Don’t get Fooled in Private Credit - Redux.

In the spring of 2023, Colin and I gave a talk at an investor conference that was entitled How to Not Get F***ed in Private Credit.  This was soon after several prominent Canadian credit funds made negative headlines for “gating redemptions”, meaning telling their investors that they could not have their investments back in accordance with the fund’s standard redemption terms.  Those investors may or may not have been able to get their money back by now.  (Okay, mostly not.)

Our discussion was summarized by these ‘pro tips’, which recommended specific due diligence topics for assessing a manager, its operational controls, and its investment strategy:

Criss-Cross Applesauce: More investors sitting on the sideline

Unfortunately, in the intervening two years more Canadian private credit funds - including some big-name real estate funds - have run into liquidity issues.  And just this week a large private credit fund that had pivoted from short term specialty finance (lending to lenders) to longer term direct lending was forced to halt redemptions.  We are obviously not privy to this manager’s due diligence room, but we strongly suspect that their investors could have circled style drift, transparency, valuation process, and concentrated portfolio on their due diligence bingo card.  We are hopeful that this temporary suspension of redemptions will allow the manager to address the excess concentration in the portfolio and achieve sufficient liquidity to repay its investors.  We remain concerned, though, that the fund offered short-term redemption rights despite holding long-term loans, the largest of which was recently the subject of a CCAA insolvency process.  Older investors will recall that such an asset/liability mismatch was the primary cause of the $32 billion Asset Back Commercial Paper meltdown, which was the primary manifestation of the Global Financial Crisis here in Canada.  Was the GFC so long ago that important lessons are being forgotten? 

How are the Kiwi funds different - and better?

Our strategy, as well as our operations and governance, is highly differentiated by many factors.  Here are some key differences:

• Massively diversified: There are over one thousand Small Business loans in our portfolio.  The average loan size is ~0.1% of assets and the largest exposure is much less than 2%.  Diversification is such that no single default could materially affect the NAV and cash flows of the fund. We also manage and optimize diversification by geography and industry.  This greatly reduces risk to investors capital.

• Strong cash flow. Average duration of our Fund’s assets is less than 12 months. All loans in our portfolio are fully amortizing and pay regular interest, apart from some short-term mortgage loans. We don't allow payment-in-kind (PIK) interest. This means that the fund generates cash flow roughly equal to 10% of investor capital each month.  In conjunction with the Fund’s access to a bank line of credit, there is sufficient liquidity to meet even highly elevated levels of redemption requests.

• Independent valuation. Since inception, we have always relied on an independent valuation firm to conduct a monthly valuation of every loan in our portfolios.  The valuation is driven by an objective statistical model based on actual historical loan performance data. A key tenet of the valuation model is that delinquency is recognized as it occurs (as opposed to waiting for a loan to default before making a valuation adjustment).  If a loan is delinquent, its price is reduced and that markdown flows through that month’s income statement and impacts the distribution made to investors that month.  Unlike other funds, our valuation approach does not include 'hold & hope' or 'extend & pretend'. 

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To learn more about our investment strategy and risk management approach, please visit www.kilgourwilliams.com or reach out directly to info@kilgourwilliams.com.