Third Eye Capital
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Toronto, Ontario, M5J 2T3

CEO Insights

CEO Insights

Banking to the Relationship, Lending to the Business (Q3-11)

Banking to the Relationship, Lending to the Business (Q3-11)

Sep 30th, 2011

The following was excerpted from Third Eye Capital Management Inc.’s Q3 2011 Investor Letter.

Private lending as an investable asset class has been historically classified as niche and been reserved for large institutional investors within closed-end investment vehicles. In Canada, we were one of the first managers to launch a pure direct lending fund for institutional investors. However, investor demand and bank regulation has promoted an inexorable trend in lending over the past thirty years towards an efficient market where loans are syndicated and traded much like bonds and shares in relatively transparent and liquid markets. Today, the U.S. has a mature secondary loan market where institutional investors can avail credit ratings, independent research, and quotations to help mark their portfolios. In fact, loans are considered a distinct asset class in the U.S. In contrast, the Canadian secondary loan market is still very small and undeveloped. We believe the main reasons for this disparity include: the large size of the Canadian chartered banks relative to the domestic loan market and their control of primary supply; the diversity of banks’ loan portfolios given their extensive branch networks and coast-to-coast lending capacities; and an absence of institutional investor demand due to lack of familiarity or expertise.

Canadian banks have been very efficient in building loan portfolios in the large segment of the commercial market and investment grade corporate market. Smaller commercial loans, where credit spreads are benchmarked off the Prime Rate (rather than interbank offer rates or yields on bankers’ acceptances, which apply to larger loans) are typically processed with minimal staff involvement based on internal rating systems that look for positive earnings history, strong tangible net worth, and sufficient collateral. Industry preferences also have an influence on the loans that Canadian banks will approve. For example, we have recently seen a rise in deal referrals from banks that are rejecting loan applications in the upstream segment of the oil and gas industry. A more defensive posture by banks has resulted in sectors like media, construction services, and technology becoming out of favour.

According to Standard and Poor’s, since the early 1990s, large banks have adopted portfolio risk management techniques that measure the returns of loans relative to risk, and have learned that bank loans are rarely compelling investments on a stand-alone basis. Monitoring costs are very high so banks diversify by number of loans to try and lower portfolio risks (see our Q3-2010 letter wherein we challenge this conventional belief). It is not uncommon to have Canadian commercial bank officers manage 200 or more credit relationships at the same time, which requires banks to have a tolerance for some losses but maintain rigidity in the criteria for loan approvals. Non-credit related income sources are driving the relationship banks want with borrowers.

Banks are reluctant to extend credit to borrowers unless the total relationship generates attractive returns, preferably from activities that do not require a capital charge. In Canada, such non-credit related business includes cash-management services, foreign exchange transactions, brokerage services, pension-fund management, employee transaction processing, and capital markets advisory work. The spread on credit has become less important for banks than the amount of fee-driven business that can be captured as a result of a borrowing relationship.

Pricing loans based on relationship returns favours larger and more established borrowers. It was no surprise then that, prior to the financial crisis, U.S. non-bank finance companies held the largest market share of middle-market commercial loans in Canada. The size and concentration of the Canadian banking oligopoly has been the source of structural inefficiencies in middle market lending that have contributed to persistent returns for non-bank lenders and dedicated funds like ours.



Domestic (Canadian) Advisor registration form:

If you are an advisor that distributes or is interested in distributing a fund advised by Third Eye Capital Management Inc. you can register to request a call or meeting. You will be asked to provide information to confirm your qualifications to invest in or distribute the funds. This brief registration process allows us to conform to applicable securities laws and to obtain some basic information about you. Once we have qualified and approved your registration, we will get in contact with you to schedule a meeting.

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Domestic (Canadian) Investor registration form:

If you are an existing or prospective accredited investor that distributes or is interested in distributing a fund advised by Third Eye Capital Management Inc. you can register to request a call or meeting. You will be asked to provide information to confirm your qualifications to invest in or distribute the funds. This brief registration process allows us to conform to applicable securities laws and to obtain some basic information about you. Once we have qualified and approved your registration, we will get in contact with you to schedule a meeting.

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International Investor registration form:

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If you are an existing or prospective accredited investor or an advisor that distributes or is interested in distributing a fund advised by Third Eye Capital Management Inc. you can register to request a call or meeting. You will be asked to provide information to confirm your qualifications to invest in or distribute the funds. This brief registration process allows us to conform to applicable securities laws and to obtain some basic information about you. Once we have qualified and approved your registration, we will get in contact with you to schedule a meeting.

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Instructions for the following sections: Individuals please answer Part A of Sections I and II; Institutions please have an authorized person answer Part B of Sections I and II.

Section I - Accredited Investor Threshold Questions:

Part A - For Individuals:

1. I certify that I have an individual net worth, or my spouse and I have a combined net worth in excess of $1,000,000.

2. I certify that I am highly a sophisticated investor who routinely invests sums of $250,000 or more.

Part B - For Institutions:

1. The submitter certifies that it is a bank, insurance company, registered investment company, business development company, or small business investment company.

2. The submitter certifies that it is a charitable organization, corporation or partnership with assets exceeding $5 million, and that was not formed to invest the Fund.

3. The submitter certifies that it is a corporation, partnership or trust with assets of at least $5 million, that was not formed to invest in the Fund, and whose purchases are directed by a sophisticated person.

4. The undersigned certifies that all of its equity owners are “accredited investors” as defined in United States Securities and Exchange Commission Rule 501(a) and who can satisfy the higher criteria for the same set forth in Section I, Part A above.

Section II - Qualified Purchaser Questions:

Part A - For Individuals:

1. I certify that I own not less than $1,000,000 in securities investments.

Part B - For Institutions:

1. The undersigned certifies that it is a bank, insurance company, registered investment company, business development company, or small business investment company

2. The undersigned certifies that it is a "family owned company" (as defined below) that owns not less than $5,000,000 in securities investments. A "family owned company" is defined as a company that is owned directly or indirectly by or for two or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendents by birth or adoption, spouses of such persons, the estate of such persons, or foundations, charitable organizations, or trust established by or for the benefit of such persons

3. The undersigned certifies that it is a trust that was not formed to invest in the Fund, the trustee or decision-making authority of which, and every person contributing assets to the same, is a “Qualified Purchaser” under one of the other definitions of this Section

4. The undersigned certifies that it is a person acting for its own account or for the accounts of other Qualified Purchasers who in the aggregate own and invest on a discretionary basis at least $5,000,000 in securities investments.

Questionnaire Submission:

Thank you for your patience in completing this questionnaire.

If you have any questions, please contact Chris Vokes, VP of Investor Relations at Third Eye Capital:

T 416-601-2270 ext 242
E chris@thirdeyecapital.com