Q&A: Old Hill's Stone On Private Debt, P2P And Credit Bubbles

Jun 6 2017 | 7:52pm ET

Editor’s note: While institutional capital continues to flow into the broader private debt sector, concerns about a bubble forming in the market for structured transactions with small- and medium-sized businesses are overblown, says Old Hill Partners portfolio manager Pat Stone, and the segment continues to offer a compelling yield premium over comparable traded credit instruments. In this interview, Stone shares his thoughts on the advantages of selectivity when originating transactions, the impact of peer-to-peer lending on the private debt space, and asset-based lending at this stage of the credit cycle.

FINalternatives: Pat, what’s your background? 

Pat Stone: While I began my career in 2006 covering credit as a researcher of hedge fund managers that invested in fixed income securities, my career as a credit underwriter really began in 2010 when I joined Full Circle Capital, at the time a publicly traded commercial finance company formed to address much the same market as Old Hill – the market for loans below $25 million. At the time, we were in the throes of the Great Recession and this was a very underserved segment of the corporate credit market. The subsequent passing of broad financial reforms ensured that many smaller and lower middle market borrowers lost access to bank loans, and a broad swath of traditional lenders continue to avoid the segment. 

What are your thoughts on where we are in the credit cycle?

Although interest rates are indeed rising, they’re doing so at a measured pace and remain historically very accommodative. When viewed from our perch, the advantages available from small-balance direct lending activities – above average yields, lower volatility, uncorrelated returns, higher recovery rates, etc. – remain pretty hard to ignore. Although late in the cycle, we think the environment for what we do will remain attractive for the foreseeable future. 

Is there a private credit bubble? What do you think?  

Without a doubt, there’s a bubble in high yield credit, but far less so in our market.  Aside from the spread widening that occurred in 2015 and effectively ended when the equity market sell-off came to a halt in February 2016, high yield spreads are amazingly low. I consider Carl Icahn one of the all-time smartest investors on Wall Street, and he was pointing to a high yield bubble as early as 2015. So there’s a credit bubble, but it’s far more glaring in the liquid credit markets, and perhaps even in the upper middle market, than it is in the market we serve.  

Taking it a step further, investors allocating to liquid credit instruments and marking to market in liquid, tradable securities on a quarterly or monthly basis should be very concerned about what’s happening at the Federal Reserve. The good news is that I think, given the pace of the Federal Reserve’s tightening policy, investors will have time to adjust their exposures and allocate away from liquid credit – if they start moving now.  If their mandate is to continue generating yield, I think the opportunities in the lower middle market are substantially greater – and more attractive – than those in liquid and upper middle market private credit.

From a portfolio construction point of view, how do private debt managers protect investors?  

I am passing on – or losing, depending on your point of view – a lot of opportunities.  At this point, I’ve probably passed on 95% of the deals that have crossed my desk, primarily ones that involve lending against highly cyclical assets that will exhibit high price volatility (i.e. wide bid/ask spreads) if and when their sponsors fall upon hard times. These are assets that are highly illiquid, and we are focused on assets, tangible and intangible, for which we’re not the buyer of last resort and where we’re not waiting more than 18 months to get paid. 

Said another way, we focus on underwriting deals collateralized with assets that will catch a bid if we’re forced to liquidate them. It’s worth noting that having the ability to pass on 95% of the deals we see is a luxury many lenders don’t enjoy, but being highly selective of the securities you originate is frankly your first line of defense.

How do you see your segment of the private debt space developing?

I alluded to this earlier, but first and foremost, the opportunity set is tremendous. We are seeing opportunities to generate mid-teen returns on an unlevered basis against assets on which we’re proposing relatively conservative advance rates, and in downside scenarios that still leave our principal with significant cushion. I can’t think of any other fixed-income market where this is the case. 

Is P2P lending a game-changer? How do you see this evolving on the institutional side?   

At some point, crowdfunding will take over the SMB market where loans are less than $500K.  We’re already seeing it with fintech companies, which are partnering with banks to evaluate their rejected deals and building the infrastructure to serve what are essentially unbankable customers, at least in the current environment. However, I think it’s going to be some time before a crowdfunding solution really addresses borrowers’ needs in a way to serves both the borrowers as well as the investors.  If you look at some of the bellwethers of the P2P industry, they have yet to develop consistently profitable business models not because they’re investing too much in overhead or technology, but because they’ve designed a product and delivery system, which after accounting for customer acquisition costs, is unprofitable. 

How do you see the secondary market for private debt funds evolving? 

I recently read an article about a large asset manager with billions under management putting itself up for sale for the second time in the last 12 months.  While this particular firm is a public company, I’d wager there are many others in similar positions. I would not be surprised if we began to see meaningful deal flow from companies that used the credit boom after the financial crisis to raise large amounts of assets to earn fees for themselves, not returns for their investors.  Unfortunately, this became a pattern in the 2010 to 2014 timeframe, especially as public market valuations for leveraged credit assets improved. 

I don’t see this market becoming very efficient until loan-level transparency improves. If you want to look at the BDC market as a benchmark for private debt performance, performance varies widely by name, and few of these asset managers share much meaningful information on even their largest positions. I wouldn’t allocate to BDCs unless I had an edge on an individual manager.

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