October 1, 2019
Clare O’Hara: Canadian institutional and retail investors are taking on more private debt, both as a replacement to their equity as well as a tool to enhance their fixed income allocations. But, what exactly is private debt, and how can it benefit both the retail and institutional investors alike? As with any asset class, there are benefits and risks associated with investing, and here to unpack all of the details surrounding this often-misunderstood asset class are three professionals at the forefront of it all.
Clare O’Hara: Joining me today is Vikram Rajagopalan, Vice President of Retail Sales and National Accounts at Trez Capital, Rob Anton, Managing Director and Partner at Next Edge Capital, and Philip Robson, Executive Vice President at Fiera Private Debt. I'm your host, Clare O'Hara with The Globe and Mail, and you're watching Asset TV's Private Debt Masterclass.
Clare O’Hara: Thank you all for joining us today, and I'm just going to dive right in. So, Vikram, I'm going to start with you. What is private debt?
Vikram Rajagopalan: Thank you, Clare, and thanks for having me on this panel. What I find ironic is I know the term private debt seems very new to a lot of investors, but really private debt has been around far longer than public debt. Public debt is what the retail investor knows very well, that is, the corporate bonds, the government kind of bonds that you see in the marketplace in the public markets, and private debt is really your quintessential debt, where you go in as a borrower. You walk into someone's office. You get your deal underwritten, be it your own family house all the way to a commercial building.
Vikram Rajagopalan: That debt is not sold in a secondary market. You hold it to maturity to a point where the lender pays you interest, at that point, pays you principal, and it doesn't matter what asset class it is. It could be mortgages that Trez, my firm, deals with. It could be factoring, which Rob and Fiera, of course, deal with and mortgages as well, but at the end of the day, it just comes down to doing it in the private markets where you're not at the beck and call of the public markets as with corporate bond, insurances, and just dealing in the private stuff.
Philip Robson: We did research on that, Vik. We found the first one in Canada was in 1853. It was bought by a Scots insurance company financing the railway when they were building the railway. It's been around a long, long time.
Vikram Rajagopalan: Well, and that's what we used to say. What is older than a bond? It's a mortgage, right?
Vikram Rajagopalan: I mean, and so just coming back to that, there will be those that say, “Is a mortgage a private debt?” It is. I think everyone can agree, is the largest form of private debt that you have out there, right?
Clare O’Hara: And, Rob, did you want to add to anything on that point?
Robert Anton: Yeah. Well put, guys. The only thing I'd add is just simplistically it is just a privately negotiated loan that happens typically outside of the traditional banking networks, and that's kind of how I break it down on a very simple format.
Clare O’Hara: Just assets under management towards private debt has grown significantly over the past decade, so why are investors allocating private debt? What's attracting them now?
Robert Anton: I think the primary reason is that the opportunities for return amongst traditional fixed-income investments has been tough, challenged due to a low interest rate environment. This has caused many investors to seek alternative forms of making returns, and private lending is one area in which people have kind of gravitated towards. Obviously, the fact that they have been able to achieve some attractive returns has helped that cause.
Philip Robson: For institutions, it's been the lower volatility, the yield pick-up, and the pretty good experience with respect to loss rates and that kind of stuff relative to other things that are out there and cash flow. You can buy a bond and get paid twice a year, or you can get into various places in-between our enterprises in the private debt market and actually get cash flow on a much more regular basis.
Philip Robson: And as people are trying to manage that kind of stuff in investment vehicle, that's been useful for them.
Robert Anton: Yeah. I'd definitely add that the consistent return stream that they've been able to generate, the fact that they tend to have lower levels of volatility, although, I think that can be a little bit of a caveat because some of that is masked in the sense that they're not traded vehicles.
Robert Anton: The fact that they have low levels of correlation to typical stocks and bonds make them a valuable portfolio diversification tool, and I think most private lending managers first and foremost, their goal is capital preservation. I think that gravitates really well with investors.
Clare O’Hara: And Vikram, just to add to that, and are advisors starting to talk about it more with clients over the past decade?
Vikram Rajagopalan: Well, I was fortuitous to join Trez in 2013. I don't know what your experiences are like, but if you look at that, that was really the part where private debt started to grow among retail advisors. I mean, the institutions and half our assets are held in the hands of big institutions. They've been doing this for years. The Canadian pensions and endowments have been far ahead even of their U.S. counterparts when doing it.
Vikram Rajagopalan: If you talk to a lot of the advisors that gravitated towards private debt initially, their ah-ha moment was 2008.
Robert Anton: Yeah.
Vikram Rajagopalan: Right? I mean, that really was what changed everything because for the longest time in the mid-2000s, they held this sort of security blanket of bonds, and they said, “It didn't matter what the equity markets were going to do because I had 40% in bonds, and that was going to save me.” And then, they woke up in '09 and realized none of that happened.
Vikram Rajagopalan: And now, some of them gravitated to what you call alternatives, which is hedge funds, and that didn't work out. And so, what happened was they started to go into real assets, and of course, you start to look at things with a steady stream of income. Obviously, for the average advisor with high net-worth clients who are aging, what is their number one need?
Vikram Rajagopalan: Income more than actual growth. And so, private debt of any kind really lends itself to that, right? And looking at it because, once again, getting back to your previous question where you're in the private markets, so you're not up to the daily ups and downs of the public market. You end up with that fixed kind of private capital preservation as Rob pointed out plus our strategies, which I'm sure we'll get into, give you an above average return. Those two things make it very attractive to retail investors.
Vikram Rajagopalan: And what we've done as our firms have done very well is we've brought what is generally and institutional mandate, and we've structured it in a way that the average retail client can get it. And as the big banks have sort of embraced it and some of the mainstream financial advisors started to embrace it, you've seen this sort of huge growth in the asset class.
Clare O’Hara: So, Vikram, private debt, in general, offers an attractive risk return potential, especially considering traditional options. So, why do you feel the yield rate premium exists?
Vikram Rajagopalan: Well, I think, first of all, from just the basics of what all private lenders do, and once again, I get back to mortgages, factoring, whatever it is that you're doing, is because there are inefficiencies in the lending market space, right? The banks throughout, and I get back to the '08 ah-ha moment. Of course, what that did is it closed the banks down in terms of the lending that they could do on presumably a lot of asset classes, right?
