Bond, Skase and Connell are names of just three of the list of high profile entrepreneurial Australians who have failed at some point in their business careers.  In Australia, the latest high-profile entrepreneur to run into financial trouble is Inverell born Nathan Tinkler who, through the good fortune of a ‘tailwind’ of inflated commodity prices and friendly lenders, in April 2012 had an estimated wealth of $1.1 billion.

nathan

Photo: Louie Douvis (Sydney Morning Herald, Business Spectator)

However, with the Australian Taxation Office being the latest creditor to seek payment of the comparatively small amount of $2.7 million in back taxes, Mr Tinkler’s wealth might have fallen to the point of him being in net debt. With his holding in Whitehaven Coal now valued at around $625 million but with estimated debts of $700 million, things are certainly tight for him.

Over the last month he has embarked on selling down much of his thoroughbred horse racing interests and has had his private jet and helicopter repossessed by financiers.  From the outset, the Achilles Heel of Tinkler’s operations was the very high levels of gearing (borrowings) and he is now in substantial financial difficulty.  There are lessons in this for every business owner; for every individual.

Firstly, much of his wealth was based on borrowed money and while, in and of itself, borrowing is not a bad thing, like many things in life too much of it is far from good.  Nathan Tinkler’s ability to borrow very large amounts has to this point been underpinned by two key planks.  Firstly, borrowings were secured by a lien (a mortgage) over his shares in Whitehaven Coal (and predecessor companies) and secondly, lenders lent against the shares on an expectation that the resources boom would continue unabated for a much longer period into the future.

With the decline in global commodity prices over the last calendar year or so, in part a response to slowing demand from China, shares in resource companies like Whitehaven Coal have been bearing considerable downward price pressure.  For all resources companies this has brought on a need to cut costs wherever possible in the face of reduced revenue from sales of commodities – witness redundancies afflicting thousands of mining workers across the nation over the last six months.

From the outside at least, the Tinkler situation appears to be a case of too much (debt) too soon.  Cash flow is ultimately the lifeblood of every business (substitute ‘salary’ for cash flow, for employees) and if it’s impeded (e.g. reduced commodity prices) then things can get grim very quickly.  With an inability to meet debt obligations because of falling revenue, it’s only a matter of time before smiling lenders start to deliver other facial expressions.

The same risks are at play for individuals. Too much debt is never a good thing and myriad risks abound to curtail loan repayment ability. Consider sickness, accident and unemployment as just three of the things that could jeopardise an individual’s capacity to meet loan repayments. Then there are issues like rising interest rate cycles which eventually send some borrowers into default on loans.

Whether or not Nathan Tinkler will be able to resurrect his business’ ascendency remains to be seen. The headwinds that confront him now seem unlikely to dissipate any time soon.

While the very essence of a successful economy is that at points along the way, people have been brave enough to be entrepreneurial and start a business, there can be failures at any time in every business cycle – in good times and bad.  Yet, thanks to sound business management, plenty do succeed.  As in nature, business evolution initially sees the strong (balance sheets) survive along with those that can adapt to a changing environment.

As you read this it’s worth remembering that the very reason you can read this online, right now, is in very large part due to the entrepreneurship of people with names like Gates and Jobs!

 

 

While we live in world seemingly full of unrelenting change, there are some things that will never change in the financial world.  For a very long time, I have maintained a set of ‘Golden Rules’ that are always relevant and good for investors to keep handy when contemplating making investments.

So let’s get started with a Golden Rule that deals with tax benefits.

1.    Tax should never be the primary reason for making an investment.

Why? (people always ask)  It’s quite simple really – taxation law is subject to change so the overriding question you should ask yourself – before investing – is:

If the government were to cancel the tax benefits associated with this investment, would I still be happy to put my money into it?

If the response is ‘No’ then that – in isolation – should be sufficient to deter you from putting your money into the investment.

