Money

Finance company investments

Updated 09 Oct 2007
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Introduction

Finance companies can offer high rates of investment return. But make sure you understand the risks hidden in the fine print.

Most of us aren't accountants, so ploughing through a huge prospectus can be daunting. What should you look for before investing your hard-earned cash?

Our report guides you through what to watch for, makes sense of some of the jargon, and sheds some light on the hidden facts of finance-company investments.

Distress signals

Nine finance company failures in 16 months highlights the volatile nature of these types of investments. There are some good finance companies out there, but you need to sort the good from the bad. You have to be your own financial planner and not rely solely on financial advice.

Kapiti Coast sharebroker Chris Lee says there are 12 key "distress signals" to watch out for.

A simple search on the internet is usually enough to see whether a company has met one or more of the "distress signals". It doesn't take a highly paid financial adviser to warn you - look on the internet yourself.

If a company in which you're thinking of investing has sent out one or more of the following signals, be extremely cautious about investing in it. Some of these distress signals may apply only to listed companies.

The 12 distress signals

  • Does the company have a credit rating from a reputable agency? Has the rating been stable in recent years?

  • Does the company have any "enforceable undertakings" or other compliance issues with the New Zealand Securities or the Australian Securities and Investment Commission? (See Jargon buster for why this matters.)

  • Does the company have any issues with the stock exchange (NZX or ASX) on either its listed or unlisted board?

  • Has the company's share price fallen recently?

  • Does the company have published bad debts? And has its percentage of bad debts been rising?

  • Does the company have significant lending to related parties (such as companies or individuals able to control or significantly influence the finance company, or who are otherwise connected with the finance company?)

  • Does the company invest in any unusual countries?

  • Do the company's published accounts show a bad "liquidity profile" - for example, does it have enough cash on hand or overdraft arrangements with banks to meet its short-term cash-flow needs? Has it been able to get overdraft or standby facilities with a bank?

  • Has the company recently increased its advertising (television, newspaper or radio)?

  • Has the company been selling loans to competitors?

  • Has the company borrowed money to meet interest payments?

  • Have senior staff been leaving the company?


Lee says failed finance company Bridgecorp met all 12 "distress signals". He questions why financial advisers - who as professionals would have been well aware of this - continued to channel their clients' funds into Bridgecorp.

Where is your money going?

The recent collapse of Nathans Finance, whose parent company VTL Group was in the vending-machine business, shows the importance of finding out what the finance company is really up to.

We examined Nathans Finance's final interim report and found that investors' money was going back to the parent company and into vending machines. How many ordinary investors would put their nest egg into vending machines? The info was there - all you had to do was read it

Finding the information

Sometimes finding out just what the company is planning on doing with your money can be a bit tricky.

Usually a prospectus will have a section called something like Concentration of credit exposure by industry or Description of activities of the company.

These sections tell you what industry or industries the finance company operates in. That is, what type of lending it does.

This information must be in the investment statement - look for the What are my risks? section.

One prospectus we looked at had basic information upfront about what the company does, in its Description of activities of the company section. It told us the company was involved in providing finance to the consumer credit market. Sounds OK so far, but back in section 34 of the prospectus under the heading Other material matters was the section on Risks specific to the company's business.

The Risks specific to the company's business tells you what the company is really up to.

According to this section in its prospectus, the "OK-sounding" finance company lends money to and finances hire purchases for people from a "wide spectrum of socio-economic backgrounds but are more concentrated in the lower to middle income bracket" whose needs "are not catered for by trading banks".

Despite the fact that "trading banks" haven't existed since 1986, we're assured that the company assesses the person's risk profile and "an appropriate interest rate is charged to reflect that".

In other words, a high interest rate is charged because of the loan's high risk - that means it's high risk for you, too, as an investor.

This company is making its profit from lending money at a high rate of interest to people who can't get loans from banks. In some cases, the security for the loan (your investment) is a now second-hand fridge or second-hand car. Does that sound like a good investment to you?

How secure is your "secured investment"?

