What to consider when selecting a private credit manager
While investors intuitively think about risk, bias plays a much bigger role in manager selection than most would care to admit. For example, some investors assume bigger is safer, while others chase the highest returns without differentiating risk between strategies. We think there is a better way: Adopting a rigorous, data-driven approach to manager selection.
One of the biggest questions in portfolio construction is the decision to include specialised or niche strategies. While adding a specialised or niche credit strategy to a portfolio may not increase its industry diversification, doing so will definitely increase strategy diversification and reduce portfolio volatility, both of which should be primary objectives. And specialised strategies may also offer other advantages, such as better downside protection or higher risk-adjusted returns, which are obviously important considerations in portfolio construction.
Speaking of performance, we recommend focusing your analysis on excess returns and the volatility of those excess returns over the long term and across economic cycles rather than absolute returns. What you want is high excess returns with low volatility across cycles.
Continue reading to learn about the eight key diligence topics that should help inform private credit manager selection.
In this issue of Perspectives, we also do a deep dive into:
- The Sharpe Ratio and why it matters
- Lessons we’ve learned over our 14-year operating history
- Venture debt defaults and how they are remedied
Have questions? Don’t hesitate to reach out, we’d love to chat.
Thinking of investing in private credit? Here’s what to consider when selecting a manager.
Alkarim Jivraj, CEO
While investors intuitively think about risk, I can share firsthand that bias plays a much bigger role in manager selection than most would care to admit. For example, some investors assume bigger is safer while others chase the highest returns without differentiating risk between strategies. We think there is a better way: Adopting a rigorous, data-driven approach to manager selection.
1. Portfolio construction and diversification
One of the biggest questions in portfolio construction is the decision to include specialised or niche strategies. While adding a specialised or niche credit strategy to a portfolio may not increase its industry diversification, doing so will definitely increase strategy diversification and reduce portfolio volatility, which should be the primary objectives. And specialised strategies may also offer other advantages such as better downside protection or higher risk-adjusted returns, which are obviously important considerations in portfolio construction.
2. Long-term excess return consistency
Instead of absolute returns, we recommend focusing analysis on excess returns and volatility of those excess returns over the long term and across cycles. You want high excess returns with low volatility across cycles. In this regard, the Sharpe Ratio is a useful analytical tool (see the next article for more on this topic).
3. Comparing performance to benchmarks
Unlike public assets, appropriate benchmarks are harder to come by for private credit. While Morningstar LSTA (leverage loans) and Bloomberg High Yield Bond indices are appropriate for comparing risk (loan losses), their return profiles differ materially from private credit. We suggest the Cliffwater Direct Lending Index instead, an asset-weighted index of more than 13,000 directly originated middle-market loans totaling $284 billion in assets. Using the Cliffwater data, however, will require a bit of work. Cliffwater presents gross income and adjusted net income comparisons (adding back all operating expenses including fees and interest costs), but does not provide a net income comparison. Additionally, you will need to make adjustments for differing asset valuation methodologies between IFRS and US-GAAP.
4. Gross interest income
Drilling down further, you should analyse gross interest income as it is by far the biggest source of returns. A strategy typically benefits from high interest income for one of two reasons: risk or arbitrage (limited competitive intensity, high complexity, etc.). Using an illustration close to home, venture debt enjoys higher gross interest yields while experiencing similar loan loss ratios as the broader direct lending category, suggesting that it benefits from some level of risk arbitrage, primarily due to regulatory obstacles that limit bank participation in venture lending.
Additionally, some strategies may also benefit from significant sources of non-interest income such as upfront fees, prepayment and exit fees, and warrants gains, all of which can be used to offset loan losses.
5. Loan losses, defaults, and loss given defaults
Speaking of loan losses, we recommend investors not limit their analysis to the loan loss ratio, but also examine default and loss given default ratios. The default ratio speaks to the risks inherent in the strategy as well as the manager’s skill in loan selection and screening, whereas the loss given default ratio speaks to the effectiveness of the strategy’s structural and contractual protective provisions, and the manager’s skill in remedying or recovering defaulted loans. Viewed together, they provide a much more nuanced perspective of the risks inherent in a given strategy.
