Wednesday, May 30, 2012

Natural Finance's comparative advantage over equity financing

The key features of natural finance are the use of open (repayable at any time) loans without fixed repayment terms.  All loans have payment priority for interest and principle in queued order of when they are placed.  A 3rd party comptroller controls all cash in the organization and ensures that investors are repaid when the organization is able to, and directs better loan bid proceeds to repay existing loans.

This post is a followup to Part 1 and 2 which dealt with income property ventures and other typically debt financed ventures.  I will focus here on larger traditional companies and new economy startups that are traditionally financed through public common shares.

First, let me repeat the major advantages of natural finance:

Advantages for borrowers,
  • Cashflow from investment similar to equity investments in that repayments are only made when revenue/income permits.
  • Control of the organization and incentives for profitability and success are retained by borrower/founders.
  • Open loans, and queued priorities, make it simple for a successful business to reduce its borrowing costs by inviting lower interest loans, ultimately achieving a perfect competition market from lenders by facilitating loans from the most willing bidders.
  • Permits continued expansion project financing without causing existing investor objections.
Advantage for lenders,
  • Being more attractive to borrowers means that buyers are more likely to accept higher loan rates.
  • Many risks and types of fraud or lapsed insurance can be eliminated.
  • Loan payment priority can never be supplanted or diluted.  It is impossible for traditional finance debt covenants to fully anticipate or satisfy objections to future dilution.
  • Risk profile of investment is much more clearly assessed at time of loan.  Much fewer things can go wrong.  For instance, generous management salaries, bonuses and perks cannot be implemented at greater risk to lenders.

The only disadvantage to borrowers of replacing equity financing with natural finance loans is that they lose opportunities for deception.  Even though common shareholders hold a theoretical right to receive dividends and to influence/control management through a board of directors, there is no obligation to pay dividends, or high enough dividends, and management regularly controls enough shares and board seats to control the firm's direction.  This can especially affect the powerlessness of minority shareholders.  Natural finance's key advantages over owning shares is that investors are repaid when the funds are available, and management and insiders can keep complete control, and benefits of long term profitability, over the enterprise.

Part 3 - Traditional Economy Corporations
I will show how natural finance can benefit a copper mine, and a large company that doesn't strictly need financing.

part 3a - A copper mine
A mining operation, at its early stages, cannot use traditional hard loans (bonds or bank loans) because project and production delays are common.   Mining projects simply lack the reliability to commit to fixed repayment terms, especially early on.

A copper mine will usually be financed with an offer similar to "$10M invested in common shares will result in $20M of profits attributable to those shares over 10 years, and a bit more profit over some more years until the hole empties out."  Even if the metal and profits estimates turn out to be accurate, the investor is extremely unlikely to be paid those future profits, because management is very likely to use those profits to drill more holes and scoop more rocks, and then with those profits, start even more mining projects.  Most public companies behave like mining companies, preferring to expand over repaying its shareholders.  Owning public shares is inherently a pyramid scheme unlikely to pay out on investment, which although carries the option to sell out, the information necessary to have the proper timing in selling out is only available to insiders.  Another issue worth emphasizing with the $20M expected value of a $10M common share offering is that it is very similar to a political campaign promise:  The goal is the physical transfer of your approval, and fulfilling the promise less important.  Natural finance solves this important issue by forcing management to believe in itself.

Natural Finance soft loans provide the mining company with the flexibility of not repaying investors until there is sufficient cashflow generated by operations, but obligates it to repay once funds are available.  While the copper mine management loses the complete control over profits, and power to obstruct investor repayments, they are still likely to be able to finance expansion projects if they properly steward the first project, because they are likely to be able to convince someone to trust them due to their past success.  Both existing and new investors should be willing to invest in those new projects.  The biggest advantage of natural finance for the copper mine management is that they can continue to own 100% of it, and they give up much less profit to investors.  Investors get the advantage of being repaid quickly and the power/choice of whether to reinvest.

