GLI Finance — Update 10 November 2015

GLI (GLIF), formerly Greenwich Loan Income fund, has transformed itself from an investor in collateralised loan obligations (CLOs) to an SME lender and an investor in alternative finance platforms, including an asset manager that invests in alternative finance loans. GLI targets a stable and predictable dividend, and a double-digit return on equity (ROE) while at least preserving its capital value.

The GLI parent financial statements, in which its investments and loans are included at their estimated fair value, are the most useful to assess GLI in its current stage of development. A large amount of GLI’s profit currently derives from unrealised revaluations of its platform investments, so it is not currently generating sufficient cash earnings to pay its 5p per year dividend. The likely issue in early 2016 of £30m of additional zeros would boost cash earnings. Supplemented by dividends remitted from a considerably expanded asset management business (AuM growth from £53m to c £1bn) and some of its profitable investments, GLI could be able to cover its dividend with cash earnings in the next couple of years.

GLI shares offer a generous c 10% dividend yield, higher than the 8% offered by alternative finance loan funds, which may reflect concerns over the sustainability of its uncovered dividend. If management’s plans to boost cash earnings to cover the dividend are achieved, the yield on GLI shares could fall towards that of the loan funds. In addition, possible capital gains from its platform investments offer the prospect of additional returns for investors.

GLI formerly invested in CLOs and paid out most of the earnings from these investments as dividends. The yield on these investments has declined and GLI has altered its business model to participate in the fast-growing and evolving alternative finance business. Alternative finance has grown rapidly since the financial crisis, which caused many traditional SME lenders to restrict their lending to SMEs to reduce risks and enhance their liquidity. Internet distribution and a SMEs' general disenchantment with banks also contributed to this growth. GLI has successfully built a portfolio of investments in alternative finance platforms and an alternative finance loan portfolio, and has just launched an investment fund investing in alternative finance loans. At the company level it targets an annual return on equity of 10-15%. It currently pays a dividend of 5p per share and hopes to continue to do so with revenues from its loan portfolio and in time, dividends from its asset management business and alternative finance investments once they become cash-generative. It funds its balance sheet with a mixture of ordinary shareholders’ equity, zero dividend preference shares (zeros) and borrowings.

We believe that the parent company's financials are the most appropriate to consider in the case of GLI. The dividend is paid from the cash balances of the parent and the parent accounts value all assets at fair value. The group accounts include cash balances of subsidiaries that could not be used to pay dividends and the group NAV does not value investments in subsidiaries and associates at fair value.

SME lending through alternative finance platforms is booming in the US and UK because of economic recovery and low interest rates. According to a 2014 report by Nesta and the University of Cambridge, the peer-to-peer (P2P) UK business lending market made £749m of loans in 2014, up from £193m in 2013 and £62m in 2012. SME lending through non-traditional channels has a very low market share of total lending at 2.4% of the total in the UK (Bank of England, Trends in Lending, October 2014), showing the market opportunity for this new form of lending.

GLI has built a portfolio of 19 alternative finance investments diversified both by type of lending and by geography, see Exhibit 1 below. The investments are fair valued in the accounts and at the end of June 2015 were recorded at a value of £61m. The preference has been to acquire significant stakes in the companies to increase its influence over its investments, and to reward GLI for its management’s efforts to help the investments develop. It owns a majority stake in 43% of its investments by value and has significant influence in 50%.

In the UK it has nine platforms on the mainland, which provide a variety of working capital and term lending to SMEs, while Sancus, based in Jersey, lends in the offshore market. The European platforms have concentrated on building their infrastructure and expect an acceleration of growth from 2016. The five US platforms focus mainly on asset-backed lending, an area of enormous opportunity as US community banks reduce their SME exposure after the financial crisis and concentrate increasingly on residential mortgage loans. Ovamba is a Francophone African platform, which is set to start expanding into Anglophone West Africa.

