KEY POINTS:
Last year, three New Zealand finance companies, National Finance 2000 Limited, Provincial Finance Limited, and Western Bay Finance Limited, collapsed owing investors $390 million.
This month, the Bridgecorp group of companies was placed in receivership owing 18,000 investors about $500 million.
So what caution should investors take when contemplating investments in finance companies, or any investments for that matter?
Some finance companies offer interest rates that appear to be very attractive. There is a reason for it: it's a riskier investment compared with investing in trading bank deposits or New Zealand Government stock, generally regarded as a risk-free investment.
Return is commensurate with risk: if you want a higher return, you must take more risk. Finance companies lend funds at a rate above what they have to pay their investors, making a margin, which is their profit.
Again, one needs to ask why they lend funds at a higher rate compared with, say, a trading bank. Clearly, the higher lending rate is because of the higher risk of the projects that some finance companies lend to.
Lending to riskier projects means the security, if any, that supports the loan is of an inferior quality - for example, where the security is a second or third mortgage instead of a first mortgage.
In the National Finance 2000 and Provincial Finance cases, loans were provided to buyers of second-hand imported vehicles, which are not regarded as a quality security.
Even if the finance companies were able to repossess them in the event of default, the vehicles' value would have dropped substantially or they could have been damaged, assuming they hadn't already been stripped for parts.
Liquidity is a major issue for finance companies and the lack of it is a cause of their demise.
Finance companies may have lent long, for example on a property development that takes three years to complete and sell, at which time the borrower repays the debt. But the company may have borrowed short, for example having investors' money maturing in a year.
If these investors continue to reinvest their money on maturity, the finance companies have cashflow that enables them to meet interest and principal payments - that is, new money used to repay old money. But if investors stop reinvesting, the finance companies' cashflow becomes a problem.
The liquidity problem is compounded when loans made by finance companies to their customers are not repaid on time, or at all, which is what happened in the four recent failures.
With low reinvestment rates and customers' unpaid loans, finance companies' funds dry up and they default on their financial obligations.
Investors should consider some basic investment fundamentals:
* Risk is related to return. If a company offers a high return, assume it's a risky investment.
* You should reduce your exposure to risk by having different investments. If one investment turns out to be a disaster, the others are less likely to be so. In other words, don't put all your eggs in one basket.
* Is there a ready market where you can sell your investment should you need to cash-up? With finance company debentures and unsecured notes you typically have to wait till maturity to get your money back.
* Consider the economic conditions. Is the economy slowing down? Is there an increase in mortgagee sales? If so, opt for the safe investments.
* Financial analysis of a finance company requires academic training and experience. If you have these skills, study the investment's prospectus and the investment statement. If not, seek the advice of independent financial advisers whose income is not dependent on selling the finance companies' securities.
* Other indicators include:
Is the return appropriate for the risk?
A perverse situation is where a finance company tries to mimic lower risk by offering a return that is lower than it should be, given the true risk of the investment.
Consider the quality of management and its track record. Has it been involved in previous corporate failures?
Find out whether the finance company has a strong parent company that is listed in New Zealand or overseas and whether it has institutional shareholders.
Examine the governance, composition of the board, presence of independent directors with finance industry knowledge and experience, the frequency of board meetings, the independence of the audit and remuneration committees, etc.
Take heed of institutional responses: the NZX refused to list Bridgecorp, and an Australian regulatory authority barred Bridgecorp from accepting deposits, both telling signs.
Search the business media for articles about the finance company you are considering investing in.
See if the investment is rated by an internationally recognised and independent credit rating agency such as Standard & Poor's. Presently, this is not mandatory in New Zealand so a finance company subjecting itself to a voluntary rating is a positive signal. But you'll also need to assess the rating that is given.
Look at the type of businesses that finance companies lend to. Shoe-box apartment developments and second-hand imported cars would not be regarded as quality assets.
Ask about related party transactions, because finance companies could be conduits for projects in which management has a financial interest.
Examine the maturity profile of the finance companies' borrowings relative to the maturity of their assets.
Read the auditors' report on the financial statements. If the report is qualified, ask a knowledgeable person what the qualification means.
Beware of advertisements that use legends to entice you to invest. Provincial Finance's advertisements pictured Colin Meads, an All Black legend, but not someone known for his financial prowess.
Also, take heed of where and when a finance company advertises. National Finance 2000's advertisements appeared on prime time television, not something that is congruent with a small finance company.
* Professor Jilnaught Wong is head of the department of accounting and finance at the University of Auckland Business School.
