Instead of marketing copy and press releases, investors and ad
visers need to spend some time combing through the legal documents that define a fund. With that in mind, we're going to take a close look from time to time at new offerings, and walk through the documents associated with them in more detail. We'll start this week with a fund that has been making headlines in the trade press recently: New Earth Solutions, which is an Isle of Man fund being marketed by the Premier Group. The fund is being pitched as the UK's first recycling fund, and news stories suggest it targets a 12% to 15% rate of return. We can see how that might appeal to some, so we thought we'd have a look at the fund's documentation. Here's what we found.
New Earth Solutions Expenses: Investing in Recycling is Going to Cost You
An investment fund is often a reasonably straightforward proposition. You pay a sales charge to get in (although you can avoid this if you're savvy) and ongoing fees for professional management. In exchange, you get exposure to a portfolio of assets that offers diversification across the area of the fund's remit.
In this case, you pay a lot. The fund has the following fees: An initial sales charge of up to 8%, an administrator's fee of 0.25% of gross assets, a custodian's fee of 0.04% of net assets, a management fee of 1.5% of gross assets, and performance fees ranging from 12.5% of returns above 12.5%, and 20% of returns in excess of 20% (the hurdles are scaled down to 10% and 16.5% for the year ending 31 March 2009, respectively). There are also exit charges of 8% on shares held up to one year; the fees reduce by 0.4% per quarter until they hit zero after five years. The firm also says the costs to start the fund are £140,000. It is entitled to recoup ½ of this fee from the fund (that means you, the investor), once net assets hit £1,500,000, and the rest when net assets reach £3,000,0000. This means that you will be charged an additional 4.67% of assets when the fund hits £1.5 million, and an additional 2.3% of assets at £3 million. In other words, this is an extremely expensive offering.
New Earth Solutions: What Does the Fund Do?
So, we've established that you're going to pay a lot of money to own this fund. So, now let's see what you get for those fees. According to the investment objective, "The New Earth Solutions Recycling Facilities Investment Sub-Fund aims to provide long term growth by investing directly or indirectly in industrial facilities incorporating recycling waste management systems in the United Kingdom and in the development of such facilities."
That sounds ok. It's much more focused than we think most investors need--after all, why pay such hefty fees only to restrict your undoubtedly talented manager to investing in a single industry? But it doesn't sound awful.
However, if you read further, you will discover that, "The primary investment strategy of the Investment Sub-Fund is to invest directly or indirectly in Recycling Facilities operated by the New Earth Solutions Group. This strategy will be overseen and directed by the Investment Committee." Now, we see that you're paying all those fees to invest in the business of a single company, New Earth Solutions. That's a lot of ongoing fees for what amounts to exposure to a single company.
If you read down a further few pages, you come to the interesting statement that "The Investment Committee has determined that the existing New Earth Solutions Recycling Facilities appear to meet the investment objective stated above and that, in principle, the Fund should invest in them by investing in NES FM".
New Earth Solutions: Fund to Make Unsecured Loan
NES FM is, we are told, New Earth Solutions Facilities Management, and the fund has entered into a joint venture with it which specifies that each sum invested by the fund in NES FM, 20% will go to series B shares, whilst 80% will go to "unsecured loan stock." Despite the use of the word "stock", that 80% does not convey any ownership--it means the fund (i.e., you) are making an outright loan to NES FM. The word "unsecured" should catch your attention. It means the fund has zero recourse if NES FM were to default on that debt. You would simply lose your money.
Finally, the document notes that the firm is essentially highly beholden to its existing lender, Norddeutsche Landesbank Girozentrale ("Nord"): "As security under the Facility Agreement, among other things, the shares in NES FM have been charged in favour of Nord and NES FM has granted a debenture in favour of Nord over all of its undertaking and assets." Although details are not given, this terminology usually suggests that Nord's interests come before other claims against the company. Finally, NES FM is indebted to New Earth Solutions to the tune of £4.1 million.
