Ghost Stories #37: Investing in Private Credit

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Summarised transcript:

A deep dive into the growing popularity of private market investments and the availability of liquid alternatives. In conversation with Reginald Labuschagne, Head of Product and Strategy at Sanlam Private Wealth; and Harris Gorre, a partner at Grovepoint Investment Management.

Hosted by The Finance Ghost, making investment concepts accessible.

Ghost: Private markets have really taken off in popularity over the last couple of years. In fact, there seems to have been a structural shift in favour of private market opportunities with fewer and fewer new opportunities coming to public markets. Even the recent listing of WeBuyCars here on the JSE (to much fanfare) was an unbundling of something that you could already buy through Transaction Capital. It’s not like the old IPOs of bull market days that I’ve admittedly only read about in the classics. So, investors need to get a bit more creative when they’re looking for new opportunities and so my first question for Reg is really to what extent do private markets feature for you, as opposed to just looking at what is publicly available?

Reginald: I think it’s a critical question, especially in our space, because we deal primarily with private clients. So that means individuals who each have their own portfolio built around their specific needs. That’s important in this discussion, we don’t run a big, pooled vehicle where it’s easy to allocate 10% of total funds to private markets. We have to sit with each client to understand their requirements and, if you go into private markets, there are quite a few hurdles, from illiquidity to the large ticket sizes often required. When you deal with private clients it’s not straight forward.

“Institutionally there’s been a shift to low-cost passives and an increased allocation to private markets to help beat the index.”

Yet we know most of the companies in the world are private and so there’s huge opportunity. Access to private markets has also increased with technology and increased access to information. It’s becoming more interesting and easier for certain institutions and people to invest in private markets and more large private market players are looking for ways to access the retail market. It normally starts in the institutional space, and then things start shifting across into the broader market and the man on the street; that’s the space we play in, that bridge between institution and retail. Our private clients typically have larger portfolios and are looking for interesting things so we’re constantly looking at how to access these markets. But the biggest challenge is access; firstly, finding the right players in the market and secondly, how to invest in those things operationally, and make it accessible to our type of investors. That’s part of the guts we’ll get into today.

“If you find good private market operators, you can extract good returns for clients.”

Ghost: Just to be clear when we talk about private assets, we’re not talking about mom-and-pop shops that you acquire for a few hundred million rand. So, before we carry on what are some examples of the private assets that do end up in portfolios where it does work from a liquidity perspective?

Reginald: Firstly, we always need to understand the fundamentals; does it add better return, or does it diversify the risk. These are two of the roles that instruments can play in the portfolio. But to answer your question on what we have invested in private companies, the example you said about R200 million, we have done one or two of those deals for clients….

Ghost: Turned out to be a terrible example, it’s always fun when you assume something, and it’s completely wrong. I love that.

Reginald: …it’s part of the debate, right? I mean we have not invested in a business where the total enterprise value is R200 million, but we have allocated R200 million across a couple of client accounts into private businesses. Dis-Chem for instance was something we were in quite early, before it listed, so we had some private exposure that worked out very well. But it’s heavy lifting, every time doing extensive due diligence on every business you invest in.

“We try to be innovative without being fancy. Everything we invest in for clients must play an important role in the portfolio.”

We’ve also have a big multi-manager team that do a lot of work in the institutional space, looking for private equity managers, private credit managers, hedge funds and other exotic assets. They do a lot of the due diligence work and then we look at those opportunities and see which of those opportunities are good opportunities for our clients to invest in. Where we’ve invested in South African middle-market, growth focused private equity funds it’s worked out very well for our clients. One of our private equity funds, currently in its final phase, has done about 28% net IRR for clients so that’s a good rate of return on an annualised basis. We’ve since invested in a couple of private credit funds locally and offshore and that’s where we’ve been in long discussions with the team at GIM around their solution, which we recently approved for investment; but again, we need to understand what role it plays in the client’s overall portfolio.

