MONTHLY MUSINGS - APRIL 2023
PRIVATE DEBT: NOT YOUR AVERAGE ASSET CLASS
Not surprisingly in our various discussions with investors we have been asked a variety of questions about Private Debt. Given this we thought that it made sense to provide a Q and A on the Australian Private Debt market
WHAT IS PRIVATE DEBT?
Private debt refers to loans made directly to private companies by non-bank financiers.
The borrowers typically cannot access the bank or public markets to raise debt to fund the opportunities they see. Increasingly, we are seeing borrowers who could access bank funding but choose not to do so as the terms do not fit their business needs or the banks cannot move fast enough or provide them with the certainty required.
The non-bank financiers can take many forms but are usually either:
Asset managers, like Roadnight Capital who specialise in credit assessment and structuring who lend on behalf of their clients; or
Non-bank finance companies, like Liberty Finance or Latrobe Finance, who provide finance to consumers and businesses outside of the traditional banking system
WHAT HAS DRIVEN THE GROWTH OF PRIVATE DEBT IN AUSTRALIA?
Private debt in Australia has grown significantly over the last 5 years, driven by:
Flexibility and speed of the non bank financiers – increased bank regulation and centralisation of credit processes has restricted bank’s ability to provide business funding. Non-bank financiers do not have these constraints and can move quickly to provide financing structures that meet the borrowers needs on terms the banks cannot.
Investor desire for yield and portfolio diversification – On the supply side, Private Debt on a like for like basis typically delivers a premium of between 150 bps to 400 bps compared to publicly traded leveraged loans. Also for appropriately structured Private Debt, there is limited correlation of returns to other investments.
WHAT ARE THE ATTRIBUTES OF A SUCCESSFUL PRIVATE DEBT FINANCIER?
As many financial commentators have observed, anyone can lend money but the key to success is making sure that you get it back. In that vein, Roadnight believes that you need three attributes to be a successful private debt financier:
Strong credit assessment process – at its core this is a well defined process for assessing the risks to getting repaid that is consistently applied
Clear risk/monitoring framework– A clear understanding of the type of risks the financier is prepared to take on and ongoing monitoring of risks at both the loan and portfolio level
Skills, capabilities and discipline to execute – to succeed it is essential to have the right experience in a culture that prizes consistent execution against set policies
If these attributes exist then over extended periods of time a private debt financier is likely to generate strong risk adjusted returns irrespective of financial markets volatility, the economic environment or the fluctuation financial asset values.
Roadnight is building these attributes based on
A credit process that focuses on financing businesses that have a combination of strong / stable cashflows and asset support with traditional financial covenants and tight structures
Typically our clients have Interest Cover ratios > 3.0x and Operating leverage < 2.75x
Risk management process that focuses on
industry and geographical diversity, and an average position size of < 10%
covenants and other protections that minimise the risk of loss in the event of default
A deep team with complimentary skills with 100+ years of credit, investment and operational experience across a variety of sectors and economic environments (including restructuring)
WHAT IS THE AUSTRALIAN DEBT MARKET LIKE TODAY?
Very simply, Private Debt financiers are firmly in the driver’s seat going into FY 2024, with financing across the economy harder to come by for borrowers large and small.
Current market dynamics are offering Private Debt financiers:
more attractive deal pricing and lender friendly terms. Compared to a year ago, pricing has increased by 300+ basis points
conservatively structured senior secured loans with lower leverage
borrowers who are generally higher-quality businesses that are or have demonstrated the capacity to deal with supply chain shortages and inflation
Meanwhile Private Debt has become an indispensable source of return and diversification for investors so is attracting strong capital inflows.
At Roadnight, we acknowledge the potential economic headwinds but believe they are manageable and we recognise the sizeable market opportunity before us and our investors.
WHAT THEMES OR CHALLENGES DOES ROADNIGHT SEE GOING FORWARD FOR PRIVATE DEBT IN AUSTRALIA?
Roadnight expects to continue to see a shift towards borrowers seeking private debt funding, with demand growing at 10%+ p.a for the next 3+ years, or 3x the expected growth rate for debt generally.
While significant amounts of capital is flowing into Australian Private Debt it is still less than required with the shortage being most acutely felt by borrowers seeking < $20m. This is happening as Private Debt financiers are tending to focus on funding loans of $30m+ and is similar to what has been seen overseas (particularly, in the US) and in property finance in Australia.
The expected ongoing shortage of financing for <$20m deals means that for a given level of risk the return will be at least 300bps higher than larger deals. This is on top of the higher return Private Debt generates for a given level of risk when compared to bank debt or publicly traded loans.
In addition, Roadnight expects that a more challenging economic environment will provide very attractive investment opportunities in the following areas:
Companies seeking capital to grow
Pre and post farm gate agriculture lending opportunities on a first registered mortgage basis.
Companies seeking bridge funding for 1 – 12 months
Companies recovering from financial stress, and demonstrating an inflection point to sustainable profitability through successfully implementation of turnaround strategies