Risks and Opportunities in Private Credit and Fund Finance

EMS:

Hi John, thank you so much for being with me today.

John Tsui:

Yeah, thank you. Thanks for having me.

EMS:

Absolutely. So, John, to kick off the conversation, tell us a little about the investment activities of your single-family office and how you got to where you are today.

JT:

Well, I morphed into a single family having started this right after graduate school when I had my interview with Goldman on a Wednesday and on Thursday I started my LLC. So that's a few years back. And how we look at investments, it's a little bit not down the fairway sometimes. We are investing either through SMAs, through funds structured through drawdown or directly. And what I can say is the theme that we look to is we try to capture this outsize alpha relative to risk. When we see spreads are 300 to a 1000 bps over what we perceive as risk, we jump in, and this could be high yield when it's over a thousand bps, but those last fairly short could be three, four weeks, two other private markets credit and others that would have a little bit longer duration. But right now, we're looking more on the short-term credit within niche type of credit in secondaries, in risk transfers, in NAV loans, etc.

And in terms of equity, we think equity is getting repriced across the board, but there are times when event-driven leads equity markets to reprice itself to its true value. And we try to jump in quickly. So if I could just quickly mention in the past we looked at after GFC, we were buying 600-700 foreclosed homes when cap rates were 12 until Blackstone came in with Invitation Homes and they collapsed it to almost three-and-a-half, which was quite low for us, but we got out within two years of that. Or we'll buy an apartment building in Beijing in 2007 or busted convertible in Hong Kong when those trading at 30 cents to face or legal claims in Brazil or going to credit funds when it was yielding me about 13% before it started to compress with all this free money. So, I don't know if that helps to give a glimpse.

EMS:

Now, it was a very nice segue into your background in history, living through the different moments in finance and investing. So as a follow-up, John, I would love to hear your thoughts. Is this a Golden Age of private credit for only the GP or both the GP and LP and why?

JT:

I think it's a Golden Age, a bit more for the GP than LP, but depends on where rates will be priced in three, four years hence, and whether the capital markets come back and whether rates hit the prior 2% rate, which I don't believe will come so quickly. When rates at 10-year was priced at 1-1.5%, I always saw it was mispriced and should have been 4-4.5% and low and behold, it shot up to almost 5.5%. And now we're back to what, 4.3%. So, I think today there's a few themes that from a big picture you have to be careful because the reason why all this private credit proliferated has to do with how banks are structured, leveraged and so forth. And with the capital requirements as a result of SVB or Signature or New York Community, you could see that the traditional banks that were leveraged 10x or BDCs that were leveraged 1.5x and LBOs leveraged 6-7x at the height. You could see how the banks now have gone the other way. And this led to a big opportunity for private credit to step in the shoes because the traditional model as a bank and there's some over 2000 banks is not so fluid as before and there's a lot more regulatory environment that impose a lot of restriction. So thus, they are starting to shed the things that need more risk weighted equity from revolvers to subscription lines to SME loans, to construction loans, to trade finance, some of these verticals they need to lessen or stop altogether to rebalance their balance sheet.

EMS:

John, as a follow-up question, what are the risks and potential losses associated with senior corporate sponsored lending or multifamily and CRE mortgage loans?

JT:

Well, I'll answer it this way. Number one, we're used to leveraging and providing leverage based on some EBITDA number and EBITDA to me doesn't really provide an accurate benchmark of where that company true EBITDA should be. And oftentimes the adjusted EBITDA is sometimes 30% discounted from EBITDA to get to the true valuation. So, you have to look at the valuation methods before you look at the credit risks associated plus each certain sectors. You may have to look at the free cashflow associated with that business as opposed to just another EBITDA leverage multiple. And second, I think the thing that is not widely talked about is more about the maturity wall that's coming. And if it's the bigger ticket investment grade corporates, that seems a little bit less risky and probably with so much access to capital markets they will be rather unscathed. But when you start to get into niche, Main Street Lending, SME lending real estate loans, especially the transitional asset, not the core real estate assets like industrial or multifamily assets like office hotels, theme park, those are going to have a very large gap upon refinancing, which has to be filled with some sort of pref and mez or it has to be extended and that's what may happen down the road.

EMS:

John, what about bridge gap financing for durable income and transitional real estate assets? And how wide is the gap upon refinancing?

