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Education - Finance Companies

If you are considering investing in a finance company you should have a look at the following articles as a start. They give you a background on the sector and then list a series of guidelines for considering these investments.

22 August 2006

News release

Finance companies - an option for investors who understand the risk

Jane Diplock, Chairman, Securities Commission

Finance companies are a relatively small part of the New Zealand investment market. Households have $7.5 billion invested in finance companies. This compares with $60 billion invested in registered banks, according to the Reserve Bank of New Zealand Financial Stability Report of May 2006.

Finance companies take in money from investors and lend money out for various ventures. People who borrow from finance companies cannot borrow money at cheaper rates from a bank because they don't meet the bank's credit criteria.

Consequently there is a significantly higher risk of the repayments falling behind or stopping altogether, and there is a risk that the finance company won't have the money to repay investors.

Currently, investing $5,000 in a registered bank for a year gives a return of about 6%. Investing the same money in a finance company for the same term returns about 3% above the bank rate. That difference might seem small in percentage terms, but it may not be representative of the higher risk an investor takes with a finance company. People should realise that an extra 3% return is a 50% increase in interest and so must represent at least a 50% increase in risk.

Investments with finance companies are generally for a fixed term. Usually this means that investors can't withdraw their money until the end of the term even if the company's financial position deteriorates. If they can cash in the investment early they will probably have to pay a penalty.

The governance of a finance company is very important and the skills and track records of its directors and managers, particularly their skills and experience in pricing risk and financial management.

Before accepting money from an investor, the law requires a finance company to disclose certain information about itself in a prospectus and an investment statement. It is very important for a potential investor to read these.

These documents must be accurate when they are prepared. If things change for the worse while the investment is being advertised, and the change makes the documents inaccurate or misleading, the finance company must stop the offer until they have been corrected.

The prospectus must contain the most recent audited financial statements of the company. If it is 9 months since the date of those statements, interim financial statements must be provided together with a certificate from the directors stating that there have been no adverse changes and the prospectus is still accurate.

If you don't understand the information in the finance company's investment statement or prospectus, you should ask an investment adviser, financial planner, broker, lawyer or accountant to explain them.

You should be especially clear about who the finance company is lending money to, and how well the repayments are going. This is why it is so important for investors and their advisers to read a prospectus.

The Securities Commission does not have a prudential regulatory role over finance companies - it cannot step in to stop a finance company failing, or take action against a finance company that fails, or help investors recover their money.

The Commission's job is to intervene only if a finance company does not provide the required information for investors to make a decision on whether or not to invest.

If the investment statement, prospectus or advertising is not up to standard the Commission can require the finance company to correct the information. If necessary the Commission can take the offer off the market until any breaches are remedied. Once the offer is stopped, the Commission's role ceases.

A finance company must have a trustee to look after the interests of investors. The trustee must be approved by the Commission or be established by Act of Parliament. The trustee's duties and powers are set out in the trust deed.

The trustee oversees the situation if a finance company is in trouble, and appoints a receiver if necessary.

The receiver's job is to recover as much money as possible for investors and other creditors, including through legal action. The trustee must advise the Registrar of Companies who has information-gathering powers and can lay criminal charges if appropriate.

With their higher rate of return than a registered bank, well-managed finance companies are still an investment option for mum and dad investors to consider.

But they must always understand the risks they take with their money. This includes assessing whether the promised return is high enough for the risk they are taking.

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http://www.seccom.govt.nz/new/releases/2006/240806.shtml 

The above article is from the securities commission website, it gives a good background to finance companies and the role of the commission and law governing the industry. It's a good start before reading through the following two articles that give excellent advice for anyone looking to invest in these companies.

Finance investments: 10 things to check

Bridgecorp is the latest example of the investment rule: buyer beware. In December of 2006, Rob Stock offered 10 tips on what to look for when investing in finance company debentures.

Investors in finance company debentures should become amateur sleuths or enlist expert help in tracking down the best rates for the lowest risk.

Just like Sherlock Holmes, they should amass the evidence they need to help them draw elementary conclusions about who to entrust their life savings to, rather than judging companies on brand and the interest rates printed in newspapers.

The clues to the best investments are there to be found, but only if investors are willing to put in a little effort to gather them. Depending on who you talk to, New Zealand investors are either a savvy bunch of Poirots, or a crowd of Inspector Clouseaus.

Many finance company bosses say investors are careful when they choose who to invest with.