GLI’s most significant investment is in Sancus, which it acquired for £37.8m at the end of December 2014 through an issue of ordinary shares (£17.8m) and zero dividend preference shares (£20m – accruing interest at 5.5% per year and repayable in December 2019). It is an offshore lender based in Jersey and is now operating in Guernsey and Gibraltar where management has said it was profitable in its first year of trading. It is considering expanding in other offshore locations including the Isle of Man, Malta and the Cayman Islands. It lends to “asset rich but cash poor entrepreneurs” on the basis that the loans are secured, usually on property with a loan-to-value ratio of c 50%. The loans are £0.5-10m in size and are short-dated for 12-24 months with an interest rate charge of c 10-12%. Sancus acts as a centre of lending expertise for GLI.

The fair values used are consistent with IFRS requirements and are appraised in accordance with International Private Equity and Venture Capital (IPEV) valuation guidelines or other valuation models and techniques that can provide a reasonable estimate of fair value. Factors considered in the valuation analysis include discounted cash flows, comparable transaction analysis and credit spread analysis. Although the appraised fair values are calculated by a leading firm of accountants, the values used in the accounts remain the responsibility of the board of directors, who can substitute their own values if they believe they are more appropriate. This is permitted by IPEV guidelines in exceptional circumstances. GLI believes that it takes a conservative approach in valuing its investments.

GLI does not publish details on the profits of its platforms nor the metrics used in their valuation beyond the general principles used. Most platforms are believed to be loss-making, but management has said that Sancus is currently earning around £2m of profit per year and BMS is also profitable. In its H115 interim statement, it said that it expects most of its platforms to be profitable by June 2016. It also made some comments about the outlook for the various individual platforms, which we summarise below, together with some subsequent developments:

Alternative finance platforms earn revenues based on the lending that they process through their platforms. They earn this revenue as fees based on the amount of lending, not as a spread between lending and borrowing rates. The fee levels vary between 1% and 4% of lending with an average of around 2%. They do not incur credit losses as the credit risk belongs to the lenders. The platforms are agency businesses so do not need large amounts of capital like banks, so that in theory, if they process enough volume, their RoEs could be very high. A complication to this simplified description is that some platforms have created 'safeguard funds' to compensate their lenders if any of their loans go bad. This is similar to capital backing, with the fund established from the revenues earned by the platform. It is not clear that the funds of those platforms that do would be large enough to compensate lenders if there were a significant level of bad debts, nor is their clarity regarding their legal standing. GLI platforms do not have 'safeguard funds'.

With a largely fixed cost base, the higher the volume of loans processed by the platform, the greater the profitability of the platform. GLI’s platforms have been showing good loan growth over the past 18 months, though so far that growth has been concentrated in five platforms. In this period Sancus accounted for 42% of the lending, Platform Black 17%, Trade River 13%, FundingKnight 5% and Finpoint 5%. These platforms account for 56% of the fair value of the platform investments. The other 14 GLI platform investments accounted for 44% of the fair value total but just 18% of lending activity over the 18 months. Their loans haves increased in each of the last two half-year periods, as we show in Exhibit 2, so that in H115 they accounted for 21% of total lending compared with just 16% in H114.

Managing the growth of the platforms is a question of balancing quality with quantity and GLI will seek to curtail a platform’s growth if it does not meet with its risk appetite. For instance, Platform Black’s loan growth has fallen over the past 18 months as it has become more selective.

There has been considerable investor interest in alternative finance platforms over the past few years, particularly at the time of the IPO in December 2014 of the largest US platform, Lending Club. It started operations in earnest in 2011 and since then has originated $11.1bn of loans. For FY15 it expects to earn revenues of $405-409m and EBITDA of $49-53m, and it is very optimistic for its future. The market currently values this company on a price/sales ratio for 2015 of 13.2x, indicating that the market shares some of this optimism, though it should be noted that the shares have fallen over 50% in value over the last year. The valuation emphasises the possible upside of alternative finance platforms, but not all platforms will succeed. A notable recent failure is Sweden’s TrustBuddy, Europe’s first listed alternative finance platform, which has filed for insolvency following the discovery of some missing client funds. Allegedly, client funds were not segregated from those of the company according to press reports, something that GLI requires at its platforms.

