21 (Plus 5) Questions for your Private Lending Manager
May 2022
What We’re Watching – April 2022
Two years ago we asked our investment team to provide us with a list of questions they would ask if they were reviewing another private lending manager. We collated their questions and also had them provide some reasons as to why the question was important.
Pretty much all of what they wrote in 2020 is relevant today but we wanted them to revisit and add 5 more questions asked through a 2022 (specifically COVID-19) lens. So here they are:
2022 Questions
| 1. Did any of your portfolio companies accept JobKeeper payments? If so, did you engage? | This question gives you some insight as to the manager’s approach to engagement with borrowers, a crucial part of the private lending toolkit. It also gives some insight into their approach to ESG integration. As a lender, the JobKeeper program was critical to some of our borrowers, but for most, was not necessary. Our attitude was that if a borrower didn’t need it, it should repay as not repaying would expose the borrower to negative reputational damage which could potentially impact their long-term creditworthiness. Engaging with borrowers and sponsors on this topic gave us insight into how they were running their businesses; was it a short- term focus or long term? |
| 2. What is your take on COVID-19 related EBITDA adjustments? | Because we love acronyms in finance Covid adjusted EBITDA is referred to as EBITDAC. Adjustments are typically used for one-off events and with the COVID pandemic extending into its 3rd year, one might think that EBITDAC should be consigned to history. Are expenses for PPE, plexiglass shields or extra office cleaning going to be a thing of the past or persist into the future? As a lender we probably want to exclude these types of adjustments. But equally we’d also be cautious of businesses that have had a significant uplift in earnings because of COVID. Consider a manufacturer of PPE or plexiglass shields. The reality is that there are no simple answers to these questions but walking through some case studies of where a manager has accepted an EBITDAC number and where they have pushed back can be helpful. |
| 3. How did you approach amendment requests during COVID-19? | COVID-19 was an equal opportunity risk event meaning all parts of the economy were impacted. Any lender with a reasonable amount of diversity in their investment portfolio would have had borrowers who were (and may still be) impacted and required some form of covenant relief. There was, however, real diversity in the approach to dealing with amendment requests during COVID-19. At one end of the spectrum were banks who, as prompted by the government, were very accommodating with amendment requests. Some investment managers followed the banks, perhaps fearing relationship friction if they pushed back too hard or potentially not having sufficient resources to triage amendment requests. In periods of elevated uncertainty like the COVID-19 pandemic we think the best approach in most circumstances is to offer short term relief to allow for more certainty to emerge. Anything longer lasting or more material should come with additional support from the equity sponsor. Time is our friend in these circumstances. |
| 4. Is your portfolio impacted by inflation? | The more superficial response to this question is, “no, all our loans are floating rate and do not have any interest rate duration.” We find this answer a tad disingenuous because hedging the interest rate risk of a non-callable corporate bond is relatively straightforward. In fact, floating rate loans are arguably more exposed to inflation because as interest rates increase their debt servicing costs increase (unless the business hedges). Add to this the significant increases in both raw material prices and labour which are starting to impact bottom line performance. |
| 5. What do you expect from the banking sector as they normalise following the withdrawal of COVID-19 support? | Banks are the original private lenders and their (government mandated) response to the COVID-19 pandemic saw them actually increase their share of corporate loans. In Australia, the bank share of private non-financial lending grew from 71% to 73% since the onset of COVID. This stands in contrast to the United States and Europe where the bank share declined. This was at least in part due to banks aggressively pursuing lending book growth to increase their Term Funding Facility allowance, abundance of deposit inflows and a very benign environment for corporates and households. Understanding the banks are key to adding alpha in domestic private lending strategies. We think the greatest opportunities are set to come in those markets where banks are pulling back. |
2020 Questions
| 1. Do you mark your portfolio to market? | This question is key for several reasons. One- it’s extremely difficult to compare a manager who does mark to market with a manager who doesn’t. Secondly, if a manager doesn’t mark-to-market (and we mean properly- incorporating change in credit risk at both a market and security level), it is extremely difficult to risk-adjust for the returns generated; you basically need to wait until a sufficient number of loans repay. Lastly, marking-to-market, or fair-valuing your portfolio is an important discipline for portfolio managers too. It forces the manager to consider the environment they are in and to price appropriately for risk. If a manager isn’t marking-to-market, then it is important to understand how they price for risk. |