6. Validating performance data
Of course, you will need comfort that the published reporting and any private data provided by the manager accurately represents its performance and is presented in accordance with applicable accounting standards — two very different assessments. Reviewing and cross-referencing the manager’s investment policy, loan tape, quarterly reporting commentary, monthly NAV books, and work-out case studies will provide important insights about the accuracy of its data and the transparency of its commentary, and will also highlight inconsistencies for further investigation.
Pay particular attention to portfolio and NAV valuations as well as fund-level cash flow reconciliation. Managers are often reluctant to share their proprietary information, but those concerns can be easily addressed by anonymising any sensitive information without materially diminishing the usefulness of this data. And this should not be a once-and-done exercise. Investors and allocators need to take a trust, but (continuously) verify, approach.
7. Isolating for manager skill
While many of the above measures speak to manager skill, they also subsume the strategy’s built-in merits. To isolate for manager skill, you should compare the manager’s performance to its direct competitors. A manager’s relative competitive differentiation will be evidenced by some combination of higher gross yields, higher cash income, higher total net income, lower volatility, lower default rates, lower loss given default rates, and lower loss rates.
8. Operational risk assessment
Operational risk assessments are all about identifying manager-level risk. Areas to focus on include: assessing the people, processes, technology, governance, and financial controls of the manager. Organisations like the Alternative Investment Management Association (AIMA) provide good due diligence questionnaire templates that are widely used by both institutional and non-institutional allocators. You can also gain comfort from any third-party audits the manager is subject to, including lenders, rating agencies, and institutional investors.
The Sharpe Ratio and why it matters
Gordon Henderson, Managing Director
The Sharpe Ratio is a measure of risk in a given investment, calculated as the average return minus the average risk-free rate for a given period (i.e., the excess return), divided by the standard deviation in the excess returns over that period. This is expressed as a real number, with a higher number signifying a better risk-adjusted return. As an illustration, a portfolio with a Sharpe Ratio of 2.4 will have generated higher risk-adjusted returns compared to a portfolio with a Sharpe Ratio of 1.7.
While the Sharpe Ratio has a number of limitations, it can drive important insights. For example, it allows investors to compare performance between funds and assist in portfolio construction and analysis. In the first case, if you compare two funds with approximately the same returns over time, the one with the higher Sharpe Ratio will be the less risky option. Or, if the addition of a new position to an existing portfolio improves its Sharpe Ratio, then you have just reduced risk in that portfolio.
The Sharpe Ratio was an output of William Sharpe’s work on the Capital Asset Pricing Model (CAPM), for which he won the Nobel Prize. The CAPM’s core thesis is that expected returns are positively correlated with risk. In other words, an investor needs to take more risk to earn higher returns. The Sharpe Ratio extends this insight, using volatility as a proxy for risk.
Mathematically, the formula is expressed as:
Here, Rp is the return on a portfolio, Rf is the risk-free rate of return, and 𝜎p is the portfolio’s standard deviation or volatility in the portfolio’s excess returns. The calculation helps formalise an investor’s intuitions: Higher returns are better than lower ones, a higher spread relative to the risk-free rate is unambiguously better than a narrower one, and lower volatility is preferable to higher volatility. Sharpe’s great insight was in linking these trivially obvious points to risk, and in doing so providing a common analytical framework for investing.
Its simplicity also makes some of the Sharpe Ratio’s shortcomings quite obvious. For example, volatility, expressed here as a portfolio’s standard deviation, is an imperfect proxy for risk. After all, not all volatility is bad. A fund that returns 1% per month for 11 months and 3% for one month is mathematically about twice as volatile as a fund that returns 1% for 11 months and 2% for one month. The second fund in this thought experiment would have a higher (better) Sharpe Ratio, which reinforces the point that the Sharpe Ratio should not be relied upon in isolation.
The ratio’s shortcomings, however, shouldn’t blind investors to its utility. Rather, it should inform the way in which they should use it. If an investor just myopically looks at the numbers on a page, adding one more number (the Sharpe Ratio) probably isn’t going to help their decision-making all that much. But, if they take the trouble to understand a manager’s strategy and investment process, the Sharpe Ratio can be a powerful tool with which to analyse the manager’s performance in the context of that understanding.
