Corporate Due Diligence & Financial Strength Assessment · AKG: CORPORATE DUE DILIGENCE & FINANCIAL...

CORPORATE DUE DILIGENCE & FINANCIAL STRENGTH

ASSESSMENT

CASTLE TRUST

GROWTH HOUSA AND INCOME HOUSA

APRIL 2013

AKG: CORPORATE DUE DILIGENCE & FINANCIAL STRENGTH ASSESSMENT CASTLE TRUST

AKG Actuaries & Consultants Ltd April 2013

CONTENTS

1. INTRODUCTION .................................................................................................................. 3 1.1. BACKGROUND .............................................................................................................................................. 3 1.2. AKG’S ASSIGNMENT................................................................................................................................... 3 1.3. RELIANCES AND LIMITATIONS .................................................................................................................. 4 1.4. CONFIDENTIALITY ...................................................................................................................................... 4

2. PROPOSITIONS/COMPANY DETAILS .............................................................................. 5 2.1. MARKET ANALYSIS ...................................................................................................................................... 5 2.2. THE CASTLE TRUST BUSINESS MODEL.................................................................................................... 6 2.3. THE PROPOSITION – CASTLE TRUST’S PRODUCTS ................................................................................ 7 2.4. HOUSA INVESTMENT STRUCTURE ........................................................................................................... 9 2.5. INVESTMENT PROVIDER .......................................................................................................................... 11 2.6. OWNERSHIP / PARENT COMPANY ......................................................................................................... 12 2.7. INVESTMENT MANAGER / DISTRIBUTOR (MARKETING MANAGER) .............................................. 12 2.8. REGISTRAR (AND COMPANY ADMINISTRATION) ................................................................................. 13 2.9. ADMINISTRATOR ........................................................................................................................................ 13 2.10. TRUSTEE – CHARITABLE TRUST COMPANY .......................................................................................... 14 2.11. NOMINEE .................................................................................................................................................... 14 2.12. OUTSOURCING / THIRD PARTY PROVIDERS ........................................................................................ 14

3. ASSESSMENT KEY CONCLUSIONS .................................................................................. 16 APPENDIX 1 CRITERIA & PROCESS ................................................................................... 19 APPENDIX 2 RELATIONSHIP CHART: CASTLE TRUST GROWTH HOUSA ................ 21 APPENDIX 3 RELATIONSHIP CHART: CASTLE TRUST INCOME HOUSA ................. 22 APPENDIX 4 ABOUT AKG ...................................................................................................... 23



1. INTRODUCTION

1.1. BACKGROUND

Castle Trust Capital plc (CTC, the Client, the Provider, the Investment Provider) is a UK registered and domiciled limited company which is part of the Castle Trust group of companies (Castle Trust).

Castle Trust is the provider of retail fixed term investment products, these being the Growth HouSA® and Income HouSA®, which provide returns to investors relative to, and in all cases in excess of, the UK housing market (as measured by the Halifax House Price Index or HHPI). Castle Trust is also the provider of a new type of shared equity mortgage, the Partnership Mortgage®, which improves affordability for homeowners and reduces the risk of negative equity.

In August 2011, Castle Trust was licensed by the Office of Fair Trading (OFT) in respect of its Partnership Mortgage lending activities.

In September 2012, Castle Trust received the regulatory capital required from its funders, J C Flowers & Co, thereby allowing the UK Financial Services Authority (FSA) to confirm its permission for Castle Trust to undertake regulated financial activities in the UK. Castle Trust commenced regulated activities on 1 October 2012.

An integral part of the process whereby a proposition is approved for use by an intermediary or group of intermediaries includes an assessment of the financial and operational capability of the provider, insomuch as it can sustain an ability to deliver the fair expectations of its customers. The key conclusions of this report can be found on page 16.

1.2. AKG’S ASSIGNMENT

The Client has commissioned AKG Actuaries & Consultants Ltd (AKG) to carry out an assessment of the Client, against specified criteria (attached as Appendix 1), in the context of the product propositions that are being offered, such assessment to include the financial strength and security of the Provider and other service providers.

Following the assessment, AKG has produced a report (the Report). The Report includes details of AKG’s key conclusions within the context of the propositions.

For the purposes of this assessment, the proposition context considered comprises the fixed term investment products to be offered by Castle Trust as at the date of the Report; the Growth HouSA and Income HouSA. The Report remains valid in respect of suitability only when this proposition context remains unaltered.

The Report is a full update / review of the Castle Trust proposition, including latest trading results and it replaces any previously issued report.



1.3. RELIANCES AND LIMITATIONS

The information upon which AKG’s assessment has been based has been supplied by Sean Oldfield (Chief Executive Officer), Keith Abercromby (Chief Financial Officer) and Martyn Guerin (Chief Operating Officer) at meetings held in Castle Trust’s offices at 41 Lothbury, London, at AKG’s offices at Anderton House, 92 South Street, Dorking, Surrey, RH4 2EW, and subsequently by telephone and e-mail.

AKG has relied upon the accuracy and completeness of this information, and will not accept any responsibility or liability for any inaccuracies or omissions or for any consequences arising. Under no circumstances will AKG accept any liability in respect of the investment decisions of investors or for any loss arising therefrom. It should be assumed that AKG has not conducted any due diligence investigations to confirm the accuracy of any of the information supplied, unless it is explicitly stated to the contrary herein.

For the avoidance of doubt, AKG has not researched background details, including previous organisations, of individuals connected with the Provider.

No account has been taken of the competitiveness, suitability or otherwise of the product terms offered by the Provider.

AKG’s assessment has been carried out in the context that the products are delivered to an investor within a regulated advice process as there is a clear need for advice and a full understanding of the products and risks involved.

Whilst many aspects underlying AKG’s conclusions are likely to change only slowly, the financial services industry is a competitive, dynamic marketplace, with new products and developments being announced regularly. As a result, AKG cannot guarantee that any particular comment will remain appropriate at any future date.