| 2. OK, but seriously- do you really mark-to-market? | Many managers say they mark-to-market but don’t actually do it. A stable NAV through time is a sign that the manager is not actively revaluing their portfolio and this can be problematic, especially within open ended funds where there may be a wealth transfer from entering unitholders to existing/exiting unitholders. Pushing a manager to illustrate their approach to valuation with real live examples is a good way to assess this. |
| 3. How can I compare the risk profile of your lending versus other strategies? | If a manager is not marking their portfolio to market, performance can seem great in the good times with stable income and low volatility. But when market conditions deteriorate, you may find that the manager has been taking on far more risk than you had anticipated (i.e., you may see defaults pick up more than anticipated). This is where credit ratings come in- properly assigned (either by an external rating agency or independent internal group) they can provide an objective measure of risk of a strategy at purchase, not at maturity. |
| 4. How are you as a manager compensated? | Low management fees can be an indication that the manager is compensated elsewhere for their work. Private lending is labour intensive and by implication negotiated. Look for leakage of economics through upfront fees, amendment fees, workout fees. Non-AUM based fees may create agency risks between manager and client that are difficult to control. |
| 5. What is your track record through a credit cycle? | This goes to the point of assessing a manager’s performance and how important proper valuations are. If they aren’t marking-to-market and don’t have an objective measure of credit risk, they had better have a long history of managing through a credit cycle. The GFC is one of the greatest data points available to asset owners and it doesn’t get used nearly enough. |
| 6. What happens if something goes wrong with a credit? | In private lending, the valuation creation is in the front end (i.e. originating great deals at attractive levels) and the back end (maximising recovery when things go wrong). Banks have learnt that it is crucial to keep these two roles separate in order to manage the inevitable conflicts that can arise. Many private lenders do not and it is inevitably the recovery that suffers. |
| 7. Who handles workouts in your team? | Another important governance and resourcing question. Workouts are very labour intensive but one of the most important marginal use of resource there is. Teams that have independent specialist workout areas recognise this fact and have prioritised for the worst. Teams that don’t are simply hoping for the best. |
| 8. Tell me about a deal that went wrong? | A lender that doesn’t have a case study of where a loan went wrong is one of these: 1) very new (no track record); 2) very dishonest (they have a case study, they just don’t want you to know about it; 3) very lucky-. It’s rarely the last one. |
| 9. How do you take impairments on underperforming assets? | If a manager doesn’t fair value their investments, then they should be provisioning under the IFRS 9/AASB 9 accounting standards. This means when a credit deteriorates, an impairment should be taken for the full expected loss over the life of the investment. Often the approach to taking impairments is arbitrary and highly subjective and this is a recipe for being over- valued/under-reserved as a credit deteriorates. |
| 10. How many credits covered per analyst? | Private lending is labour intensive. For the most part you can’t rely on public information, so the analysts need to source information themselves, either through direct communication with the company or via other secondary sources. One analyst cannot cover 40-50 credits as is the case in public markets. In our view, up to 15 is defensible, ideally, it is closer to 10. And, covering a credit is only part of the story; on top of that you need all the additional origination, portfolio construction, workout and transactional support. You need a big team to do it. |
| 11. Can you invest in different parts of the capital structure for different funds? | In general investing in different parts of the capital structure across different strategies should be verboten, due to potential conflicts of interest, except in limited circumstances. Examples of these limited circumstances are those areas where the different parts of the capital structure have very limited rights/influence. These may be mezzanine tranches in securitisations or minority stakes in a large senior loan with no influence over pricing, amendments or restructures. |
