Pictures or Words ‘What’s in a Label?..’

By Paul Payani, CEO at OPTIMUS

The saying a picture is worth a thousand words is no more apposite than when used to highlight the toxicity of everyday products such as cigarettes, bleach and dishwasher tablets to name a few.

However, in the world of fnancial services, the current regulator the Financial Services Authority (FSA) & the “old money” incarnates such as Fimbra and the PIA have not been able to bring themselves to use a picture to represent potentially hazardous investments and instead they rely on at least a thousand words to explain the risks to retail consumers.

Nevertheless when things do go wrong, it can affect millions of people and cost the fnancial services industry billions in compensation payments.

Despite the existing warnings, any investors who suffered fnancial loss from precipice bonds, split caps, Key Data, Arch Cru and most recently PPI insurance, it’s a moot point whether the loss was the fault of the product design or a consequence of miss-selling.

Not until 2007 and the start of the fnancial crisis, was the word ‘toxic’ widely introduced to the general lexicon of fnance.

At the time it was largely in the context of mortgage-backed securities, which were confned to institutional investors.

However, the repercussions of the global fnancial crisis are now, eleven years on, being felt at the retail level. The FSA is now using the word toxic to describe certain asset classes, as the UK Regulator attempts to shift emphasis to monitoring such investments at the source and not, as is normally the case, placing the emphasis on fnancial advisors, as to their suitability for a client.

However, the global nature of the world economy is not just confned to macroeconomics. We have witnessed a growing trend over the last few years for many esoteric investments to originate outside of the UK and be offered to UK investors. In the last few months alone, we have seen UK clients being presented with investment opportunities as diverse as a Chinese contemporary art, Argentinean farmland, German real estate and Australian Green Oil.

It is not feasible to assume the FSA will be able to police all these investment offerings.

Furthermore these investments are often packaged and marketed in the UK by unregulated frms. This may only be an issue if the investments fail and the usual routes for compensation such as the FSCS and the fnancial ombudsman are not open to them.

It may require civil litigation through the UK courts, which can be prohibitively expensive, time consuming and has an uncertain outcome. Nevertheless in a world where UK interest rates are at a historic low and infation remaining stubbornly high, I fear the temptation for some investors to seek out higher than average returns will be just too great.

Experience shows certain characteristics are common to many potential toxic investments, one of which is the word “guarantee”, being used in the offer documentation.

This guarantee could be on the original capital invested; perhaps on the minimum expected return for the investment or even on the provision of a guaranteed exit mechanism from that particular investment.

A key question to ask is: what are you actually investing in? Is it a recognised asset class, which has a robust method of valuation and a large enough market to be sold into on disposal? Is there legal title and under what conditions will you be allowed to sell? If the sponsors of the investment are “guaranteeing” to buy back the asset from you in ‘x’ years time, will they still be solvent and have suffcient resources to do so, when you are selling to them?

After all, we live in a world where Sovereign Governments cannot make good on their debts. Why should an investor automatically assume a lesser entity will be able to so? A simple mechanism we use for clients to counter this issue is to say they should mentally place the word “may” in front of any guarantee on offer, to have a more realistic expectation of the risks.

For example, when several clients were looking to invest signifcant sums into a renewable solar energy project, the rationale was twofold, frstly to diversify their investment portfolio and also to take advantage of the two guarantees on offer, which made the investments more attractive to the clients.

The frst guarantee was the fact that the solar panel manufacturer was providing a 25-year guarantee on the solar panels themselves.

These solar panels were to be ftted onto commercial buildings, predominately in the South East of England, to generate electricity, which would then be sold to the national grid. The second guarantee was the feed in tariffs (FIT’s) provided by the UK government for a period of 25 years for the purchase of the electricity produced.

Other considerations being equal, these two guarantees were the key drivers for the clients to consider making this investment.

The clients commissioned an independent industry expert to examine the manufacturer’s guarantee. It was their opinion that whilst the guarantee was valid, it was probably not worth enforcing, as the solar panels would be required to be returned to the factory for testing. In short, it would cost more to send them back than to buy and install new ones.

In the event of a mass product failure, it would be better to actually sue the manufacturer.

At the time the investment was being considered, it seemed unfeasible the UK government would move the goalposts on the FIT’s; especially as the new Coalition government was committed to increasing renewable energy sources.

However, the UK government did indeed reduce the FIT’s and effectively changed the whole profle of the investment, making it unattractive. The recent UK Supreme Court ruling that the government FIT U-turn was deemed illegal may be of little comfort to other investors who relied upon it to make an investment decision.