The Report remains current until 30 April 2014, unless otherwise updated, or in the event of a significant or material change in the proposition context, as referred to under section 1.2 above. In the event of updating, the new report should be used in replacement of the Report. Notwithstanding any updates the Report should no longer be used after 30 April 2014.

AKG personnel are available to expand upon the comments in the Report, if required.

1.4. CONFIDENTIALITY

The Report has been produced for the Client’s consideration, and for use in accordance with the conditions outlined above.

AKG is happy for the Client to reproduce all or part of the Report in any internal or external published material, subject to prior written agreement of the content, context, duration and volume of such reproduction and of any reference, explicit or implicit, to AKG’s involvement in producing the Report



2. PROPOSITIONS/COMPANY DETAILS

The main focus in AKG’s assessment of the Client has been Castle Trust Capital plc (CTC), in its capacity as the UK parent company of the Castle Trust group, and the Provider of the HouSA investment products. CTC also provides Partnership Mortgages which it uses to match the HouSA investments, and a summary of the Partnership Mortgage is included here such as it forms an element of the overall proposition, although the return to investors in the HouSAs are not linked to the performance of Partnership Mortgages.

This company, through the knowledge and experience of its directors and senior management, is central to the proposition(s) – in essence it is this skill and experience that investors are buying into.

Furthermore, within the assessment process AKG has also looked through to the other corporate entities which make up the overall propositions, for instance Castle Trust Capital Management Ltd (CTCM) the Marketing Manager, and International Financial Data Services Ltd (IFDS) which is contracted to administer the HouSAs.

To record these, and illustrate their inter-relationship in simple terms, schematic representations outlining the main relationships within the overall structures in respect of the HouSA products are given in Appendices 2 and 3.

2.1. MARKET ANALYSIS

The relevant features of the UK housing market, as presented by Castle Trust as background rationale for its creation, and raison d’être in terms of anticipated traction, are:

• borrowers accessing the housing market are generally stretched in terms of affordability. Typically, they take on high levels of gearing through the use of a mortgage and, other than in a period of rapid growth in house prices, negative equity is a very real risk for them;

• savers building a deposit have no access to a house price based investment and investors who seek to invest in housing, typically through a buy- to- let investment, take on a high level of gearing through the use of a mortgage, specific house risk, significant illiquidity, tenant vacancy and property maintenance risks;

• irrespective of the overall movement in house prices, there is a wide dispersion around any index average. Even if house prices overall increase by 3% per annum, over five years some 31% of individual homes will fall in value. The specific risk associated with an individual property purchase is comparable in risk to the assets of oil & gas or mining stocks;

• as an investment medium, however, housing in general is relatively stable: index based returns have historically consistently exceeded inflation and those obtained from cash deposits with considerably less volatility than equities (eg the FTSE 100);

• homeowners have little option but to take specific house risk (i.e. their own home), whereas investors would prefer, if the option were available to them, to take general house price exposure, which Castle Trust will provide via the national Halifax House Price Index (HHPI);



• housing is a £4 trillion asset class (the UK’s largest) but, as yet, there is no ready way of matching homeowners’ financial overexposure to their properties with the existing natural desire of investors and savers to assume general housing returns. As a result, mortgages have historically been funded from deposits (shorter dated, more liquid and with no matching of house price risk) and latterly from wholesale funding which was very significantly sourced from outside the UK.

Castle Trust aims to provide answers to these issues, which it does not believe are satisfied by existing forms of housing finance, through an application of financial analysis and financial solutions. It believes that these solutions bring substantial benefit to both investors and borrowers. Either in terms of actuality (the verification of which is outside the scope of the Report), or simply in terms of perception in the market, these factors do suggest a tangible landscape for the proposition.

2.2. THE CASTLE TRUST BUSINESS MODEL

Castle Trust’s business model uses its balance sheet to match individual housing exposure assumed by home-owning borrowers with the general house price exposure sought by investors. The products and risks on each side of the balance sheet are therefore linked and thus its business model is implicitly financially stable by design. More specifically:

• Its investment product, the HouSA, allows investors to invest in national house price movements for fixed terms. Both the Growth HouSA and the Income HouSA deliver investor returns relative to, and in all cases in excess of, the HHPI;

• The lending product, a Partnership Mortgage, is shown to reduce monthly mortgage commitments, whilst also reducing the probability of borrowers falling into negative equity;

• The user of a Partnership Mortgage will benefit from increasing equity ownership of his or her house (in both £ and % terms) in all circumstances when that house increases in value – whilst this will not be the whole of the increase, they will receive the majority (60%) of it;

• Castle Trust’s margin is derived from the difference between the returns received from borrowers via Partnership Mortgages and cash/gilt investments and that provided to investors via HouSAs;

• Castle Trust seeks to avoid carrying house price risk on its balance sheet, by transferring the costs and risk of homeownership between homeowners and retail investors – but therefore does expose itself to the risk of an index tracking error. This is where a difference may arise in the returns provided by Partnership Mortgages, which are based upon individual properties (and which Castle Trust aims to provide nationally), to the returns provided to HouSA investors which are based upon the national Halifax House Price Index. Castle Trust makes a margin that is independent of house prices;

• The stability of its margins, the relatively precise way Castle Trust’s business model seeks to match house price risk across its balance sheet and the fixed term, as opposed to “on demand”, nature of its liabilities makes Castle Trust a stable financial institution, which if necessary could go into run off mode successfully with minimal impact on either investors or borrowers.

Whilst the mechanisms and structure (not least for taxation purposes) are fairly complex, the business model, with its balance sheet matching, is relatively straightforward and suggests a potential robustness.



2.3. THE PROPOSITION – CASTLE TRUST’S PRODUCTS

The HouSA is designed to deliver returns relative to the Halifax House Price Index (HHPI) - a widely recognised national house price index. It is closed-ended in structure, but in practice an investor will always be able to invest, as a new tranche will be launched each month, as the previous one closes. There are two types of HouSA: Growth HouSA and Income HouSA.

