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Loan notes: A Ponzi Scheme’s best friend

Joe Moore - Financial Services > Blog > Loan notes: A Ponzi Scheme’s best friend

Loan notes: A Ponzi Scheme’s best friend

As a broker who take’s the task of minimising client risk very seriously, I have never advised on investing in Loan notes. Analysing the risk of an investment is the cornerstone of sound financial advice. For me, the level of risk involved is not justified for the level of return available to clients.

 I should point out that not every company issuing loan notes are doing anything wrong, the problem is that it can be very difficult to decipher which companies are good and which are Ponzi schemes, when operating in an unregulated market.

On RTE’s show, Primetime, an expose was aired on a particular company, Dolphin Trust. The company was operating a Ponzi scheme through loan notes that they were distributing through financial brokers. I would be shocked if they were the only Ponzi scheme in the Irish market using loan notes.

Before getting into the risks involved, let’s describe how a loan note works;

It’s very similar to an IOU. The company issuing the loan note is essentially borrowing money from you, the investor. In return they promise to repay the loan at a future date along with some interest.

Usually there will be some security offered up by the borrower, such as first claim on some assets eg a building, land, or something else of value. So in the event that the borrower fails to make the repayments, you have a legal claim to the asset that was offered as security.

So that doesn’t sound too bad, but under closer inspection there is cause for concern.

Why Are They Risky

1 Currently in Ireland, loan notes are not regulated.

This means that there is no oversight of these products. Doing the required due diligence to satisfy oneself that the security being offered up is legitimate and of sufficient value, that you do have a legal claim on it, and that it has not been offered up as security to more investors than its total worth is beyond the reach of most brokerages.

Any investments that are regulated by the Central Bank of Ireland are covered by investor compensation schemes if an investment firm fails.

-2 Most brokers insurance will not cover unregulated investments:

The cost of insuring an investment is directly linked to the risk of the investment itself.

That’s should tell you everything you need to know about the risk of these products.

There is insurance available for Brokers to cover unregulated investments but it is astronomically expensive and so it’s likely to not be economically viable for a broker to insure himself on these investments.

-3 Why wouldn’t they just borrow money from a bank?

These loan notes could be paying interest rates of more than double the market interest rate for a mortgage. In addition they’re paying brokers a handsome commission, so the effective interest rate they’re paying could be 3 or more times a mortgage interest rate.

If they had the security to offer, why wouldn’t they get a cheaper interest rate from a bank?

Maybe following some proper due diligence, a bank would refuse the loan.

-4 Why not raise money through Venture Capital?

Similar to the question around why they don’t approach venture capital firm, banks or investment banks, these larger institutions have the firepower to actually do the thorough due diligence required to assess unregulated investments.

I had a client express an interest in one such loan note before as they had heard someone else talk about it. I advised the client that I would not arrange the investment for them, but as a courtesy I would do some background research for them to see if I could spot some red flags.

I reached out to the company in question to ask some questions about the investment.

E.g, can you provide me with the contracts, proof of ownership of the assets, proof that the loan notes weren’t oversubscribed, valuations of the assets etc. What I got back was shockingly light on detail. A PowerPoint presentation telling a lovely story about the market they worked in and their track record without any of the detail around security that I required.  

If you have been advised to invest in a loan note, ask your broker;

-1 Can I see some of the due diligence research that you did before advising me on this?

-2 Do you have evidence that the security offered is not over subscribed?

-3 do you have evidence of a recent valuation of the assets that are used for security?

-4 How did you satisfy yourself that I have proper legal claim over the assets? Did you get legal advice to that effect?

If you don’t get prompt answers to these questions, don’t panic, wait for your loan notes to mature but in the meantime find a new broker. The loan notes may be fine, but your broker is not doing his job and is playing fast and loose with your money.

There are far better investment opportunities out there that are regulated, are more transparent, and are covered by compensation schemes, or Professional indemnity insurance.

I hope you found this article helpful. 

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