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Finance companies – Does risk equal return?

With the spotlight now firmly on finance companies and the potential or perceived risk to investors, Trustees Executors provides some points to ponder.

Monday, August 14th 2006, 11:58AM
Finance companies have traditionally looked to the public to raise funds to finance their activities, offering interest rates to the public that are generally higher than those offered by banks. Recently there has been much speculative media commentary on the inherent risks and impending collapse of the finance company sector.

While there may be some finance company failures, it should be kept in mind that finance companies have played an important part in the fabric of New Zealand commerce for decades. Many investors will have had very favourable long term experiences with finance companies.

Finance companies have traditionally provided finance for commercial and personal chattels. Examples include finance for machinery such as logging trucks for the forestry sector, restaurant equipment for the hospitality sector, or finance for household chattels such as whiteware. The motor vehicle industry has also been a major source of business with a substantial portion of New Zealand’s motor vehicles being purchased with motor vehicle finance.

Over recent years, new finance companies have been established essentially to finance property developments, to lend in circumstances where finance for developers may not be available from the major trading banks.

Due to the inherent risks associated with these transactions, those finance companies that have been able to raise funds at slightly higher rates than mainstream deposit rates have been able to make substantial profits where the borrowers have repaid the principal and interest on the loan on time.

When considering investing with a finance company, we suggest that you think about the following but not exhaustive list of matters:

  1. Deposit rates do not always indicate risk.
    Be aware that a finance company is a business that ultimately is conducted for the benefit of its shareholders. It is in its interests to offer interest rates to the public that are sufficiently attractive to source funds for investment. The lower the rate the better from a finance company’s perspective. You need to make the assessment as to whether the interest rate offered adequately compensates for the risk you are taking.
  2. Know the risk you are taking.
    All securities issued to the public by a finance company need to be issued under a trust deed. This regulates such matters as the ranking of the securities, and what financial and other agreements the finance company will abide by. A trustee is appointed as a party to the trust deed. Generally, the trustee’s role is to monitor the activities of the finance company and its compliance with the terms of the trust deed.

    The terms of the trust deed are a reflection of the risk that the finance company is able to take. The terms will vary depending on the type of security offered. A higher level of risk will generally be associated with an investment in subordinated notes or unsecured deposits than first ranking secured debenture stock.

    Be aware however that even if two finance companies are offering the same ranked debenture investment, the financial and other operating covenants contained in their respective trust deeds may be substantially different. The same type of security may reflect very different risk profiles.

  3. Read the investment statement. If in doubt, read the prospectus.
    New Zealand securities legislation is designed to require finance companies to provide sufficient information to you to allow you to make an informed investment decision. Make sure that you read the information carefully. While all investment statements must provide the answers to the same set of questions, these documents should at least provide answers to the following list of basic questions:
    • What are the principal activities of the finance company?
    • Who are the people involved?
    • What is the company’s track record?
    • Are they exposed to any particular financing area?
    • Have they adequately diversified their loan portfolio across sectors and limited their risk exposures to any individual borrower or group?
    • What are the risks associated with the investment? If the investment turns out for the worst, where are you in the payout order?
  4. Diversify.
    Sometimes the investments that look the best may turn out to be the worst. Ensure you diversify your allocation to the finance company sector across a range of finance companies. The economic conditions affecting finance companies in one sector is likely to affect all of the finance companies in that sector! Additionally, ensure that you have truly diversified with exposure to other asset classes and types of investment.
  5. Seek Advice.
    Seek the help of a qualified financial adviser. Having an objective, professional view on these kinds of decisions can help save you a lot of worry.

This article has been provided by Trustees Executors Limited.

« Finance company rates about rightA warning, a brickbat and some free advice »

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