A secured investment, often referred to as a debenture, sounds reassuring doesn't it?

But your investment is only as secure as the assets it's secured against. Finance companies' largest assets are often the amount of their outstanding loans - and these are of uncertain value.

When a finance company lends your money in the car or consumer finance market, the loan (your security) may be used for the purchase of a second-hand appliance or a second-hand car. The borrower is also quite likely paying a high interest rate. As we reported in our article on Debt consolidation, we've seen car loans charged an interest rate of 32 percent a year - that's quite a ripoff.

It's the soundness of the finance company's loans that are the security for your investment.

Our tip

Be wary of investing in a finance company that specialises in a single industry such as second-hand cars or personal consumer finance. Look for a company operating in a range of industry sectors, so that your risk is spread.

Risk versus return

The headline-grabbing interest rates offered by finance companies can make their investments seem attractive. "A figure this good should be in Sports Illustrated" claims one finance company.

This is just hype to distract you from the real issue - the soundness of the investment.

What the interest rate is really telling you is the level of risk involved in the investment. Usually the higher the interest rate, the higher the risk.

Take the example of a bank investment returning 6 percent a year and a finance company offering 9 percent for the same term.

Securities Commission Chair Jane Diplock says: "People should realise that an extra 3 percent return is a 50 percent increase in interest and so must represent at least a 50 percent increase in risk."

Pay attention to the margin between finance company and bank interest rates - the finance companies we surveyed were offering rates that on average were 3 percent higher than bank rates.

A new twist is for finance companies to offer interest rates that are closer to bank rates, to make their investments seem less risky. You'll need to weigh up the interest rate against the other information from the prospectus before you can get a real picture of the investment.

Our tip

Never rely on the interest rate alone - whether it's high or low.

Related party lending

The Notes to the financial statements section of the prospectus is where you can find information on what's called related-party transactions.

One type of related party transaction is money lent to shareholders and directors, or the other businesses the shareholders or directors own.

Be particularly cautious about companies that do related-party lending. Finance companies may just be fronts for channelling funds into other projects that related parties - like shareholders and directors - are interested in.

One finance company made headlines recently when it used its shareholding in a second finance company to raise a 3-month loan. The initial finance company has also lent money to no less than 11 related parties - including $20 million to a company owned by a director.

Another that we looked at loaned $2.8 million to a subsidiary holding company, $1.1 million to a subsidiary insurance company, and made a personal loan of $225,000 to the director. This was all in the last two years.

Finance companies that lend your money in this way should be avoided.

According to a report by former investigative journalist Chris Rennie, the reason they do this is that often the business and credit history of a shareholder or director is so bad that they can't get a loan from a bank - so they set up a finance company and borrow from you instead.

Our tip

Avoid companies that do related-party lending. They're just recycling your money around the same group of companies.

Bad debts

Finance companies are in the debt business - so a soundly managed one will tell you upfront how good they are at chasing up bad loans. Sending the repo man around is one option if all else fails, but it's not a good solution for anyone.

A prospectus should list three types of bad debts. In the jargon of investment land, these are:

  • impaired assets
  • past due assets
  • bad and doubtful debts.

What bad debts tells you is that the company has some doubts about the quality of these parts of its assets.

Where to find the information

Information about debts can be found in the Notes to the financial statements section of the prospectus.

An easy assessment of a company's assets can be quickly carried out by looking at the Statement of financial position. Divide the total liabilities by total assets - if the answer is more than one, the company has more debts than assets.

One of the finance companies we looked at had net receivables (money it receives in loan payments) of $110 million in 2006 - but it had $3.2 million worth of past due loans. This was way over a prudent limit of 2 percent of receivables. It was able to sell those loans for $250,000 to another company and so write them off from their accounts. Its doubtful debt provision for next year is a smidge over $2 million - up from $650,000 the year before.

According to The Independent, another finance company had lent a massive $191 million of investors' money - mainly in residential housing - but managed a profit of only $591,132 for year ended September 2005. The 2006 accounts show the company has over $17.2 million in past due assets.

