A re“generation” roadmap using alternative investments

The wealth disparity gap globally has expanded wider for the lower to upper middle classes more in the last five years then it has in the past decade. This is not just important in the United States or the European Union, it is also important to recognize that capital formation is a global process.  

When approached objectively, capital formation enhances confidence, promotes integrity and fosters market transparency. The result is increased liquidity for investment seeking ventures. When investors have no confidence that the market knows how to price a security, then liquidity is low and few transactions take place. 

For many people, the objective of investing is to achieve long-term capital growth with an acceptable risk level. Over the last decade the challenging economic and market background has led to lower returns across many asset classes, as well as higher than normal volatility especially for shares exposed to growth markets.

There is, however, a low risk − easy to understand way to invest in the global market via a new asset class. By taking an equity income approach, an approach which has become more attractive with traditional equity investments as the yields available on other income generating assets, such as bank deposits or bonds, have fallen to record low levels; this approach can be achieved using alternative investment mechanisms such as crowdfund investing (in Europe mostly referred to as crowdinvesting).

The Jumpstart Our Business Act, or JOBS Act, changed the U.S. securities laws of 1933 and ‘34 that expands access to capital formation for the market, rather than the laws serving as only a facility to raise capital in its current state. As of September 23, 2013, Title II of the JOBS Act, the use of Regulation D, 506(c) will begin to transform the financial markets in which investment opportunities can be generally solicited and advertised to the accredited investor via broadened access channels; henceforth, creating new investor opportunities.

In uncertain economic times why should you consider investing in smaller companies? Large companies offer familiar names and often a reassuringly defensive position to weather unsettled financial conditions. ‘Blue chip’ might convey a feeling of security but even in volatile markets small caps can offer great long-term investment opportunities.

Many agree that crowdfund investing works worldwide, in places like Australia and many parts of Europe, amongst others in Austria, Germany, the Netherlands, Switzerland and the United Kingdom. Whereby the models applied, range from equity to quasi-equity and subordinated loans, sometimes with an equity kicker. Often these types of investments provide an ongoing cash incentive to investors while also providing a longer term potential upside.

Across Europe crowdfund investment websites explore different models of how to best provide equity or equity like investments. The current market is in flux, with new and different approaches – sometimes inspired by regulatory restrictions – testing boundaries of how online fundraising for business can work both for investors and entrepreneurs alike. But how can we be certain that it will work in the United States, if not tried?

Information from the Australian Small Securities Offering Board (ASSOB) indicates that the average ASSOB-listed company raise is $544,000 through the ASSOB platform, and over 86 percent of all companies who have raised capital on ASSOB over the past seven years are still in operation today. It is this history of success that helps to inform one’s position that crowdfund investing is remarkably advantageous to the small securities marketplace.

“Existing European regulation allows for crowdfund investing in general and equity crowdfund investing is in most legislation possible for investment rounds of up to €100,000, in some significantly higher,” says Oliver Gajda, chairman & co-founder, European Crowdfunding Network AISBL. “It is the various interpretations of a patchwork of European rules by its 27 EU member states that are providing a large part of the restrictions for crowd fund investing today. For example, in Italy, the financial services authority CONSOB adopted crowdfunding laws after an extensive public consultation that enables crowdfund investing in technology start-ups of up to €5 million, as of July 2013. In Belgium, on the other hand, the financial services authorities FSMA forced the closure of the oldest Belgian crowdfunding platform in April.”

In Austria political discussions led by the Chambers of Commerce on changes to existing capital market and banking regulation is expected to result in a more lenient interpretation of existing rules for crowdfunding.

The Financial Services Authority in the United Kingdom has for the first time, approved individual websites that allow members of the public to take direct equity stakes in small, unlisted businesses.

“In many other European countries a political discourse on relevant approaches to regulation is advancing, including in France, where President François Hollande announced a liberalization of existing rules for this year or in the Netherlands, where the financial services regulator AFM and the Dutch National Bank are now openly looking into how to further support crowdfunding,” says Gajda.

