The investment game has changed. Here's what you need to know

Once upon a time, the world of private credit was one purely restricted to institutional investors. Times have changed, however, the space has opened up, and it couldn't have come at a better moment for investors

To quote legendary investor Howard Marks:

"Thanks to the changes over the last year and a half, investors today can get equity-like returns from investments in credit."

One of the changes referred to is quantitative tightening - a normalisation after a decade of easy money and virtually non-existent interest rates - creating a market reset. There's also a structural shift taking place, with more companies staying private for longer, listing in their prime rather than in earlier stages.

Marks also argues that investors should be considering credit instruments as a substantial portion of portfolios today. 

While Marks might have been referring more broadly to the global credit space, there's equally much to be excited about in the Australian market. 

Justin Lal, managing director at Keyview, concurs with Marks’ views and sees a lot to be excited about in the Australian market, pointing to a range of factors unique to the Australian market for its appeal. He also focuses on an aspect of private credit that is underserviced - opportunistic credit - making it a sweet spot for the Keyview team.

In a recent interview, Lal discussed the Australian private credit market, why he likes opportunistic credit, and the key criteria Keyview looks for in deals.

The trillion-dollar opportunity

Private credit has grown exponentially in recent years. One aspect of that has been regulations on the banking sector, which has opened the space to non-bank lenders. Another is Australia’s legal framework, which is creditor-friendly.

The changes in banking regulation have been a significant driver of the space. Lal estimates that the major banks had 90% market share of the total lending space in the lead-up to 2017.

"If you compare that to other developed countries, such as the US and UK, major banks only control 30-50% of total lending markets with the balance in bond markets and private markets," says Lal.

The tighter lending requirements on banks opened a gap for alternative lenders in this space - after all, demand hadn't dropped off and has only grown.

Currently, the Reserve Bank of Australia notes that 15% of loans to SMEs and middle-market businesses are provided by non-bank enterprises, like Keyview. The RBA tips further growth in this space, and particularly fuelled in the secondary market.

The need for capital has attracted international lenders too - after all, Lal points out our legal framework is one of the best in the world. It offers lenders confidence in their ability to hold borrowers to the terms of a contract.

Alongside this - and referring back to Marks' point about the returns on offer - Lal notes that investors increasingly see the potential in private credit.

“Private credit is also growing in popularity as a high-yielding investment in a rising interest rate environment,” said Lal.

He expects ongoing economic adjustment to higher for longer rates will see investors continue to turn to private credit as a staple in their alternative asset allocations. Lal also suggested that what we see in terms of transactions today barely scratches the surface.

“We believe the overall market size or opportunity for private credit is in excess of $1 trillion and our estimate is that there’s only around 20% penetration of that to date.”

The sweet spot in private credit

With an enormous addressable market to pick from, Keyview focuses on opportunistic credit, also called "special situations investing". 

It still involves lending money with the expectation of a contractual return but is a niche aspect of private credit.

“Opportunistic credit is usually defined by a situation where we see one or more of three characteristics. 

Complexity in terms of business structure or technical requirements of underlying assets. A bespoke solution, and the need for capital in an expedited manner,” said Lal.

The idea of a more complex business structure or asset may seem like an unusual choice, but Lal is clear that it's about seeing opportunities others may have missed. It can also result in a better credit opportunity than a more straightforward deal because it puts off the competition. Less competition can offer the ability to set more favourable pricing terms.

“Complexity does not mean riskier. It just means more time and effort to resolve and the result is more tailored protection, which can be less risky than traditional private credit,” he said.

Combining the three characteristics often puts off competitors because it is resource-intensive. The upside of that is greater pricing power, with Keyview having a greater ability to negotiate loan terms.

An example of this occurred within the last month, in a transaction Keyview closed with a large and well-established Australian industrial company. The deal had a complex capital structure, and the added complication of some negative publicity, which put off competitors trying to price risk. 

Keyview provided a senior secured loan against the company’s most business-critical assets. Keyview's team has also structured a tailored financing package to cater for the capital structure complexity, and is being paid a double-digit return in exchange.

“We have security over the business, and the valuation of the assets and the business has a consistent long-term earnings track record. The combination of these is multiple times larger than the size of our loan. The level of recovery we can lean on against our investment is around 5-6x our loan,” said Lal.

Why size is also a competitive advantage

Keyview focuses on mid-market lending for opportunistic credit – deals less than $100 million, particularly deals to be between $20 million and $75 million. The team typically closes up to 20 transactions a year on this basis.

