A good yield that won't cost a good sleep

Michael Houghton

Lucerne Investment Partners

As one of the last bastions of decent risk-adjusted yield, where 7% p.a. - 12% p.a. is typical, private debt is becoming increasingly popular with investors looking to boost income and diversify portfolios.

Yet while private debt is often presented as a new thing, quite the opposite is true. In fact, it is possibly the oldest asset class out there. After all, it’s simply ‘peer-to-peer lending’ as they call it these days; just the $10-million-version. Somebody lends money to someone else at an agreed rate, for an agreed term and secured in an agreed way.

This has been happening since time immemorial. It is just that where banks had monopolised the market, new investors and lenders are now muscling in. In this wire, I discuss the risks and opportunities in the sector and show it is still possible to get a good yield that shouldn't cost you a good sleep.

Reclaiming a multi-billion-dollar market from the banks

Private debt can mean different things to different investors, so here I refer to first mortgage arrangements secured by real property and limited to 65% of the value of the asset that they're lending against. 

Historically, one of the best-known ways of getting first mortgage finance - and investing in first mortgages - was through ‘Solicitor's Trust Accounts’. Solicitors would run a mortgage book and had clients' money sitting in a trust account. They created a private debt market by lending that money to a borrower who approached them for finance. Typically they would lend up to 65% of the value of the security property as the only criteria. Borrowers could keep rolling the debt every few years, ultimately getting repaid based on whatever exit strategy or liquidity was available to the borrower. Investors meanwhile would be earning interest.

This started to change through the '80s and '90s with a lot of the merchant banks that tried to disrupt the market, however many failed after the ‘87 crash (because, as it turned out, they didn't understand what they were doing). Most were getting well away from what traditional loans looked like for first mortgage investors. Some of the big names here include Rothwells, Tricontinental, Spedley, and all these other entities that people older than me will recall!

In recent decades, the big four Australian banks have dominated the debt market making it seem private lenders were usually lenders of last resort. However, regulatory changes, in particular APRA’s Prudential Standard APS 120, which required banks to bolster their regulatory capital, forced them to reconsider the type of lending they undertook, particularly where the deals were sub-$100 million. This has opened up a vast opportunity measured in the tens of billions of dollars for non-bank lenders with the specific skills needed to navigate the market judiciously and prudently for their investors.

Fast-forward to today, and non-bank lenders are reclaiming the sector. With the yield on term deposits not even matching inflation and the dividend yield on ASX stocks deteriorating, there is an obvious appeal in a tangible asset that provides a solid investment return that isn’t hostage to the vagaries of a volatile equity market.

A good yield that won't cost a good night's sleep

One big question on investors’ minds today is: 'What can provide me the yield that I need with a level of risk I feel comfortable with'? 

Assessing yield in the context of the risk that it comes with is critical, to avoid getting caught out by something that looks ‘too good to be true’. A key concept here is the ‘capital stack’. 

With listed companies, there are numerous tiers in the hierarchy of their capital, from senior secured (investment grade), to unsecured (sub-investment grade) and, then equity.  Which tier you are in within this capital stack defines your priority when it comes to being repaid.

In a private debt transaction, it's far less complex: private debt investors that have the mortgage are at the top of the capital stack, and the equity investors sit below them. Sometimes you may also have mezzanine investors somewhere in the middle. The first person to get paid though, irrespective of what else happens, is the private debt investor. If a good night’s sleep is important to you, this is where you want to be.

Consider the 'risk' in your 'risk-adjusted return'

A focus on capital preservation is part of the Lucerne DNA, and the way private debt deals are structured is in line with our investment philosophy of limited downside risk while generating strong returns through the cycle. In contrast, when you look at some of the income investments being offered to investors now, as a way of getting access to better returns and the claim of lower risk, the reality is not always well understood.

A great example would be bank hybrid notes which can pay ~4.2%, and are widely perceived as a low-risk source of yield. Yet, the regulator treats them as equity and they are the first thing to be written off if a bank gets into trouble

They also have more equity-like risk and can fall sharply in price. As an example, the NAB hybrid note went from ~$102 on a $100 par issue price, down to approximately $82 when the market collapsed in Feb/March. While they ultimately recovered, investors understandably panicked when faced with a lack of liquidity and took a 20% haircut on their capital as they exited.

With private debt investments, however, for every dollar you put in, the expectation is that you'll get a dollar at the end plus the interest promised on that dollar. 

You won’t see twenty speculators standing on the front lawn of a property naming a price that they'd be prepared to pay minute-by-minute through the term of the investment, so you don’t need to lose sleep over short-term asset price volatility. And if there were to be a major market dislocation and the asset price did actually fall, those at the top of the capital stack have priority, while it is the equity investors that would take any haircut.