An example copper mine that needs to raise a $10M investment.  Under natural finance, 10 investors could each bid $1M (shown as 1000 in column 1 of chart below) at various interest rates from 6% to 24% (column 2), and they each receive their queue priority position based on lowest bid interest rate first (top row).  After the 3rd year, the project will start contributing $2M (2000 in chart) per year in surpluses available to repay investors.  For the example's simplicity, investors are only repaid at the end of a year (real companies would pay weekly or monthly).  You may scroll the chart to the right to inspect accrued loan balances and repayments.  Column 3 summarizes which year each investor is first repaid in, and column 4 show their total return on investment.  The key result is that $6.9M in total interest is repaid to investors under this natural finance example compared to the $10M that would have been "promised" to new shareholders.  Management also gets to keep all future profits for itself.  

To understand why each investor would bid very different interest rate demands, lets look at their actual returns.  The first 6 investors receive exactly what they bid, with the 6th investor having the highest total return of 16%/year.  Investors 7 to 10, due to the 100% total interest cap, receive less than their bid rates.  Their annual returns are 14%, 12.5%, 11% and 10% respectively.

A copper mine project has several risks that can affect actual performance/profitability.  Delays, the price of copper, the percentage of copper in rocks, and the cost of labour and fuel.  The first 3 investors (6-10%) are the most secure against adverse risks, while the last 4 investors (18%-24%) may be hopeful that profits will be better than expected.  But the motives for each investor choosing his position in the queue are deeper than this.

Loan queue investors have 2 important options when they are about to be repaid.  Their first, and most important, option is the right to not be repaid at that time, and instead keep their position in queue.  When this right is exercised, repayment is then offered to the next investor in queue, who has the same option.  The reason an investor would refuse to be repaid are: 1. He would like to continue earning interest, and 2. He would like to keep his priority position in queue because it is more secure, and 3. expects the opportunity to make a decision on receiving payment again soon.  In our copper mine example, in the first year of operations (year 3), it is likely that the first 6 investors (those with interest rates of 6%-16%) would all refuse the first repayment because they are content with the ROI they expect to receive, and content with the security of being at the head of the queue.  The 18% and 20% investor might choose either to be repaid or repaid partially, or also pass until their next opportunity.  Both these investors do not expect to make their full bid ROI (due to interest rate cap), but it will take a few years before they reach their cap, and they can expect to have the same decision opportunity at time of next payment.  They might also hope that operating profits could increase in coming years and thus pay them their full bid ROI. Receiving partial payment would reduce risk, and extend the time until they reach their interest cap.  The 9th investor (22%) would most likely take payment because of uncertainty in having the option to decide again.  The advantage of this mechanism for the borrowing copper mine is that the process allows it to pay off 20%+ interest debt instead of 6% debt, and so would typically save it interest expenses.

Under natural finance, investors know precisely their position in queue priority and know the amounts and interest rates of all other loans.  Together with straightforward information on past, current, and possibly expected future operational surpluses on the project, the investors can have a clear projection on an expected repayment date, and so able to make informed decisions as to how to act on repayment opportunities.  Unlike traditional investing shareholders, natural finance investors are not at the mercy of management's decision to finance new projects, give themselves bonuses or options, or fancy new offices.  Under natural finance all of those management decisions require new financing which will be placed at a priority payment position that is at the end of the existing investor queue.  In the case of our copper mine example, if annual operational surpluses were below $2M (or expected to be), then it would result in the 16% or 14% investor choosing to be repaid.

The 2nd option available to natural finance queued investors with an offer to be repaid, is to reinvest any part of their repayment back into the queue at an interest rate slightly lower than the copper mine's average/natural interest rate.  In the example, the average interest rate among all investors is 15%.  This is called the firm's natural rate, and represents its total interest costs on the full loan queue value.  In the first couple of years of production where the company is returning $2m per year to investors, the attractiveness of investing will have been established.  Reinvesting repayment proceeds at 14.9% would have a full ROI expected repayment date in 6 years if operations continue at experienced pace.  If the 5 investors at the head of the queue (6%-14%) prefer to obtain an expected return of 14.9% over 6 years (maybe shorter) instead of their more secure position at the head of the queue, then those 5 investors would move to the end of the queue in payment priority, and the 16% investor would now be at the head of the queue.  All investors would now expect to be paid their full bid ROI.  When the firm offers a $2M repayment to the investor at the head of the queue, if that investor refuses payment on a portion of his investment, and chooses to reinvest the remaining portion at the natural rate offer, then a $2M repayment offer remains available to the next investor in line.  If all 5 of the first investors (6-14%) choose reinvestment, it is likely that all other investors would prefer to refuse payment over cashing out or reinvesting.  Although, the 24% investor (originally last in queue) would likely also prefer to keep his interest earning investment, and normally has the option to do so, the copper mine has the right to choose which investor to repay when several choose refusal of payment.  As a result, the copper mine will choose to repay the highest interest 24% investor even if he would prefer not to be repaid.  It also has a bit left over to repay the 22% investor.

