DBS

40 DUE DILIGENCE CONSIDERATIONS Although the platforms offering debt based securities are expected to do their own due diligence on the offerings they make available to investors (they must disclose what due diligence they have or have not done), it’s essential that advisers look into potential DBS investments to ensure that they are suitable for their clients. What follows is a summary of some of the key areas of due diligence that need to be looked at before proceeding with investment into DBS. Many, if not all, of these items are likely to have been considered by the platform which is offering the investment in its own due diligence review and this can be very helpful to advisers when they are evaluating how closely an offering matches their clients’ requirements. For much larger entities and PLCs, a credit rating from one of the major credit agencies such as Standard and Poors’ is all the due diligence that is required when assessing a bond, debenture or loan note issuer. But where, as is more probable, this is not the case, the platform should be able to provide recent reports and accounts from the issuer and other third parties that it has thoroughly researched and for the adviser’s review. The cash flow should be healthy and consistent. Also, the interest cover – the ratio that shows how easily a firm will be able to meet interest repayments on its debt, is a useful indicator of financial strength. This is calculated by dividing earnings before interest and taxes (known as EBIT) by what it spends on paying interest. The level of turnover and pre-tax profits will also provide a picture of the issuer’s state of financial health. If only a very limited amount of this type of financial information is available (where no credit rating is provided), any investment should only be entered into extremely cautiously. The promotional documentation will generally have been authorised by the platform, whose experience and independence should inform the robustness of the processes undertaken. It‘s very important to find out what the debt is secured against, and where the investor would stand in the queue of creditors if the issuer went bust. This should be included in the details of the bond, debenture or loan note. The valuation of any security and possibility of fluctuation of it need to be assessed, as well as any mortgages, liens, fixed or floating charges or other encumbrances which would impair investor access to the security. Those with assets already pledged to other parties should offer higher coupons to attract investors who are taking more risk with less collateral on offer 79 . Although, on the other hand, companies that are extremely creditworthy may have little real reason to pledge specific assets in order to sell a bond issue. (This is why debentures from creditworthy issuers can sometimes sell for more than asset-backed bonds of less creditworthy issuers.) Check any debentures/charges offered as security are registered correctly at Companies House. If they aren’t, they are void and the investor will be treated as an unsecured creditor. If a fixed charge is taken over land, it should be also be registered at the Land Registry 80 . Investors also need to look at other terms such as what debt covenants (agreements between a company and its creditors that the company should operate within certain limits) have been agreed (even if related to other debt). The terms of the covenant should be fair to the investor, without undue bias in favour of the issuer. Debt levels should be restricted; minimum levels of working capital must be maintained; executive pay and dividends should be restricted so that directors who are also shareholders do not borrow money to reward themselves at the expense of the company and its creditors. If a trustee has been appointed to hold the security for investors, it must be independent and there should be no conflicts of interest. It is the job of the security trustee to take charge of the security and to liaise with investors in a default scenario as to the sale and distribution of proceeds from the security assets at a fair price. When investing through a platform or exchange, liquidity should not be taken for granted. The depth of any available secondary market should be examined, where possible, by looking at transaction history. Is liquidity only provided at a low price point, or do costs and commissions take a chunk out of the exit price? Investors who are keen to stay in for the full duration of the investment may not be alarmed by this, but this is still worth knowing. When considering returns, as well as higher risk, lower liquidity should be compensated for by a higher yield. The specifics of debt based securities are not standardised, meaning that items such as duration, type of yield – fixed or variable, when yield is paid – quarterly, annually, rolled up, bonus payments and payments in kind should be reviewed carefully. It can be harder to judge the risk involved in investing in some debt based securities than in others – it is easier to assess the likelihood of a PLC going bust than smaller and more specialist businesses 81 . “The Innovative Finance ISA has introduced a new group of investors to the benefits of crowdfunded bonds and debentures and accelerated its acceptance amongst mainstream clients.” – Bruce Davis, Abundance