Return of capital isn’t the same as return on capital

In our latest quarterly investor letter, I reflect on a subtle but growing risk I’m seeing across parts of private credit markets: accepting inadequate compensation simply because capital appears well protected. 

While capital preservation remains the first rule of credit investing, I argue that it is not sufficient on its own. Avoiding losses does not automatically make an investment a good one. I outline what I see as the “second rule” of credit investing, and explain how we structure portfolios at MA Financial to maintain pricing discipline as private credit continues to mature.

Today, we do not see widespread examples of reckless lending that are likely to cause immediate or systemic losses. Underwriting standards have not collapsed. Balance sheets of banks and non-banks are generally more robust than they were in prior cycles. Over the past two decades, private credit has evolved from distressed and opportunistic lending into predominantly performing credit, often in areas where banks are no longer the efficient source of capital.

These market conditions require discipline of a different kind.

What we are increasingly observing is not a disregard for downside, but weaker pricing discipline. In some parts of the market, too much capital is chasing too few genuinely attractive lending opportunities. Yield compression is being justified by the comfort that loans are senior, secured or asset-backed, and unlikely to result in principal loss.

The implicit conclusion is that if the return of capital appears secure, then the return on capital matters less.

That’s wrong. You can avoid losers and still make bad investments.

This is where the second rule of credit investing comes into play.

Rule #2

Warren Buffett famously says: “Rule #1: Don’t lose money. Rule #2: Don’t forget rule number one.”

I’d propose a variation on these two cautionary rules, tailored for the world of credit:

• First rule: Don’t lose money;
• Second rule: Don’t accept inadequate compensation for risk simply because the first rule is likely to be satisfied.

Accepting poor pricing because ‘nothing will go badly wrong’ is not conservative. It mistakes comfort for discipline. It results in capital being allocated to assets that are structurally sound, but economically inferior to other alternatives.

This distinction matters at all points in the cycle, but it is most often forgotten after periods of strong performance.

Instances of default or spectacular loan blow-ups grab headlines. While there are a few outliers, mainly niche operators, it’s our observation that most major lenders and substantial managers in private credit have done a pretty good job avoiding these situations in the current market.

What we’re more concerned about at present is the prevalence of loans that quietly deliver inadequate compensation for the risks embedded within them, while tying up capital that could have been better deployed elsewhere.

This is how disciplined portfolios gradually lose their edge.

The error is rarely dramatic. It is incremental. It is rationalised away by comfort. But it erodes the returns that investors should expect for putting their money to work and for paying their manager.

Yes, the philosophy of avoiding losers, not picking winners has continued to serve us well. However, we are also carefully attuned to ensuring that we earn our clients an attractive relative return, compared to other homes for their capital. They should earn a compelling premium for being in a fixed income alternative product.

Why structure matters as much as philosophy

At MA Financial, we have deliberately designed our GCS platform to reduce the probability of making these mistakes.

First, we’re not a monoline credit manager.

Being able to invest across asset-backed lending, direct asset lending and corporate credit matters is a real advantage. Relative value shifts. Opportunities rotate. Pricing discipline varies by segment. A manager that can only do one thing is often forced to do it – whether the risk-reward is compelling or not.

Second, we maintain a clear separation between investment and portfolio management.

Investment teams are naturally focused on sourcing opportunities, structuring deals and managing credit positions. Portfolio teams are focused on credit strategy, portfolio construction, risk management, treasury and liquidity dynamics. These groups collaborate, but naturally debate. That tension is healthy to ensure we are delivering the right returns on our clients’ money.

In stable markets, the most dangerous phrase in credit is: “This won’t lose money.”

One of our core values is being ‘co-creators of value’. In private credit, we do this by the firm and staff co-investing with our clients (now about $230 million in our underlying portfolios). With our own capital at stake, we care deeply about ensuring the returns we generate are compelling.

When assets are sourced through competitive auctions, pricing discipline is often the first casualty.

‘The return on my money’

The return on your money needs to be attractive, or at least adequate, for the risks taken within the credit portfolio that generates your income return.

Private credit has matured into a US$3 trillion industry focused on performing credit and continues to march towards a US$5 trillion market by the end of the decade.3 It will continue to be an important source of real-world economy financing as banks further rationalise balance sheets and banking prudential frameworks remain tight.

That is why transparency and disclosure are essential. Investors should be able to understand what’s under the hood within their portfolio to assess whether the compensation they are earning is appropriate and sufficiently attractive.

Visit the MA Financial website for more insights.

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