Finance firms: over-geared, over-exposed and over here

By Deborah Hill Cone

Friday 18th June 2004

The burgeoning finance company scene is in for a shake-up with one or more failures to be expected, the first in-depth research study on the sector has predicted.

A significant report by independent broking house McDouall Stuart has baldly stated that some finance companies pose a significant risk to investors a risk for which they are being "woefully compensated."

It highlights how some investors are getting interest rates of only 1% above the 90-day bill rate or less despite taking on this risk.

That means they could get practically the same return from putting their money into nice, safe, government-backed stock.

And depositors who put money into risky debenture stock may be highly exposed to the fluctuations of the property sector, especially the Auckland market, the 94-page report finds.

It flags finance company failures ahead with the sector to come under increasing pressure as the debt market tightens.

The dark clouds gathering over the finance market are due to high household debt, tightening of monetary policy, house prices easing and a tapering off in the growth of lending.

"A growing market has seen the formation of countless finance companies. Many are small, over-geared or over-exposed to a sector and a tightening market may see one or more collapse," the report warns.

The report does not single out which companies might be likely to topple but its analysis lays bare companies that could fit the criteria above.

"The shakeout will bring greater scrutiny, perhaps more regulation, but it will more starkly differentiate the quality of finance companies."

McDouall Stuart, which carries out work for a number of finance companies, is the lead manager and organising broker for Dominion Finance's proposed capital raising and listing.

Finance companies still represent only a small fraction $10 billion of the total $230 billion borrowed by the public.

But of the 180 or so finance companies the 10 largest account for 80% of total assets.

The report analyses 24 companies, including the largest five Marac (part of Pyne Gould Corporation), South Canterbury Finance, Elders Finance, Bridgecorp and F&P Finance.

(Elders' parent company Hanover Group claims to be the largest finance company in the country but is diversified into other businesses and does not provide consolidated accounts.)

The McDouall Stuart report backs up NBR's scrutiny of related-party transactions in the finance sector, saying this is potentially a risk item for investors.

The concern is that where the scale of related-party transactions is significant, there is a perception that debenture investors are funding the activities of finance company principals, regardless of whether the terms are favourable or not.

It is also of concern that the commercial terms of the disclosed related-party transactions may not be fully or sufficiently disclosed to determine whether the transaction is truly on commercial "arm's length" terms.

Transactions may also occur with parties which, while not technically related parties may not be at arm's length.

"This may include business acquaintances, indirect family or friends or quid pro quo arrangements.

"These arrangements are not disclosed."

McDouall Stuart has drawn attention to concern over mismatching of funding lines, as finance companies try to line up their borrowing terms to their lending.

There is a problem where lending is short term but borrowing on that time frame is very expensive.

Most finance companies source 40-50% of their funding from short-term secured debentures, the report finds.

"Some sectors of financing exhibit very short lending terms, such as bridging or development finance, whereas the cost of borrowing on equally short terms may be exorbitantly high."

Finance companies are competing most vigorously for funding over terms of 12-48 months, with interest rates going up to reflect this.

"This bulge [in interest rates] reflects their need to match the term of borrowing against the typical term of finance advances."

McDouall Stuart's analysis of yields against risk (as shown in Rapid Ratings' credit ratings) shows there are many investment offerings where the issuer is offering inadequate yields for the risk investors are taking.

Consumer finance company Five Star Finance was singled out as having a "surprisingly low" premium of 1.8% above 90-day bill rates.

In contrast, the report noted Peter Francis' newly set up Geneva Finance offered a hefty premium of 7.1% over the 90- day bill rate.

Geneva, which was established in 2002, is not yet making a profit.

The largest finance company, Marac, had a very low cost of funding, implied to be only 0.3% to 1% above 90-day bill rates.

"Debenture yields for higher rated finance companies are trading broadly in line with the Optimal Yield curve ...

"Debenture investors in several lower-rated finance companies appear to be inadequately compensated through higher yields."

The report notes there is a wide range of treatments for bad debts, making direct comparisons between companies difficult.

Most companies adopted a conservative approach provisioning at the time of writing the loan.

"Others, we understand anecdotally, may shield bad debts by a variety of means, including 'repaying' an under-performing loan and then writing a new loan contract.

"This does not conform to generally accepted accounting practices," the report notes.

There are four categories which reflect bad debt:

doubtful debt provision to reflect the expected rate of default. Usually recognised at the time the loan is written;

debts written off debts deemed to be irretrievable;

impaired assets loans in default but expected to be recovered; and

past due loans where interest payments are behind schedule.

The largest company, Marac, provides for 2.2% doubtful debts, 2.2% written off debts, 2.1% impaired assets and 1.1% past due loans.

That compares to Bridgecorp which has 3.5% doubtful debts, 1.3% written off, 9.4% impaired assets and 2.6% past due.

One of McDouall Stuart's principals, Andrew McDouall, is a director of Allied Farmers Finance and a director and shareholder of its parent.

Opening the books

Marac

enjoys a low cost of funding (0.3-1% above 90-day bill rates);

operating expenses have risen;

growth of the loan book (66%) reflects acquisitions.

South Canterbury Finance

competitive funding lines 1% above 90-day bill rates;

book growth reflects conservative management;

property exposure below 20%.

Elders

weighted into property;

a "rather high" ratio of liabilities to total tangible assets (93%);

shareholders' returns have been strong;

related-party transactions represent 22% of the book.

Bridgecorp

complex structure may create confusion;

the 3.5% provision for bad debts is high compared to other property financiers;

large number of related party transactions.

Dominion Finance

debenture funding set at 2% above 90-day bill rates;

strong book growth has come from residential property development;

operating expenses among the three lowest of the finance companies surveyed.

Lombard Finance & Investments

small book (Total assets: $23 million);

no related-party borrowing;

trust covenants are liberal, allowing liabilities to reach 20 times shareholder funds.

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