Growth HouSA

The Growth HouSA is an offshore investment for a fixed term of three, five or ten years, giving investors the opportunity to share in the performance of UK house prices through the Halifax House Price Index (HHPI). The investment will outperform house prices, as represented by the HHPI, over any term chosen, whether those house prices rise or fall.

If house prices are higher at the end of the chosen investment term, the investor will earn more than the increase. How much more depends on how long the investor chooses to invest for. If the HHPI is lower at the end of the term, the investor will lose less than the amount it has fallen by.

When investing in a Growth HouSA, the investor buys shares in a Jersey company, Castle Trust PCC. CTC will buy the shares back from the investor at the end of the term to give the Investment Return (see below), based on the change in the HHPI.

’Investment Return’ for Growth HouSAs

HouSA term Return if HHPI rises Return if HHPI falls

3 years 1.25 multiplied by the HHPI

percentage rise 0.75 multiplied by the HHPI

percentage fall



percentage fall



percentage fall

Income HouSA

An Income HouSA is an investment for a fixed term of three, five or ten years, giving investors the opportunity to participate in the performance of housing through the Halifax House Price Index (HHPI) and receive a fixed income every three months.

An Income HouSA is a ‘loan note’ issued by Castle Trust Income HouSA plc (CTIH), a Jersey company. Whilst it is registered off-shore, the company is domiciled in the UK and as such the structure is that of an on-shore investment.

The level of income an investor receives depends on the investment term (three, five or ten years) the investor chooses at the start and is paid out every three months for the full term. Income details are shown below.



‘Investment Return’ for Income HouSAs

Term Return based on change in HHPI Annual income

3 years 100% of any rise or fall 2.0%



The income the investor receives is the interest CTIH pays on the loan note; the price of the loan note at the end of the investment term is directly linked to the change in the HHPI, so the amount the investor receives will be the original investment adjusted for the rise or fall in the HHPI over the term. Whether house prices rise or fall over the investment term, the investor will outperform them by the amount of the income received.

CT has received advice from Macfarlanes LLP on the tax status of the proposed products, and this has led to a structure that CT believes can provide tax efficient investment options and appropriate tax treatment for investors of the Income and Growth HouSAs i.e. the income the investor receives through the Income HouSA is the interest CTIH pays on the loan note; if the investment is through a tax-efficient product such as an ISA or pension, the investor will receive this income free of any income tax. Any potential investor should of course seek professional tax advice in respect of his or her own circumstances.

There is no guarantee that the investment objective of the HouSAs or the returns stated will be achieved.

Investment Philosophy and Partnership Mortgages

The Investment Return is not dependent upon CTC’s investment philosophy. However, CTC looks to match the promises to repurchase HouSAs with its investment in Partnership Mortgages and cash/gilts. CTC’s main source of income in the long term is intended to be the returns it makes from its Partnership Mortgage product advanced to borrowers. Rather than charge interest on these mortgages, CTC will share any increase in the value of the property against which the mortgage is secured. CTC will also hold a substantial proportion of its assets (over 20% of the original HouSA investment amount) in cash and gilts.

CTC plans to provide Partnership Mortgages which are 20% of the value of the property by way of secured loan (second charge behind the traditional mortgage), with no monthly payments of interest or capital required. The borrower will be required to provide at least 20% deposit also, with the traditional mortgage company providing the balance – the traditional mortgage will therefore be a maximum loan-to-value of 60%. Given the lower traditional mortgage amount and reduced monthly costs (by virtue of having a smaller traditional mortgage, as well as the lower loan-to-value improving access to the lowest mortgage rates available), Partnership Mortgages will lead to an improvement in affordability for homeowners.

The Partnership Mortgage must be repaid upon sale of the property or at the end of the mortgage term, at which time CTC then shares asymmetrically in any increase / decrease in property value. A positive return (or ‘Profit Share’) is calculated as 40% of the increase in property value, i.e. if £100k was provided as 20% of the purchase price (i.e. market value of the property was £500k) and the value increased by £50k to £550k, CTC would receive back £120k (i.e. its capital of £100k plus 40% x £50k increase = £20k).



If the property value has fallen at the time the property is sold and the Partnership Mortgage is repaid, then CTC absorbs some of this loss in value and the repayment amount is adjusted pro-rata with the fall in property value i.e. in the first example above, if the value had fallen by £50k, to £450k, the amount to repay under the Partnership Mortgage would be £90k (being £100k less 20% of £50k = £10k).

The above conditions generally apply assuming the mortgage has been held for over 12 months. Optional repayment conditions exist for repayment without selling the property, as the Partnership Mortgage customer must repay the greater of (i) 4.5% simple interest per annum and (ii) the Profit Share (ie 40% of the growth in value of the property).

Castle Trust Balance Sheet Matching

The returns from the HouSA investments are not directly linked to the performance of the Partnership Mortgages but are provided by the obligation that CTC has to purchase the investment at maturity for the Investment Return. Anything that happens to the Partnership Mortgages (and the underlying properties securing them) bears no direct influence on the returns from the HouSA products.

However, the Partnership Mortgage portfolio and the cash/gilts is the basis upon which Castle Trust has been designed to fund the HHPI linked returns of the HouSAs. Having reviewed the financial forecasts in the business model provided to the FSA in respect of its ICAAP submission (which included various stress testing / sensitised scenarios, and a reverse stress test), and having undertaken further analysis of Castle Trust, AKG believes that due to the high level of equity on the balance sheet compared to the investments expected to be taken in by Castle Trust, the material risks to investors have been substantially mitigated. Castle Trust aims to have a higher tier one capital ratio than all of the large UK banks (and much higher than that proposed by the Independent Commission on Banking chaired by Sir John Vickers); CTC’s tier one capital ratio is forecast to be in excess of 20% at all times, which compares very favourably with the large banks’ tier one capital ratio of around 10% (even less than this in the case of mid-tier institutions).