A European Directive for crowdfunding, defining a role of a “crowdfunding provider” − similar in concept to the U.S. Funding Portal, that was established under the JOBS Act, but detached from specific financial instruments – should not be expected any time soon. While the notion of a single European passport for this role could create legal certainty that enables operations on a cross-border basis without facing new compliance costs and procedures, the reality is that the local venture capital industry is after years of political discourse only now, in 2013, expecting to get such a passport. “For crowdfunding, and crowd fund investing in particular, the more realistic expectation should in the short term lie on national interpretations of existing European rules within the member states,” notes Gajda.

Burgeoning market place, young investors

There are few job prospects for the next generation, towering student loans, and what appears to be a bleak future, Generation Y, which is defined by demographers as ranging from ages 18 up to as old as 37 – make up the largest population cohort we have ever seen. Eighty six million strong in the U.S. alone, it is 7 percent larger than the baby boom generation, which came of age in the 1970s and 80’s. “Gen Y could keep growing to 88.5 million people by 2020, owing to immigration,” says demographer Peter Francese, an analyst at MetLife Mature Market Institute. Generation Y totals 27 percent of the U.S. population, less than 35 percent the boomers represented at the peak in 1980.

In the coming years, the world economy will need to depend on their economic might and spending power. But for now, Generation Y is financially disenfranchised and discouraged. For example, across Europe some 20 percent of those under 25 years of age are without a job, in countries harder hit by the economic crisis the rate is above 40 percent. Industries from housing and autos to retailing and financial services could be transformed by this generation’s collective demands and desires. It is therefore vital to enable this generation to establish themselves in society, to create value and wealth.

Alternative investments like crowdfund investing can be a significant source of liquidity for small cap investments. It can enable Generation Y and others on the investing and receiving side to gain skill sets that increase their employability, creates innovation and build small business. This would result in much needed economic growth and provide Generation Y with a place in society. Coupled with young people’s doubts about the future of government entitlement programs, this could usher in a new era of saving and a bull market for investment opportunities and wealth income across society.
Small caps – share the dividends

The term “small cap” might be a little misleading. Although small cap stocks occupy the bottom 10 percent of the market they range in size, up to $1billion in market capitalization. There is a diverse spectrum of sectors and share price drivers that influence investors; therefore, a range of opportunities and the chance to balance smaller illiquid stocks with larger, more liquid ones will abound.

Researching smaller companies takes time and is a great opportunity for investors and small cap fund managers seeking alternative investments through small and emerging companies, as they can meet the management of a company, perhaps visit their facilities and then take a view on the valuation of the business, its profit potential and valuation relative to the current share price.

As a company grows its revenues, earnings and investor profile over time, demand for the stock inevitably increases. When a large number of investors start to clamor over a limited amount of stock, this gives small company shares the potential to rise in price quite rapidly. Ironically, many fund managers will only become interested in a company when it grows beyond small cap – by which point much of the growth potential has already been realized. While long-term performance can be spectacular, the timing of entry and exit is a great challenge for the small company investors.
What is an “equity income approach”?

Building wealth income has been a challenge for the average investor and through using an equity income investing approach there is potential for income generation. There are many variations at the heart of any equity income approach as an investment in a portfolio of companies, which have higher dividend yields than the overall market. As well as a higher yield they often have strong and sustainable dividend growth and therefore their dividend distributions should increase over time.

While there isn’t necessarily anything extraordinary about dividends, after all they are only the way in which companies distribute their annual profits, they represent a tangible store of value and are usually paid out of cash, not accounting profits, and are therefore a better proxy for a company’s real return.

As investors move into new markets like crowdfund investments, where historical information may be hard to find, issuers willing to pay dividends might realize that this is one of the best roadmaps available to building capital formation and shareholder confidence, since paying dividends usually telegraph management’s confidence in the future of the company.

So why are dividends so important?

Generally, companies pay a dividend twice a year providing regular payments for shareholders, which can either be spent as income or reinvested by the investor. Importantly, dividends provide a signaling mechanism to shareholders about the longer-term prospects for a company, especially if current trading is challenging.

With crowdfund investments in the U.S., the investor will only be able to trade shares after holding for a 12-month period, however, these investment should be considered – value investments. Implementing an informal dividend policy like many companies, based for example on a dividend pay-out of a certain percentage of annual profits, or on a medium-term growth target can provide further visibility on the future flow of dividends.

