MONTHLY MUSINGS - MAY 2023

PRICING PRIVATE CREDIT RISK IN THE CURRENT ENVIRONMENT

In past musings, we have reflected on concentrating on what is in front of us, managing risk in an uncertain environment, lessons from GFC and Covid, and explaining what private debt is.  

We are happy to admit we have no expertise in forecasting the economy. However, we are opportunistic investors across private markets and are fanatical about ensuring we price for risk.   

This month, the RBA increased the cash rate by another 25bps. The pace of rate increases has been dramatic, with the cash rate now at 3.85% compared with only 10bps in April 2022. We continue to ask ourselves, what are various asset classes generating in the current environment, and are we still generating superior risk-adjusted returns for our investors? 

So how do we assess if we are generating superior risk-adjusted returns? 

Risk-adjusted return is simply the return generated by an investment for a given level of risk.  To assess, it is necessary to understand an investment’s: 

• Expected return:  Determining the expected return on private debt is usually pretty easy as it is the interest rate being paid plus any fees or charges (annualised); 

• Risk:  The risk of an investment is the probability that the capital invested (plus the expected return) will be repaid.  However, it is not easy to assess the associated risk as it can be impacted by a wide variety of factors, including, amongst other things, the cash generation of the business, the priority of access to security or cash flows, industry, and the amount of leverage.  For some corporate and government bonds, S&P and Moody’s estimate the credit risk rating (for more detail, see Credit rating - Wikipedia).   

Generally, the expected return increases as the risk associated with the investment increases. This is why government bond returns are less than corporate bonds or private debt.   The chart below shows the general trade-off between return and risk associated with an investment. 

Chart 1  – Risk/return associated with different forms of investments 

Part of Roadnight’s assessment process for a private debt opportunity includes determining the risk rating of the opportunity using a risk-weighted factor model.  This model allows us to indicatively map to other credit risk ratings and see the expected return relative to investments of an equivalent risk rating. 

At its heart, we want to invest in senior or subordinated private debt that earns returns equivalent to that generated by unsecured debt or preferred equity. 

So what are we seeing? 

Roadnight has traditionally found the best risk-adjusted returns by focusing on providing debt facilities to smaller borrowers looking to raise between $2-to-$30mil, and where we have the skill and expertise to manage these loans. Roadnight’s sweet spot is helping smaller borrowers transition into larger institutional funding markets. These companies generally seek growth capital or bridge financing but sit below the radar of bank and institutional capital.  

We have historically derived a 3+% premium over markets that fund larger borrowers ($30mil+) and 5+% over larger liquid markets. As can be seen in the table below, the Roadnight Capital Diversified fund continues to exploit this premium.  

Chart 2  – Current Yields of Income-Based Investments.

We believe a range of factors underpin the premium- 

• Greater fragmentation of capital providers, with less institutional capital competing. 

• Often, complex businesses require the same amount of work to analyse. 

• Deep credit and valuation skills needed to structure investments. 

• Deal terms range from short-to-medium term facilities, requiring the capacity to manage a portfolio of investments actively. 

• Loan facilities are illiquid. 

The perfect storm caused by rising interest rates, financiers scaling back lending, and equity markets effectively shut for fundraising has dramatically improved prospective returns for private credit. We have entered a period where pricing for risk is dramatically better than it has been since the global financial crisis. Nevertheless, the rapid rise in interest rates will inevitably lead to more significant financial stress for some borrowers and higher default rates across Australia. Mainly where a company’s financial leverage is too high or the economic slowdown materially impacts business.  

While smaller companies are generally nimble and flexible and can quickly adapt to changing customer preferences, they can be more concentrated in the makeup of their funding base and revenue streams. While we are happy to exploit the lack of funding diversity in this environment, we are also heavily focused on ensuring businesses can withstand unforeseen downturns. 

We remain vigilant on- 

• Structuring loan facilities with appropriate protections, i.e. low loan-to-value ratios, cash flow coverage, and strong covenant protections for investors. 

• Funding diversified businesses and pools of assets that can weather economic cycles. 

• Stressing our borrower’s and deal’s capacity to pay in the rising rate cycle. 

• Ensuring there are multiple pathways to repayment. 

• Remaining focused on pricing for risk. 

• Structuring our funds and co-invest opportunities to benefit from rising interest rates.