Want double digit returns with nearly 100% downside protection? This may be the answer

We have over the last couple of years incubated a fairly good corporate finance function in-house. We have a good team of investment professionals that being bankers, ex-bankers, analysts, and actuaries, which work with us on a day-to-day basis and provide us with necessary due diligence. The assessment in our pipeline is usually done in multiple stages.

One is high level. Do the overall metrics make sense? If you have a business which has usually zero return and you're asking for millions of dollars of capital, then you have no security available for us, then it's usually a no. Whereas you have a business and you have a historically well-defined revenue stream, income stream profits, we look at the magnitude of the debt and can we digest it.

Part of the overall assessment is making a quick call, not just for us, but also for the borrower because we can often be very quick, we know what we are looking for and give them feedback. That's what we can do. And often that means you come to us and you ask for $20 million, but we look at it and say "I think we can do 10." If you could live with 10, subject to further review, that's something we can potentially provide.

To be very honest with the businesses upfront, we also let them know what the costs are. Usually, the first conversation we have is about our range of funds range in the low to mid-teens. That's what we are charging, and we need to charge that to satisfy our investor base. So we have full transparency.

Due diligence is usually done in-house. We do a deep dive into the businesses. After we've done the first initial assessment of financial statements, we go all the way to insurance statements, to the management, investigate how the business processes work, and perform site visits. Our due diligence is to a level where I would say we have a PE-style due diligence process, although not necessarily to create an equity business case. It's more for us to be satisfied with how the business operates and where the business potentially has shortfalls.

The main focus often is the fine function. Small and low-middle market businesses often have a lack of financial proficiency in their day-to-day business. Do you have a CFO? Usually not. Do you have a director of finance? Maybe. Do you have an external bookkeeper? Yes. How does it all work? How does it all hang together? That's where we spend a lot of time and focus on how we can basically put all due diligence together. That's where we bring in specialists, we have a corporate finance function in-house. We can run numbers, we can do models. That's not a problem.

But we often, for example, in the mining space, don't necessarily have operating experience in-house. We need to bring in external consultants who work with us on various projects. This helps us to link our conceptual understanding of the business, the numbers presented, and the documents presented, to the actual operational part. In mining, for example, this is a quite unique skill and is very experience-based.

Overall, it's usually a quick process, but it's only a quick process if you can work with a borrower. Some borrowers are very good. We had an example with small transactions of $3-5 million, which added up to 10 in the end, in which there was a fantastic flow of information. Where borrowers can get stuck, and where we get stuck is when the flow slows down or borrowers are unprepared. Part of the journey is also the understanding of "Do you have this information at hand?" Because if you don't, then I think you may not be prepared for us to provide capital.

LW: What return can investors expect from the fund?

We are in a time, not just in Australia, but on a global scale where the investor community is shifting towards private debt. That is your wholesale investor, your individual in Australia. That is your Australian superannuation fund, that's your US pension scheme. That's your Korean investor, that's your Chinese investor, your family office.

Expectations on the investor side are always double-digit. That's what we have to deal with, meaning we have to make a double-digit return when borrowers take our fee for deploying and managing capital. What it means for borrowers is that traditional single-digit lending may not exist anymore. In some circumstances it probably still does, but looking into the private debt space, the small low-middle market, it'll be tricky to write a ticket or provide funds to borrowers in the single digits. The rate has moved up over the last 12 months. Interest rates have been rising, and are still rising, which has potentially made borrowing more expensive.

LW: What risks do these investments carry?

The risks in our investments and loans are limited in the sense that our focus is on downside protection. We could write much more business. If you would accept the fact that in a downside scenario, you don't recover 100%. You may recover only 50. That might be a valid scenario at some stage. At the moment it's not for us.

Our focus is on full recoverability. If you find that, not just due diligence, just in a downside scenario, which we always run. Most of our time, rather than reconfirming financials, understanding operational processes and whatnot, is spent on understanding "how would the business perform in a downside scenario?" And the downside scenario for every lend we are doing is quite unique. It depends on the borrower, it depends on the circumstances, depends on how the borrower operates.

If we try to recreate scenarios, with COVID in mind, what happens if we have another pandemic? How would the business respond? Usually, you see an impact, a negative impact, but does the negative impact break the bank? That's the question. And what does it mean for the investors?

Often a negative impact might be an event where we have to reset pricing, which the investor might see as, "look, it's still a good borrower". The borrower might be a bit lower in terms of the quality they then present, but the pricing reflects that. In this regard, double-digit pricing. That's what you would expect from borrowers, to go with the risk you're taking.

The question obviously is; if you compare our loans here in Australia to other loans around the world, most of our loans are asset-backed. There's some hard security there which you can liquidate. Not necessary property. That could be equipment, that could be all sorts of things. That could be shipping containers, you name it. Something you can liquidate, not necessarily tomorrow, but in two or three months. That's something that forms part of the assessment and the risks you're taking.

Looking into the US, and Europe, you may see there are a lot of businesses that are pure cashflow lends. And the senior secured nature is only on the security of the cash flows you have. There are no businesses. There are no assets on the business. They're only cash flow. Here we would probably say, "Look, what we are doing, you actually have the asset base. You can liquidate and you should recover 100 cents on the dollar."