But Ron Keene of Rapid Ratings, which has decided to stop providing credit ratings for finance companies, speaks of a nation of investors aware of the risks they are taking, but preferring to ignore them. So how do investors cut through finance company advertising - which cheerfully assures investors how safe their investments are - and decide where to invest their savings?

The Sunday Star-Times has spoken to experts and compiled a list of 10 lines of investigation for careful investors. But be warned, there is no smoking gun, no killer indicator of a good or bad company, says David Chaston of interest rate comparison website interest.co.nz. Instead, investors must build a rounded picture of firms they are considering.

Ratings: The easiest way to get a view on the stability of a finance company is to look at its credit rating. Standard & Poor's rates Geneva Finance and UDC, and Rapid Ratings has ratings on Strategic Finance, Bridgecorp, St Lawrence Mortgages and Instant Finance, although those will come to an end in the next 12 months. Companies rated by Standard & Poor's are considered to have safe "investment grade" rankings. UDC is rated AA- and Geneva B+. Ratings can be cross-referenced with interest rates. UDC pays $5000 investors 7.1% for 12 months. Geneva pays 9.2%.

Size: Go for a biggie. Size is one indicator of stability - though not a perfect one. Investors should demand a premium on interest rates to invest with one of the rats and mice of the finance company market. Why settle for 8.5% from a finance company run by one man and his dog over the garage when you can get the same from a $200 million-plus operation?

Founding date: A company founded 20 or even 10 years ago is much easier to trust than one founded last year to cash in on the boom in lending. Let Johnny-come-lately earn his stripes before you entrust him with your money.

Interest rates: The higher the rate you are offered, the more risky the investment, right? Not necessarily. Some high-risk finance companies pay far less to investors than they should. Chaston suggests investors look at the average rate at which finance companies lend to their borrowers. For example, Dominion Finance lends at 14.3%, and pays debenture investors 8.5%, and Instant Finance lends at 29.3% and pays investors 8.25%.

Who is getting a better risk/return? The data is available for free.

Who they lend to: Some finance companies lend your money to help businesses grow, others to help people buy stereos or cars. Some lend to property developers, some to a mixture of all these. Some loans are riskier than others. Some lending is secured against real assets, some debt is not. The more you know about who finance companies are lending to, the more forewarned you are. Finance company prospectuses help here. The more you know, the easier it will be to diversify your portfolio.

Gearing: All finance companies are leveraged. They borrow money to lend, and tend to have little shareholder capital. Should the worst happen and a finance company goes bust, the first investors to lose their money are the shareholders. Then come the debenture holders (in some cases the banks take precedence over them). The more there is in shareholder funds, the bigger the loss the company would have to make before debenture investors feel the pain. Again, www.interest.co.nz can help with research. High gearing levels aren't necessarily bad, but can be an indicator of a higher risk and investors should demand a premium for investing in a company whose shareholders have little of their own cash at risk.

Free advice: Some websites, such as Bondwatch and the site of Sunday Star-Times columnist and New Plymouth financial planner Peter Hensley, provide ratings on stocks which investors can use to help them make decisions.

Management: Spend a little time to look up the finance companies, and their bosses, on the internet. Look for stories from newspapers which could indicate something fishy is going on.

Get a guarantee: Some companies, such as Capital & Merchant, offer insurance-backed debenture investments which reduce the risk of debts going bad.

Profitability: Look for a history of profitability. Companies that do not make much money do not last long. If you are investing for three years, you want to see at least three profitable years. Past performance is no guarantee of future performance, but it is one indicator. Just ask Crusaders supporters.

http://www.stuff.co.nz/sundaystartimes/4118530a22981.html 

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The above article on the back of the bridgecorp failure points out 10 areas to check before making an investment in a finance company. It is similar to the article below that's also very helpful.

How to pick a finance company

In the wake of Bridgecorp's $700 million collapse, Duncan Cotterill investment adviser Ian Dalley reviews your checklist for picking finance company securities.

There's a cliche that "it's the return of your money, not the return on your money", which is important.

As far as finance company securities are concerned, that has surely never been more true. And investors are understandably wary.

According to a recent survey, there are 86 finance and banking institutions operating in New Zealand. Better make that 85 after the $700 million Bridgecorp group was put into receivership.

With so many choices, how does anyone decide? Most investors simply decide on the basis of the interest rate quoted. Clearly, this is not the best way to choose a finance company, or indeed, any investment.

Here are some basic pointers on how you should approach your decision.

Your first principle – never have all your money with one institution.
A balanced investment portfolio might have between 40 and 60 per cent allocated to fixed-interest investments – bonds, debentures and bank term deposits, depending on an investors' appetite for risk. Of that up to half could be invested in finance company debentures, particularly to cover the shorter-term end of a fixed-interest portfolio, from one to two years.