Vikram Rajagopalan: And so, I can only speak to what Trez does, which is short-term bridge lending on real estate and mortgages to be more specific. Why that premium exists is because if you are someone constructing an office building, if you're someone constructing an apartment building, you need money in an expedient fashion. You need to work some nuances within your deals. There's various risks there that the bank will not take the time nor effort really to go through.
Vikram Rajagopalan: There are borrowers out there who are well capitalized willing to pay a premium in order to get that capital knowing fully well that once they get their deal to a certain level, they can go for more quintessential bank financing and a cheaper rate. And so, those occur as well.
Vikram Rajagopalan: Anecdotally, we have an office in Dallas, for example, that we opened seven years ago, and that was right at the time of Basel III and Dodd-Frank regulations coming in. And so, you end up in a state like Texas that is booming in the economy, population growth, needs housing, and not a single dime to be lent by the major banks.
Vikram Rajagopalan: And so, here you are in Canada circa 2010, and of course, our real estate market not long in the tooth but really had not had a correction at that point, and here was a market that had corrected but not as much. It was booming with no real capital. What does that mean? When supply of money is less than demand, when demand for money outweighs the supply of money, you start to get above average rates of return for the risk that you're taking, and so that's where we see in some ...
Vikram Rajagopalan: That's why that occurs, and secondly is liquidity, right? Inherently, everything that we invest in, the underlying assets are illiquid, and I mean, that takes various forms. Some are 90 days. Some are 180 days, but you get that liquidity premium because it's not an asset class that you get in today and go out tomorrow. You have to make very discerning decisions regarding how it fits in your portfolio.
Robert Anton: Yeah. It's a really good question, Clare, and one that I've spent a lot of time, actually, researching and studying. So, we got into the private lending marketplace initially as investors or interested investors looking at capitalizing on an opportunity.
Robert Anton: Over that timeframe, we've now built a fairly large lending business to capitalize on that opportunity, but the first thing that kind of had my Spidey senses kind of go up about the industry was the yields relative to the risk that you were taking. Was there something that we were missing on the risk side that we just didn't know about that was giving that higher yields. And we really needed to tackle why that excess premium was happening.
Robert Anton: And I think there's a lot of different reasons for it. It varies depending on which area in the private lending marketplace you are at, but definitely, the fact that the 2008, 2009 credit crisis, changing of the regulatory marketplace, deleveraging of the banks, and them making a conscious decision to pull back from lending to certain areas of the marketplace definitely created a void that a lot of non-bank lenders came in to fill.
Robert Anton: That inefficiency coupled with the whole inefficiency of a lot of businesses and companies around the world are now having to find alternative means of financing, which is an inefficiency in itself. They're used to going to the bank, and now they have to find other means, and it's very inefficient. A lot of people don't talk about this, but the actual cost of capital for non-bank lenders is vastly higher than the banks' cost of capital, which is predominantly GICs or savings in banks which is very, very low.
Robert Anton: So, that's a few reasons. We think that you can capture other premiums in the marketplace and kind of navigate our investing style to try, and capture as many of these yield premiums as possible. One we think we're picking up is size. Lending to businesses under a certain loan size we think has less competition, and you can pick up some excess spread.
Robert Anton: Complexity of the loan transaction creates less competition and sometimes excess yield. The speed at which the company needs money, you can sometimes charge an higher rate just because you have to get around that very quickly, so-
Vikram Rajagopalan: And we're all short-term lenders, too, right? So, people are willing to pay the premium because they're not in here for the long haul, right?
Clare O’Hara: Mm-hmm (affirmative).
Vikram Rajagopalan: They can keep sort of above average interest rates for a short time.
Philip Robson: Yeah. You can see the exit on the way in, but I think part of what we're seeing is we're all creators and managers of kind of niche funds, although they're bigger now than they used to be, obviously. But when you get all those things there, you've got the origination activity that is bringing these things for you to see. People are looking to do stuff.
Philip Robson: The only caveat I'll have is we have an infrastructure debt fund, so we're doing fixed rate for 25 years. That's a whole different ballpark, but again, it's the same fundamental issue and the size, the transaction we're playing with, and we're still writing average checks in there for like $20-odd million. There's not a lot of suppliers of that kind of capital to that space.
Vikram Rajagopalan: Very few.
Philip Robson: Our competition in there would be the life cos, but they want to write bigger checks. And if I had their balance sheet, I'd have the same problem. We all would, but it's that ability to pick those niches and recognize where the premiums come from. And we're now all in a place where we've been at it long enough where investors, both retail and institutional, realize that the proposition we've always put in front of them about risk-reward is not just hot air. We can actually demonstrate that their capital is pretty safe.
Vikram Rajagopalan: Philip brings up a really good point because specifically for us in the U.S. where we gain a real competitive advantage is either people are too small, and they do the smaller loans to move the needle, or they end up being sort of the BlackRocks and Blackstones of the world that have to fund out 200, $300 million just to move the needle.
Vikram Rajagopalan: So, there's that real mid-tier pie that needs to be filled, and what's interesting in the U.S., it just wasn't as, and I know, Philip, you've seen this, but in the U.S., it just wasn't as big as it was in Canada when you look at divided by the population, right?
Robert Anton: Yeah.
Vikram Rajagopalan: There was a lot of private lenders here because the banks were so conservative here even prior to the '08 crisis. Well, the banks did a whole lot more in the U.S. in post-financial crisis. It was almost like it was a desert, right?
Robert Anton: Exactly the same. Yeah.
Clare O’Hara: So, Philip, just sticking with the risk conversation, there's a long-held belief that higher returns are tethered to higher risk, but in the case of private debt, that's not necessarily true. So, can you walk us through the whys?
Philip Robson: Sure. So again, back to an earlier comment. We are not takers of transactions and price. We are makers, so when you're doing a private debt transaction and Rob made this point earlier, there's a direct connection, a direct negotiation between the lender and the borrower, depending on the length and where you are in the risk profile.
Philip Robson: Some of the due diligence we're doing is not just desktop, run the numbers due diligence. We're traveling. We're looking at sites. We're meeting management. We're checking on their history and track record, so we're doing everything we can to take as much of that risk off the table as we can.
