Building a resilient Alternative Credit portfolio

Role of credit in a portfolio

Alternative Credit serves as a potentially valuable source of portfolio diversification from both traditional fixed income as well as equities for investors. It can offer higher returns and reduced interest rate sensitivity versus government bonds and investment grade credit. Examples include broadly syndicated loans, direct and asset backed lending, emerging market debt (EMD) and structured credit, to name but a few.

Some of the component parts have been around since the 1980s, such as the introduction of Brady Bonds for EMD, and the work of Michael Milken for the high yield bond market. However, since the Global Financial Crisis, there has been an explosion in the variety of alternative finance instruments, designed to suit the needs of borrowers and lenders. These innovations were in response to stricter bank regulation, the search for yield in a world of lower interest rates, a desire for more bespoke borrowing packages and an increase in the range of entities able to participate in the lending markets.

Investors are generally looking for reliable return streams from their Alternative Credit investments. Any direct threat to this gives rise to questions about how these assets contribute to portfolio resilience, and this is what we will explore in this thought piece.

The asymmetric nature of credit’s return profile means it must be assessed and monitored quite differently from equities and other risk assets. On the one hand, the best-case outcome is that you get all your money back in the form of coupon payments and the return of capital at the end of the loan/maturity of the bond. Accordingly, the emphasis of your due diligence, or research, needs to be on a borrower’s cashflow generation for the term of the loan or bond. If you invest until maturity on a buy-and-hold basis, that’s all that really matters – the rest is ‘noise’.

However, there are multiple forces that can derail this journey, either temporarily or permanently, which give rise to the asymmetric nature of the return profile. These include events linked to the issuer, their industry, the country in which the bonds/loans are issued and traded, investor behaviour and of significant importance today, geopolitics. How a manager assesses these challenges and the resulting opportunities govern Fulcrum’s manager selection and monitoring processes.

Cornerstones of building a credit portfolio

Within the Fulcrum Alternative Solutions team, we seek to identify fund managers with a repeatable investment process, designed to maximise the probability of a return of capital. Our investment process is designed to draw this out, framed within the Five Key Ingredients for Competitive Advantage and Four Key Factors, which are used to guide portfolio construction.

Five Key Ingredients for Competitive AdvantageSource: Fulcrum Asset Management LLP.

Four Key FactorsSource: Fulcrum Asset Management LLP.

As they apply to credit, we pay particular attention to:

• Team structure and resourcing
• Breadth of opportunity set
• (Deal) Sourcing
• Underwriting quality
• Sustainability
• Portfolio profile
• Risk and Controls, including leverage, liquidity, security pricing processes, diversification tolerances, and governance
• Terms & Conditions – do we have a clear understanding of what we are paying for and what we are receiving in return? A key example within direct lending in this context is whether loan origination fees are passed to the fund in full versus some or all being retained by the manager to help keep the “management fee” optic down

Portfolio monitoring

Credit portfolios are often very diversified to minimise idiosyncratic risk, reflecting the asymmetry of the opportunity set we describe above. As such, it makes sense to review portfolio-level metrics at the outset and then monitor how these evolve over time to get an indication of the evolving ‘health’ of the portfolio. For example:

• Key Ratios and Metrics (using ‘acquisition price’ statistics), including:
  • the range of loan-to-values (LTV) in a portfolio
  • loan seniority, e.g. % of senior secured, 1st lien loans
  • nature of the underlying assets upon which loans/bonds are secured
  • portfolio leverage
  • financial covenants
  • interest cost coverage from free cash flow
  • % of the portfolio in ‘non-accrual’
  • % of the portfolio priced below 90c in the $ which had a price closer to par at purchase
  • use of payment-in-kind (PIK) amendments (not always a bad thing)
  • % of portfolio on the manager’s credit watchlist
  • overall credit quality
  • portfolio yield-to-worst
  • credit and interest rate duration

What these statistics indicate will vary from mandate to mandate and one cannot simply say a given metric is good or bad. They have to be considered in the context of the portfolio’s objectives and versus peers. Typically, for example, an asset-backed loan will have a higher LTV than a balance sheet-backed loan, given the nature of the underlying asset that can be called upon in the event of a default. To take another example, compare a direct lending portfolio with an opportunistic credit fund. The latter will likely be fairly concentrated, contain a good number of securities acquired for/through a capital solution and/or feature bonds and loans which trade at stressed prices with what look like worrying ratios and metrics. Here, there may be a more symmetric return opportunity, with the potential magnitude for capital gain and loss more equally balanced.

In all cases, a portfolio should be evaluated over time to determine process discipline and any emerging evidence of portfolio stress.

