Background

Many people have been invested into loan notes, commercial papers, promissory notes in the “loan note boom” since 2019. They can be a relatively easy, simple and cheap way for a corporate to raise finance for the first time. In this article, we aim to address the underlying reason why there has been such a spike in delayed payments and defaults in recent months, as well as the key things to look out for when deciding whether to invest in these types of investments.

Loan Notes have and still are offering between 8% and 20% return to investors on an annualised basis. However, these types of financial instruments are not available to retail investors. They fall under regulatory exemptions that are adopted by most jurisdictions across the world. Loan Notes are only available to sophisticated, professional or high-net-worth investors. With this being said, investors often rely on their financial advisor, wealth manager or similar for the recommendation on these types of instruments.

The Marketing

The greatest problem Kingsbury & Partners, and our Product & Risk Committee, has found is that most loan notes are generally marketed to investors in the exact same way, such as:

  • "Secured"
  • "Lucrative return"
  • "Low risk"
  • "Fancy marketing"

In reality, there are only a handful of loan notes that can actually live up any of these promises. When we have conducted our due diligence and reading all fine print, most of these loan notes are in fact:

  • Unsecured and uncollateralised
  • Speculative return
  • Many high risk factors
  • Companies are focused too much on the liabilities i.e. raising more investor capital and not the assets and profits themselves.

The Financial Conduct Authority (FCA) have a very blanket response to investments “You don’t have to be an expert to be a successful investor. But taking some time to understand what you’re investing in should give you a better chance of achieving your goals.” (https://www.fca.org.uk/investsmart/right-investment-you).

In short, a company may be able to provide very attractive returns, but if all goes wrong, often the investor is left with complete capital loss. For advisors, this can often mean many unhappy clients and is potentially ruinous to their reputation.

We understand this, which is why we assess every investment on a risk-adjusted return scale. If everything goes wrong, could you lose your entire investment? If the answer is yes, investors must be aware of that risk and the “reward” i.e. interest payments, should therefore be commensurate to that risk.

Back to basics: What is a Loan Note?

A loan note is a financial instrument that serves as a written promise by the borrower to repay a specified sum of money to the lender, along with any agreed-upon interest, over a defined period. Loan notes are commonly used in various types of lending arrangements, including personal loans, business loans, and real estate transactions.

Here are the key characteristics of a loan note:

  1. Principal Amount: The amount of money that is borrowed.
  2. Interest Rate: The rate at which interest will be paid on the borrowed amount. This can be fixed or variable.
  3. Maturity Date: The date by which the loan must be fully repaid.
  4. Repayment Schedule: The schedule outlining how the borrower will repay the loan, which may include regular instalment payments or a lump-sum payment at maturity.
  5. Collateral: For secured loan notes, the collateral is the asset that backs the loan. If the borrower defaults, the lender can claim the collateral to recoup their investment.
  6. Terms and Conditions: Additional terms such as prepayment penalties, late fees, and covenants that the borrower must adhere to.
  7. Signatures: The loan note is a legally binding document and typically requires the signatures of both the borrower and the lender.

Types of Loan Notes:

  • Secured Loan Note: Backed by collateral, reducing the lender's risk.
  • Unsecured Loan Note: Not backed by collateral, higher risk for the lender, usually associated with higher interest rates.
  • Convertible Loan Note: Can be converted into equity at a later date, often used in venture capital and startup financing.
  • Promissory Note: A simple form of loan note, often used for personal loans.

Loan notes are used in a variety of contexts, including private lending, corporate finance, and real estate. They provide a clear, legally enforceable framework for the lending and repayment of funds, offering protection and clarity for both parties involved in the transaction.

Secured vs Unsecured Investments

A secured investment does not mean that the interest and capital is guaranteed. However, it drastically increases the odds of you receiving both you capital and interest payments. The way it should be looked at is “what is the risk of total capital loss”. By having security, this effectively means that the risk of you losing all your investment is mitigated.

The key area we would like to focus on here, regardless of how these loan notes have been “marketed,” is how to truly assess whether a particular loan note is an unsecured loan note, or a secured loan note. If potential investors understand this, they can make a more informed decision about whether to invest and whether the expected return justifies the level of risk.

For a loan note to be truly “secure” it must have a tangible asset as collateral. Some forms of acceptable collateral may include:

  • First or second charge security over real estate (residential, commercial, or land)
  • Tangible assets (vehicles, boats, aircraft)
  • Cash, bonds, and/or equities
  • Receivables
  • Onward lending which is secured via one of the assets above

What does not qualify as security, in our opinion, is where investors have a debenture over the investment vehicle. This does not qualify as security as there is no recourse available to investors unless that company has tangible “assets” it can liquidate in the event of a default. Contrary the businesses that offer unsecured loan notes, or security with no assets, could in fact be a very lucrative business that is deploying capital to make a substantial return.

Our Approach

Consequently, it is then vital to look at every single other area of the business to further assess whether it is feasible of them making a return on your investment.

This takes serious time to analyse, it takes hours of scrawling through agreements, certificates of incorporation, deeds, debenture deeds, investment memorandum, guarantees. From there, you will have to assess the:

  • Company philosophy & strategy
  • Corporate Structure
  • Track Record & historic performance
  • Financials, reporting & operations
  • Structure, Legal & Regulatory
  • Investment Structure

On average, it requires a minimum of 30 hours for our Product & Risk Committee to analyse each investment product. This is because we have a dedicated due diligence framework. We cut through the sales and market pitches to truly understand the level of risk involved.

The Committee authors impartial reports making fair, informed judgements on issuers and products as reviewed.

Following the decision, it is required by the Board to make its assessments available for viewing by clients and partners as part of Kingsbury & Partners’ commitment to transparency in its decision-making processes.

All findings are made available with the sources consulted as presented at the Product & Risk Committee meeting. The use and framework of this report is for internal purposes only and clients and partners should only consider this report for information purposes only.