Philip Robson: We're in the business of lending money. We all have problems that we have to deal with. I'm in the midst of three right now. It comes with the territory, but you're always trying to minimize that. You're always looking at, “How can we structure the loan, structure security?”
Philip Robson: And we have no other noise in the system other than between us and the lenders to get that where it works for them, but it also works for us, and we can make it work. And then, we monitor the spots off every loan. I'm sure you guys do, too, like on a daily, monthly, quarterly, whatever the call is.
Clare O’Hara: Okay. And so, Rob, do you agree with that?
Robert Anton: Yeah, correct, and I just think that the amount of companies out there looking for capital is immense. We run across so many different businesses. Our focus is in North America, but so many businesses in North America that require lending capital a lot of times for growth, and you can kind of pick and choose your spots as to what fits kind of your box that you invest or lend towards.
Robert Anton: And like Phil said, it's a negotiation. You might not come to terms on stuff. And a lot of deals do fall apart after those initial negotiations because you're looking for more collateral, and they're not willing to give it, or they just don't have it. So, it's definitely a negotiation process there.
Robert Anton: We think what's important to, in addition to some of my previous comments as far as why that excess yield exists, supply-demand fundamentals are obviously the biggest, but we think we can put those odds in our favor through a number of factors.
Robert Anton: One, in addition to that, is actually origination efforts. We feel that putting a lot of money and capital into origination can actually help us find more deals which we can be more selective on, which has, we think, a knock-on effect to lower default rates but as well, potential premium pick-up on loans.
Clare O’Hara: And, Vikram, your thoughts?
Vikram Rajagopalan: We live this internally at Trez all the time because when we launched, and I get back to our US only mortgage fund, it was yielding far higher than our Canadian-only mortgage fund. We had to explain to people that, of course, quintessentially it meant if you're getting a higher yield, you must be taking on more risk.
Vikram Rajagopalan: And we try to explain to people even though, quite frankly, it doesn't matter to us where our investors put their money at that particular point of time, that when you have structural imbalances that occur in the United States that might not be here in Canada, where it's becoming a more efficient market by the day, that is where you're able to get extra risks from what we perceive not to be, or extra yield, without what we perceive to be extra risk.
Vikram Rajagopalan: We see that today at credit committee. Your risk is really in all of these firms is your credit process. Right? That is where that old adage, how the sausage is made, right? It comes down to the credit process and how you look at these deals because it's very hard to quantify to the average investor why you did this at 8%, why you did this at 10%, why you did this at 12%.
Vikram Rajagopalan: And so, for us, when we look at it from a real estate perspective, and we're only real estate and mortgages, it comes down to okay, if someone is willing to 40% down, and we're at 60% loan to value.
Vikram Rajagopalan: And we're getting 12%, and on a comparable deal here in Canada because there is a lot more. It's a lot more competitive market. Someone's like, "Well, we'll only put 20% down." And it looks like and smells like the same deal, but you're only getting 10%, therein itself, that is where you care what the market thinks. If this was a public fund, they would say, "There's no way."
Philip Robson: Let's go into the lowest price. That's what we're doing.
Vikram Rajagopalan: Yeah, exactly. And back to even, when we were... at one point when Alberta Oil had swept from a 100 to 30 bucks, one of our funds was 50% in Alberta. And so I always say, if that was a public fund, watch out. That would have gone to pennies on the dollar. But because of its on the private side, we kept getting paid. We exited all the deals. And so when that noise is gone, you can actually earn a significant premium on those loans.
Clare O’Hara: Are investors capable of omitting the noise or are they still focused on the market? Do they understand the difference?
Philip Robson: One of the things I see at credit committee every time, blah, blah, blah, blah, blah, blah. And I said, “Guys, this is going to be front page news. Are you ready to address front page news? And it's a foot wide and a quarter of an inch deep and it's what everybody will remember.” So you've got to manage that kind of stuff.
Philip Robson: I think, my general sense is in many investors re much more sophisticated than they were 20 years ago. I was in the investment business when you want to get a stock price, you ran up to a machine and looked at the ticker tape.
Vikram Rajagopalan: I did that also came out of it.
Philip Robson: So, I think there's a lot more of that going on. I think people know more. I think people have higher expectations because of their loans, and there's just more transparency in the market style. You look at the amount of places you can go to get research independent or otherwise, information. So I think it's coming, and I don't see rates going anywhere. So I think we're all going to be in business for awhile.
Vikram Rajagopalan: One of our challenges actually is as these markets turn more volatile, and that's why I've always loved working... I predominantly work with family offices and the more sophisticated financial advisors our team does across the country. One of the real challenges actually is investors who gravitate far too much into this asset class because it looks and smells like everything they want, and the stock market looks like everything they don't want.
Vikram Rajagopalan: And there's still that education process on the flip side saying, this is only for a portion of your portfolio. Like at the end of the day, there's still room for stocks, there's still room for bonds. We're not here to be 100% of your portfolio. And I think you too have probably saw this in December of last year, right? I mean, people calling you up and saying, “Thank God.” We did, but you have to educate them and say, oh, I want to put in more money.
Vikram Rajagopalan: And that's once again as advisors have come in between the end investor and the firm. I think you've seen a broad more more education. You see more portfolio managers come in and look at it in their models, and the institutions. Once again, the institutional consultants, obviously, the institutions are well educated in this place.
Vikram Rajagopalan: But the advisors coming in between has been the biggest change because they look at it from how much of a per person percentages, and how much by the way their advisors own all of our companies, right?
Clare O’Hara: Yeah.
Robert Anton: Yeah.
Philip Robson: Yeah.
Vikram Rajagopalan: And how much do you allocate to each one of us.
Clare O’Hara: As I was going to ask about asset allocation. When we were talking about markets maybe not giving the traditional opportunities out there, could an investors swing too far?
Philip Robson: I think we've all seen that happen or have been approached by that, and you have to, they're our expertise. You don't want credit guys, but say, hold, hold the phone. There's a lot of good reasons to have exposure to all other aspects of the market, public and private and balance that. And one of the things when you get into the kind of, especially some of the stuff we do, which has much longer terms in it, you need to have other parts of your portfolio allow you to manage the liquidity.
