Ever since the result of the EU referendum held in June 2016 was known, investors have been puzzling over the best way to manage their way through the uncertainty of the future. 
Public markets in equities, bonds and real estate are all hazardous paths to tread given the inherent volatility that they are exposed to. Many managers are keeping cash levels high to satisfy any redemption requests and lower marks to market for core assets. However, fund managers are paid to invest and their customers expect them to make a return, no matter what the markets deliver at their feet. So the desire for assets that are uncorrelated, deliver income and maintain a stable net asset value are in high demand and short in supply.
Direct loans are one of the few asset classes that, if managed effectively, can offer these uncorrelated returns investors seek. In recent years, the asset class has been corrupted somewhat by a myriad of variations on the same theme. Gearing, technology-based credit scoring and new entrants offering peer to peer lending have all provided mixed results, with the safest and most secure direct lending models reserved for segregated mandates in the larger pension and superannuation funds. This is because loans are not permissible securities under UCITS and UK unit trust rules, the most common, easily accessible fund wrapper available to UK and EU investors. These vehicles have two key determinants for an asset to qualify for inclusion; it has to be freely transferrable and have a recognised market on which it can be traded. This is unlike US mutual fund wrappers that do allow for loans.
Direct lending is a private contract between borrower and underwriter and so investors can only get access to direct loan strategies via a loan note, an investment trust company listed on an exchange or a Qualified Investor Alternative Invest Fund or “QIAIF” available in Ireland.
From the outset, direct lending is all about the underwriting and the legal structure of the contract. A significant differentiator is that the investor buys a share or a unit in a fund that owns whole loans, underwritten using conventional credit methods. They will focus on credit quality and will work with the borrower to ensure that rate and maturity fit the requirements of the business. Small businesses are rarely rated by the ratings agencies due to costs associated with gaining a rating, so analysis is conducted using published and management accounts. Each loan will be assessed on its individual merits and then how it will behave in a portfolio. Direct loan positions tend to represent a larger percentage of the portfolio than in peer-to-peer platforms as the cost of underwriting is high and makes smaller loans uneconomic. Because of this concentration, the level of detail used in order to reach a credit decision is extensive and the risk management style is very hands-on.
Debt serviceability is a key metric and direct lenders will endeavour to shape amortisation of the loan around business needs, the external market and cash flow modelling. This avoids the need for expensive refinancing and reduces the risk of default as the principal is repaid throughout the life of the loan.
Although these loans are unrated, they often exhibit lower default rates than the high yield and collateralised loan markets. There are many reasons for this; the relationship between borrower and lender is close with information shared on a continuous basis, the loan is tailored to the borrowers’ needs, the maturity fits the business model and the credit work is intense.
To say that direct lending is “recession proof” is a dangerous assertion to make. To state that a portfolio of loans is uncorrelated to conventional markets and that credit metrics are tested to a level to sustain debt service of loans through a downturn in the domestic economy is fair. There are other considerations too. Does the manager take consumer-linked or cyclical industry exposure? Is FX hedged to allow for income to flow, unencumbered by currency fluctuations and are the loans sufficiently collateralised and senior to all other debt in the stack? Less experienced, new entrants to this asset class may be more predisposed to taking short cuts to save on cost and this should be thoroughly tested before taking exposure.
A carefully constructed loan portfolio should possess a diverse selection of assets serving a number of different sectors and geographies. It should be FX-hedged and all loans should be senior in the debt stack with good, unencumbered collateral. A further overlay of rules preventing exposure to consumer linked loans provides greater comfort. Second derivative risks such as exposure to one counterparty by several borrowers should also be avoided, for example, the demise of Carillion during 2018 caught a number of lenders by surprise. This is inexcusable as a matrix of all core risks should highlight these pitfalls long before a catastrophic consequence.
It is also important to respect the fact that things can go wrong. A side-swipe caused by regulatory change or the failure of a new product can have brutal consequences for a smaller company that is less able to sustain the cost of these events. All loans should be tested for these eventualities but if they fail, swift communication and ability to re-engineer, to re-assess and negotiate a work-out are skills that the lender should possess within their organisation. As a lender, ability to take control of bank accounts and ultimately ensure value is retained is an essential aspect of any restructure. Leaving these tasks to outsourced collection agencies is costly and often the outcome falls short of a desired outcome whereby the lender and the investor are able to retain their capital and income.
So, the message is clear. Loan investments can offer an uncorrelated, stable return. An allocation to an alternative lender who is a specialist in this field can deliver this outcome but the buyer should be conscious of the risks and apply a high degree of scrutiny with regard to credit underwriting, history of successful work-outs and infrastructure.
Dawn Kendall is managing director of SQN Asset Management. The views expressed above are her own and should not be taken as investment advice.