Ghost: Those returns are great, but risk return is ultimately the trade-off in in finance, right? So, when you talk about 28% returns in private equity, that’s good but private equity needs to give you those high 20s to make up for the risk involved. The beauty of portfolio construction is looking for returns that are commensurate for the risk you’re taking, and then adding diversification to create a good outcome for clients. With this in mind the proliferation of listed instruments that reference private market assets must help with the liquidity problem and some of the due diligence issues you’ve raised?

Reginald: Even if it’s listed, your due diligence work is still the heavy lifting. You have to understand the team and their strategy. Take private equity as an example, private equity is broad, from early-stage high risk companies to later stage large buyouts. There’s a big spread in private equity strategies and in each one of those categories. Some managers will take minority stakes and have a passive view on a business, some will take significant minorities all the way to majority stakes and take control of the businesses change management, etc. You’ve got to understand each one of those managers and what role they play, what value they add to businesses and how they crystallise value. Quoting one good example is always dangerous. The spread in returns on private equity is very big. You can invest in the same sector and the same strategy, and one manager will produce negative returns and another manager will do 30% per annum. As you say the risk return payoff is significant.

“Liquidity is a massive thing for clients, you only realise it when you need capital.”

Even in the listed space, you must be very careful about the managers you pick. You still need due diligence and an understanding of the underlying. The listing helps with access and hopefully liquidity, but you can suffer big discounts in the listed space. When we trace the prices of these things; at some points they trade at significant discounts to the underlying assets, we’ve seen 30, 40, 50% discounts on some of these counters. So as much as a listing is convenient, there’s risk in buying these things for clients. You must be very aware of what you go into.

Ghost: Absolutely. I guess listed instruments also do help with access to other markets. It’s one thing to do private deals in your home market. It’s another thing entirely to be able to find opportunities offshore and be able to bring those into a portfolio. Harris, that’s ultimately where liquid private credit is very interesting as it gives people the ability to invest in private markets somewhere else in the world. I’ve been to many a presentation in my life about how small South Africa is in the global context and by the time you consider the property you own, your job and everything else you’re probably too exposed, so it’s really cool when there are opportunities on the local market to be able to get exposure to stuff elsewhere in the world.

Harris: Certainly Ghost, building on what Reg said earlier the market has trended in two directions. One is passive investing i.e. cheap low-cost access to listed equity via ETFs. Today, if you look across most client portfolios, they have some exposure to these low-cost strategies. Number two is the search for alpha often via private markets where excess returns can be generated as a result of asymmetric information, deep sector expertise, scale, a shortage of capital, complexity, etc. But as Reg said, it’s very much about which horse you back and your access to that horse, your information in that space and how you select the right manager(s), the right underlying’s, and how you deploy your capital.  

In terms of portfolio positioning, I’d say anyone listening probably has exposure to the S&P 500 but very few have exposure to U.S. middle-market private companies. We can touch on how big that market is, but senior debt in these companies can generate very attractive returns through market cycles and that’s an example of where private credit is a good diversifier.

“Loans to high-quality private companies earning 10 or 11% p.a. in USD can be a wonderful diversifier.”

Ghost: Yeah, I mean, there must have been quite a lot that attracted you to this space I mean, it’s quite a big career decision to move from public markets into doing more private stuff. There a lot of different opportunities and you really have to scratch to find the right stuff. It’s harder in that regard than some of the public markets stuff which is available on a screen and there’s so much you’ve got to balance. The quality of the assets, the depth of disclosure available and the level of the management teams in those companies, people forget that there are private companies that are as big and impressive as public companies and run to the same standards or better.

Harris: Without a doubt. In the U.S. market 90% of companies generating more than $100 million dollars of revenue are private. That market, taken in isolation, is a $10 trillion a year market in GDP terms. You’re talking about a market that is three times greater than the UK economy, bigger than India, Japan, and Germany, yet this is a market that very few investors have exposure to. These private companies are generating earnings of up to $1bn a year and there are almost 200,000 of them.