Philip Robson: If you're a pension plan, you've got to write cheques every month. I can't be the sole source of income for that cheque every month. You need to have other things in place that help manage every section of the short, the mid, the long stuff in there.
Robert Anton: I really feel that it really depends on the mandate of the fund, the liquidity in the fund and how it's sold. I know all of our private lending vehicles are sold by accredited investor type status. It's not something that's necessarily bought.
Robert Anton: It's something that we're going out and telling the story. Our client base is varied, but we partner with our client base in the sense that we're very transparent as to what type of loans that we're putting out in the marketplace. The risks that are inherent with that goal forward, that sort of thing. So, our client base is a combination of very successful investment advisors that tend to be portfolio managers. So they're running discretionary on behalf of their clients.
Robert Anton: Some investment council firms, family offices and a handful of small fund companies. As far as educating them on what they're actually getting into is we feel is just part of the process. We very much open to that sort of thing, and making them aware of where things can go wrong and stuff like that I think helps create sticky money so that during the next economic downturn when companies are making less money, and people are making less money and there's less money to go around is typically when companies might have less ability to actually pay back their debt.
Robert Anton: So getting them to understand how we can work through these things, where the security is, that sort of thing, and that it's not just a foolproof way of investing I think is really important.
Robert Anton: Regarding asset allocation decisions, I think it really varies. At the core root of private lending is their fixed income investments, their liquid nature of private loans is the fact that it makes a little bit more tricky. So, depending on who's doing the investing, and you'll probably agree Phil, but I see it most often allocated to within an alternatives, general alternatives bucket, which is kind of catchall.
Robert Anton: Some haven't a carve out for actually a fixed income alternative. Some put it within fixed income with the caveat of the liquidity portion there. And some actually have a separate carve out for private lending itself.
Philip Robson: In the last 2-4 years, we've seen more of that, right?
Robert Anton: Yeah. Correct.
Vikram Rajagopalan: It comes down to your size. I mean the bigger you are as an institution adviser, even the retail clients is how granular you can become in your asset allocation. We were with pensions debt that go down to short term mortgage debt. So you can get very hard to be.
Vikram Rajagopalan: And Rob hit on a a point that I've seen now for the last couple of years because coming off, when I started to join, it was more of saying, okay, you add your equities, your bonds, and now you need your alternatives. And so it was equities, bonds, alternatives. And what I'm seeing now is people taking, okay, I don't need three asset classes, I only need two and out of the fixed income now, D, I will move this in there. So it's no more of it considered to be this outlier.
Vikram Rajagopalan: It's now, that's where you see it being brought into mainstream portfolios and saying, okay, it looks and feels like fixed income. It is fixed income, it's time tested. So, we bring it into the two major assets. I don't know if you've really-
Philip Robson: Now, we're seeing a lot of consultants have enough, here's your core fixed income product, and here are the bubbles you hang around it, they're going to give you enhanced return-
Vikram Rajagopalan: Like their core and explore.
Philip Robson: Yeah.
Clare O’Hara: So Rob, I'll jump back to you. It's often mentioned that as an investor at factoring as an arbitrage opportunity. So can you explain what's meant by that?
Robert Anton: Yeah, for sure. It really attracted those types of investors to that space. So factoring is a means of financing a company through the purchase of the receivables and it allows that company to advance their cashflow cycle, in most cases actually help the company grow, start working on their next purchase order, things like that.
Robert Anton: The opportunity as an investor is often the receivables that you're purchasing off this company tend to be of a higher credit quality than the company that you're buying them off of. So what you're able to do is purchase higher credit quality receivables, yet charge a rate more attributable to the lower credit quality company that you're purchasing off of.
Robert Anton: So having spent a decade and a half in hedge fund land, arbitrage is a fairly large opportunity. When we were looking into this space as an investor, we definitely saw that right away, and built an entire business around trying to capture that inefficiency.
Clare O’Hara: Vikram do you want to weigh in on?
Vikram Rajagopalan: I'll delegate that to the two of you who are far more in tune with factoring as probable. But yes, to Rob point that I think factoring has come a long way as an asset class. We see it a lot because again, if I get back to my mortgages and real estate boys to predominant ask, and I think people are getting a lot more educated on the word factoring because the word itself is not very intuitive to, it is actually, what is happening, but it is becoming more popular.
Philip Robson: It had sort of a negative connotation to the back of the days. It was the guidance skinny. It was like, loan sharking then factoring. And I'm talking like 25, 30 years ago, but it's become, we've bumped into some fairly major corporations, like billion dollar corporations who are effectively factoring two or three of their key customers because in their overall capital cost to capital, but they're paying for that. They're not really that fussed about but generates cash, like, boom. You guys know how fast you can make those things move, and so it accelerates their cash, which is what they're really after it for so they can do other things with it.
Clare O’Hara: Right. So Phillip, just to stick with you for a sec, private debt funds tend to have very low volatility. So maybe you just want to go in a bit more detail on why that is.
Philip Robson: Rob talked about this earlier, obviously because they're private, they're not really any market forces pushing them around. We all mark to market or have some sort of NAV process largely driven by that's what our customers need for reports and statements and stuff.
Philip Robson: But you don't get that sort of noise in the system. If you look at the bond market or corporates in the bond market where they're going up and down relative to where the yield curve is more even, we don't get quite that same impact from that stuff.
Philip Robson: Our mark to market will move a little bit, but it doesn't get that same, interest rates are up, interest rates are down, the bond market selling off the bond market's not, risk on risk off. kind of avoid most of that. Not totally immune. And I think you raised a good point. It's masked a little bit sometimes unfairly. Is that a good point?
Robert Anton: Yeah. It depends on the type of lending, obviously you're doing. The valuations in the private lending world are more based on the actual fundamentals of the actual underlying loan. And they don't... because they actually don't trade. In a formal marketplace, they're not subject to the market sediment pricing and the laws of supply demand, things like that.
Robert Anton: It doesn't mean that if you have write downs on a loan that it's not going to be impacted in the net asset value and add to the volatility of the loan, but you really don't have to worry about the fluctuations from the buy and sale demand. And one good example of that is throughout 2008.
