Transactional lending is characterized by a single instance financing that relies on “hard” information readily available and views a loan similar to a trade. Transactional lenders are usually large and apply standardized processes to manage their loan portfolios. Since they invest in many loans across many industries, transactional lenders tend to apply statistical methods in determining pricing and credit availability. When competition is high, and the lending environment is more borrower-friendly, transactional lending increases due to the low (or no) costs of servicing a borrower relationship. Examples of transactional lenders today include large BDCs, CLOs, multi-strategy credit hedge funds, and leveraged finance companies.

Relationship lending involves working one-on-one with the borrower in order to gain insight into its business that cannot be revealed from the “hard” information alone, including management, customers, suppliers, owners, competitors, and key stakeholders. For a borrower in exigent circumstances, building a relationship should not be considered a sacrifice of limited time. Today’s most prominent alternative lending firms have in-house operational and management experience in targeted industries and can quickly understand a borrower’s unique financial or business situation. Also, since many relationship lenders gain information by maintaining borrower bank accounts and sometimes serving on their board of directors, they are able to attenuate the noise in credit evaluation and reduce adverse selection risks. Relationship lenders are willing to maintain concentrated portfolios with high conviction loans due to familiarity with borrowers’ industry, business, and management familiarity. They also experience recurring business from repeat borrowers and referrals from borrower stakeholders.

One of the prerequisites of relationship lending is experience: information gathered over time has significant value beyond a firm’s financial statements, collateral, and credit rating. This is another reason why new entrants into the private debt market are necessarily transactional in nature. But experience is expensive and, by definition, time-consuming to build. Market and regulatory reforms are mandating higher equity buffers and putting pressure on banks and other financial institutions to reduce costs, such as laying off loan officers and other frontline lending staff, which further de-emphasizes relationship lending. The ability (and apparently, willingness) of lenders to distinguish between borrowers with and without solid growth prospects is diminishing, and this will exacerbate credit market damage during a downturn.

There is extensive theoretical and empirical research on relationship lending (see the July 2013 study from the Bank for International Settlements entitled “Relationship and Transaction Lending in a Crisis” for a summary). Relationship lenders show lower credit risk sensitivity and less exposure to defaults than transactional lenders due to superior monitoring capabilities and, from our direct experience, because borrowers regard relationship lenders as long-term partners rather than arms-length capital providers.

In our ten year experience as active direct lenders, we have witnessed a distinct pattern in the volume and margin between lending approaches.

Transactional lenders are more prolific as the economy recovers and expands and can quickly capture margins through credit growth and lower fixed costs in making credit decisions. Established relationship lenders, like us, perform best at the peak of the cycle and through the cyclical downturn due to lower variable costs and by growing loans at the expense of transactional lenders faced with rising defaults and losses. Margins of relationship lenders rise due to the contraction in transactional lending. Relationship lenders experience less variability in margins than their transactional brethren but lag in loan volume especially as increasing competition from transactional lenders magnifies the amplitude of the credit cycle.

Lenders and their investors need to carefully evaluate whether their current business approach can flourish in today’s crowded credit market. Some lenders will choose to compete by further lowering costs and moving farther away from relationship lending. We believe the relationship between lenders and businesses must be based on more than just credit, but predicated on expert advice and tangible support to nurture future growth. This will give borrowers confidence in credit availability and a greater chance for growth, and provide lenders with less churn and insulation against a credit incident.

Excerpted from Third Eye Capital Management Inc.’s Q4 2014 Investor Letter.

The post Factories vs Tailors (Q4-14) appeared first on Third Eye Capital.

BDCs were created by the US Congress in 1986 as a means to encourage the flow of capital to private, middle-market businesses in the US. It was not until the private equity industry’s demand for leverage accelerated at the turn of the last century that BDCs really took off. BDCs are unique investment companies in that they primarily focus on lending to private companies but provide investors with the liquidity of a publicly-traded stock. The retrenchment in traditional lending that accompanied the financial crisis, and the aftershock of increased bank regulation, catapulted alternative private lending activity in the US and grew the market capitalization of listed BDCs at a compounded annualized rate of 39% from the end of 2009 through 2013. The number of listed BDCs has increased by 78% in the last five years and today has about $65 Billion in assets. The backdrop of ultra-accommodative monetary policy and yield-starved investors has made BDCs extremely popular.

Excessive loan growth by a lender should never be interpreted by investors as good news on its own. In a highly competitive credit market like today, with benevolent default conditions, risk can be easily mispriced. As Figure 1 illustrates, the growth in aggregate portfolios of BDCs and an influx of private credit competition has weighed on yields. At the same time, leverage multiples have been increasing thereby causing credit quality to suffer at the expense of asset growth.

