The Importance of Rock-Solid Foundations versus Sandcastles in Private Credit Strategies
By Bob Sahota, Chief Investment Officer
“In a time of universal deceit, telling the truth is a revolutionary act” – George Orwell
There has been much written of late on the ever-rising popularity and “golden age” of private credit. After all, the attraction of a non-correlated, defensive strategy that has enjoyed the benefits of a rapidly rising interest rate environment in developed countries has become compelling from institutional to retail investors alike.
Having been through an environment of high valuations fuelled by cheap liquidity from low interest rates, it was easy for private credit funds to deploy capital (make loans) and deliver excellent returns which rewarded higher risk strategies when default rates remained historically low. Through this period, the pendulum swung very much in favour of sponsor or issuer friendly terms and documentation in leveraged buy-out transactions, as an abundance of private credit funds competed for a finite number of funding opportunities.
At Revolution Asset Management (Revolution), we have long argued that not all private credit strategies have been created equally. The success or failure through a cycle comes down to whether a strategy and investment philosophy has been established on a solid foundation of bedrock, where the manager’s interests closely align with underlying investors, or merely a pretty sandcastle that gets washed away with the tide or first sign of a storm.
The Australian and New Zealand private credit markets are largely illiquid, unlike the US and Europe, where loans can be actively traded on secondary markets, like equity markets. Private credit managers in Australia must conduct thorough due diligence on loan opportunities before committing, as there is limited ability to trade or exit loans later. Hence as the macroeconomic headwinds of a slowing Australian economy and New Zealand’s economy already in recession, now more than ever it is incumbent on investors to select their domestic private credit managers extremely carefully to realise their target returns in the asset class.
The Revolution Difference
How are we different?
Origination Fees associated with new loans received by private credit managers can be referred to by various names, including upfront fees, structuring fees, arranging fees, or original issue discount (OID). These one-off fees, in addition to the margin charged on a loan, form part of the overall economics of a transaction.
At Revolution, we have always maintained a core philosophy: no matter what they are called, these fees belong to investors, and not the fund managers. Hence, all fees generated by all lending activities are passed on to our investors in their entirety. This ensures that there is proper alignment of interest between investors and Revolution i.e. we have no incentive as a large cornerstone investor in a loan, to skew the economics of the loan by demanding a higher proportion as upfront fees versus the ongoing margin of the loan.
Our flagship strategy does not include a performance fee, which often prompts the question: why?
Our focus is on providing loans to stable, non-cyclical businesses or pools of assets. We are looking to build a non-correlated diversified portfolio of loans that delivers a capital stable income. Introducing a performance fee incentive can create misalignment of interests between credit managers and investors. Performance fees may encourage managers to seek a higher risk, higher return portfolio to earn these performance fees. Upholding our core philosophy of clear and transparent alignment of interest with our clients means we do not charge performance fees.
Unlike the US and Europe, the Australian and New Zealand private credit markets are not quite as deep and broad with thousands of issuers and sponsors from which to originate loans. Therefore, if a private credit manager is confined to one specific sector in Australia and New Zealand, and there is limited issuance or opportunities in that sector, it could lead to investing in loans that underperform due to pressure to simply deploy capital.
Our investment strategy, guided by our Chief Investment Officer, has a track record dating back to 2005. This strategy focuses on originating loans from three distinct private credit sectors: senior secured leveraged buyouts, Asset Backed Securities and non-development/construction real estate loans. We are able to construct diversified portfolios that take advantage of relative value, aiming to deliver on the targeted return of the floating rate plus 4% to 5% after of fees.
The ability to increase the total addressable market in the strategy and select from three distinct sectors is a considerable advantage in avoiding risky loans and building a well-diversified portfolio of greater than 50 loans, which is a highly attractive feature of a well-constructed private credit fund.
In recent times there has been an increasing number of players that have entered the Australian private credit sector. In fact, we are aware of more than 200 active private credit managers in Australia. These newer entrants fall into two broad categories: new start-up managers with small levels of assets under management looking to grow their scale, and very large global players seeking to deploy capital in Australia and New Zealand (and the APAC region). The smaller players are predominantly focused on lending to real estate development opportunities with typically higher risk and return profiles that are not targeted by Revolution and hence are not considered direct competitors.