Historically lending to these companies was highly prized business for the U.S. banks but this all changed in 2008. Banks were badly wounded by the Global Financial Crisis and lending dried up around the world but especially in the U.S, which was the eye of the storm. You then had a deluge of regulation that sought to limit how many private company loans U.S. banks could hold on balance sheet and as a result you had an exodus of bankers, often to private credit managers.

The pace of change has undoubtedly been greatest in the U.S. If you look at the numbers, there was a 50% fall in the number of U.S. banks between 2008 and 2022. In the UK there’s been a less than 5% fall in the number of banks over that same period. In fact, there’s been an increase in challenger banks, as many people in South Africa have probably followed. It’s worth pausing on that; this dramatic decrease in U.S. banks, combined with regulations that made it more expensive to lend to quality middle-market companies, this is what created the opportunity in private credit.

“40% of U.S. private credit assets can now be accessed via the listed market.”

In fact, the opening left by the banks in the U.S. was so large that many private credit managers Apollo, Ares, Oak Tree, Blue Owl, New Mountain, Blackstone etc. listed vehicles to take advantage of the opportunity to lend to these middle-market corporates. They already had their private credit funds but they added to them with vehicles that they listed on the New York Stock Exchange and the NASDAQ, these vehicles raised additional capital from public market investors supporting their growing direct lending franchises. Importantly the listed vehicles have the same management teams, originators, and underlying borrowers. What many investors don’t know is that today, there are over 130 of these listed private credit vehicles in the U.S. and that many of them are larger than the SA financial institutions. Their shares are certainly more liquid; a well-constructed portfolio could easily trade around $700 million a day. Speaking to Reg’s point earlier about liquidity this means you can invest R500 million or a billion rand in this market in a day and not move the price. That’s very, very attractive.

Ghost: Crisis breeds opportunity, right. It’s the most horrible cliche in the book, but it is very true. Now that yields are higher and interest rates are higher aren’t the banks starting to compete in this space. Surely they’ll come back in, or is the cost of compliance just too heavy for them?

Harris: That’s an interesting question. The banks have never gone away entirely. You’re always going to have banks competing to lend to high quality middle-market companies, especially as the loans get larger and when the broadly syndicated loan (BSL) markets are working well. Often $1bn+ loans will be divided up and sold to asset managers and so the banks don’t need to hold them on balance sheet. Syndicated loans generally have standardised terms and are often cov-lite due to the standardised loan documentation. Direct lenders tend to focus on loans below this threshold, they can move faster than the banks and offer more flexibility and price certainty to the borrower. In exchange borrowers pay a higher credit margin and agree to customised loan documentation which often includes greater monitoring rights, security over assets and / or cash flows, better financial covenants, and greater lender rights in the event of default.

“The relationships and skills have moved out of the U.S. banks and it’s hard to reverse that trend.”

It’s hard to see how banks re-enter this market when the relationships, origination and structuring skills have relocated. We’ve had almost 20 years of this trend, where the number of banks has decreased, and the direct lenders have got bigger. Being quite blunt about it, top lenders have more flexibility to originate business, and get paid more, at a private credit manager than they could ever do at a listed bank.

This transfer of market share and skills from banks to non-bank lenders has really been unique to the U.S. In South Africa banks are still your first stop if you’re running a business generating R2 billion a year. Similarly in the UK and Europe you’ve got lots of regional banks and lots of smaller banks that still dominate this market. In the U.S. this market belongs to the non-bank lenders.

This business also fits better in a direct lender or a private credit fund. If you’re going to hold illiquid loans on your balance sheet, and you’re going to fund those with short term deposits then you’re asking for trouble. It doesn’t matter how big your bank is, if you’re holding too many illiquid assets and deposits start running out the door you have a big problem, which is why U.S. regulators are again trying to tighten the bank capital rules. But if you raise permanent capital, like these listed vehicles on the New York Stock Exchange and the NASDAQ, then you can recycle that capital whilst paying out the distributions from the loans as dividends. That’s a better place for these loans to sit from a regulator’s point of view.

