Loan notes: Is the risk worth double-digit returns?

They may have come to the fore earlier this year following the collapse of German property vehicle Dolphin Trust, but loan notes have been around the Irish market for quite some time now.

Student accommodation, an energy company, new houses, a distillery, a bread maker; these are just some of the loan note opportunities sold in recent years, promising, in some cases, double-digit annual returns.

But as the experience of investors in Dolphin Trust shows, due caution is needed when considering such an investment. After all, in the age of low interest rates, such high fixed returns may only be possible if they also carry significant risk.

What is a loan note?

Loan notes are, in effect, loans to a corporate entity, which may allow them to build properties or grow their business.

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They are typically distributed by brokers and financial advisers. Cantor Fitzgerald, for example, has arranged a number of such deals, including a junior loan note promising 9 per cent a year over three years in bread company McCambridges, and a €6.75 million deal for Ballisk Homes to build 82 homes in Donabate, Co Dublin, also promising a return of 9 per cent a year. Some estimate the overall market in Ireland to be worth as much as €500 million.

Corporates like the structure of a loan note as it doesn’t result in any dilution of equity, while they can also be a means of funding for some sectors – such as property development – which find it difficult to access bank finance for the full project cost.

Where it can sometimes get confusing for investors is when unregulated products – such as loan notes – are sold by advisers who are regulated by the Central Bank

Loan notes are described as either senior or junior debt. Senior loan note holders having first charge over the business and its assets; junior investors having a second charge behind them, so they carry greater risk. The nature of the loan note gives an investor an idea of the security they have of getting some or all of their money back should the borrower default on the loan.

Loan notes will typically offer returns of between 6 and 10 per cent a year and short investment terms of up to about three years. Interest, also called a “coupon”, is paid at stated points during the term, with the capital repaid at the end.

Minimum investment usually starts at upwards of about €20,000.

The benefits

The benefits of loan notes are very clear; in a low interest rate environment, the promise of annual returns of up to 10 per cent is undoubtedly very attractive.

They can be particularly attractive for those with approved retirement funds (ARFs) or those with self-administered pensions, as tax won’t apply to the investment while, with ARFs, the returns may match the required drawdown of 4 per cent a year.

And very often they will do exactly as they say on the tin. In 2017 for example, Cantor Fitzgerald disclosed that investors who invested in loan notes issued by Ballisk Homes were repaid early, receiving a return of 13.87 per cent over about 13 months.

How are loan notes sold?

Where it can sometimes get confusing for investors is when unregulated products – such as loan notes – are sold by advisers who are regulated by the Central Bank.

As the Central Bank noted in a “dear CEO” letter to the industry last year, “Where firms engage in both regulated and unregulated activities, there is a significant risk that clients may misunderstand the protections they are afforded when investing in unregulated products.”

This may have been a factor in the number of investors in Dolphin Trust.

Ciarán Leavy, partner and head of commercial litigation in Lavelle Partners, is representing a number of investors in the German property fund in respect of potential claims. He notes that a number of such investors were not told by their financial adviser that they were investing in an unregulated product, and were specifically advised that the investment was low-risk.

The fact that these products are unregulated also means that salespeople don’t have to disclose the commission they earn from the transaction, with fees often in the double digits on such products.

With Dolphin Trust, for example, commissions were as much as 20 per cent. Small business association Isme has told members it has heard of other schemes with commission rates of up to 21 per cent.

A side note here is that fees and commission earned from the sale of unregulated products don’t count in the calculations used to work out how much an adviser must pay the Central Bank each year for its industry funding levy. This then can mean a lower funding bill for that adviser, depending on the scale of business on the unregulated side.

Risks

While a fixed return north of 6 per cent may sound great when compared with current deposit rates, for example, the two products are worlds apart when it comes to assessing risk.

Joe Moore, founder of Donegal-based JMoore Financial, has his doubts about such products, noting that he wouldn't recommend them to his clients.

“My position would be, in terms of the level of risk you want to take on and the level of return you’re looking for, I just don’t see that the upside is large enough for the level of risk you’re taking,” he says, pointing to a possible lack of information on the borrower for the investor to be able to make an informed decision, as well as the lack of liquidity in the product. “There may be a false sense of security with them as they pay a fixed return,” he adds.

Earlier this year, Isme issued a warning to small business owners on the sale of such products, urging them to take their own professional advice before investing or risk losing their money.

This came following the collapse of Dolphin Trust. About 1,800 Irish investors put a minimum of €15,000 each into the German property vehicle on the promise of annual returns of up to 15 per cent, only to see their €150 million or so most likely wiped out.

Of course Dolphin Trust is an isolated investment, complicated by the fact that its assets are in another jurisdiction. Nonetheless, it does highlight the need for caution.

“In an unregulated space, there’s going to be room for products to be substandard,” says Moore.

While the loan notes are secured, this security is only as good as the strength of the assets, and the legal contracts on which this is based. As Leavy notes, Dolphin Trust investors were advised that charges would be put in place over the German properties they invested in to secure the investors’ capital. However, there is now uncertainty over whether this ever happened.

“A claim that a property structure has a first charge over assets should always be verified to ensure such a representation is accurate. However, it is understandable for investors not to look behind representations made to them by their financial adviser,” Leavy says.

There is also the issue of what comeback you might have if things go wrong. As unregulated products, investors have no recourse to the Investor Compensation Scheme, which protects regulated investments up to €20,000.

Given the fallout from the Dolphin Trust affair, the appetite for loan notes will likely diminish

And a further issue which might arise is in relation to professional indemnity insurance. When selling regulated products, an adviser must have cover of about €1.3 million under the Investment Intermediaries Act 1995. This allows a customer to take a claim against the seller of financial products in the event of negligence/mis-selling.

However, with unregulated products, no such insurance cover is needed. And while a broker may choose to extend its cover, this is something that should be checked by potential investors. Without such cover in place, the size of a case that may be taken against them may be limited.

“If a financial adviser does not have professional indemnity insurance to cover the sale of unregulated products, that financial adviser will be [personally] responsible for any award ultimately obtained in court and their ability to satisfy any judgment will depend on the means of the financial adviser,” says Leavy.

In some cases, the cost of the insurance may mean cover isn’t extended – which can tell its own story.

“One of the key ways of measuring this risk is that there is insurance out there to insure [brokers selling] unregulated investments but it is prohibitively expensive. That should tell you all you need to know about unregulated investments,” says Moore.

Outlook

Given the fallout from the Dolphin Trust affair, the appetite for loan notes will likely diminish. In addition, some pension investors may also soon find themselves restricted from investing in such products, following the transposition of the IORP II directive.

This will restrict investment choices for holders of occupational/self-directed pensions schemes, as they will only be able to have 50 per cent of their pension fund invested in unregulated products, such as loan notes or property.

According to Munro O'Dwyer, partner with PwC, while all pre-existing investments are exempt from the IORP II restrictions, and do not need to comply with the investment rules for five years, when it comes to new investments such as a further contribution to an existing pension scheme, the restrictions will apply immediately.

There may also be moves on the regulatory front.

When asked as to whether or not the Central Bank has any plans to tighten the distribution of these products in Ireland, a spokeswoman for the regulator said that the issue was “under review”, adding that it would “continue to engage with domestic and European counterparts to determine if further action is needed to ensure additional clarity for investors on the implications of investing in unregulated products of this nature”.