At 30 June 2015 GLI had lent £83.3m, up from £34.8 at the end of 2014. The loan book at the end of June 2015 is shown in Exhibits 3 and 4 below.

The largest individual loan exposure is to Sancus, which on-lends the money to its borrowers. Sancus is an offshore lender based in Jersey and started trading in January 2014. By December 2014 it had made £62m of loans, 60% on average financed by third parties. By 30 June 2015 Sancus had approved £117m of cumulative lending since the business's inception, 68% on average financed by third parties. The co-lenders are primarily Channel Island-based family offices and high net worth individuals (HNWIs). The loans are secured, usually on property. The market for these loans has opened up for firms such as Sancus because the traditional lenders – the private banks – have exited the market after the financial crisis as they have become more risk-averse. GLI estimates that the total market in the Channel Islands for these loans is several hundred million pounds. It is currently expanding its operations to the Isle of Man, where it believes the market opportunity is of a similar size, and Malta, where the opportunity could be even greater. Management states that Sancus is profitable and earns around £2m of profit per year. Given the high level of security for all loans it makes, often augmented by guarantees from the borrower, no bad debts have been incurred on the loans it has arranged.

The next largest source of loan was through its 66.7%-owned subsidiary, BMS Holdings (BMS). This company lends to high-growth SMEs with a focus on business services and technology. It is based in the UK and mainly lends amounts up to £5m to companies with revenues of less than £25m, which may not have a sufficient long-term record (three years or more) that many of the traditional lenders require. BMS has been operating since 2005 and has incurred losses just once.

GLI credit controls

GLI’s loan book is limited in size to the surplus of its funding over the amounts invested in its alternative finance platforms. Its funding is limited to its equity, zero issues and a £30m limit on borrowing included in the terms of issue of its zeros. If it wanted to borrow more than this it would require the permission of the holders of the zeros. GLI cannot gear up its balance sheet above this level to earn higher interest income, as a bank would. However, it has an asset management subsidiary that will acquire platform loans on behalf of investors. GLI’s credit controls are therefore important not just for its own balance sheet but for the investors in the funds of its asset management subsidiary.

Following the acquisition of Sancus in December 2014, GLI’s loan book is controlled by the director of lending, Andrew Whelan, CEO of Sancus. GLI has suffered some loan impairments (c £0.5m) and the prospect of loan losses is a major consideration for GLI and its investors. The recently published prospectus for the listing of the zero’s included a discussion on loan risks undertaken by GLI, which we itemise in Exhibit 5 below, together with the risk mitigation put in place by GLI.

Depending on their nature, loan requests for more than £100k may require prior approval by the GLI credit committee, which comprises representatives from finance and the board. Loans considered low risk by the platform may not go to the credit committee even if they are for amounts greater than £100k. Management tells us that currently 80% of loans by value are referred to the GLI credit committee with full details of the borrower, including its identity, available to the committee. A major risk for GLI therefore arises from the fact that its platforms are responsible for credit assessment and collection for a large part of its loan book. Frequently GLI is unaware of the identity of the borrowers. It is therefore particularly important that GLI can rely on the platforms to undertake the appropriate credit assessment and debt collection. GLI places considerable reliance on the due diligence it undertook when it acquired the platform investments and its ongoing monitoring of their activities. GLI undertook its acquisition due diligence with the help of outside experts from Baker Tilly (accountants) and Stephenson Harwood (lawyers) with roughly only one out of every five detailed due diligence assessments carried out resulting in an investment. Ongoing monitoring of the platforms is carried out by a team of four, up from two at the beginning of 2015, and which is likely to rise to five or six in 2016. A leading member of the team is Waldo de Vleeschauwer, who formerly worked at two of GLI’s platforms, Platform Black and Finpoint, and who has eight years of commercial and corporate finance experience in trade, working capital and mezzanine finance.