Our tip

Divide the total liabilities by total assets to find out if the company has more debts than assets. Past due assets shouldn't be much more than 2 percent of the net income the finance company receives from loan repayments.

Credit ratings

Currently only a handful of finance companies have a credit rating - but it may soon be mandatory for all.

The rating agencies use different scales, so they can be hard to decipher and compare. The table below shows the investment-grade ratings used by three international agencies: Standard & Poor's, Moody's, and Fitch.

"Investment grade" ratings are at least BBB- (S&P), Baa3 (Moody's), BBB- (Fitch). Any ratings below this are regarded as "speculative" or "sub-investment grade" and so they're higher risk than investment-grade finance companies - sometimes substantially so.

Financial information toolkit

You need to keep yourself up-to-date - and you need to know where to look for financial information. There are plenty of sources. Here are some of them.

Magazines

Read the National Business Review for in-depth business news. You can visit the magazines' website and sign up for a "daily headlines" email service.

Newspapers

Regularly read the business section of the large daily and weekly papers for information about financial markets, company announcements, regulatory and legislative updates and senior staff appointments.

The New Zealand Herald's business supplement, published on Fridays, is a useful weekly overview.

Business stories also feature in the general sections of newspapers and on websites, with commentary and additional reporting from other sources.

Websites

Several specialist financial-sector websites are worth a visit for up-to-date stories, performance figures, and research.

  • At the FundSource website, investors can view (for free) specific information such as prices, performance, FundSource "Star Ratings", and general information and articles.
     
  • Sharebroker Chris Lee has a 21-year track record of providing independent advice. His website includes a comparative grading system for finance companies that's free to view.
     
  • The Securities Commission website has media releases, details of enforceable undertakings, and information for investors.
     
  • The Companies Office website allows you to search the companies register, and to search for current and banned directors or managers.
     
  • Details of bankrupts and liquidations are available by searching on the Insolvency and Trustee Service website.
     
  • New Consumer website: From mid-October our new subscriber-only website will give up-to-date information on fixed-interest investments, including finance company debentures.

Using a financial adviser

If you use an adviser, check them thoroughly to make sure they're up to the task of looking after your money. Ask your adviser to supply or explain the information on which they have based their advice. A good adviser will be happy to teach you about your investments - this will help your relationship.

Qualities to look for in an adviser are:

  • knowledge
  • experience
  • clearly demonstrated ability to research and analyse investments
  • industry qualifications
  • integrity.

David Hutton, chief executive of the Institute of Financial Advisers (IFA), says that IFA members must have minimum qualifications plus two years of mentoring before they can become full practitioner members. He says "IFA members are also subject to a code of ethics (requiring disclosure of fees or commission), practice standards and a formal complaints and disciplinary process."

Financial advisers' commissions

Find out whether an adviser charges you an hourly rate for their advice or gets paid a commission on the investments they sell you. An adviser who charges an hourly rate will be more objective and independent than one who gets paid a commission. We think more financial advisers should shift from commissions to charging fees.

Bill Wilson, lecturer in finance at Massey University, agrees: "Clients should expect to pay fees for professional financial advice. If the 'adviser' is not charging for their services then they are commission salespeople working for investment providers. Advisers who do receive commission should rebate these fees back to clients to offset their service fee. The bottom line is that all commissions should be disclosed, allowing the client to judge their relevance."

We are aware of commissions paid by finance companies to financial advisers that are twice as high for more risky investments. The only person getting a guaranteed reward for the risk you carry is your financial adviser.

Disclosure documents

If you ask for a disclosure document from an adviser, the law says certain information must be included.

If the adviser gets a payment that's "reasonably likely" to influence the advice they give, they have to tell you "the nature and (to the extent practicable) the amount or rate of the remuneration".

Advisers should not only tell you they get incentives to sell certain investment products, they should tell you how much those incentives are.

Financial advisers are lightly regulated in New Zealand, and the government's Review of Financial Products and Providers is now looking at options for improving consumer protection. We've made a submission to the Review in favour of tighter regulation - for more information see our submissions.

