The case for alternative credit

Philippa Owen, Grayswan Alternative Credit

Alternative credit is simply defined as any credit that is not traditional investment-grade corporate or sovereign debt (fixed income). Alternative credit includes high-yield credit, bank loans, structured credit and hedged credit on the liquid side and strategies such as direct lending (private debt) and speciality finance on the illiquid side.

In direct lending, or private debt, a loan is directly originated to a private company (typically a small or medium-sized enterprise) and is secured by the cash flows of that company. By contrast, speciality lending ties to the performance of specific assets (credit card receivables, equipment leases, insurance claim pay-outs, development finance etc.) and investment managers provide financing, primarily through highly structured asset- backed facilities, to speciality finance companies who originate the loans.

Each of these sub-asset classes carries a different set of return drivers to traditional credit, which is mostly driven by investment-grade credit risk, interest-rate risk and inflation uncertainty. Most investors have significant core fixed income exposure, leaving them exposed to credit cycles and interest rates. While there is some longer-term correlation to interest-rate levels (interest on private loans is normally structured as interest rate (Jibar) plus an additional margin) these returns do not fluctuate with shorter-term interest-rate expectations. Alternative credit strategies generate additional returns through illiquidity and complexity, through thematic market drivers and through manager skill in a space where active management is more likely to be rewarded. Accessing these different sources of return and thereby increasing diversification can create a better risk-adjusted return profile for investors.

The investment opportunity is also very compelling. Alternative credit and private debt strategies have ballooned globally due to banks being unable to lend to companies to finance growth. With institutional investors increasing their allocations to private debt, and companies turning increasingly to this market for funding, capital markets are playing a bigger role in supporting the real economy. In South Africa, the opportunity set reflects the dynamics of the global economy and is highly attractive. It is not anticipated that the fundamentals driving this dynamic are likely to change in the near term – on the contrary, many financial market participants believe that alternative credit strategies will continue to play a major and increasing role in corporate financing solutions in the future.

Managers focusing on alternative credit strategies have proven their ability to add value through skill in investment selection and deal negotiation, through ongoing interaction with their borrowers and through their ability to successfully navigate challenging market environments. Private debt deals are structured so that both the return and duration of the loan are known, and payments are backed either by strong cash flows and guarantees or by some form of surety/collateral. Private debt deals are used to finance capital expenditure (growth), specific projects, property deals or acquisitions and are carefully structured to maximise return and minimise risk to the lender and thus to the end investor. These deals are individually negotiated to include specific covenants and protections and the manager will monitor the performance of the company in meeting agreed target measures and deliverables. While the downside of private debt as a strategy is illiquidity, the upside is a steady return stream that is uncorrelated to other fixed income and equity strategies.

Another significant benefit of private debt as a strategy is that it can also be specifically dedicated to responsible/ESG (environmental, social and governance) investing. Loans can be directed to companies that are investing in clean energy, social upliftment, infrastructure development, and community health and education initiatives. We have seen a number of managers who have a high ESG focus developing funds that invest specifically in these areas: infrastructure funds, clean energy funds and community development funds are becoming more widely available for investment. Impact investors focus on investments that have a direct social or environmental benefit while generating a good financial return for investors. In South Africa, impact investing ensures that more money is made available to invest in projects that tackle unemployment, poverty and inequality. Smarter agriculture (investing in technology and other solutions to improve output and sustainability) and renewable energy also present untapped opportunities that can provide solid financial returns while addressing important socio- economic development goals (SDGs).

Investors can access these investments in a number of ways: retail investors can invest in dedicated unit trusts, tax-efficient vehicles and even impact farming (a type ofcrowd funding/crowd farming that enables individuals to ‘buy’ a share of a sustainable venture – a South African innovation, which is a global-first, allows investors to direct their investments into specific ventures via an app with very small contributions). Institutional investors and asset owners (pensions funds) can invest directly in private debt funds. With a greater requirement for asset owners to incorporate ESG considerations into their investment selection and to report on their ESG initiatives, investing in impact funds has become increasingly appealing. Allocating capital to dedicated ESG-focused private debt funds demonstrates a specific and direct commitment to responsible investing. Alternative credit funds that focus on ESG criteria have delivered attractive returns and demonstrated that investing responsibly does not have to mean sacrificing returns.

Investing in alternative credit/private debt funds can pose a challenge to investors: the funds tend to be illiquid (longer lock- ups), structured as private partnerships or trusts, have high investment minimums and be relatively complex. Complex strategies require specialist expertise and transparency in order to fully understand the opportunity set and the risks being taken. It is essential that a thorough due diligence is done prior to investment in order to fully understand the opportunity.

Investments in these strategies require a specialist approach and as such are best accessed via a fund of funds. Not only will the fund of funds provide additional diversification benefits across the alternative credit asset class, but the fund of funds manager takes the responsibility for evaluating underlying manager skill, fund structure and governance and for ongoing monitoring of the underlying portfolios. The fund of funds manager may also tilt investments according to identified market themes and towards managers who align with specific objectives, such as responsible investing and ESG. Liquidity is managed at the fund of funds level.

As an investment strategy to consider, alternative credit is an exciting area with a vast number of return and opportunity benefits to the investor and is a strategy that can be used as a tool to direct impact investment as part of a responsible investment programme. However, the strategy is not simple and does require specialised understanding of the risks involved. Accessing the strategy then, either via a regulated fund of funds, or directly with the advice of an experienced consultant, is recommended in order to benefit from the potential of these investments while ensuring the risks are managed. Copyright. HedgeNews Africa – November 2021.

Philippa Owen at Grayswan Alternative Credit has more than 20 years’ investment experience. Before returning to South Africa in 2012, she was investment director and portfolio manager for a number of large institutional fund of hedge fund portfolios in London. She has a B Business Science degree with Honours in Information Systems, and is a CFA charterholder.