Loans: what can possibly go wrong?Posted: 2018-02-10
Just over a year ago, an unusual opportunity arose. A friend asked if I might be up for lending his small property development company some money. I ended up going ahead with it. What happened? What lessons can I learn? I’ll share the former, hoping my readers can help me with the latter.
Who was the borrower?
The loan was to a small private company doing real estate development. Basically they buy buildings in London where they believe they can get planning permission to increase the number of dwellings; they then maximise the planning potential of the buildings, do the work themselves, and sell on the units. They’ve got a few years’ successful track record.
I have known the three principals for over twenty years; one of them is a very close friend of mine, admittedly one who has radically different approaches to FIRE/money/investing.
What were the terms?
I reached agreement as follows:
- the loan to come out of my Ltd company
- 1% arrangement fee, added to the loan, and repayable at the end.
- interest of 1% per month for the first 12 months, and 1.5% per month thereafter
- half the interest to be payable in cash, monthly; the other half to be paid off at the end with the principal.
- all the principal to repaid at the end of the loan
- no fixed term – the timing of repayment to be at the borrower’s discretion
- security: a second charge against one of their properties. This wasn’t documented properly.
The agreement was written up (in not a lot more detail/length than the list above) and signed by both parties.
My thinking here was that I would probably either receive my money back quite fast – within 2-3 months, or around month 12. If within 2-3 months then this was a lot of work for very little return; in this scenario the arrangement fee of 1% would be a material improvement in my IRR – potentially almost doubling the return to 20%+ p.a. If however I was repaid after 12 months then I was looking at an IRR of around 14%. Any later and my IRR would improve up to around 20%, if I got my money back at all.
What happened next?
After the borrower drew down the loan, I found myself almost immediately regretting providing it.
To explain a bit more of my reasoning; part of why I wanted monthly interest payments was to provide a ‘heartbeat’ pulse which I could use to reassure myself the loan was being serviced properly. The contract stipulated the exact dates of the month these payments were due – the same every month.
In fact what happened was all of the first 3-4 payments due needed to be chased. The borrower wasn’t the most organised and they did all the payments manually. At some point I flipped my lid – with my close friend and his boss – and actually at that point they very quickly fixed the situation by setting up a standing order.
Peace then reigned until about month 11. At that point I enquired about when I might get my money back. No plans were imminent. I reminded them that the interest rate was about to spike up to close to 20% – knowing that they regarded 12% as ‘cheap’ money and 20% as ‘expensive’ money – and, sure enough, suddenly they got their skates on.
The next thing I know is that their finance department takes over the operational side and emails me a draft spreadsheet detailing his calculation of the final sum due. I built my own spreadsheet and quickly saw that they were significantly off – due to basic incompetence. I sent them my spreadsheet; they quickly reverted to me accepting my calculations, and I duly received all the money outstanding at the end of month twelve.
All in all I made about £6.5k, gross, on a £50k loan. In effect this loan was borrowed on margin, at a cost of about 2% (i.e. £1k). So I made a profit of about £5.5k pre-tax. As this was in my Ltd company the tax rate will be about 20% and I will retain about £4.5k.
What did it feel like?
For me the enlightening thing about this whole exercise was the emotions it triggered at the time.
Though I never seriously doubted I would get my money back, I found the comparison with equity investing instructive.
When I make equity investments I know I am taking on risk. I know there is a chance – a very real chance in the case of private companies and even with small-caps – that I lose 50%+ of my money.
By contrast, with a loan I run a risk of default. I thought of this risk as a small probability that I lost the vast majority of the loan.
I realised as I contemplated the prospect of loss that by far the biggest downside I faced was the damage it would do to my relationship with three friends. I think there is a very simple and clear strategy I could endorse, based on these learnings, which is: “never lend money to friends/family”.
On the other hand, my ability to judge the risk and manage my exposure was far greater because I knew the borrower well. As well as knowing the three principals well, I know several of the equity investors who have backed the business. I am, separately, a small equity investor myself, so I receive periodic shareholder information. And my ability to make things happen can be done with a WhatsApp message, or over a beer, and didn’t require a formal letter. So in fact the relationship I had with the borrower made this loan a lower risk, more attractive opportunity than some anonymous small company loan on FundingCircle/etc. So there is another strategy I think that makes sense which is: “what’s business is business, and mustn’t interfere with my personal life – i.e. provided I can maintain separation between the two then proceed, with suitable caution”.
The other thing I found very frustrating was that the work/energy required to monitor those first few payments felt very disproportionate to the return I was making. With hindsight, I think I was over-reacting a bit here. I think my logic for wanting a standing order set up was correct. But the actual time spend managing the relationship didn’t in truth amount to more than a day or two of my time, over the whole term of the loan, and I think this effort was appropriately rewarded with the return I made on the money.
My other reflection on the incident is that when I provided the loan I was consciously looking to rotate some of my equity exposure out of equities and into other asset classes; in late 2016 with equities at seemingly record highs I didn’t expect to see a further 12%+ return over the next 12 months. Having got my 12%+ return from my loan, how did equities do? In fact even better – most markets were up by more over the same period. Doh.
I’m replaying this incident in my mind because the same borrower has now returned and asked for the same deal, again. I’ve asked myself if this is sensible, and concluded it is. My cost of funds has risen slightly but I have the personal balance sheet capacity to make the loan, stock markets are near all-time highs so don’t feel likely to offer me a 12%+ return over the next 12 months, and I think the next time round the loan would go a little bit more smoothly – e.g. I would push for a standing order to be set up on day 1. Against that, maybe I dodged a bullet last time, and will find myself facing difficulties getting repaid next time around?
If an opportunity presents itself I will look to negotiate a slightly different deal; I will ask for a minimum repayment of 25-50% of the loan after 12 months; this would have the effect on providing a more substantial signal of the borrower’s means/intent to honour the agreement, as well as capping my downside closer to the level that I’m familiar with from investing in equities.
I’d love to know reader’s reactions/thoughts – do you think I’ve been sensible here? Is there a better loan structure for me and the borrower? Would you take this opportunity if it presented it? Should I look for more?