By Rupert Taylor on Friday 17 October 2014
When the world of alternative finance was broken down into the relatively simple distinctions of ‘equity crowdfunding’ and ‘peer to peer lending’ there was already a bewildering array of investments available. But at least it was easy to recognize the difference between a crowdfunded equity investment and a peer to peer loan. However the water has been muddied significantly by the arrival of hybrid instruments that are now being issued by crowdfunding platforms. The most obvious of these are the ‘mini-bonds’. Whilst these instruments may have their merits – which I am happy to allow the platforms themselves to articulate - I think it is worth emphasizing what they are not:
1 – They are not necessarily safer than equity
If a Start-up Company has recently launched a successful crowdfunded equity raise, that doesn’t necessarily put it in a position to be ready to issue debt. Effectively, with respect to a start up or young SME, debt is just as risky as equity. In fact arguably more so as by adding an interest payment obligation there are now even more claims on stretched cash flows. In other words there is a good reason why ‘venture’ capital is usually equity – because young companies are not ready to take on debt. Venture debt sounds like a mis-nomer because it would just be a bad idea.
2 – Equity offers capital appreciation. Debt does not. Effectively the prospect of capital appreciation is the compensation the equity holder gets for taking extra risk. The debt of a start up could be just as risky as equity but without offering any capital appreciation as compensation. With an un-secured loan the investor could lose everything and so is in effect taking just as much risk as the equity investor. However for the debt investor the potential return is no more than the annual coupon. Essentially the investor in the debt of a start-up is not being compensated with the possibility of capital growth for the significant risk that they are taking.
It is perhaps simplest to recognize the differences by comparing two recent offerings. Whilst optically similar they are in fact incredibly different.
Second we have a first charge mortgage loan secured against student accommodation in Camden, Central London, listed on LendInvest. This is a 12 month secured, non-convertible, non-transferable bond, paying a monthly coupon of 0.667% amounting to 8% p.a.
The Chilango mini-bond has been a huge success. With a target of raising £1,000,000 they in fact raised over £2,100,000. Chilango is an excellent story. It is a restaurant chain that has clearly created an impressive buzz with both customers and investors, and fresh from an equity raise they launched the mini-bond. The story seems typical of an equity raise for an ambitious young business. They have proven a concept and after a subtle change in direction to target the format to the most appropriate locations, are now raising capital for an aggressive rollout of new restaurants. The accompanying documents provide a certain amount of financial data albeit up to September 2013, for a bond launched in June 2014. There is some information on current trading up to March 2014 but without much detail. This accompanying data shows that the business is indeed growing but without the detail of the last 6 months it is very hard to make any confident forecasts and none are provided by the company.
None of this is totally unreasonable for a risky equity offering. But to support a loan this seems surprising. Clearly there could be significant upside if the restaurant can be made to work in multiple locations and economies of scale kick in. And to compensate the equity investor for the risk that it could all go wrong there is the prospect of capital appreciation.
The mini-bond in question is effectively a 4 year loan. Without the prospect of significant capital appreciation the investor needs to be confident that as well as his 8% coupon he will get his principal re-paid. And given that there is no security behind this at all (not even a personal guarantee) you would imagine an investor might require the ability to perform an in depth analysis on the prospects of the company. Essentially I am being asked to take a view on two things here:
If I had to take a strong view on these my objective answers would be:
My uncertainty in answering these two questions highlights my inability to have a high conviction view as to the likelihood of success for Chilangos. This would suggest that compensation of just 8% p.a. for a highly speculative bet in which I could lose everything is insufficient to make this an attractive proposition. Equity at the right price could be interesting but ‘venture debt’ seems un-attractive.
LendInvest’s loan doesn’t have much of a story to tell. It doesn’t even offer me free burritos if I invest. Incidentally Chillangos do offer investors free burritos – and if I could model their sales with any confidence I would wonder how many I should assume that they will be giving away to investors - thereby foregoing precious revenue!
In fact, LendInvest’s loan looks incredibly boring. Indeed, it looks like a loan. Like the Chilangos mini-bond I can only get re-paid my principal and the interest. However the likelihood of this not happening seems low given the presence of significant security. Not only is the loan backed by a first charge mortgage, but there is also a personal guarantee by the company directors. The loan has a 70% LTV against an asset that was valued in April of this year. So whilst this is tranche B of a much larger loan, the property would have to fall in value by 30%, for the capital to be at risk. And with a 12 month term, property prices would have to go sour fast. And the directors of the development company would also have to be willing to destroy their personal credit records for it to default. As such, given the reduced risk that I lose my principal, 8% seems like adequate compensation for the modest risk that I would take.
So whilst these instruments have some similarities – principally that they both offer an annual return of 8% - they are in fact remarkably different. As an investor I like to be compensated for taking risk. The burrito bond offers me none of the upside of the undeniably exciting Chilangos story, but it does involve significant risk. The LendInvest loan offers me the same return and with significant assurance that I am taking less risk. So whilst I am huge supporter of the innovation being delivered by Alternative Finance, for now I am going to avoid mini-bonds and stick to loans that are boring and that look like loans.