The net result of the initial $2M payment is that all loans that were from 6%-14% are now costing the company about 14.9% (actually slightly higher as the natural rate will edge higher when 6% investor reinvests at 14.9%), and it has removed one loan at 24%.  The 24% loan was originally scheduled to "cap out" and cost the company only 10% interest per year over its lifetime.  Thus, the reinvestment process would appear to be costing the company significantly higher interest costs, but the cascade of reinvestments isn't finished yet.    The copper mine, once it is operating successfully, will appear to be an attractive investment at 8%-10%.   The 24% investor that when we last left the example was paid out retains the option to reinvest, and since the natural interest rate being offered is well above 10%, the 24% investor should choose to reinvest.  Natural finance queue positions are like a game of musical chairs where each player can shove others out of their chairs.  If all the company's investors believe that investing in the copper mine as low as 10% is a good idea, then the natural rate will be driven down to 10%, and all of the investors will hold loans around a 10% interest rate.

Under natural finance, since there is a $12.5M loan balance after the end of the copper mine's 3rd year and first repayment, if there is $12.5M of investment capital in the world that thinks the copper mine is a good investment at 10% or 7% (or any rate below the company's current natural rate), then the company's interest costs will drop down to that level as a result of new investors buying out existing investors each at slightly below the company's natural rate.  Using computer's and investors predetermining their responses to repayment offers between the time it is announced and paid, the musical chairs shuffling of investor queue positions can unfold in under 1 second, and the original steep interest curve (6%-24%) transformed into a relatively flat curve where each investor holds 10% interest rate loans almost instantly.  For instance, the 6% investor could pre-decide his reactions to payment offers as: take 10% of the loan balance or just the interest profit portion as repayment, with the remainder reinvested to interest rates as low as 9% only if a payment offer of $5M or more is made, with 70% of the remainder to be refused payment, and the remainder reinvested as low as 8%.  All of these predeterminations could be kept secret from the company and other investors.  The logic of the 6% investor's example decision sequence is that he would like to leverage his optimal queue position to gain some regular income from the investment, is very willing to reinvest, swapping his queue position, if there is a large investment, because he won't be all the way at the more risky end of the queue, but is willing to reinvest a smaller portion of his investment anyway.  Even if an investor secretly accepts a rate as low as 8% or 9%, he still gets to reinvest at the higher natural rate offer of the company, until other investors drive down the natural rate to his minimum acceptable rate.

Summary of the repayment opportunities for investors at head of queue:
  • Company surpluses which must be offered as repayment
  • New investor funds wishing to bid at an interest rate lower than the company's current average interest rate
The repayment opportunities for lower priority investors are:

  • If higher queue priority investors refuse any repayment opportunity
  • If higher queue priority investors reinvest some of their repayments into the queue.
For the borrowing company, natural finance has a clear advantage over traditional debt in that repayments are made only when there is incoming cashflow.  And, clear advantages over shareholder financing, in that 100% control and ownership is maintained by insiders/management, and investors are repaid a capped amount calculated by an interest formula over the time of repayment.

Part 3b - A failing company
Let's consider what happens under natural finance when a company is failing.  Lets say our copper mine has an expected 3 years of life remaining (after which all the accessible copper is expected to be gone), and that each of these years it will generate $1M in surpluses available to repay investors, but there is $10M in outstanding natural finance queued loans.  For simplicity, let's say the queue is made up of 10 investors each owed $1M.

