In the first part of this article we highlighted the need for yields for traditional fixed income investors and pinpointed to the asset class Private Debt as an interesting opportunity to substitute some fixed income exposure with.
A few characteristics were named previously, and we will now highlight a few investments in the Private Debt space that illustrate how diverse but also specialized the managers can be, what kind of opportunity for a meaningful income distribution they can achieve in their niche and most importantly what downside may have to be considered.
Private Mortgage Loan (I): The firm operates in the bridge lending market by investing in short-term senior debt, secured by income-producing US real estate. The focus is on providing flexible capital to borrowers experiencing liquidity constraints and, in addition, providing capital to other types of borrowers who have an interest in taking advantage of time sensitive opportunities.
The firm has built a moat with being extremely fast in accessing, providing flexible structures and executing on loans as well as committing sums that fall below the radar of traditional lenders. While banks have shut out many borrowers, the demand for alternative mortgage financing has increased dramatically. The network of broker relationships, appraisers, attorneys, in-house credit analysts and experienced underwriters provides a strong foundation to the firm. The comprehensive Due Diligence, dealing with senior-secured mortgages, personal guarantees and a focus on high-grade collateral continue serving the firm well.
Within the last 3 years, they had only one case where they were forced to call collateral and in that instance it had more value than the outstanding mortgage. The firm delivered an approx. 9% net return with no negative monthly return yet. The return stream should be seen as a monthly coupon payment.
US Franchise Loans (II): The firm operates primarily in the direct lending business of the US Quick-Service Restaurant franchise sector. The philosophy is based on the belief that this segment is highly inefficient, and no capital is available for smaller borrowers. Thus, the firm provides not only capital but also consultant services that enable borrowers to continue their growth path efficiently.
The firm has sharpened its competitive edge over the course of 8 years in this business. The depth of operational expertise and contacts within the franchise ecosystem is vital and not easy to replicate. Competition in the focused deal size of USD 5-10mn is non-existing. The firm applies a rigorous Due Diligence process on potential borrowers.
They provide capital to businesses with generally stable, simple, formulaic and proven business models with recognizable brands, well-established customer demand and support from a franchisor. In the past, tight covenants and monitoring processes helped avoiding any defaults.
The Fund’s overall strategy relies on the high cash yield and additional return pick-up through more hybrid and equity-related investments. A net cash yield of 10-12% is accepted by the borrowers. Due to equity kickers the firm achieved an asset-weighted Track Record of almost 14% gross IRR for the investors.
Litigation Financing (III): The firmhas in investing in commercial legal claims and financing litigation defense, providing capital to sophisticated companies and their leading legal representatives. Primarily, the investments are used for attorney’s fees and other litigation costs that companies do not want to take out from their ordinary cash flow.
The US market that can be described as infant is characterized by a complete mismatch between supply and demand of capital. Only a few players are active in the US whereas it is an established asset class in the UK. The size and costs of US litigation put pressure on companies seeking alternative ways to cover legal costs. Traditional capital providers are not in the position to finance a litigation. The firm has built a framework of lawyers and financial professional who understand both sides of the equation and are able to price litigation-related risks effectively. With little competition, law firms as well as companies do not have many financing options on hands making this business model very attractive for a foreseeable future.
The firm is positioned to generate attractive deal flow from top-tier law firms and companies. The comprehensive Due Diligence and underwriting process, portfolio structure and risk monitoring, collaboration with the involved parties (tailoring), acting as strategic partner and integrity are the relevant success factors of the firm. The diligent management process made sure that asset coverage ratios are sound and investments are structured to ensure that the principal is protected. The Track Record for the firm is stellar with double-digit returns beyond 20% and not a single collateral call.
What are the drawbacks of this – apparently – compelling asset class?
Research, Due Diligence and Implementation are not as straight forward in private credit compared to identifying fungible fixed income securities such as US Treasuries or German Bunds. As the universe of Private Debt managers is very broad, knowing who has an edge in his particular strategy and being able to execute a thorough Due Diligence that uncovers the potential risks with a manager are critical components for success. From our experiences, the challenges are worth the consideration, particularly for those investors who have a need of stable coupon type returns with controllable downside protection.
Against the backdrop of a prolonged low yield environment, investors will need to unlock new sources of return – including investment strategies and asset classes – for the potential replacement of yield from traditional sources. For those institutional investors willing to think outside of the box of “traditional” income-generating strategies, Private Debt can be reviewed as an attractive alternative as it can help replace lost yield, adds diversification, has limited interest rate sensitivity, offers uncorrelated absolute and overall attractive risk-adjusted returns. We would welcome getting in touch with you to discuss the strategy in more detail and to consider how it could be implemented within your asset allocation.