THE COLLATERAL GUARANTEE SYSTEM
The Collateral Guarantee System (CGS) is the working title of an organisation that utilises collateral, issues guarantees and manages the process or system. The purpose is to finance infrastructure and commercial projects that would not be funded through the normal financial channels available to government and commercial businesses. The fundamental structure and concept allow many projects to be financed and constructed by issuing guarantees to lenders, collateralised by prime assets which are refinanced by equity and loans or bonds when they are completed.
There are various mechanisms that could be used to structure the CGS which involve the techniques to borrow the assets to issue the guarantees. That depends on whether it is government or private sources of commitment or a combination of both. However it is done, the demand for an organisation that can stimulate access to finance has never been greater to assist with the low growth economies that prevail in developed countries. The UK especially has a requirement to counter the potential adverse reactions from the Brexit outcome which do remain very uncertain for some time to come.
Although most economies are beginning to recover from the effects of the financial crisis many are still not restored to adequate health and could be adversely affected at any time. Government finances are still weak and cannot afford the massive requirement of infrastructure investment that has been neglected for many years even prior to the problems created by the 2007/8 crisis. European and American politicians have recognised this failing and suggested formats to help resolve the under investment but the amounts proposed to correct the shortfall over the last 25 years are clearly inadequate.
The advantage of the CGS is that it does not impose on budget deficits and can provide the funding without incurring massive government borrowing at a time when tax revenues are still insufficient to allow for the investment required. In essence, the CGS allows governments to undertake substantial investment and spread the cost over a long period while benefitting from the tax revenue it generates and the stimulus to economic growth that all politicians and businesses would like to achieve.
Financial institutions have a need to generate sufficient income to cover their commitments to pay a decent return to savers and pensioners and have made a big effort to find suitable long term fixed interest investments to meet these demands. They have been attempting to organise mechanisms to invest in infrastructure but do not wish to take on the early risk of construction with the uncertain outcomes that may occur. An entity that can provide long term investment opportunities without the construction risk would clearly be in great demand.
The CGS would be able to satisfy this need because it would be large enough to cover unexpected problems and provide a steady flow of bonds paying a reasonable yield that are desperately needed in the current market conditions.
The simplicity of the CGS makes it easy to understand and straightforward to implement whichever method is used to apply the concept. The practical function of the CGS is to acquire assets and pay a fee for their use, a standard practice in all markets for many decades, and use that collateral to issue guarantees for a fee to protect the lender from risk in the event of default. The difference is that in the case of the CGS it is specifically targeted to benefit the nation to enhance the capability of government or a sponsored private entity to make capital investment that is required for a successful economy to function at its most efficient and productive capacity.
Although many countries, both developed and developing, have government sponsored organisations that provide similar support as described above, they do not encompass the innovative opportunities that the CGS provides. The usual practice is to work closely with banks to provide loans to identified sectors of the economy and then securitise (package the loans together) these into bonds which are issued in the capital markets. These bonds are guaranteed by the sponsored entity and ultimately guaranteed by governments. This has been a practice conducted for many years and has proved very successful for many countries.
The CGS is a different version of these entities and allows much more private involvement to bring in the expertise to make it function effectively and employ all the market creativity that is vital for a comprehensive enterprise that is really needed. The concept is very adaptable and can be applied in many different ways. Under the heading ‘Reports and Papers’ in the right hand column of this page you can read an example of this in ‘The Collateral Guarantee System 2016’ which has been specifically designed to apply to government debt acquired by the Bank of England under their quantitative easing policy.
It explains in detail how the CGS can be applied and utilised in a specific circumstance without putting pressure on government finances and since it is collateralised by government debt it would not need to be ultimately guaranteed by government. This means that this version of the CGS would not be included in the government debt calculations which would allow politicians much more freedom to allocate expenditure. In these times of austerity, this is an enormous advantage for future long-term planning for government.
It would be perfectly possible for an enterprise such as the CGS to be established entirely by the private sector and supported by a group of fund management companies. For example, if the top ten largest fund managers cooperated, they could provide collateral of just 2% of the assets they manage and benefit from the 3% fees that it would attract as well as providing fixed interest bonds for their income funds. If that occurred there would be a CGS with about $500 billion to provide support for infrastructure and commercial projects worldwide which clearly could be increased or geared up above the 100% guarantee cover represented by the value of the collateral without calling for more assets.
There are plans to create large infrastructure funds involving American fund managers in conjunction with sovereign wealth funds mainly in the Middle East. Whether these funds will take on construction risk is not yet clear but traditionally they do not. We will comment on this when we have more details.
There will be numerous comments on this blog about this subject and if new, innovative and interesting plans and ideas come forward, we will discuss them in the ‘Weekly Comment’ at the time.
One of the biggest problems encountered by SME venture capital investors and banks is the supply of properly assessed and prepared enterprises to choose from when and if the funds are made available in any reasonable amount.
