MONTHLY MUSINGS – FEBRUARY 2023
MANAGING RISK IN AN UNCERTAIN ENVIRONMENT
Like many things, investing requires deciding what to invest in without knowing how future events will impact the investment. To assess an investment opportunity, it is necessary to hypothesise and plan how various scenarios or economic environments will affect the investment. This assessment process is at the heart of every investment decision, and the process’s adequacy determines how much risk is associated with the investment.
Given how hard it is to predict the future Roadnight has sought to build an investment process that generates excellent risk-adjusted returns irrespective of the economic environment based on the following principles:
1) While you want to know who you are funding, it is more important to know who you do NOT want to fund.
For Roadnight this means only:
– Funding customers with the capacity and commitment to repay
– Lending what a customer can repay
– Lending when we understand and can manage associated risks
2) Plan for the possibility of default.
Things can and do go wrong, which is why we provide for future losses to protect our investors and our risk review process focuses on the level of recoveries in various economic environments
3) The collective makes better decisions than an individual.
For Roadnight this means assessing a potential loan from a credit, a risk and a reputational perspective. Risk assessment at Roadnight is a separate role and independently participates in all credit decisions jointly approving individual transactions and approving portfolio credit strategies. The collective strength of individuals with different skills, experiences and perspectives results in a better decision
4) Be proactive in identifying, managing and communicating credit risk.
Be alert and react promptly to warning signs of credit deterioration since there is often a limited window of opportunity to influence the direction of events
5) Checklists and processes complement deeply understanding a borrower
Our people exercise diligence in the compilation and presentation of information. Policy and procedures cannot cater to all circumstance, and our people need to exercise common sense and judgement in all situations and seek guidance as required.
6) Optimise risk and reward
Negotiate the transaction structure (price, security tenor, repayment, covenants) to match the risk to the reward. An exceptional expected return alone is not sufficient to justify risking investors capital without an appropriate structure that manages the associated risks.
7) Build and maintain a diversified investment portfolio
The ability to limit potential losses is managed at both the investment and portfolio level and is based on maintaining a diverse range of risks without any undue concentrations.
Irrespective of the economic cycle or point in the investment clock, these credit principles guide our behaviour and actions.
Supporting and surrounding these credit principles are the best practice risk and governance framework found at the best fund managers:
1) Structural and Operating Independence
2) Acknowledgement of fiduciary responsibility to our investors
3) Credit Policy and supporting ancillary policies
4) Investment and Credit Committee that robustly assesses the risks and mitigants of each transaction
5) Risk Appetite Statement and Risk Plan that clearly articulates the type and level of risk we are prepared to accept
6) Risk and Compliance Frameworks
7) Audit Risk & Compliance Committee
While the risk and governance framework provides the guardrails to Roadnight’s behaviours and actions, it is the underlying DNA of our people and how we implement our investment process that generates our returns.
Our investment process is not a one-off application of our credit principles to a private debt opportunity but an ongoing process that involves three lines of risk defence:
· First line of defence - The initial credit assessment of the opportunity and application of the credit principles to borrower’s particular circumstances
· Second line of defence - Review/sign off by the credit committee and structuring of a potential investment
· Third line of defence - Due diligence and execution of the investment. Once funded, ongoing monitoring and reporting. If necessary, enforcement.
We have invested heavily in technology solutions to reduce customer and investor friction, improve data flow and enhance the process flows.
At Roadnight, we will continue to focus on the opportunities in front of us, and treat the overall environment as a driver of our stress testing and investment principles. We will look through the cycle and find the “diamonds in the rough”.