Ghost: Indeed, asset liability mismatch poses serious risk for banks. Reg, I want to bring you back into the discussion here to just give us some South African context. Harris has given a good lay of the land of what’s going on in the U.S. where there are so many big companies that it creates this large alternative debt market. Do we really have something like that in South Africa? Or do the banks pretty much address all the high-quality borrowers and the rest of it is working capital loans into SMEs and not a hell of a lot else?

Reginald: I think it’s changing. The first difference, as you said, is the depth of the market. The size of the market and the quality of the underlying businesses, the growth in the economy, that’s fueling business’s growth, that’s where South Africa is very different.

We have some good stories in South Africa with some private businesses doing well. And again, in South Africa, you’ve got more private businesses than listed businesses doing significantly well. You just have to drive around some of the industrial areas and look at the brands out there. You are seeing these businesses more and more via private credit funds and we’ve invested in one or two local private credit fund managers that have done extremely well for our clients. One of the managers who has been doing this for a long time, probably 11 years, generating between 16 and 19% per annum.

But it is extremely hard work for the guys in South Africa to find proper deal flow. If you speak to these managers everyone’s looking for funding in South Africa. There’s a big funding gap, but to find good quality businesses is hard. Most of these guys will want to securitise their loans so if you loan R10 million to business you want security of at least two times. So, they must have assets worth R20 million + as an example, and you need to have control of their business when things go wrong. You need to be able to dictate the terms and control your security to get your money back. That’s where you really start seeing the good managers versus the bad and how they structure those loans.

“You see more private lending but finding good quality deal flow is hard. You’ve got to do a proper due diligence.”

So, to answer your question, you definitely see more private lending starting to take place in SA, including a lot of working capital financing and factoring; some of it directly from family offices where they’ve built teams, but you are also seeing an increase in funds. To be clear though, it’s no different to the private equity model, you’ve got to do proper due diligence on the underlying managers and understand their process. You need to understand how they roll up their sleeves and get involved in the underlying businesses. They can probably only run 8 to 10 big deals at a time, because they have to closely monitor these businesses every month, see what’s going on in their businesses and manage the cash flows. A lot of these private businesses go through cycles; you run into problems at some point and then you have to get the equity holders and management teams around the table and discuss adding more equity or selling something to service your debt.

How this situation is managed is where the banks are failing. I don’t want to generalise but banks are very systematic, if you don’t pay, they come for your assets, they don’t restructure, they’re not flexible in how they manage the situation with the underlying loans. They don’t have the teams and they don’t have the skill set or spend the time and effort. They’re very compliance driven and use systematic decision-making processes. And that’s where you see the secret sauce, I was nervous to say that as it sounds sexy, but it’s just bloody hard work in the background, to go and make those loans and squeeze out the extra returns over time. That’s where you really see the difference.

Ghost: I’m lucky enough to have had a bit of exposure to banking, because I didn’t do articles in the traditional way. So, it was very cool to see how balance sheet management really does drive everything the bank is doing, there’s this holistic view that says what the bank can afford to do in terms of the assets, what they’re willing to bring on to the balance sheet based on what their funding looks like. And therefore, that team over there, they’re getting a lot of capital this year to go off and do renewables or infrastructure or whatever, but if you’re stuck in the team that does lending to private companies, you might not get such a big allocation of balance sheet and that absolutely creates the opportunity for other players to come in. And that explains why these private market lenders have a business.

