Yield-hungry investors zero in on private debt

Yield-hungry investors zero in on private debt

This article appeared in the Australian Financial Review.

The search for decent fixed income investments has been intensifying since the COVID crisis ushered in the lowest government bond yields in history. Not only are rates very low, but the March selloff reminded us that any investment that is traded on a market, even fixed income, can see its price drop like a stone when panic-stricken buyers disappear.

‘Private debt’, where you invest in a secured loan between a borrower and a non-bank lender which in turn syndicates the loan to outside investors, has become increasingly popular over the past few years as yields have steadily declined. Market researcher, SQM, reported growth in the mortgage loan sector of nearly 200% in 2019.

The main reason for the surge in popularity is investors are able to earn yields that can vary between 5-11% per annum on loans with a typical term of 6-24 months. Another benefit is the loans have no direct correlation to shares because they are not traded on a market, which means their value doesn’t fluctuate.

The critical thing for any investor is to remember these investments are not risk-free, so you need to make sure you’re comfortable with the risks involved and do your homework on the provider of the loan. If a loan goes bad, you could lose all your money. However, if you choose wisely, private debt can be the hidden gem of your portfolio.

Giles Borten, CEO of boutique lender Bass Capital, says this asset class has flourished because small commercial lenders seized on the major banks all but walking away from middle market loans ranging from $3-20 million. This came about after APRA, the banking regulator, amended its prudential guidance to the big banks in an effort to make sure the Australian banking system is amongst the strongest in the world.

One of the consequences of those changes is that it became unprofitable for the banks to dedicate much of their precious capital to lending to small property developers, which has become the bread and butter of the private loan market.

Wary investors might ask why would borrowers pay such high interest rates – up to 11% – at a time when you can take out a mortgage to buy a house for less than 3%? One reason is because the risks are very different in lending on a property development project compared to buying a residential property to live in, there are the construction risks and then the finished product has to be sold. Another is precisely because the banks are not competing in the space and the borrowers need to get financing from somewhere. As Adam Smyth, a co-founder of Bowery Capital in Melbourne, said, “It’s a lender’s market at the moment, quality deals are plentiful and there’s no need to compromise on lending standards or price.”

Another concern for some investors might be the possibility of a fall in property prices. The first thing to remember with these deals is that you’re effectively in the shoes of the bank, so you have no exposure to the equity side of the property transaction. The borrower might double their money, but the most you can make is the agreed interest on the loan.

Likewise, the borrower might make no profit at all or even lose money. In that case, the security you have on the loan becomes critical. There are two elements to every loan’s security. Firstly, the vast majority of loans are secured by a first mortgage over the property together with any improvements, and many will also include a personal guarantee from the developer.

Secondly, the loan to valuation ratio (LVR) determines your margin of safety. If a finished development is valued at $2 million and the loan is for $1 million, then the LVR is 50%. It means if the borrower defaults and the lender is forced to sell the property, it can be sold for half its estimated market value and the lenders will still get their money back. It shows how important it is the valuation is carried out by a reputable, independent expert.

How do you access the private loans market? There are again two parts to this answer. First, if you qualify as a wholesale investor (gross income of more than $250,000 for the last two years or more than $2.5 million of net assets) there are many more opportunities available to you, through boutiques like Bass Capital and Bowery Capital, whose returns have averaged 9% per annum with 12 month terms, or the range of larger lenders like Wingate or Qualitas. For retail investors the alternatives are more limited, but it’s still accessible through groups like Australian Unity or even LICs on the ASX (like QRI, but beware, being a traded security, its price fluctuates along with the market).

Second, you can invest in a pooled mortgage fund, where the manager selects the investments, or a ‘contributory fund’, where you choose which deals to go into. As with all portfolio decisions, diversification is an important way to mitigate risk.

In an environment where yield is harder to find and volatile markets can wreak havoc with asset values, private loans can be an attractive option, but you must make sure you’re aware of the risks involved with each and every transaction and, as always, it pays to deal only with reputable providers. If you’re still not sure, then speak to an adviser, but make certain it’s one that’s familiar with the asset class.

