It is not uncommon to see alternative lenders negotiate equity kickers and other incentives as part of their lending arrangements, often as trade-offs for lower contractual interest rates and fees. We usually obtain such supplementary benefits as consideration for the strategic consulting and operational improvements we provide borrowers. These assets are rarely reported on lenders’ financial statements (except as footnote disclosures) because they are received for no cost, are contingent in nature, and due to the lack of universally-accepted measures to reliably value them. Currently, it is our practice to recognize the value of financial derivatives of private companies, such as options and warrants, and contingent payments on future revenues, such as royalties, only to the extent that we collect cash on these assets or when these assets convert to financial instruments that are actively traded in liquid markets. IFRS9 changes the measurement of these assets and forces managers of private debt funds to ascribe them a fair value.

Effective January 1, 2018, fund managers must value options, warrants, and royalties at fair value with changes in fair value at each measurement date recognized in profit and loss as they arise (“FVTPL”). Prior to IFRS9, managers could rely on accommodations and exceptions to measure these private, non-traded derivatives and contingent payment assets at cost (usually zero) given the significant range of possible fair value estimates and probabilities. Measuring fair value of these assets is complex and potentially costly because it requires manager to consider various valuation techniques such as the market approach (recent transaction prices for identical or similar instruments), income approach (discounted cash flow), and adjusted net asset (market value of assets less market value of liabilities). A major consequence will be selection bias, where managers pick the model that provides the highest value. In addition, because of FVTPL, income statement volatility is bound to increase.

Managers can manipulate model inputs, making fair value estimates more subjective. Informational asymmetry and the potential for adverse selection combined with the moral hazard of having managers apply the information to fair value measurements in a neutral and unbiased way are issues that impact the reliability of such measures. The greater the subjectivity involved in a valuation, the greater potential for unreliability. Can fair value be reliably measurable for a long-dated call option on a private business? We do not think so as the range of possible outcomes is too large or irrational given the substantial time value. As Warren Buffett rightly points out, “If the Black-Scholes formula is applied to extended time periods, it can produce absurd results”.

Fair values are only relevant to the extent that are reliable. The use of manager discretion on calculating fair value has no unifying benchmark that can align assumptions across funds with any economic reality. IFRS9 potentially makes it easier for managers to downplay problems and evade an investor’s early warning signals by picking the right model to value an asset until, in the case of a private option for example, it expires worthless. Investors’ capital is needlessly put at risk when they depend on assumptions that cannot be relied upon.

Our views definitely put us in the minority. Most financial institutions, institutional investors, and auditors staunchly support IFRS9. They believe regulatory sanctions such as monetary penalties and investing bans for improper valuation are major deterrents that will compel managers to ensure a higher degree of representational faithfulness in their measurements of private assets. Regulators are not an effective disciplinary force to keep funds and managers honest because it does so with a significant lag. Proponents also point to research that shows investors have been able to, over time, see through attempts by managers of less healthy funds make their funds appear healthier by exercising discretion when estimating investment fair values. We do not see this taking place in practice. One notorious, publicly-traded asset-based lender has a market capitalization that exceeds its net loans receivables despite the fact that 78% of such loans are an “airball”, meaning they are not actually secured by any discrete assets and instead valued according to the lender’s models. The lender even, in some cases, used fair value estimates to justify marking-up an investment that it acquired through a credit bid from its own defaulted loan!

Investors should carefully consider how certain accounting rules under IFRS9 will impact the reliability of valuation estimates provided by their managers. To assess reliability, investors should request transparency into all of the elements that make up a valuation for private assets determined by a model. For private debt investors, good governance and consistently-applied processes that are well-defined will be hallmarks for reliable valuations. The potential for large profits or losses from re-marks is enormous. In periods of rising asset prices, FVTPL will accelerate the recognition of gains, and therefore the compensation of managers. The question of whether IFRS9 will provide intended benefits in a downturn through fewer unexpected markdowns will eventually get answered.

Excerpted from Third Eye Capital Management Inc.’s Q4 2017 Investor Letter.

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The most fundamental change under IFRS9 is that private lenders such as banks will now be required to take a provision on all loans as opposed to the current standard that requires objective evidence that the loan has become impaired before a reserve is established. Prior to the new standard, lenders would simply hold the loan at cost less amortization for repayments, with losses taken only when incurred. Now, lenders will be forced to provision for expected losses immediately based on the probability of the loan defaulting within 12-months. If, at each reporting period (which for some private debt funds could be monthly), the loan has experienced a significant increase in credit risk, then the provision would be increased based on the probability of default over the lifetime of the loan. Lenders will need to show some external validation for these loss provisions and incorporate macroeconomic and industry-related statistics into their analysis. Under IFRS9, loan loss provisions will increase and become more volatile.