Where higher levels of credit risk are taken, more idiosyncratic analysis is required. For example:

• Additional Pricing protocols:
  • comparing how different managers price the same private credit security, particularly in the case of them being somewhat stressed/distressed
  • how a given manager prices different securities by the same issuer
• Capital Solutions:
  • How and when did the manager get involved and the extent to which they are in control of the path forward, particularly versus any other stakeholders. This is captured in the nature of the revised financial covenants and whether they are the sole or majority lender
  • Impact on other holdings by the same issuer
  • How their seniority, covenant protection, leverage, income etc. have changed/will change as a result of the capital solution
  • Potential concentration risk where equity stakes are involved and material value is unlocked

20 years of lessons learned

Questions about the resilience of credit markets have become more prevalent recently, and we thought it would be useful to list some of the lessons we have learned over the years:

• Portfolio transparency – can you fully understand what is held in your portfolio? Can you appraise from your portfolio reports any signs of trouble or anomalies?
• Gain comfort that you are being compensated for the different risks you are taking, be that liquidity, complexity, currency, term or, of course, credit
• Strategy creep – we often observe a gradual increase in risk, leverage and complexity as spreads tighten and managers/manager researchers ‘stretch’ to meet return expectations. It is hard, both mentally and emotionally, to resist the temptation to reach for additional return, especially when, as a researcher, you are regularly faced with innovations and fresh opportunities to explore. Being grounded, focused on what makes fundamental sense, and being as risk aware as possible requires discipline and strong governance/teamwork
• Weakening underwriting/lending disciplines (metrics, protections) given increased competition to lend and/or the need to deploy increasing amounts of capital quickly.
• Respect the asymmetry of bonds and market liquidity; our best-case outcome is the return of capital so do not chase returns
• Beware complexity – the industry is good at innovating and creating sources of profit for itself.
• Beware of who is paying whom for what, and fee leakage. This is especially prevalent in structured credit given the complexity and number of moving pieces
• Potential vulnerability to changing regulation – just as regulation has led to the creation of risk-tranched and risk-transfer assets and mandates, any reversal could have a seismic impact on the related markets. What would happen to the syndicated loan market if there were no buyers of collateralised loan obligations (CLOs)?
• Portfolio cross holdings; for example, there are many common holdings across some US Business Development Companies (BDCs) so what value is your manager really offering you above a passive solution?
• Portfolio concentrations – how much risk is concentrated in select positions?
• Pricing practices, particularly in private credit markets
• Things that look too good to be true typically are, eventually. We see some astonishing track records, and it can be hard to isolate what might derail the future path of returns. At a minimum, seek thoughtful diversification across genuinely different strategies
• Beware the crowded trade – just as capital can flow into an investment driving in spreads, so to can it flow out, causing liquidity to dry up and spreads to gap out

Investing in credit today

There has been a flood of capital into private credit markets over the past few years and for much of that period, investors were relatively unscathed. To where has this capital been directed? Upper middle market direct lending is one notable area.

This flood has, in some cases, resulted in weaker underwriting standards and loan covenants as lenders competed to lend money on increasingly easy terms in order to invest client inflows in a timely fashion. It has also driven in spreads to historically tight levels, meaning you receive little compensation for taking credit risk; higher yields help compensate for this, but if they remain elevated, they place more stress on the borrower, particularly in the case of floating rate securities.

There are a number of other current issues that we examine below, alongside a summary of how we have addressed them in our own credit analysis process:

First is the issue of circularity within credit markets, particularly linked to the vast amount of expenditure pouring into AI and Tech, but also associated with Risk Transfer securities, which are used by banks and institutions to move the credit or default risk of a loan portfolio to other investors. Could all this lead to bubbles and crowded trades? Public and private investment grade credit markets are in scope here.

Our response: try and stay away from the crowd.

We have also seen increased complexity in portfolio construction techniques, rendering it difficult for even an expert eye to fully understand the nature of the underlying loan-level risks in a portfolio.

Our response: undertake bottom-up analysis of the portfolio, leveraging AI, to look for anything untoward or ‘different’.

For the past year, public and private credit market vulnerabilities have begun to be ‘tested’, mainly as a result of geopolitical or idiosyncratic events, with only short-lived systemic dislocations. Default levels remain at historically low levels, but there are many ways for a borrower (or lender) to avoid such lengthy, expensive and headline-grabbing outcomes, such as capital solutions, whereby lenders work with borrowers to create a revised, often bespoke financing package which the borrower can better afford and which helps them navigate periods of financial stress. As such, taking comfort from reports of low default rates is potentially misguided and does not necessarily reflect a truly sanguine market.

Our response: seek to understand any losses the manager is carrying, and lessons learned where they experience a default/realise a more material loss.

Broadly, however, many portfolio metrics remain positive and corporate balance sheets strong. Most credit managers have been deploying capital using tried and tested investment processes. The new issue market is alive and kicking.

Despite this, there has been a persistent wave of negative media coverage about underwriting and portfolio management standards, and this has led some investors to rush for the exit, especially in the US BDC market. The image below summarises a handful of recent headlines pointing to related stresses in private credit markets:

It is important to note that the liquidity provisions in these vehicles are being followed, not breached, when it comes to the redemption limits (gates) being applied. This market is principally the domain of high-net-worth investors and there appears to have been a misunderstanding about investment liquidity.

Our response: invest via institutional vehicles.

Conclusion

Given all this, how does one build a resilient portfolio?

Try to keep things simple in an increasingly complex world:

• be disciplined to your investment process
• respect the desired role you expect credit to play in your portfolio
• beware the crowded trade
• monitor for portfolio manager discipline and any ‘different’ line items
• don’t be greedy!