Traditional fixed income isn’t cutting it for clients needing capital preservation with reliable growth. Senior secured debt can be a safe alternative, suggests one advisor.
That’s when your client’s investment helps fund alternative lenders specializing in loans banks traditionally don’t make. But, fortunately, the borrowers aren’t high risk.
The loans are for specific types of companies that have shown strong growth and are deemed to have explosive potential, such as Software-as-a-Service (SaaS) firms, explains Paul McKenna, an investment advisor at Richardson GMP in Toronto. “They grow 100% to 125% per year, with gross margins around 95%.”
Firms that provide subscription-based sales-tracking software are one example.
Since the business model is based on licensing, “a company with 25 salespeople buys [that] many subscriptions. It costs the provider little because the software’s already written,” says McKenna. “That’s why profit margins are so high.”
These firms need capital to expand R&D and hire more salespeople, but banks aren’t interested because there’s no collateral. Private equity can mean handing over 50% ownership. And that’s where alternative lenders come in.
The interest rate is between 15% and 17%. “That may seem high, but it’s an attractive option given the alternative,” McKenna says.
Terms are typically 36 months, with many loans settled in 24. One source of repayment is Scientific Research and Experimental Development (SR&ED) tax credits from the federal government.
According to our source, this investment’s rating lies between government and high-yield bonds
“Firms qualify if they can show strong growth potential based on R&D,” says McKenna. “Lenders help make their case and, in exchange, have dibs on SR&ED dollars.”
That money typically covers the entire loan. If not, the firm’s profits take care of the balance. “Because the company’s doubling in size every year,” McKenna says, “repayment is almost certain. And since the loan’s senior secured debt, the lender’s first in line if the firm goes sideways.”
McKenna’s preferred lender is BEST Funds, based in Toronto. “It gets two firms to independently audit borrowers every quarter and annually. BEST sends reports to us so we always know what’s going on.” Other players include Quebec-based Finalta Capital and Vancouver-based Espresso.
Clients are committed for two to three years and must be accredited investors. The minimum investment’s historically been $100,000, but more recently some firms have offered a $25,000 buy in. Returns for the full period are usually 12% to 15% after fees, which in BEST’s case are 2-and-20 with a hurdle rate of 8% per annum.
“Our clients love it, especially the entrepreneurs,” he says. “They faced the same funding issues when starting their businesses, and in many cases had to give up equity for cash. They made money, but it would have been more had these loans been available.” The investment can also be tax-advantaged for clients with corporations. “BEST’s returns may qualify as active business income because the loans help companies grow,” McKenna explains. “For some clients, holding the investment within a holding company means returns are taxed at 15.5%, instead of the personal rate.”
What if a borrower misses a monthly payment or sales target?
There’s a meeting with the lender to assess the cause. “The first time there’s usually nothing to be concerned about,” advisor Paul McKenna says. “But if it happens again, interest could go up one-to-two percent.” He’s only seen this happen once, and to remedy the issue “one of the company’s founding members put a consortium together to inject fresh capital into the business.” No defaults or trips to court were required.
Dean DiSpalatro is a Toronto-based financial writer.