COVID-19: How Revolution prepares for downturns in markets
Revolution’s core philosophy of capital preservation and credit discipline will never be better tested than through this significant period of market dislocation. In being true to this core philosophy, we have deliberately avoided pro-cyclical industries such as media, advertising, tourism, retail, mining, construction/development and hospitality. Instead, we have key overweights to stable and defensive sectors such as Healthcare, Consumer Staples, mission critical software, infrastructure services and Asset Backed Securities (ABS) transactions and structures with greater ability to withstand the current market dislocation and beyond.
In addition, while today’s market volatility may concern investors in various asset classes, Revolution’s private debt investments are in the right investment structure and are less-correlated to listed markets, offering true diversification and capital preservation, which should provide our clients added comfort during this time of heightened volatility.
We would like to reiterate to our investors that manager selection is paramount in private debt markets. It’s important to allocate capital to fund managers that apply a deeply disciplined approach to deal flow and who understand the structure of the fund is crucial to its success.
March Quarter Market Review
The first quarter of 2020 can be best described as completely unprecedented. The year began amid a continuing equity market bull run, where valuations were observed at or near record highs in the developed world. The bullishness was fuelled by the signing of the ‘Phase One’ trade agreement between the US and China reached in mid-January, after 18 months of negotiations that had caused a significant amount of volatility in global markets. On 31 January, Brexit was finally achieved with Britain formally leaving the EU and negotiations commenced on a new trade deal following the three years of dispute.
In mid-January, the world learnt of a new threat facing both the health and wealth of the human race, the likes which have not been witnessed since 1918’s ‘Spanish Flu’ and the 1930’s Great Depression. From reports in early January of a new SARS-like outbreak in China, the coronavirus (COVID-19) rapidly reached epidemic proportions around the world.
Worldwide response has been to virtually shut down vast proportions of each country’s and state’s non-essential services and to effectively quarantine the public at home, in an effort to reduce the rate of infections and deaths. This caused one of the quickest and most violent corrections in the world’s history as many businesses and their employees found themselves unable to operate within days from the COVID-19 threat being realised. Governments worldwide having effectively ordered businesses to close, have embarked on economic relief packages to compensate the majority of those affected by the COVID-19 outbreak. In Australia, the Morrison Government has rushed through Parliament in record time, a series of economic relief packages that are in excess of $200bn. These packages are aimed squarely at reducing the impacts to GDP and unemployment rates through support of businesses and individuals in the period where social distancing measures are in place until the virus becomes more manageable for the healthcare sector.
At the same time, the RBA has cut the cash rate to a record low of 0.25% and embarked on unprecedented quantitative easing (QE) measures in Australia. The QE measures have initially taken the form of allowing banks to access a line of funding directly from the RBA at a rate of 0.25%, effectively allowing banks to pass on this liquidity to their SME borrowers. The RBA is also buying back Australian Government Bonds to relieve liquidity and funding pressures. In addition, the Treasury and the Australian Office of Financial Management (AOFM) have unveiled the Structured Finance Support Fund (SFSF), a $15bn fund established with the sole purpose of supporting non-bank originators who use securitisation to fund their ongoing lending activities.
These rapid, transparent, wide ranging and generous government initiatives will most likely provide a shock absorber effect to the economy through this period where we have witnessed ‘demand shock’ rather than one that was caused by high financial leverage, as we witnessed in the GFC.
Portfolio and Sector Review
The Revolution Wholesale Private Debt Fund II (Wholesale Fund) invests in the Revolution Private Debt Fund II (Underlying Fund). As at 31 March 2020, the Underlying Fund had called 53.4% of the capital of the Wholesale Fund, with the remainder of uncalled capital invested in cash equivalents, investment grade securities and/or Asset-Backed Securities (ABS). Revolution maintained a strong credit discipline based on relative value across the three key focus areas being: Australian and NZ Leveraged Loans, Asset Backed Securities (ABS) and Real Estate loans.
As at 31 March 2020, the Underlying Fund held a total of 12 individual investments (with a further 2 investments settling imminently) with an average life of the portfolio of 3.2 years. The credit spread of the portfolio above BBSW is 5.06% − above the original target of the Underlying Fund and the average credit rating of the portfolio is BB.
Deal pipeline: The deal pipeline is expected to be strong as a result of secondary market opportunities and we expect to be able to take advantage of purchasing higher quality debt instruments in the secondary market at very attractive risk adjusted returns. This has already been evident in some investments that we have made at the early stages of the COVID-19 affected market, where we have been able to purchase both AUD and USD denominated debt issued by Australian domiciled issuers at significant discounts to face value. We expect that there will be both domestic and offshore funds that may have become forced sellers of otherwise high quality and performing loans and bonds that we can acquire at opportunistic levels for the benefit of our investors.
Whilst the deal pipeline for new leveraged buyout transactions is expected to be on hold due to market volatility and dislocation, we expect the market in ABS to provide some significant opportunities as a result of the Structured Finance Support Fund (SFSF) support for the sector. In addition, while we have been extremely selective and disciplined on real estate lending, we expect that there will be significant opportunities in this sector going forward.
Australian and New Zealand Leveraged Loans: The Leveraged Buyout (LBO) loans in the Underlying Fund are in industries that are largely resilient in economic downturns and it is our assessment that they are capable of facing the current market dislocation until the threat of the COVID-19 pandemic subsides. All of the LBO transactions are senior secured sharing the same terms and conditions alongside other syndicated lenders in providing acquisition financing to leading private equity funds, acquiring market leading companies with strong barriers to entry.
