Rarely are the most important lessons on investing learnt by trawling through excel spreadsheets or due diligence packs. Rather it is the osmotic learning gained by listening to others around you; their perspectives; how they communicate with clients, that has the greatest influence on personal development.
This was true for me recently as I was listening to a conversation relating to the management of a potential client that had been causing angst for some time. After several minutes of discussion about how to manage the client, a very senior executive quietly exclaimed “I kill Kenny.” It must have gone unheard because after a few more minutes of lively debate, he repeated, this time more loudly “I kill Kenny.”
Satisfied with the perplexed looks around him, he went on to explain that the client’s behaviour was not a one-off occurrence but rather a pattern. It was the recurring motif in South Park when the character Kenny was killed off each episode in some new and creative way. Albeit in this case it was the recurring disagreement between client and lender. It served as a metaphor for the disconnect the team was having with the client.
Interestingly, once it was agreed the disconnect was the root of the problem, all parties surrounding the desk were on the same page. It was obvious that the fundamental principle, drilled into every young investor, that is of the importance of the client relationship and mutual trust, had momentarily been lost in the detail around financial metrics and legalese. Re-centring the discussion on this key fundamental made the answer clear.
Fundamental principles: why they should not be ignored
While there are complexities to credit investment, given its nature, in my experience there are fundamental principles that should not be ignored.
Unlike an equity investment offering unlimited upside, in a credit investment upside is capped. The best-case scenario for a credit investor is that your principal is repaid, and you receive predetermined interest payments over time.
This is the same case for a portfolio of credit investments, and as such it is considerably more difficult for the failure of one investment to be masked by the success of another.
It should be said that for receiving a fixed (and capped) return, a credit investor does also generally receive the benefit of security over assets and seniority to equity holders as protection against loss. However, it is for these reasons that investing in credit is far more about avoiding the losers than picking the winners.
In my experience, I have found that losses can be mitigated by following some simple but important principles applicable to all investing, both debt and equity.
Leverage: The magnification of outcomes
It may seem lazy to include leverage as a key principle of credit investing, given the two are synonymous, however the concept of leverage is often oversimplified and misunderstood.
Too often leverage is viewed as binary; more leverage equals more risk. Leverage however does not follow this linear equation. There are businesses that can support a great deal of leverage with minimal risk, and businesses where even the slightest bit of leverage may be cause for concern.
The importance of stability
What dictates the appropriateness of leverage is quite simple: stability. The more stable the asset, the more leverage is safe to use. Riskier assets demand less leverage.
While this concept is not earth-shattering, what often gets neglected is what Oaktree Capital Management co-founder, Howard Marks, articulated in his memo ‘Volatility + Leverage = Dynamite’.
Marks highlighted that underestimating risks inherent in assets may lead to the misapplication of leverage. An example of this, Marks considers, is the underestimation of risk in residential mortgages that led to banks buying too much mortgage-backed paper with too much borrowed money during the GFC.
To mitigate this risk, Marks’ states “leverage should only be used on the basis of demonstrably cautious assumptions.”
Determining these assumptions is becoming increasingly difficult. Strong macroeconomic conditions in Australia over a prolonged period has made it is difficult to test assumptions against any meaningful event of heightened volatility. Validating the correct level of conservatism to be applied to risk assumptions is therefore the challenge.
Be wary of a credit paper’s ‘key risks’ section
One may attempt to tackle this challenge through detailed financial modelling. However, more times than not, downside financial modelling is based on key identifiable risks.
A credit officer once said to me “It is rare that the cause of a business’ demise is perfectly articulated in the Key Risk section of the credit paper.” This makes sense – risks that are clearly identifiable have likely been properly considered and accounted for.
What is more important is to try and consider unknown risks. Inevitably, this is difficult and there is no silver bullet. A starting point is to consider the worst-case scenario. For a debt investor this is generally the breakeven analysis: what needs to occur for me as a debt holder to lose money. Not only does this analysis force consideration of the different ways such events could occur, it highlights the level of an asset’s resiliency and allows a judgement call to be made on the likelihood of that breakeven point occurring.
Applying the appropriate amount of leverage will always require a judgement on stability and resiliency.
As Marks' surmises:
“Leverage is neither good nor bad in and of itself. In the right amount, applied to the right assets, it’s good. When used to excess given the underlying assets, it’s bad. It doesn’t add value; it merely magnifies both good and bad outcomes.”
Effective diversification: more than just owning different things
Diversification is a fundamental cornerstone of investing. However, its importance can be overstated and it can be over-relied upon in decision making.
Warren Buffet put this more frankly when he said “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
Rather than assuming you can never have too much diversification, a more nuanced approach is to consider whether diversification enhances the credit quality of the actual position or diminishes it.
Effective diversification doesn’t mean owning different things, rather owning things that respond differently to macroeconomic events. Does splitting a contract between two parties still make sense if one party is on the verge of bankruptcy? Does lending to a lower tier party in the same sector make sense because portfolio concentration limits to a top tier party have been met?
The importance of considering diversification was made acute by Greensill. It appears Greensill’s collapse was partly due to concentrated lending to just a small handful of corporations. In hindsight it was obvious the level of exposure to the relevant counterparties was considerably above reasonable risk tolerances, with lenders and investors paying the ultimate price.
The importance of strong management: the ultimate custodians of capital
The management of a potential investment is as, if not more, important than industry tailwinds or market dynamics, as management are the ultimate custodians of capital.
Identifying high quality management is less about empirical analysis and rather requires personal engagement and a degree of emotional intelligence. Some things to consider include track record of the management team, their attitude to future growth and milestones, response to adversity, honesty in their assessment of failures and successes and maybe most importantly, understanding their values and the culture that drives the business.
In addition to pursuing high quality management should also be the desire to build strong relationships. There needs to exist mutual trust and alignment of expectations between parties. While no one likes delivering or hearing bad news, it’s better for a client to feel comfortable giving you advanced warning of an issue rather than concealing it until it is too late.
The Fear of Missing Out: ignore it
The Fear of Missing Out, or FOMO, is a real phenomenon.
The desire, and in some cases, the pressure to invest can impact decision making particularly in times when markets are increasingly competitive, such as in the current Australian credit environment.
A basic principle often overlooked is to set price and financial structures appropriately for the determined level of risk. One of the most powerful and relevant quotes I have heard on this topic was from a US Private Credit Summit panel when a credit manager stated, “Fundamentally credit is basic, you need to price for credit risk, not for the commoditisation of capital.”
The best way to avoid this pressure is to have a competitive advantage. Whether it be targeting a niche market, providing quality service, building strong relationships that transcend price or a combination of all of these, being able to differentiate oneself is critical to avoiding the increasingly crowded market.
The private credit landscape in Australia has rapidly evolved over the past five years and is likely to continue to evolve even further over the next five. With this will come more opportunity but also a new set of challenges.
Successful private credit investment will always be far more about avoiding the losers (the Kennys) than picking the winners. That is the importance of keeping the fundamental principles top of mind.
Please get in touch to arrange a discussion, and to learn more about our structured credit capabilities.
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