Loans and other finance products provided by the banking sector to unlisted businesses – even to those with an annual turnover well over AUD 50 million – are invariably conditional on their owners providing personal guarantees and demonstrating that they will be able to repay the loans by liquidating personal assets.
By insisting on personal guarantees the banking sector is not relying on the business borrowing the money to get repaid. It is relying on the financial strength of the owners. So although the banks say they support unlisted businesses, they are in effect lending to individuals. While one could argue that the banks are misrepresenting their position, more concerning is the adverse impact this is having on the Australian economy. It also raises the question of whether business owners are being adequately compensated for providing personal guarantees.
The requirement for personal guarantees excludes many businesses from achieving their potential. Businesses with minority shareholders, particularly those who are non-executive, are generally unable to borrow money from the banking sector and since many of the non-bank lenders are themselves funded by the banking sector, those businesses are also not able to borrow from many non-bank lenders. As a result those businesses with minority (non-executive) shareholders, of which there are many, are deprived of the capital they need to achieve their potential. With access to capital businesses would be able to embark on projects, buy more goods and services, employ more people and pay more tax. Without access to capital they would not be able to reach their potential and the Australian economy will suffer as a result.
Many business owners seek no compensation (not even notional compensation) for providing personal guarantees. This is a mistake! By providing a personal guarantee the business owner places his/her personal assets and probably also his/her family’s wealth and wellbeing at risk. If the business collapses, for whatever reason, the business owner will not only lose his/her job and investment in the business but potentially also his/her family home, investment property/s, share portfolio, cars and other precious things. This would put enormous strain on his/her personal relationships. The business owner should therefore expect to be well compensated for taking this risk.
People are likely to differ in their opinions of what is ‘well compensated’. I would argue that the minimum return a business owner should expect is a market related return on investing in the ordinary shares of unlisted private companies. That is because the business owner could, rather than providing the personal guarantee, borrow money against his/her personal assets and invest those funds in his/her business. In this case the net return the business owner would expect to earn would be the difference between the effective interest rate payable to the bank on the loan and the rate of return the business owner would expect to earn on an equity investment in his/her business. The latter should be no less than the ‘average’ market related return on an investment in the ordinary shares of unlisted private companies. In the current market this net return would be around 20% per annum. (Well established and profitable private businesses sell for an EBIT return of about 4 times. This translates to a pre-tax return of 25% per annum on the capital invested. I have assumed the cost of borrowing against residential real estate is about 5% pa.) In other words, in return for providing the personal guarantee to the lender, the business owner should require (even if only notionally) a return of 20% per annum on that exposure. If the guarantee is limited to the amount borrowed (which is unlikely), then the 20% pa return should be applied to that amount. If the guarantee is not limited, the return should apply to the business owner’s entire net worth outside the business.
Another approach for determining the return the business owner should require for providing the personal guarantee is to answer the following question: If he/she borrowed the maximum amount possible and in doing so gave the family home, investment property, share portfolio and other assets as security, and then invested all the borrowed money in the ordinary shares of just one unlisted private company (which he/she controlled), what return would he/she require on that investment? The return the business owner should require for providing the personal guarantee is that return less the cost of the loan.
Whether or not one agrees with my approach for determining the return one should require, the point I am trying to get across is that the cost of the loan supported by personal guarantees is not the effective interest rate (interest, fees and charges) payable on the business loan but that interest rate plus the risk-adjusted return the business owner should expect to earn as compensation for placing his/her entire net worth and family wellbeing at risk.
If the business is not expected to generate the pre-tax return required by the business owner on his/her total exposure (which invariably is well above the loan amount), the business owner should not provide the personal guarantee. The business should seek other sources of capital. Capital that will not expose the business owner to losing his/her entire net worth and should not dilute the business owner’s investment in the business. It will probably cost more than a loan from a bank but less than the cost of equity.
While some non-bank lenders provide loans and other financial projects without the need for personal guarantees, they generally require a handsome premium for it, far higher than any perceived increase in risk. There is a need for more competition and more capital in this market – providing loans to businesses without the need for personal guarantees from directors and shareholders.
This is an opportunity I see for the funds management industry. By providing these loans (directly or through lending businesses) they could reasonably expect to earn higher interest rates than the rates the banking sector charges. This could materially boost their returns on investment, which in the longer term (average over the past 10+ years), have been rather disappointing.
By providing these loans the funds management industry would provide a benefit to unlisted businesses (by giving them access to capital they might not otherwise have been able to secure); to the directors and shareholders of unlisted businesses (who would no longer need to place personal assets and family wellbeing at risk); and to themselves (by enjoying materially higher returns on investment). A win-win-win outcome!
Prepared by: Mark Morris (May 2017)