IFRS9 establishes a three-stage approach for loan impairment tied to whether underlying credit risk of the borrower has deteriorated since inception (see chart below).

At initial recognition of the loan, the loan is in Stage 1, and the lender recognizes a loss provision equal to the 12-month expected credit loss, which is essentially the credit loss that is expected to result from default events possible within 12 months. This is determined by multiplying the probability of such default events by the loss that would occur given default within 12 months. If, at the reporting date, there has been no significant increase in credit risk, the exposure continues to be classified in Stage 1 (performing) and a loss allowance equal to 12-months expected credit loss is provided. If, however, there has been a significant increase in credit risk (Stage 2), an allowance equal to the “lifetime” expected credit loss is provided, that is, the credit loss that is expected to result from default events possible within the loan’s term. IFRS9 provides a non-exhaustive list of indicators relevant to assessing a significant increase in credit risk. These indicators can include: a decline in a borrower’s revenue; changes in contractual terms that would be made if the financial asset was newly-originated; adverse changes in general economic or market conditions; changes in borrower’s regulatory, economic, or technological environment; changes in value of collateral or guarantees; and expected or potential covenant breaches.

If there is objective evidence as at a reporting date of a detrimental impact on the estimated cash flows from a loan (for example, the borrower has filed for bankruptcy), then the loan is classified to be in Stage 3 and is in default or impaired. An allowance equal to lifetime expected credit losses is provided and interest income is recognized based on the impaired loan amount (i.e., gross carrying amount of loan less the lifetime expected credit losses).

A loan can migrate between stages based on whether there has been a significant increase in credit risk, which is a source of volatility in loan loss provisions and reported earnings (or returns for private debt funds). However, it is important to note that a loan that is overcollateralized may not require a loan provision even if default probability is high, depending on the liquidity and marketability of the collateral. All of TEC’s loans are overcollateralized at inception, and we do not anticipate any large swings in the returns of our loan portfolio as a result of IFRS9. We think the lenders most vulnerable to IFRS9 will be cash-flow-based lenders, which comprise the vast majority of the lending market, and regulated financial institutions such as banks that have capital adequacy requirements.

IFRS9 will have a major impact on bank capital levels. Higher and more volatile provisions will get recognized through the income statement, flow-through to reduce retained earnings, and thereby capital ratios. A turn in the credit cycle, which we have posited is becoming more likely, will decrease retained earnings faster than in previous downturns, just as capital ratio requirements increase causing banks to quickly curtail lending and leading to a self-fulfilling cycle. The differences between capital, stress testing, and accounting treatments will prevent banks from trying to underprovision or otherwise manipulate expected losses. A survey of global banks by Deloitte indicates that under IFRS9 loan loss reserves could increase by up to 50% for some banks. KPMG reported that “credit losses are expected to increase” along with “the number and complexity of judgments”.

The transition to the new accounting standard will impose systems challenges on smaller financial institutions and private debt funds. The expected loss model will increase the complexity of these lenders’ credit risk systems and require building new sets of models. Larger banks will try to extend existing Basel capital models, but because significant judgment is necessary to determine loan losses at each reporting period, IFRS9 introduces new operational risks. Smaller private debt funds will not have the resources to make the necessary investments in systems, and will not be equipped to coordinate origination, credit, and risk functions in the provisioning exercise to meet stated investment objectives. This will promote consolidation and favor larger private debt funds like ours that have the scale to reduce risk and maximize returns. IFRS9 will be a game changer for the lending markets.

We expect banks will be inclined to allocate capital to the lowest risk activities and reduce lending activities generally. Our own internal study of commercial loan growth at the five largest chartered banks in Canada showed that since 2015, banks expanded their book at an average rate of 11% per year, or about $30 Billion in the past twelve months. That impressive growth has coincided with a rapidly improving economy and benign default environment. We visit frequently with the special accounts units of banks and all of them are quiet or empty with little or no bad loans to manage. IFRS9 forces banks to look at different economic conditions and default situations, and acknowledge the pro-cyclicality of lending that can cause complacency in good times. Moody’s Analytics survey of banks found that more than 90% of respondents plan to integrate IFRS9 scenario analysis into their capital planning and origination activities. As Canadian banks reassess the way they model credit loss impairments, it is inevitable that they will slow the pace of commercial loan growth. The implications of IFRS9 to lenders will be particularly profound during the next credit downturn.

Excerpted from Third Eye Capital Management Inc.’s Q4 2017 Investor Letter.

