Capitalising on Canada’s mid-market

For institutional investors, mid-market private debt funds deliver a premium rate of return over public market bonds while maintaining the risk profile of investment grade debt.  For mid-market borrowers, the funds  provide custom designed debt capital funding solutions that are an attractive alternative to bank financing.

More than $1.5 billion has been raised for the investment-grade Canadian mid-market since the closing of the  first limited partnership private debt fund in 2004. The limited partners in such funds are institutional investors, primarily Canadian pension funds, who lack the scale or structure to develop the in-house resources required to efficiently access the premium risk adjusted rates of return available in the private debt market. They are attracted to the investment grade private debt market by its higher yield, lower default risk, lower volatility and broader diversification compared to public market bonds.

Successful  private debt funds invest in good quality businesses with investment grade characteristics.  Such funds have proven to be a reliable source of higher rates of return than public market bonds primarily because they lock in the higher interest rates available in the private debt market.  The rate of return premium over the public market is generally about 200 basis points.

There are two sources for the higher interest rates, an illiquidity premium and a uniqueness premium.

The illiquidity premium is compensation for private debt being a buy-and-hold investment that is intended to be held to maturity and for which there is no active secondary market.  To deal with the illiquidity, funds are structured as flow through vehicles with no reinvestment of capital thus distributing the cash flow from the investment portfolios as they self liquidate over time.  The portfolios have structural liquidity as each investment has a contractual maturity date, many have amortization schedules that partially or fully repay the debt during the term of the loan and most of the interest and principal payments are monthly.

A uniqueness premium is obtained when an investment opportunity involves a borrower who has an unusual or complex borrowing requirement and is having difficulty obtaining financing.  In these situations, greater time, effort and evaluation skills are required to assess creditworthiness and to structure the loan.  The payoff for the investor is often a higher interest rate for less credit risk than for easier to understand credits.

There are many successful and well managed private and public businesses in the Canadian mid-market.  Their borrowing requirements for capital are typically in the $10 million to $50 million range. In securing this financing they face many hurdles including: they are too small to access the public bond market; they fall below the radar screen of most investment bankers; many are private companies where it is challenging to gather and assess information to determine their creditworthiness; many have unique or unusual borrowing requirements that require additional time, effort and expertise to understand their business and to custom design a loan. 

A reliable and predictable premium rate of return is realized for investors by building well diversified portfolios of private placement loans to mid-market businesses and projects.  Taking exposure to credit risk and actively managing that risk  maximizes expected rate of return and minimizes loss. A  cradle to grave approach to managing credit risk has three key components: pro-active direct origination of investment opportunities, custom designing loan structures and maintaining a direct relationship with each borrower throughout the term of the investment

Proactive direct origination provides  access to the underserved mid-market and it puts the manager in control of the investment process.  Until contact is made with them, most mid-market businesses are unaware that a fixed interest rate, medium to long term borrowing option is available.   There is great natural diversification of investment opportunities in the market and, while the manager  can actively control processes to gain access to investment opportunities, which borrower and the timing of when they choose to borrow is their choice.

The custom design of a loan structure flows logically from the fundamental analysis that is undertaken to determine a prospective borrower’s creditworthiness.  Default risk is reduced and the borrower’s prospects for future prosperity are improved when the nature of the business and its unique operating features are taken into consideration when negotiating the loan’s terms and conditions.

 The manager establishes a direct relationship with the borrower when the investment opportunity is first examined.   An important consideration in the assessment of investment opportunities is having confidence that the borrower’s management team is proven, reputable and committed to the future success of the business.  Experience has shown repeatedly that a short and constant line of communication with the borrower can significantly reduce default risk.  There is early identification of any emerging credit issues and, with a well established and positive working relationship in place with the borrower,  credit issues can usually be resolved before they get out of hand.

Achieving credit quality and rate of return objectives requires a team of highly skilled debt investment generalists who have the depth and breadth of investment experience to deal with the wide variety of businesses and projects who are potential borrowers in the Canadian mid-market.

Investing in the private debt market is a manufacturing process where the end product is the rate of return ultimately earned on each investment.  While it is disciplined post-closing investment management that ensures the realisation of the expected rate of return, the largest amount of time and effort is spent on the acquisition of investments. 

The investment manufacturing process involves several steps and requires different skills and experience at each step.  Consistent with an in-house investment team being highly skilled generalists, you should expect each  investment manager to be knowledgeable about, and participate in, all of the steps. 

At the investment acquisition stage, there are four basic processes.  First, there is proactive origination of investment opportunities which identifies and establishes contact with prospective borrowers.  Second  is the evaluation process which involves information gathering, credit analysis and due diligence to determine the prospect’s creditworthiness and the most appropriate structure for the loan.  Third is negotiating the terms and conditions of the loan with the borrower.  Fourth  is working with legal counsel to ensure the loan documentation accurately captures the agreed terms and conditions of the loan and is enforceable.

In the post-closing period, there is continuous monitoring of each borrower’s credit quality and covenant compliance and, to ensure timely receipt of payments and information, ongoing in-house administration of the investments.  Serious credit issues are infrequent in the investment grade debt market.  However, if a default occurs, the in-house investment skills of analysis, structuring, negotiation and documentation are employed to resolve the  situation.

In conclusion, the investment grade private debt market is an attractive asset class for investors seeking a safe and reliable yield pick-up for their fixed income portfolios. With its stable, predictable and relatively high cash flow, it is an ideal investment for investors implementing a liability driven investment strategy.

Most importantly, with changes in risk management and capital requirements arising from the financial crisis, there exists an excellent opportunity for investors to provide capital to mid-market borrowers and capture enhanced fixed income returns.