Robert Anton: If you look at a number of the corporate bond indices versus actual the corporate defaults that they actually received during that time period, a lot of corporate bond defaults were under 10% yet their indices were down 35, 40%. So there was absolutely no reflection or very little reflection to the true underlying value, and they had to deal with the market sentiment pricing.
Robert Anton: So I think that makes it quite attractive. From a private lending standpoint, an investor, what investors really like about it is that you don't have to deal with that fluctuation. Obviously the flip side is that you don't have a formable market to trade these ends so you're going to get less liquidity.
Clare O’Hara: 30:23 I was going to ask you Robson.
Philip Robson: Also Vickram stuff to liquidity, and then the factory stuff they move pretty quickly in our smaller business lending that stuff, I think, if we stopped lending in that portfolio today, you'd go to zero in less than 12 months.
Vikram Rajagopalan: That's pretty low.
Philip Robson: But you don't want the other core products that we have in the longer stuff. You're dealing with durations of four and a half, seven and a half, 10 and a half, that kind of stuff. But they're all amortizing loans in our portfolios. So while there is some liquidity-
Robert Anton: No refi risk.
Philip Robson: Well I hate refi risk. I can never get my head around it but, but there is cashflow coming up to the investors every month, principle and interest, principle and interest. We don't re up. So there is some liquidity in there, and to the high net worth and the family offices and the institutions and say, look, you've got, we're 3% of your portfolio. There's 9,000 other places to find-
Clare O’Hara: That isn't necessarily looking for liquidity, it's asset class. It's cleared.
Vikram Rajagopalan: Well, actually for us, nothing talks to the subject more than our flagship fund in O8 where client's got positive rates of return in 08, but for six months they couldn't get their money if they wanted it, because at that point of time you didn't know how to value mortgages.
Vikram Rajagopalan: We stay at a steady $10 unit value because when we get loan losses, we don't hit the net asset value. We hit the interest that is payable to unit older so it takes down your interest as opposed to net asset value until you bring it down.
Vikram Rajagopalan: But at that point, a determination was made that you couldn't sell or buy a $10 unit value without... you didn't know exactly what it was worth. I always tell advisors is the biggest dichotomy you'll ever face with an investor. In one end, you're making positive rates of return, on the other hand, you want your money, and you can get it.
Vikram Rajagopalan: So that is what I love about that story is that it really in the smallest or the most succinct fashion explains private debt, right? And then is that your boards will continue to pay you unless of course you're dealing with sort of low credit boards. But for most part, if you're dealing with good boards or continue to pay you, they're well capitalized, but it might be an illiquidity in the market where you can transact, right?
Vikram Rajagopalan: And that translates into, I can't get my money, but someone is paying, right? And so that is the double edged sword, right?
Clare O’Hara: So you're making sure that, that percentage of your portfolio-
Philip Robson: Be prepared for it to get stuck for a little while.
Vikram Rajagopalan: And also remember the psyche of most investors in OA they're smart. Like when look at something like Trez for example, on a statement it's at $10, right? And it's spitting out this interest. And if the rest of your portfolio is down 20 to 30% what is the one thing someone wants to sell? Right?
Vikram Rajagopalan: It's probably the thing at $10, so there is that part of it where you have to be protected against that scenario where people like I'm going to go after that because it hasn't lost value. I don't know if you two agree on that.
Philip Robson: We're all closed in funds, so we deal with a different, mostly closed and funds we do a different reality. But on our real estate stuff we say if we have to we can sell a building. Selling a loan always starts with one word that I hate, which is haircut. And I don't like taking those. So it's a bit more difficult to do that.
Robert Anton: Obviously in good times, we could probably sell a lot of our loan book actually at a premium. When the next recession comes, we'll see if there's as many bidders. So you're really planning to... you're coaching your clients and stuff like that, that we do have a fair bit of liquidity in our portfolio just in the sense that we're on the shorter end of the private lending spectrum. That being said, we can't snap a finger and get liquidity the next day.
Philip Robson: Even Robert both talked about that earlier in the conversation about how you have to educate the investors irrespective of what is really part of the spectrum they're. This is the reality of this asset class. This could happen, this has happened, that might happen, and here's where you're going to be in that and just make sure that they understand this because things will happen.
Vikram Rajagopalan: That seems to be a big conversation now given all, everything that's going on with trade wars and [inaudible 00:34:34] and everything else. I don't know. The number one question we're getting now is how does this react in this kind of environment, the interest rates going up, all of these things-
Philip Robson: Where are we in the credit cycle, what do you think? And so you get your team angry with you every once in a while because I dictated the other day that it's time to talk to every borrower again, and ask them to key questions. What do you think about trade, what do you think about this? And we have an exposure to oil and gas, automotive, forest products, like-
Robert Anton: Similar [crosstalk 00:35:03].
Philip Robson: Stuff moving around.
Clare O’Hara: So they pay attention to the noise.
Philip Robson: Yeah.
Clare O’Hara: You just have to be able to address-
Vikram Rajagopalan: You got to get to it [crosstalk 00:35:11].
Philip Robson: Find out what's going on because our investors are going to say, what are you hearing, what are you seeing? And we need to be able to say, look, look, look, like, right?
Clare O’Hara: So they come over-
Philip Robson: And hey, do you want to do that sir?
Clare O’Hara: So over the last five years there's been a lot of new private debt funds that have been launched. And as more retail investors are starting to look at this as well, how can you differentiate between these funds and what's becoming, I wouldn't say crowded but busier universe?
Vikram Rajagopalan: Yeah. Look, that is absolutely the biggest challenge I think for the average investment advisor right now and institutions, everybody quite frankly, I see it firsthand. When you compare all our products and people in this room, not in this room, we all look and smell exactly alike. We are all targeting around that same area.
Vikram Rajagopalan: And for the average layman investor, it's hard to say, okay, why's something eight, why's something nine? One of the things that I've tried to go out there and say is, there has to be greater transparency between your gross yield and your net yield, right? Like that sort of thing. Because what I see is people coming into the market and saying, okay, looks like 8% or 7% is the sweet spot. So we lend at 25 and still give seven, people will come.