We should also highlight that different measurement periods will yield different Sharpe Ratios. For example fund returns measured monthly will generate a higher volatility, and therefore a lower Sharpe Ratio, than the same fund returns measured quarterly or annually. Therefore, care should be taken to compare volatility and Sharpe Ratios using the same measurement period.
Lessons we’ve learned over our 14-year operating history
Enio Lazzer, Chief Operating Officer & CFO
Venture debt firms (like most private credit firms) operate in a rapidly changing environment where decisions are as much about assessing risks as they are about recognizing opportunities. The following is a summary of the valuable lessons our firm has accumulated over our 14-year operating history.
Lending to borrowers backed by traditional sponsors yields better outcomes
Our loan losses stand significantly lower than those of our competitors. But if we exclude unsponsored borrowers and those backed by non-traditional sponsors like family offices (i.e., non-traditional sponsors), our loan losses are virtually non-existent. And this is not a statistical aberration as approximately three-quarters of our historical lending has been to traditional, i.e., professional venture capital backed, borrowers.
While it makes sense that sponsor-backed borrowers should be less risky, our experience has shown that lending to non-traditional sponsored-backed companies is even riskier than lending to unsponsored borrowers. Why the disconnect? As we dug into our data, the answer became apparent: Traditional (i.e., professional venture capital) sponsors exhibit more rational behaviour and greater urgency in resolving poor-performing loans. This is in part because their priority is overall portfolio performance and they are therefore motivated to backstop poor-performing investments to exit even if that results in a loss.
Since venture capital sponsors are specialists in the categories they invest in, they are not only better equipped than their non-traditional counterparts to determine the optimal timing to exit an investment, but also have greater capacity to assist management in achieving the highest exit price possible. Additionally, they value their relationships with their venture lending partners, resulting in more transparent and constructive engagement. Consequently, we’ve made the strategic decision to narrow our lending to traditional sponsor-backed companies only.
Shareholder misalignment can nullify the benefits of investor support
While sponsor backing is a powerful backstop to venture loans, shareholder misalignment can nullify its benefits. An example of shareholder misalignment is a situation where you’ve got one or more investors with approval rights on future financing but without the capacity to participate in future financings. Or it could be where you have two or more investors with approval rights on M&A transactions but different views on the best timing to sell the company.
Since shareholder misalignment can be difficult to fix after the fact, it is essential to identify any such issues during initial screening and due diligence. This requires understanding each investor’s investment horizon, their capacity and willingness to continue to support the borrower, and their track record as co-investors. Equally important is assessing the various preferred rights held by each class of preferred shares, and identifying potential sources of misalignment that could impact our loan.
Thankfully, venture lending is a very relationship-centric business, and therefore you can have very detailed and frank conversations regarding strategic direction and investor support upfront, including addressing any approval rights that might adversely impact a loan.
Software companies are more resilient and offer better security
When borrowers get into trouble, our experience has been that software companies tend to be more resilient than non-software companies. This is primarily due to the fact that software companies, particularly those selling mission-critical or core operations solutions to business customers, are better positioned to retain their revenues during an economic downturn while continuing to benefit from secular growth. While they may not showcase the astronomical growth rates seen in other venture capital categories, enterprise and mid-market software firms are also notably less volatile in their growth rates, churn rates, capital efficiency, and cash burn rates.
Their sticky revenues also make them attractive tuck-in acquisition targets for larger software companies, providing a viable path for exiting poor-performing loans if need be. Unsurprisingly, the vast majority of lending is focused on software companies serving enterprise and mid-market customers.
Speed is everything when it comes to venture debt risk mitigation
The biggest risk in venture lending is decelerating revenue growth, and if left unresolved, it will ultimately result in a cascading set of other risks. The big lesson learned is that we need to engage with the borrower and its sponsors at the first sign of revenue deceleration rather than waiting until the growth covenant has been tripped. While our negotiating leverage is limited pre-covenant breach, we can still apply moral suasion, including projecting when future defaults will occur based on the current reporting and growth trajectory.
