Private Debt Update: March 2020

2020-03-30T09:51:41+00:00 March 23rd, 2020|Insights|

The Revolution Asset Management investment team is fortunate to have witnessed and managed private debt portfolios through a number of full market cycles prior to the current dislocation. This has given us valuable insights that we are now able to apply to our portfolio. In fact, we established our business to be able to trade through the conditions we are now witnessing in capital markets, for our investors’ benefit.

Importantly, we are predominantly investing at the top of the capital structure in senior secured debt and we have patient capital that is resilient as markets rise and fall. We also don’t offer short-term liquidity so there is no requirement to sell down assets in a downward market. Given we underwrite with the deliberate intention to hold our assets to maturity, we’re not concerned if the value of the underlying asset fluctuates short-term. Our focus is purely on delivering income to our investors coupled with our core philosophy of capital preservation through full market cycles.

Additionally, every quarter an independent third party verifies the performance of the assets in the strategy. This gives us confidence to mark them at par, plus any accrued income, which is then distributed every quarter. This is attractive to investors in or near retirement who don’t want as much exposure to market volatility in public equity and fixed income markets.

A disciplined approach that helps us mitigate risk

Our investment team is particularly mindful of the downside scenarios when selecting investments. We only invest in secured debt issued by high-quality mature companies that operate in industry sectors in which there are strong barriers to entry.

Most importantly, we avoid cyclical industries. This means our assets have strong and defendable cash flows with significant equity cushions provided by the sponsors. To help manage our risk, we don’t participate in bilateral loans to smaller companies. Rather, we are part of syndicates or club transactions, which ensures our investments are well secured and structured. As an example, we recently participated in a transaction involving Brookfield’s acquisition of Healthscope Hospitals, the number two provider of private hospitals in Australia.

Moreover, we only back very strong companies with good management teams and excellent sponsors. In the asset-backed securities market, we work exclusively with originators with a first-class proven track record and have been repeat issuers in the capital markets through market cycles.

From a sector perspective, we have exposure to consumer staples, with Revolution forming part of a consortium of senior secured lenders to Arnott’s Biscuits, a 150-year-old household name that was acquired by the private equity firm KKR in 2019.

Another of our portfolio businesses is Genesis Care, a leading provider of radiation oncology services in Australia, the UK and Spain. This business is about to make a large acquisition in the US from which our fund and its investors will benefit through providing the senior secured loan alongside many other banks and institutional lenders in the same syndicate.

Infrastructure services business Ventia is also part of our portfolio. This business administers very long-dated concessions on toll roads, desalination plants, transmission poles and wires as well as providing the operations and maintenance to the telecommunications industry.

These companies are well cushioned against market downturns and external shocks that are outside the management team’s control. We will not invest when forward cash flows cannot be predicted or are of a volatile nature in pro-cyclical industries.

We would like to assure our investors that we stress test all our investments for a severe market dislocation and undertake substantial work before we make an investment. This involves ensuring our portfolio companies have enough liquidity on their balance sheet, or have access to revolving lines of credit, to withstand the current market shock. We ensure when we assess a deal, the business can trade through a situation in which their earnings experience a short-term to medium-term decline. Moreover, we are assessing whether there is an adequate equity cushion to support any modelled downturn such that interest is able to be met, as and when due, and the debt is able to be comfortably refinanced by their legal final maturity.

Future opportunities

In our opinion and through our experience through various cycles, the current market dislocation is likely to uncover incredibly attractive investments for our strategy. We will continue to focus on opportunities to provide senior, secured debt to a number of leading Australian and New Zealand businesses that meet our due diligence requirements in addition to meeting the broader characteristics that we look for such as ‘non-cyclical’ and ‘stable and defendable cash flows’.

Although short-term, there may be a decline in activity in mergers and acquisitions, given the market dislocations, we foresee substantial opportunities coming to us via the secondary market via forced selling from more liquid strategies that are required to meet redemptions and hence forced to sell high quality investment grade names. We anticipate a repeat of the conditions that we witnessed throughout the GFC, where the requirement for liquidity within various strategies caused otherwise performing assets to be sold at significant discounts.

In times like these, the illiquidity premium we enjoy tends to grow, given the lack of buyers. How that translates into the strategy is that Revolution expects to achieve its targeted returns, while at the same time managing the risks to which the portfolio is exposed. We do this via considering opportunities that meet the fund’s return target, whilst effectively taking less risk. Given our strategy does not charge performance fees, Revolution is solely focused on delivering stated return objectives with the least amount of capital risk. There are very few strategies in the market that enjoy the flexible mandate and structure, which can deliver for investors through a full market cycle.

Commercial real estate lending is an example. At the moment, we only have an extremely limited exposure to real estate assets. This is because we took the view that cap rates were very low and these assets don’t have the ability to pay the margin on the debt we require to provide finance. This is something that will likely change if the current market shock continues. As a result, good quality real estate with secure, underlying tenants and cash flow may become more attractive in the medium-term.

The ageing population challenge

As investors approach or enter retirement, they face serious risks in the context of a sharp decline in equities markets. Dividends and imputation credits are also at risk as company earnings are likely to drop as a result of current market conditions.

Therefore, assets that produce higher stability of income, with the aim of preserving capital are going to become an even more important part of investor portfolios. Private debt is an asset class that aims to provide stable income in a balanced portfolio and can provide an important source of diversification away from equities, property and traditional fixed rate bonds.

We would like to reiterate 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.

Ultimately, 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 diversification, which should provide our clients added comfort during this time of heightened volatility.

Please get in touch with our investment manager partner Channel Capital for more information or to assist you with your portfolio needs.

Bob Sahota, CIO
Revolution Asset Management

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.