Questions to ask your financial adviser

Before investing in a finance company, ask your adviser:

  • How much capital does the finance company have as a percentage of total assets? Is it adequate for the current market conditions?

  • How profitable has the finance company been over time?

  • What is the company's bad debt ratio (percentage of bad debts to total lending)?

  • Does the company have a good "liquidity profile"? A good finance company "borrows long and lends short".

  • How transparent is the company? Who are the directors and senior managers - what is their history?

  • Is your adviser receiving a commission or kickback of any kind from the finance company? Is this commission higher than that received from another similar investment?

Jargon buster

Bad and doubtful debts

Loans that are likely to remain uncollectible and will be written off.

Enforceable undertaking

A written undertaking offered by an investment company to the Securities Commission, usually because of non-compliance with securities law or some other areas of concern. The undertaking specifies the steps the company agrees to take to remedy the breach. "Enforceable" means the undertaking is enforceable in the courts.

Impaired and past due assets

Overdue loans that may not be recoverable. These could be as much as 90 days overdue but the number of days differs among companies.

Impaired asset expense

The money put aside by the finance company to cover bad and doubtful debts.

Investment statement

An advertisement for an offering of securities. The purpose of the investment statement is to provide key information to the prudent but non-expert investor. The investment statement is the primary disclosure document.

Net receivables

The income a finance company receives from loan repayments, less expenses.

Prospectus

Contains more detailed information concerning the offer of securities than the investment statement. Explains the offer, including the terms, issuer, planned use of the money, historical financial statements, and other information that could help you decide if the investment is suitable for you.

Receiver

Person appointed to manage the affairs of a company that can't pay its debts.

Related-party transactions

Transactions between a company and others (companies or individuals) that have personal or business links with the company or its management.

Our advice

  • Go to the bank - bank on-call accounts are a much safer option. Why take the risk when you can have on-call funds with much more security and a good rate of return?
     
  • Read the prospectus and the investment statement - the good or bad news is always in there somewhere. It may pay to start with the small print at the back rather than the glossy pictures up front. If you're having trouble understanding the documents, seek advice from a financial adviser.
     
  • Find a reliable financial adviser - we recommend you use an adviser who charges a set fee or hourly rate, rather than one who earns a commission.
     
  • Check the security behind your secured investment - check the quality of the finance company's loans.
     
  • Avoid concentration of risk - before you invest, make sure you know exactly what the finance company is doing with your money. Look for a spread of investments (including property, consumer finance and others). Also look for lending that is not concentrated on one borrower or business, especially if it is a related party.
     
  • Check the interest rate risk - a high return doesn't make up for the risk. Be wary of companies with lower interest rates which seem to be risky as well.
     
  • Look for flexibility - with fixed-term investments you can't withdraw your money until the end of the term, even if the finance company's financial position deteriorates. A bank on-call online account is a better option but has a lower return.
     
  • Get accurate rate information - for up-to-date term-investment rates see Term deposits.


Ramping up the regulations

We think it's high time that the finance company sector was cleaned up. Changes to strengthen existing regulations were proposed in the recent Review of Financial Products and Providers (RFPP), and they're now underway.

The trouble is some of them won't happen until 2010, although compulsory ratings and a few other requirements will come into force earlier. Commerce Minister Lianne Dalziel recently fast-tracked others - such as a review of trust deeds, a public information campaign about risk and return, and implementation of parts of the RFPP ahead of schedule.

Some of the proposed changes include mandatory credit ratings from ratings agencies approved by the Reserve Bank, licensing of finance companies (and building societies and other deposit takers) by the Reserve Bank, minimum capital of $2 million, restrictions on related party lending, and fit and proper requirements for directors and senior managers of these companies.

We'll see the first round of these regulations come in either late next year or in 2009. We made a submission to the RFFP in support of mandatory credit ratings, a consumer disputes-resolution process with real teeth, and regulation by the Reserve Bank.

 

More information

Report by Rachael Bowie