JT:

Yeah, it's a good question. I think for multifamily apartments, say for example, which is a very stable income, you can pretty much see the same that occurred in Japan, for example. In 2012 to 2014, there was different funds that raised money to buy apartment buildings in Tokyo at five cap, they levered 80% LTV at maybe 3% cost of borrowing 2% or 3%. So, there was a lot of positive leverage while the market turned. So, what happens, the cap rate shot up to 7%, the LTV went from 80% to 50% and basically you wiped out all the equity, thus a lot of insolvency or fund closures. I think you've seen the same here in the United States in that just a multifamily apartment while leased, you still, because of the increase or doubling of rates, you're still going to see I think a minimum of 20% gap in two years, three years, whenever the maturity occurs. And you need to fill that with some sort of mez loan to fill the gap.

EMS:

John, what about GP and LP liquidity solutions as well as NAV loans and whether there is outsized alpha in this burgeoning credit strategy?

JT:

Yeah, the NAV loan space I think is a very interesting area. I think it could be a new pillar in private markets, much like private credit, which today is a subsegment of private credit, but it could be it's all vertical much like secondaries. I think the fund finance business, which really that's what they're doing, is providing GP and LP liquidity solution, there's so many sub-verticals for that and players playing in the different niche markets. Some play in what I call manco, which is management fee or GP financing, some play in the holdco, which is really the GP private equity and credit funds. Others will finance the collateral through the portco, which is the portfolio company. And now growing need is in the property asset portfolios, which are somewhat underwater and needs a lot of liquidity, especially for the GP. So, within NAV loans, you really are looking at some of the three type of funds maybe that do this. You have the branded funds, the larger players, some fund diversified portfolios, some does a major branded funds with portfolio companies underneath through various funds. Then you have the mid-tier guys, and then you have the niche guys that are funding end of life stuff at huge discounts. Some are doing sub $50 million of NAV loans, which I really like that space, which are producing mid-to-high teens. And the last point I want to make is a number of these NAV strategy are either in the private equity GP, some are moving into the GP real estate fund arena, and some are picking over secondary credit to provide financing.

EMS:

John, outside of the typical corporate lending, what sectors to which the banks are abandoning and what esoteric and specialty lending programs produces best risk adjusted returns; (1) risk transfer CRT synthetic loans for banks; (2) asset-based loans ABL (i.e., sports media rights, equipment, aircraft, containers, trade finance, supply chain)? I would love to hear your thoughts on this.

JT:

Well, I guess you want to make the distinction between what's beta and what's alpha or outsized alpha, true alpha and much of the sponsored, I believe, levered or unlevered sponsored corporate loans are more beta plays. The outsize alpha you really need to capture in what I put in maybe four buckets. Either you could get it in complexity, you can get it in a smaller size, you can capture that in shorter duration or through speed or through very nichey areas which you just mentioned. I think other than the plain vanilla corporate loans, I think we're moving into an area where all kinds of stuff in structured finance will come about. And when I say outsize alpha, I think in NAV loans, you could theoretically capture 300 to 600 of outsized alpha, depending more on within the four or five strategy I mentioned. Or you can move into more the asset-based lending, which is a massive market and many of the bigger branded firms are starting to focus on. And that could be in the legal claims receivable, it could be in music royalties, it could be in equipment financing, it could be franchise finance. Others could be mortgage backed or consumer or esoteric type stuff or risk transfer, which if you start to look at that sector, the banks are in a position where they need this synthetic tech credit where today there's not that much money plowed into this where if you look at maybe 120 type of risk transfers done, maybe 100 is done mostly in Europe, but there's been three or four done in Canada and some done completed like with Western Alliance Bank here or a few of these regional savings bank. But I think that has some outsize alpha, but it's a very stable type of financing where underneath you're really looking to either, some are looking to just do sub line, some will only do revolvers and others will look at SME loans and some that don't want so much risk will only look at the larger investment grade corporates like the P&G or Johnson& Johnson type credit.

EMS:

John, we've covered a lot of ground and wanted to see if you have any final thoughts you'd like to share with us today.

JT:

Well, I think the Golden Age is here and in the next two or three years, I think the Golden Age exists for GPs and LPs and I think it has to be structured and aligned better between GP and LP. And then if you start looking ahead, rates will drop, who knows by how much, but I don't believe we'll get to the 2% range. So, if it hovers in the 3-4% range, you still got that gap that has to be dealt with. But that said, I think some opportunity exists in the short duration, which is what we focus on the five months, six months to 3-4-year type loans and I think there's a very large market to address that because most people are having much longer duration. And if you speak to family offices here and abroad, they like a portion of their yielding credit to be in the short duration so they don't have that refinancing maturity wall.

EMS:

John, I want to thank you so much for sharing your perspective with our listeners.

JT:

Sure, yeah. Appreciate it.

EMS:

And thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.