| 12. Can you share your portfolio? | It’s a trick question! If the manager is acting in the private space, the deal was likely done under an NDA and contains non-public information. At a minimum, consent would be required from the borrower. Beware the manager that discloses their entire portfolio- it is extremely unlikely that they received consent so they are likely breaching the terms of the NDA. While this may seem minor, it raises important questions around the manager’s attitude to governance. |
| 13. How important are covenants? | Covenants are not a virtue unto themselves and beware the manager that suggests they are. Underwriting a private loan is not a tick the box exercise; the beauty of the private lending market is that loans can be specifically tailored for the borrower- not every loan needs a leverage covenant. |
| 14. Is it better to be a big fish in a little pond or a little fish in a big pond? | Scale matters in private markets and this manifests itself in access to deals and in returns -most clearly through upfront fees. The larger players originate deals directly rather than through an intermediary and by virtue of this can negotiate upfront fees which are 1-2% better than smaller competitors. Scale also gives you a seat at the table to negotiate terms and conditions as well as a wider funnel to filter deals because you get the first call. Depending on the market this can be worth a lot. The value creation that comes simply from being the “big fish” can offset any perceived negatives from the “smaller pond”. |
| 15. Why does a borrower come to you? | A private lender should know what their value proposition is. Does the lender provide size and certainty of execution? Is it flexibility in terms/mandate? Expertise in a niche sector or geography? Is it price? Hint: it is almost always price (and sometimes one of the other two). |
| 16. How do you approach ESG investing in private markets? | In public markets, there are many eyes holding the management of a business to account. Equity analysts, rating agencies, journalists, investment managers all watching a business closely. In private markets, especially where a sponsor is not involved, there are only the lenders. To an even greater extent than in public markets ESG analysis starts with the G. |
| 17. Public markets are selling off. How does that change your approach in private markets? | Private lenders ignore public markets at their peril. Public markets give real time indications of financial conditions. If a private lender is not increasing pricing during a time of public market stress, they are not paying attention. |
| 18. What’s your approach to portfolio construction? | Private lending strategies are origination led and this can create unique challenges for portfolio construction; i.e. what do you do if the last three deals you saw were in the education sector? A real risk is that the manager is actually just ignoring the portfolio construction question altogether and ends up highly concentrated in a small number of sectors. |
| 19. Who is your main competition? | In Australia, investment managers are dwarfed by the banking system. If a manager does include a bank in their list of competitors, then they are operating at a different risk level. Make sure they (and you) are getting paid for it. Getting a manager to talk about their competition away from banks can also give you more insight into exactly where a manager is positioned in the market in terms of size, sector and risk profile. |
| 20. Who handles documentation of the transaction? | In privately negotiated transactions, documentation is crucial. It is be-spoke which means you cannot invest off a term sheet or a previous transaction. Every deal needs review. This requires specialist legal and tax resources. Does the manager have them in-house or do they rely on lenders counsel who acts for all investors? |
| 21. Can I see an investment paper/credit memorandum? | There’s nothing like finding out if a manager who has been talking the talk, is walking the walk. |
As always, thanks for reading.
Pete Robinson
This material has been prepared by Challenger Investment Partners Limited (ABN 29 092 382 842, AFSL 234 678) (CIP Asset Management or CIPAM) the investment manager of the CIPAM Credit Income Fund and the CIPAM Multi-Sector Private Lending Fund (the Funds). Fidante Partners Limited ABN 94 002 835 592 AFSL 234668 (Fidante) is a member of the Challenger Limited group of companies (Challenger Group) and is the responsible entity of the Funds. Other than information which is identified as sourced from Fidante in relation to the Funds, Fidante is not responsible for the information in this material, including any statements of opinion. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable to your circumstances. The Fund’s Target Market Determination and Product Disclosure Statement (PDS) available at www.fidante.com should be considered before making a decision about whether to buy or hold units in the Funds. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Past performance is not a reliable indicator of future performance. Any projections are based on assumptions which we believe are reasonable but are subject to change and should not be relied upon.
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