Well-structured private debt deals can clearly present a compelling risk-adjusted return, so what are the risks then

The primary risk in a private debt deal is that the borrower doesn't repay. This typically happens when the debt-to-equity ratio is too high and the interest burden too steep. A high-interest rate appeals to investors. 

However, the prospect of the return of your capital, rather than just the return on your capital, should be part of the decision-making process

Well-structured deals in the private debt space tend to mitigate the interest payment risk, either by capitalising the interest upfront and then paying it to investors monthly over the term of the debt, or requiring the borrower to be sufficiently liquid to meet their interest from their own resources. 

The other risk is if it's construction or development funding, then there are risks associated with getting permits from a development perspective, and from a construction perspective that the builder remains liquid and is able to complete the project.

Some typical opportunities

As the banks continue their retreat from the market, private debt opportunities in the $10 - $50 mil range are becoming increasingly common and are potentially very rewarding. Capital can be rotated regularly and it doesn’t take too many deals like this to generate a meaningful flow of income for investors.

While there seems to be a growing number of less experienced players ‘trying their luck’ in this space, more than two decades in big banks, both on the lending and the investing side has given me the contacts and experience to capitalise on this growing opportunity. We field numerous approaches for deals - yet few pass our filters. 

The most recent deal that passed our screening process was a townhouse project in inner metropolitan Melbourne with a valuation on completion of $11.8 million, where our investors receive 7.5% p.a., paid monthly for an agreed term on the $7.5 million we provided. 

We have also recently funded a very complex SMSF structure earning our investors 12% p.a. Our experience in the sector meant we could see through the complexities and facilitate a good outcome for the borrower as well as investors. 

How to screen for the best risk-adjusted opportunities

Yet the due diligence process to get to this point is extensive and involves hundreds of hours of work and the input from many professional service providers from the network. Firstly, it is essential to have a recognised professional valuer. 

If it is a construction loan it is also essential to use a quantity surveyor appointed by the lender to review the work. They ensure the building contractor prices works fairly; reviews the progress when the builder makes progress claims; runs the physical inspections of the site; and reconciles invoices and the paperwork against the initial contract. You'd also need to do your own due diligence on the builder and ensure that they have capacity, are liquid, experienced, and able to support the project on hand.

The other piece is to look at your borrower. Who are they and what have they done in the past? Do they have a history of repaying their loans and meeting their interest obligations? If it's a corporate entity or a trust, who are the people that stand behind it? How do they operate and do they have the experience, capability, and financial depth to support the project? Obviously, you also need a solicitor to document everything.

You then have to assess what the exit strategy is for your investors. Will the borrower be selling the asset, or is there another liquidity event available? Is it going to be refinanced elsewhere, and if so, what's the likelihood of that happening? Do you feel comfortable that they'll succeed with that based on what you see today, and what's projected to happen in the future?

Over the 25 years that I've been working in banking and finance and investments, time and time again it's those who come later to the party without the experience in the particular field but have had exposure to one aspect of it, that think they can extrapolate that experience into an opportunity. They might understand the asset, but they may not understand the creditworthiness and how to assess that, and how to make sure that the return's being priced appropriately, and that the risk is understood.

Getting it right

With experience, it is quite possible to follow a defined process and use your panel of independent experts to select the highest quality private debt deals and deliver strong risk-adjusted returns for your investors.

Sitting at the top of the capital stack, investors can sleep well at night knowing that, as well as a yield of 7.5% p.a. or higher, their capital is secure in a bricks-and-mortar investment that they can drive past, and whose price is relatively stable. 

This investment profile matches Lucerne’s philosophy of limiting downside and keeping a low correlation to equities to produce outperformance for investors through the market cycle.

A different type of wealth management

Lucerne is Australia’s pre-eminent independent Investment Group, providing high net worth investors access to a family office-style service. We allocate to any investment that meets your objectives and we invest alongside you. Click ‘CONTACT’ to talk with us about our private debt opportunities. 

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This has been prepared by Lucerne Australia Pty Ltd ACN 609 346 581 a Corporate Authorised Representative of AFSL number 481 217 and issued by The Trust Company (RE Services) Limited ACN 003 278 831 as responsible entity and the issuer of units in the Lucerne Alternative Investments Fund. It is general information only and is not intended to provide you with financial advice and has been prepared without taking into account your objectives, financial situation or needs. You should consider the product disclosure statement, available by calling 03 8560 1440 or visiting our website (VIEW LINK), prior to making any investment decisions. If you require financial advice that takes into account your personal objectives, financial situation or needs, you should consult your licensed or authorised financial adviser. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital.

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Michael Houghton
Executive Director
Lucerne Investment Partners

Over a 25-year career, I've worked with ultra-high net worth investors, family offices, and property investors to provide investment advice, portfolio construction, debt structuring and lending. As an experienced finance and investment executive...

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