It is important that GLI's the mitigating measures are truly embedded in the platforms and in GLI itself. This is likely to be a particular challenge for GLI given the embryonic stage of development of many of their investments, the fast-changing state of the industry and the high rate of growth to which they aspire. From outside we cannot form an opinion of whether the mitigating measures have become embedded in GLI and its platforms. We understand that GLI is in the process of appointing a head of risk and compliance whose duties will include, among others, the internal audit of GLI platforms to verify if the platforms are carrying out the appropriate credit assessment procedures. When in place, this will add another powerful mitigant to control credit risk.

GLI has reported an increase in the number of loans made on its platforms. In the 12 months to June 2015 its platforms made 3,296 loans, with an average value of £69k, which compares with 2,274 loans in the 12 months to June 2014 with an average value of £45k. The number of new loans in 12 months to June 2015 was £227.4m compared with £103.3m in the 12 months to June 2014.

GLI expects that platform loan growth will accelerate in H215 and into 2016. One area that could accelerate its loan growth even further is its so-called 'neutral platforms', Funding Options and Finpoint. These aggregate loan offers from many alternative finance providers and present them to borrowers who decide which one to select. By the end of 2015 HM Treasury will designate which 'neutral platforms' will be part of the British Business Bank’s alternative finance referral scheme. Under this scheme, the main high street banks will be required to give SMEs to which they have refused loans the contact details of alternative finance providers. GLI hopes that Funding Options and Finpoint, which are on the Treasury shortlist, will be selected. If they are, it could considerably increase their business.

In September 2015, a £52.7m closed-end fund, GLI Alternative Finance (GLIAF) was launched. It invests in alternative finance loans, mostly originated by GLI platforms. The fund is managed by GLI Asset Management, a wholly-owned subsidiary of GLI. GLIAF acquired an initial portfolio of loans amounting to c £40m from GLI in exchange for shares in GLIAF. The fund was listed on the London Stock Exchange (Specialist Fund Market) and dealings started on 23 September 2015. The fund will distribute at least 85% of its distributable income as dividends and will target a net dividend yield of 8% on the initial issue price. At the date of listing, GLI owned 76.4% of the listed ordinary shares in GLIAF. In addition, GLIAF may issue a further 200m new ordinary or C class shares until 31 August 2016, depending on investor demand.

GLI Asset Management will earn fees of 0.75% for the first £100m raised in the closed-end fund and 0.5% thereafter. GLI will benefit from asset management fees earned by its subsidiary and the provision of finance to its platform investments, which should enable the platforms to compete with other lenders, including other alternative finance platforms. There has been considerable institutional liquidity directed towards platform lenders in general and GLI Asset Management will initially focus on the institutional market. During its H115 results conference call, management said it expects to increase its asset under management (AuM) to more than £100m by the end of 2015 and a multiple of this by the end of 2016.

There is currently a large appetite for alternative loan funds. The sector leader, P2P Global Investments, first listed a fund of £200m in May 2014 and subsequently raised another £200m in January 2015 and £400m in June 2015. Other listed funds include VPC Speciality Lending (£205m) and Ranger Direct Lending (£144m). Funding Circle, one of the leading alternative finance platforms in the UK, has just announced that it will launch a new £150m fund in the near future while LendInvest, another alternative finance company, plans to raise £150m through a fund listing.

In addition to its closed-end fund, GLI Asset Management will seek to manage segregated mandates for institutions looking to invest in alternative finance loans. It may also launch specific funds investing in loans in a particular platform if it sees institutional demand. Its future funds may also charge performance fees.