• Do not invest more than 10 per cent of your money in one single security or issue.
  This is possibly the most important part of any investment advice.

   

• Seek professional advice.
  When selecting finance company securities, most financial advisers will have a rigorous process to reduce risk. This will include considering the company's financial position, track record, management expertise, lending criteria, lending portfolio composition, and its trust deed, among others.

   

• Digest the financial information.
  This will include information about the profitability, size and makeup of the company's lending book and can usually be found in the annual financial statements. A good adviser will have met the management and/or owners of finance companies to discuss their annual reports in detail.

   

• Consider the management and track record.
  Financial information provided to the market is historic and not necessarily an indicator of future performance. So investors should be confident that the company's management is not about to change its lending policies and that it also has experience in dealing with lending in good and bad market conditions.

   

• Check the lending criteria.
  A finance company should be able to provide up-to-date information about where your money will be lent. Each sector has a different risk profile and some companies specialise in one niche while others spread their loans across a range of sectors. The geographic breakdown of the loan book can also be useful. Companies lending in the property sector should tell you what percentage of their lending is first, second or third mortgage. The information is usually in the prospectus, as is required by law. It might take a little practice to dig it out.

   

• Be sure about exactly what is being offered.
  Finance companies can offer both secured and unsecured debentures or deposits. The interest rate will be different – and so is the risk. Unsecured means that if the finance firm goes bust, you are right at the back of the queue to be repaid. And in recent collapses, unsecured creditors have indeed missed out. There is also a trust deed governing the debenture offering. This has all sorts of clauses about how the finance company runs its business. This is another document a good financial adviser will have looked at closely.

   

• Interest rates.
  The old rule of "the higher the rate, the higher the risk" does not apply as many weaker finance companies cunningly pitch their rates in the middle range to appear conservative. If you take the time to check, you may find the risk profile of the loan book can be quite different to a company with similar interest rates. Investors should also take care to compare the interest rate offered with that of a highly rated institution such as a bank. Half a per cent above the bank rate is rarely enough for the added risk.

   

• Regulation
  Finance companies do not have to comply with the same capital adequacy ratios – the amount of cash in hand compared with the amount out on loan – that a bank has to in New Zealand. The trust deed will prescribe certain ratios, but most DIY investors will not be able to judge if these are appropriate for the investment being made. The Government has recently announced changes to the regulation of non-bank deposit-takers like finance companies and building societies. The Reserve Bank will have more oversight and it will be mandatory for finance companies to have a credit rating. The objective is to assist investors in making a better-informed decision. However the nature of the rating system – or even whether most companies will use the same rating agency – has yet to be decided.

   

• Credit ratings.
  A wide variety of credit ratings exists. The best-known and most respected is Standard & Poor's. A New Zealand finance company ought to score BBB- or better on the S&P scale. Above this is termed investment grade. Below is a junk bond. The Grosvenor Bondwatch ratings are also useful and available on the Internet. It is possible to build a simple evaluation table using various criteria. But be careful of relying too heavily on credit ratings – there have been many famous failures of companies with good ratings.

  So as our table at the right taking a typical example illustrates, other important criteria to weigh would be profitability and governance. A score exceeding 25 would be enough and an adviser would have no problem recommending this company.

  Much of this information is publicly available but some aspects would require a judgment call.

   

• What should getting advice cost?
  Many advisers will give it free if you are interested in buying debentures through them. This is because the finance company will pay brokerage to the adviser – a middleman sales commission of 1 to 3 per cent. Other advisers prefer to charge an upfront fee and so should rebate any extra commission, passing the brokerage back to you.

  So always ask about the fees involved and how brokerage differs between the various different finance companies on its rate card. The replies could be telling. It is also worth checking the qualifications of an adviser. Do they belong to an approved industry body?

  In the end, time spent on proper research and taking professional advice will save you many sleepless nights if another finance company ever hits the headlines.

   

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http://www.stuff.co.nz/stuff/4122970a9113.html 

The above article by Duncan Cotterill gives another check list of sorts and is also very insightful. Now that you've read these three articles you should have a good background to assess finance company investments, for a list of some of these investments see the fixed income section of this website (here).

Also check out the following websites for more information:
www.seccom.govt.nz
www.goodreturns.co.nz 
www.interest.co.nz 
www.debex.co.nz 
www.consumer.org.nz 

And of course you should also see your financial adviser, the important thing is to ask how an investment fits into your investment portfolio and financial plan.

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