April was a busy month for Old Hill Partners, so for this month’s commentary we’ve decided to depart from our traditional format and provide an update on what the company has been doing.
In a word, we’re expanding. It’s a perfect time to stretch our wings further, given the tremendous interest in customized small-balance private debt solutions on the part of both investors and borrowers, as well as the robust economic environment we believe is taking shape through a business-friendly mix of tax reform, regulatory rollbacks and pro-growth policies. The overall combination is as conducive to capital expansion as we’ve ever seen, particularly among small businesses that will be at the forefront of any increased growth yet still struggle to obtain adequate financing from traditional lenders.
At the same time, although interest rates are indeed rising they’re doing so at a measured pace and remain historically very accommodative. When viewed from our perch, the advantages available from prudent small-balance direct lending activities – above average yields, lower volatility, uncorrelated returns, higher recovery rates, etc. – seem hard to ignore.
Accordingly, we’re hard at work launching new domestic and offshore variants of our OHP Asset Income Fund, our very own Jeff Haas was featured in Preqin’s prestigious 2017 Global Private Debt Report in April,and we’ve welcomed two new associates to our team; Kevin Mallon joins as our new Director of Marketing and Pat Stone has come aboard as a Portfolio Manager.
Pat’s experience in specialty finance and structured lending are going to be valuable assets as Old Hill positions for the next phase of its development, so we caught up with him for an introduction and to get his insights on the sector, Old Hill’s expertise as a highly selective niche lender, and what he thinks is next for one of the fastest-growing areas of finance.
Old Hill Partners: Pat, talk about your background and what led you here.
Pat Stone: While I began my career in 2006 covering credit as a researcher of hedge fund managers that invested in fixed income securities, my career as a credit underwriter really began in 2010 when I joined Full Circle Capital, at the time a publicly traded commercial finance company formed to address much the same market as Old Hill – the market for loans below $25 million. At the time, we were in the throes of the Great Recession and this was a very underserved segment of the corporate credit market. The subsequent passing of broad financial reforms ensured that many smaller and lower middle market borrowers lost access to bank loans, and a broad swath of traditional lenders continue to avoid the segment. I joined Old Hill for the opportunity to serve this under-banked corner of the market in a different fashion than at Full Circle, through loans that are collateralized by a borrower’s assets.
Immediately prior to joining Old Hill, I was director of credit & risk at Fundation Group LLC, where I gained firsthand experience in the control room of a fintech-heavy small business lender, and I believe this experience dovetails extremely well with Old Hill’s competency in lending to similar type businesses that operate in consumer and commercial specialty finance. At Fundation, I was able to build a network in the specialty finance industry that should produce substantial and repeatable lending opportunities for Old Hill.
Is there a private credit bubble? What do you think?
Without a doubt, there’s a bubble in high yield credit, but far less so in the market that Old Hill serves. Aside from the spread widening that occurred in 2015 and effectively ended when the equity market sell-off came to a halt in February 2016, high yield spreads are at lows that we’ve never seen before, even pre-financial crisis. I consider Carl Icahn one of the all-time smartest investors on Wall Street, and he was pointing to a high yield bubble as early as 2015 when he accused BlackRock of fueling spread compression through their marketing of exchange-traded funds. I agree with him that there’s a credit bubble, but I think it’s far more glaring in the liquid credit markets, and perhaps even in the upper middle market, than it is in the market for loans that we serve at Old Hill.
Investors that allocate to liquid credit instruments and mark their book to market in liquid, tradable securities on a quarterly (like BDCs) or monthly basis should be very concerned about what’s happening at the Federal Reserve. The good news is that I think, given the pace of the Federal Reserve’s tightening policy, investors have time to adjust their exposures and allocate away from liquid credit if they start moving now. If their mandate is to continue generating yield, the opportunities in the lower middle market are substantially greater – and more attractive – than those in liquid and upper middle market private credit.
From a portfolio construction point of view, what are you doing to protect Old Hill’s investors?
I am passing on – or losing, depending on your point of view – a lot of opportunities. At this point, I’ve passed on 95% of the deals that have crossed my desk. For the most part, I’m passing on chances to lend against highly cyclical assets that will exhibit high price volatility (i.e. wide bid/ask spreads) if and when their sponsors fall upon hard times. These are assets that are highly illiquid, and we are focused on assets – tangible and intangible – where Old Hill is not the buyer of last resort, and where we’re not waiting longer than 18 months to get paid. Said another way, our collateral underwriting is focused on assets that will catch a bid if we’re forced to liquidate them. It’s worth noting that having the ability to pass on 95% of the deals we see is a luxury many lenders don’t enjoy. Based on just the deal flow that’s come through Old Hill since I joined, we’re in the enviable position – and by extension, so are our investors – of being highly selective of the securities we originate here.
What do you like most about Old Hill’s strategy? How are we different from the larger names in the space?
I alluded to this above, but first and foremost, the opportunity set for Old Hill is tremendous. We are seeing opportunities to generate mid-teen returns on an unlevered basis against assets on which we’re proposing relatively conservative advance rates and in downside scenarios that still leave our principal with significant cushion. I can’t think of any other fixed income markets where this is the case. Where we differ from the big names is that we’ve been focused on this market for a long time, and we have significant experience lending against specialized assets, be it consumer/commercial loan portfolios, aircraft, or railroads. Most lenders, even very large ones, do not have our degree of experience. The stellar track record in asset-based lending developed by Old Hill since 2009 has been built as many other lenders, focused on what are generally considered stable, sponsor-supported companies, have failed due to poor deal structuring.
Where is the private credit industry heading? Is P2P lending a game-changer? How do you see this evolving on the institutional side?
At some point, crowdfunding will take over the SMB market (loans less than $500k) completely. We’re already seeing it with fintech companies, which are partnering with banks to evaluate their rejects and building the infrastructure to serve unbankable customers. In Old Hill’s market, I think it’s going to be some time before a crowdfunding solution really addresses borrowers’ needs in a way to serves both the borrowers as well as the investors. If you look at some of the bellwethers of the P2P industry, they have yet to develop profitable business models not because they’re investing too much in overhead or technology, but because they’ve designed a product and delivery system, which after accounting for customer acquisition costs, is unprofitable.
How do you see the secondary market for private debt funds evolving?
I recently read an article about a large asset manager with billions under management putting itself up for sale for the second time in the last 12 months. While this particular firm is a public company, I’d wager there are many others in similar positions that haven’t been written up in The Wall Street Journal, and I would not be surprised if we began to see meaningful deal flow from companies that used the credit boom after the financial crisis to raise large amounts of assets to earn fees for themselves, not returns for their investors. Unfortunately, this became a pattern in the 2010 to 2014 timeframe, especially as public market valuations for leveraged credit assets improved.
I don’t see this market becoming very efficient until loan-level transparency improves. If you want to look at the BDC market as a benchmark for private debt performance, performance varies widely by name, and few of these asset managers share much meaningful information on even their largest positions. I wouldn’t allocate to BDCs unless I had an edge on an individual manager.
Pat Stone is a Portfolio Manager for Old Hill and is responsible for sourcing transactions, analysis, structuring and asset management for the company’s asset-backed investments. His background in the high yield, leveraged loan, and direct lending markets dates back to 2006, where as a member of UBS’s global hedge fund of funds business, he researched managers investing across fixed income markets. Most recently, Pat was a Director of Credit & Risk at Fundation Group, a fintech company backed by Garrison Investment Group.