MONTHLY MUSINGS – AUGUST 2023
HOW DO YOU GENERATE SUPERIOR INVESTMENT PERFORMANCE IN PRIVATE CREDIT?
There are many ways to slice and dice the investment universe. The list below sets out some of the characteristic’s investors consider:
Priority in the balance sheet – equity, debt (senior, subordinated, unsecured), hybrids, derivatives
Whether it is publicly traded or private
Type of asset – real estate, agriculture, infrastructure, financial asset, etc
Term of the financial investment
Yield
However, no matter how investments are categorized, superior investment performance involves generating better-than-average returns over the economic cycle without accepting commensurate risk. The key is working out how this can be achieved.
For Roadnight, we seek to generate superior investment performance by:
Investing in private credit in relatively illiquid markets that provides asymmetric advantage by limited competition or informational advantage
Clearly understanding the risk associated with the given investment. That is, the investment has a risk rating that facilitates a relative ranking of equivalent investments by risk and return
Directly comparing the price received for a given level
of risk to that available across the financial universeIdentifying and responsibly investing in event driven opportunities
So let’s break down each of these elements to understand how Roadnight seeks to generate superior investment performance.
PRIVATE CREDIT
Private credit has grown in prominence in recent years aided by the Global Financial Crisis leading to new banking regulations that constrained lending by banks. This has provided space for non-bank lenders to provide credit directly to borrowers across the economy.
This is especially the case for small to mid-sized companies as they can only access private markets to raise debt. Private Credit strategies, like direct lending, can offer an attractive option for investors looking to generate higher yields and diversify their portfolio from traditional fixed income. Due to the privately negotiated nature of direct loans, they often have faster underwriting and closing timelines, and certainty of completion.
The main types of private credit are:
1. Direct Lending – involves loans made directly from the lender to the company to support growth, acquisitions, or refinancing needs. These loans are typically senior in ranking, secured by collateral, and offer floating rate coupons.
2. Mezzanine or hybrid debt – subordinated debt that sits between senior debt and equity, which carries more risk but offers higher potential returns.
3. Venture debt – loans to venture capital-backed companies by a specialized lender, typically combining debt with warrants or other mechanisms to compensate for the higher risk of lending.
4. Distressed debt – usually involves loans provided to financially troubled companies at a discount, usually on the secondary market. These loans carry the highest risk and return dependent on a successful restructuring of the company.
Roadnight focuses on direct lending. Assessing private debt is not like buying a share or a fixed income product from a broker. Rather it involves assessing the following elements of a private debt investment:
• Interest Rate – typically a floating rate structure which helps mitigate interest rate risk in a rising interest rate environment. The coupon paid by the borrower resets periodically based on the spread over a floating benchmark like BBSW. These loans will typically have interest rate floors so even if the actual benchmark rates drop, there is minimal yield and spread protection in a declining interest rate environment.
• Collateral – loans are typically secured by collateral like General Security Agreement over the company’s assets, and first registered mortgages over land and buildings. In the case of default, these loans can have higher recovery rates ranging from 70 – 100%.
• Debt Covenants – direct lending often implement debt covenants that are designed to protect the interest of the lender by ensuring the borrower remains financially stable to repay the debt, and if there is any deterioration, the lender is notified early so that remedial actions can be implemented.
• Illiquidity – direct lending can involves loan tenor ranging from 1- 7 years, tying up an investors capital for that period. Investors will have limited ability to sell prior to maturity. These loans also have a callable structure where the investor needs to ensure they have cash ready to deploy.
• Limited transparency – direct loans are not publicly traded and therefore have lower volatility compared to public traded instruments. However, data transparency is often lower and the marked-to-market values of the investments are either.
Roadnight manages these elements by:
ASSESSING AND MANAGING RISK
Roadnight has a strong credit assessment process framework that consistently identifies the risks to getting repaid. The firm has a clear Credit Risk Strategy that defines the types of risks the manager is willing to accept, which is very closely aligned to the skills and capabilities of the team. Once an investment is made, the team works closely with the borrower to dynamically monitor risks and performance at the loan level and ultimately at the portfolio level.
Roadnight Differentiator:
– We are direct investors, not syndicated investors. We have bi-lateral facilities where we structure terms, receive ongoing information and conduct surveillance, structure covenants and undertakings to act as early warning signals of deteriorating financial performance, and provide us with the ability to step in and manage.
PRICING EACH TRANSACTION FOR ITS RISK
A through the cycle returns needs to be generated comprising:
An entry price to provide an adequate return to cover both illiquidity and risk through the life of the investment.
Generate a premium for investors using manager skill and experience, and responsibly investing in parts of the market facing temporary dislocation or fragmentation. Roadnight is typically generating a risk premium of 300-600 bps above BBB- risk rated debt.
Roadnight Differentiator:
– Ensuring our due diligence process can accurately determine the risk of an asset, and that our depth of pricing comps through the cycle allow us to appropriately price for risk given the 1-to-4 year duration of our investments.
DURATION
Roadnight typically makes shorter duration investments (1 to 3 years), and hence through portfolio structuring and diversity, can overcome many of the downside of longer dated illiquid assets such as private equity or infrastructure assets.
Direct property and infrastructure equity are two such sectors with very long duration assets, which are being heavily impacted at this part of the cycle. A case in point being we can see many listed property REITs trading at material discounts to book value, while the formal valuations of the underlying assets are only just starting to hit many of the private syndicates. Whether that revaluation cycle hits ultimate investor returns on exits, will come back to how well the manager/investor was able to price for risk on entry.
Roadnight Differentiator
– Our Funds are appropriately structured to manage the asset liability mismatch risk. We have seen all too often, the promise of liquidity
EVENTS AND OPPORTUNISITC EXECUTION
While the market cycle does drive prices at particular points in time, there are also external factors which can impact the short-to-medium term demand/supply of a particular asset class. A good example are changes to benchmarks of a particular type of investor. Recent changes to MySuper, valuation policies, and liquidity requirements on the ability to draw down on super, has impacted the Industry Funds, who have been large buyers of illiquid assets historically.
Roadnight Differentiator:
– Our pricing for risk mentality, and core expertise across several sectors in private markets, allows us to responsibly capitalise on opportunities as they arise. The opportunities may arise due to capital markets mispricing an asset at certain points of the cycle, or an external factor is impacting the supply of capital.
– The Diversified Income fund and Opportunity Fund 1 are two great examples of this in practice.
