Companies: AGP    GMA    IAM    LII    PCF    TFL    TMG   

Until recently, loan notes were rarely issued by smaller quoted companies to private investors. But as interest rates fall this method of raising finance is becoming increasing popular and brave investors could profit. Christopher Spink reports

At the beginning of September, FTSE 100 property concern Liberty International created a furore over its issue of convertible bonds worth £240 million. The interest paid to investors will be just 3.95 per cent per annum, or only a little more than the current Bank of England base rate, which stands at 3.5 per cent.

In addition, the price at which investors can convert their seven-year bonds into shares is 800p, nearly a third above the current 625p price. This was seen as 'tough' pricing by analysts.

Nevertheless, the company, which owns numerous shopping centres, has managed to raise this money, taking advantage of its FTSE 100 status 'to access the convertible bond market on attractive terms and thereby augment the group's aggregate cash resources'.

Asset backing?

Property companies are frequently financed by such debt instruments – since they have substantial assets to put up as security – but these methods of raising money are becoming increasingly popular with companies in other sectors at the smaller end of the stock market.

For instance, in late June, jewellery designer and retailer Theo Fennell raised £1 million through an issue of secured loan stock, convertible at any time over the next five years into shares at a price of 30p, a premium of 10p or so to the share price then.

Investors, who were mainly directors, will also receive annual interest of seven per cent, double what can be achieved by leaving the money on deposit in a savings account. In addition, the notes were secured against the company's assets and ranked after the group's overdraft with Clydesdale Bank.

In this way Theo Fennell has taken advantage of the relative cheapness of debt and satisfied the desire of investors to achieve decent levels of income in a period of very low interest rates.

Credit risk?

However, private investors need to keep their wits about them when considering these seemingly attractive instruments, as some companies present more of a risk than others. The security offered by Liberty's property seems more solid than loss-making Theo Fennell's promises.

The saga surrounding The Market Age amply demonstrates the hazards investors can encounter in this area.

Cashflow problems forced the financial application services provider to cancel the interest payment due to holders of unsecured loan notes in the company and convert the notes into cash, giving holders just 10p for every £1 of notes held. Since then, the cash crisis has worsened and the company's shares have been suspended, as directors continue refinancing talks.

Nevertheless, backing a company via loan notes, rather than direct equity, is normally seen as less risky, because if the company does fail then you are ahead of shareholders in the queue of creditors but behind others, such as banks and other lenders.

The risk is normally reflected in the level of interest paid or conversion price set.

Varying interest

For example, Aim-listed Thistle Mining, which principally wants to revitalise the President Steyn gold mining complex in South Africa amongst other interests, managed to raise $24 million of convertible loan notes in July paying ten per cent interest per annum.

The money will pay down existing debts and help finance work on Thistle's projects. The notes are convertible into shares at 32.5p, above the current price of 28p per share. In general, a company's loan notes will pay a higher rate of interest if their conversion price is at a premium to the current share price.

However, there are circumstances where the reverse applies. Software developer AIT issued £5 million of loan notes recently where the interest rate was LIBOR (the London Inter Bank Offered Rate) minus two per cent. LIBOR is roughly akin to current base rates of 3.5 per cent, so investors will currently receive just 1.5 per cent annually.

To compensate for this though, the notes, which have a life of five years, can be converted into shares at 25p per share. This represented a discount of 7.4 per cent to AIT's share price on the day of the announcement but with the shares now standing at 69p, loan note holders now stand to make a profit of over 150 per cent.

The AIT notes helped to re-finance the company, which notched up a £37.8 million interim loss, reflecting massive write-offs incurred on its balance sheet over the past year.

With their attractively low conversion price, one might imagine these AIT notes would prove easily sellable. Yet, only a handful of notes are listed on the stock market with the majority remaining unlisted.

Listed on Aim

However, the Thistle Mining notes are listed, as are those issued by asset-finance specialist Private & Commercial Finance. This company periodically issues sizeable loan note issues to fund its own lending activities.

The latest issue in July, which raised £2.5 million, will pay eight per cent interest annually and can be converted into Private & Commercial Finance shares at 76p until 2010. The share price is currently 57.5p.

Again investors are happy to back these issues as the debt is backed by the group's own loan book of debts repayable by its clients in the motor trade. Indeed, the majority of Aim-listed loan notes have been issued by asset-backed companies, such as those in property, mining and finance companies.

Other examples include notes from miners GMA Resources and Gympie Gold, fund manager Integrated Asset Management, shopping centre owner Peel Holdings and traditional Devon brewer Heavitree Brewery.

A number of other listed loan notes were issued by former fully-listed companies that have moved to Aim, such as flooring maker James Halstead and engineer Widney.

Public-to-private proposal

If a proposal by financial advisers Kinmont and lawyer Travers Smith Braithwaite is taken up, then Aim investors can expect many more issues of loan stock to be listed on the junior market.

The duo believe that 80 per cent of attempts to take public companies private fail because investors in such concerns believe the offer frequently values their investment too meagrely.

Their solution to enable more public-to-private deals to proceed is to encourage such companies to arrange a possible loan note alternative to any cash offer.

The unsecured notes would be listed on Aim, pay a suitable rate of interest and be convertible into equity should the company re-list or be taken over subsequently. If this transaction was done at a higher price, then these note holders would benefit from any increase in value.

This meets the Aim rules and should satisfy disgruntled shareholders. After all, unlisted loan notes are frequently offered as an alternative to cash, in order to prevent a chargeable capital gain from being incurred. By listing on Aim, note holders can also take advantage of the tax break that reduces the rate of capital gains tax to ten per cent after two years.

Development capital

Other companies are following AIT and Theo Fennell and issuing small amounts of loan notes in order to raise working capital to expand and develop their business.

One recent case is smart card producer ID Data, which wants to raise up to £4 million via a secured convertible loan note issue, paying seven per cent interest and convertible at 5.5p, against a share price of 3p on the announcement date. Since then the shares have risen to 6.5p, putting the notes 'in the money', so to speak.

ID Data's chief executive Peter Cox describes the issue, agreed in August, as a 'win-win situation'. He argues that 'investors receive a decent yield of seven per cent and significant upside from 5.5p'. It also reduces the risk of backing ID Data's developing business by providing interim interest payments.

However, although this makes debt financing cheaper initially for companies, potential investors should also be wary that hefty interest payments will also increase the ongoing costs of the business devoted to servicing such debt. This paradoxically may increase the risk for investors.

Nevertheless, loan notes look like becoming an increasingly common part of the smaller company financial landscape if interest rates remain at their current low levels.