Debating leverage embedded within Business Relief investment services appropriate or not?

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1 WHITE PAPER Debating leverage embedded within Business Relief investment services appropriate or not? Henny Dovland Senior Business Development Manager Stephen Daniels Head of Investments Many Business Relief (BR) services are targeted at investors looking for a low volatility proposition that generates modest returns from income and capital. These investors are also typically more mature and more risk averse; however, many are investing their money in BR services with embedded longer term leverage i.e. debt is built within the very structure of the investment over a period of multiple years. Is this use of leverage appropriate given the attitudes and risk tolerance of the client base? At the end of the global financial crisis (GFC) in the last decade many observers started to debate the virtues and vices of leverage. Many of the corporate implosions which occurred during the GFC had it seemed in hindsight been caused by complicated financial structures which boasted high s of embedded leverage. Arguably the best explanation of these concerns came in the film The Big Short which explained how complex financial structures such as CLOs and mortgage backed securities had caused massive volatility within the US financial system all accomplished using actress Margot Robbie memorably reclining in a bubble bath sipping champagne whilst explaining the logic of financial engineering. Its not so subliminal message was that embedded leverage might encourage speculation which in turn would result in bubble-like valuations, with inevitable downside volatility once that bubble burst. Tel: questions@time-investments.com

2 But embedding long-term leverage within asset backed structures typically involving less than liquid tangible assets such as property or renewable assets can in some circumstances work to the investor s favour. The challenge however is for the investor to understand and evaluate the risks that accompany these financial engineered structures. To illustrate this point, consider the following scenario. Imagine an investor looking to buy an asset worth 100, producing a stream of predictable cashflows worth 5% per annum. How could the investor fund this purchase? The traditional route paying for the asset upfront Price of asset Debt Equity Cash flows per annum rate on any debt charges per year Yield p.a. 0% 0 = 5% In this entirely equity-based consideration the investor has an asset worth 100 and cashflows of 5 per annum. The challenge here of course is that the investor would need that 100 of capital upfront to pay for the asset. The alternative route using debt to fund asset purchases Price of asset Debt Equity Cash flows per annum rate on any debt charges per year Yield p.a. 3.5% 1.75 = 6.5% If 50% leverage was employed when purchasing our hypothetical asset, this would involve 50 of debt and 50 of equity. Let s further assume that the cost of that leverage is less than the (5%) yield on the asset say a cost of 3.5% per annum. Thus in our simplistic example our 50 equity investment costs 1.75 per annum to service via interest charges but is producing a stream of income worth 5 per annum. That leaves the investor with a net yearly return of 3.25 ( 5 less the 1.75 interest charge) on a 50 investment which equates to a yield of 6.5%. After five years a not un-typical duration of investment finance - let s further assume that our 100 asset has increased in value to 110. The equity in this structure is now worth 60 all other things being equal ( 110 less 50 of debt). That equates to a return of 10 on the initial 50 investment. Leverage can increase the potential for capital gains Leverage in this scenario has some obvious benefits. Firstly it has increased the net equity return on an investment as long as the cost of that debt remains lower than the return on the asset. In addition, leverage allowed the investor greater upside returns because a smaller initial equity investment has been wagered at the beginning. However, we might also add another more cynical observation. The potentially higher income yield would allow the manager of said investment to levy additional charges whilst still promising an average return i.e. the fund manager could offer a 5 income return or 5% yield on the leveraged 100 project but pocket the other 1.50 in income as charges. 2

3 If interest rates rise. Price of asset Debt Equity Cash flows per annum rate on any debt charges per year Yield % 3.00 = 4% The downsides to this leverage scenario should also by now be obvious. Consider first the potential risk of rising interest rates; a risk which increases if the term of the debt runs for a number of years. If the investor and their fund manager had not locked in the interest rate, they might be vulnerable if LIBOR rates were to increase. In our scenario let s assume that the 3.5% annual interest charge on the 50 loan increased to 6% per annum after a series of sharp interest rate rises. Suddenly our 50 loan is costing us 3 per annum in interest costs, reducing the net return to just 2 ( 5 less 3 cost of capital), pushing the yield on the initial 50 equity invested down to just 4%. Leverage can increase the volatility of equity holder s returns, and if interest rates increase sharply, can also destroy the income returns from an asset. Increasing interest rates might also be associated with a sharp economic deceleration which in turn MIGHT result in the value of real assets being revised downwards. So a 100 asset in a few years time after a recession might be worth just 90. That s reduced the equity component to just 40 (against an initial 50 investment). In simple terms, a 10% change in the underlying value of an asset has been turned into a 20% fall in the value of the equity. Leverage can amplify both gains on the upside AND losses on the downside. It s also worth noting that leverage comes in many durations. Some short term cash flow finance for instance lasts for just a few months or maybe as much as a year. This shorter term form of leverage arguably runs a lower risk than longer term project finance loans embedded into the financial structure over multiple years. Why is this? By definition a loan with just a few months to run required perhaps to fill an immediate gap in cashflows - is much less vulnerable to sudden changes in the economy or the interest rate regime. A loan over say five or even more years, by definition again, must carry greater duration risk of being affected by macro-economic changes and will be more sensitive to changes in interest rates. Long term debt and the economic cycle 95% of the time, equity investors can get by just fine without having to worry about balance sheets. But the remaining 5% of the time, credit suddenly rears its ugly head and bites them. That tends to be right around late or end cycle- exactly where we are now. Matt King, Global Head of Credit Products Strategy, Citi 31 May 2018 Let s repeat the basic facts in our simplified scenario taking into account King s thoughts on debt above. Leverage can increase both the potential for income returns AND capital gains. In addition, it can also provide extra returns to accommodate increased charges. Lastly, leverage and its impact varies with duration risk- leverage can also increase the volatility of equity holder s returns, and if interest rates increase sharply, can also destroy the income returns from an asset. Bearing in mind that we are possibly entering a period of higher interest rates and we are in many market observers opinion late in the economic cycle, with a downturn growing more possible by the month, leverage might be viewed as carrying a higher prevailing risk than has recently been the case. 3

