Stable and steady wins the race

Patrick Poke

Livewire Markets

With equities haring away, it's easy to turn a blind eye to the stable and steady tortoise in your periphery.  But a defensive play, one with strong diversification to public markets, may be just what your portfolio needs. 

Private debt is one such tortoise, providing investors with the capital stability and yields of around 4-5% (plus cash) to build out the defensive allocation within their portfolios.  

Private debt investments derive income from floating rates which change in line with the RBA's cash rate, unlike fixed rate bonds. As such, they can also provide investors with an inflation hedge.

In this wire, Revolution Asset Management's Bob Sahota shares the opportunities he believes that private debt investors can exploit in the wake of the COVID-crisis, as well as the sectors that he believes may continue to be impacted in its fallout. 

When we last sat down with Sahota in June, he highlighted three significant risks facing the private debt market, including:

  1. The partly completed construction of residential areas and higher vacancy rates;
  2. Doubts surrounding a recovery in physical retail; and
  3. The impacts of WFH on commercial office buildings.

So, do these risks remain? Are there any other alarming trends emerging?

The risks that we highlighted in June have not entirely diminished as we approach the year end. While the housing market as a whole has proven to be quite resilient throughout this year, we remain cautious on the apartment sector. 

In apartments, we believe there is a high risk of oversupply and rental market weakness going forward. This is due to a very large pipeline of new apartments that were being constructed in the lead up to the pandemic. The private certification of newer apartment developments and issues surrounding flammable cladding also leads us to remain cautious on this market.

What's your view on other sectors within private debt market? 

The retail sector appears to have experienced a strong rebound following the reopening of state economies and the relaxation of stringent restrictions. As consumers are unable to travel overseas, domestic consumption is expected to return, assisting retail sales both in physical stores and online. 

We remain very constructive on well-established non-discretionary (grocery-based) retail centres that have a dominant position in their local area catchment. In real estate, we also favour well located industrial property with leases to sound corporates with longer lease terms and commercial offices with long and high credit quality tenants. 

The commercial office market, however, is yet to fully readjust to the post-pandemic world. On the one hand, more employees are favouring and are willing to work from home, which reduces centralised office demand. On the other, there is a requirement for greater distancing between each employee, increasing floor space requirements. 

The final outcome will very much hinge on whether an effective vaccine can be rolled out for office demand to be accurately predicted over the medium- to long-term. 

At Revolution Asset Management, we remain patient in assessing any opportunities in the commercial real estate segment and maintain a high degree of discipline to support only the highest quality opportunities.

When we last spoke, you highlighted the importance of your investment process, with a particular emphasis on not being forced to sell prematurely. Could you unpack this process for our members and highlight the key red flags they should look out for within private debt markets?

The Australian and New Zealand private debt market is essentially illiquid in nature. As such, this necessarily compels lenders to adopt a ‘buy and hold’ investment horizon to the asset class. 

In establishing Revolution Asset Management, it was a key imperative to launch funds or products that are fit to invest in these illiquid assets. It's important that investors clearly understand that their investment horizon is medium- to longer-term in nature; in order to harvest an illiquidity premium from private debt investments. 

In our view, fund structures must be consistent with the underlying investments. However, we have witnessed many instances where investment managers have offered daily liquid funds with investments in illiquid assets. 

During periods of market stress or dislocation, these funds have to impose lock-ups or have to significantly widen sell spreads to stem the redemption tide. Whereas we had very minimal redemptions throughout the pandemic as the structure of our products stated limited liquidity provisions, which are clearly articulated to all prospective investors. 

What is your process in originating new investments? 

The investment team have extensive, long-standing and market-leading relationships with bank originators, key sponsors, advisers and intermediaries, which provide access to quality deal origination pipelines.

The higher capital regulations imposed on banks in our chosen areas of investment focus provide significant opportunities to source high quality loans and asset-backed securities.

In sourcing transactions at the initial screening phase, we adopt a relative value analysis model in evaluating all proposed investments in the context of other possible investments with similar risk characteristics across different markets, sectors and geographies - with the aim of maximising return while minimising risk.

Assessment of ESG principles are applied at the sourcing stage to ensure that all proposed investments are consistent with our ESG policy. Top down macro filters are applied to assess sector appropriate leverage for an investment. This means that highly volatile sectors, such as mining and media/advertising, can sustain much lower levels of leverage than sectors such as infrastructure and consumer staples, as an example.