Over the last two years, GLI's management team has expanded considerably to cope with the many demands of 19 investments in three continents and a loan book that was over £80m at end H115. It could grow to multiples of that size if the asset management business expands as planned. The key members of the management team at GLI are as follows:

Geoff Miller is GLI's CEO. He has spent 20 years in the UK financial services industry as an analyst and fund manager with a focus on the non-bank financial services sector. He directed the GLI strategy away from investing in CLO and towards its current direction of investment in alternative finance lender platforms and SME loans. His main responsibility in the group, after setting overall strategy, is the platform investments, and he represents GLI on many of their boards.

Andrew Whelan, the CEO of Sancus, joined GLI's board when Sancus was acquired and has become director of lending. He is responsible for GLI's loan book. He has responsibility for GLI's entire loan book of GLI as well as that of Sancus. He has previous experience at Kleinwort Benson and Dresdner Private Banking Group, and has more than 25 years' financial experience.

Emma Stubbs, GLI's CFO, qualified as a chartered certified accountant in Guernsey in 2004 and since then has been an account manager at a captive insurance company in Guernsey and head of business analysis and projects at Sportingbet, where she formulated strategy in Europe and emerging markets.

Marc Krombach is managing director at GLI and has spent 28 years in the Guernsey banking industry, usually in treasury and FX functions including periods at Investec, Kleinwort Benson and Chase Bank.

Louise Beaumont is head of public affairs and marketing at GLI. She has over 20 years' experience in growing companies and has previously worked at companies such as Siemens and Microsoft. She has been an adviser to the UK government on FinTech and AltFin and was a co-founder of one of GLI’s investees, Platform Black.

Graham Glass is managing director of GLI Asset Management and is an experienced fixed income fund manager. He has 20 years of managing fixed income assets at major institutions including UBS, Generali and Norges Bank.

GLI’s parent accounts value its assets and liabilities at fair value, while its group accounts value subsidiaries and associates at net asset value – subsidiaries are fully consolidated and associates equity accounted. At 30 June 2015 the equity of the GLI group belonging to ordinary shareholders was £92.9m while that of the parent was £112.5m, a difference of £19.6m mainly comprising the difference in valuation of the investments in subsidiaries (£8.3m) and associates (£11.3m). We currently believe that the parent accounts are the most appropriate to assess GLI, as the dividend, which is important for most investors, is paid by the parent so that its financial position and prospects are important for investors. Also, the group accounts do not give the level of detail required to properly assess the performance and prospects of each of its platforms.

Income sources for the company comprise the following elements:

In H215 we anticipate the platform loans on GLI’s balance sheet will produce £2.6m of interest income. Platform loans (excluding Sancus) at the start of the half year were £60.5m and we expect that another £13.5m of lending was made at the beginning of H215, taking the total to £74m. In mid-September c £40m was transferred to its closed-end fund, GLI Alternative Finance, in exchange for shares in GLIAF, lowering the loan volume to £34m. Also, at the start of October 2015 another £4.7m of loans were transferred to GLIAF in exchange for cash. We have therefore estimated H215 platform interest as just over three months of interest at a rate of around 10% (annualised) on a balance of £74m, and just under three months on a balance of £29.3m. In 2016 we estimate interest income from platform loans of £3.2m (£29.3m at 11%). We have assumed a higher interest rate on the 2016 loans, 11%, as GLI intends to source more of its loans from its US platforms where interest rates are slightly higher. In addition, GLI has a loan to Sancus of £22.8m, which in H115 produced interest income of £0.6m. We anticipate a similar level in H215, making £1.3m for the full year. In 2016 we forecast this loan to produce interest income similar to 2015, on the basis that its outstanding balance remains the same.

