GLI Finance — Update 28 April 2016

In the last two years GLI has undergone a transformation from an investor in collateralised loan obligations (CLOs) to an investor in 19 alternative finance platforms providing loans to SMEs, mainly in the UK, US and Europe. It is now in the midst of a strategic review to focus its capital and human resources on those platforms that it believes will have most potential to maximise shareholder value. Already included in its retention list will be its two large subsidiaries, Sancus and BMS, and four fintech enabled platforms in which it has minority holdings. It is not yet clear what will happen to the others, but they may also be added to the retention list. GLI has effectively become an operating company rather than an investment company, which should give it greater control over its assets and enable it to provide investors with increased transparency of its businesses operations. At its forthcoming AGM it is asking for shareholder approval to be declassified as an Investing Company under AIM rules.

GLI’s valuation is particularly subjective given the evolving nature of the alternative finance industry, the embryonic state of many of its investments and its own strategic review. It has set its dividend at 2.5p per share for 2016 and so offers investors a yield of 7.8%, which compares favourably with equities generally and long-dated gilts, and is comparable to the yields offered by the recently launched investment trusts specialising in SME loans. However, its dividend is not expected to be covered by cash inflows from operations in 2016, so it will have to pay it by using its cash resources, selling some assets or increasing borrowing. In time, it anticipates that profits from its investments in platforms will be paid to the company as a dividend and will cover its own dividend, but there is currently little clarity on when that might be.

GLI’s P/NAV of 75% is low compared with the SME loan funds, where the average is around 94%. However, a large element of GLI’s NAV, c 40%, is invested in alternative finance platforms. There is little transparency about the financial success of these operations, so GLI’s NAV is likely to be an unreliable guide to valuation at the moment, and as the company increasingly become viewed as an operating company less emphasis is likely to be placed by investors on its NAV. GLI does intend to increase the amount of information in publishes on its operating activities, which could reduce the uncertainty about its NAV. It is currently implementing “Project Clarity” which defines the company as a speciality lender and not an investment company.

GLI has taken measures to strengthen its balance sheet and we expect that net debt/equity will fall from 45% at end 2015 to 38% by end 2016. It is also taking steps to extract cash from its subsidiaries, where possible, and in 2016 is expected to receive £2.5m of dividends from Sancus and BMS. The 2.5p annual dividend will not be covered by cash earnings in 2016, but GLI could cover the payment from its cash resources, asset sales or increased borrowing.

GLI formerly invested in CLOs and paid out most of the earnings from these investments as dividends. However, the yield on these investments declined in recent years and in 2014 GLI altered its business model to participate in the fast-growing and evolving alternative finance business with a specialisation of providing loans to SMEs, as the banks, the traditional SME lenders, were scaling back their exposure. GLI quickly acquired a portfolio of holdings in 19 alternative finance platforms: a majority holding in five, ownership of 20% to 50% in 11 and stakes of less than 20% in three. See our outlook note of 11 November 2015 for details on its finance platforms. For the most part, its investments were in small companies in the early stages of their development and most were loss making and required funds to develop. In September 2015 GLI launched a closed-end fund, GLIAF, to invest institutional funds in loans originated by these platforms. The fund did not raise as much as planned, and following an unsuccessful capital raising effort by GLI in December 2015, GLI announced a strategic review of its activities and that the Somerston Group (see page 6) would subscribe to an equity issue by GLI and negotiate a comprehensive strategic relationship with it. GLI’s CEO was replaced by Andrew Whelan, who was the CEO of its largest platform investment, and the dividend was cut by 50% to a level that GLI’s board considered more sustainable.

Alternative finance brings together finance providers with borrowers outside the traditional banking system. According to data collated by AltFi, a news service focused on the industry, the cumulative total of alternative finance in the UK since 2005 amounts to £5.1bn of loans, with over half of this made to SMEs (including the sale of invoices), lending to consumers accounting for around 41% and equity crowdfunding about 4%. However, AlfFi data does not include balance sheet lenders and so excludes a significant number of alternative finance providers making their data, at best, only indicative.

