Nick Rees, chief executive officer of the Blu family office discusses why non-bank lending assets are attractive for income investors.
As a family office, we believe in the principles of diversification and efficiency. We spread our investments across various strategies in the hope that over time we will generate efficient risk adjusted absolute returns. However, unlike many investors, we do not diversify across different asset classes; rather we look to identify the risks associated with every investment we make and to diversify across those risk drivers.
Very simply, at the core of this process we identify two main types of risk – you either own something (in which case you are exposed to price risk – the risk of it going up or down); or you lend to someone (you are exposed to the risk that that person or entity cannot pay you back – credit risk).
Now in financial markets, getting exposure to price risk is relatively efficiently done. With expertise you can do it yourself (and we do), or you can outsource this to fund managers (just be careful that the risk you think you are getting from a manager is ‘pure’ and not a combination of other risks as well).
The Credit Conundrum
Within credit, however, the solution financial markets were previously able to provide (yield in the form of bonds) has largely disappeared over the last 10 years with the ultra-low interest rate environment much of the developed world has experienced. Put another way, credit risk is relatively poorly rewarded by financial markets today.
So, if we are to generate attractive returns in what we view as our most conservative ‘bucket’, then we have to look outside of financial markets and that is why the alternative/private lending market is attractive at this time.
But what is Private Lending?
Very simply, private lending is the disintermediation of banks by other liquidity providers in the form of individual and institutional investors pooling assets to lend. These vehicles are able to provide much the same financing, but more quickly and nimbly than traditional lenders.
However, the ‘double whammy’ here is that in conjunction with the public markets not providing a solution to borrowers, competition from banks in the private lending markets has largely evaporated, so these pooled vehicles are able to operate relatively freely in servicing a natural demand from (typically smaller) well run businesses.
And unlike the public markets which are ruthlessly price efficient, private lenders are not typically competing on price; they are competing on speed of service, hence the attractive, stable yields.
Private Lending - A Secular Trend?
It is clear that over the last few years, lots of money has flowed into this asset class and as a result yields have undoubtedly come down as more investors chase a limited number of opportunities. In that sense, we are clearly well into an established trend which cannot continue indefinitely. However, pockets of opportunity definitely exist. Below we outline two specific ones:
No Free Lunch
Of course, there is no free lunch and risks do exist in the private lending markets. In our opinion, though, credit risk isn’t the biggest concern as collateral tends to be (a) easily identifiable (b) realisable. Also, loan to value coverage levels are also reasonable, typically 60-75% LTVs.
One risk we have identified and focus on is liquidity – put simply, you can’t achieve a 6% return by lending money for 1 year and yet have daily/weekly/monthly liquidity. Beware of strategies that promise this.
Another set of risks are the operational risks associated with monitoring loans and lending money – who can physically move money, to where and to who? How are loans valued when they are extended or impaired, etc?
And there are many more, so our humble advice would not to be too aggressive with your return targets. If something is too good to be true, it is.
Short Duration Focus
How we approached the asset class is to focus on secured, short duration lending (<1 year loans on average) because we feel that the risk return profile is more attractive here relative to locking your money up for longer in return for a relatively small return enhancement.
Why stay in the fully secured space? Well this is our most conservative strategy - there is no need to take big risks when your return targets are relatively modest (5-6% is very achievable).
How do we do this? We have established a fund vehicle – The Blu Income Fund – to construct a diverse portfolio and to allow likeminded investors to co-invest alongside us. If you would like to find out more about our approach, feel free to contact us.