Earlier this week The Times newspaper reported that Square Pie, a start up funded via debt through Crowdcube, had folded. You can see the article online here.
The excellent James Hurley, enterprise editor of The Times, quite reasonably raised the wider issue of mini bonds - the restaurant group had raised debt via a ‘pie bond’ on the Crowdcube platform at an 8 per cent rate. In his article James observed that “there have been warnings that these returns do not fairly reflect the risks being taken since investors are effectively taking the same level of risk as any unsecured supplier. In essence, critics argue, the bonds are quasi-equity in terms of the risk they carry, without offering the chance of a significant return that shares might. Unlike more conventional bonds, the products are also “illiquid” — you can’t sell them on.”
Spot on. Let’s be honest, these bonds were venture debt pure and simple. And as I and my colleague at AltFi Data Rupert Taylor have consistently argued on these pages, these bonds have generically been mis priced (in our humble opinion). Private investors were and are being asked to take on too much enterprise risk for single digit returns. Crucially these mini bonds have proliferated, with Crowdcube far from being the only originator – in fact truth be told the crowdfunding platform has now stopped issuing them. Unfortunately though for Crowdcube, what makes the story even juicier is that when these bonds were issued they were also accompanied by a note from credit ratings agency Moody’s that suggested there was only a 0.7 per cent probability of default. You can see my colleague Ryan Weeks' note on this credit analysis from back in 2015 here.
I don’t think it’s fair to dwell on the specifics of this specific failure not least because the founders of Square Pie have self-evidently also suffered from this failure – I’m sure they’re as gutted by the dismal state of affairs as the rest of us. But my suspicion is that this is just the start of a string of future mini bond failures. As the UK economy lags behind the wider global recovery, we’ll see more and more defaults as the consumer holds fire on extra spending – blame surging inflation levels domestically.
What doesn’t help matters is that in my view, mini bonds are generally an unsuitable investment for private investors unless they offer true diversification via some pooled structure of underlying borrowers or involve a substantial business with proven P&Ls and cashflows (as in most retail bonds listed on the London Stock Exchange).
I suppose at this point I could also make some smart ass remarks about the Moody’s analysis – it doesn’t sound like 0.7 per cent was a very realistic probability of loss. But in truth Moody’s did the best they could with the limited data. And here is my main concern. If we accept that these mini bonds will continue to be sold, we need much better disclosure of the ‘real’ risks. Platforms and borrowers need to be brutally honest and transparent in their handling of the data for all mini bonds.
I currently have the sense that many issuers hide behind the obscure regulatory language demanded of them by compliance officers – and presumably the regulators. You get some sense of this with the hideously long and largely pointless documents issued by any firm looking to list a retail bond on the stock exchange. Page after page of largely meaningless gobbledegook exposes three behaviourally influenced problems:
First the kitchen sink is thrown at these documents, with vast amounts of information slammed into the documents with no real narrative for the investor to grip on to.
The cookie cutter vice. Precisely because these documents are so damned expensive to produce, law firms are tempted to borrow the same language from each other, thus making any company specific analysis nigh on impossible.
Hiding in plain sight. Because all these regulatory documents must follow the same structure, borrowers are frequently able to hide crucial distinctions and complications in the small print.
What stands true for these listing documents also holds true for many private placements of debt. Issuers frequently obfuscate and complicate and hide behind their regulations, making the task of insightful analysis almost impossible except for the trained professional.
To be fair some online platforms do try their best to overcome these challenges – thus the Moody's analysis which accompanied the Square Pie issue. But this exposes another problem. How can anyone make any reliable estimates about the future trading potential for a young firm? Credit ratings agencies will valiantly argue that they can generalise from sectors as well make meaningful conclusions from peer group analysis, but I don’t believe them. Every young business is utterly unique and frankly the temptation to game numbers is overwhelming – to be clear I don’t think lots of young businesses lie, its just that they underestimate the risks and over estimate the opportunities.
To be fair, I also think that most private investors are also far from being idiots. I suspect that they take all these verbose reports and incredibly detailed projections with a lorry load of salt. But I also think they are starved of valuable information. I’d offer up three simple suggestions for improved disclosure.
When venture debt at 8 per cent is issued for instance, how does this level of yield compare with other forms of fixed income? How much would I, as an investor, receive from other forms of high risk corporate lending? Where are the tables comparing this form of internet enabled venture debt with direct lending, mid-market secured loans, high yield credit and other forms of alternative credit? If investors were provided with this comparative data they could then sensibly compare venture debt yields with other forms of debt. I also think they’d rapidly discover that 8 per cent represents only a very a small premium for lashings of extra risk.
Next up, which issuer has bothered to provide its potential lenders with generic industry by industry, and age cohort default and bankruptcy data? The big SME credit ratings agencies have copious amounts of data which tells us very clearly the risk of default for say a restaurant group, under 5 years old. Why can’t this generic top level data be shared with potential lenders so they can make an informed choice?
Lastly, investors are usually spoon-fed company specific data on a pro forma, year by year basis. Why can’t investors see historic month by month revenue and cash sales data? I’m not arguing that it will be especially revelatory, but it would give investors a more dynamic sense of the growth of the firm over time?
Crucially I think a smart lending platform might present all this comparative info in the opening preamble of a placement note or presentation – preferably in a nice easy to understand table highlighting the risks.
Cynics might argue that precisely because SME lending is so risky, these snippets of data will scare off investors – if that is the case maybe platforms and borrowers might think of improving the terms? If venture debt really is risky (which it is), why not cut borrowers into the equity upside as well as paying out a yield? Only a few issuers have had the courage so far to consider convertible like structures but in truth many of these mini bonds look and feel much closer to hybrid equity structures – without the upside. Better to be honest and embrace the convertible? If only the regulators agreed.
