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Retail investors must steer clear of unregulated products

3 May 2019

There are lessons to be learned from the collapse of London Capital & Finance says Claire Madden, Managing Partner

The recent collapse of London Capital & Finance (LCF) has understandably provoked an outcry, with much soul-searching about how such a thing could have happened. Thousands of investors in unregulated “mini-bonds” have lost their money, prompting an investigation by the Financial Conduct Authority (FCA) and a criminal probe by the Serious Fraud Office. Leaving the question of criminal activity aside, the demise of LCF shines a spotlight on an important issue: should retail investors be able to invest in unregulated products?

They’re certainly a target for marketing – adverts for unregulated investments (which includes mini-bonds and peer-to-peer (P2P) lending) are everywhere these days: on public transport and in the media, dangling mouth-watering returns under the noses of ordinary punters. And it’s easy to see why they are so tempting. As well as the prospective returns – way above what you’d get from a bank - and with stock market valuations close to record highs, they appear to be a simple and accessible alternative.

And it’s true there are some fantastic unregulated investment opportunities out there – unregulated doesn’t mean investments are poor quality or are being sold by charlatans. But retail investors generally lack the skills and investment experience to properly assess what are often more opaque and/or quite complex structures in non-traditional opportunities. If they did have those skills and the financial capacity and appetite to invest in higher risk investments, they’d fall into the “sophisticated” private investor bracket (to use the FCA’s term to describe those with the requisite experience and net worth to take on more advanced types of investments) and should be certified as such.

Dangerous assumptions

It’s likely that a number of incorrect assumptions are putting retail investors at risk of committing capital to investments that are unsuitable for their risk profile, financial capacity and level of investment expertise.

People often think that because a financial services firm is regulated, the opportunity they’re offering is too. That’s simply not the case, meaning that there are no regulatory checks on specific products, and there may not be recourse to the Financial Services Compensation Scheme (FSCS) if things go wrong.

Moreover, in the case of “mini-bonds”, the very name makes them sound non-threatening – like bonds only more appropriate for the man or woman on the street some may believe. Actually, the reverse is true – mini-bonds are less liquid than corporate bonds because they can’t be traded on public markets, and they tend to be riskier because they are investments in small businesses rather than large corporates. Often there is less transparency around mini-bonds since, being unlisted, disclosure requirements are less onerous too.

And sometimes – as reportedly happened in the case of LCF, products are sold under the “ISA” banner, putting them squarely in retail investor territory – seemingly on a par with other “low risk” ISA products that you could get on the high street. Whatever the specifics of the LCF case, it’s important to note that, now that “Innovative Finance ISAs” (which allow investments in P2P) have come onto the market, there’s far more risk and reward to the ISA product suite than there used to be. However, to most people the ISA label still implies a sense of safety.

Calculating the risks

The reason why such big rewards are targeted is because there is typically greater risk attached. Investors should always carefully consider prospective returns relative to risk but retail investors may not be in a position to do this in enough depth.

For instance, it’s understandably tempting for retail investors to compare the promised impressive returns of mini-bonds (up to 8% in the case of LCF) against the lacklustre interest they can get from even the best fixed rate bank bonds which are still paying out less than 2% and cash ISAs which deliver even less. Even government bonds are only paying out 1.17%! The problem is, in doing so, they are not comparing apples with apples, and that can be very misleading: these asset classes are very different.

Furthermore, risk can be difficult to assess accurately. While it may be relatively easy to evaluate the risk with savings and investment products offered by mainstream providers, such as high street banks or well-known investment brokers, less “plain vanilla” products such as mini-bonds issued by private companies are far less straightforward, for the reasons given above (i.e. they are SME investments often with limited transparency). Experienced investors would class this in the same risk/reward bracket as private equity, retail investors may not.

And in some cases, there’s a bit of a “sleight of hand” going on, with investments marketed as having stronger asset-backed security than they do. The Providence Bonds scandal a couple of years ago is an extreme example of a scenario where funds were not used for their stated purpose of invoice factoring, but the point is: investors need to fully understand what it is that they are really backing. For example, are they investing in property or a property company? It’s an important distinction to make.

The other characteristic of experienced or “sophisticated” investors compared to retail investors is that they are more likely to be in a position (financially and expertise-wise) to take a diversified approach to their investment portfolio. “Sophisticated” high net worth investors will typically seek to enhance returns and spread risk by investing across a number of different asset classes. Retail investors may not have the funds, appetite or ability to do this – making them prone to putting too many eggs in one basket. Therefore, if an investment goes wrong, the stakes are comparatively higher: they could lose all the money they’ve got invested not just a proportion, which could have serious financial repercussions for them.

Experience is essential

As the old saying goes, no pain, no gain, or to put it another way, in the investment space there’s no reward without risk. The challenge for all private investors is to be able weigh up that balance in an informed and calculated way to ensure that they maximise their chances of a positive return outcome. When it comes to unregulated investments – no matter how enticing or fundamentally sound they might be – my concern is that they simply aren’t suitable for the retail market. Experience and financial capacity is essential.

The LCF debacle isn’t the first, and it won’t be the last – so unless would-be investors are really sure they know what they’re doing, my advice is to steer well clear. Only those who can certify as “sophisticated” or “professional” should apply.

Claire Madden, May 2019

Claire is a founding partner of Connection Capital. As Managing Partner, she heads up all of our activities in respect of our investments in alternative asset funds, real estate and private debt.

 Russell O'Connor
07760 282 586 or Email