BDCs argue that they have a better cost structure and higher yields versus specialty finance companies, despite similar credit risks. Expenses as a percentage of average assets is 3.9% for BDCs compared to 6.2% for specialty finance companies (like CIT). But BDCs are typically externally managed and should therefore benefit from the operating leverage in the existing credit platform of the manager. Investors in BDCs, which give their managers permanent investable capital, should not be paying fees based on assets; instead, managers should be compensated against earnings or distribution growth.

BDCs are also more tax-advantaged than specialty finance companies and distribute at least 90% of their income to investors in order to avoid corporate income tax. Higher yields of BDCs are due to a combination of leverage (1-to-1 debt-to-equity) and their niche focus on transactions in the lower, middle-market where specialty finance companies, that are 10X larger, are not inclined to compete. Smaller, middle-market companies have less information transparency so require much greater analysis and monitoring to properly underwrite and manage risks. The rapid growth in industry assets suggests that not all BDCs will have maintained credit discipline. We expect the number of defaulted loans, non-accruals, and portfolio reserves to be higher within BDCs versus other specialty lenders. In their most recent earnings releases, some of the largest BDCs reported higher non-accruals on existing loan portfolios and lower average yields on new loans. Since BDCs are leveraged, typically with floating rate debt, the impending rise in interest rates will further diminish the appeal of BDCs.

We believe that we are in the early stages of capital formation in the alternative lending markets. Conventional lenders are facing increasing scrutiny, as recently underscored by the leveraged lending guidelines promulgated by the three US federal regulatory bodies for banks. Those guidelines will limit leverage and severely impact a borrower’s ability to repay a loan. Banks are getting pushed out of the lending market and this is steadily contributing to BDCs, CLOs, private debt funds, and other alternative lenders to gain share. Consolidation will eventually overcome the obstacles of underperforming portfolios and drive capital to the most successful lenders. In the meantime, investors should focus on alternative lenders with consistent track records and experienced management teams that place credit discipline and capital preservation ahead of asset growth.

Excerpted from Third Eye Capital Management Inc.’s Q3 2014 Investor Letter.

The post BDCya, Wouldn’t Wanna Be Ya (Q3-14) appeared first on Third Eye Capital.

In the United States, real GDP rebounded in the second quarter after contracting at the start of the year due to severe winter weather. The 4% annualized pace of expansion in the U.S. economy was broadly supported by business spending, exports, and employment. The U.S. economy created 816,000 jobs in the second quarter, the strongest quarter for job creation since the low point of the recession. The Institute for Supply Management (ISM) Purchasing Managers Index (PMI) combines five manufacturing indicators (new orders, production, employment, deliveries, and inventories) to create a composite of U.S. manufacturing activity. The ISM PMI Index posted a 55.3 reading for June 2014 (a PMI reading above 50 generally indicates manufacturing expansion), with all categories rising. The most recent U.S. Industrial Production Index also gained 4.3% over the prior year, and the non-manufacturing PMI jumped to 58.7 in July 2014, the highest reading since December 2005. Expectations for a rise in U.S. GDP for the balance of the year seem well supported by the data, and this is good news for Canadian businesses.

The Bank of Canada’s Summer 2014 Business Outlook Survey shows that Canadian firms are now more confident about the positive direction of the economy and plan to increase investment in machinery and equipment over the next 12 months, with a focus on efficiency gains from upgrades. The accommodative interest rate environment and generally favorable borrowing terms, are also making investment decisions easier to make. Companies are likely to invest in order to alleviate capacity constraints since Canada’s industrial capacity rate reached 82.5% in the first quarter, just 2% below its prerecession peak in 2005. Companies do not make capital expenditures for its own sake – it is only when they see rising demand for their goods and services that they undertake new investment spending. We believe the pent-up demand for machinery and equipment is high and that this will underpin the cyclical recovery in commercial credit.

Strong economic fundamentals, low rates, and easy money will continue to provoke demand for risk assets. Although rockets in Gaza, US airstrikes in Iraq, crisis in Ukraine, Ebola in West Africa, and stagnating European growth have returned volatility to markets in recent weeks, the corrections in stock and corporate bond markets have been neither severe nor broad-based. The bounce in second quarter U.S. GDP has reignited expectations for rising interest rates, which should keep investors attracted to yield paying asset classes such as dividend stocks and corporate credit. Investors need to be careful about compounding their equity exposure since certain types of corporate credit, such as high-yield bonds, have a high correlation to stocks and will reduce any diversification benefits if unexpected shocks cause a broader market correction. As our clients know, we believe investors should adopt a more guarded posture toward traded corporate credit, where leverage levels and covenant-lite structures are on the rise while coupons and downside protections are on the decline. Investors need to select their exposures to credit in terms of valuation and risk, focusing on investments that preserve capital and generate returns through consistent execution rather than taking on higher risk. With weaker borrowers accessing credit markets, and more loan proceeds applied to unproductive uses (such as share buybacks and dividend payments), investors must put manager selection ahead of asset class exposure.

