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The company behind the preference shares offering 14.5%

Can it be sustainable?

Cape Town – One of the messages investors are constantly hearing at the moment is that they should expect lower returns over the next few years. Corporate profits are likely to be muted, and markets will be subdued.

So when a JSE-listed small cap offers preference shares yielding 10% and prime + 4% (currently 14.5%) per annum up to 2020, the immediate reaction is to question how this could be sustainable.

The company in question is financial services provider Ecsponent. It was formerly known as John Daniel Holdings in its previous life as a venture capital firm. 

Ecsponent didn’t entirely move away from its venture capital roots when it changed its name and still owns some biotechnology and other investments made as John Daniel, but it reinvented itself as a provider of credit. It also expanded into Botswana, Swaziland and Zambia.

However, as unsecured lending in South Africa has become fraught with problems, the company has moved away from that sector locally. Its primary business is now small and medium enterprise (SME) finance.

“We have exited the retail space in South Africa because we found it too high risk,” says Ecsponent’s COO Terence Gregory. “Other parts of Africa are different because you can get government payroll deductions, which allows far greater security and a lower bad debt rate, so you can rely on your returns. In South Africa we rather deployed funds into SME lending in niche markets.”

The business model is to not only provide the finance, but expertise in these specialist markets to support the deal. This not only means that Ecsponent charges a fee on top of the loan, but it also has the ability to control the transaction.

This, Gregory argues, allows them to target opportunities where they can gain the necessary returns to meet the dividend payment obligations on their preference shares.

“In terms of deploying our funds into our existing subsidiaries we make sure that they are deployed in areas where we can make a margin on what we’re paying our investor base,” he says. “We have accrued dividends of R25 million, and in respect of those dividends, we have achieved a net return of 34% on funds deployed. So there is a reasonably healthy margin.”

Over the last few years, this has translated into a growing asset base, larger revenues and positive earnings. The table below highlights some of the company’s key financial indicators since 2010 (note that the 2011 and 2012 reporting periods were 15 months each):

Ecsponent Ltd key financial indicators

Financial year end

30-Jun-2010

30-Sep-2011

31-Dec2012

31-Dec-2013

31-Dec-2014

31-Dec-2015

Total assets

R8 774 878

R26 147 261

R55 020 987

R60 698 223

R150 183 049

R466 178 735

Revenue

R5 714 233

R6 463 609

R29 793 507

R37 317 199

R57 395 751

R159 712 275

Profit after tax

R-9 084 125

R279 388

R508 225

R1 033 466

R5 230 911

R19 934 212

HEPS

-6.735c

0.135c

0.485c

0.526c

0.935c

2.490c

Source: Ecsponent Ltd

Gregory also highlights that Ecsponent manages the issuing of its preference shares so that there isn’t pressure on the company to deploy capital simply because it has it.

“We look to ensure sustainable returns, so we only take in capital that we are able to more than service,” he says. “We control the quantum of the pref shares sold, so if we do not have ready avenues to deploy the capital, we don’t take the capital in.”

It looks like a good story, but it nevertheless comes with a big warning.

“We are very transparent,” says Gregory. “The prospectus does highlight that this is a high risk investment, as is any investment when there isn’t a bank behind it having to meet capital adequacy retirements. So there is risk involved, and that is why investors are getting a higher return.”

It’s critical for investors to consider that Ecsponent has a market capitalisation of just R185 million. That is very small in JSE terms, so it would be wrong to make the assumption that just because it is listed it must be stable.

It’s recent track record may also look good, but it is incredibly short term. The company was making an operating loss as recently as 2011.

Investors looking at these preference shares also need to consider why the company would choose this as the preferred way to raise capital.

“Raising capital through these pref shares is very expensive and you have to ask why they wouldn’t approach a bank and get a better rate,” says Simon Brown of JustOneLap. “We have to assume that a bank wouldn’t give a better rate, and so they end up taking on this expensive debt.”

The five-year terms of the preference shares also mean that the company is essentially forced to manage itself to a short-term time horizon, and that may be problematic for investors looking for sustainable long term returns. So while Brown acknowledges that the yields look good, he would be very cautious about investing.

“They don’t have a track record to speak of,” he says, “and while prime + 4% is attractive for an investor the risks are very real and I would stay away.

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