Vikram Rajagopalan: And so I've seen venture capital funds, right? That say, okay, we're coming out, it's 8%, but I know the underlying loan is in the 20s, right? And so the family offices, particularly the multi-family offices, that I saw deal with a very good at that because they understand it. The advisors are starting to ask those very same questions in terms of... because if you've dealt on your mutual funds, what are you only looking at your fees, your management expense ratio.
Vikram Rajagopalan: But there's a lot of other fees that fall into this, right? And the fee of just the leakage of interest rates. So it is very hard. But obviously, selfishly, longevity matters because we've been there a lot, so it's easy for me to say your credit process, has it been time tested?
Vikram Rajagopalan: All of those things, you really have to get a real understanding of how it's... again, I get back to how the sausage is made as much as you possibly can, but a lot of that comes down to, do you have a board of governors, do you have a credit process, do you have offices where you're doing all of these? Of course, once again, selfishly, come back to it. We do, but I think that's a part of it.
Robert Anton: Obviously, a lot of investors look at the returns. What I think they should really focus on is what is it that this company is doing that's delivering the returns, and what kind of lending are they actually doing? One key thing that everyone should know is, where do these loans sit in the capital stack, are they senior loans, or are they junior loans, are they secured loans, are they unsecured loans?
Robert Anton: Those type of questions are quite key in order to understanding the potential risks associated with those loans. So outside of that, experience and quality of the credit team, I think is quite important. A bore market I think masks quite a bit, so I personally think there's going to be a large separation during the next economic downturn between a strong lending companies and funds versus ones that are weaker. And it'll also create a huge opportunity for stronger lending businesses.
Philip Robson: Absolutely. And when we raised our first fund and we were talking to one of the institutional investors questions, questions, questions, how do you guys do this, how do you find that, how do you strain on? It just went on and on and on.
Philip Robson: And my predecessor finally got quite frustrated and he said, “Look, I'll tell you something.” He says, “Any chump can lend money.” And he's like, “Getting it back, now there's the trick.” Right? And so that's when we're all, I think educating investors about is manager selection, track record, experience, governance, credit processes, not just. Stay tuned, right?
Vikram Rajagopalan: Our founder always has this great line that says, a stancher for bad loan far outweighs the perfume of a high interest rate.
Philip Robson: Yeah.
Vikram Rajagopalan: Right?
Philip Robson: Exactly.
Vikram Rajagopalan: So you have to be still very cognizant in that regard, right? Because you always have to look and exactly why you're getting these high interest rates. Are there inefficiencies that you're taking advantages often. I still get back to this whole notion that, okay, what are you lending at and what are your criteria of doing it and what ends up coming back to you? Right?
Clare O’Hara: I'm sure investors when they see the... like when we're talking about markets are down and their rates are still high, they're happy, but they might be a bit skeptical about where is it coming from or someone's looking to get into it. They start to ask the questions like how, so it goes back to education.
Vikram Rajagopalan: It does. I mean when I present, I always say, if I were just to present the benefits of our funds, it stays at $10 and goes for between five and 8%. I'm done, right? That would be a two second presentation. And then you work backwards and saying, okay, now let's just talk about how this actually happens. Because if you don't talk about the risks and you don't get granular, you're leaving the elephant in the room, which really says, this sounds too good to be true, right?
Robert Anton: Yeah.
Vikram Rajagopalan: And I did that mistake once. I was lecturing at a university with these young kids. And I was talking about it, and these young kids, as always, they go on Instagram and one of my sales guys were behind and go, one of these guys like, "This guy's talking about his Ponzi scheme." Right?
Vikram Rajagopalan: Because to the university students, I didn't want to come across and talk to granular about all these nuances and it made it realize, yeah. If you just talk about it to top level, you have to get right into the weeds. But how-
Philip Robson: Can you get down to the short strokes with manager selection and due diligence questionnaires and we all live in that space. They're really focusing on, how does this actually go from something that your origination team brought in the door. Where are the checks, where are the balances?
Philip Robson: And then they also want to know how you fix it when it gets broken because those things happen too. And what expertise do you have in that space? Again, we're taking exposure risk. Sometimes it doesn't quite work out the way you thought.
Robert Anton: Yeah. And I'd add to that too. Although there are a number of lending funds that I've popped up post 2008, 2009, there is a lot of credit teams that have been around for 20, 30 years, just not in a retail format. So just because they have maybe not as long a track record doesn't mean they don't have an experienced skilled team that have navigated through recessions as well.
Clare O’Hara: It's a good point. So paying attention to the team behind the fund is just as important.
Vikram Rajagopalan: At the end of the day, even if we've been around for 20 something years, we've evolved, the team has evolved, so the team today is not the same as much as the founders and everyone else. I mean chief risk officers knew all those things. So yeah, your point is the longevity of the team as opposed to a firm.
Robert Anton: Right.
Clare O’Hara: So Vikram, just to stick with you for a second, when the average investor is looking at mortgage rates, they wrote the two to 3% range, how is it that firms such as yours are able to lend at such a premium above the eight to 12% range? And I know we've touched upon some of the greatest names, but maybe you can walk us through again the borrowers that need that type of financing.
Vikram Rajagopalan: Yeah. So when you talk about private mortgage lending, the first thing someone gets to the average retail investor is a couple of looking to buy a house. They can't afford that house. Therefore, we are going to lend to them at some shark rate, and then hope we take over the house.
Vikram Rajagopalan: So that was one of the things that I was going to take. No, we were one of the first to get into real commercial lending multi-residential back in the late 90s, commercial, industrial multi-residential. And what you find is that, there's two things. One is expediency, right? Because quite frankly, a lot of the value in these, these are refurbishments, these are bridge loans.
Vikram Rajagopalan: So there's a lot of value to be gained right at the very beginning, right? And so if you're waiting around for four or five months for a loan to be approved and one of the big banks, you lose a lot of that value. So expediency definitely matters.
Vikram Rajagopalan: Two is, if you're in the US and you're doing say an office building in Florida and it's $100 million, a lot of the borrowers could go to the bank. Some of our borrowers could go, but they would only be able to get 50 million from the banks. Then they would have to go to what you call a mezzanine partner for another 20. Then you'd have to find Equity Partners and share the profits there.
