Market overview
The beginning of a new year and the holiday period affords the time to spend some much-needed rest and relaxation with family and friends and an opportunity to reflect and set priorities and goals for the year ahead. In investment markets, we begin the year faced with a very interesting set of macroeconomic factors globally that will continue to test and challenge all investors and asset classes into 2023. The continuing conflict in Ukraine, geo-political tensions between China and Taiwan, inflation persisting well above central banks’ target levels, coupled with significantly higher interest rates around the world are all factors that will weigh on investors’ minds this year.
Interest rates
Closer to home, the RBA must grapple with a scenario of sending the country into a prolonged recession and plunging house prices by continuing aggressive interest rate hikes on the one hand, with the threat of letting the inflation ‘genie’ out of the bottle and becoming rampant if the pace of rate hikes is reduced, on the other. This conundrum is only exacerbated by Australian consumers being amongst the most indebted in the developed world. The RBA estimates that the current household debt to disposable income ratio for Australians is at an all-time high of 188.5% for periods in which rates have risen, compared to 162.0% in 2012 and 130.2% in 2002. Furthermore, in Australia there is a direct transmission of interest rate impacts on the economy whereby the majority of consumers and businesses are financed with floating rate borrowings (albeit with some lag), compared to other countries such as the US where borrowers commonly lock in 30-year fixed rates. This is not an ideal situation for Australia, given the current cost of household living pressures, there is a significant cohort of mortgage holders due to transition from lower fixed interest rates (some below 2%) to higher interest rates projected to be between 5-6%, the bulk of which will occur in Q3 2023.
Loans we avoid
Given the challenging investment market backdrop of greater volatility and uncertainty, we have continually been asked by investors how our private debt strategy is expected to fare under these conditions. We expect that many private debt strategies will come under some serious pressure this year and beyond. The fact that a vast majority of these investments are illiquid means that there is limited ability for private debt managers to exit current positions to avoid potential losses, and the stress will likely come from loans made to the following assets:
- thinly capitalised property developers/builders;
- small to medium sized companies that are unable to pass on key input costs (including interest costs, raw material and labour costs);
- companies that have been trading at or close to insolvency through the Covid period that were granted some immunity for a period on filing for bankruptcy/receivership/liquidation – so called ‘zombie’ companies;
- early stage fintech non-bank lenders that are facing net interest margin pressures before they have reached break-even profitability in their operations;
- companies in consumer discretionary sectors such as retail, hospitality and tourism, as consumers are forced to ‘tighten their belts’ these sectors will be under more pressure from a top line revenue perspective;
- companies with a high proportion of fixed costs and high debt loads.
Loans we find attractive
Revolution has actively avoided all the above-mentioned areas in its investment portfolio – a strategy that has stood up to multiple market cycles including the GFC. It has always been the focus of our firm to concentrate on lending to companies that occupy market leading positions, with high barriers to entry and transparent cashflows, which sustain through the market cycle in leveraged buyout senior secured lending. In Asset Back Securities, the focus has been on the more established non-bank lenders that have scale and access to both debt and equity capital if required. Moreover, the pools of loans that Revolution lends against are focused on prime borrowers who are older and more established, with high credit scores. These are loan pools that are expected to perform well even under a recessionary scenario. In real estate lending, we seek to make loans to fund established and stabilised properties in office, retail and industrial with quality tenant cashflow. It is this cashflow that is assessed for debt serviceability and repayment, rather than merely relying on a forward view of valuations.
Overall, the portfolio is in a robust position as evidenced by timely receipt of privileged private side information from each counterparty. This allows the investment team to accurately assess the health of every loan on a real time basis. This same information is provided by Leadenhall, an independent valuation agent, who provides reporting on the current position and valuation of each loan.
Rising interest rate implications on valuations
Much has been written and discussed recently about ‘private market investments’ having stale and overvalued assets in light of the significant increase in base interest rates. Revolution’s view is that not all ‘private market investments’ should be lumped into the same basket. There is a strong argument that as risk free rates have increased, it is difficult to imagine how long-term illiquid assets such as real estate equity, private equity, long dated infrastructure debt and equity, and venture capital are able to maintain their lofty valuations. If investors can achieve a similar return for a credit risk free 10-year government bond – this should not be the equivalent to the capitalisation rate for a real estate equity investment, or the return on an infrastructure asset – where is the risk premium that adequately compensates investors for the additional risk?
Revolution invests in loans which are private, however they have some very different characteristics which make a much stronger argument to maintain par valuations for performing loans despite changes in risk free rates and general public market volatility. Firstly, all investments made by Revolution have a stated legal final maturity date – they do not rely on the manager to decide to sell the investment at a future uncertain date as is the case with direct real estate and private equity. Furthermore, the credit duration of the portfolios managed by Revolution have a credit duration of approximately 1.5 years and no interest rate duration. This means all loans are floating rate and have increased in yield in line with base rates. There is no observable secondary market for the loans that Revolution invests in and hence they are all are ‘buy and hold to maturity’ in nature and a diversified portfolio must be patiently built over time. The relatively short credit duration of the portfolios means that upon rollover of existing loans or origination of new loans, the prevailing market credit spreads are negotiated into new loan agreements.
As a result, Revolution’s valuation policy of marking all assets at par in the case where the loans are performing (based on real time information) is justified and quite different in nature to many other private market investments.
Private debt, being a floating rate asset class means the interest earned on each underlying loan is based on a floating interest rate (called the base rate) plus a margin for the term of each loan. This provides protection against inflation, as when interest rates rise, so does the floating base rate, resulting in investors receiving higher income and protecting them from inflation. In turn, the private debt principal remains protected (price doesn’t fall as is the case with traditional bonds) and overall yield actually increases.