Excerpted from Third Eye Capital Management Inc.’s Q2 2014 Investor Letter.

The post Risk Provacateur (Q2-14) appeared first on Third Eye Capital.

The monetary machine of global central banks, led by the U.S. Federal Reserve, unleashed an unprecedented and radical amount of stimulus to prevent the world from falling into the abyss during the financial crisis. This “wall of liquidity” successfully surmounted the “wall of worry” caused by the crisis but the Fed’s continued zero-interest rate policy has artificially preserved investors’ preference for risky assets. The massive rally in risk since 2009 has in turn caused investors to chase returns, which like any desperate pursuit, can result in complete exhaustion.

Ben Bernanke, the former Chairman of the U.S. Federal Reserve, sided with Aristotle during recent conferences in Toronto and Washington where he reflected on his actions during the financial crisis. “In the fog of war there are many things we did that were imperfect”, he said, referring to the ad-hoc interventions to bail out certain non-bank financial firms (like AIG, Morgan Stanley, and Goldman Sachs). “The Fed should be out of the business of weekend emergencies”. Bernanke seemed to concede that many of the characters of the crisis drama should have been left to their own devices. Broker dealers played a leading role in the tragedy, who through unbridled leverage made obscene profits through speculative bubbles but were extraordinarily vulnerable when the crisis hit. The biggest survived due to the Fed’s bailout of counterparties, lender-of-last resort support, permission to convert to a bank holding company, and access to TARP funds. These broker dealers, now banks with the option of using FDIC-insured deposits, are back in business pursuing the same risky strategies that brought them close to annihilation. However, moral hazard, the willingness to take risks knowing the Fed or government will assume whatever negative consequences follow, has made them so big, leveraged and connected to the global financial system that their collapse could have systemic and catastrophic effects. This is the unlikely ending that Aristotle warned interveners about in Ancient Greece.

The overabundance of liquidity has driven up asset prices on investments in every risk category. On a global basis, stocks are up more than 40% from 2012 and have gained 150% from the 2009 lows. In the first quarter of 2014, U.S. bonds outperformed the stock market: the S&P 500 posted a total return of 1.8% while long-term U.S. Treasuries rose 7.5%, and corporate bonds and high yield each advanced 3%. Gold was one of the best performing asset classes of the quarter, rising 7.5%. With higher prices come lower yields, and the total yield on high yield and leveraged loans are near all-time lows. Many bond investors expect U.S. Treasury rates to rise as the Fed begins reduce its monetary stimulus, which will further compress spreads in the high yield and leveraged loan markets. The marginal buyers of traded credit are now large ETFs and mutual funds, which investors (especially retail) are treating like money market funds and driving massive inflows into the sector at a pace exceeding primary supply. To compensate, investors are loosening underwriting standards and even encouraging shareholders, especially private equity investors, to take money off the proverbial table. Between January and March of this year, PE-backed issuers tapped the loan market for $16.9 Billion of dividend-related recap loans, the largest sum since the second quarter of 2013 and up nearly $10 Billion from the fourth quarter of last year. Covenant-lite structures represented 60% of new-issue flow during the quarter, continuing last year’s trend and bringing the benchmark S&P/LSTA Index to be dominated by covenant-lite loans. This supports a benign default outlook but also poses danger signs for a future crisis. Investors in traded credit should be very concerned above the flagging quality of deals coming to market.

We have been warning about the high-yield and leveraged loan markets for nearly two years (see our 2012 Annual Investor Letter) and we risk becoming a “Credit Cassandra”, but the data is frightening. Loans with debt-to-EBITDA ratios of more than 6X grew to a six-year high of 37.5% in the first quarter of 2014, according to S&P Capital IQ Leveraged Comps Data.

This is lower than the pre-crisis high of 60% until you dissect the debt stack and notice that the amount of first-lien leverage was a record 4.2X in the first quarter, which will inevitably lead to higher defaults and lower recoveries in the future. Traded credit has been rigged by a liquidity machine. Aristotle was concerned about preserving the identification of the audience with the actions depicted in the tragedy. Investors would be foolhardy in believing that today’s credit market story will end any differently than before.

Excerpted from Third Eye Capital Management Inc.’s Q2 2014 Investor Letter.

The post A Deus ex Machina (Q1-14) appeared first on Third Eye Capital.