4 Additional complications Leverage and renewable energy assets Back in the real world that sits beyond our simplistic financial models, there are some additional complications. Many BR services invest heavily in renewable energy assets. Typically, these renewable energy projects are wasting assets. Banks typically do not allow interest only debt on wasting assets. Instead, the manager will be required to amortise (pay-down to zero) the debt principal from the cashflows of the project. Amortisation profiles are typically 15 years for new renewables sites which have a 20 year subsidy. The amortisation term will be much shorter for second hand assets that have a shorter subsidy period remaining. The requirement to amortise the debt principal and service the interest on the debt and maintain debt reserve accounts required by the lender and pay the manager s fees, usually means that there is little or no cash remaining in the early years of the debt facility. As an investor will not be receiving income from the project, his / her return will therefore be wholly reliant on the project s capital value not declining faster than the rate of amortisation of the loan. This in turn leads us to the next observation, already stated, which is that debt magnifies the effect of valuation movements. If renewable energy values fall, the adverse NAV impact is magnified by the presence of debt. If the opposite occurs, investors should experience increased returns. With a downturn growing more possible by the month, leverage might be viewed as carrying a higher prevailing risk than has recently been the case. In defence of leverage mitigating risk via hedging Defenders of leverage will of course at this point lodge many objections, not least that the risk of increasing rates can be mitigated by hedging especially if one is working with long term debt. In fact it is rare for banks to provide 5 year plus debt without an interest rate swap being sold to hedge the borrower s exposure to increases in interest rates. rate swaps are derivative contracts which carry additional risks and potential liabilities, including the requirement for monthly changes in the value of swap contracts to be included in the share price of the IHT portfolio company. Managers that do not mark-to-market the swap value and pass any losses through the share price of the IHT portfolio company might be doing their investors a grave disservice by overstating the NAV. This brings us to the question of what those investors might think about leverage and the volatility it can potentially introduce into their investments. Most BR services for instance are sold to older investors concerned about mitigating future IHT liabilities. There are some younger investors in these services but the vast majority are likely to be over 65 with substantial assets to protect. What might the attitudes of the elderly be towards debt, leverage and volatility? Charity Age UK asked research organisation the International Longevity Centre (UK) to look at problem debt among older people. Debt s amongst over 65 s have been rising in recent years and the research started by asking whether this might be viewed as a negative i.e. would debt worry older people? Unsurprisingly the survey found that negative attitudes towards debt, credit and leverage increased with age. One small example. The report observed that very few older people would use credit to meet an unexpected 200 expense many more say they simply could not pay. The research looked at the responses of people aged 65+ to a question on how they would deal with an unexpected expense of 200. According to the report most people said they would meet the bill through savings or from their income, however, overall the research found that more than one in nine (11 per cent) said they could not pay, with only 3 per cent saying they would use credit. 4

5 See report at among_older_people.pdf Mainstream equities may be expected to deliver a more volatile but higher return than an investment in a BR service. Returns of between 3% and 5% are not uncommon in such services after costs. In these circumstances any strategy that potentially increases the volatility of returns either from income or capital is likely to have a disproportionate impact on these investors. If 50% leverage is used and a 10% decline in capital values translates into a 20% decline in values, suddenly that target return of 3% to 5% per annum looks rather less appealing. In the language of financial analysis, this represents a poor risk adjusted return. Within the mainstream world of equity and bond investing, it s commonly understood that what matters is risk adjusted returns. In equities for instance, good years (bull markets) can produce returns of anything between 10% and 50% per annum but these can also be followed by volatile bear markets where losses can also be between 10% and 50%. Investment strategies that use embedded leverage in equities can result in huge losses but that can be compensated for by years in which returns are huge. At TIME we believe that leverage within BR products should be kept to a minimum, and thus should reflect the risk tolerance s of the average BR investor. The cynic might observe that embedding high s of leverage within BR serviceswhich only seek to deliver a fairly defined smaller return might be guilty of introducing too much potential for downside volatility, especially if that leverage is of a longer term nature. Or to put it another way - is a 3% to 5% annual return really a suitable risk adjusted return if leverage could result in magnified capital or income losses? To conclude, let s return to the question we posed at the outset: Is the use of leverage appropriate for typical investors in BR services? Given that many typical BR investors are risk averse and on a personal reluctant to borrow, at TIME we believe that leverage within BR products should be kept to a minimum, and thus should reflect the risk tolerance s of the average BR investor. We do not use long-term leverage within our capital preservation focused BR solutions to boost returns and and would only seek to use leverage in the short term to acquire new projects. In addition, we believe that as the economy nears the end of the economic cycle and the spectre of rising interest rates looms ever larger, it is prudent to keep leverage to a minimum to avoid possible losses being magnified if we enter an economic downturn. Tel: questions@time-investments.com 5

6 Important information This document is provided for information purposes to professional clients only. Any views and opinions are those of the investment manager, unless otherwise noted. The information provided does not constitute investment advice, and is not warranted to be accurate, complete, or error-free. Neither TIME Investments nor its third-party information providers are responsible for any losses or damages arising directly or indirectly from any use of this information. All information correct as at TIME Investments 338 Euston Road London NW1 3BG Tel: Web: time-investments.com