Castle Trust also has fixed term investments, rather than ‘on-demand’ or overnight deposits, which increases the strength of its funding profile.

Liquidity / early redemption of HouSA investments.

All transactions pass through CTC which effectively acts as the principal for investor monies. In simple terms, if HouSAs are held until maturity the investor will receive the Investment Return. At Castle Trust’s discretion, if earlier encashment is requested, this may be agreed but only if sufficient liquidity exists and subject to the possibility of loss of capital for the investor as Castle Trust will take into consideration the prevailing market conditions and its own balance sheet obligations with respect to maturing HouSAs.

2.4. HOUSA INVESTMENT STRUCTURE

The returns of the Growth HouSA and Income HouSA are underwritten by the full balance sheet of CTC. That is to say, Castle Trust Capital plc has an obligation to repurchase the Growth HouSA shares and Income HouSA loan notes from the investor at the end of the investment term for the full amount due to the investor (i.e. the Investment Return in the terms and conditions of the Growth HouSA and Income HouSA).

Whilst the vehicle by which the Investment Return is delivered to the investor is not critical to achieving the returns (given the obligation that CTC has to repurchase from the investor at the Investment Return), the underlying vehicles are important to the retail investor given their abilities to deliver the appropriate tax outcomes.



The underlying investments in the Growth HouSAs are shares and the in the Income HouSAs are bonds. In both structures below, the only cash movement will be between the investor and CTC in each case - all other transactions are dealt with by offsetting between the Castle Trust companies under an ‘umbrella’ arrangement.

As such, only CTC will hold client monies, which it is authorised to do under its permissions with the FSA. Whilst CTC holds these monies, any movement of cash is controlled by the Administrator, IFDS. All HouSA returns due to investors are covered by the Financial Services Compensation Scheme (FSCS) up to a limit of £50,000.

Growth HouSA

The underlying vehicle for the Growth HouSA is Castle Trust PCC (CTPCC), a Jersey incorporated closed-ended protected cell company (PCC) registered with JFSC Companies Registry in June 2011. Before issuing the Growth HouSA to investors, the shares will be listed on the Channel Islands Stock Exchange (CISX).

The PCC will have a single cell, the Castle Trust Growth HouSA PC (the Cell). This fund is not regulated in Jersey or approved by the JFSC. The prospectus for the Growth HouSA investment in shares will be approved by the FSA prior to offering to the public. It is not intended that the Cell or the PCC will have any borrowing powers, and as such the structure contains no mechanism for gearing.

An investor’s money received by CTC is used to subscribe for shares in the Cell. The shares are sold to the investor by CTC, with an obligation to buy them back at maturity at an amount adjusted by any movement in HHPI over the period, enhanced or protected on a +/- basis as described above (the Investment Return). Three new share classes will be created each month (for durations of 3, 5 and 10 years) to provide the specified return / term.

The shares acquired by CTC and passed on to the investor are non-voting – the voting shares are held by The Housing Foundation Charitable Trust, a Jersey Charitable Trust with trustees provided by JTC Management Ltd (see Section 2.8 – The Registrar).

Audited Report and Accounts for CTPCC covering the period July 2011 to October 2012 have been provided, which confirm the creation of the Cell during the period, as at 5 September 2012, with Participating Redeemable Preference Shares being created and listed on the CISX on 4 October 2012. No other financial transactions are recorded during this period.

Income HouSA

The underlying vehicle for the Income HouSA is CTIH and this is a Jersey incorporated and registered private company, established in May 2011 on the JFSC Companies Registry. CTIH is a wholly owned subsidiary of CTC, and it is UK domiciled (and subject to UK tax laws). It is not regulated in Jersey or approved by the JFSC. The prospectus for the Income HouSA investment in loan notes will be approved by the FSA prior to offering to the public. The directors of CTIH are the same as the directors of CTC.

An investor’s money received by CTC is used to purchase loan notes from CTIH, with such loan notes paying a quarterly coupon and thereby providing an income to the investor. The loan notes are sold to the investor by CTC, with an obligation to buy them back at maturity at an amount adjusted by the movement in the HHPI over the period.

Three new loan notes will be issued each month (for durations of 3, 5 and 10 years to provide the specified return / term), and these will be listed on the CISX immediately prior to issue. As with the Growth HouSA, given the structure of delivery of the product through the FSA-authorised CTC in the UK, this provides for protection under the FSCS to apply.



In both cases above, CTC enters into a loan contract to effectively ‘borrow back’ the subscription monies from the PCC or CTIH (together, the Issuers). This is achieved by CTC and the Issuers entering into a loan contract that is struck to deliver an amount equivalent to the Investment Returns. Under the contract the invested monies are transferred back to CTC and are used to fund the Partnership Mortgage business.

At maturity an investor’s shares / loan notes will be bought from them by CTC for the agreed return. The Issuers will redeem these using the payment due from CTC under the maturing loan contract, which will be equivalent to the Investment Returns.

CTIH began trading in October 2012. Audited Report & Accounts for the 16 months from 24 May 2011 to 30 September 2012 have been provided and confirm this as a period of dormancy.

2.5. INVESTMENT PROVIDER

As the Investment Provider, CTC is responsible for the management of the cash investment operation and consequently is responsible for payments due to the shareholders and loan note holders under the HouSA investments.

Castle Trust Capital plc (CTC) is a wholly owned subsidiary of Castle Trust Holdings (Jersey) Ltd (CTHJ), a Jersey based entity established in November 2010. CTHJ is ultimately owned by its management team and the majority shareholder is J.C. Flowers & Co. LLC (JC Flowers - see Section 2.6).