After the financial crisis, UK banks cut back lending to both SMEs and large companies. The rate of reduction in loan books for both SMEs and larger companies has diminished in the last couple of years and we believe it is reasonable to expect growth of a few percentage points per year in the next years. GLI’s platforms are therefore seeking to serve a market that is showing signs of cyclical recovery, but in addition, its platforms seek to win market share from incumbent banks and generate new SME loans by closing the funding gap that exists for SME borrowers. This is a longstanding structural issue and has been defined as “the inability of creditworthy SMEs to obtain finance from the formal financial system, regardless of the state of the economy” (Ian McCafferty, external member of the Monetary Policy Committee, Bank of England, October 2015). It is believed to arise from SMEs’ inability to access the capital markets (because they are too small), the high costs of acquiring information about the creditworthiness of SMEs and the high costs of monitoring loans. With its new distribution channels it is hoped that alternative finance will close the gap.

Lending to SMEs through alternative finance platforms is growing rapidly in the UK. In the six months to 30 June 2015, loan growth increased by 75% y-o-y and industry commentators expect growth to remain at a high level. Even so, the market share of alternative lenders is still a fraction of the total market, around 3% according to the Bank of England Trends in Lending survey, indicating the growth potential for alternative finance lenders. In the past fast loan growth by new entrants in a market has frequently been associated with poor-quality lending, as credit control standards are relaxed in the search for volume over quality. The challenge for the alternative finance industry is therefore to take the market opportunities available to it, without making the mistakes of the traditional banking sector.

Marketplace lending, a subset of alternative finance, is dominated by three companies, which together have a market share of around 70% of the cumulative industry according to data from AltFi. These are Funding Circle, Market Invoice and LendInvest. GLI’s Platform Black has a market share of cumulative lending of around 4%. However, GLI’s largest generator of loans, Sancus, is based in Jersey and lends mainly to offshore locations and is not included in in the AltFi data for the UK. Its cumulative lending to end-December 2015 was in excess of £150m according to the company, equivalent to c5% of the cumulative UK SME industry total.

New loans by GLI platforms in the 12 months to 31 December 2015 amounted to £276.8m compared with £148.8m in 2014, an increase of 86%, with Sancus increasing lending by 74% y-o-y and the other platforms by 97% according to management. We estimate that Sancus is the largest provider with around 40% of the total in 2014 and 2015, but the other platforms are now growing faster.

Most 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%. Most do not incur credit losses as the credit risk belongs to the lenders, but certain of GLI’s platforms, notably Sancus and BMS, do have some credit risk and some of its other platforms also have an element of own capital at risk. As the platforms are predominantly agency businesses they do not need large amounts of capital like banks, so that in theory, if they process enough volume, their ROEs could be very high. With a largely fixed cost base, the higher the volume of loans processed by the platform, the greater the platform’s profitability.

The strategic review instigated by GLI in December 2015 was designed to determine the best utilisation of its human and capital resources and to build shareholder value most effectively. It is currently ongoing, but on 16 February 2016 GLI announced a set of short-term goals, subsequently elaborated in the annual report. These, together with our comments, are discussed below:

GLI is now moving into the second leg of its strategic review (Project Clarity). In this it will complete its review of all its investments, take the necessary measures to ensure all possible cash flow from its investments are remitted to the company and align the interest of senior management with GLI, removing conflicts of interest and mitigating key man risks.

At the end of 2015 GLI attempted to raise £20-40m through an issue of zero dividend preference shares and was seeking shareholder approval to issue convertible unsecured bonds. However, its plans were changed significantly following investor feedback and both these issues were cancelled on 21 December 2015. Instead, it announced that it was pursuing a strategic relationship with the Somerston Group, a Jersey-based, privately owned group of companies. Somerston, through Golf Investments, a newly created special purpose vehicle, agreed to subscribe to 15m new GLI ordinary shares at 37p, raising £5.5m by year end 2015 for GLI. Somerston and GLI also announced they were negotiating a strategic relationship which, among other measures, would further improve GLI’s cash position and give Somerston warrants to subscribe to 32m additional GLI shares, potentially increasing its holding to 24%. More details are given in our update note of 26 January 2016. The required shareholder approval was given on 25 February 2016.

