Under the Basel III framework drawn up by the Bank of International Settlements’ Basel Committee on Banking Supervision, minimum capital requirements for banks is 8% of risk-weighted assets (as it was under Basel II), but 4.5% must be common equity Tier 1, the highest quality capital (compared to just 2% under Basel II). Private-sector loans have a 100% risk weighting among assets, and can increase up to 150% for the riskiest borrowers, making it more difficult for banks to generate returns on such loans on a risk-adjusted basis. In addition, there are several add-ons to Tier 1 capital, such as capital conservation and countercyclical buffers that at the highest rate would increase the minimum capital for banks to 13% of risk-weighted assets. Bank will also have to comply with liquidity coverage requirements and restrict asset-liability mismatches, which will further discourage growth in business loans. Overall, requirements under Basel III will penalize commercial credit through higher costs for banks and decreased availability for their borrowers. If Mark Twain was alive, he would have summed up the impact of Basel III this way: bankers will be reluctant to lend you their umbrella even when the sun is shining.

In Canada, implementation of Basel III began in 2013 with a quicker phase-in of requirements than recommended under the rules. The U.S. and European Union begin implementation this year. In the U.S., the Dodd-Frank Act, leverage lending guidance from the Federal Reserve, Office of the Comptroller of Currency, and Federal Deposit Insurance Corporation (“FDIC”), and reform of the Chapter 11 bankruptcy code will also have profound impact on banks’ ability and willingness to provide business loans. For instance, asset-based loans, which have traditionally been considered the least risky form of commercial lending assets due to their tie to asset values rather than cash flow, will now be included in the definition of “leveraged finance” that regulators will use to calculate leverage ratios. Definitional changes could result in higher reported leverage and therefore larger capital reserves as a buffer against potential losses. Another example is the FDIC’s shift in insurance assessments from deposits to loans, with higher assessments placed on commercial loans regarded as “higher risk”. Generally, higher risk includes any loan greater than 20% of the total funded debt of a borrower and that has a senior debt leverage multiple of greater than 3X. ABL invariably falls in this category because asset-based borrowers tend to be highly-levered when analyzed on a cash flow-basis. The lending business is becoming more expensive for banks in the U.S., and will only be compounded once the Basel III rules start to get implemented. The good news is that alternative lenders, like our funds, will be able to reap significant profits through regulatory arbitrage because they will not be subject to the same costs and oversight as banks. The challenge for investors desirous of benefiting from this opportunity is selecting the alternative lender with the best risk management capabilities. Most lenders, including banks, fail not because they have insufficient capital reserves but because they suffer unbearable losses.

Regulatory constraints notwithstanding, bank shareholders want to see their investment strongly capitalized to avoid the government bail-out and dilution risks that occurred during the financial crisis. Banks are increasing shareholder value, not through loan growth, but by limiting expenses and growing non-interest income. According to a 2013 study on the banking industry by Deloitte LLP, banks are reshuffling their product mix to generate increased revenue, particularly from fee-based businesses such as foreign exchange, cash management, and wealth advisory. Bank earnings in the U.S. posted eighteen consecutive quarters of year-over-year growth through 2013, yet ROE for banks at 10.6% is still below the 1993-2006 average of 14.4%. This makes capital allocation a bigger priority for bank management, and reducing risk exposures that force higher risk weightings to capital, such as loans to small, unrated borrowers, is an imperative toward increasing profitability in a more regulated banking environment. Previously, banks might have kept certain business lines as part of their core even if they did not meet return hurdles but they are now more ruthless about eliminating laggard activities, especially if they impact capital. Banks everywhere are motivated to shift to businesses that use less capital, are more fee-based, and attract lower costs and risk weights. Private credit is not such a business.