All material capital and liquidity in the proposition structures is held by CTC. As the Investment Provider, it stands behind the HouSA transactions, buying back shares and loan notes at maturity and potentially upon early redemption requests. It faces a number of risks, such as the demands of its operations in providing Partnership Mortgages, where it is directly exposed to changes in the value of housing (as are HouSAs), and to default on the primary mortgage borrowing; and its continued obligations to the FSA in maintaining its regulated status.

The Senior Management Team of CTC consists of Sean Oldfield (CEO), Keith Abercromby (CFO) and Martyn Guerin (COO) all of whom have held senior positions with leading global financial or related institutions, and have excellent credentials in this respect. The non-executive directors of Castle Trust are Sir Callum McCarthy (former chairman of the FSA) and Dr. David Morgan (JC Flowers’ Managing Director in Europe), along with Lord Deben (The Rt Hon. John Gummer), Dame Deirdre Hutton, Tim Hanford (also of JC Flowers), Patrick Gale and Richard Ramsay. Detailed biographies of these individuals are available on the Castle Trust website and these outline the strength and depth of the non-executive team.

CTC is undertaking its stated aims in an independent capacity (arm’s length with CTIH and CTCM, for example). However, it remains a company within a group that is managed by common individuals. AKG acknowledges that Castle Trust states no director in a company above CTC has a controlling influence over the operations of CTC or CTCM; it is clear, though, that JC Flowers holds a significant and influential shareholding interest in CTC, along with non-executive directorial positions, within the structure.

As a recently established entity, only a limited financial and operational track record is available on CTC. AKG has been provided with audited accounts for the years ending September 2011 and 2012. The accounts confirm the equity funding provided by JC Flowers and the management team to date (the original equity received plus an additional £5.1m from JC Flowers during 2012). Further to this, on 4 September 2012, JC Flowers provided £50.6m additional equity to act as the tier one capital for largely regulatory capital requirements (with some as a buffer). JC Flowers is fully behind the proposition and would be expected to be in a position to provide further capital if this were required – such further capital is not required under the current business plan.



Administrative expenses in the year ending September 2012 totalled £6.6m [2011: £7.2m] and with the only income being a small amount of interest receivable, the loss before tax was £6.6m [£7.2m]. The only other significant entry was a transfer of £12.8m from share premium to retained earnings. There are no restrictions on the ability to distribute this reserve, although no dividend was declared in 2012 and there are no plans to distribute this. This outcome is in line with that expected for the period under the Castle Trust business plan.

2.6. OWNERSHIP / PARENT COMPANY

J.C. Flowers & Co. LLC is a leading specialist private equity investor in the global financial services industry with over US$10bn of committed investment funds. The firm is located in New York and was founded by J. Christopher Flowers, a former Goldman Sachs & Co partner, in 2001. It typically invests in financial services companies with a focus on banks, insurance and re-insurance companies, asset management and brokerage houses, consumer finance businesses, mortgage companies, credit card companies, and stock exchanges. It has launched three funds over the last 10 years focussed on providing equity to a select number of businesses.

JC Flowers’ first fund closed in 2002 with capital of US$900 million and subsequently made 11 investments. Its next fund closed with US$7 billion of capital in 2006. Now J.C. Flowers Fund III LP, the third fund with US$2.2 billion of capital, has provided funding to Castle Trust.

In the UK in 2006, JC Flowers was the founding investor in Pension Corporation which provides bespoke risk management solutions to the trustees and sponsors of defined benefit pension funds. Pension Corporation has insured 50,000 defined benefit pension fund members, has £4 billion of assets under management and has worked with clients such as Cadbury and Alliance Boots.

In the UK, JC Flowers has most recently been involved in purchasing a stake in the Kent Reliance Building Society. In February 2011, it completed on its purchase of a 40.1% stake in the company which led to the formation of OneSavings Bank plc. Following the transfer of business in February 2011, the Kent Reliance Building Society was dissolved and its members became members of Kent Reliance Provident Society, which holds the other 59.9%.

Dr David Morgan AO, JC Flowers’ Managing Director in Europe and a non-executive director of Castle Trust, was previously the CEO of Westpac Banking Corporation, one of Australia’s largest banks, for nine years.

No other financial information on J.C. Flowers & Co. LLP or the J.C. Flowers Fund III LP has been provided.

2.7. INVESTMENT MANAGER / DISTRIBUTOR (MARKETING MANAGER)

Castle Trust Capital Management Ltd (CTCM) is the Investment Manager and Marketing Manager of the HouSA products. It is authorised and regulated by the FSA in the UK. CTCM is a wholly owned subsidiary of CTC and was established in the UK in January 2011, and it has executive and non-executive directorships in common with CTC. Because CTC underwrites the performance of HouSAs, the underlying performance of the investment manager is independent of the returns experienced by investors in Growth HouSAs and Income HouSAs.

In respect of the Growth HouSA, the PCC and the Cell have delegated the powers of determining investment policy and carrying out investment management and marketing activity to CTCM.

Following authorisation by the FSA, CTCM has since been approved by HMRC as an ISA Manager in respect of Stocks & Shares ISAs.

http://en.wikipedia.org/wiki/OneSavings_Bank



Audited Report & Accounts for the year ending September 2012 have been provided and show administrative expenses totalled £1.6m [2011: £2.1m] and with no income, loss before tax was also £1.6m [2011: £2.1m]. Capital was provided by parent CTC who took up £1m of share capital issued by CTCM and waived an intercompany loan of £3.2m (consequently stated as a capital contribution). Additionally, CTC has provided a letter of financial support. Hence CTCM is viewed as a going concern on this basis by the Auditors, despite the losses incurred. This outcome is stated to be in line with that expected for the period in the Castle Trust business plan.

2.8. REGISTRAR (AND COMPANY ADMINISTRATION)

The Registrar (in the Growth HouSA) is JTC Management Ltd (JTC), a Jersey registered, limited company, licensed by JFSC to act as Administrator, Registrar, Transfer Agent, Paying Agent and Receiving Agent. JTC Management Ltd is the PCC Registrar and has been appointed to legally maintain the Register; however IFDS will undertake the operation of the Register.