 

The Australian investment landscape is littered with the carcasses of investments that were marketed to investors on the basis of tax benefits which were, at times, questionable to say the least. As I write, the collapses of more than twenty years of professional practice come flooding back.  Over the years I’ve witnessed, from the sidelines, collapses of investment schemes which involved:

  • Pine trees
  • Jojoba beans
  • Cray fish farms
  • Wild flower plantations
  • Tea tree plantations
  • Ostrich breeding
  • Oak trees
  • Cattle breeding
  • Film production

Rest assured there are more failures than recorded above.  All the schemes above were variations of a theme – investors borrowed all or part of their investment and hoped for that the forecast capital and income returns came true. In many cases it was little more than the proverbial ‘wing and a prayer’ due to the fundamental flaws in the investment structures.  Some such schemes claimed that for every $1 invested a tax deduction of $5 could be claimed.

Consider this excerpt from a 2006 report by the Australian Taxation Office:

The Senate Economics References Committee found support for the view that “the growth of a highly competitive entrepreneurial promoter market … has been the most significant driver of the growth in aggressive tax planning.”

This finding built on the Committee’s previous reports. In its Interim Report it concluded:
“ it is the view of the Committee that a large number of these schemes appeared to be designed specifically to defraud the tax system and to use ordinary taxpayers in that process. Not only have they left many taxpayers with large tax bills, but many of these schemes have ceased to exist. The Committee is of the view that few schemes represented ‘a good investment’ in the ordinary meaning of the term, and that without the ‘tax deductibility’ factor, very few would have got off the ground.”

I recall explaining to students in an adult learning program which I taught that: “If the tax office ever disallows the tax deductions (on these exotic investment schemes) people will march in the street!”  And so I was not surprised to see that in Sydney, Melbourne, Perth and Canberra, so-called ‘tax effective’ scheme investors marched in protest at the Australian Taxation Office’s early 2000s decision to disallow tax deductions on such schemes[1].

To make matters worse (for such investors), the decision was made with retrospective effect to 1992.

What appealed to such investors was, in effect, a view of getting something for nothing; the so-called ‘free-ride’ that investors sometimes believe they receive when tax deductions are on offer. Of course there is no such thing as a ‘free lunch’ and many such investors were subsequently hit by the dual impact of a failed investment followed by a retrospective disallowance of tax deductions from many years previous.  For many investors, the losses amounted to hundred of thousands of dollars.

‘Tax effective schemes’ are by no means the only area where investors focused on tax deductions can be at risk. For example while I’m a great supporter of superannuation as an investment vehicle to accumulate retirement savings, it concerns me when investors have all their investment capital in superannuation. This is because – no matter how many super funds you have – superannuation is subject to constant legislative change and such change isn’t always beneficial for investors.  While it’s a very tax efficient system through which most Australians can save for retirement, there is substantial legislation risk with it.  It is sound planning to accumulate wealth in superannuation and outside of superannuation.

So the ‘Golden Rule’ is:

1.    Tax should never be the primary reason for making an investment.

Tax should only ever be a secondary consideration.  Remember: Tax laws change.

 

 



[1] The Australian Taxation Office has previously referred to the schemes as ‘abusive tax schemes’.

A lot of people in Victoria and southern New South Wales have lost a lot of money with collapse of Kyabram based Banksia Securities Limited (Banksia).  While it appears customers might yet have a reasonable chance of recovering of some of their money[1], the collapse has no doubt caused sleepless nights for many.

Banksia type collapses are nothing new in Australia – it’s happened before. Westpoint springs to mind so too does Estate Mortgage in 1990 and some readers might recall the collapse of Cambridge Credit in the mid-1970s which took more than 20 years to see some money returned to depositors.

You can be sure that unless we see sensible regulation of the non-bank deposit sector, this type of collapse will happen again.

Your task is to avoid these high-risk investments for the rest of your days!

Banksia was not a bank!

