Worse To Come For Alternative Finance Funds?
10th March 2016
Much as my colleagues at AltFi Data get terrifically excited about direct investment transactions at the platform level, the truth is that for many investors the most popular way to play the alternative finance space is through a fund. On the UK market there’s a growing gaggle of listed closed end funds which have collectively raised around £1.5 billion to invest in both business and consumer loans. The direct route investing through platforms has its obvious attractions but it seems that many sophisticated investors prefer to use a fund where the manager can diversify between asset classes and platforms.
But there is an obvious downside to investing in a fund, especially one on the London stock market. These funds – popular as they are – will trade up and down in price along with market sentiment. Until fairly recently the share price of most of the leading alternative funds in this space such as P2PGI, VPC, GLIAF and Ranger had held up well in the face of very negative market sentiment. But the most recent stock market down turn starting in January inflicted huge damage on this specialised space with some listed funds going to discounts ( this means the share price trades at a discount to the net asset value of all the assets in the fund) of more than 15%.
The good news is that the stockmarket has recently regained much of its confidence and powered back up to near term highs, and many of the funds in this space has tagged along with this rally.We estimate that the average alternative finance fund is now trading at a discount of 4.35% (if one excludes GLIF which operates more of a hybrid equity and debt model).i.e for every 96p a share, you are buying 100p of assets.
That compares well with equivalent distressed debt funds where the discount is 7.8% and CLO corporate loans funds which are running close to 10% - we’ll come back to those CLO funds in a short while.
So far, so good. But we think investors need to be careful at this juncture – if evidence from similar funds is anything to go by, much worse may be on its way. In sum those discounts could start to widen again if the recent experience of CLO and American based BDCs are anything to go by. In the worst case scenario discounts could widen out to as much as 20% to 30% if investors turn really bearish.
To understand this dismal scenario let's revisit those acronyms – CLOs and BDCs.
We’ll kick off with CLOs are which are arelatively new way of lumping together loans from mostly sub investment grade corporate issuers (usually though not exclusively American), and then making them investor friendly with generous yields and in built leverage. The London stockmarket even features a small handful of perfectly respectable CLO closed end funds including the venerable Carador vehicle and more recent Fair Oaks. Both have raised considerable chunks of capital from UK wealth investors, tempted by initial yields not that far off 10% per annum.
Perhaps most importantly these funds also matter because they are in effect useful canaries in the coal mine telling us about the (deteriorating) state of US corporates.
Put simply these poor complex creatures are ailing, with sharp price falls in the last year and recent months. Market insiders now reckon that B-rated tranches are collectively trading down about 25% on the year. Event-driven hedge funds have twigged and are now taking aim at the market.
Reading between the lines in a recent Carador statement, it emerges that in some structures every single tranche has recently suffered negative returns for the first time since inception. The average price of post crisis CLOS has now fallen 8.9%, and we’ve experienced eight consecutive monthly declines, the longest losing streak on record. Crucially CLO issuance is now running at the slowest rate since 2011.
Perhaps the key measure though is the default rate – which has actually only bobbed up a tiny amount from 1.69% to 1.96% although analysts expect 3% in the next few years. In sum the CLO market is in a pretty terrible state, and getting worse by the day.
Next up let's look at the specialist US market for Business Development Companies or BDCs for short. These funds are closed end funds like our investment trusts here in the UK and they put US investors money to work in lending to smaller businesses with sales of anything between $1 to $100 million. Funds such as Funding Circle’s SME fund are very similar in style to BDCs in that they warehouse a bunch of loans and then pay out nearly all the interest to investors.
To be fair there are some differences between BDCs and the wider alternative finance funds in the UK not least that outfits such as P2PGI put money to work lending to consumers. But the BDC space is nevertheless relevant for UK investors because it gives us an indication of what could happen to alternative finance funds if investor sentiment sours.
In the last six months the share price of BDCs has fallen off a cliff. Big outfits such as Prospect Capital (PSEC) have seen their shares trade at a discount of upto 40% with dividend yields approaching 17.7%. Not all BDCs have traded at these extreme levels, with outfits such as Apollo doing much better. But the general message is clear. US investors are worried about lending to businesses. A number of catalysts have emerged in the last 12 months not least the threat of increasing interest rates (though most BDC loans are variable rates), as well rising corporate defaults especially in energy related sectors.
Investors have in effect started applying a hefty discount to the book of loans within the fund, assuming that defaults will soar if the US falls into recession. Crucially investors have also started looking even more closely at those loans books and the ways in which fund managers recover money as a result of bad debts. In practical terms that means investors want to be able see through into exposure towards key sectors. They also want to understand how funds will recover money if things go wrong – and how quickly.
In conclusion our big worry is that many of the issues that have hit both the CLO and BDO sector will now have an impact on marketplace/P2P and direct lending markets here in the UK – and the funds that invest in this space. The leading alternative finance platforms may have survived the recent market carnage in good shape but the worst could still be to come!