Somerston’s support could be crucial to GLI's success by providing its platforms with the finance they need to arrange loans to their customers. For most of GLI’s alternative finance platforms to be profitable they need to grow their businesses to a size at which revenues earned from arranging loans are large enough to cover the mostly fixed costs of their operations. Additional revenue over and above the fixed costs should flow through as profit to the platform owners, including GLI. GLI does not have the resources to invest through the platforms to boost their volumes, so lending by Somerston, or other like-minded institutions, through the platforms could be vital to their success. That lending is likely to be through GLIAF, or new funds launched by Amberton in the future.

Andrew Whelan, the CEO, joined GLI's board when Sancus was acquired and became permanent CEO on 16 February 2016 following the departure of the former CEO, Geoff Miller, in December 2015. 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 investment platforms, Platform Black.

GLI is exposed to many factors that will have an influence on its success. The most important are:

One business development that has emerged in the last 18 months has been the growth of institutional money to platforms through the growth of specialised lending investment companies such as P2P Global Investors, which has raised over £800m. This does give the platforms the funds that their borrowers require and the launch of GLIAF was an attempt by GLI to tap into this market. However, there is a danger that the larger funds lend to the larger platforms, who they consider better placed to satisfy their demand for lending. The larger platforms could therefore grow at a faster rate and squeeze smaller platforms, such as some of those owned by GLI, out of the market, or at least hinder their growth.

At the current stage of its development, GLI believes that the NAV at the company, as opposed to the group, is the more appropriate measure for assessment of its underlying performance. At the end of December 2015 the NAV of the company was £98.2m (2014: £88.2m), while that for group was £95.4m (2014: £74.5m). The difference arises from the historic cost measure of accounting used in the group accounts compared with the use of fair value accounting at the company level.

In 2015 GLI recorded a company loss of £3.9m before investment losses and £9.5m after losses. This compared with a profit of £0.3m before investment gains in 2014 and £6.7m after investment gains, as we show in the exhibit below. In 2014 GLI was mainly invested in CLOs, which it sold in Q115, whereas its performance in 2015 shows the early results of its activities as an alternative finance and loan investor.

The decline in CLO income in 2015 occurred because of its disposal of the last of its CLO investments in Q115. GLI invested the proceeds in its loan book, which rose from £34.8m at end 2014 to £83.3m at 30 June 2015. The increase in the loan book resulted in a rise in interest income from £1.6m in 2014 to £2.6m in H115. On 22 September 2015 GLI transferred £42m of its loans to GLIAF, which reduced interest income. It had received loan interest of around 10% annualised on these loans, so the transfer reduced its interest income in H215 by around £1.0m. GLIAF paid a first-time dividend to GLI of £0.2m on its shares in H215, so the net effect of the creation of GLIAF was the loss of around £0.8m in H215, although only £0.5m if GLI’s share of GLIAF’s earnings were included. However, in H215 GLI also wrote-off £0.4m of interest it had previously accrued relating to a loan it had transferred to GLIAF on the inception of the fund, but which was subsequently considered impaired and transferred back to GLI on 23 December 2015. GLI reversed the loan interest in H215 and wrote down the value of the loan by £4.9m as well. It should be noted that this loan was not made by one of GLI’s platforms, but was a loan previously acquired by the old GLI management.

Operating expenses in 2015 were £0.2m lower than in 2014. However, there was a £2.6m CLO management fee in 2014, which did not occur in 2015 and in fact there was a £0.4m management fee write-back as the result of previous over accruals. Excluding CLO management fees, operating expenses therefore increased from £3.3m in 2014 to £6.1m in 2015, a rise of £2.8m. A large part of the increase arose from additional legal and professional fees, which were £2.4m in 2015, up £1.5m on the previous year, as a result of work on platform acquisitions and investments. There was also a £0.7m increase in marketing and PR expenses, which are considered ongoing, but cost savings are being sought.

