Taking a holistic investment approach in private credit

As the major Australian banks shift away from commercial lending (a trend that has accelerated in recent years post royal commission) there has been significant growth in private credit as an asset class. This growth has created an opportunity for new private credit managers to enter the space and fill the lending gap which has resulted in greater access and choice for investors.

Much like a variety of equity investment styles (growth, value, index), sizes (mega cap, large cap, small cap, microcap) and sectors (tech, healthcare, industrials) exist for investors, private credit funds can be segmented into an array of specific mandates such as those that focus on property lending (commercial or residential), corporate lending (large, mid-market or SME), thematic-driven, sector-specific or diversified. This makes the selection process a crucial exercise for investors.

Investment styles also differ among private credit managers, and one unique way potential borrowers are assessed is with a more holistic investment approach rather than a pure corporate credit approach. Such an approach is multi-faceted and provides significant downside protection while also capturing additional returns for investors through attaching equity-like instruments as part of the loan facilities.

A traditional credit due diligence process involves quite a passive reporting requirement that is a backward-looking view on historical financials provided by borrowers. On the other hand, an investor aims to fundamentally understand the key growth drivers of the business, its competitive moat, management strength and whether its industry faces structural or macro-economic tailwinds. 

Such attributes allow a business to ride through a business cycle. Once these broader and holistic attributes of a borrower are well understood the manager then can move to a traditional credit due diligence process.

Why take a Holistic Investment Approach?

Combining a more holistic approach with traditional credit analysis allows the manager to:

1. Recognise future value drivers of the borrower;
2. Assess and prepare for business and market risks that have been identified during due diligence;
3. Effectively structure and protect the downside via the loan documentation; and
4. Position the fund for potential upside, via free attaching equity securities as part of the loan agreement.

Financial models are often constructed to form a clear view of the future state of the business in context with historical performance. This along with a scenario analysis to stress test downside and upside cases helps ensure that the business has a sound ability to meet their obligations. These steps minimise the risk of default and ensure that "investee" businesses have growth potential that can be captured through attaching equity-like instruments.

Unique loan structures such as a mixture of amortising and term debt facilities are developed to meet the needs of both parties and increases downside protection through a senior secured facility. This is combined with various loan covenants such as minimum cash balances, gearing ratios, revenue and EBITDA targets, budget approvals and negative pledges. Where appropriate, board step-in rights can be included in the loan agreements to enable intervention if the Company comes into difficulty, further protecting the downside. Equity-like instruments such as options, warrants or free equity are commonly included in the structure which can provide material benefit to investors when taking a value-add approach.

Post-investment, a value-added approach to portfolio management and monitoring involves hands-on active management. Partnering with investee companies helps to unlock the value drivers identified earlier in the screening and due diligence process and may involve assisting with business strategy, operational improvements, stakeholder relations and financial management. An example of this is developing and implementing 100-day plans to mitigate identified risks and unlock value improvement strategies.

Taking a board seat or observer rights (where appropriate) in investee companies is an additional step for ongoing oversight, enabling the fund manager to be proactive rather than reactive in the event conditions change and a business requires more assistance. This approach not only improves the credit position and reduces credit risk, but it also increases the value of the attaching equity instruments.

Conclusion

Through applying a more holistic approach to private credit investing, investors can benefit from superior returns with significantly less risk than other private credit investment approaches. This type of credit strategy provides investors with sufficient income that can provide a buffer to downside risks but also is a strategy that can generate additional positive investment performance if market or economic conditions improve.

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