Given the RBA’s commitment to holding interest rates at record lows and deploying QE, in tandem with continued fiscal stimulus from the government, what impacts do you see this having across credit markets?

The RBA’s commitment to holding interest rates lower for longer, as well as considerable fiscal stimulus, has been very welcome for the economy and indeed credit markets. This concerted effort has essentially provided much needed ‘breathing room’ for individual consumers and businesses alike, helping them to remain viable throughout the worst period of the pandemic. 

Lowering interest burdens through lower rates and providing short-term payments by way of JobKeeper have had a significant impact on allowing individuals and businesses to maintain their financial obligations through the COVID-19 period. While this has been a welcome relief for the lending markets, it will be interesting to see the final outcome when these stimulus payments come to an end in March 2021. 

There will inevitably be businesses and industries that will be negatively impacted – particularly the more cyclical businesses like retail, tourism, mining, property development and advertising. 

At Revolution Asset Management we have favoured to lend to more stable industries like consumer staples, mission critical software, infrastructure services and healthcare, where the ability to withstand downturns and recession is far greater.

With economies reopening and lockdowns easing domestically, are there any new opportunities that appear compelling to you right now?

In the current environment of rising business and consumer confidence after a long period of restrictions, we expect there will be a significant rebound in consumer spending. This is expected to lead to strong retail sales, domestic tourism, and auto and real estate sales aided by historically low interest rates. 

At the same time, banks are being subject to ever-increasing and onerous regulatory capital requirements, which is expected to generate a period where non-bank lenders gradually gain higher market shares from banks. Revolution Asset Management views this as an opportunity to assist in funding these non-bank lenders through private asset-backed securities transactions across a wide array of lending products, such as mortgages, auto loans, credit cards and personal loans.

In addition, with an excess of $13 billion in ‘dry powder’ raised by private equity firms to be deployed in Australia, we anticipate a strong year of M&A transactions ahead. 

This will provide us with a strong pipeline of opportunities to provide senior secured funding for these acquisitions as a syndicated lender alongside other lenders.

You have also previously mentioned your willingness to buy from distressed sellers at deep discounts. Have you had any of these opportunities come up of late?

There were a number of opportunities that we were able to seize in the most COVID-19-affected markets in March and April from motivated sellers of otherwise high-quality private debt investments. However, as a result of the concerted fiscal and monetary policy stimuli from developed market economies this sharp dislocation was relatively short-lived. 

Consequently, we have not purchased many deeply discounted investments more recently. However, we have witnessed the illiquidity premium for Australian and New Zealand private debt investments widen by 1% to 1.5% in yield compared to pre-COVID times. This has been as a result of fewer active participants in these markets post-pandemic. As a result, our investors have enjoyed a significant increase in performance for the same risk and tenor assets.

Finally, and with a post‐COVID world in mind, what is your outlook for the Australian economy and our major trading partners; the US and China? 

Australia and New Zealand have proven to have the most effective responses to the pandemic, with the two economies returning to somewhat 'normal' conditions. The key difference, however, is that international borders remain closed and are not anticipated to reopen until the latter half of 2021.

In this environment the Australian and New Zealand economies have proven to be very resilient, with a strong rebound witnessed after stringent lockdowns and the successful suppression of the pandemic. Business and consumer confidence are at all time highs, with GDP in the September quarter reaching 3.3% after a slump of 7% in the two previous quarters. 

After some dire predictions on house prices were made in the midst of the COVID-19 crisis, most economists have now pivoted to be constructive on the sector, with predictions of strong gains expected into 2021.

However, the biggest threat to the Australian economy is the heightened trade tensions with China; Australia’s largest trading partner. Sectors such as mining, agriculture and tertiary education rely heavily on China. In addition, the closure of international borders has curtailed net immigration for the first time in decades. These effects will mean that the Australian economy is set to face some challenges in 2021 and beyond.

For this reason, we believe that in this environment, it is important for a private debt manager investing in Australia and New Zealand to remain very disciplined and to avoid cyclical sectors and industries that are prone to distress in the event of a future downturn.  

Looking to learn more about the role of private debt in a balanced portfolio?

Defensive, capital-protected, private debt is becoming increasingly appealing to investors as a viable asset class for a number of reasons. Unlike many assets, this strategy generates income through market cycles and it can provide diversification away from the publicly listed, big-four Australian banks and broader market movements.

For more information visit the Revolution Asset Management website or send an enquiry using the 'contact' button below.

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1 contributor mentioned

Patrick Poke
Managing Editor
Livewire Markets

Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.


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