At the other end of the spectrum, large international managers are mostly focused on much higher risk adjusted returns – typically targeting highly leveraged loans with credit margins of 650 basis points and above. This is to compensate for the costs of FX hedging back to their home currency and to also account for the lack of liquidity in the Australian and New Zealand market.
Moreover, they generally seek much larger opportunities, often exceeding A$750 million. To achieve these margins, they typically offer sponsors a much higher leveraged option, usually in a unitranche format, normally without any loan covenants (or protections). Due to the higher margins on the loans, we have also observed instances where a portion of the margin is capitalised, due to the business being unable to service the debt on a full ‘cash-pay’ basis.
We do not consider these loan opportunities to be consistent with our capital preservation and income-focused philosophy. As such, large international players are also not considered to be direct competitors of ours.
Revolution is focused on loan opportunities that are more conservative in nature: less levered at the outset (hence a higher equity contribution by the sponsor), all cash pay interest, with at least one loan covenant. The all-in margins sought for these types of loans are between 400 basis points and 600 basis points. At this target return level, there are very few scaled players in Australia and New Zealand that can bring sponsors with ‘buy-and-hold’ capacity in excess of A$150 million.
In practice, Revolution’s scale in the risk/return profile that we target, provides us with early access to new transactions with the ability to engage directly with sponsors. This allows proactive negotiations on the key loan terms and conditions to be more lender friendly than would be the case if a bank was underwriting the loans to distribute. In addition to superior terms and conditions, Revolution has been able to demand far higher upfront fees as an arranger compared to acting as a syndicate member. As all fees are passed onto investors, this materially benefits investors through better risk-adjusted returns.
It has been long said in lending circles that it is easy to lend money, the challenge is to ensure that interest is paid when due and the loan is repaid at maturity.
There are many private credit managers that have been established with teams that have never really experienced a full default cycle and effects of a recession. In Australia and New Zealand, unlike the US and Europe there is little or no ability to trade out of loans as there is no liquid market. This is principally due to a lack of banks making markets in loans with trading books because of the absence of a Collateralised Loan Obligation (CLO) market domestically (which creates liquidity). Hence investing in loans in Australia and New Zealand is essentially ‘buy and hold’.
In benign periods, with low default rates and relatively easy monetary conditions, a certain degree of complacency can develop where all managers look relatively similar. In fact, the managers taking the highest amount of risk appear to outperform compared to more measured and disciplined ones. However, it is also true that it is difficult to foresee or quantify risk until it arrives. As a result, the true times of reckoning on whether a private credit manager has adhered to its credit discipline is when there is a protracted economic downturn and default rates rise.
Our investment philosophy and private credit strategy has been rigorously tested since 2005, including during the GFC ― a period in which many private credit funds either underperformed or failed. There are very few active private credit managers in the Australian and New Zealand market with such experience navigating these challenging conditions. This experience is extremely valuable not only in selecting appropriate loans, but also in selecting the most appropriate investment vehicle that combines the advantages of open-ended structures with the strength of closed-ended ones.
Through the GFC the two main issues for private credit managers were poor discipline (lending to weak or cyclical counterparties) and selling to end investors with a promise of daily or monthly liquidity.
It is easy to understand why a manager would fail due to poor lending decisions as these loans ultimately get distressed and default, resulting in capital losses that negatively impact performance. However, even sound and disciplined credit managers failed during this period. Investor anxiety led to heightened demands for return of capital, forcing managers to raise liquidity by selling their best loans in a weak market environment. By selling materially below face value, this led to the crystallising of losses, further exacerbating the panic selling due to redemption requests.
Credit discipline is at the forefront of our ethos and hence avoiding pro-cyclical industries and businesses, start-up fintech’s in Asset Backed Securities or property development/construction has been part of our core strategy since our inception.
Our favoured sectors include healthcare, mission critical software, consumer staples, lending to well established profitable Non-Bank Financial Institutions that lend to prime borrowers as well as lending to stabilised real estate with quality tenant cashflow. We are proud of the loans within our portfolio, but even more proud of the loans that we have avoided as we observe a number of them underperforming.