Vikram Rajagopalan: And what we allow for a lot of our borrowers to do, is the one stop shop. You come to us, we'll take you all the way up to say, 75 to 80% on that. And then in that way, you get to keep all that equity return without finding equity partners, without finding to pay a mezzanine debt partner, at the same time you get to get rid of us very quickly as opposed to we're dating as opposed to getting married, right? It's in a year and a half, two years, you're able to really feed a lot of that profits.
Philip Robson: That's a really key point though. So you're charging 12%?
Vikram Rajagopalan: Yeah.
Philip Robson: And on a relative cost to capital basis, finding an equity investor, 12% is like-
Vikram Rajagopalan: Yeah. And that's how we grew it-
Philip Robson: Take the money. Thank you very much.
Vikram Rajagopalan: In Texas, that was what we brought in specifically a lot because until that point, they would have to find Equity Partners. And so when we came up with this whole new models, like 12, 13% versus take having to share my 35% internal IRR for 17 to 18 months, it made huge sense, right? For them.
Philip Robson: You did the same thing with factoring, right?
Vikram Rajagopalan: Yeah.
Robert Anton: Correct.
Philip Robson: Grinding along with their banks or trying to grow their business. The bank is asking questions, asking questions, asking questions. You can create cash flow for them very quickly-
Robert Anton: Yeah. Very, quickly. So we obviously like the collateral of the receivables.
Philip Robson: When we say quickly, like how quick?
Robert Anton: Well, our typical receivables factoring book is turning over in 48, 50 days. So that's fairly liquid transaction. More often they're not a company that we provide factoring or purchase the receivables as a means of financing for our companies that are typically growing, whereby they a lot of times don't have unencumbered assets that they can pledge for an asset based loan, which tends to be a little bit cheaper, but they do business with a lot of good people and those people become basically the collateral that we buy off them, the receivables.
Robert Anton: And more often than not because they're growing, they're having more purchase orders that they need to start work on, and they need to actually bring that, instead of waiting 30 or 60 days to get paid from those companies that owe them money for goods and services that they delivered. We can turn those deals quite quickly and put that cash in their company so that they can start work on their next business.
Philip Robson: Days, not weeks, right?
Robert Anton: Yeah. So we do a combination of factoring and then we do asset based lending as well.
Clare O’Hara: Great. So Rob, just sticking with you and we've probably touched upon some of these, but what are the key factors that make a good lending fund or business? Maybe you can recap some of those for us.
Robert Anton: Yeah, so the obvious one, obviously is a good credit and underwriting team. I think that's the first thing that a lot of people focus on. I mentioned this a little bit earlier, but we think that the origination team is vastly under appreciated on the street by investors and lending businesses, that's a whole. We spent a lot of time and effort building a very quality origination team throughout North America.
Robert Anton: A number of reasons for that. We want to see as many deals as we possibly can. Obviously, they'll screen them, and feed through to the system, the ones that fit our box. But we feel that by seeing more transaction that allows us to be more selective in the types of deals that we're funding, even within our own box of factoring in asset based lending.
Robert Anton: So, that's quite key. I mentioned before, we think that seeing more deals can actually lead to potential premium and yield just because you're seeing more opportunities. So there're some that might fit into some of these yield premiums that we've talked about earlier.
Robert Anton: And we think that seeing more deals can lead to lower credit quality, which is quite key. A colleague of mine who I've known for about 25 years, the company that he was working for about 25 years ago did a research study, and they tried to figure out, what... this was actually related to private equity funds, but they were trying to figure out if there was one definable difference on what led to out-performance of one private equity fund over another.
Robert Anton: And the only conclusive evidence that they could actually find was actually origination, was actually being invited to the table in the first place, was what they found to be one of that consistent, repetitive things that allowed one private equity firm, achieving a better return than the others. We think the same phenomenon exists in private lending and have put a lot of our capital into it to try, and take advantage of that.
Philip Robson: You're absolutely right. All of us in the process of selecting investments, growing the opportunity set, makes the rest of the job somewhat easier to do. And I can't speak for you guys. For us, the approval rate moves somewhere between eight and 10% of what we look at because we were like, “Nope, nope, nope, nope, nope." Yeah, that's the game.
Robert Anton: We probably approve less than 1% of actually what our originators see, but what they actually put through, even to the system that anyone sees, probably in the tune of five to 7%, that we find.
Vikram Rajagopalan: Yeah. We've tried to build a lot of hierarchy, did share `at the credit committee, it ends up seeing what is good quality deals-
Philip Robson: They're actually to be done.
Vikram Rajagopalan:... but it might not because quite frankly, at some point, that's why we hired people from the banks to come in and CIVC and BMO to look at the deals when new originators get in there, because I think at the end of the day, I think at one point, we receive roughly $2 billion of deals in Canada and another, one or 2 billion in the US and what do we fund at the end?
Vikram Rajagopalan: Maybe between the two of them, just roughly over a billion dollars at the end of the day. So there's just so much that you just don't have the time of effort to move through. And there are various parameters, right?
Robert Anton: Yes.
Philip Robson: Yeah.
Vikram Rajagopalan: There's just capacity and character borrower and then, the character of the borrower. That's very discernible. That right off the back, you can see it can be the greatest deal, but if it looks like someone specifically, if you think you're coming into hard times, that's where a character outweighs collateral.
Vikram Rajagopalan: Maybe I'm using it here, but for us specifically we're character lender. It's very important that they toughen it out during the tough time because we have gotten into trouble. It's a learning experience where we've had good collateral, but bad character borrowers. And that has proven to not be a very good recipe for us.
Philip Robson: If you look-
Vikram Rajagopalan: Now the reverse has-
Philip Robson:... nine times out of 10, it's a management issue, right?
Vikram Rajagopalan: Exactly.
Philip Robson: That's correct. And the way to fix these things for all of us is to not just toss it out the door or hand it into a receiver or something like this. We get our capital back by fixing it, right?
Clare O’Hara: Right.
Vikram Rajagopalan: Yeah.
Robert Anton: One thing I'll add in that theme is once you put a loan on, it's not like buy and hold, set it and forget it. Monitoring becomes extremely key in that whole process. Having your own team look at the financials each month, have calls and meetings with the team.
