Given the unprecedented events of the past week, we have been witnessing the adverse effects of volatility in our own public market portfolios, and we assume you have as well. It is in times like these that we have greater conviction than ever that private credit remains an uncorrelated asset class that can continue to consistently deliver attractive risk-adjusted returns for investors, especially in low rate environments.
Private debt has experienced steady growth through several downturns, including the most recent financial crisis in 2008/2009, and has managed to increase in market size almost every year since 2006.
Investors have often cited 2008 and 2009 as their best performing vintages, as hundreds of thousands of high quality borrowers and small businesses owners who rely upon their cash flow and credit to pay their children’s tuition, put food on the table, and save for retirement, were left stranded by banks who pared back. Their livelihoods are completely intertwined with their businesses and were dependent upon reliable financing to pay their employees on time, purchase inventory and grow. Non-bank lenders stepped in and these high quality borrowers and small businesses performed well, just as expected.
We see a similar situation playing out today – there are still many pockets of high quality borrowers and small businesses that are deserving of capital in these trying times. With disciplined underwriting, quality structuring, and vigilance around performance monitoring, we are confident in our ability to leverage our technology and emerge from this downturn with a portfolio of originators that can deliver on our commitment to creating high quality alternative investment products.
While the very nature of our short-term note program is built around robust risk mitigation, we understand these are rare times. As such, we thought it would be prudent to outline our multi-tiered approach below and share information we received from our originators this week in conjunction with our ongoing due diligence and performance monitoring process.
Given the recent market movements, we have been in close contact with our origination partners for updates on their risk management strategies. While this is part of our ongoing due diligence responsibilities, we wanted to provide investors with an added layer of transparency to understand what specifically our originators are doing in response to recent market developments. In general, most originators have reported muted impacts on their respective portfolios. This is largely credited to their strong underwriting practices and ability to leverage technology and data to react seamlessly to changes in marketplace dynamics.
Trevor Smyth, Managing Partner at Arctos, reports that their “loans are underwritten and structured with an expectation of collateral volatility, and safeguards including margin calls and put options remain in place as usual.”
Although black swan events are by their nature impossible to predict, it is important to highlight that our originators have still positioned their portfolios for the possibility of such occurrences.
Bharath Krishnamoorthy, CEO of Axle, said they “don’t expect to see many coronavirus-related losses in the near term. We will continue to monitor the situation as it develops, and will make any required changes to our risk mitigation and underwriting policies as necessary.”
Despite recent volatility, our origination partners continue to improve upon and monitor their underwriting standards. For example, Guillermo Hernandez, CEO of Aspiria, stated that they “have installed a series of guidelines to have a better communication and reaction speed with our clientele to prevent any unforeseen events with our portfolio.”
Many originators depend heavily on data driven methodologies. Nelson Ortiz, Head of Finance at Zinobe, highlights this data driven approach coupled with, “the short tenure of [their] product and [their] ability to monitor payments on a daily basis” allows the company to adjust “model parameters to reduce default risk.”
Suffice it to say that we will continue to be in close contact with all of our origination partners over the coming weeks and months as we navigate through a potential prolonged global economic downturn.
Cadence continues to closely monitor underlying loan tapes and payment information received from our originators for any under performance and/or overweight exposures to any identifiable at-risk segments.
As part of our risk management policy, it is important that we maintain a diversity of originators on our platform. As such, the majority of our originators are from a diverse array of niche sub-sectors (except for the MCAs we work with that are broadly diversified within the SMB sector).
We have proactively scanned those portfolios that have known at-risk exposures this week and will continue to actively monitor these segments going forward. Even prior to current events, many of our originators have also been proactively identifying industries with higher exposure to market volatility and allocating more of their portfolio to non-cyclical industries less impacted by recessions.
Guillermo Hernandez, CEO of Aspiria, stated, “Our company has been working over the last years in originating predominantly financing secured by real estate, with a focus on prime clientele. We have also made a special effort in financing non-cyclical or recession-free industries, such as healthcare and education, as well as upgrading our internal procedures. We will abide by our strict credit policies which have historically provided low default rates, and we will continue to uphold best practices in our underwriting systems.”
In addition, SellersFunding CEO, Ricardo Pero, explained, “We’re asking additional questions related to where manufactures are based, turnaround time for shipments, limiting disbursements based on inventory levels, etc.” to help gauge and assess the client’s exposure risks to COVID-19.
If needed, Cadence has many tools at its disposal to simultaneously protect note investors and support originators and maintain consistent performance going forward.
The four main variables we can directly adjust on the structure of our notes are (1) increase first loss levels with certain originators with at-risk exposures and/or experiencing underlying performance drift, (2) curtail the amount we issue for such programs, (3) further shorten the tenor of our notes, and/or (4) increase the expected APYs to our investors to right size the risk-reward balance.
On (1), we will be increasing the contingent first loss provisions on some future notes, in anticipation of potential effects to portfolios that maintain meaningful exposure to consumer discretionary. This will act as a credit enhancement for our investors, while adding further protection from potential underperformance of notes. This also translates to a lower advance rate for the originators, thus slowing the speed at which they can continue to grow until performance is restored.
On (2), we will endeavor to maintain the current size of our programs as long as underlying cash flows can support such size. If we begin to see a material uptick in defaults or delinquencies, we will downsize our programs accordingly to maintain consistent risk/return profiles alongside raising first loss provisions as described in (1) above.
On (3), we may further shorten the tenor of our notes so that we may have more flexibility to adjust the variables described in (1) and (2) and effectively mark-to-market our notes in a more frequent manner. This is a key value proposition with our short term note programs and we will strive to be as flexible as possible, which in turn provides our investors with the most liquid private credit investment on the market.
On (4), once the prior three steps have been taken into consideration, we always have the option to increase the APY on our notes to accommodate investor demand. Given our market-based pricing approach, we are keenly aware risk premia has adjusted in other markets and should we need to find a market-clearing level, we’ll be in a position to adjust accordingly to the extent possible. This is largely a factor of what cost of capital our originators can bear based on the returns they garner from their underlying portfolios.
As we continue to monitor performance data, as well as receive ongoing feedback on the steps our originators are taking to bolster underwriting standards, shore up liquidity and/or tactically adjust exposures, we’ll use the various structuring tools at our disposal to right-size the risk/return profile of our notes accordingly. The benefit to our short term notes is that it allows us this flexibility in order to better ensure principal is protected. Ultimately, we can, of course, always suspend or discontinue a note program altogether should we have any reason to believe potential losses cannot be adequately structured away.
Protecting investor capital is our primary objective at Cadence, and everyone here remains committed to our risk management framework. While the recent market movements have been tumultuous, these unique conditions have provided us an opportunity to analyze and improve our already robust risk management models. Ultimately, this is all to better protect you, our valued investors. Please don’t hesitate to reach out to us if you have any specific questions.