As expected, Old Hill Partners’ private debt strategy weathered the extraordinary market volatility last month very well. While a myriad of concerns, including flattening yield curves, a stronger dollar, China’s slipping growth rate and the onset of negative interest rates in Europe and Japan have combined to give investors in global equity and traded credit markets an understandable case of heartburn, private debt strategies like the one pursued by Old Hill Partners have remained relatively unaffected by the turmoil.
This is because in our case, risk is largely concentrated in the issuer, the collateral and the specifics of the transaction we have negotiated. It’s a bit like looking through a soda straw; through proper diligence, collateral and structure, lenders can essentially wall off all the noise generated by the broader markets, and zero in on the particular aspects of each deal that warrant additional attention.
From our point of view, therefore, the most important question that has been raised since the start of the year is whether the U.S. is headed for a recession, which would obviously impact the business environment in which our issuers operate and, presumably, increase the risk of defaults.
As we wrote in our 2016 Outlook (available by emailing firstname.lastname@example.org), we believe the chances of a full-blown recession in the U.S. remain slim. Recent economic data, including January’s higher-than-expected industrial production numbers, continue to reflect a recovery that, while tepid, is chugging along at 2-2.5% annual GDP growth. U.S. consumers are in the best financial shape since the crisis, while S&P 500 corporate profit margins –often cited recently as an early-warning indicator – are actually fairly flat when one adjusts for the decimated energy sector.
Meanwhile, the collapse in oil prices will obviously have dramatic downstream effects that will range from a series of high-yield debt defaults by over-levered producers and/or service-related companies to what could amount to a redrawing of the geopolitical map in the Middle East. Indeed, part of the sharp downdraft in equity prices has been due to the liquidation of blue-chip positions (i.e. stocks that often comprise major market indices) by the sovereign wealth funds of oil-producing countries. They have been forced to plug the budget gaps created by sub-$30/barrel oil. However, this sort of thing goes in the tactical bucket when looking at the market; it is a transitory effect that eventually runs its course.
The decline in energy prices, on the other hand, is a strategic change that alters the numbers within whole swaths of the economy. It does not take a genius to understand why the Dow Transports Index has blossomed over the past few weeks – operating costs for virtually everything that moves, from cars to trucks to trains and planes, have been slashed, and this will have a buoyant impact on the real economy over the next 12-18 months. While financial pundits debate various recession indicators, they should recall that the Dow Transports Index remains one of the simplest and most prescient leading indicators in history. Remember, a Wall Street recession is very different than a Main Street one, and the latter is of much greater concern to us than the former.
And although we’re not market timers, we can’t help but notice that cash levels at major hedge funds have reached the highest levels since November 2001, according to a global fund manager survey done this week by Bank of America Merrill Lynch. The measure is a fairly unambiguous contrarian signal – when cash levels reach more than 4.5%, according to BofAML, it has historically meant at least a short-term bottom was at hand. Cash levels reached 5.6% in the most recent survey, an extreme reading not seen since the immediate aftermath of the 9/11 attacks.
In the midst of all the market bloodletting since the start of the year, the U.S. Fed has openly acknowledged that the pace of its policy normalization may have to be modified. While the market is still pricing at least two more hikes this year (down from four a month ago), the Fed is clearly on its back foot regarding last year’s plan to tighten monetary policy in 2016. This makes sense, since financial conditions have already tightened considerably since the December rate hike. Barring a major policy mistake, the Fed will stand pat for the time being, which further supports our contention that a recession is not immediately in the cards, default rates ex-energy will remain manageable, yields will remain low, and businesses will continue to require growth capital.
From our perspective, therefore, both the economic environment and the overall market climate are supportive of our asset-backed lending activities. Uncorrelated to broader market volatility and often able to deliver attractive risk-adjusted returns, direct lending transactions such as those pursued by Old Hill should continue to benefit from the unsettled nature of global traded markets.
Illustrating our approach
Each month, we like to include an example of a transaction Old Hill is either considering or has rejected as a way of illustrating our general approach.
At the moment, we’re evaluating a loan to a company that originates, acquires and services non-cancelable, full-payout micro-leases on point-of-sale credit card authorization equipment. Small- to medium-sized businesses around the U.S. use these terminals, and the leases that correspond to them range from $600 to $30,000 payable monthly via automatic ACH pulls and secured by the general credit of the business that uses them, as well as personal guarantees from the business owners themselves.
The originator is a leading lessor of point-of-sale credit/debit card authorization systems and is engaged in leasing other business and product delivery service equipment. The company services more than 350,000 lease contracts and originates in all 50 states and Canada through a network of independent sales organizations.
Accordingly, the issuer is a credit lender. It focuses on the creditworthiness of the lessee, rather than on the value of the point-of-sale equipment financed. For us, this is important since it increases the credit quality of the underlying borrowers. The company originates $15-20 million in 48-month leases per month.
If we proceed, the transaction would be a $10 million revolver with an advance rate of 90% of the lease acquisition cost. The coupon rate will be 11% and there will be no origination fee given the company’s long-standing track record. The loan will be secured by a first lien perfected security interest in all assets of the borrower, including the leases, applicable contracts, and related proceeds.
Old Hill has long-standing experience with wholesale lending transactions like this one. Generally speaking, the deals are attractive because there of multiple levels of diligence and borrower alignment, cash flows are robust and predictable, and collateral is diversified. If we proceed, this transaction will become another example of private lending stepping in to fill the void left by the inability of larger, more traditional financial institutions to meet corporate demand for growth capital.