Can Guarantees offer real security?

When I first started renting, I was asked to provide a ‘guarantor’ of security before my landlord would take me on as a tenant. Being young and lacking experience, I called a relative, got their agreement to use them and then thought no more about it. Essentially, I was offering a ‘guarantee’ that if I dodged rent, the landlord could pursue my guarantor to attempt to secure the money they were owed. Many years later, I was discussing the idea of investment security with a friend – the topic of guarantees and whether they can provide any real security against loss of an investment.

In this article, I’ll be explaining what a guarantee is but also why I think they’ve got limited use for an investor looking to protect themselves. Whilst many people feel more secure with the presence of a guarantee in an agreement, the legal protection and reality of an investment with a guarantee can be very different things. Although they have the potential to improve security, guarantees don’t necessarily fully ensure against a loss of capital.

Understanding “guarantee”

Theoretically, a guaranteed investment is one which cannot lose money. Whether the FTSE100 plummets to 1000, or if Russia decided to invade overnight, the original capital paid by an investor would be returned in full. For example, savings with NS&I are guaranteed – if the company were to fold, HM Government would refund savers the full value of their balances.

In this situation, HM Government is a guarantor – a third party that has promised to cover the value of capital lost in the event of an entity going bankrupt. In the case of the Government, this is a great thing, as the guarantor is stable enough to fulfil the responsibility of covering the capital. In the case of smaller deals, however, this is not always a given; if I were to attract investment of £10,000,000, secured with a guarantor of a relative, how likely would it be that the relative could afford to pay out the £10,000,000 if the venture lost the money?

Essentially, a guarantee is just a promise that someone will pay you ‘as long as they can’. Contrary to what many investors assume, this is not the same thing as having absolute certainty of repayment. This is an extremely important concept to understand when investing – here’s an example to clarify.

Chris and Moose International Investing Corporation

Chris is approached by Moose International Investing Corporation (MIIC). MIIC is trying to raise £10,000,000 to fund their latest venture – a series of retail units for a franchising operation they were launching. Instead of selling shares in their business, MIIC decided to borrow the funds from investors. To do this, they issued bonds which bore interest of 10% a year.

Chris thought that the bonds could be a good passive income investment. He was personally willing to invest £100,000 but wanted extra security to hedge against the risk of the venture collapsing. The security would come in the form of a personal guarantee, securing his investment against the personal assets of the owners of MIIC. The guarantee would force the owners to personally pay the company’s debt to him in the case of the company being unable to service its liabilities. When the owners of MIIC agreed, Chris believed he had a guaranteed investment.

When a recession hit five years later, MIIC began to hit trouble servicing its debts and later collapsed. Having put in a further £25,000, Steve then sued the owners personally for £125,000, hiring a lawyer to take them to court and winning the ensuing case.

Unfortunately, the owners of the business had put everything they owned into separate corporations, holding little in the way of personal assets. When Chris brought his case against them, they were unable to pay the debts as they had nothing left to their names. Because of this, not only did Chris lose his investment, but also the cost of hiring the lawyer to fight the case for him.

Assessing the guarantor’s abilities

Although Chris had taken steps to protect his investment, they ultimately turned out to be useless in securing the return of his capital. In truth, they cost him extra cash to implement, she had to hire a lawyer to fight the case.

Instead of implementing these guarantees, Chris would have been better placed looking at the circumstances of the individuals who were offering them. He should have researched their ability (and likelihood) of honouring those guarantees as part of his due diligence process.

In my original example of NS&I, the guarantor (HM Government) is highly likely to have the ability and willingness to honour a debt in times of financial strife. Of course, this level of security comes with a pretty paltry ROI (1-2% at most), but essentially your money cannot be lost.

This ability for an average citizen to honour their guarantee is far less significant; they’re unlikely to have vast sums of capital in reserve and certainly don’t have the option of printing more. When they hit financial headwinds, no one is there to pick up their obligations and there is little that an average investor can do about it.

Determining the value of guarantees

There are several ways to assess whether a guarantee is worth the paper it’s written on. An investor can start by asking the following questions;

  • Does the guarantor have the means to honour their promises?
  • Will the guarantor have the means to do so in the future?
  • What can I do about it if they can’t?

Finding sensible answers to these questions can be challenging, but a common-sense approach is often the best way to start. Begin by researching the borrower on Google – look up their LinkedIn profile and website; look for reviews on investment forums; ask contacts on social media networks if they’ve ever had dealings with them.

Moving on, you can ask for documentation to support the guarantee – payslips and bank statements are often a good indicator of ability to support the guarantee but remember; the past is not always an accurate predictor of the future.

The answer to the final question is often the same; nothing. If you’ve taken them to court and they have no assets, you’re likely out of luck. As an investor, it’s sometimes possible to put a capital repayment plan in place, whereby the debtor agrees to repay the capital from future earnings. Of course, this relies on you being able to enforce this and to keep in contact with them.

Conclusion

The global investment market relies on a certain level of protection to function. If investors believe that they will lose their money giving it to someone else, they’ll either spend it all or withdraw it and keep it under the mattress. A guarantee can help to provide this protection, but it’s important to remember that it comes with limitations. If a guarantor cannot physically honour the guarantee, then it’s not even worth the paper it’s written on.

When investing, it’s important to avoid confusion guarantee with security. Courts and guarantees cannot compel a guarantor to create wealth out of thin air – if they have no money and no ability to earn any, the investor will likely end up out of pocket if a deal goes bad. I’ve met plenty of investors who were encouraged by such promises, only to discover later on that they were meaningless.

In addition to this, be aware of the slick salesman who is happy to give copious verbal assurances, but is reticent about putting them in writing. Written guarantees aren’t perfect, but they’re much better than having nothing at all. To investors, verbal promises are worthless, and in many cases are indicative of a potentially dodgy investment.

 

Sign up to receive the latest content, fresh from the press.

I don’t spam! Read our disclaimer for more info.