Small companies even if they are growing quickly have little exposure to potential equity investors because there are not many recognised channels to access venture capital and the whole process is confusing and time consuming. This puts off many entrepreneurs from even trying to look for equity and they find it easier to pressure their banks into supporting them which usually only succeeds in the good times.
Bank finance for small companies is not a suitable source for many of these businesses beyond the short term cash flow provision to finance orders; the banks are traditionally organised to provide this kind of funding. The funding outside this requirement should be supported by long term loan funding and equity. There is no organisation providing funding, advice and continued support that these businesses can approach to satisfy this demand with the expertise to work with them and put in place the complete support package they really need.
Clearly, until organisations with this capability are created with the support of government initially, there will never be a successful SME venture capital sector able to fulfil the requirement for early stage and growth funding that government and many large businesses would like to see. These days, the alternative finance sector is making an impact but it is still only a small percentage of the market and does not fulfil the entire requirement that is needed. Clearly, close cooperation with these crowd funders and peer to peer lenders would be very beneficial for the SME sector.
If these total support organisations were created, they would be able to work closely with the banks and provide that vital supply of well prepared and properly assessed growing businesses. Investors would be able to see that there is a good supply of suitable enterprises to invest in and SME’s would have that support to prepare and guide them towards the right kind of funding to allow them to grow in the right way.
Therefore, it is suggested that organisations called Enterprise Managers (EM’s) are created to fulfil this role and the following description explains how they could operate and the support they would require from government initially. The alternative would be that these EM’s would be funded by the CGS described above.
- It is proposed that Enterprise Managers (EM’s) are authorised by Government to invest equity capital into early stage companies and any viable SME with the potential to grow. In addition, they would offer an advisory service to all SME’s preparing and presenting proposals for lending to banks and other lenders with the option to guarantee all or part of that funding. The rules establishing the EM’s need to be carefully discussed to ensure protection for all parties.
- The companies that approach the EM’s for the advisory service would be asked to sign a simple agreement to state that if they take up the offer made to them by the EM there would be no cost since this would be allowed for in the funding arrangement. If they can find a better offer elsewhere then they would be charged for the work done.
- It is suggested that the Government allows the EM’s to participate in the current Enterprise Finance Guarantee (EFG) to give them the necessary influence in dealing with investors and lenders. This scheme is currently managed by the banks and other asset finance lenders. The EM’s would also be authorised to issue guarantees for a fee to lenders to SME’s when all other avenues of financial support have been explored and failed to provide a solution. These loans are currently 75% guaranteed by Government, the directors of the SME’s and the lenders providing the balance of 25%. It is proposed that the EM’s could guarantee 100% of a loan in exchange for a small equity stake for the balance of 25% not guaranteed by Government. There are a whole range of alternative proposals to achieve this objective that could be considered.
- These EM’s would be authorised to issue 5 year zero coupon bonds on a rolling basis as demand dictates which would provide the equity investment funding. It is proposed these bonds are quoted on the stock market to attract a wide range of investors who would be encouraged to invest on a tax-free basis. It is proposed these bonds would be priced to give a redemption yield of 7% compound. At this yield, each bond would raise £70 on issuance after 2% costs and be redeemed at £100 in 5 years’ time.
- The cash raised from the sale of the bonds would be used for equity investment or profit participating loan instruments (such as convertible loan stock). The cash investment and guarantees would be limited to the full redemption value of the bonds (£100). This would allow the difference of £30 per bond to be used for guarantees for lending (the 25% portion by the EM’s) at a fee of 3% per annum. The purpose of this is to impose a limit on the issuance of guarantees by each EM, this amount could be increased within reason if it was decided it is too low.
- The sale of the equity investments would be used to repay the bonds and any excess would be divided equally between the bondholders and the EM’s. In the event of any shortfall, the bondholders would receive less than the full amount of the redemption price at the end of the 5 years if the reserves of the EM’s are not sufficient to make up the difference. An alternative could be that the Government could consider guaranteeing these bonds, similar to the KfW organisation in Germany and removing the tax-free status.
- The EM’s would be encouraged to use all the equity and loan structures available including convertible loans and profit participating instruments, where a share of the annual profit is paid over and above the rate of interest fixed when the loan is made.
- The Government would be asked to pass legislation to extend tax free status to the capital gains generated from investment in the zero coupon bonds and any equity investment by the EM’s to individuals for the risk of investing in the bonds.
- Once the EM’s have been established for a while, the guarantee issuing function of the EM’s for loans could be extended to include a securitisation programme for the loans by issuing bonds similar to some other European countries and in the USA. The banks and other lenders would lend initially and then have the option to submit loans that meet the EM’s criteria for inclusion in the programme. Those loans would determine the amount of bonds to be issued. This would provide access to this sector by institutions and smaller banks that do not have the staff and the monitoring capability in place. This would be important to extend the exposure to the SME sector to those that have not been involved in the past.
