[Note: I started to write this using a ‘trusted advisor’ voice with objective observations sprinkled with general recommendations. But forget that. This is not an unbiased piece, and I won’t pretend that it is.]
We, Kilgour Williams Capital, manage a Canadian Private Credit fund and we have strong opinions on how to do it right.
With the recent news of the Ontario Securities Commission placing Bridging Finance into receivership and the increasingly-gnarly details of allegations of malpractice and malfeasance, there has been a chorus of commentary about the impending implosion of Canadian private credit. We get ticked off when the hubris or outright corruption of other managers brings out the chattering hordes to denigrate and cancel the entire sector.
But we also appreciate that recent events may cause investors to take a closer look at private investments. This skepticism is healthy, in our view.
Here are some of our perspectives on private credit, which may also serve as a starting point for investors asking due diligence questions of credit fund managers.
Private Credit borrowers are not always “too risky for the banks”
The media often characterizes Private Credit as loans that are “too risky for the banks.” This is not accurate. Private Credit is simply a label to describe loans not originated by banks. It is not necessarily a reflection on credit quality.
Yes, some private credit loans are made where banks would deem the credit risk as too high (such as in the case of a recently headline-grabbing direct lender). But there are many other cases where banks choose, for reasons unrelated to credit quality, not to lend to good borrowers – such as high origination and servicing costs, high regulatory capital requirements, inflexibility of bank processes and systems, or inefficiency of banks’ ‘brick-and-mortar’ networks.
This is especially true of small balance lending. Smaller balance loans tend to have proportionately higher origination and administration costs than larger loans, so banks find them less attractive generally. For example, banks do not provide unsecured term loans to consumers, preferring instead to dole out higher-priced credit card debt. Banks do not have systems to provide point-of-sale credit. Banks don’t like to refinance student debt. Banks prefer to not lend to companies without a bond rating due to the high amount of regulatory capital they need to commit to unrated debt. Banks do not lend to small businesses, full stop.
In each of these segments, alternative financial technology (‘fintech’) lenders have stepped in to supply capital to people and small businesses that need it.
Our KiWi Private Credit Fund concentrates on high quality small balance loans of types that banks do not want to fund or are not equipped to fund. We partner with nimble, fintech-based lenders who focus on these types of loans. We are not ‘direct lenders’ to corporations that are otherwise too risky for banks.
Don’t trust lenders who claim, ‘I’ve never lost a dollar’.
If you routinely lend money, sometimes you do not get it back. This is intuitively known by anyone who has ever tried to collect on a group gift, gone halvesies on a snowblower with the neighbour, or fallen for the ‘forgot my wallet, so I’ll pick up the tab next time’ trick. Banks and other experienced lenders know this and take loan loss provisions to account for future defaults. Credit card issuers know this, as they typically have credit losses of 3-4% per year. Even mortgage lenders know this, which is why it is not possible to borrow 100% of a house price.
There is nothing about Private Credit that obviates credit risk… so don’t trust a fund manager who tells you otherwise. At KiWi Private Credit Fund, with thousands of loans in the portfolio at all times, we know and expect that some of them will default.
(Related, also don’t trust a manager who puts themselves in a position to hide losses. See our recent commentary for more on how we manage our fund.)
There is a price for risk and that is a good thing.
If there weren’t credit losses, there would be no credit premium above the risk-free rate. Everyone would just borrow at the central bank rate. Prevailing interest rates are at historic lows and the yield curve offers no succor to investors hoping to earn income from traditional fixed income investments. Private Credit – when done right – is a better alternative for income-seeking investors.
But loan losses need not lead to investor losses.
I recently read a rather bizarre comment that a credit portfolio manager is not credible until they have posted negative returns. Really? You know what is even more credible: a manager that doesn’t lose your principal.
Lending is profitable when the interest on the loans more than compensates for the risk that you are not going to get all of your money back. Simply put, Interest – Losses = Profit. Simple enough, except that interest on loans is determined up-front, and before the losses manifest. So, interest rates must be set with consideration for expected losses. Private lenders who don’t compete with banks can charge higher interest rates to cover expected loss.
Credit managers can lose their investors’ money two ways. First, if their assessment of credit risk leads them to underestimate losses in the long-term. Namely, their expectation of losses is unrealistically low, resulting in actual losses not being covered by the interest charged. This is colloquially known as being ‘bad at credit’. So look for managers with an excellent track record, with proven lending experience, strong risk models, who have been through a few cycles and crises, who have grey hair (or, in my case, grey shortage-of-hair).
The second way a credit manager can lose their investors’ capital is if losses suddenly spike above expectations in the short-term. This is not ‘just unlucky’’, this is also being bad at portfolio management.
Portfolio diversification protects against unexpected losses.
I was once chided that “Diversification is for those who lack conviction”. We strongly dispute this notion, particularly if conviction means placing large bets on single loans.
We are proponents of diversification as a key way to avoid sudden spikes in losses in normal conditions. As a rather facile illustration, let us assume that all loans in a portfolio have a 1% chance of defaulting each month. If the portfolio is spread across 100 loans, it can expect to lose 1% each month. That level of losses can be covered by the interest received and still provide a monthly profit. Contrast that to putting all the chips on just 1 loan. Sure, most months that loan won’t default and you would have ‘zero losses’ (see “Don’t trust managers who claim, etc.” above), but once every eight years 100% of your portfolio would default. Investors should not be exposed to a risk that, even at normal/expected loss, there is a chance of a huge loss of principal. In our KiWi Private Credit Fund, the maximum loan size is 1% of assets and the average loan is about 1/20th of 1%.
Diversification also mitigates against loss in stressed conditions. Diversification, such as by loan type, by borrowers, by industry, by geography, etc. reduces shared exposure to a risk factor. Kiwi Private Credit Fund lends to borrowers in Texas, but also in every other state. When hurricanes hit the Gulf Coast a few years ago, only a small part of the portfolio was stressed, and our Fund remained profitable. Similarly, we had loans to white-tablecloth restaurants at the outbreak of COVID and our Fund experienced higher delinquency in that sector. But we also lend to grocery stores and liquor stores and auto repair shops and PPE importers which have experienced less-than-expected loss. Although the Fund distribution was lower than average in April of last year when the US shutdowns were most pronounced, the Fund has remained profitable with no reduction in value in any month.
With the pressure of low bond yields, the risk of rising rates, and the need to protect capital from inflation, investors are looking to alternative investments as a source of yield. But someone looking for a steady 7-8% should not be at risk of a large principal loss. This is not a ‘get rich’ asset class, so managers should have a ‘stay rich’ risk management stance. Private Credit remains an attractive alternative when it is done right.
So, let’s not tar all private credit funds with the same brush.