Jazzing up returns

Private debt typically is not investment-grade and does not involve any public issue of bonds and debentures that can be rated by a credit-rating agency. Direct loans, asset-based lending, mezzanine financing, distress debt and venture capital all can be considered forms of private debt. These loans don’t have the transparency, pricing mechanisms or liquidity of stocks and bonds.

Clients looking to jazz up their returns with private debt are partnered with mid-sized companies requiring capital through a variety of non-bank lenders that act as middlemen. These brokering firms conduct rigorous risk assessment and negotiate the terms of the various loans – whether they’re construction loans for a real estate developer or short-term bridge financing for a manufacturer’s receivables – then package them into diversified products.

Private debt has grown dramatically as an investment category since the global financial crisis of 2008-09, when regulators required banks to repair their balance sheets and shore up capital. Banks, now with less leeway to lend, became more discriminating and cautious, but mid-market companies continued to need fresh capital to finance growth, improvements or acquisitions.

This need gave rise to the non-bank, private-debt marketplace when new asset-management firms stepped into the breach and became alternative lenders. Institutional investors were the first to take an interest in what has become a recognized and sizable asset class that has little correlation to public securities markets.

“The vast majority of products have been launched [since the] financial crisis, and there hasn’t been an opportunity to see how they perform through a real-life stress test,” says Hallett. “Private-debt portfolio advisors are picking the individual companies to lend money to, and that’s a due-diligence challenge.”

Until recently, private debt mostly was the domain of large institutional investors and high net-worth individuals participating through limited partnerships and private pools. However, some retail investment fund providers, including Toronto-based Sprott Asset Management LP (SAM), and Montreal-based Fiera Capital Corp., are developing more liquid investment funds with varying exposures to private debt that are accessible to qualified retail investors through securities dealers. SAM has launched a few private-debt funds while Fiera is hoping to have retail products available through securities dealers by yearend.

“We’re seeing low rates on a global basis, we’re seeing zero and negative interest rate bonds, and many other bonds are negative on a real basis,” says Scott Colbourne, co-chief investment officer and senior portfolio manager at SAM. “The bedrock of the income portion of portfolio construction previously were traditional Canadian bonds, but they no longer provide the anchor investors [desire].”

With a 10-year Canada bond now yielding just 1.2%, many bond investors have been forced to move to longer durations in search of better rates. However, this means locking in money for a longer time and exposes investors to duration risk if market interest rates rise. With private debt, which is typically shorter-term, the risk lies more in the characteristics of the business and its management, as well as the quality of the underlying collateral, than in the duration of the loan or the direction of interest rates.

“Private debt has attractive risk/return characteristics,” says Ramash Kashyap, senior vice president of the alternative income group at SAM. “It’s higher-yielding than government bonds, but is better secured and has a lower default rate than many high-yield bonds. [Private debt] usually has floating rates. [These investments] require microanalysis that focuses on the merits of each individual loan; it’s a bespoke approach.”

Investors in a diversified portfolio of private loans can expect a yield of 6%-8% a year, according to estimates from SAM and Fiera, providing equities-like returns without the volatile swings in publicly traded stock markets.

“Private debt is where supply is meeting demand,” says François Bourdon, chief investment solutions officer at Fiera. “Companies need capital, and there’s investor demand for higher-yielding assets. That’s why we’re in the space.”

Fiera’s private-debt investment vehicles primarily provide access to loans to small and medium-sized companies, with loan values of $1 million-$20 million, Bourdon says. Terms generally are 12 to 18 months, which limits the interest rate risk.

The rate of interest varies, but usually floats with the prime rate. For example, the rate charged to a company would be lower for commercial real estate loans on an attractive property, for which the market is competitive and financing is easier to come by than it would be for an unproven research and development company. Many loan applications are reviewed, but typically only one in 20 finds its way into the portfolio, he adds.

SAM recently launched Sprott Alternative Income Fund, a multi-strategy, fund-of-funds sold by offering memorandum and requires a minimum investment of $25,000 for accredited investors and $150,000 for non-accredited investors. The fund’s monthly liquidity feature gives investors more flexibility than other types of private-debt vehicles they’re committed for longer periods do. Due to the lack of a liquid market for loans, private debt is not a suitable holding for open-ended mutual funds that offer daily redemption and sale of units.

“Investors have a choice of how they want to access private debt,” Colbourne says, “but many [investors] are sensitive to liquidity.”

Four existing SAM funds comprise Sprott Alternative Income Fund: Sprott Private Credit Trust 11; Sprott Bridging Income Fund; Sprott Credit Income Opportunities Fund; and Sprott Diversified Bond Fund.

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