Another characteristic common to potential toxic investments is debt or leverage. If there is leverage or debt involved, then there will also generally be a requirement from the lender that the loan be serviced during the term of the investment.

Also the loan will need, at some point, to be repaid in full, whilst the lender will require adequate security to give comfort, generally throughout the term of the investment. They are often found in property related deals.

When things do go wrong it is often because of a domino effect, generally starting with an unforeseen event. So investors must always ask the “what happens if …” questions and if the answers are not simple, clear, concise and enough to assuage their concerns, then simply avoid making that investment.

For example, a FTSE-100 company with a market capitalisation of £7billion is the tenant to a £23m syndicated commercial property. The original loan to buy the building had been serviced in full for 5 years, yet the lending bank recently forced a sale of the building, resulting in a 100% loss to all the equity investors.

The reason for the forced sale was that the original loan to value covenants of 2007 had been breached and despite the investors agreeing to put more equity into the deal to stave off the enforced sale, the bank’s desire to shrink their loan book ruled the day. The unforeseen event was the fnancial crisis and the requirement of the now UK state owned bank to reduce their balance sheet. It just took 5 years to materialise and hit investors in their pocket.

Investments offering tax relief can sometimes blind investors to the potential toxicity of the underlying assets themselves. If there are generous tax reliefs for investing, investors may feel the tax relief actually reduces risk, if HMRC are subsidising the underlying investment. Of course it is supposed to be a three legged stool. The Government needs to encourage growth in the economy and targets a specifc geographic location or industry and offers generous tax reliefs. In the long term this will encourage employment and increase the overall tax take.

The sponsors will package the deal, apply the tax rules judiciously and market it to potential investors. Finally, the investors who partake are attracted by the tax relief and perhaps the underlying investment story and choose to invest. But it is they, the investors, who end up with a sore backside if a leg of the stool gives way. Invest £100 and receive anywhere from £30 - £100 back from HMRC, what can go wrong? However, the key question to ask is would the investment be considered if not for the tax relief?

We recently attended a conference call on behalf of a client where there was generous tax relief to invest into the renovation of an existing building into a hotel. Ignoring the tax relief, the client was essentially investing into the hotel business which also included some development risk and leverage.

The sponsors walked the client through the numbers in the projected business plan. Specifcally outlining the assumed occupancy and room rates, which coupled with a leading global operator of the business, would produce excellent anticipated returns in 2019. Coincidently our offce at the time was next to the London franchise of the same hotel chain. We knew the management who would often comment how low occupancy was since the launch of the London hotel in 2010.

When asked directly what impact a continued slowdown of the UK economy would have on projected returns, the sponsors acknowledged it would have a considerable negative impact, which could result in limited or perhaps even no returns to clients, as any potential exit would be dependent on a trade sell. What is clear, is investors will need to conduct more robust due diligence when they are skiing off Piste, with part of their investment portfolio. They should examine how they make investment decisions? What processes do they use to arrive at the decision? Who do they consult and seek advice from and is that advice truly impartial?

We typically create for our clients a family board, which can meet as often as the family wishes, but usually 4 times a year. The composition of the board can be anyone the client chooses and the meetings can be as formal or informal as the client wishes.

At these meetings any investment opportunities can be considered and looked at from different perspectives. It gives a process to the actual decision making. This structure can also take the pressure off clients making a quick and perhaps rash decision, when presented with an investment opportunity, often when there is also an impending deadline.

Of course there will always be risk in any investment and even the mighty Warren Buffett, arguably one of the world’s greatest investors, has made his share of bad calls. However, the type of investments which could be labelled as potentially toxic are ones that on frst glance, may actually look innocuous albeit slightly alternative in terms of the asset class. It is only over time that it may become something that could seriously harm your wealth.

In anthropological studies conducted some years ago, it was found when a picture of a venomous snake was shown to Inuit Eskimo children they would instantly recoil. This is despite the children having no experience or contact with such creatures. Perhaps we should have a nationwide schools competition to design labels to put on fnancial products to describe their toxicity. In 2013 we will have a successor to the FSA, the Prudential Regulation Authority (PRA). No doubt the powers that be, spent many hours and considerable sums on creating the new entity. Quite why they chose to have the name of a product provider included in the title is anyone’s guess. Then again, what is the signifcance of a label?

Paul Panayi, CEO Optimus – The Family Manifesto™ creating smart family offces