Let’s be very clear here – Banksia was not a bank yet, according to some reports, many customers assumed that they had ‘bank’ like security of their deposits.  Similar to a bank, the money deposited by Banksia customers was largely then on-lent to borrowers – home buyers, farmers, businesses and property developers – at a higher interest rate than what the Bankisa depositors were being paid. Banksia’s profit was essentially the difference (the margin) between the interest charged to borrowers and the interest paid to debenture holders (depositors).  While this is not unlike a bank’s primary role, the bottom line is that Banksia was not a bank.

In order for a bank to be licensed by the Reserve Bank of Australia, and thereby have access to a ‘lender of last resort’[2] facility, an Australian bank must meet legislative requirements that are administered by the Australian Prudential Regulation Authority (APRA).

In short, the banking regulations administered by APRA dictate that banks must maintain certain levels of capital in particular assets to protect against ‘bad loans’ – these are the so called ‘Capital Adequacy Requirements’ (CAR).  In return for meeting the CAR requirements, since the onset of the Global Financial Crisis, banks now also receive a government guarantee of the deposits they hold.

While non-bank deposit takers like Banksia also have capital requirements administered by APRA, if they don’t comply the legislation merely requires them to disclose their capital position to investors in prospectuses – it does not preclude them from taking deposits.  In more than 20 years of professional practice, I’m yet to meet an investor who would be able to see the risk that’s embedded in a prospectus which discloses a non-bank depositor taker’s (eg Banksia) compliance failures.

In broad terms, a bank must hold $10 of capital for every $100 of loans it writes.  In Banksia’s case, there was less than $3.60 capital for every $100 of loans.  Leading up to its demise, the number of Banksia loans in default rose quite dramatically. In part, this was a reflection of downturns in the regional economies where Banksia was based however it also reflected the higher risk nature of the parties that borrowed from it.

And ‘debenture’ means?

From an investor’s perspective, a debenture is a document which simply acknowledges that money has been lent to another party at an agreed rate of interest for an agreed term.  In the case of Banksia debentures, depositors lent money to (invested with) Banksia and it then lent that money on to borrowers.

The crucial point here is that there is very little – if anything – securing the debenture.  In general terms the only security which might underpin debentures is a so-called ‘fixed and floating charge’ over the borrower’s (eg Banksia’s) assets however there is no guarantee – no lender of last resort facility for the finance company (Banksia) to rely on in the event of needing to pay back debenture holders.

Debenture investors almost always have absolutely no protection!

If the interest rate is higher than bank interest rates…

Here’s the bottom line on debenture risk! If you see any interest bearing investment offering you interest rates that are higher than stock-standard bank deposit rates you can be sure there is much higher risk.

Why so? Well think about what’s going on here.  An investor lends money onto a finance company (eg Banksia) which then lends that money on to a borrower.  How good (bad?) a risk is the borrower?

Here’s the question you need to ask: Why doesn’t the party borrowing the (your) money from the finance company borrow it from a bank? 

And this is THE point!  The answer is that the borrower is too high of a risk for a bank to lend to so they need to borrow from a lending source that is prepared to accept the higher risk.  However, the lender (eg Banksia) knows the borrower is high risk so they charge a higher loan interest rate than what a bank would charge.  The higher loan rate results in a higher interest paid to the debenture (lender) holder and therein lays the risk for the investor.

Buyer (investor) beware!

On a final note, I should point out that it is possible for investors to earn very competitive interest rates with strong capital stability that are not high-risk debentures.  It’s a matter of knowing where risk exists and understanding how to reduce it, before investing.

[1] The receivers recently indicated they hope to make a payment of 15 cents in the dollar to account holders before Christmas 2012.

[2] A lender of last resort facility is provided to allow licensed banks to borrow from the RBA in the event that they should experience a ‘run’ on depositors’ funds. In such an event the RBA would provide (lend) funds to the bank to cope with the withdrawal requests from depositors.