JTC also provides the directors of the PCC, administering the business of the PCC and the Cell.

JTC is part of the Jersey Trust Company Group of Companies. It was registered in Jersey in 1987 and is regulated by the Jersey Financial Services Commission. The JTC Group was itself established in 1987 and has its main offices in the Jersey, Guernsey, Luxembourg, Switzerland, British Virgin Islands and the UK, providing fund administration, management and trustee services. The group employs around 140 staff and has in excess of £13bn assets under administration.

JTC has acted in this capacity for many listed and unlisted funds and as such has appropriate experience. The directors of JTC have significant experience of many funds in differing markets including launch and administration of European property funds. The key Directors / MD of JTC hold directorships of many such funds and associated companies.

JTC have previously provided financial accounts to AKG for the group headed by JTC Management Ltd, which have been audited by PricewaterhouseCoopers CI LLP (Jersey, Channel Islands) – these indicate a satisfactory position.

2.9. ADMINISTRATOR

The day to day administration of processing subscriptions and maturities for the Growth and Income HouSAs is conducted by International Financial Data Services Ltd (IFDS). IFDS will hold the share register of the Cell – such shares held by the Nominee, Castle Trust Capital Nominees Ltd (CTCN) on behalf of the investors (see Section 2.11). The only holding on the PCC register will therefore be CTCN, reflecting the beneficial ownership of all the investors.

IFDS has a subsidiary, International Financial Data Services (UK) Ltd, which is the FSA-regulated entity within the IFDS group. Whilst client monies are held by CTC, in designated accounts, IFDS has to authorise any payments or transfers of cash from these accounts in its role as Administrator.

IFDS is a 50/50 joint venture between affiliates of Boston-based State Street Corporation, a global provider of services to institutional investors, and DST Systems Inc., a Kansas City, Missouri-based provider of shareholder accounting services and proprietary systems.

IFDS provides significant service as a provider of investor record keeping, wealth management and transfer agency solutions on a BPO (Business Process Outsourcing) and ASP (Application Service Provision) basis. End users are typically global collective investment, wealth management and platform



clients, and IFDS supports in excess of 17 million investor accounts for over 160 organizations, with over 2,500 experienced staff based in four locations (Canada, Ireland, Luxembourg & United Kingdom), on figures as at May 2012.

State Street Corporation

State Street Corporation is one of the world's leading providers of financial services to institutional investors, including investment servicing, investment management and investment research and trading. It was founded as a bank in 1792 in Boston, Massachusetts, and is one of the world’s largest alternative asset servicing providers. As at December 2012 it had 29,655 employees, with US$22.4trn in assets under custody and administration. In Europe it stated the equivalent of US$2.9trn in assets under custody and administration, with US$188bn in assets under management (including the assets of SPDR Gold Trust of approx US$46bn as at 31 December 2012, for which State Street Global Markets LLC, an affiliate of State Street Global Advisors serves as the marketing agent). State Street operates in 26 countries and more than 100 geographic markets worldwide. It is listed on the NYSE, and as at last full year ended 2012 it produced Net Income (Net Profit before Tax) of US$2bn on US$9.7bn of Revenue for the year, and increased its Shareholder Equity to US$20.9bn. State Street Corporation is rated A+ by S&P.

DST Systems, Inc

DST Systems, Inc. provides sophisticated information processing and computer software products and services to support the mutual fund, investment management, insurance and healthcare industries. In addition to technology products and services, DST provides integrated print and electronic statement and billing output solutions through a wholly owned subsidiary. DST’s data centres provide technology infrastructure support for mutual fund companies, healthcare providers, banks, mortgage bankers and insurance companies. It is also listed on the NYSE.

2.10. TRUSTEE – CHARITABLE TRUST COMPANY

The Housing Foundation Charitable Trust holds in trust the voting shares of the PCC. These carry nil value, as opposed to the shares held by HouSA investors, which are non-voting and carry all of the value.

The trustees of The Housing Foundation Charitable Trust are officers of JTC. The stated intention for the Housing Foundation Charitable Trust is to distribute all available proceeds (after prudent retention for administrative purposes) to charitable activities focused on housing in the UK and overseas. AKG understands that the scale of charitable donations will be proportional with the scale of investment made by HouSA investors. However, such donations do not affect the return experienced by HouSA investors.

2.11. NOMINEE

Castle Trust Capital Nominees Ltd (CTCN) is the registered shareholder of the PCC (in respect of any non-voting shares). CTCN is a wholly owned subsidiary of CTC.

2.12. OUTSOURCING / THIRD PARTY PROVIDERS

CTC outsources the vast majority of its IT and administrative requirements to reputable third party suppliers, namely through IFDS as the Administrator in respect of the HouSA products (see section 2.9), and with Target Group for the Partnership Mortgage products.



Target Group is one of the UK's leading providers of software and outsourcing solutions to financial services companies. Target specialise in delivering advanced business solutions to the following markets: mortgages, investments, general insurance and utilities. Target operates internationally, providing over 30 years' specialist expertise to a blue chip client base that includes many of the world's leading financial services companies. Target is currently delivering solutions for a quarter of the top 20 global banks.

Both IFDS and Target are client facing and thus there is potential for reputational and operational damage in the event of failure of the process or systems involved. AKG has spoken with senior representatives of both companies and the important role that both play is fully acknowledged and keenly appreciated – these companies have significant experience in the market place, having worked with many market-leading clients over recent times.



3. ASSESSMENT KEY CONCLUSIONS

The criteria, outlined in Appendix 1, are those on which AKG has carried out the assessment in considering the appropriateness or otherwise of Castle Trust (Castle Trust Capital plc and Castle Trust Capital Management Ltd, amongst others) as the provider of HouSAs.