Just as competitors are put off by more complicated and niche opportunistic credit situations, deals under $100 million can also be a dealbreaker for them. Often as not, major banks won't even look at this space.

“The majority of special situation lenders are offshore funds or investment banks using their balance sheets. They typically have a minimum transaction size of $100 million. They won’t look at something below that, so it’s less competition,” said Lal.

The lack of service means that Keyview can be highly selective - there's a greater variety of deal types across multiple sectors and less competition. Keyview is able to not only focus on the best quality credit opportunities in any sector, but structure the contracts around these more favourably.

While deal size is something that Keyview factors, they are sector-agnostic - meaning they will invest in companies regardless of sector, providing Keyview determines the company is high quality and worthy. It also allows flexibility: as Lal notes, he doesn't need to stick to certain sectors if he thinks they are in for tougher climes.

“We are a sector agnostic provider, which can give some inherent diversification and also allows us to see where the best risk-adjusted returns are and to switch, based on market activity, rather than be constrained to one area,” Lal said.

The non-negotiables for loans

The nature of opportunistic credit requires Lal and his team to be flexible and tailored in their approach to assessing a loan, but there are a few things he never compromises on.

“Quality underpins everything that we do and we will not go ahead with an investment where we believe there is risk of a capital loss under a severe downside case,” he says.

“We will look at all the potential things that can go wrong and balance this against other protections and mitigants we can put in place to protect against capital loss. We will always prioritise managing risk over simply chasing return,” says Lal.

It’s a different approach to a traditional credit lender who can focus on where they are in the capital structure and base decisions of risk and reward on that. Keyview considers the risks of the asset itself.

The binary approach to risk creating additional opportunity

Part of Keyview’s investment philosophy involves looking for market inefficiencies, and unsurprisingly, it sees opportunity in the challenging macroeconomic environment.

One of the most prominent of these is that banks and even some private lenders are taking a more binary approach to reducing risk. They’ve reduced the amount of money available regardless of the quality of the underlying company and apply this rigorously.

“Some good quality companies and assets are being painted with the same brush as lesser quality companies and can’t raise the same capital that they otherwise could have in traditional courses of funding," Lal said.

"We’ve seen many examples in the last 12 months where we’ve been able to take advantage of that pullback, and this means we end up lending to high-quality companies. 

We put a low-risk capital solution in place but we’re getting a higher return premium compared to the pricing from some of the banks."

Lal shared the example of an energy company he dealt with under a year ago. Its existing lender could not provide additional growth capital, even though that capital would increase earnings, because of the technical risk associated with the capital expenditure. 

Keyview was able to fund the transaction and take equity in the business as well. Lal anticipates the internal rate of return from the debt and equity in the business is likely to be in excess of 20%, for no greater risk than banks generating a 6-7% return.

Another inefficiency comes from out-of-favour sectors with good businesses.

For example, the team is currently working on due diligence for an established company that provides consumer loans. In a challenging economic environment, many lenders would have concerns over the ability of consumers to repay their loans to such a company and view it as a higher risk.

Lal views this business as having a diversified customer base with substantial equity behind it and a robust framework for lending to consumers. But he is also considering at what point there’s a substantial risk to Keyview’s loan being repaid.

“We think that if the company’s losses were to increase 3-5x higher than what it is at the moment, we’d still be able to get our money back,” he said.

Lal will walk away if he sees a real risk of loss, but at this stage, he sees the opportunity for negotiating better credit protection than market terms due to the lack of competition from other lenders.

The bright side of quantitative tightening

Investors have spent much of the past year trying to manage rapidly rising interest rates and tighter monetary conditions in their portfolios. While we've seen a resurgence in public markets fuelled by the AI trend and tech stocks this year, the opportunity set in markets has changed and as Marks points out, credit has come into its own. If there's an unexpected silver lining to those higher interest repayments, it might be the emergence of a viable alternative to public equities.

Taking a step further, perhaps now is the time to rethink traditional views of opportunistic credit. Lal notes that with a careful approach and the right selection of opportunities, you can manage risk in ways you might not see in other parts of credit, let alone in the public equity space. With $1 trillion addressable market, it might warrant a closer look.

Open the door to new opportunities

The Keyview Credit Opportunities Fund is currently open for investment and is available for wholesale investors. For further information, please visit the Keyview website.

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