We expect GLI operating expenses, excluding finance costs, to be around £3.7m in 2015 and 2016. In H115 underlying operating expenses amounted to £1.5m with one-off corporate costs for issuing shares and acquisition-related expenses of £0.7m some £0.2m higher than a rebate it received on fees it had previously paid to the managers of its CLO investments. We anticipate a slightly higher level of underlying operating expenses in H215 as the company increases the number of employees in line with the increased scope of its activities, especially in asset management. We expect more one-off costs in H215 given the number of corporate actions the company is undertaking, resulting in operating expenses for 2015 of £3.7m. In 2016 we anticipate a decrease in one-off costs but further increases in payroll costs, taking the total to around £3.7m for the year.

Finance costs at GLI include the following:

We anticipate that pre- and post-tax profit for 2015 and 2016 will be £7.8m. There is no corporation tax in Guernsey, where GLI is registered. A large part of our estimate for GLI’s profit in 2015 and 2016 arises from expected unrealised gains in its platform investments, which are non-cash items. We calculate that cash profits in 2015 will be around £1.9m and £4.2m in 2016, while we calculate non-cash profits will be £5.8m in 2015 and £3.6m in 2016.

GLI’s cash earnings, which we forecast at 0.46p per share for 2015 and 1.97p per share in 2016, will not be sufficient to pay its 5p per share dividend. At 30 June 2015 GLI had cash on its balance sheet of £2.5m, £16.5m of borrowings from its subsidiary, Sancus, and £21.5m of zeros outstanding, so net debt was £35.5m. The sale of some of its loans to the loan fund managed by GLIAF should help ensure that GLI has cash at end FY15 of c £2m and net debt of c £50m. If GLI pays a 5p per share dividend in 2016, we estimate that it will have cash of £0.1m at end 2016 and net debt of £59.5m, of which c £55m will be zeros.

GLI could reduce borrowing in 2016 by arranging for dividends to be remitted from its subsidiaries and associates. We estimate that the cash outflow, assuming an unchanged dividend, will be £6.5m in 2016. Sancus and BMS together earn c £2-3m according to GLI management and a successful asset management business could make up the £3.5-4.5m gap. To quantify this, it would require the asset management business to increase its AuM to around £1bn, from its current £53m, to produce around £5.3m of revenue per year if fees were 0.53% of AuM, in line with the current listed closed-end fund fee rate. If fee rates were higher, perhaps because they included performance fees, the required AuMs would be lower. With costs, say, equal to about 20% of revenue, £5.3m of revenue would produce profits of some £4m per year, roughly equal to the gap.

GLI’s current issue of zeros will mature in early December 2019. The funds to repay them could be obtained from asset sales or increased borrowing, including another issue of zeros.

Yield

GLI’s yield of c 10% is one of the highest yields in the UK equity market and is therefore attractive to investors. For yield investors, the most obvious comparisons are the various alternative finance loan companies that have listed over the last 18 months. On average we estimate that they yield c 8.3%, as we show in the exhibit below, which is less than the 10% yield offered by GLI. The GLI yield premium compared with these companies may reflect concerns over its uncovered dividend. If GLI can execute its plan to cover its dividend from a further issue of zeros remittance of dividends from its profitable investments, the yield premium may fall, implying good upside potential for GLI shares.

NAV

GLI is currently trading in line with its NAV, which is calculated as the sum of the fair value of its assets less the fair value of its liabilities. As we discuss on page 5, it uses accepted industry guidelines to assess the fair values. They include an assessment of the future prospects of the platform investments, so differ from a NAV calculated on the historic costs of acquired assets, which is how most operating entities determine their NAV. Therefore, GLI’s NAV involves an estimate of the future success of its platform investments. We estimate that c 40% of GLI’s assets at the end of 2015 will be represented by platform investments. GLI does not provide details of KPIs behind the valuation of its investments, unlike many investment companies that give details such as discount rates used, estimated growth rates and EBITDA margins. A share price in line with GLI's NAV suggests that the equity market currently accepts the published NAV as a reasonable measure of its value.