yield is coming from and if there will be enough cash flow to meet the interest obligations in both good times and bad.
If an Issuer’s business does not cash flow, but still offers regular interest payments to Investors, such as a real estate development deal, it is not necessarily a scam but it needs to be given a different level of scrutiny. Prospective Investors, DRs, and EMDs alike need to ask whether interest payments are being serviced from external or internal cash reserves. If they are being paid from an external party, as is sometimes the case, then it may well be a deal worth considering but if subscribers are ultimately being paid back with their own money, it is just another house of cards waiting to collapse.
In the case of ‘blind pool’ offerings, establishing what sustainable cash flow and investor payments are is extremely challenging, if not impossible as there are only theoretical cash flowing assets being acquired, nothing material that can be analyzed. Interested parties should heavily scrutinize a ‘cash flowing’ deal in which there is not a target asset yet identified.
CAN YOU REALLY AFFORD TO PAY THIS MUCH ?
The Exempt Market is competitive…there is no question about that. I regularly hear from Issuers about how difficult it is to get on an EMD’s product shelf even though they have what they deem to be a solid product. Without capital, business does not happen. Knowing this, some Issuers have become very ‘flexible’ with the terms of the securities they are offering in order to get on a shelf, but at a point flexibility may jeopardize both their business and investor’s principal.
While EMDs and DRs should continue to want the best for their clients, including the greatest returns possible, today’s sale should not be at the potential cost of a client’s principal and accordingly the relationship. While we have all seen some pretty juicy yields being not only possible but paid as promised (with principal returned), more often than not products that pay euphoric yields are ill conceived and bound to inevitably fail. Good ones are certainly out there but they need to be scrutinized to the highest level when they sound too good to be true.
Commissions, fees, and taxes should also not be overlooked when considering what interest-bearing product to sell. Assuming an Issuer is selling a debt security such as a bond or debenture and the Issuer itself is covering the commissions, the business will need to generate cash flows in excess of the promoted yield in order to make the payments. If an Issuer has costs and commissions of 15%, they will only have $0.85 of every dollar to work with. Obvious right? But if we extend that thinking you need to question not only how the Issuer will make up the 15% short fall (as they will still owe Investors $1.00 for every $1.00 invested at the end of the term) but how they will be able to generate the fully promised yield with only 85% of the money. For interest bearing securities that are not debt, such as a preferred share, the enterprise will need to generate returns far in excess of the promised yield as Investors are paid with after tax dollars instead of pre-tax as they are with a debt security. Will the Issuer really have enough money after taxes to service investor obligations and leave something for themselves (which is why they are doing proceeding with the offering in the first place)?
WHAT IF THINGS GO WRONG ?
While failure is not something that anyone likes to discuss, all investments need to be sold with knowledge about where everyone stands if things do not go as planned. As I said above, today’s sale should not be at the cost of tomorrow. While these times may make it easy to sell high-yielding products to prospective clients, EMDs and DRs would be well served to look at products with principal protection as their fundamental goal with a yield being secondary. An Issuer’s answer to the following should help provide some clarification on the differences between those products you want to sell and the ones you should avoid.
- Who cleans things up ?
If an Issuer misses an interest payment or return of capital on maturity, whose in charge of sorting things out? Is it the Directors and Officers of the Issuer? If so, will they handle things prudently, or steer the deal into receivership? If Investors need to contact each other to decide a plan of action, will they be able to do so if the offering was sold by multiple EMDs? Many EMDs are starting to demand a formal trust indenture be implemented in such debt deals as the trustee allows for Investors to organize and act as they see fit without the chaos seen in many past deals.
- Just how are Investor’s funds secured ?
There are many types of security available on debt offerings but not all are created equal and not all are tied directly to Investors. In some cases a mortgage may be appropriate whereas in others a general security agreement or other charge may make sense. It is imperative to make sure that the right kind of security is in place given the type of underlying asset be it real estate, receivables, automobiles, or otherwise. Selling parties are also cautioned to verify whether the security is registered just on behalf of the Issuer (if the Issuer itself is a lender) or actually registered on behalf of individual Investors. While there is an idea that an Issuer’s security on a deal ‘flows through’ to Investors, an Investor’s legal entitlements are quite different if they are directly registered as opposed to just an unsecured creditor of a secured lender. This is another case where a trust indenture may be helpful.
- Just how secured are Investor funds ?
Debt offerings in the Exempt Market are different as night and day from one to the next. In some, Investors are the only creditors of the underlying business and in others there are external creditors that may rank in priority or subordinate to Investors. This is where the loan to value (LTV) and position of investor funds comes into play. LTV speaks to how much money is borrowed by a company relative to the value of their assets. By their nature, Exempt Market offerings often have very high LTV ratios sometimes encroaching 100% (meaning that there is effectively no equity in a deal). The lower the ratio, the more secure Investor’s funds theoretically are, however readers are cautioned to thoroughly review how the underlying ‘value’ was arrived at. If the ‘value’ is somewhat generous, the LTV ratio has little meaning. Investor position is just as important as external creditors whose security ranks in priority to Investor funds may seize the assets in the event of a default and they will get paid first, often only leaving crumbs, if anything to secondary creditors. Lastly, part of the security factor relates to the liquidity of the underlying asset. If an offering falters and Investors realize on their security and seize the underlying assets, they’re not out of the woods yet. Those assets will need to be sold to pay back Investors and depending on their nature, they may prove to be nearly as illiquid as Exempt Market securities themselves, leaving Investors with little option but to ‘fire sale’ them, meaning the theorized value will not ever be realized.
While my crystal ball works no better than anyone else’s, it does not appear to me that the low interest rate environment we find ourselves in will drastically change anytime soon. Given that, inquiries from Investors about yield products in the Exempt Market will only increase and accordingly so should our industry’s sophistication and expectations about the types of products we offer to ensure only the highest quality ones have a home here.