Robert Anton: In our case, independent appraisers coming in and reappraising assets or field auditors coming in and doing a full scrubbing of the company, it becomes very important part of the process. Anything that could lead to early indications of warning signs that can help you tackle a potential problem earlier than later is really key to the process.
Philip Robson: Our mantra is problems just surprises.
Vikram Rajagopalan: Yeah.
Philip Robson: No.
Robert Anton: Right. Really good point in there.
Vikram Rajagopalan: We're being transparent with our investors. What we need is our borrowers to be as transparent with us, right?
Robert Anton: Yup.
Vikram Rajagopalan: If we feel our borrowers are not being completely transparent because, let's face it, we're earning also premium because every deal has an iota of risk to it, right? These are not cookie cutter deals. And so for those things to be successful, for that deal to go from step one to step 10 we need to know all the information because there are going to be problems along the way as long as they're foreseen, as long as you pointed out, no surprises, right?
Vikram Rajagopalan: And when you end up in a situation where the borrower only has another bank account that they're putting money through or they have a shell company, those kinds of things, those are the things we're naturally, that's why I bring back character. Those are the things that generally if you look back, have been the crux of the problem.
Clare O’Hara: What can you do in that scenario though? You've already loaned out the money and then you start to-
Vikram Rajagopalan: Well, in that case, you're in technical default, right? And in that case, we have every right to take over the deal, which is again... actually, bringing back to why private debt has become popular and specifically private mortgages in my case, is because people have wanted to go out that capital stack, right?
Vikram Rajagopalan: Because when you're the debt, you can do that. You can just come in and take it over versus when you're the equity of course, you're the equity owner, you get the highest return, but you also are at first loss, right? We have very strong covenants going into it, personal covenants.
Vikram Rajagopalan: People can go into default for many reasons. Some of them are not all malicious. Some are just, for example, in Texas, you could have a hurricane, in Florida, you could have a hurricane and-
Clare O’Hara: Exactly.
Vikram Rajagopalan:... there could be a delay or two. That's not a malicious nature. And we work with the borrowers. If there's fraud involved, well, that's why we love some states in Texas because it'd be 45 days, and the court steps and we can just take it over, right? So yeah, we would take it over in that circumstance.
Clare O’Hara: We're talking about risk yourself. I'm wondering, can you give us like a quick rundown of the risks that investors need to think about? We've talked a lot in depth, but maybe if a checklist of if they're thinking about getting or advisors are thinking about getting into this asset class.
Philip Robson: Industry risk, management risk, leverage risk, event risk, black Swan events and you need to be comfortable that the manager's got a handle on the people. We're in the people business, we lend money to people, right? And we're a bunch of people lending. I say to people, my assets go down in the elevator at the end of the day, every night.
Philip Robson: So, you need to be comfortable that there's that kind of stuff going on. And then to look through those risks. That's where we're looking through. We're looking through past performance, we're looking at what are the things that are happen, trade economics, industry changes that could impact this company in a negative way, and how do we build our covenant structures and our reporting structures to catch those, because they do happen, even in the best of times, things go wrong, right?
Philip Robson: And so those are the kinds of risks. It's hard for an investor to get into that level of... especially for a retail investor, no matter how transparent you are, with some of our institutional investors, they have the right to see every investment memo we put together and some of them actually ask for copies and read them, and reach into our team and ask questions.
Philip Robson: And we're cool with that. That's tough to do. And then we also have to, every once in a while say, “Yeah, it's a really private company and we can't show you.” That always gets them up tight.
Vikram Rajagopalan: Yeah.
Clare O’Hara: Is this an asset class? I've heard you say credited investors. Is it still at that for the retail investor? Is that where it lies right now? Has this really opened up to the everyday retail investor at this point?
Robert Anton: The liquidity constraints on the underlying loans don't allow them to be. So it's not necessarily that we wish not them not to be, but I guess an added risk and why a lot of us couldn't do that anyways, and offer daily liquidity to fit under certain regulations, nor could we just because the underlying doesn't have liquidity, so it wouldn't fit anyways.
Robert Anton: But the big risk out there that you didn't mention in addition to those, is just the fact of liquidity mismatch. Lending funds, maybe offering monthly liquidity and having three year loans on the books that it would take them a long time to actually receive liquidity. So that's an added thing-
Philip Robson: That's real hip.
Robert Anton:... to keeping and a look at. And I would say that, that risk isn't necessarily just an alternative lending. There's a big risk-
Philip Robson: No.
Robert Anton:... in some traditional areas so lots better offering daily liquidity which we take many months to get.
Vikram Rajagopalan: When look back at the biggest mistakes or the biggest bad stories in the space is the mismatch of liquidity.
Robert Anton: Yeah.
Vikram Rajagopalan: Right? People live in private debt, private mortgage funds that promise daily liquidity where... and people fall for it still. That hasn't actually gone away. If I might just go back to risk for a second. The one risk of course for all of us right now, is we are now in a place where we have become very popular as an asset class. And so there is a lot of capital-
Philip Robson: Crowding over risk as well.
Vikram Rajagopalan: So your reinvestment risk is a big risk. When you're doing 90 day paper, you're doing year and half, you're always turning around the portfolio. So you have to be very cognizant that you're maintaining your strict standards. Because you are getting this capital, it has to go out. Obviously holding cash is the mirror image of return, right?
Vikram Rajagopalan: And so you have to be very prudent as a firm. We just went through our first since I've been here where we stopped taking on money for a couple of months because we felt that we were getting a lot of capital. We need to flush it out. We just reopened, but these are the decisions that we all have to make going forward, is to make sure that we don't try to just underwrite deals just because of the popularity of the asset class.
Clare O’Hara: Great. Well, I'd like to thank all of you today for joining me in this thorough discussion of the private debt market. It's a very interesting asset class and as like many other investments, not all strategies are created equal.
Robert Anton: Correct.
Clare O’Hara: Right.
Robert Anton: Thank you Clare.
Clare O’Hara: And thank you for joining us. I'm Clare O'Hara with the Globe and Mail, and this has been Asset TV's Private Debt Masterclass.