CONCLUSION - Overall AKG’s assessment considers Castle Trust Capital plc (and Castle Trust group as a whole) to be an appropriately qualified provider of investment products with a clear strategy to deliver these solutions to investors to integrate into typically diversified portfolios. The shareholders, directors and management of Castle Trust have the appropriate knowledge and ability commensurate with Castle Trust’s objectives. J.C. Flowers & Co. LLP is a significant international organisation and its involvement is viewed positively. The Castle Trust non-executive team is drawn from a range of complementary disciplines, with wide ranging and relevant experience. The management team similarly have in-depth, hands-on experience in this chosen market.

Castle Trust appears more than adequately capitalised for the business it has now commenced undertaking, and the risk framework and philosophy are well regarded by AKG. CTC and CTCM are authorised by the FSA and are open for business, and the FSCS applies to the Growth HouSA and Income HouSA.

The infrastructure around the delivery of Growth HouSAs and Income HouSAs appears prudent, sound and there are robust relationships between the various parties.

Castle Trust management show a strong understanding of the risks associated with the products and their delivery to the market place, and have operational and governance frameworks in place to manage these as effectively as possible.

Castle Trust has an executive board and senior management team who appear to have the requisite experience and knowledge to deliver the propositions. The nature of the propositions offered through Castle Trust is such as to require individual investors to be advised within an appropriate regulated process and to gain a full understanding of the risks involved. Products of this type carry a number of inherent risks for the investor, included within the comments below: -

• The value of the HouSA investment products will go down if HHPI falls, given the index matching nature of the investment.

• There is underlying index tracking error risk here in that a mismatch between the portfolio of mortgages and the HHPI may arise. However this risk is retained by Castle Trust and not passed onto investors.

• Duration risk also exists between the profiles of Partnership Mortgages and HouSAs - although this risk is also retained by Castle Trust and not passed onto investors.

• CTC is obliged to provide the Investment Return (see section 2.3).

• The structure of the PCC (and Cell) in the Growth HouSA is well established but there remains no test of the law relating to this in courts of the UK or elsewhere. However it is CT’s intention to have only one cell, so this is not considered an issue. There are various share classes, and liabilities in one share class can be recoverable against assets of another. There is no issue with this either, as CT does not seek to attach any CT assets (the HHPI loans) to any particular share class and it has a contractual repurchase obligation in all circumstances.



• This is the first time the investments and mortgage solutions proposed have been brought together in a single business and so, whilst the products and concepts individually are not new or particularly complex, the overall structure does represent a different approach and is untested holistically.

• The executive team and directors have excellent credentials and understanding of the market in which they operate, and the loss of any individual could be significant. However, there are clear contingency plans to replace individuals if any of the key personnel were unable to perform their roles due to death or departure.

• In respect of redemptions and their impact on liquidity, the draft prospectuses seen to date state clearly that there is no right of early redemption available for the HouSAs, so this is purely at the discretion of CTC. HouSA investments are designed to be held until maturity. If early redemption is allowed, this may result in a capital loss to the customer regardless of HHPI movement.

• Administration is carried out by IFDS, which is an experienced, properly authorised and regulated organisation.

• Client money is held by CTC and CTCM, in line with their permissions from the FSA, and movement of cash is controlled / authorised by the Administrator (IFDS).

• Investor Protection - FSCS provides protection if an authorised investment firm is unable to pay claims against it. For example: for loss arising from bad investment advice, poor investment management or misrepresentation; or when an authorised investment firm goes out of business and cannot return investments or money. Before any HouSAs are issued, CTC will be authorised and regulated by the FSA and HouSAs will be covered by the FSCS.

• Misselling or inappropriate advice – this is outside the remit of this assessment

Key points evident in AKG’s assessment are:

• Castle Trust is recently established and has no prior financial or operational record. However, it has suitably qualified and experienced personnel and management and as such would be expected to be operated satisfactorily within the requirements of the FSA and in a profitable manner maintaining the appropriate liquidity and capital adequacy necessary, and to ensure investment return is provided over the proposed period. Audited Report & Accounts, and further updates received on current trading (see below), give no cause for concern.

• Castle Trust is funded by JC Flowers Fund III and the Castle Trust Senior Management Team, and outline details of the funding terms have been provided to AKG. The quantum of capital and the mechanics for accessing it appear reasonable and whilst there is no guarantee that the capital will be sufficient, a significant amount of work has been undertaken to establish that the capital position is as strong as possible – this has been tested through a very robust set of scenarios and stresses which provide significant comfort that the business is more than adequately capitalised. AKG is informed that JC Flowers & Co have committed further funds if necessary.

• There are inter-relationships between the directors and shareholders of the various counterparties to the products. The management of conflicts of interest is presented transparently. The infrastructure around the delivery of these products appears sound and there are robust relationships between the various parties.

• There are a number of tangible market factors that support the rationale behind the potential demand for the HouSA and Partnership Mortgage products.



• The HouSA products appear to be well constructed, having been rigorously developed, diligenced independently, and with consideration given to regulatory and compliance requirements and to the tax position in respect of the provider company and the investor.

• The balance sheet matching that underlies the business model is relatively straightforward.

• The Partnership Mortgage (a shared equity mortgage) will be provided to credit-worthy borrowers and secured (behind the primary mortgage company) against the property asset, with a minimum equity contribution of 20% of the property value from the purchaser / mortgagor.

• The investment performance is underwritten by CTC insofar as it will provide income payments (the Income HouSA product, at a fixed %), and returns linked to HHPI, which may rise or fall. There are no other guarantees.

• The Administrator and Registrar are both authorised and regulated as appropriate and appear suitable for the requirements of Castle Trust.

• Although take up of the investment products has been slower than originally anticipated under the business plan, this has been due to the launch being delayed whilst Castle Trust was awaiting FSA authorisation, and the market remaining subdued. It remains early days and the position does not raise any significant issues.

• CT has commenced communication with investors and other interested parties with the issue of its first newsletter in Q1 2013.