New Earth Solutions: Pay Off Our Debts, Please
NES FM would rather like to get some of that debt off its books, don't you imagine? Of course they would. That's apparently why they're seeking your money: "It is anticipated that the funds invested in NES FM by the Investment Sub-Fund will initially be applied in repaying the Existing NES Indebtedness, unless NES FM identifies particular business opportunities to which those funds would be better applied."
New Earth Solutions: The Risks
So, we can see that the risks are high. NES FM may be a very fine company, but we don't know much about it because the fund offering documents don't give sufficient information to make that assessment. What they do say is that it has one recycling facility built, is undertaking to build another, and has significant debt. Further, it appears to have had to grant generous terms to obtain credit from Nord. Finally, there's this little caveat all the way down on page 20 of the offering document:
"NES FM has very significant obligations under the Facility Agreement with Nord referred to in section 8.4. It will only be able to fulfil these obligations if all of the counterparties with which it deals perform their contractual and other obligations. If NES FM does not fulfill its obligations to Nord, Nord may seek to enforce any charge that it holds over the B Shares to the detriment of the Investment Sub-Fund. In such circumstances, the Investment Sub-Fund may lose its entire investment in NES FM." So, you can lose all your money, and Nord has priority over everyone else.
New Earth Solutions: The Timing
There are a number of time frames quoted in the document, and few of them are in sync with each other. Some of the relevant ones include the time period for which the stated strategy must remain in place (three years), the period for which you must hold your shares in order to exit without incurring a penalty charge (five years), and the period of time that will elapse before NES FM is obligated to repay the loan(s) made by the fund, and thus you, to NES FM (fifteen years). So, the strategy of the fund might change after three years; you have to pay a penalty charge to get your money back before five years have elapsed; but NES FM gets to keep money lent to it by the fund for fifteen years. If NES FM takes fifteen years to pay off its obligations to the fund, but investors want their money back after five years, it seems like liquidity will be an issue, and possibly a serious one. And if the fund changes strategy after three years, what happens to all the money it lent to NES FM?
New Earth Solutions: The Return
So what's the payoff? Well, the interest on the unsecured debt portion of your investment (this is 80% of the fund's "investments" in NES FM, recall) is 8.75%. How does that stack up? As of Friday, according to the Financial Times, sterling debt from Boots due in 2009 and rated BBB by Fitch traded at a bid-yield of 9.92%. Sterling debt from Goldman Sachs, rated AA- by S&P and Fitch, and Aa3 by Moodys, traded at a bid yield of 7.95%. Sterling LIBOR recently ran from 5% to a bit over 6% for loans of 1 week and 12 months, respectively, and option-adjusted spreads on Merrill Lynch Sterling High Yield indexes ran from 572 basis points for BB issues, to 1502 basis points for C-rated issues. The Merrill Lynch Investment Sterling Corporate 10+ yr Index recently had a spread of 263 basis points. In other words, the rate on the unsecured loan to a company without a credit rating that is already heavily indebted to another entity (Nord) seems low by market standards, particularly in an extremely tight credit environment. But the document gives the reader no context to evaluate this.
There is also a chance of capital appreciation, enhanced by gearing. But as far as we can tell from the rather opaque documents for the fund, this will be generated only by about 20% of the fund's investments (the other 80% going to the unsecured loan, which is earning 8.75% gross of tax and fund fees).
Conclusions
This is a fund that is very expensive, that has few, if any, of the benefits of a professionally managed, diversified portfolio, and which appears to be subject to a high degree of risk, including granting unsecured credit to a tiny company on what appear to be fairly generous terms. Smarter investors know better--Impax gave New Earth Solutions £4 million in early 2008, but it received equity in the company in exchange for its investment. And yet this fund sounds very appealing at a surface level. Who wouldn't like to invest in recycling and help the planet? Buyer beware, indeed.