Finance costs in 2015 were £4.1m compared with £0.8m in 2014. 2015 included a full year’s accrual of the dividend on the 2014 zero issue of £1.3m plus interest expense on the borrowing from Sancus, which averaged around £23m in the year (2014: nil). Excluding investment gains and losses, losses for 2015 amounted to £3.9m from a profit of £0.3m in 2014.

Gains of £6.5m in 2014 arise from GLI’s CLO activities. In H115 GLI recorded an unrealised gain of £4.5m as it marked up the fair value of its platform investments. However, in H2 there was an unrealised loss of £11.3m, of which £4.9m arose from the write-down of a loan discussed above and £6.4m was due to the write-down of fair value of its platform investments.

Forecasting the results of GLI is particularly problematic while it continues with its strategic review. Our approach is to restrict our forecasts to just one year and model only those developments that have occurred or been announced by the company. These are:

Our profit forecast for 2016 is explained in Exhibit 2 below. Given the strategic review is ongoing and may result in the sale at a profit or loss of some or many of its platforms, we believe it would be more appropriate if we do not include the unwind of the fair value discount in our 2016 forecasts.

We expect that the 2016 profit (excluding realised and unrealised gains) will be £1.6m, from a loss of £3.9m in 2015. On a cash basis, excluding the zero interest expense, which is a non-cash item, we expect a profit of £2.8m in 2016 from a loss of £2.6m in 2015. The cash recurring profit of £2.8m will not be enough to pay the proposed dividend payment, which at 2.5p per share, amounts to around £5.7m for a full year. It could cover this from remitting more dividends from its investment platforms, if possible, or using cash, asset sales or increased borrowing. Our forecast for 2016 assumes that it will use cash so that current borrowing amounts to £1.2m at the end of the year, from £7m of cash at the end of 2015.

Our forecast revisions for 2016 are shown in Exhibit 3. Our NAV per share falls 11.5p or 22%. Most of the decline was due to the lower starting point for 2016 of 42.73p per share compared with 50.82p previously forecast because of worse than anticipated 2015 results, mainly arising from the loan and investment write-downs. Also, in 2016 we have not included an assumed fair value uplift on the unwind of the DCF fair value discount in our company profit forecast as we did previously. If we did it would add around 2.5p per share to our 2016 NAV forecast. Our cash profit forecast for 2016 is 53% higher than our previous forecast mainly as a result of the following factors:

GLI’s valuation is particularly difficult to judge because of the embryonic stage of development of the industry in which it operates, the absence of meaningful financial information on its operating activities and its ongoing strategic review, which could significantly change the scope of operations. At best we believe valuation measures are only indicative and until there is more transparency on its activities, investors will focus on its yield rather than its P/NAV or P/E ratio. There are no comparable alternative finance operating companies to compare with GLI quoted in London, so we have compared it with the alternative finance investment funds, as shown in the exhibit below.

NAV: GLI’s P/NAV at 75% is below the 97% average of the others in this sample. The assets of the others consist almost exclusively of loans and at this stage of the credit cycle investors consider that there is low likelihood of loan impairments. Loans, including its investment in GLIAF, account for 57% of GLI’s assets and its investments in platforms account for 37% of its assets, of which 24% points is invested in Sancus, BMS and the four prioritised alternative finance platforms, with around £20m (13%) in the other platforms. If the value of these were written down to zero, the fully diluted NAV of GLI would fall from 42.73p per share to 34.03p and the price/NAV would be 92%, in line with the loan funds. This suggests that the market has already discounted the worst for these investments.

Yield: GLI’s yield of 7.8% is comparable to that of the SME loan funds, which is around 8.0% (after excluding the outliner Ranger Direct Lending) after they achieve their target dividend payments. While GLI’s dividend is not covered by its current operating cash flow, it does have the ability to pay the dividend for the next year and in the longer term it expects its platform investments to start paying dividends to the parent and enable it to pay the 2.5p dividend out of its operating cash flow.