London's "Burrito Bonds" could be hard to digest

6 min read
Robert Smith

This is because the debt instruments may offer coupons equivalent to those in the high-yield bond market, but they offer none of the protection professional investors demand when lending to junk-rated companies.

The companies are raising the mini-bonds on a new crowdfunding platform called Crowdcube, which allows everyday investors to place orders as small as £500. Chilango has raised more than £650,000 of its £1m target, and can raise up to £3m if it receives enough demand. Restaurant business River Cottage has also raised a £1m five-year bond on the platform.

Explaining what will happen if the deal is oversubscribed, the document states that Chilango’s management will “have a shot of tequila, which will lead to a celebratory dance around our office”

Chilango’s four-year deal pays 8% annual interest, exceeding even the highest yielding tranche of the recent record-breaking €12bn-equivalent high-yield bond package sold in April for the buyout by cable companies Altice and Numericable of French telecoms business SFR. Investors who put in more than £10,000 for Chilango’s deal also get the added perk of one free burrito a week for the life of the bond.

Tequila shots and dancing

Professional investors, however, have not found this an appetizing prospect.

“It’s incredible that they’re able to do this; are yields really so low that payments in burritos look attractive?” said one London based high-yield bond portfolio manager.

“Unfortunately, the average buyer of this isn’t someone who’s going to check the cash flow statements.”

The offering memorandum for Altice’s bonds ran to more than 1,100 pages, presenting detailed financial information and outlining the risks associated with the deal. In contrast, Chilango’s “invitation document” is just 33 pages, with only one page outlining the deal’s key risks and two pages presenting the company’s financial performance.

Details may be lacking in the brightly coloured document, but it does employ a healthy dose of humour. Explaining what will happen if the deal is oversubscribed, the document states that Chilango’s management will “have a shot of tequila, which will lead to a celebratory dance around our office”.

One of the reasons high-yield offering memorandums run to hundreds and sometimes thousands of pages is that institutional investors usually require a robust covenant package to lend to companies without an investment-grade rating.

High-yield bonds typically carry incurrence covenants, which restrict the amount of debt a company can incur, as well limiting the amount of money that can be used to pay dividends. This stops a company from raising more debt than it can afford.

The invitation documents for mini-bonds such as Chilango’s contain none of these restrictions on debt raising or dividend payments, meaning investors have less control than in some of the riskiest types of junk-rated debt.

This is particularly concerning as Chilango’s bond is unsecured but the company also has secured borrowings. As of 3 June 2014, Chilango had £51,000 of drawn secured debt facilities, but the absence of covenants means the bond places no limits on how much it can draw.

Doing the maths

Directly after discussing tequila shots and dancing, Chilango’s invitation document states “with careful help from our advisors we’ve done the maths and worked out that we can afford to repay up to £3 million”.

But while Chilango may have done the maths, it does not show its working.

If the company raises £3m, 8% annual interest would equate to £240,000 a year. For bond investors the key metric for whether a company can service its debt is Ebitda - earnings before interest, tax, depreciation and amortisation.

While corporate bond issuers have to present their most recent quarterly earnings, Chilango lists the nearly nine-month-old results for the 53 weeks ending 29 September 2013. Chilango posted Ebitda of just £111,708 in this time, less than half the required amount needed to service the coupon if it sells the full £3m.

Chilango is using the bond to fuel expansion, and hopes to open six new stores in London if £3m is raised. The company does not list what the expected Ebitda would be from six additional stores, however. In contrast, high-yield offering memorandums often present a run-rate Ebitda figure showing expected gains from any planned changes to a business.

Chilango has misjudged expansion in the past, closing two stores in shopping centres after they failed to perform. The company booked more than £1m in closure costs, losses and write-offs to wind down the stores in 2011 and 2012.

Some investors are evidently concerned by the lack of information. The deal’s fundraising page has a forum where potential investors can ask questions, and one person has asked for a more detailed version of the company’s balance sheet.

Chilango responded that some of these figures are commercially sensitive and “we’d like to keep [them] confidential to make sure Chilango continues to kick ass.”

Exits locked

The mini-bonds also lack one of the key ingredients of fixed-income investors’ returns: a secondary market. While coupons look attractive, the returns from holding an asset are just one way bond investors usually make money.

If a company performs well, for example, then the risk of it defaulting on its debt lessens and the bond appreciates in price. With an active secondary market, an investor can realise these added returns by selling the paper. Mini-bonds such as Chilango’s are explicitly non-transferable, however, meaning investors cannot sell before maturity.

This not only caps returns if things go well, but locks all the exits if things turn ugly. If a company with publicly listed bonds runs into trouble, investors can sell their holdings, staunching potential losses.

This is not possible with mini-bonds, so investors will have to hope Chilango has done its maths correctly if they want to be repaid in full.

Chilango’s co-founders Eric Partaker and Dan Houghton did not respond to a request for comment.

Chilango Burrito Bond