In periods of benign credit defaults and high liquidity, these strategies may look sound and achieve their desired objectives. It is however a very different scenario in periods of stress and limited liquidity. As private credit has an asymmetric pay-off with very limited upside and a downside that can involve significant capital losses when defaults occur, these strategies can significantly underperform in stressed scenarios.
Our Australian and New Zealand private debt strategy is focused on making loans at margins with the RBA Cash Rate plus 4% to 6%. The lack of performance fees charged by Revolution discourages taking risks beyond our focused risk/return range. Equally, the banks operating in Australian and New Zealand are very competitive in the provision of loans at margins below this range.
Hence, we believe this is the optimal range of risk/return to be able to deliver investors with attractive returns whilst at the same time being consistent with the principal focus on risk and capital preservation.
Greater Scrutiny & Regulatory Oversight in Private Credit
The Australian press has focused much attention on the lack of regulatory oversight and transparency when it comes to private credit managers. Critics have raised concerns about the emerging shadow banking system, where the absence of regulations could leave unsuspecting investors facing significant losses, and expose them to questionable practices by private credit managers.
At the same time, there has been an explosion of new, smaller entrants into the private credit space as the attraction of higher returns through rising interest rates has lured many investors. Currently, there are over 200 private credit managers that are operating in Australia.
We very much support enhanced oversight and governance within private credit. As highlighted in this article, we are proud of the high level of governance and investor alignment embedded in our investment philosophy and process. We welcome this greater scrutiny to ensure investors’ interests are protected and that poor practices are highlighted to avoid the entire private credit sector from being tarnished.
Overall, investment strategies built on solid foundations will stand out against those that are merely built on sand.
Important Information
This information has been prepared by the Investment Manager, Revolution Asset Management Pty Ltd ACN 623 140 607 AFSL 507353 (‘Revolution’). Channel Investment Management Limited ACN 163 234 240 AFSL 439007 (‘CIML’) is the trustee and issuer of units in the Revolution Private Debt Fund II and Revolution Wholesale Private Debt Fund II (collectively ‘the AU Funds’). Channel Capital Pty Ltd ACN 162 591 568 AR No. 001274413 (‘Channel’) is Revolution’s non-investment services provider and the holding company of CIML.
FundRock NZ Limited is the issuer of units in the Revolution Private Debt PIE Fund (NZD) (the ‘NZ Fund’). Public Trust is the independent trustee of the Scheme of the Fund. Revolution is the appointed Investment Manager for the NZ Fund. Refer to fundrock.com/fundrock-new-zealand for more information. The NZ Fund is intended for the exclusive use of wholesale investors, as defined by the Financial Markets Conduct Act 2013.
This information is supplied on the following conditions which are expressly accepted and agreed to by each interested party (‘Recipient’). The information is general financial product advice only and has been prepared without taking into account the objectives, financial situation or needs of any particular person. The information is not intended for any general distribution or publication and must be retained in a confidential manner. Information contained herein consists of confidential proprietary information constituting the sole property of Revolution and respecting Revolution and its investment activities; its use is restricted accordingly. All such information should be maintained in a strictly confidential manner. This information does not purport to contain all of the information that may be required to evaluate Revolution, or its investment strategy and the Recipient should conduct their own independent review, investigations and analysis of Revolution and its investment strategy and of the information contained or referred to in this document. Neither Revolution, Channel, CIML, FundRock NZ nor their related bodies corporate, representatives and respective employees or officers (collectively, the Beneficiaries) make any representation or warranty, express or implied, as to the accuracy, reliability or completeness of the information contained in this document or subsequently provided to the Recipient or its advisers by any of the Beneficiaries, including, without limitation, any historical financial information, the estimates and projections and any other financial information derived there from, 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 indicator of future performance. The information in this document has not been the subject of complete due diligence nor has all such information been the subject of proper verification by the Beneficiaries. Except insofar as liability under any law cannot be excluded, the Beneficiaries shall have no responsibility arising in respect of the information contained in this document or subsequently provided by them or in any other way for errors or omissions (including responsibility to any person by reason of negligence). An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. For further information and before investing, please read the offer document which is available upon request.