The Benefits Of Private Debt Investing

May 7 2015 | 10:43am ET

Jeffrey Haas is chief operating officer of Old Hill Partners Inc., an SEC-registered investment adviser focused on asset-backed lending transactions and alternative investment management. The Darien, CT–based fund was founded by CEO John Howe in 1996 and offers customized lending products to small to medium size corporate borrowers. Old Hill has funded approximately $600 million in asset-backed lending transactions, and has approximately $500 million in assets under management.

Before joining Old Hill, Haas was COO and co-portfolio manager of Juniperhill Asset Management, portfolio manager for Centrecourt Asset Management, and co-managed proprietary trading in illiquid investments and structured lending products for CIBC. Hass recently spoke with FINalternatives’ Steven Lord about private debt investing and the benefits it can bring to investors.

Tell us about Old Hill Partners.

Our primary strategy is asset-backed lending, or secured private debt transactions created in tandem with small to medium size corporate borrowers seeking growth capital. We have other strategies involving aircraft and real estate finance and a quantitative absolute return trading model, but the lion’s share of our work involves private debt that is for the most part senior secured.

Private debt seems to be everywhere these days. What’s the draw?

The asset-backed lending space is attractive right now for two reasons. First, the low-yield environment naturally makes structured private transactions, which typically yield several hundred basis points higher than comparable traded credit instruments, popular with investors. Secondly, these transactions usually generate uncorrelated absolute returns with low volatility and an emphasis on capital preservation, so they’re attractive from a portfolio management perspective as well.

Hasn’t the market for lending shifted significantly since the financial crisis?

Absolutely. In fact, the changes in traditional lending are partly responsible for the growth in our business. Since the financial crisis, stricter regulatory requirements, increased risk capital ratios, and the increasingly poor economics of lending to small-and medium sized businesses (SMEs) have discouraged many of the large money center banks from lending to them.

Yet at the same time, the economic recovery has meant small to medium sized companies need capital in order to grow. This combination has opened up a particularly attractive niche for companies like ours. Finally, I think the macro environment for credit formation is very attractive. Very low yields available from traded credit instruments, decent economic growth, and low default rates translate into a generally positive risk-reward profile for lenders like us.

How do you address risk?

Proper management of risk is the name of the game in this business. It’s the cornerstone on which we can build consistent, above-average returns. We can’t control benchmark yields, but if we do thorough due diligence and lend at a proper loan-to-value ratio, we can minimize default risk. We have an extremely disciplined risk management process developed over decades of experience in the asset-backed lending business.

We put each issuer under consideration through an exhaustive due diligence process, and perform comprehensive risk modeling on the transaction. Our goal is to ascertain our true exposure under a variety of potential scenarios. Only when we are comfortable with the protection of our capital will we proceed, regardless of how attractive the potential return might be. This discipline is the foundation of our whole approach.

What does your typical transaction look like?

From the outset, each transaction is designed with absolute return and capital preservation in mind. Over the years, we’ve learned that a particular set of transaction characteristics represent a sweet spot of sorts in terms of risk versus return. Generally, we want borrowers to have capital at risk in a transaction, so our interests are aligned, and we look for management teams that have experience in the business they are running. We also tend to avoid transactions with potentially binary outcomes. Our transaction are normally structured with annual coupons of 8% to 15%, maturities of one to four years, loan principal below $25 million, and loan-to-value ratios ranging from 35% to 85%. Many also include origination fees, and we will occasionally take warrant coverage or other downstream equity participation if we particularly like the company, its principals, and its prospects.

From there, each Old Hill transaction is anchored on collateral analysis. All our transactions are secured by identifiable hard and/or financial assets, senior in the capital structure of the issuer, and built with self-liquidation in mind. We fully understand the value and the liquidity of the underlying collateral backstopping a loan facility before we enter it, while low loan-to-value rates help ensure that should a problem arise, our capital is more than likely recoverable.

Finally, we mitigate interest rate risk by usually structuring each deal with floating rate coupons with a floor. For us, the trick is accurately determining the sufficiency of our collateral coverage, while consistently ensuring transactions fit within a discrete set of criteria that delivers the greatest risk-adjusted return.

What sort of investor is drawn to your strategy?

The Old Hill Asset Income Strategy is especially applicable to insurance companies, pensions and foundations, since they generally have long-dated liabilities for which longer-term, illiquid assets are a good fit. Additionally, high net worth individuals, other hedge funds and institutional investors can benefit from what we’re doing, since our strategy is anchored on capital preservation and above average yield, both of which can be hard to come in the current investment landscape.

Investors in this space know that success in the private debt market depends on manager selection. There is no one-size-fits-all, plain vanilla approach – the manager must have a robust process of deal origination, structuring expertise, transaction execution and monitoring capabilities. And they must be fanatical about risk mitigation. We are all of the above.

Why concentrate on small and medium-sized businesses? Aren’t bigger loans to bigger companies better?

Not for us. Larger companies have greater access to capital since the larger loan balances create more competition from traditional and alternative lenders, resulting in lower yields than those to which we are accustomed. We like SME’s because we can understand them and their businesses. Finally, the regulatory constraints mentioned earlier are such that this segment simply offers the most compelling opportunities.

It’s hard to overstate how important these smaller businesses are. They account for nine out of ten companies globally and roughly half the U.S.’s annual GDP. SME’s generate the lion’s share of U.S. economic growth and over 60% of net new job creation. Yet paradoxically, it is precisely these firms that are being shut out of traditional lending. The old saying about the bank being happy to lend you $500,000 if you have $1 million in the bank has never been more apt.

What are your thoughts on the macro environment? How will rising interest rates affect Old Hill’s private lending strategy?

First, we think the economic foundation underpinning U.S. businesses will remain strong, especially within the SME segment in which we operate.

Secondly, we’re not convinced the Federal Reserve will start normalizing interest rate policy this year. A 2016 date is more likely, given what’s happened with the dollar. At the same time, the collapse in energy prices will start to percolate through to SMEs by the end of this year, which should improve the operating environment even more.

Thirdly, upticks in benchmark yields, when they come, will happen at a measured pace. For the foreseeable future, this means fixed-income investors will remain interested in products that generate significantly higher risk-adjusted returns, uncorrelated to other asset classes, that don’t carry mark-to-market risk.

Finally, the benefits of private debt investing are fairly evergreen. We’ve been doing this for a long time, through rising and falling rate cycles and everything in between. Private debt managers like us offer investors stable income in the form of current, floating-rate coupon payments from very transparent, thoughtfully structured transactions. If we’ve done our job and our homework, these transactions result in returns that tend to be less volatile and higher than their public market equivalents. Done correctly, private debt should be an integral part of every investor’s portfolios.

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