- Accounts; every company assisted by the EM’s would be required to make their accounts accessible by the EM’s on line on a regular basis (at least once a week) allowing constant monitoring. It would be a requirement that the accounts are prepared in the format set out by the EM system to enable immediate assistance to be given if the analysis shows that the company is not performing in accordance with the business plan. In some cases this would mean the EM’s appoint financial controllers that provide this service for the companies they support where there is no proper financial management.
- Net Asset Value; on day one a formal asset valuation would be carried out and then the on line accounting format would make it possible to calculate the net asset value giving a true value to the zero coupon bonds issued throughout the year. The EM’s would have the option to purchase them if they are quoted below net asset value (not expected to happen unless a large discount occurs). It is proposed that the bonds would be marketable without restriction and capital gains tax free to encourage trading activity.
- Coordinators; every company that is supported by the EM’s would have a Coordinator appointed to visit the company at least once a month to establish everything is conforming to the business plan and discuss with the executive directors the strategy and development of the business. These Coordinators would also be non-executive directors paid for by the company and be the main connection between the EM’s and the company in conjunction with the on line accounting and monitoring process. All these positions will be reviewed annually to confirm compatibility.
- Specialist Professional Advisors; the EM’s would retain a group of specialist professional advisors to provide their expertise when required for the use by companies that they support. Initial consultation would be free to the SME and only work to be carried out would be charged at an agreed rate. It is anticipated that these advisors would be used constantly and permanently engaged for most of their time although they would be self-employed.
- The structure of the EM’s is proposed to be limited liability companies with a small equity base provided by private sources and possibly initial Government guarantees to ensure an administration can be properly created to manage the processing of applicants for funding. It is expected that most of the licensed EM’s would already be active in the SME market with experienced people familiar with funding and advising these businesses. For most it would not take much time to gear up to cope with demand.
- The income generated from the accounting, monitoring, consultancy, interest and guarantee fees would be the revenue to cover the costs of the EM’s. These are costs all companies would normally be paying and are not likely to be that different apart from the all-important expert advice which would be allowed for in the funding package.
- The equity investment made by the EM’s is intended to be for early stage and all SME’s below an agreed turnover level to fill the current gap in the market that has proved difficult to satisfy. The companies supported would have to show that they have the potential to grow to above £500K turnover within 3 years and employ additional people on a long-term basis to be eligible for funding.
- To complement the existing venture capital market, there will need to be new and larger venture capital funds (VCF) with a longer time frame created to take these companies on to the next stage when they have had the opportunity to prove their growth potential and allow the EM’s to re-invest the proceeds into other early stage and growing businesses. The EM’s may also be involved in these VCF’s but independently from their main purpose. They could still provide the monitoring and financial control service for a fee for extra income.
- The EM’s would provide Government with the mechanism to encourage certain sectors of business if they believe special incentives are required to stimulate activity in a specific industry. Another real advantage for Government would be the accurate up to date information available for the SME sector and through the EM’s, enable them to assist and support the whole sector during slow growth or recessionary times when the banks traditionally withdraw from the market.
This scheme offers a number of advantages:-
- The banks are regularly castigated for failing to lend to SME’s. At the same time they are under pressure to improve their capital bases, further reducing the liquid funds that they have available, this scheme would bring an entirely new stream of funding for SME’s to the market.
- It will enable institutional investors to take part in a market segment which has always proved impossible for them to penetrate. It will make it easier for private investors to fund and support SME’s but by investing in a spread of investments, their risk will be significantly reduced and it will become much easier to choose where they invest.
- Constant monitoring of financial performance and regular support from Co-ordinators will greatly enhance the performance of the SME’s supported under this scheme and reduce the risk of failure.
- While the tax-free provision of the bonds will be a cost on Government, the actual cost will be dependent on the success of the scheme. The more successful the EM’s become, the businesses supported by the scheme will increase the cost in tax advantages; however this will be more than offset by the tax produced by these companies and the employment they create. Additionally the constant monitoring and support will reduce the failure rate. Failing businesses are an expense to the public purse since they cease to generate tax revenue.
- By creating the EM’s you have control over the early development of new businesses and those that have evolved to begin growing quickly. Many of the mistakes and problems that many SME’s encounter would be avoided or controlled to allow progress to continue. The close collaboration of the banks and other lenders with the EM’s and their relationship with the venture capitalists would smooth out the path of a growing business providing the financial support with strategic planning all through the development period. This would take them to the stage where they have the resources to employ the specialist people and continue growing under their own steam.
There will be regular posts on this blog concerning corporate strategy and advice for SME’s. It is very much a subject matter that is of core importance to Barry Edwards & Associates and any help we can provide to improve funding and support for this sector will be forthcoming.