Are you reviewing your SMSF’s investment strategy?

Are you reviewing your SMSF’s investment strategy?

As trustee of a SMSF, you have many obligations to ensure the smooth running of your fund. One such obligation, which is often overlooked, or inadequately prepared, is your fund’s investment strategy.

The Australian Tax Office (ATO) has issued letters to nearly 18,000 SMSF trustees as part of a campaign to ensure trustees are aware of their investment obligations.

The primary concern is ensuring that trustees have considered the diversification and liquidity of their assets when formulating and executing their fund’s investment strategy.

Importantly, it should be noted the ATO is not attempting to regulate and limit the control and freedom SMSF trustees have, but rather ensuring that if trustees wish to invest their assets in a certain way that they must clearly articulate their reasons for doing so.

An investment strategy should be considering the SMSF’s blueprint when dealing with the fund’s assets to ensure the fund’s investment objectives and the members’ goals are met. It provides the parameters to ensure you invest your money in accordance with that strategy. This is where the ATO has a primary function to ensure that trustees act in accordance with these obligations. Strategies can change, and there is no reason why you can’t change the way you invest. However, your investment strategy should be updated to reflect this.

An SMSF investment strategy must take into account the following items:

  • The risks involving in making, holding and realising the SMSFs investments, their expected return and cash flow requirements of your SMSF.
  • The diversification and composition of your SMSF investments.
  • The liquidity of your SMSF investments, having regard to expected cash flow requirements.
  • The SMSFs ability to pay your current and future liabilities, including benefits to the members.
  • Considering whether to hold insurance cover for each member of your SMSF.

An important requirement for you as trustee of your SMSF is to have an investment objective and a strategy to achieve that objective in place, before you start to make decisions about how you want to invest your SMSF’s money and change the investment objectives you have set for your SMSF at any time.

It’s not uncommon for SMSFs with lower member balances to find diversification a challenge as there is limited money to invest. Nonetheless, you are still required to demonstrate that you adequately understand and mitigate the associated investment risks.

If you find yourself in this position, it is important your investment strategy reflects these risks.

If you have invested in a large illiquid asset such as real property which may form the majority of your fund, it is timely to ensure your strategy reflects the concentration and liquidity risk associated with this investment.

For example, we met with a trustee who was running an account-based pension within his SMSF. His fund was fully invested in just the one asset being a commercial property. The challenge he faced each year was that the net rental income wasn’t sufficient to cover his minimum pension payments and the costs of running the fund. He relied on making annual contribution to his fund in order meet his pension obligations. This liquidity risk wasn’t adequately reflected in his investment strategy.

Where you have an investment strategy in place that deals with these risks and can provide the necessary evidence to support your investment decisions, no further action is expected.

Where your fund has not complied with its investment strategy requirements under superannuation law, you may be liable to administrative penalties being imposed by the ATO, as Regulator of the SMSF sector.

Your investment strategy does need to be reviewed at least once a year and this will be evidenced by your approved SMSF auditor. It is also important to review your strategy whenever the circumstances of any of your members change or as often as you feel it is necessary. The following practical tips will help you keep on top of your obligations:

  • Put your investment objective and strategy in writing
  • Set an investment objective that you can realistically achieve with the investments you are comfortable to invest in
  • There is no template for an investment objective and strategy, but make sure they reflect how you intent to invest your fund
  • The investments you actually make must be accommodated by the investment strategy you have set
  • Most importantly, document your actions and decisions, as well as your reasons, and keep them as a record in order to demonstrate that you have indeed satisfied your obligations as a trustee in this important area

How can we help?

If you need assistance with your fund’s investment strategy, please feel free to give us a call to arrange a time to meet so that we can discuss your particular requirements in more detail.

