We regularly respond to due diligence questionnaires on our private lending capability. Here we have put our portfolio managers in the hot seat and asked them to provide us with a list of questions they would ask if they were reviewing a potential manager and why. Here’s what they came up with.
1. Do you mark your portfolio to market?
This question is key for several reasons. One, it’s extremely difficult to compare a manager who does mark-to-market with a manager who doesn’t. Secondly, if a manager doesn’t mark-to-market (and we mean properly- incorporating change in credit risk at both a market and security level), it is extremely difficult to risk-adjust for the returns generated; you basically need to wait until a sufficient number of loans repay. Lastly, marking-to-market, or fair-valuing your portfolio is an important discipline for portfolio managers too. It forces the manager to consider the environment they are in and to price appropriately for risk. If a manager isn’t marking-to-market, then it is important to understand how they price for risk.
2. OK, but seriously- do you really mark-to-market?
Many managers say they mark-to-market but don’t actually do it. A stable NAV through time is a sign that the manager is not actively revaluing their portfolio and this can be problematic, especially within open ended funds where there may be a wealth transfer from entering unitholders to existing/exiting unitholders. Pushing a manager to illustrate their approach to valuation with real live examples is a good way to assess this.
3. How can I compare the risk profile of your lending versus other strategies?
If a manager is not marking their portfolio to market, performance can seem great in the good times with stable income and low volatility. But when market conditions deteriorate, you may find that the manager has been taking on far more risk than you had anticipated(i.e. you may see defaults pick up more than anticipated). This is where credit ratings come in – properly assigned (either by an external rating agency or independent internal group) they can provide an objective measure of risk of a strategy at purchase, not at maturity.
4. How are you as a manager compensated?
Low management fees can be an indication that the manager is compensated elsewhere for their work. Private lending is labour intensive and by implication negotiated. Look for leakage of economics through upfront fees, amendment fees, workout fees. Non AUM based fees may create agency risks between manager and client that are difficult to control.
5. What is your track record through a credit cycle?
This goes to the point of assessing a manager’s performance and how important proper valuations are. If they aren’t marking-to-market and don’t have an objective measure of credit risk, they had better have a long history of managing through a credit cycle. The GFC is one of the greatest data points available to asset owners and it doesn’t get used nearly enough.
6. What happens if something goes wrong with a credit?
In private lending, the valuation creation is in the front end (i.e. originating great deals at attractive levels) and the back end (maximising recovery when things go wrong). Banks have learnt that it is crucial to keep these two roles separate in order to manage the inevitable conflicts that can arise. Many private lenders do not and it is inevitably the recovery that suffers.
7. Who handles workouts in your team?
Another important governance and resourcing question. Workouts are very labour intensive but one of the most important marginal use of resource there is. Teams that have independent specialist workout areas recognise this fact and have prioritised for the worst. Teams that don’t are simply hoping for the best.
8. Tell me about a deal that went wrong?
A lender that doesn’t have a case study of where a loan went wrong is one of these: 1) very new (no track record); 2) very dishonest (they have a case study, they just don’t want you to know about it; 3) very lucky. It’s rarely the last one.
9. How do you take impairments on underperforming assets?
If a manager doesn’t fair value their investments, then they should be provisioning under the IFRS 9/AASB 9 accounting standards. This means when a credit deteriorates, an impairment should be taken for the full expected loss over the life of the investment. Often the approach to taking impairments is arbitrary and highly subjective and this is a recipe for being over-valued/under-reserved as a credit deteriorates.
10. How many credits covered per analyst?
Private lending is labour intensive. For the most part you can’t rely on public information so the analysts need to source information themselves, either through direct communication with the company or via other secondary sources. One analyst cannot cover 40-50 credits as is the case in public markets. In our view, up to 15 is defensible, ideally, it is closer to 10.And covering a credit is only part of the story; on top of that you need all the additional origination, portfolio construction, workout and transactional support. You need a big team to do it.
11. Can you invest in different parts of the capital structure for different funds?
In general investing in different parts of the capital structure across different strategies should be verboten, due to potential conflicts of interest, except in limited circumstances. Examples of these limited circumstances are those areas where the different parts of the capital structure have very limited rights/influence. These may be mezzanine tranches in securitisations or minority stakes in a large senior loan with no influence over pricing, amendments or restructures.
12. Can you share your portfolio?
It’s a trick question! If the manager is acting in the private space, the deal was likely done under an NDA and contains non-public information. At a minimum, consent would be required from the borrower. Beware the manager that discloses their entire portfolio- it is extremely unlikely that they received consent so they are likely breaching the terms of the NDA. While this may seem minor, it raises important questions around the manager’s attitude to governance.
13. How important are covenants?
Covenants are not a virtue unto themselves and beware the manager that suggests they are. Underwriting a private loan is not a tick the box exercise; the beauty of the private lending market is that loans can be specifically tailored for the borrower – not every loan needs a leverage covenant.
14. Is it better to be a big fish in a little pond or a little fish in a big pond?
Scale matters in private markets and this manifests itself in access to deals and in returns – most clearly through upfront fees. The larger players originate deals directly rather than through an intermediary and by virtue of this can negotiate upfront fees which are 1-2% better than smaller competitors. Scale also gives you a seat at the table to negotiate terms and conditions as well as a wider funnel to filter deals because you get the first call. Depending on the market this can be worth a lot. The value creation that comes simply from being the “big fish” can offset any perceived negatives from the “smaller pond”.
15. Why does a borrower come to you?
A private lender should know what their value proposition is. Does the lender provide size and certainty of execution? Is it flexibility in terms/mandate? Expertise in a niche sector or geography? Is it price? Hint: it is almost always price (and sometimes one of the other two).
16. How do you approach ESG investing in private markets?
In public markets, there are many eyes holding the management of a business to account. Equity analysts, rating agencies, journalists, investment managers all watching a business closely. In private markets, especially where a sponsor is not involved, there are only the lenders. To an even greater extent than in public markets ESG analysis starts with the G.
17. Public markets are selling off. How does that change your approach in private markets?
Private lenders ignore public markets at their peril. Public markets give real time indications of financial conditions. If a private lender is not increasing pricing during a time of public market stress, they are not paying attention.
18. What’s your approach to portfolio construction?
Private lending strategies are origination led and this can create unique challenges for portfolio construction; i.e. what do you do if the last three deals you saw were in the education sector? A real risk is that the manager actually just ignores the portfolio construction question altogether and ends up highly concentrated in a small number of sectors.
19. Who is your main competition?
In Australia, investment managers are dwarfed by the banking system. If a manager does include a bank in their list of competitors, then they are operating at a different risk level. Make sure they (and you) are getting paid for it. Getting a manager to talk about their competition away from banks can also give you more insight into exactly where a manager is positioned in the market in terms of size, sector and risk profile.
20. Who handles documentation of the transaction?
In privately negotiated transactions, documentation is crucial. It is bespoke which means you cannot invest off a term sheet or a previous transaction. Every deal needs review. This requires specialist legal and tax resources. Does the manager have them in-house or do they rely on lenders counsel who acts for all investors?
21. Can I see an investment paper/credit memorandum?
There’s nothing like finding out if a manager who has been talking the talk, is walking the walk.