Reginald: the simplest analogy for people that have been around long enough; is that in the old days you used to walk into your bank manager, as a business owner in a small town like I’m sitting in Swellendam now. The farmers would walk to their local manager, have a discussion, and that guy would have the authority to do a deal with that farmer. It was based on a trusted relationship. That whole model has changed fundamentally, that decision making at the branch was taken away to mitigate the risk of people doing irresponsible things. Compliance systems now drive the whole risk matrix of banks, so that model has been drawn back to the center where everything lives and decisions are made. That opens opportunities for the people that build those relationships with that farmer, understand their business, and fill that gap that’s been left by the banks. That’s a really simple analogy of how that model has changed and what’s created the opportunity.

Ghost: Yeah, absolutely. And of course, trying to find opportunities to deploy capital at scale. That’s the challenge, right, you are trying to scale into an area of the world that is hard to scale into via the right types of investments. Harris, I know you have experience in this space and that Sanlam has just completed due diligence on your process so maybe you can add some colour?

Harris: Thanks Ghost, as we discussed earlier, I think the size of the U.S. market combined with the dominance of non-bank lenders in that market makes the job a little easier for investors there. When considering the U.S. market, the question of how to scale is probably better approached by comparing an investor allocating to private credit via a traditional illiquid lock-up fund verses investing in their listed liquid cousins. When approaching scale from this angle there are really 5 key points worth considering:

1. How do you earn that illiquidity premium in the most efficient way? The U.S. market is unique in that it offers a deep, broad, and liquid universe of listed vehicles managed by the same leading private credit managers that run the illiquid funds. This allows you to capture the illiquidity yield premium via listed liquid shares – for most investors retaining liquidity is a clear win.
2. How do you manage your exposure? Deep market liquidity means you can be fully invested when you see opportunity, rather than wait for capital to be drawn over several years. Investors can also rotate their exposure to capture market moves and idiosyncratic pricing opportunities. Liquidity also means that asset allocators can rebalance portfolios in line with their macroeconomic view and to reflect changing client requirements.
3. Can you create a well-diversified portfolio across both high-quality managers and underlying borrowers?  You generally need $5m – $10m minimum investment to access a single top U.S. private credit fund that then originates less than 100 loans over a 3 – 5yr period. This means only the largest institutional investors can create a very well diversified portfolio. By comparison, via the listed market, you can create a portfolio of thousands of underlying loans to great companies with substantial market share and wide competitive moats.
4. When investing in credit, this diversification is incredibly valuable as, unlike equity, credit has limited upside (the yield you receive on the loans) but can have full downside, so you want to make sure you’re in a broad range of high-quality companies in steady sectors and avoid cyclical industries such as energy, hospitality, aviation retail, etc.
5. You need to have the correct systems in place to extract the best results.  A regulatory change introduced in 2015 by then U.S. President Obama permanently changed the withholding tax treatment for non-US investors in this space.  For those unfamiliar with the U.S. withholding tax regime, non-U.S. investors are charged up to 30% withholding tax on certain U.S. source income such as dividends and interest income. Historically this would have cost investors up to 3% p.a., which is a material portion of the 10% – 12% p.a. target return when investing in private credit. The 2015 change meant non-U.S. investors can now reclaim most of this tax. To do this they need the right systems in place to monitor, calculate, and claim the rebate. For investors with a few hundred million dollars invested, the few thousand dollars it costs to lodge a tax return with Uncle Sam is more than covered by the taxes recovered.

“Non-U.S. investors, in certain listed private credit vehicles, can reclaim most of their withholding tax.”

When thinking about asset allocation; this liquidity, coupled with the ability to create a very well diversified portfolio means you can be flexible with your asset allocation.  Like endowment style managers who favour a larger allocation to private markets, a well-diversified portfolio of private credit managers could then be as much as 15% of a client’s asset allocation.

“Liquid access to private credit is unique to the U.S.”

Ghost: I’ll will have to get you back to talk more through that process, you’ve been threatening me with the pleasure of another podcast, and I’m going to have to take it up with you. Because clearly, there’s a lot in there.