The WeWork debacle shows private equity is not a one way street

The WeWork debacle shows private equity is not a one way street

The Yale Endowment Fund was an early mover toward big allocations to private equity, which accounted for 40% of the fund’s assets last year. After returning more than 11% per year for the past 20 years, it’s made David Swenson a rock star among portfolio managers and started a movement that’s seen private equity’s share of giant investment funds go from barely being on the radar 20-odd years ago to now being a meaningful and indispensable portion.

Australia’s own Future Fund has 16% of its $160 billion in private equity, most of our big industry super funds include some weighting to it, and over the past five years there’s been an increasing number of vehicles offering private equity exposure to mum and dad investors that have proved very popular. And why wouldn’t they: as an asset class, private equity’s delivered returns that have averaged about 4% per year more than global share markets over the past 10 years or so and usually without the big swings share markets can suffer from. But the recent WeWork debacle and the dismal performance of Uber since it listed have shone a light on some of the risks in the space, risks that all investors need to be mindful of.

Private equity is investing in assets that sit outside public markets, and it can range from backing businesses in the earliest stages of starting up, right through to buying and selling long-established businesses or assets. The asset can be in private hands to begin with, or a private equity firm might buy a company listed on a share market and take it private.

One huge advantage of private equity is that if they’re transacting on a private company there are no insider trading laws, which is fair enough, if you were buying an asset from your neighbour there’s no reason the general public needs to know all the details. That means when a private equity firm does due diligence on buying a company they can insist on getting access to every detail available, information that a fund manager buying shares in a listed company would go to jail for.

Returns have also been less volatile than share markets, which is because the funds are not traded on a public market. When an asset only gets valued once or twice a year, it’s unlikely you’ll see a lot of ups and downs in the price. The downside of that is private equity is usually an illiquid asset, meaning you can’t buy and sell it whenever you want. Instead you’re typically locked into a fund for anything up to five to seven years, and in return you hope to harvest what’s called the “illiquidity premium”.

Because of that illiquidity, returns from private equity can be totally unrelated to share markets, which can be very handy when markets correct and you’ve got a chunk of your portfolio that barely moves. It’s close to the holy grail of “equity-like returns with bond-like volatility” that so many investors dream about.

With the huge rise in popularity of private equity as an asset class for institutional investors over the past 10 years, there’s likewise been a huge rise in the amount of money chasing private assets. It’s estimated there’s US$5 trillion locked away in private equity funds already, and Prequin, an alternative asset analyst, found more than half the large pension funds and family offices it surveyed intended to increase their allocation.

Of that US$5 trillion, US$2 trillion is ‘dry powder’ that hasn’t been invested yet and the intense competition for assets has seen the multiples paid rise by 20% over the past eight years. After the GFC, US regulators guided private equity firms to paying no more than six times ‘EBITDA’ (a proxy measure for how much cash a business spits out), but recently almost 40% of deals have been done at more than seven times.

While that may not sound like much, it’s a 17% rise and the way a lot of firms are looking to maintain strong returns on higher priced acquisitions is by jacking up the debt, which has seen average debt multiples increase 20% over the past few years. In just the last few years, once household names like Debenhams, Toys R Us and Pizza Express, have collapsed under the weight of the debt piled on by their private equity owners.

In January of this year Japan’s Softbank, one of the biggest private equity firms in the world, put money into WeWork at a valuation of US$47 billion. In the build up to listing the company in the US, which is the way many private equity firms cash in to realise their profit, Goldman Sachs and J.P.Morgan valued it at US$50-60 billion, but after closer scrutiny by regulators and fund managers the deal was pulled and the valuation is now estimated at more like US$10 billion.

That came after another private equity darling, Uber, was valued last year as highly as US$120 billion, then listed at US$80 billion, and is now US$50 billion. Likewise, its competitor, Lyft, has seen its valuation fall by 40% since it listed six months ago.

Having an exposure to private equity in your portfolio can be great for returns and can reduce its volatility, but like anything, you really need to know what you’re buying first. There are some companies that run like a Swiss watch, others that grab headlines for what can be the wrong reasons, and others that are clearly trying to jump on the bandwagon and raise money from unsuspecting mums and dads. The low interest rate environment is a double tailwind for private equity: lower yields are encouraging investors to look elsewhere for a return boost, and debt is cheap. Just make sure you don’t get blown off course.

