High returns without high risk - Is it possible?

With some private credit funds generating attractive equity-like returns and seeing growing investor interest, we unpack the answer to a common question: Can you achieve high returns without high risk? To answer that question, we need to look beyond just risk/return and introduce a third lever – complexity.

A triangle, not a seesaw

When buying property, people typically understand the three balancing factors: location, price and quality. In private market investments, people often consider only a two-factor relationship between risk and returns, viewing it as a binary trade-off and expressing scepticism that you can achieve equity-like returns while maintaining low risk.

A third factor – complexity – is often overlooked which can present opportunities for investors to manage risks and still achieve high returns. Opportunistic private credit is one such asset class that can allow the unusual, rather than the risky, to create value for investors.

Diagram 1: The risk, reward and complexity triad of private credit

What is complexity

Complexity in private credit might mean an investment opportunity is harder to find or analyse, has unusual aspects that require more detailed due diligence or requires more tailored structuring and expert hands-on management to manage risks – or a combination of all of these. Borrowers with these characteristics are often unattractive to traditional lenders yet do not want to dilute their shareholding with even more expensive equity. Many of these borrowers are high quality/low risk and willing to pay a premium for fast, bespoke credit solutions.

An example of a business more likely to be seen as too hard for a traditional lender is an entertainment venue company because of:

• Seasonal and variable cash flows: The entertainment business experiences seasonal fluctuations and variability in cash flows based on event schedules, making it challenging to fit within traditional lending criteria.

• Complex revenue streams: Revenue comes from ticket sales, food and beverage services, merchandise and event bookings, requiring a nuanced understanding of the business model.

• Non-traditional collateral: The company’s assets include leased properties, specialised equipment and intellectual property (e.g. brand value and exclusive booking contracts), which are less straightforward for traditional banks to collateralise.

However, none of these parameters address the quality of the business, its ability to service its debt and the capital preservation terms available to protect investors.

Turning the unusual into returns

In the private credit market, complexity can simply mean opportunities that don’t fit institutions’ standardised deal types or terms and are therefore not easily scalable. These are often the situations where strong returns can be achieved thanks to one or more of the following factors:

1. Mispriced: Many traditional lenders take a top-down view of sectors based on the macroeconomic environment despite widespread recognition that these forecasts can be notoriously inaccurate. Investors that have a more flexible and opportunistic mandate can focus on analysing the unique idiosyncratic risk of each opportunity and deploying capital where the risk-adjusted returns are attractive, rather than avoiding entire sectors or subsets of the market based on perceived risks.

Taking a more agnostic view can lead to finding low-risk opportunities with high returns. The investor is not simply taking beta risk in the market but is generating alpha by finding unique opportunities where they can extract excess returns by structuring for the specific opportunity’s risks.

1. Mid-sized: Most lenders (banks and some large private credit funds) are looking to deploy at least $100 million or more on any single transaction. However, Australia’s mid-market i.e. borrowers requiring between $20-$75 million of capital, represent a less competitive segment that can present highly attractive funding opportunities.

2. Out of step: Traditional lenders often have fixed and constrained mandates. Their funds usually need to be deployed within a certain window of time and with capital dedicated to specific sectors - often sectors where the consensus view is favourable. An alternative approach that can be taken by a private credit fund specialising in opportunistic and special situation investments is to invest with a flexible mandate that is sector-agnostic and does not have specific allocations to fill. So rather than competing in over-fished waters where quality and returns could be reduced, the fund can find quality investments all year round, wherever they present themselves. As mentioned above, this occurs in overlooked parts of the market where a supply and demand imbalance exists.

3. Need speed: Borrowers that need capital fast will often find traditional lenders’ processes too slow. For example, if they have an opportunity for profitable growth through acquiring a valuable asset or making an acquisition, it is beneficial for them to pay a premium for faster funding. Paying more for the speed, bespoke structuring and funding certainty allows the borrower to secure a strategic asset on attractive terms, rather than miss out on the opportunity altogether.

4. Need bespoke attention: Deals that need unique structuring, a technical understanding, additional due diligence, active management, or support with the funding pitch are often outside traditional lenders’ remits. These can offer great investment opportunities. Where a quality business does not fit into the right box for traditional lenders, additional attention to assessing risk can uncover great value.

In summary, investors who focus on special situations and opportunistic credit can add value by increasing fund returns by generating excess returns per unit of risk and avoiding beta or market risk in reaching for returns. The opportunity to add attractive risk-adjusted returns to portfolios is available because the additional work and expertise required to work through complex situations means there are fewer market participants focused on complex or special situations. 

Ultimately, this allows opportunistic investors to find the most compelling investments, negotiate strong protections and allocate capital on attractive terms that generate excess returns whilst maintaining low risk.

Before you invest

Investors could be well served to understand the details behind the private credit funds they are considering. They will want a manager that focuses on quality companies and assets, always invests with a large margin of safety and negotiates enhanced credit protections which enable the investments to be less susceptible to general market movements and, most importantly, ensure capital is preserved in any downside scenario. 

This comes down to the ability of the investment team to work through complexity, creatively solve business funding challenges and actively manage investment to allow the fund to achieve outsized returns for investors for the relative risks.

For more insights, visit our news and insights page here. 

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Keyview Credit Opportunities Fund

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