Take some time to understand the market segment targeted by the manager. Major market segments are large volume ones mostly dominated by the banks where yields are generally too low for managed funds that have substantially less scale and market power – unless fund leverage is added, which may add significant risk.
However there are many non-bank market niches where higher yields are possible. For example, one niche is purchase order financing, an area that caused considerable damage in the last private debt investing cycle. If investors had taken the time to research the market sizing then the relatively large fund exposures in this small niche market would have seemed implausible – and they were, with a large scale fraud perpetrated on the most sophisticated investors. Do your diligence in this area carefully.
Small and mid-sized entities (SMEs) are much different to larger corporate borrowers, where operations are more stable, information is more transparent, and third party credit ratings are available. So for SME markets, make sure the manager’s focus is on collateral valuation and realisation, not on historical financials. Collateral should consist of senior lien security on productive, strategic assets – in SME lending, second lien finance is very risky.
Look for managers who can provide revolver facilities with dominion over cash – besides offering the most liquid collateral, this significantly enhances visibility and control over the borrower’s operations and liquidity. Some fixed asset collateral values can be volatile, so look for managers that have a deep understanding of more valuable and strategic assets, such as intellectual property, certain business rights, and contracts. I have been fortunate to have a partner with a background in private equity investing, and have found this ‘lens’ to be very powerful in avoiding credit losses.
Economics and Structure
Understand the source of returns on the loan portfolios, and make sure the manager provides historical attribution analyses – the majority of returns should be cash from interest and fees, not future unrealized income. Closed-end/PE-type structures are the best funding match for this asset class, although some investment strategies involve loans that have a quicker churn so a hedge fund structure can be used. Closed-end/PE-type structures often calculate returns on an IRR, or a cash weighted basis; however, private debt returns should be calculated on a time-weighted basis, similar to other fixed income asset classes. There is a big difference and no mathematical formula that converts one to another – IRRs are exaggerated compared to time-weighted returns. Make sure that your manager calculates IRR on the portfolio loans when doing attribution analysis so that you can see this for yourself.
This is by far the most difficult variable to assess, so the safest and most reliable measure continues to be experience and track record – this means investing experience going back at least 25 years on the manager’s decision-making team, and portfolio credit losses that are verifiable and consistent with industry standards. Look for a similar depth of experience and track record in the finance and portfolio administration teams. It is also important that the managers be investors in their funds – 1 percent of AUM used to be the standard but 5 percent or more is the norm for the most successful managers. I would also insist on re-investment requirements on performance fees.
A final cautionary note to investors – avoid under-compensating your managers. There are many investment strategies and market niches in the private debt asset class, and the economics and structures vary, however the commonality is that all investments must be directly sourced, underwritten and managed, similar to private equity, and this is very time consuming and costly. If you do not compensate your managers appropriately, this work cannot be done properly and the consequence will be increased credit losses.
David Alexander co-founded Third Eye Capital in 2005 with his partner Arif N. Bhalwani. Third Eye Capital is a Canadian-focused private debt manager specialising in senior secured loans that are perceived to be too risky by conventional lenders due to size, timing, or complexity.