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We know from past credit cycles that, in the final innings, tail risks move higher and challenges begin to appear in pockets of the market. One reliable late-cycle signal is falling correlations, when credit performance across sectors is no longer in sync. As monetary policy slowly tightens and liquidity buffer in markets shrinks, default risks begin to rise and problems within highly-leveraged sectors begin to surface. Looking at both high yield and leveraged loan markets today, some sectors like retail, energy, and telecom, are showing low correlations to the overall markets and greater default risks illustrated by widening spreads. Still, realized defaults remain conspicuously low (1.36% over the last 12 months), masked by the low cost of debt and weak loan underwriting standards. The loan default rate forecast for sub-investment grade and unrated debt by the end of 2018, based on LCD’s latest quarterly buyside survey conducted in late September 2017, is 2.42%. This is a muted increase given rising leverage and lower interest payment capacity among stressed issuers in the S&P/LSTA Leveraged Loan Index. Empirical indicators are all flashing red but with only a short list of borrowers with near-term maturities, the outlook for defaults remains benign. In fact, respondents in LCD’s buyside survey do not expect to see any recessionary pressure until 2019 or early 2020. This should not lull investors into complacency; instead, we should be vigilant about both credit quality (favoring businesses with scale) and collateral liquidity (emphasis on self-liquidating collateral).

The implication of these market signals to investors should be that credit selection is more critical than ever. Credit investors will find it tempting to buy names in lagging, low-quality sectors but valuations tend to overshoot on the downside when credit cycles turn. Fundamentals and structure matter, and indiscriminate buying of distressed loans is not going to work the same way it did in 2009-10. The erosion in protections for lenders over the past few years, and the greater relative bargaining power of borrowers, means recoveries on even first-lien loans will drastically disappoint investor expectations. Recent restructurings have revealed the pernicious effect that looser loan protections can have on creditors. Take the example of J. Crew, the private equity-owned apparel retailer. J. Crew took advantage of weak covenants in its credit documents to strip away its trademarks and brands from the collateral backing its senior secured term loans, and pledging it for new debt. Standard & Poor’s believes this transaction alone cut the likely recovery rate for J. Crew’s term loans to an unimaginable 15% in a bankruptcy!

According to Moody’s Investor Service, the average recovery for first-lien bank debt is currently at an astonishing 65%, its lowest levels in more than fifteen years, even lower than recoveries during the GFC. A frightening statistic for private debt investors that fails to attract any attention in a goldilocks market. Sentiment urges investors to get on the traded credit wave but investors should resist. Well-structured private loans will outperform traded loans and high-yield debt in today’s red-hot credit environment.

Our high selectively, in-depth due diligence, disciplined risk structuring and overcollateralization, our interpolation of operational expertise, and intensive, regular monitoring are all features of our process that are absent from traded credit. Zoom out of the horizon and look at what could happen when the cycle does turn and the benefits that the best private debt managers can provide will be revealed.

Excerpted from Third Eye Capital Management Inc.’s Q3 2017 Investor Letter.

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Such overt accounting gimmicks have not deterred credit investors. When the private equity firm Hellman & Friedman sought US$265 Million in debt to help finance its purchase of SnapAV, a manufacturer of audio visual products, the add-backs boosted EBITDA by close to a third and reduced leverage to 5.4 times from more than 7 times. Multiple lenders made offers, resulting in a loan with even cheaper pricing than initially discussed and no financial covenants. Perhaps one of the most shocking use of add-backs was a debt financing in February 2017 by GoDaddy, in which lenders allowed the web-hosting and registration service to adjust EBITDA upward for savings and synergies that it does or expects to do in “good faith” over a two-year period.

According to data from Covenant Review, 44% of new loans in Q3-2017 had add-backs without caps or restrictions for synergies and cost savings. So far this year more than 90% of North American bonds had add-backs that were considered “too aggressive” by Moody’s.

Add-backs are not illegal as all adjustments are agreed and laid out in the credit documents. But the aggressive attempt to make borrowers look more creditworthy than they are is understating the amount of leverage in today’s credit markets. Such egregious adjustments are further examples of the reckless habits of some of today’s deal-starved lenders. Either the borrower will need to exceed projections to realize the add-backs, or the lender will be forced to restructure its loan. The latter is substantially more likely but the day of reckoning is far enough out in the future, in large part because of loose covenants, that lenders can enjoy temporary glory in their hyped-up returns.

Our investors know that we believe the next downturn will be painful for a lot of alternative lenders and their clients. Adverse structures, weak protections, and overindulgent add-backs will only exacerbate the potential for losses.

Excerpted from Third Eye Capital Management Inc.’s Q3 2017 Investor Letter.

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