Harris: I’ll gladly do round two with you guys, but frankly I would suggest anyone interested should speak to Reg and the team at Sanlam Private Wealth who have gone through it several times over the past year or so.

Ghost: Reg has a queue of people outside that window waiting to come and speak to the manager who’s got the private credit, they heard about him coming to Swellendam. He’s gonna be a busy man soon.

Reginald:…if I had that they would be in here already. The process is definitely worth spending time on; it’s when the switch went on in our heads about what they do.  Anyone could go and buy this private credit stuff; you can go do that yourself tomorrow. But having the discipline and the process to consistently apply something that delivers returns over time, that’s what we’ve appreciated. So, I’d recommend spending some time on that. For us, as I said earlier, we need to spend a lot of time understanding every instrument we invest in, the team behind it and how it works. That’s for us to tick the box on and hopefully lend some credit to the whole process.

“The process is worth spending time on. Anyone could buy this private credit stuff, but having the discipline to consistently apply something that delivers returns over time, that’s what we’ve appreciated.”

Ghost: Absolutely worth spending time there. It’s scaling the unscalable.  Of course, the one other thing we need to touch on when we talk about investing is the fees. People are always obviously very sensitive to that.

Harris: 100% Ghost. I think managers in this space should be aligned with investor outcomes and so a material portion of the fee should be linked to performance over time. As an investor you want the best net return for a given level of risk and so linking some of the managers’ compensation to performance makes sense. Historically this has played out well for investors who have taken c. 90% of the return generated since 2015; once you’ve recovered taxes due this adds up to 11 – 12% p.a. in dollars net of fees. Based on this performance fees would have been c. 1.4% p.a.

Fees are important but as Reg mentioned earlier, it’s more than just paying people to select the right vehicles. You want a manager with a detailed and disciplined process making sure you’re not overpaying for vehicles, and crystallising gains when the market is overpaying. They should have the right process in place to reclaim the tax, and they should have deep insight into the underlying universe of managers and assets.

Ghost: Yeah, I mean double digits in dollars is hard to come by. Anyway Reg, I think a closing comment from your side. You guys have been through the process with Harris and the team at GIM and you’ve gotten yourselves comfortable, but maybe we can just end off with what sort of role this plays for you in terms of your view and the comfort around the instrument and the liquidity?

Reginald: Absolutely. This comes down to portfolio construction. There’ll be a portion of the portfolio where we’re looking for yield, especially dollar yield over time. And something that is not necessarily correlated with other parts of the portfolio for a client. Meaning it doesn’t move up and down in the same direction as some other assets and is therefore part of your portfolio diversification.

I want to clarify the access point though; a lot of people think because the GIMLPC vehicle is listed it’s going to trade up and down with NAVs and discounts. But the way this instrument is set up, you can almost see it as a listed fund. When we invest in this vehicle, it creates new units that then invest in the underlying assets so there’s no discount or premium on the JSE listing. In general, just because something is listed doesn’t mean there is always liquidity but here you buy into a very big liquid pool in the background. I think it’s important to understand that distinction.

“The underlying investments are very liquid, traded on large U.S. stock exchanges. So, when you sell units on the JSE you’re selling the underlying. It’s not this illiquid thing.”

And then at a later stage we need to spend some time on asset allocation and correlation. But that’s a debate for another day.

Ghost: Thanks Reg, hopefully you can join us on the next one; we can do a tour of South Africa’s greatest small towns. Gentlemen, we’re out of time. I think it’s been an awesome podcast. Thank you so much. I’ve learned a lot.

Sanlam Private Wealth (Pty) Ltd, registration number 2000/023234/07, is a licensed Financial Services Provider (FSP 37473), a registered Credit Provider (NCRCP1867) and a member of the Johannesburg Stock Exchange (‘SPW’).

Nothing in this podcast should be taken as advice. You must always do your own research on opportunities and speak to your financial advisor.