Asset Backed Securities (ABS): The most significant near-term issues for the ABS market to digest is the expected material increase in the number of borrowers who apply to their lender for COVID-19-related financial hardship relief. Such relief would typically include the freezing of loan irrespective of note rating level – are reduced collection receipts, changes in default curve timing, and lower prepayment rates.
In an extremely strong direct response to the issue, the government has established the Structured Finance Support Fund, which is initially sized at $15bn and will enable the Government to make investments in a range of public and private structured finance transactions originated by smaller ADI and non-ADI lenders. In addition to this direct measure, the JobKeeper Payment is a temporary scheme open to businesses impacted by the Coronavirus. This initiative will have a positive impact on the rate of unemployment and will greatly reduce the pressure on borrowers over the short term. As a result of these measures, we are confident that the ABS transactions in the Underlying Fund are robust and are able to withstand the current market standstill as we have modelled downside risks such as these in all investments.
The public term primary market for ABS transactions is largely shut in the near term, with the exception of transactions that can secure Australian Office of Financial Management support. As such, we don’t expect this market to provide many meaningful investment opportunities for us in the near term. In these circumstances, the private warehouse market takes on an even greater importance, and we expect to continue to deploy capital selectively with well-established originators of loans that have demonstrated a long track record in their chosen sub-sector of ABS.
For the secondary ABS market, a dislocation has opened up between offshore-based investors looking to sell Australian and New Zealand ABS at very wide levels to generate cash, either to pay down leverage facilities (repurchase agreements) or invest into heavily discounted assets in their local markets. We expect the secondary market to continue to provide compelling opportunities over the coming months.
The Underlying Fund invested in two ABS transactions during the quarter. The first investment is in a private consumer loan ABS Warehouse facility to a well-established non-bank originator, with significant alignment via first loss equity and targeting prime borrowers. The other transaction was a secondary investment in a short dated, junior AAA-rated RMBS, with one of the largest non-bank mortgage originators in the Australian market. The seller is a high-profile offshore fund that desperately needed to generate liquidity, so was willing to accept a significant discount to par as very few funds have the dry powder to invest in the current market.
Real Estate Loans: We continued to be extremely selective in the sector of real estate lending as the vast majority of opportunities in the target range for our return have involved construction or development loans or have been backed by residential property. The investment strategy of the Underlying Fund excludes these loans as they largely do not generate stable cashflows from the underlying properties with loan repayments being reliant solely on asset sale.
In the current environment where there are fewer lenders, and banks may be looking to reduce their exposures to real estate, we expect there to be some interesting opportunities in lending to stabilised real estate assets with high quality cashflows at very attractive margins. Specifically, we are focussed on lending to non-discretionary retail assets that are predominantly grocery backed neighbourhood and regional shopping centres that are anchor tenanted by the major supermarket chains; high quality industrial properties with blue chip, long dated tenancy arrangements in place; and selective commercial office assets given the whole paradigm of the COVID-19 pandemic fast-tracking individuals to work remotely rather than necessarily all being in one office. Over time this could represent significant softening of demand and rent across the board that will first be felt in lower quality B grade office markets, in less attractive fringe locations.
For more information on performance and the portfolio of loans or about the Revolution Private Debt strategy, contact us.
^ The Net Internal Rate of Return (IRR) is the net return earned by investors over a particular period, calculated on the basis of the weighted cash flows to and from investors, after the deduction of all fees. ^^ Yield to Maturity (YTM) is the current total return anticipated on the portfolio if the portfolio is held until it matures. ^^^ Credit Spread is the weighted average credit margin over the bank bill swap rate (BBSW), which is the market benchmark rate. # Interest Rate Duration measures how much bond prices are likely to change if and when interest rates move and is measured in years. ## The Weighted Average Credit rating is used to indicate the credit quality of a portfolio and is an aggregate of the internal credit ratings of the portfolio’s holdings, weighted by exposure size. Internally rated by Revolution on the basis of ratings substantially equivalent to Standard & Poor’s ratings. Examples of ratings include credit ratings issued by Moody’s, Fitch and Kroll Bond Rating Agency.
This information is for institutional and professional investors only and has been prepared by Revolution Asset Management Pty Ltd ACN 623 140 607 AFSL 507353 (‘Revolution’) who is the appointed investment manager of the Revolution Private Debt Fund I, the Revolution Private Debt Fund II and the Revolution Wholesale Private Debt Fund II (together ‘the Funds’). Channel Investment Management Limited ACN 163 234 240 AFSL 439007 (‘CIML’) is the Trustee and issuer of units for the Funds. Channel Capital Pty Ltd ACN 162 591 568 AR No. 001274413 (‘Channel’) provides investment infrastructure services to Revolution and Channel and is the holding company of CIML. None of CIML, Channel or Revolution, their officers, or employees make any representations or warranties, express or implied as to the accuracy, reliability or completeness of the information, including forecast information, contained in this document and nothing contained in this document is or shall be relied upon as a promise or representation, whether as to the past or the future. Past performance is not a reliable indication of future performance. All investments contain risk. This information is given in summary form and does not purport to be complete. To the extent that information in this document is considered advice or a recommendation to investors or potential investors in relation to holding, purchasing or selling units in the Funds please note that it does not take into account your particular investment objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information having regard to these matters, any relevant offer document and in particular, you should seek independent financial advice. For further information and before investing, please read the relevant Information Memorandum available on request.