The retreat by banks from business lending is ongoing and is creating a growing gap that needs to be filled. Alternative lending funds are being formed at a frenetic pace to replace the supply of credit to the middle-market and meet higher demand expectations from an improving economy and more optimistic borrowers. Private debt funds raised over $322 Billion over the past five years, according to data compiled by Private Debt Investor Magazine, and there are currently more than 200 funds targeting combined capital commitments of $114 Billion. While other alternative asset classes are undergoing consolidation, private debt is growing and institutional investors are building internal teams and carving out portfolio allocations dedicated to private debt funds. However, the boon to private debt funds means lower quality borrowers will receive financing even if they should not, and better quality borrowers will benefit from intense competition for their financing requirements. Not all of the managers of private debt funds will possess the specialized skills and experience necessary to properly assess credit quality. The dispersion in returns among funds will be large and manager selection will be challenging yet critical for investors. Given the tectonic shifts taking place in the lending landscape, the challenge will be extremely worthwhile.

Excerpted from Third Eye Capital Management Inc.’s Q4 2013 Annual Investor Letter.

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The combination of stronger growth and accommodative policy continues to favour risk assets, but not in a straight line as evidenced by the mini riot in credit markets when the Fed signaled its exit from QE. The search for yield is certainly pushing investors further out on the risk curve, increasing the volatility within fixed-income, a sector traditionally considered to be a refuge from choppy markets. Cash as an investment will guarantee losses in real terms. Government bonds in the US and Canada offer 2.5% returns at best. Spread products, such as investment grade and high yield, are only 0.5-3.0% better. With fading interest rate expectations, investors are repositioning for yield rather than capital preservation, and because concerns about company defaults are more muted when rates are lows, the riskiest grades within high-yield are attracting the greatest flows. The lack of yield-bearing investment alternatives is also causing more investors to sell liquidity in exchange for a return premium, and this is a worrisome trend at a time when inflation expectations are greatly underestimated. The price of liquidity will increase dramatically under an inflation surprise, and investors will be more concerned about the return of their capital than the return ontheir capital.

Private credit does derive part of its excess returns from a liquidity premium but unlike in high yield, firm specific risks can be influenced through active management. Embedded in all of our investments are explicit access rights – to information, to management, and to assets, especially cash. Senior liens, controls, and covenants, including a dynamic link between borrowing availability and collateral, reduce agency conflicts and loss of capital. Perhaps private credit’s most important contribution to investor portfolios in the next few years is its inflation fighting properties: short duration loans with minimum coupons that rise with market rates and are overcollateralized by critical assets with values measured in real terms. Private credit is a sanctuary for any capital fleeing the dangers of volatility and inflation.

Excerpted from Third Eye Capital Management Inc.’s Q3 2013 Investor Letter.

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Equity markets, which are more liquid and transparent than the inefficient and opaque corporate credit markets, are an excellent source of information and, because of their ubiquity, provide a relatively quick and easy method to estimate underlying asset value. Equity markets are also important barometers of investor sentiment and perceptions about a given industry sector. Equity market volatility can provide a check on whether a particular company or sector is out-of-favour, and if underlying asset values are stable. For these reasons, credit portfolio managers should pay attention to stock prices even when their borrowers are private. The liquidity and news flow on public equities means that the active monitoring of a borrower’s publicly-traded peers can provide insight into sudden or unusual industry activity and key events that could impact credit fundamentals. In the context of the current rate environment, equities may have even greater predictive power for credit investors. According to Barclays Capital, over the past twenty years stocks have been more likely to rally when rates are rising, and strong equity markets tend to support corporate credit prices by reducing default risks.