APPENDIX 1 CRITERIA & PROCESS

AKG has reviewed the Provider in the context, specifically, of understanding the proposition and how this might be affected in the event of failure or other untoward event and the onward impact on investors.

It is important to understand what is meant by Financial Strength. In this, AKG’s origins are important. As an organisation AKG comes from the perspective of providing ratings and assessment together with support for the UK intermediary sector in the context of required information on life companies, and other entities which that sector advises on. This focus, together with its use of an actuarial skill set blended with market/ distribution knowledge, has created a unique expertise, as distinct from the less specialist global ratings agencies or those providing credit ratings.

This is manifest in the key definition AKG places on financial strength (for both ratings and assessment). Namely, that the objective is to go beyond purely a consideration of solvency (albeit this will always be an important part of the mix) and consider in what format an organisation may be able to survive to meet the reasonable expectations of customers and their advisers. Expectations, which must include the experience encountered by these two groups, will therefore include ongoing operational abilities and performance.

This is often summarised as three key underlying questions relevant to an intermediary and their clients:

Will a company survive?

If so, in what form?

Are expectations likely to be met? The following listing outlines elements considered within this process, where relevant:

Broad element considered Areas of focus

Strategic appraisal • Distribution Focus • Process • Competitive Position

o Barriers to entry in segment o Competition o Areas of sustainable competitive advantage

• Company Structure and its fit with strategy • Customer Focus • Performance – Current and Past • Risks and Risk Controls – Strategic, Market and Business Risks

Financial and actuarial appraisal • Company Structure • Capital Structure • Use of Capital / Capital Availability • Solvency Levels (Statutory and Realistic) • ICAs • Realistic Reporting, PPFMs, TCF • Process • Valuation Bases • Expenses • Reinsurance Arrangements • Business Mix • Margins • Customer Focus (TCF) • Risk Tolerance; Risks and Risk Controls



Operational appraisal • Company Structure • Management • Servicing / Administration • Management of / Coordination with Independent Companies,

e.g. Outsourcing, Open Architecture • Investment – Philosophy, Matching, Asset Splits, Management • Product Lines • Customer Focus • Risk Control – Operational Risks, including Business Continuity

Analysis of the Group and other entities

The Group

• Group Structure • Where and how does the company fit in? • Why? Is it core? • Financial Support – Past, Present and in the Future • Capital Availability to Company

Relevant Other Entities – ‘Collaborative’

• Reinsurers • Outsourcers

o Servicing / Administration o Investment o Within Group

• Counterparties • Process • Distributors • External Fund Managers • MoM Managers • FoF Managers

Note: The above listing outlines elements considered within the process (a number will be more or less appropriate in each case and will depend on entity type.)



APPENDIX 2 RELATIONSHIP CHART: CASTLE TRUST GROWTH HOUSA

Administrator

InternationalFinancial

DataServices Ltd

Intermediaryrelationships

Investors

Promoter / Investment Manager / Distributor

Castle Trust Capital Management Ltd

Provider / Investment Counterparty

Castle Trust Capital plc

Castle TrustPCC

(Jersey) PartnershipMortgages

Trustee

HousingFoundation

Charitable Trust

Cell

Castle TrustGrowth

HouSA PC

MortgageAdvisers

MortgageAdministration

Target Group Ltd

Auditor

Ernst & Young

Registrar

JTCManagement

Ltd

The table above is provided as a means of representing the various entities present within the proposition and their inter-relationships.



APPENDIX 3 RELATIONSHIP CHART: CASTLE TRUST INCOME HOUSA

Intermediaryrelationships

Investors

Promoter / Investment Manager / Distributor

Castle Trust Capital Management Ltd

Provider / Investment Counterparty

Castle Trust Capital plc

IncomeHouSA

Castle TrustIncome

HouSA plc

PartnershipMortgages

Administrator

InternationalFinancial

DataServices Ltd

MortgageAdministration

Target Group Ltd

Auditor

Ernst & Young

MortgageAdvisers

The table above is provided as a means of representing the various entities present within the proposition and their inter-relationships.



APPENDIX 4 ABOUT AKG

AKG is an actuarially based consultancy specialising in the provision of ratings, information and market assistance to the financial services industry.

A wide range of Clients

Within a specialist focus on the financial services industry, AKG has developed a broad, complementary range of clients including: Intermediaries (IFAs), Life Companies, Friendly Societies, IFA Networks, Regulators, Fund Managers, Trade Bodies, Service Providers, Banks, and Building Societies.

Support for Product Providers

AKG assists Providers in:

• Financial Strength Analysis and Presentation

• Data and Information Provision

• Actuarial Consultancy

• Distribution Consultancy

Assistance to Financial Intermediaries

AKG assists Intermediaries in:

• Financial Strength Analysis and Ratings of Product Providers

• Best Advice Panel Services

• Data and Information Provision

• Actuarial and Technical Support

Regular Reports

AKG publishes the following reports to assist providers and intermediaries:

• AKG Company Profile & Financial Strength Reports

(Covering UK life assurance companies)

• AKG Offshore Profile & Financial Strength Reports

(Covering Offshore life assurance companies)

• AKG Platform Profile & Financial Strength Reports

(Covering UK Platform operations)

• AKG UK Life Office With Profits Report

For further details on any of the above please contact AKG:

Tel: +44 (0) 1306 876439, email: [email protected]

Or online at www.akg.co.uk

mailto:[email protected]

http://www.akg.co.uk/



Produced by:

AKG Actuaries & Consultants Limited

Anderton House, 92 South Street, Dorking, Surrey, RH4 2EW

Tel No: 01306 876439 | Fax No: 01306 885325 | e-mail: [email protected]

www.akg.co.uk

Corporate Due Diligence & Financial Strength Assessment · AKG: CORPORATE DUE DILIGENCE & FINANCIAL...

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Transcript of Corporate Due Diligence & Financial Strength Assessment · AKG: CORPORATE DUE DILIGENCE & FINANCIAL...