In this scenario, the owners will never be able to profit from the copper mine.  Their only interest in continuing to manage the company would be earning wages and salaries.  The sustainability provisions of the comptrollership function would ensure that before this point is reached, management salaries would be reduced to below market rates, and so in a failing company, the owner management is likely to just walk away, and they don't even have an incentive to lie about the health of the company.

The company still has full value for the first 3 investors ($3M combined due loans), and has no expected value for the remaining 7 investors.  The natural finance bankruptcy process is simply a formalization of owners walking away from the project.  Debt is never discharged, but some of the debt holders become naturally interested parties in keeping the company a going concern.  These investors can convince management to walk away through some kind of payment/incentive.

If the 3rd investor assumed 100% control of the company, there would be no inconvenience borne by the first 2 investors since they will need to be repaid before the 3rd investor can repay himself.  The only hard rule in deciding which investors split control over the company, in a natural finance bankruptcy, is that any investor that is fully repaid, drops all of his further control without additional compensation.

Part 3c - A failing company that can benefit from additional investment
In the last scenario, $3M in available surpluses will be repaid to investors over 3 years.  These projections are based on no new investments, but cover wages, energy costs, and rents.  If $500K in new investments (covering machine maintenance, digging out adjacent areas of the mine, reprocessing tailings/left over rubble) were to generate an expected $2M in additional surpluses, then that investment is economical and worth it for someone.

The issue is that the first investor is uninterested in spending even a penny in unnecessary expenses.  While the 4th and 5th investors would have their respective $1M loans be worthless if the investment is not made, and worth their full $1M if the investment is as successful as expected.  The obvious answer for where the $500k in new investment capital will come from is the 4th and 5th investors.  If these investors don't feel like putting up additional money, or don't believe in the new investment, they can sell their "worthless" $1M claims to anyone in a market-based transaction ($about $10k-$100k, likely), to someone that does believe in the investment.  Any additional investment, in a natural finance bankruptcy, is in the form of a loan with priority at the end of the queue, just as in a non bankruptcy situation.  The difference being that no one expects it to ever be repaid, and the motivation for the investment is the opportunity to repay higher priority loans owned by the same investor(s).

The next issue is how should the 4th and 5th investor split the investment.  The 4th investor would prefer paying the full $500k amount over the investment not being made at all (because he would make $500k instead of $0).  He'd also prefer that the 5th investor pay for some of it as well.  The 4th investor will receive a maximum of $1M, and any new investment he makes will almost certainly be lost.  Any amount that the 5th investor puts up as new investment will help the 4th investor's total return.

The recommended process, in natural finance bankruptcies, is that control of the company is entirely proportional to dollars of new investment made.  The investor putting up additional investment also decides what those funds will be used for.  If only the 4th and 5th investors put up investment capital then only they will have any decision input on the company.  The 5th investor will only be paid if the company makes an additional (to $3M) $1M to $2M in operating surpluses.  The 5th investor may prefer (to 4th investor's delight) to put up $251k ( 51%) of the new investment, in order to steward the company to make its full $5M.  Part of the negotiation can also involve the 4th and 5th investors offering to buy out or swap parts of each others loan holdings. After the 5th investor is fully repaid, control and ownership would pass to the 6th investor, and would be abandoned at his discretion if the company is worthless at that time.  

The other issue with allocating control of the company, is that the future may be predictable but it is never certain.  If copper prices were to fall, such that the original expected $3M turned into $2M, the 3rd investor would want the copany to stop producing temporarily, while the first 2 investors would prefer it keep going.  Such decisions would be given to whoever puts up additional investment.  Since the 2nd investor is only inconvenienced by a delay in being repaid if operations are suspended, he's unlikely to outbid the 3rd investor on new investment, since the 3rd investor risks losing everything if the copper is sold at too low prices.

Natural financed companies not only have an advantage of avoiding bankruptcy longer through owner "hope", once the bankruptcy process starts, there is a sensible process that keeps the company operating as normal through the bankruptcy, and even allows new investment to occur.  Under traditional finance' bankruptcies, new investment is impossible until all debt is "cleansed"/signed off, and even continued operations are likely to be terminated prematurely due to having to negotiate with creditors as a group.  Traditional finance bankruptcy is also expensive for all parties involved, and potential creditor dilutions are complex matters that can fool even sophisticated investors.


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