Finding the investment strategy that’s right for you

Finding the investment strategy that’s right for you

One of the biggest challenges any investor faces is working out the most suitable investment strategy. There’s no end of options to choose from and how do you know which one’s right for you? And once you’ve worked out a strategy how do you decide what specific investments to choose?

There are many, many books dedicated to these questions, so this post aims only to suggest some ways to start thinking about it. The key is, think about it you must!

When you’re trying to work out an appropriate investment strategy there are some basic questions to consider, the answers to which can be different for everybody:

  • What’s your time frame? Are you talking about a strategy to set you up for retirement, or to reach a specific goal (fund a house deposit), or is it open-ended (perhaps starting a nest egg for your kids)?

Put simply, the longer the time frame the more options you have to choose from. For example, if you’re 20 years old and want to start a long-term savings program, you can look at anything; on the other hand if you’re planning to retire in five years and work out you need to double your current savings in that time, well, your options are seriously limited.

  • How much are you going to invest? Are you starting from scratch or do you already have a lump sum? Again, you might be at uni and you’ve heard the best savings program is one that starts as early as possible, or perhaps you’ve just inherited a sizeable chunk of money and you’re presented with a challenge you’ve never had before.

If you’re starting from zero then presumably you’re going to be quite young; clearly the property market is out of the question, so you need to look at either shares or some kind of managed investment where you can drip feed money in.

Obviously the more you have to invest the more options you’ve got. Everything from property and shares to private equity and venture capital. Or a combination of things, that is, a diversified portfolio.

  • What is your appetite for risk? While this is possibly the most important question in investing, it can be a really difficult question to answer because everybody wants the joy of high returns without the stress of facing potential losses. Until you’ve lived through a market correction, where you’ve watched 20% of your money disappear in a hurry, you’re only able to guess what your risk tolerance is.

Conventional wisdom says if you’re young you should take on more risk, but what’s the point of that if you lie awake at night stressing about a potential share market fall? Likewise, if you’re embarking on an investment strategy relatively late in life that realistically may have to support you for 30-40 years, it would be unlikely that a super low risk strategy will see you meet your objectives.

At the end of the day you have to find a strategy you’re comfortable with and you’ll be able to stick to. Some people love property and just don’t really understand shares, others might freak out at the illiquidity of property. It ends up being a balancing act between where you want to get to (your risk requirement), being able to sleep at night (your risk tolerance) and your ability to recover from a correction (your risk capacity).

  • How much do you really know? One of the most influential biases identified by behavioural economics is that we tend to overestimate how clever we are. Believe me, there’s no point deciding you’re going to make your fortune trading futures if you don’t know a pork belly from a forex swap. And you may have heard you can make great money trading antique guitars, but if you don’t know how to pick a Fender Telecaster from a Gibson Les Paul with your eyes closed you’re going to get taken out backwards.

Work out if you’ve got an edge or if you have the time and inclination to learn one. If you’re a builder then naturally you may have developed a good feel for a property bargain. There are plenty of seriously wealthy self-taught investors, many of whom have taken the time to write books letting you in on their secrets, and if you’re not into reading, then check out YouTube.

Investing is like many things in life: if you have a plan and stick to it you’re likely to get much better results than making it up as you go. If you don’t really know where to start, then ask somebody whose understanding of how to make money you respect or admire. And if you don’t know someone who fits that bill, then find yourself a good adviser.

If you’re interested here are two books to get you started:

“The Intelligent Investor” by Benjamin Graham. This was first published in 1949 and is famous as being the most influential book for Warren Buffet and every on of his millions of acolytes.

“The Essays of Warren Buffett”, edited by Lawrence Cunningham, highlights some of the fireside chat wisdom from the man broadly acknowledged as the most accomplished investor ever.