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April 2018 Commentary: Old hill's Jeffrey Haas on Volatility, Correlation and Return Advantages in Private Debt

In February, investors were reminded that both equity and bond market volatility can return on a whim and move contrary to what the broader financial and economic data might suggest. With the indication that market volatility may continue well into the second quarter of 2018, we decided to utilize this month’s commentary for a conversation with Old Hill’s COO, Jeff Haas, about the volatility, correlation, and return advantages that may be available via prudently-structured private debt transactions.

 Can you describe the private debt space?

Private debt transactions are custom structures in which an alternative lender offers financing solutions, generally not available from traditional lenders, to businesses that seek capital for growth. Often described as direct lending, these transactions are generally secured against either assets or the company’s future cash flows and have become very popular with a wide range of investors since the financial crisis primarily because they tend to yield several hundred basis points higher than comparable traded credit instruments. In light of the low-yield environment in place for nearly a decade, they can be an important source of attractive risk-adjusted returns.

Aren’t there liquidity concerns with such transactions?

Actually, the lack of liquidity has a number of advantages.  Provided the lender has done its homework on the borrower and is comfortable with the business risk, we think approximately 400-700 basis points of excess spread can be earned over a comparable publicly traded security by accepting and managing the illiquidity of a private credit transaction. It comes down to risk management; liquidity is most useful when an investor needs to exit in order to match their assets and liabilities.   In many instances, investors overstate their need for liquidity and most can afford some illiquidity in their portfolios, especially if it can provide a good return, has low volatility and is generally uncorrelated with other investments.   If the manager has done proper due diligence, remains in close contact with the borrower, and has structured the transaction to emphasize capital preservation and minimized risk, then the disadvantage of illiquidity is amply absorbed by a significant pickup in risk-adjusted yield.

The illiquidity premium you mentioned compensates the lender for a range of risks, including interest rate and default risk. How are these handled?

Every transaction is unique because every borrower is unique, but there are a number of prudent rules private debt lenders can take to adequately mitigate such concerns. For instance, to address the advent of a rising interest rate environment, many asset-based transactions are structured using floating-rate coupons pegged to a benchmark and a floor under which the coupons never go. As rates rise, so do the coupons, keeping the lender’s cash model on an even keel. As for default risk, private lending generally yields above traded credit instruments because of the illiquidity of the loans and the size of the transactions, not necessarily because of materially higher credit risk. Where liquidity does come into play, though, is with the assets securing a loan; understanding the value and the potential liquidity of a transaction’s underlying collateral is key to the private debt calculus, as is lending conservatively against it so the lender’s capital is likely recoverable should a problem arise. The irony is that private debt lenders are usually far more familiar with the business health of their borrowers than they would be if they were to invest the same capital in a comparable corporate bond issue. They can work with the borrower to restructure long before a crisis ensues, an advantage not necessarily available to a corporate bondholder.

You also mentioned low volatility and correlations. Can you explain?

The market swoon in February was a perfect reminder of the interconnected, volatile nature of modern traded markets. Both equities and bonds tanked, illustrating that at least in the current environment, high relative prices in both means they move in lockstep when a correction arrives. By nature, private debt transactions are isolated from the volatility inherent in other markets because they don’t trade in a public forum, and they are uncorrelated against those markets for the same reason. Indeed, when set against the S&P 500 and a range of credit benchmarks, Old Hill’s asset-based lending transactions exhibit very minimal standard deviations, slightly negative correlations against blue-chip equities and slightly positive ones against aggregate bond indexes.

Why is private debt attractive for family offices?

Since asset-based lending transactions can result in both uncorrelated absolute returns and low volatility, the space is ideal for two groups of investors. First, those with longer time horizons or long-dated liabilities, such as insurance companies, pensions and foundations, are generally more willing to incorporate illiquid assets into their portfolios because they have a mandate to be patient. The second group tends to be investors for whom capital preservation, low volatility and uncorrelated absolute returns are an important part of their overall strategy – such as family offices, high net worth individuals, some hedge funds and other institutional investors. For this latter group, asset-based private debt can be compelling adjunct to their existing fixed-income allocations. It’s really the best of both worlds – attractive risk-adjusted yields that are not joined to this or that asset class and can’t be yanked around by increasingly fickle public markets.

 

We’d be happy to explain this approach in greater detail or answer any questions you have. Please contact cfogelstrom@oldhill.com for additional information.