Corporate Bonds

Why should SMEs consider an alternative to bank finance?

In the aftermath of the global financial crisis that has seen trillions of dollars wiped off the value of assets, and many banks liquidated or nationalised, many banks left standing remain under severe financial distress, for the following key reasons:

• Impaired assets
• Weakened capital
• Tougher capital adequacy rules
• Reduced investor confidence
• Sluggish economic growth

These reasons will reduce banks' capacity to lend to businesses and will increase their operational costs.  To offset these constraints, banks are likely to raise their lending interest rates and their associated fees. Businesses will ultimately pay more for less. 

Banks are unlikely to recover for several years.

There is an alternative for small businesses to raise essential finance – corporate bonds.

Corporate bonds have been used for decades by big borrowers (such as Tesco, BP, and Centrica) and big institutional investors (such as pension funds, sovereign wealth funds, and investment companies) as an alternative to bank loans.  The amounts borrowed and invested at a time can easily be in the hundreds of millions, and for up to 100 years.

Small business corporate bonds apply the same concepts of corporate bonds issued by the big players, but on a smaller scale.  The amounts raised per bond range from £0.2m to £2 million and they mature 1 to 5 years.

Unlike bank loans where the money comes from a single bank, with corporate bonds the money comes from many individual investors.  Most are high net worth sophisticated individual investors.  Though acting as individuals, collectively they form an investor community or market, to whom small businesses can offer their investment propositions from time to time.     The offer is made via a coordinator, a public company authorised by the Financial Services Authority.

Investor community coordinator

The coordinator, or its professional partners, will undertake a high-level assessment of a business that wants to raise finance immediately.  If the business is deemed suitable, the coordinator will then undertake a detailed business review, prepare an information memorandum for the investor community, and invite investors to bid to invest in the business's bonds. The cost of the initial review ranges from £100-£150+VAT.  If the SME is considered unready for funding, feedback can be given to improve its chances in a future application.

The detailed business review costs up to £10,000 and takes up to 12 days to prepare. It will assess the SME’s funding options, needs, and strategy, and provide a valuation of the business if equity funding is required.  It will also form the basis of information provided to the investor network.

Successful bids will be collated and disbursed to the business by an independent receiving agent and corresponding corporate bond certificates issued. 

The process from initial enquiry to receipt of bond proceeds can take up to 12 weeks.

Business preparation and fitness

Some businesses will want to raise finance immediately but they are not actually in a fit state to do so,i.e., if they were presented to investors they would probably be turned away because they are too risky and so unattractive.  For these businesses, the coordinator and its professional partners can guide and develop them over time into a condition where they will be an attractive investment opportunity to the investor community.

Corporate Bonds

A corporate bond is a secured loan with a fixed rate of interest and payable in full at maturity, or at pre-agreed interim maturity dates. For example, for a business that wants to raise £1m for 5 years, it could be structured as a series of 1 year bonds each for £0.2m maturing consecutively over 5 years. 

This maturity ladder would avoid refinancing risk, i.e., where the borrower was forced to find £1m in year 5.  Instead he refinances just £0.2m annually. Interest would be fixed rate, providing stability and assisting budgetting and cashflow management.  Instead of being paid annually, interest could be deferred (rolled over) allowing the business to reinvest interest and grow more quickly, thereby enhancing business stability and cashflow management.

Security and Trustee

The bonds would be secured over the business's assets (fixed and/or floating assets), and an independent valuer would value them quarterly and report the value to investors.  Maintaining adequate asset cover and quality will reassure investors and enhance the business's credibility and ability to obtain further finance from the investor community.

A Trustee acting independently of the coordinator, would be appointed to represent the interests of investors, providing further assurance to investors and lowering their risk, which will benefit the business also.

Complementary business support services

The coordinator and its professional partners, also provide a range of complementary business services to help the business financially.  For example, better working capital management, reducing interest and currency risk, better cashflow forecasting and budgetting, and preparing a business for sale.

Access to investors and borrowers

For borrowers to get access to investors in the investor community, or for investors to get access to investing opportunities, each can pay the network coordinator an ongoing membership fee, or an annual fee, or no fee except for processing a borrower's application.  Where no ongoing fee is payable, the coordinator will usually make its return by taking a percentage of any money actually invested, e.g., 5% (though often coordinators take both a membership fee and a success fee).  

Direct SME retail bonds

It is not essential for SMEs to target investor networks to issue corporate bonds.  They can be issued directly to retail investors generally.  This direct route will avoid private investor network membership fees and might involve lower arrangement fees, but they will probably incure additional costs, such as marketing, and possibly fees to intermediaries such as stock brokers, to distribute the bonds to retail investors. 

Direct SME retail bonds should not be confused with retail bonds that have recently been issued by large companies and banks, such as Tesco, Lloyds TSB, and RBS.  The latter retail bonds are listed on a stock exchange and subject to complex and expensive documentation.  They are therefore relatively more expensive to issue than direct retail bonds.  They have also been relatively large transactions (tens of £millions).   They are in essence standard corporate bonds that big companies have been issuing for decades and have used to raise £billions from institutional investors in capital markets.

Direct SME retail bonds are genuinely suited for SMEs because the documentation is simpler, the transaction size is small, denominations are small, and listing is unnecessary.  Costs can be much lower too. 

Turnaround finance

This form of finance can be in the form of debt or equity.  It is raised from sophisticated and high net worth private investors rather than retail investors because it is of higher risk.  Why is it of higher risk?  Because it is used by SMEs that are in financial distress, who are close to insolvency or administration.  The debt is an urgent injection of funding to keep the SME afloat and to give it breathing space to effect a turnaround. 

To see if your business can raise finance by issuing corporate bonds, of if you wish to take advantage of the other benefits of membership, or if you are looking for urgent turnaround financing, then email ACF to request a free and no-obligation discussion, or call 07800 862499.

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