Junior debt financing - corporate bond, PIC, or?

[mattnovak]

Hi all

quick rundown of where we're at:

My company has a senior debt line which funds x% of each loan. We would like to self fund (via investment, until we are capital adequate) the junior slice, y%.

The FCA is typically opaque around our obligations if we were to set up a 'Property Investment Club' - however, if we were to issue a corporate bond paying a coupon and return of initial investment after a set period, could this be used to fund the mezzanine portion of the loan?

Any / all other ideas and suggestions are welcome.

Best,

Matt

[anonymous-user]

You can issue bonds but the problems would begin if you start "offering" or "marketing" them to the public. You can ask a small number of people whether they might be interested, so that essentially they are approaching you to find out more about the opportunity, but that's about it. You can't print up a colour brochure full of financial projections and go handing it round the pub.

As regards getting some friends to invest in a business this link has some useful guidance. https://factor-this.com/how-to-ask-friends-to-inve...

Would I invest in your bonds? No.
Why not? Because if your company goes down the tubes I'll lose my money and if your company is a huge success I won't get to participate in that success. I'd want equity participation with appropriately favourable dividend rights. Otherwise the risk/reward balance is out of kilter. If your company is making enough money to pay interest on bonds it'll be capable of using the same money to pay out my dividend.

[mattnovak]

Many thanks, Rockin, for your reply. Without getting into details, any participants would be part of a wider group of companies known / related to mine, rather than Joe Public.

Best,

Matt

[NickCQ]

rockin said:

Would I invest in your bonds? No. Why not? Because if your company goes down the tubes I'll lose my money and if your company is a huge success I won't get to participate in that success.

I think the idea here is that you are funding the junior tranche in some kind of loan origination business. The success of the originator (OP's company) is somewhat divorced from the individual credit risk of the loans, so it makes sense to look for different types of capital up and down the stack. Even if the originator goes tits up you should still be able to recover on the underlying collateral.

We do these kinds of deals and for start-ups with limited track record we would price the mezz at somewhere in the low double digits with stapled warrants on the originator to get us to a c. 20% IRR if everything went well.

[mattnovak]

NickCQ said:

I think the idea here is that you are funding the junior tranche in some kind of loan origination business. The success of the originator (OP's company) is somewhat divorced from the individual credit risk of the loans, so it makes sense to look for different types of capital up and down the stack. Even if the originator goes tits up you should still be able to recover on the underlying collateral.

We do these kinds of deals and for start-ups with limited track record we would price the mezz at somewhere in the low double digits with stapled warrants on the originator to get us to a c. 20% IRR if everything went well.

That's my position in a nutshell, NickCQ. Thank you for the reply. The senior line requires us to take a notional first loss ahead of loan maturity (loans in this instance are commercial bridging, secured on UK property). This junior debt gives a higher return than the senior line, as it bears a higher risk. I wanted to fund the y% junior portion via a group of (known to me) investors via a bond, as there are quite stringent rules around property investment clubs and land investment schemes.

Happy to chew the fat in more detail if you're interested, as it appears we're in similar markets.

Best,

Matt

[NickCQ]

mattnovak said:

I wanted to fund the y% junior portion via a group of (known to me) investors via a bond, as there are quite stringent rules around property investment clubs and land investment schemes.

Is the idea to have one bond that would cover the whole pool of loans, or do the investors want to be able to fund specific loans but benefit from their share of the senior financing?

[mattnovak]

NickCQ said:

Is the idea to have one bond that would cover the whole pool of loans, or do the investors want to be able to fund specific loans but benefit from their share of the senior financing?

All loans will be funded by the senior investor and junior bond debts at the same ratio.

Best,

Matt

[NickCQ]

mattnovak said:

All loans will be funded by the senior investor and junior bond debts at the same ratio.

It sounds like a piece of junior corporate debt is what you need then. You'd have to check the provisions of the senior debt as to what kind of junior security you can grant and whether you need an intercreditor agreement to slot it in.

Other things to bear in mind are the 5% risk retention rules (not sure if this applies to you) and HMRC rules on thin capitalisation that may limit your tax deductibility on interest?

[anonymous-user]

For anyone who's trying to follow this my layman's guide is,

• Companies raise money either by issuing shares to shareholders and/or by borrowing from lenders.
• Borrowings may be either normal bank borrowings or in the form of bonds - essentially units of debt.
• Company debt my be either "secured" like your home mortgage or "unsecured" like your credit card.
• A company that's already mortgaged all its assets may still want to raise for money from lenders if the existing shareholders don't want to put in more of their own money and don't want to dilute their shareholdings by bringing in new shareholders (if any potential new shareholders are available).

In these situations where a company is already mortgaged up the the hilt accountants and solicitors have to get inventive! They come up with ways of raising money which are "somewhere between shares and debt". That may either be a bond which can behave like a share (NickCQ's mezzanine debt) or share which can behave like a bond. With either approach it's the "higher risk" end of investing.

Mezzanine debt may typically start out as a bond with quite a high rate of interest. After all, and as mentioned above, it's a higher risk loan. If the company defaults (fails to pay the loan interest) the bond holder may have the right to convert his loan into equity (shares). That doesn't miraculously recover the lender's money but will give the lender a stake in the ownership and management of the company. Possibly even complete control. If the mezzanine level lender happens to be the same lender which granted the secured debt (mortgage) then conversion into shares at the mezzanine level may help them protect their exposure right across the board.

Separately, the thin capitalisation rules mentioned by NickCQ don't apply to most normal companies - a small business might have issued just one £1 share and have loan finance (debt) of £100,000. However, HMRC has rules which prevent groups of companies (i.e. stacks or pyramids of companies) shuffling debt around the group to maximise tax deductions for interest payments where the loan is not genuinely commercial for the particular borrowing company.

[NickCQ]

Without wishing to disagree with the helpful guide above I would differentiate between security and ranking when talking about debt.

You can have junior secured debt (i.e. a second ranking charge on an asset) or junior unsecured debt. The mezz I was proposing is not really a hybrid or pref equity security because it would still have most of the key features of debt such as a hard maturity and acceleration / enforcement rights after a covenant breach or payment default.

[NickCQ]

rockin said:

Separately, the thin capitalisation rules mentioned by NickCQ don't apply to most normal companies - a small business might have issued just one £1 share and have loan finance (debt) of £100,000. However, HMRC has rules which prevent groups of companies (i.e. stacks or pyramids of companies) shuffling debt around the group to maximise tax deductions for interest payments where the loan is not genuinely commercial for the particular borrowing company.

Sorry, I forget that most people aren't investing out Cayman / Marshall islands domiciled funds through Lux / Irish blockers

[anonymous-user]

Fair enough, I recognise they are all matters of definition and jargon. I simply thought it might be informative to say something about the curious "in-betweenland" in which many of these concepts live. At the end of the day clever advisers can design all sorts of stuff!