ROADNIGHT MUSING – DECEMBER 2023
REFLECTIONS ON 2023
2023 feels like a verse of Billy Joel’s “We Didn’t Start the Fire” has happened in 12 months rather than the 30-year period he sang about [1] So, given this, here are some of Roadnight's reflections on 2023:
1) WHEN BUILDING A BUSINESS, THERE IS ALWAYS MORE WOOD TO CHOP
It has been a busy 2023:
We have maintained our history of delivering strong risk-adjusted returns to our investors,
with the Diversified Income Fund (Fund) generating roughly 13% p.a. after fees.We have used the 4.00%+ p.a. increase in the cash rate over the last 18 months to decrease
the average risk rating of investments in the Fund while maintaining a similar level of return for investors.The gross assets of the Fund have grown by 2.5x.
The number of Roadnight Capital team members has doubled.
We implemented a loan management system that is integrated with our accounting system, allowing us to track how many opportunities we have reviewed, how many term sheets have been issued, and track covenant compliance by the Borrowers.
Received an AFSL and implemented a risk and compliance system.
Despite achieving all this (and more), the list of what we are looking to do in 2024 is even longer.
To that end, we are continuing to invest in people, technology, research, and systems, allowing Roadnight to keep scaling while maintaining our goal of delivering strong risk adjusted returns
to investors.
2) THERE IS A SUBSTANTIAL SHORTAGE OF FUNDING FOR PRIVATE BUSINESSES
We noted this point in our initial Musing in January 2023. The $1.2 trillion Australian business debt market is growing at 6- 10% per annum, and like the US markets Private Debt funders are increasingly filling the void left by our major banks. Our estimate is there is at least a $50b+ shortage of debt funding for private businesses in Australia, with a significant portion of that for companies looking to borrow less than $30m. The relative shortage of funding is greater as the loan size goes down.
The factors driving this funding gap, including tightening prudential regulation on banks, centralisation of bank credit processes, and a move to digital platforms has diverted bank capital away from small to medium sized enterprises, and into more commoditized markets such as mortgages. The quantum of capital invested into private debt markets is still not filling the void. This shortage will remain for an extended period and allow investors to generate excess returns relative to the risks. We believe the Fund’s portfolio of directly negotiated private loans is well positioned to capitalise on this dynamic for the foreseeable future.
3) HOWEVER, NOT ALL ‘PRIVATE DEBT’ IS THE SAME
The term “private debt” has become a generic high-level term that describes any form of non-public or non-bank debt. However, private debt funds focus on everything from direct private lending to securitisation, leveraged loans to SME lending, RMBS to CMBS, and property to corporate. Each private debt segment has a different risk profile, return that can be generated, and level of competition.
We have noticed that not all segments have a shortage of capital, with some segments still being highly competitive. This is most obvious with property-related private debt investments, where we have observed over the last 18 months:
Yields on loans not increasing materially despite the significant increase in the cash rate, and
Effective leverage moving higher as underlying property prices have fallen, while covenant and structural protections have reduced
When markets turn, this dynamic can make it more difficult to generate returns commensurate to the level of risk assumed or are available elsewhere.
4) YOU CANNOT DETERMINE THE REQUIRED RETURN ON PRIVATE DEBT WITHOUT A RISK RATING
An underrated component of successful private debt investing is ensuring you are paid appropriately for the “riskiness” of an investment. It is impossible to do that unless you can:
Objectively assess the relative risk of the investment and
Show that the expected return on the investment is the same or better than what can be achieved elsewhere for the equivalent level of risk
A key part of Roadnight’s assessment process is the generation of a risk rating for each investment opportunity. Our risk rating:
uses objective data
is tailored for different sectors
dynamic and updated as part of our review process
can be mapped to publicly available ratings data (S&P, Moody’s etc)
used to compare returns generated to market returns for similar risk
The risk rating does not determine whether an investment is made. Instead, the first question we ask ourselves is ‘is the investment money good, and if things go wrong is there a sufficient margin of safety to ensure our capital is repaid in a broad range of circumstances?’ However, once we have answered those questions, the risk rating is critical in determining the required return for an investment.
LOOKING FORWARD TO 2024
Given the team and platform we have, we are excited about 2024 and what lies ahead for Roadnight. Our achievements to date have been built on our investors’ ongoing support. We look forward to this continuing and urge our investors (or those interested in investing) to reach out if they have any questions.