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Old Hill Partners May 2018 Commentary: What a Difference a Year (or Two) Makes

After twenty-four months of nearly uninterrupted gains in equity markets – including the post-election surge that began in November of 2016 – the saw-tooth move during the first quarter of 2018 amply reminded everyone that stocks can, in fact, go in more than one direction. 

Not since mid-2016 have equity markets see-sawed as much as they have over the past three months. At the time, we wrote extensively about the value of asset-based private debt strategies like the ones pursued by Old Hill Partners. The difference this time around? Interest rates have finally, after a multi-year holding pattern, broken out to the upside as monetary policy normalizes. 

Now bond prices are falling too, especially the short and intermediate durations that usually jump when stocks falter. In essence, this means there is no easy answer for traders looking for a place to ride out a storm – although an answer does exist. In fact, it’s when the wheels come off both stock and bond markets at the same time that the minimal volatility and low correlations of private debt strategies really stand out. 

Strategically, the shift in the bond market portends other issues. It is a simple market truism – albeit a largely irrelevant one for much of the past decade – that the higher the “risk-free” Treasury bond yield goes, the less attractive stocks become. In fact, a flattening yield curve – when short-term rates rise to come close to surpassing long-term ones – is historically a precursor to an inverted one, which in turn is among the most accurate warnings of an incipient economic slowdown. 

And as is often the case, the renewed volatility in stocks and bonds since the start of the year has coincided with a renewed surge in oil prices. Just over two years ago, in March 2016, we wrote that far from signaling a recession, the collapse in oil at the time would have a “buoyant effect on the real economy over the next 12-18 months” and set the stage for a powerful acceleration of the lukewarm recovery underway at the time. 

This time around, the rally in energy suggests something else. When considered in conjunction with a growing economy chugging along at what can be charitably described as full employment, it means the fundamental shift in interest rate bias from persistently downwards to persistently upwards that we described in our 2017 Outlook is playing out as expected. The long-awaited transition from post-crisis monetary policies is nearing its final act. 

Importantly, the advantages of private debt investing have remained unscathed by this transition, and the volatility it has engendered. Our risk is still mostly concentrated in the issuers we finance, which is in turn largely addressable though proper due diligence, advantageous transaction structures, conservative loan-to-value ratios, and sufficient collateral protection. In the past, we have described private debt as a sort of soda straw, able to wall off the noise of broader traded markets and concentrate one’s field of vision only on the consequential elements of each specific transaction. This remains the case. 

However, what will always matter the most to asset-based lenders like Old Hill is the chance of recession. Recessions negatively impact the business environment in which our borrowers operate (although we’re typically protected by strong collateral coverage and recovery rates), particularly in the consumer specialty finance niches which make up a portion of our portfolios. While a Wall Street recession is very different than a Main Street one, an increase in volatility in both stocks and bonds, that is also coordinated against a backdrop of a flattening yield curve and steadily tighter macroeconomic policy, results in a scenario we haven’t seen since at least the middle of the last decade, so it bears watching. 

For the moment, the most important indicator in our field of view, the default rate of small and medium sized borrowers, has not moved in a manner that suggests a recession is imminent. On the contrary, the Thomson/Reuters Paynet Small Business Default Index has reversed the worrisome year-over-year percent increases of the past 12 months and now trending back down. Meanwhile, optimism, as tracked by the National Federation of Independent Business, remains near record highs, suggesting demand for growth credit continues apace. Nonetheless, the basic foundation of metrics such as these has shifted; it remains to be seen whether deterioration in things like the yield curve or inflation rate begin to chip away at them. 

In the meantime, the steady-as-she-goes current income and capital preservation characteristics of asset-based private debt shine in moments like these. All else being equal, the asset-based lending space will continue to be an attractive solution for both borrowers seeking growth capital to expand and fixed-income investors seeking attractive, risk-adjusted safe havens from the swings and swoons increasingly prevalent on equity and bond markets. 

Periodically, we like to include an example of a transaction we are pursuing, have rejected, or finalized, to illustrate not only our approach, but also our depth of process and risk management. This month, we’re highlighting a senior secured term loan to an aviation company that needed financing to acquire two used Eurocopter Super Puma helicopters. The company focuses on serving commercial and government clients as well distribution of spare parts. The company operates a fleet of helicopters that are deployed on contracts across the world. A majority of its contracts are to support U.S. government operations globally. The loan is secured by a first lien perfected security interest in the helicopters. This transaction was sourced through one of the senior members of the Old Hill team and was structured with a reasonable LTV and a 12% coupon.  The term of the facility is three (3) years and the principal partially amortizes. This transaction is an example of an attractive risk/return proposition, leveraging off our experience in transactions secured by hard assets. 

Find last month's article featured on page 103 of the Spring 2018 issue of Family Office Magazine. Read the full issue here