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Old Hill's June 2018 Commentary: Other Voices, Pt. 1

Two articles in the financial press caught our eye recently. One was on the current prospects for high yield bond investing, and the other on the popularity of private credit among U.S. public pension funds. Although both were fairly superficial in the treatment of their respective topics, they were interesting to us because they touched on elements that impact the private credit landscape generally and what we do at Old Hill Partners in particular.

The first article, through a conversation about high yield bonds, tackles the thorny topic of where we currently are in the credit cycle. Written by AllianceBernstein’s Gerson Distenfeld and Will Smith, the article argues that high yield remains an attractive sector this year because the three red flags traditionally associated with trouble on the horizon have yet to appear: The emergence of high leverage ratios among U.S. companies, rising dominance of junk bond issuance, and rising default rates among high yield bond issues. Although we generally dislike using the high yield market as a benchmark for our private credit activities because of the different underwriting approach (i.e. cash flow versus asset-based lending), there are parallels worth pointing out.

Granted, the credit cycle is now ten years old, the economy is performing well, inflation is re-appearing for the first time since the financial crisis, and credit spreads are at record lows. However, these factors don’t necessarily presage a high-yield market meltdown because the underlying health of the sector’s issuers is stronger now than it has been for a long time. Although they may differ, we believe that the health of the borrower in the high yield market bodes well for our smaller borrower, regardless of the fact that we lend on asset values. As with the transactions we undertake, lower leverage suggests fundamentally healthier corporate balance sheets which, in turn, leads to a lower default rate – a key metric in our business.

The article also makes note of a decline in junk bond issuance and compares the credit quality of CCC-rated bonds with the increasing number of covenant-light leveraged loans. The implied assumption is that the rise in cov-lite bonds is a danger signal, and yes, they have returned in some types of transactions. Investors should take note of this development, since lite-to-no covenants have fewer protections built into lending transactions for the companies to which they lend. Interestingly enough, this is another area where Old Hill differs from its cash flow lending brethren, as we have not compromised the protections structured into our transactions.

The second article, written by Bloomberg’s Martin Braun, highlights the advantages of private credit for U.S. pension fund managers, who are prime examples of the investors hunting for the highest-yielding assets. Braun cites statistics from Preqin that illustrate the rapid growth of the asset class (30% more pension funds were invested in private debt at the end of last year than in 2015). Private credit opportunities have been driven by the overall contraction in the number of traditional banks and the challenging regulatory environment faced by the remaining lending institutions. This market shift has not been lost on pension funds and other institutional investors that have recognized private debt as its own asset class. These investors are finding it to be a healthy supplement to traditional fixed income investing. In the article, the executive director of Ohio’s Police and Fire Pension Fund articulated the dilemma faced by most institutional investors who typically rely on U.S. Treasury bonds and other public fixed income securities for a substantial portion of their portfolio yield but are not seeing desirable returns. Instead, he continued, they are investing higher in the capital structure of private companies in order to lower risk without sacrificing return – precisely one of the benefits for the type of asset-based transaction pursued by Old Hill Partners.

The article touched upon another key element of what we do: Process. There are a few aspects of direct lending than can be generalized, but by and large, transactions require tremendous customization and due diligence– a thoroughness not lost on the pension fund managers quoted in Braun’s article. “If it got overheated, we would potentially cut back,” said the Ohio pension executive. “The managers we have are disciplined and wouldn’t make loans if they didn’t make sense" – a philosophy ingrained in our approach at Old Hill Partners.

The article also notes that Arizona’s State Retirement System only hires managers that have track records, a commitment to credit analysis, and internal monitoring and servicing operations. the immensely complicated and often unheralded back office elements of direct lending can be what separates the wheat from the chaff in this business. At Old Hill, we describe our process as a full-service lending platform complete with structuring, due diligence, servicing and monitoring, which is crucial to our success in small-balance lending.

These articles tell us two things: First, as evidenced by the participation of pension funds, private credit has matured into a mainstream asset class distinct from traditional fixed income. Secondly, as it relates to Old Hill’s private credit strategy, the three red flags which typically indicate trouble on the horizion have yet to emerge. While the warning signs are somewhat relevant to our business, they hold greater significance for funds and alternative investment pools that focus on large-balance, cash flow-lending deals with private equity sponsored companies. Old Hill’s focus, conversely, is on small-balance, asset-backed transactions that are primarily non-sponsored.

As we have discussed previously, an asset-based approach tends to be less sensitive to macroeconomic developments because asset values remain more stable during various economic cycles. The increasing participation of pension funds suggests a realization that they can continue to generate substantial risk-adjusted returns in the current environment by investing in private credit. We believe questions surrounding the stage of the credit cycle, the current health of borrowers in the high-yield market, and the on-going chase for yield have heightened the attractiveness of well-constructed asset-based lending transactions – like those offered by Old Hill Partners - and the yield pickup they can deliver when properly managed.