Our objective is to focus everyone’s attention as soon as possible on identifying the root causes of decelerating growth and determining if the original growth trajectory can be restored. The sooner that determination can be made, the sooner the remedies can be applied, including resetting the financial plan and raising additional capital, or selling the business.
Near real-time account management and the power of predictive intelligence
Having already highlighted that decelerating growth is typically the first and most relevant risk indicator in venture debt, it naturally follows that if we can better predict growth rates, both at loan inception and over the lifetime of the loan, then doing so should reduce defaults as well as other compliance noise. Of course, that requires a fairly sophisticated data infrastructure, which we thankfully have due to our years-long investment in Espresso Insights, our proprietary portfolio analytics and risk management platform. The platform has not only enabled us to achieve lower loan losses compared to our peers, but also positions us to take advantage of recent advances in generative AI to apply predictive intelligence more broadly across our business, including predicting borrower growth rates and loan compliance risk.
But we don’t want to stop there. We think that our predictive models can also help our borrowers to build more realistic forecasts and operating plans, and that our benchmarking data can help suggest areas for operational improvement, particularly in their marketing, sales, and customer success functions. All this, of course, will further reduce the risk we are exposed to!
Understanding venture debt defaults and how they are remedied
Will Jin, Managing Director
Before jumping into a discussion on defaults and remedies, it’s worth highlighting that different credit strategies require different approaches to risk and portfolio management. Venture debt is all about proactive risk management, so not surprisingly venture debt covenants have evolved into early warning signals rather than immediate triggers to demand loan repayment.
What is a default?
A default occurs when a borrower fails to adhere to the terms of its loan agreement and fails to cure this non-compliance within the defined cure period. The primary triggers for a default include:
- Failure to make interest or principal payments when due
- Non-compliance with loan covenants
- Non-compliance with other loan terms such as failure to provide reporting when due
Clearly not all of the above defaults pose the same risk. For example, while non-compliance with financial covenants shows that the borrower is underperforming relative to plan, depending on its severity, it may or may not signal a future risk of capital loss. By contrast, failure to pay interest or principal suggests the risk has now become critical. Non-compliance with other terms, such as late reporting, may be entirely unrelated to borrower health.
Typical venture debt covenants
As alluded to earlier, venture debt covenants are designed to work as early warning signals and typically focus on the metrics that matter most to venture lenders: growth and liquidity. If a company is growing rapidly (and capital efficiently), it will attract follow-on financing during both good times and bad times. However, when growth starts to plateau, follow-on financing risk increases. That is why a growth covenant is the best early warning signal.
The objective of the liquidity covenant on the other hand is to ensure that the borrower raises its next round of equity capital in a timely manner, and if it can’t do so, to provide the lender with sufficient runway to execute a sale transaction.
Other covenants in venture debt deals include limits on customer churn, minimum gross margins targets, minimum capital efficiency measures, and cash flow targets.
The cause of venture loan problems is almost always insufficient growth to attract follow-on financing, though root causes vary greatly. Slowing growth rates may also cause a cascade of other issues, including missing financial targets, burning more capital than planned, and eventually failing the liquidity test.
Obviously we want to get to the root causes of slowing growth as soon as possible. And while we are doing that, we also want the business to reduce its overhead so that it maximises its funding runway to the extent possible. Next, we need to determine if growth can be restored, and if not, whether the business remains viable as a standalone entity at its lower growth rate. In both cases we may require equity investors to refuel the business, depending on its cash reserves and runway.
If the determination is made that the business should be sold, then all parties need to agree on an exit strategy and timeline. Depending on the borrower’s liquidity, we may also require the investors to provide bridge financing.
Of course, engaging all stakeholders well in advance of a covenant breach not only helps to build consensus sooner to act faster, but also establishes the fact pattern to justify Espresso’s enforcement actions, should we need to go down that path.
Good working relationships with borrowers and their sponsors are critical for effective risk management
Lenders need to foster good working relationships with borrowers and their sponsors. Doing so should lead to greater transparency, more constructive conversations, and faster issue resolution, all of which have a far greater impact on loan outcomes than reliance on enforcement action.