Jenny Ruth: Riskiness warnings tar all with same brush

It is questionable how useful to investors it has been for the likes of the Securities Commission, FundSource and others to issue generalised warnings about the riskiness of finance companies without identifying specific firms with demonstrable problems.

The general effect has been to tar the entire sector with the same brush.

There's no doubt some finance companies are riskier than others or, at the other extreme, that some are more conservative than many banks.

It is also true that a sector which has grown as exponentially as finance companies have over the past few years certainly bears some scrutiny.

A positive outcome of the warnings has been that several finance companies have been looking for ways to differentiate themselves from those in the worrying category.

Capital + Merchant Finance, which lends on property, particularly property developments, has come up with an innovative way of reassuring investors in its debentures. Not only has it paid for an independent rating of its debenture offerings, it also offers an option whereby its lending is insured by Lloyd's of London.

In some respects, the company is operating at the upper limits of its own safeguards and those safeguards themselves are at the riskier end of the spectrum.

At March 31, it had only $1 million in paid-up ordinary shares and a further $2.1 million in retained earnings supporting $176.4 million in total assets. It also had $5.8 million worth of capital notes that mature in September 2008 - the company has the option of then converting the notes into ordinary shares, which is its intention. So it is reasonable for the company to treat the notes as equity, bringing that total to $8.9 million.

That still means total assets are 19.8 times equity and that total liabilities of $167.5 million are 94.95 per cent of total assets, just inside the 95 per cent limit of the company's trust deed.

To put that in context, international rules require banks to carry at least 8 per cent equity and most banks carry considerably more.

It is evident the company's fast growth has been requiring repeated top-ups of capital notes to keep it within that 95 per cent ratio. There were $1.29 million notes issued in the latest year and $4.5 million the previous year.

As for that growth, total assets jumped 38.8 per cent in the year ended March, from $127 million in March 2004, and had more than trebled the previous year from $38.6 million in March 2003. Capital + Merchant has only been operating since early 2002.

But investors in its capital secured debentures have the added comfort of the Lloyd's insurance. Under the conditions of the policy, Capital + Merchant can lend up to two-thirds of valuation up to 75 per cent with specific approval from Lloyd's, and can claim as much as $20 million back from Lloyd's in any one year on loans that go sour.

Investors pay a price for that protection in that they receive considerably less in interest than those who opt to invest in the ordinary debentures. Currently, someone investing less than $5000 in the capital-secured debentures for a year would get 6.95 per cent interest, compared with 7.98 per cent if they invested in the ordinary debentures.

The effect of the Lloyd's policy also means there's more fat in the company left to protect investors in the ordinary debentures if loans develop problems.

Given its relative youth, it isn't surprising that Capital + Merchant hasn't had any bad debts. It has had one loan that got into difficulties, a problem it solved by taking over the development after it ran into delays. That development was in its books at $8.1 million at March 31, but was sold in September and the loan fully recovered.

Capital + Merchant's major shareholders are directors Wayne Douglas and Neal Nicholls, who also own most of the notes.

Douglas says he finds the criticism of finance companies "disconcerting", and says a lot of it has come from competitors for investment funds, such as fund managers - some of whom have little to crow about in terms of recent performance - and ASB Bank.

"It seems that in the finance industry, the non-bank finance companies are the soft belly," Douglas says.

In the past 15 years he has only known of two finance company failures, and compares that with the ups and downs investors have experienced in the equities market, most recently in the bursting tech bubble.

Douglas explains his company's fast growth on the contacts he and his partners made in previous property-related ventures - he previously ran one of the larger contributory mortgage companies, which has since been wound up.

Capital + Merchant does have a high dependence on a few borrowers. Its six largest borrowers accounted for nearly 44 per cent of its total loan book at March 31. Douglas says that's by design.

"We like to roll with people we know as much as possible on the basis that we're used to dealing with them, we understand their psychology and there's a level of trust and communication that you can rely on."

But Capital + Merchant's own debenture profile doesn't suggest its investors are overly worried about security. Its shorter-term and ordinary debentures have grown much faster than capital-secured debentures.

While investment in capital-secured stock maturing in less than a year rose 20.3 per cent to $67.3 million in the year ended March, investment in its ordinary debentures maturing in the same period jumped 133 per cent to $54.1 million. Investment in longer maturities of the capital-secured debentures actually fell 1.5 per cent to $31.7 million in the year but investment in longer-term ordinary debentures rose almost 60 per cent to $12.5 million.

Douglas says that rising interest rates have made the rates on the capital-secured debentures less competitive with what the banks can offer. He also says it is logical when interest rates are rising that investors "go short".

As investors and advisers have gained greater experience of the company, they've begun to feel safer going for the higher, although less protected, option, he says.

The company's rating is by Australia-based Property Investment Research (PIR), which gives it four stars out of a possible five.

New Zealand-based Grosvenor rates its debentures G5, on par with Dominion Finance, Fisher & Paykel Finance and Sky City's capital notes. Grosvenor says G5 means "adequate ability to meet current obligations, but uncertainty about levels of security over the longer term, particularly under adverse business conditions".

Capital + Merchant also owns 66 per cent of another New Zealand finance company, Numeria.


Capital + Merchant Finance

* Results: Net profit rose to $2 million in the year to March 31, from $1.3 million the previous year.
* Total assets: $176.4 million at March 31.
* Total liabilities: $167.5 million at March 31.
* Management: Executive director Wayne Douglas and chief executive Owen Tallentire.
* Major shareholders: Wayne Douglas and Neal Nicholls.