Stock market data is very useful in calculating a benchmark enterprise value, a proxy for a company’s underlying asset value. Whether determining the enterprise value for a private company, or validating the enterprise value for a public one, the analysis begins by choosing a comparable set of publicly-traded peers based on size, geographic, and industry criteria. Then one or more key valuation metrics must be selected. For simplicity sake, most credit investors calculate enterprise value based on a multiple of some observable quantity, usually revenue or EBITDA but these traditional multiples are not always useful (or relevant) for certain types of companies. At TEC, where loans are strictly based on our opinion of the borrower’s assets, we assess asset values directly through audits of receivables, expert appraisals of inventory and fixed assets, review of intellectual property, and discussions with customers, suppliers, competitors, and liquidators. However, we also gain insight into the broader market’s opinion of firm asset value by looking at key valuation multiples of comparable peers that vary by industry. Some of the non-traditional valuation metrics we have found to be especially effective in determining benchmark enterprise values for companies in our portfolio include:

Industry Sector
Key Valuation Metrics to Calculate EV

Oil and Gas
EV to Proved and Probable Reserves (BOE)

Mining
EV to Measured and Indicated Resources

Software
EV to Recurring Revenues

Media
EV to Subscribers

Financials
EV to Book Value

Multiple-based valuations reflect the mood of the market, which means value estimates can sometimes be too high when stock markets overheat. Using the equity market to determine asset values relies on a belief in market values and the efficiency of the market to reflect all available information in equity prices. But an efficient market is not the same as a rationale one, and as the great financial analyst Benjamin Graham once proposed, the price of every stock contains a “speculative element” driven by sentiment and emotion, fear and greed. The speculative element in pricing is prone to extreme swings that can distort equity valuations and give false comfort to lenders who derive asset values only from the market price of the stock of their borrowers or peers.

Equity markets provide valuable information to credit investors about underlying asset valuation, peer comparisons, industry trends, and market sentiment. Lenders that ignore the cues provided by equity markets do so at their own peril.

Excerpted from Third Eye Capital Management Inc.’s Q2 2013 Investor Letter.

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In the U.S., there is no consensus among equity investors over the recent rally in the S&P 500. Even though equities have more than doubled since March 2009, investors still withdrew $200 Billion out of U.S. domestic mutual funds and exchange traded funds between 2010 and 2012. According to research and consulting firm Hennessee Group, so-called “smart money” hedge funds remain mostly short or hedged due to “historically low VIX and unresolved structural issues in the economy”.

One equity valuation measure widely followed by hedge funds is Yale professor Robert Shiller’s cyclically adjusted price-to-earnings ratio (“CAPE“), which uses the inflation-adjusted price level of the S&P 500 Index over the trailing 10-year average of S&P500 reported earnings (also inflation-adjusted). The use of the 10-year average earnings is to smooth out business cycle effects. Shiller’s version of the P/E ratio correctly predicted overvalued markets in 1929, 1999, and 2008. The CAPE is currently above 23 compared to a median level of about 16 since 1880, suggesting that the stock market is poised for a substantial correction.

The problem with CAPE is that earnings smoothing can underestimate average earnings during an expansion and overestimate average earnings during a contraction, especially when you consider that the current trailing 10-year average is a historical aberration because it includes two of the worst profit recessions ever recorded: in the aftermath of the dot-com bust from 2000 through 2003, and as a result of the financial crisis in 2008 and 2009. Recessions of the past decade forced companies to shrink their balance sheets through write-offs of non-performing assets, which negatively affected profitability. Averaging in these earnings distorts the valuation picture.

S&P 500 earnings have grown 100% since their nadir in 2009, further emboldening hedge funds’ current anti-equity bias. However, the earnings yield is roughly 7.5% compared with 1.6% for Treasury yields, and such a sizable equity risk premium should continue to support stock prices in the U.S. The relative stability of data and forecasts, improving U.S. household finances, fading political uncertainty, and simulative monetary conditions are keeping both volatility and downside risks low. Companies are still deleveraging and earnings momentum is not credit driven like in previous cycles. Meanwhile, policymakers are curtailing deflationary tail risks, which is helping investor confidence. Central banks have made an open-ended commitment to reflation, making higher prices for risk assets an objective not a by-product. U.S. equity prices should continue their rise in this environment, and the smart money may need to throw away the CAPE in order to fly.

Excerpted from Third Eye Capital Management Inc.’s Q1 2013 Investor Letter.

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