Occasionally we receive calls from clients who have come across an opportunity that offers amazing returns. Not all of these “opportunities” are run by scam artists intent on putting your hard-earned cash at risk. And sadly, often the people who do put their money into these “investments” can ill afford to lose any capital, but are desperate to make their money, and in particular their income, grow.
Today’s article is about being cautious, and the questions you should ask when you come across an abnormally high return. You should always approach these with your eyes wide open and shift your thinking from a “Return on Capital” to a “Return of Capital.”
It is possible that many investment ‘’opportunities’’ were that at the start, however by the time they land on your desk they have often already been turned into pyramid schemes, and the people involved are effectively operating unlawfully. The investors become “unsuspecting and uneducated pensioners” as the press carries the story.
How does an investment opportunity end up being a pyramid scheme?
Let’s create an example. Johan has a great business that he got up and running, with a proven market and a product that works. He now needs to make the operation bigger to really make it successful. Johan will initially borrow as much as he can from his own bond and may even pay the tax and cash in on his pension fund.
He would then turn to a commercial bank (8%) and they would assess his credit rating, but inevitably the bank will never support an entrepreneur who has maxed out his own savings. Johan will then turn to close family members and potentially friends in order to ask for a loan. To make it attractive to them, he has to offer them a return that is far greater than the one from the bank, i.e. 15 – 20%.
At this point, no crime has been committed.
Johan needs money to buy equipment to produce more products to sell at a greater profit. In his mind he can see this business and cash flow turning within a few months. Unfortunately, things take longer than anyone expected.
Double Trouble
There is now no cash flow coming from the newly installed production line, and Johan needs to pay his creditors the guaranteed monthly payment he agreed to. He tries to encourage new investors to invest in the company, believing that he will turn the corner very soon. He is then forced to use the new capital invested from the new investors to make the income payments to the first investors.
Johan’s problems are starting to compound. He cannot find new investors in the next month and he misses a monthly payment. He desperately tries to alleviate investor fears, passionately believing that there will soon be a turnaround, but he is in real trouble. An angry investor contacts the media and exposes Johan’s activities and he is accused of running a pyramid scheme and being compared to Masterbond. Retail stores cancel their orders, the business is closed down by the authorities and Johan is forced to plead with them to allow him to trade out of these circumstances. It is the only way to pay everyone back.
All investors interviewed by the media claim that Johan promised them 15 – 20% returns. Understandably, they are emotional and many claim that this will ruin them financially, all the time forgetting that they were attracted to the investment because of the high returns on offer. The more desperate the personal financial circumstances of all parties involved, the more appealing the investment “opportunity’’. They never question the true risk: the return of their capital
Johan’s story is just an example, however it details a very real situation that occurs quite frequently in South Africa and shines a light on the background to many of these investment opportunities. They may be tempting at face value, but be aware, that by the time you are asked to get involved, there is a whole lot of baggage that could very well end up costing you dearly.
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