Within the market many higher yielding stocks are often found among companies that exhibit stable and strong cashflow, hence utilities, staples such as (beverages, clothes and food producers) and pharmaceuticals tend to have high yields. These types of companies may not have the same growth characteristics as some other sectors, such as technology or biotech, but what they lack in growth they usually make up for by reliable and attractive cashflow and dividends. Importantly, as a function of their more reliable profits and cashflows they are inherently more defensive assets than the wider market and suffer less when company profits come under pressure, such as during a slowdown or recession.

Therefore higher yielding stocks perform well when equity markets come under pressure and usually have a much lower volatility than the overall market as a direct function of their safer and more secure cashflow.

A little bit of theory for the crowd…

According to much of modern portfolio management theory, investors should not care whether they receive the profits of a company now, via a cash dividend, or have those ‘profits’ reinvested by the company, as the theory says that the current share price should reflect all the future earnings of the company. Most investors, however, do not worry too much about modern portfolio theory and realize a good thing when they see it. Paying dividends now can be reinvested by shareholders; if they choose or used for another purpose. The bottom line is that it’s growing wealth and demonstrating a return on the investment.

…and a little bit of common sense

But dividends also serve another purpose, which should benefit investors. Because they are normally priced out of a company’s operating cash-flow they create an internal hurdle for the board of a company when they come to make the critical decisions on whether to pay more out in dividends or use the cash for new capital investment or acquisitions. Obviously, if a company used all its cash to pay out dividends rather than investing in sustaining its capital base, eventually profits would collapse as the company becomes outdated and uncompetitive. However a realistic and sustainable dividend policy provides a common sense check for management and also investors when considering the size and pace of investment, compared to returning capital by dividend distribution.

Bide your time

Some small caps witness stellar growth but investing is not always a case of overnight success. Successful smaller companies will attract a great deal of attention from larger organizations looking to gain inroads on new developments. Merger and acquisition activity can therefore be lucrative for small cap investors. Of course, not all small companies succeed initially. Some struggle and ‘wither on the vine’ – providing the opportunity to identify good ‘recovery options’.

An equity income approach often means more limited exposure to the current market fashion or fad, especially when equities are rising strongly, and sometimes it seems like high income stocks will be left behind in a more speedy market. However while the equity income approach sometimes struggles in a bullish market, over time this approach should deliver a more consistent and profitable return profile over a full market cycle and with lower volatility. Slower perhaps, but equity income investors should outperform over the longer term with patience.

Happy returns

Investing in smaller companies can form part of a balanced portfolio. However, investing in small, less liquid companies is likely to provide a higher level of volatility and this may carry increased risk.

One approach to investing in alternative asset classes such as crowdfund investments is an equity income approach since it has many benefits although there are obviously many other ways to invest. Over the medium-term a return on investment strategy has been hard to imagine, but portfolio management theories have shown consistent outperformance as the dividend income is reinvested and the more stable character of higher yielding stocks come to the market. Dividend growth is beginning to recover from the 2008/9 down turn and the quality of income is growing. Equity crowdfund investments offer attractive real yields with the ability to grow their distribution over the medium term.

For investors with an income requirement, who are happy to ride out market cycles but prefer lower volatility, this approach may really pay dividends.

 

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Kim Wales

Kim was the CEO of a fund administrator and has 17 years of experience, advising and leading Banking initiatives in various jurisdictions including New York, United Kingdom, Bermuda, Cayman Islands, Malta, Guernsey and Switzerland.  Kim is the founder of Wales Capital, specialising in Crowd funding and social, environmental and economic sustainability using Global Impact Investing Rating Standards.  Kim is a founding member of the Crowdfunding Intermediary Regulatory Advocacy and Crowdfunding Professional Association.  
 

Kim Wales
Founder & CEO
Wales Capital
New York
NY 10018

T: +1 (212) 736 6884 
E: kim@walescapital.com  
W: www.walescapital.com

 

 

 

Wales Capital

A global business development company with 18 years of experience leading and harnessing projects. Our mission is to nurture and help to grow your business.

Building successful growth companies and creating equity value are our two goals for:

  • Emerging growth and market companies in the initial stages of their development
  • Later stage companies where management has no clear exit strategy  

Contact us for the following services:

Advisor. Development. Production. Finance. Management.

 

New York
NY 10018

T: +1 (212) 736 6884 
E: kim@walescapital.com  
W: www.walescapital.com