Fund I – Portfolio and Pipeline Review
The Revolution Private Debt Fund I (Fund I) currently has a total fund size of A$193.8m. There is a cash buffer retained in Fund I for hedging purposes which means that Fund I is currently fully deployed.
The objective of Fund I is to actively invest in a portfolio of Australian and New Zealand loans and ABS with the target return of cash plus 4% to 5% p.a. (net of fees and expenses) with low volatility and with the benefit of having security over the underlying assets.
During portfolio construction, Revolution maintained strong credit discipline based on relative value across the three key focus areas of Fund I being: Australian and New Zealand Leveraged Loans (LBO), Asset Backed Securities (ABS) and Real Estate loans. Fund I is now past its investment period with no new investments or reinvestments occurring.
Fund I held a total of 22 loans as at 31 December 2022, with the average expected life of the portfolio being 1.4 years. The portfolio yield is 8.57% and the credit spread of the portfolio above BBSW is 543 bps, which is above the original target of Fund I. The average credit rating of the portfolio is currently BB.
Fund II – Portfolio and Pipeline Review
The Revolution Private Debt Fund II (Fund II) currently has a total fund size of A$1,615.6m. This is a pleasing rate of deployment since inception of Fund II in December 2019.
Fund II is performing well and is meeting its target return of cash plus 4% to 5% p.a. (net of fees and expenses) with low volatility.
During portfolio construction, Revolution maintained strong credit discipline based on relative value across the three key focus areas of Fund II being: Australian and New Zealand Leveraged Loans (LBO), Asset Backed Securities (ABS) and Real Estate loans.
Fund II held a total of 43 loans as at 31 December 2022, with an average expected life of the portfolio being 1.7 years. The portfolio yield is 9.26% and the credit spread of the portfolio above BBSW is 586 bps, which is above the original target of Fund II and the average credit rating of the portfolio is BB+.
The deal pipeline in Australia and New Zealand remains robust across LBO and ABS, which should allow for continued strong deployment. In LBO, activity has slowed down somewhat from an all-time high level of M&A activity to a more steady market state, however quality borrowers continue to access capital. Revolution is seeing similar dynamics playing out in the ABS market. Additionally, Revolution is seeing attractive secondary market opportunities, which Fund II has been taking advantage of.
Revolution Private Debt Fund I (CHN7934AU) – Performance as at 31 December 2022*
| Return | 1 month | Rolling quarter | 6 months | 1 year | 2 years p.a. | 3 years p.a. | Since inception p.a. (11 Dec 2018) |
|---|---|---|---|---|---|---|---|
| Fund I (after fees) | 0.68% | 1.38% | 2.42% | 3.90% | 4.25% | 4.46% | 4.73% |
| RBA Cash Rate | 0.25% | 0.69% | 1.13% | 1.23% | 0.63% | 0.50% | 0.68% |
| Active Return (after fees) | 0.43% | 0.69% | 1.29% | 2.67% | 3.62% | 3.96% | 4.05% |
Revolution Private Debt Fund II (CHN3796AU) – Performance as at 31 December 2022*
| Return | 1 month | Rolling quarter | 6 months | 1 year | 2 years p.a. | 3 years p.a. | Since inception p.a. (11 Dec 2018) |
|---|---|---|---|---|---|---|---|
| Fund II (after fees) | 0.71% | 1.89% | 3.50% | 6.14% | 5.95% | 5.81% | 5.81% |
| RBA Cash Rate | 0.25% | 0.69% | 1.13% | 1.23% | 0.63% | 0.50% | 0.50% |
| Active Return (after fees) | 0.46% | 1.20% | 2.37% | 4.91% | 5.32% | 5.31% | 5.31% |
* Performance is based on month end unit prices before tax. Gross performance (before fees) is stated excluding all fees, costs and taxation. Net performance (after fees) is calculated after management fees and operating costs, excluding taxation. This is historical performance data. The value of an investment can rise and fall and past performance is not indicative of future performance. The value of an investment can rise and fall and past performance is not indicative of future performance. The comparison to the RBA Cash Rate is displayed as a reference to the target return for the Fund and is not intended to compare an investment in the Fund to a cash holding. Loans held by the Fund are subject to borrower default risk and as such the Fund is of higher risk than an investment in cash.
Portfolio characteristics as at 31 December 2022
| Fund characteristics | Fund I | Fund II |
|---|---|---|
| Yield to Maturity | 8.57% | 9.26% |
| Credit Spread | 543 bps | 586 bps |
| Interest Rate Duration (years) | 0.1 | 0.1 |
| Weighted Ave. Credit Rating | BB | BB+ |
| Annualised 1 Month Net Return | 8.44% | 8.82% |
| Deal Approval Rate | N/A | 25% |
Source: Revolution Asset Management. See below for defined terms. These ‘forward-looking statements’ are not guarantees or predictions of future performance, and involve known and unknown risks, uncertainties and other factors, many of which are beyond our control, and which may cause actual results to differ materially from those expressed. Although we believe that the Fund’s anticipated future results, performance or achievements expressed or implied by those forward-looking statements are based upon reasonable assumptions and expectations, the reader should not place undue reliance on forward-looking statements.
For more information on performance and the portfolio of loans or about the Revolution Private Debt strategy, contact us.
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. Annualised Net Return is the monthly net return of the Fund annualised for the next 12 months.
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.