Recently, we travelled to the southern U.S. to attend a conference about private debt, hosted by a company I will call ABC.
It is worth mentioning that industry regulation prohibits companies from influencing advisors and cannot pay for any travel or accommodation. We feel it is important to mention because it demonstrates our thorough due diligence and our unbiased approach to investing.
Private debt is considered an alternative to traditional stocks and bonds and typically available to only accredited investor, who must have a minimum level of income, investable assets or net worth.
Private debt typically finances loans or mortgages by non-banks and is less liquid because it doesn’t trade on the public markets. There are many companies that specialize in this field, where they lend money to a person or company and take collateral and personal guarantees.
Since the 2008 financial crisis, many banks have strict lending guidelines. As such, entrepreneurs are not able to get all their financing from the big banks. Generally, the debt hierarchy looks like this:
ABC focuses on direct real estate and has been in business for more than two decades. We met the founder, partners, portfolio managers, clients, CEO and chief credit officer. They outlined how ABC is different and relies on a four-level structure to maximize success:
• Origination: Brokers are paid to find good deals. Approximately 30 per cent of their commission occurs upon repayment of the debt;
• Underwriters: They look at the 5 Cs of credit: character, capital, capacity, collateral and conditions. The five-member committee must unanimously agree to proceed or the deal is rejected;
• Investment committee: It reviews concentration, maturities, risk and into which fund to place the debt;
• Board of governors: There are four independent members ensuring there are no related party transactions, as well as proper valuations. When a default occurs, it must be reviewed by the auditors and decided whether to take an impairment charge.
The founder repeatedly said, “This is not our money,” reminding his team it always needs to remember the trust that is bestowed upon them. We were told about 90 per cent of the deals offered to ABC do not even go to underwriting. Of the ones that do, 80 per cent are accepted, but only 30 per cent get funded due to competition, dislike of terms or the deal dies. The returns vary, but typically range between five and eight per cent.
When a deal goes into default (missed payment), it may be resolved quickly or it could deteriorate and require enforcement, which can lead to impairment (permanent loss).
Different jurisdictions (provinces and states) are better than others in terms of collecting.
According to Moody’s, between 1987 and 2016, the recovery on bad debts has averaged:
• Commercial mortgages (75%);
• Corporate bonds, secured (63%);
• Corporate bonds, unsecured (48%);
• Corporate bonds, subordinate,(28%);
As one employee said, “It is easy to make a loan, but hard to collect.” Since inception, ABC has had a 99.5 per cent recovery rate. The company attributes this to the fact it is in control of the recovery process and knows its clients, of which approximately 70 per cent are repeat customers.
We also met some of their customers who valued the business partnership. Among the most important criteria to the borrower are speed of execution and certainty that the deal will be approved. ABC is able to accomplish this by having boots on the ground in all the areas it lends. The firm has a deep understanding of the demographics, economics, immigration, real estate laws, governments, etc.
For example, Texas’ economy is nearly the size of Canada, has no state income tax, is among the fastest-growing in the U.S. and can foreclose within 45 days without court.
Despite the old real estate adage of location, location, location, the company feels the most important thing is people, people, people.
On a personal note, despite all knowledge, statistics and solid historic results, what we got to experience was a sense of their culture, which is an intangible and cannot be found on a website or document.
Until next time, invest well, live well.
This document was prepared by Eric Davis, vice-president, portfolio manager and investment advisor, and Keith Davis, investment advisor, for informational purposes only and is subject to change. The contents of this document are not endorsed by TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc.-Member of the Canadian Investor Protection Fund. All insurance products and services are offered by life licensed advisors of TD Waterhouse Insurance Services Inc., a member of TD Bank Group. For more information, call 250-314-5124 or email Keith.firstname.lastname@example.org.