Niche Credit Strategies for Opportunistic Investors

27th May, 2021

Credit investments play a core feature in investors’ portfolios for a number of reasons.  These products are generally considered “safer” than equity investments such as publicly traded stocks as they display less volatility and more emphasis on capital preservation.  This arises from credit investments carrying a contractual obligation to be repaid and security with claims on collateral, versus an equity investment with value that is tied to cash flows that can decline.  Credit investments also typically provide “income” in the form of steady cash interest payments that can be used to meet everyday obligations, versus stock investments that might not carry a dividend and become liquid only when sold.

However, mainstream strategies to gain exposure to credit investments have recently become problematic, predominantly due to the low interest rate environment having persisted for years.  As the yield on many credit investments hover at rock bottom rates, it has become more important than ever to explore alternative methods and ideas to replace traditional strategies with those that still can generate sufficient income for investors, while being mindful of the risks these strategies may carry. 

We’ve identified three credit managers with experience with “non mainstream” approaches to credit investing, and they share their knowledge of these strategies and the risks and opportunities that exist in this space. 

Michael Scarangella, Carlton Credit Partners

We believe there is a funding gap in lower-middle-market lending.  Traditional commercial banks used to be very willing to lend to lower-middle-market companies, but because of increased regulation post-financial crisis, their lending criteria has gotten much more stringent and banks have started to limit the types of companies they finance and the amount of credit they advance to a single borrower.  Additionally, while commercial banks can be very effective at providing smaller working capital revolvers for everyday lending needs, in certain instances they can be a wrong fit. 

Private debt capital can be a very effective financing solution when a company has a big borrowing need, for example when they need to make a large acquisition, build a new facility or want to pay a large dividend using the company’s balance sheet.  In these situations, banks can be unwilling to take the risk, and issuing equity can be very expensive and viewed as a last resort-option.  

We think further opportunity exists within private debt capital that is focused on lower-middle market businesses, as this space is more limited in terms of  competition.  This dynamic arises because while many private debt funds may start out in the lower-middle market, as they grow in size and raise second and third funds, they slowly migrate “up-market” and invest in larger companies.  This presents an attractive dynamic for funds like Carlton Credit that choose to remain focused on the lower-middle-market as it allows firms to leverage the credit gap that opens up and be helpful to borrowers who may not have many options.

Typically, private debt instruments are structured as four-to-five-year loans at final maturity, though they can be called earlier at a premium. Borrowers usually can’t repay the loan within the first or second year, after which they can repay with a fee.  So, like a bond, borrowers can prepay at 101-103 cents of par and the investor would get that extra premium to enhance their yield.  The reason this kind of investment is attractive to the investor is that if the borrower keeps the loan outstanding for five years, investors can receive a good stream of coupon income for extended periods.  And if borrowers pay off early, investors get a premium to compensate for that early pay-off.

In terms of other structural points, there is usually a cash coupon, and sometimes on top of that there are yield enhancements such as a Payment in Kind (“PIK”) coupon, which is a non-cash coupon that accrues during the life of the loan and is paid at maturity.  Closing fees of 1.5-3.0% are common, and depending on the risk of the company, there may be some upside at maturity in the form of equity warrants or an exit fee based on the value of the company.  All in, investors can expect mid-double-digit returns, with the coupon likely to be high single-digit to low double-digit, and the yield enhancements making up the balance of the return profile.

For this strategy to be successful, investors should consider funds that are good at borrower education, because many times borrowers are approaching the private credit market for the first time and don’t always understand that this market functions differently than traditional bank lending.  Funds like ours need to present themselves as a partner that can offer more than capital.  At Carlton Credit, for example, both partners have been in the market for 20-25 years each and have a deep list of contacts, including consultants, industry executives, lawyers etc.  We can help borrowers with various needs, ranging from filling a board seat, finding a CFO, connecting with an investment banker, or helping explore an acquisition opportunity.  The approach is to provide the capital and then be a partner going forward and try to be accretive to the company’s process.  The strategy benefits from our readiness to roll up our sleeves, get to know the management team and their story, customize a credit facility for their needs, and stay engaged post-close.

Daniel Rubin, YAD Capital

An innovative credit strategy that is both beneficial to investors and small businesses is merchant cash advance (“MCA”). In a nutshell, an MCA is a short-term financing solution to small- and medium-sized businesses whereby a business receives a cash advance in exchange for selling a portion of its future revenues.  This is different from factoring, where a company can go to a lender and sell their receivables for a 5-10% discount because the factoring company has only to assess the credit risk of the customer that is supposed to pay that factored-invoice, generally within 60 days.  In the case of an MCA, instead of buying past revenues, investors acquire future revenues (generally between 5 to 12 months).  This means that investors are making an educated assumption that the business will continue to operate, won’t file for bankruptcy or liquidate, and will continue to generate enough revenues (even after taking account seasonality) to repay the MCA. 

Essentially, an MCA is a commercial transaction: a purchase and sell agreement of future revenues in return for an immediate cash advance.  What is interesting about this strategy is that even though it is categorized as a niche product of the credit market, it is not a loan: there is no interest rate, no repayment schedule, no minimum payment due, and no maturity date. Amount owed never grows. The risk to investors is that this is an unsecured product.

MCA has been around since 2008 (and to a smaller extent since 1999). It has been tested through two economic cycles.  During the 2008 financial crisis, banks tightened their lending standards and stopped lending to small businesses which created an untenable liquidity void: MCA funders stepped in and helped businesses stay afloat.  More than a decade later, the Covid-19 pandemic hit: while the government provided unprecedented levels of support to small businesses (through PPP), those were to be mainly used for payroll, rent, utilities and mortgage interests (if businesses want their PPP to be forgiven). There were still strong outstanding liquidity working capital needs which were once again met by non-traditional credit providers, including MCA funders. 

Aside from the obvious need for MCA in a time where small businesses are just getting back to normal, opportunities for the strategy remains strongly in an up-cycle.  The addressable market is large: there are 29 million small businesses in the U.S. employing half of the workforce, for a total annual origination of $15 to $20 billion.

An MCA investor should do thorough due diligence and underwriting to understand the intricacies, risks and terms associated with such investments; however, the potential for very attractive risk-adjusted returns exists.  Even though default rates are much higher than in other credit strategies (e.g. real estate debt, credit card, auto leasing, etc.), the strategy can still deliver double-digit returns with good downside protection.

We have been investing in this strategy for the past four years and have deployed more than $85 million across 4,500+ businesses.  We thoroughly build our portfolio through extensive due diligence and investment selection to ensure proper diversification across geographies and industries.  What is interesting is that when we first began investing in MCA, the economy was booming and clients were asking us if the strategy would work when a downturn occurs.  Now that we’ve been through a recession (time will tell when we exit) and things start to normalize, clients are curious if the opportunity still exists in a fully open economy.  The answer to both questions is yes.

Christopher Winkler, Longhorn Debt Recovery Management

Portfolios of nonperforming, low balance consumer installment loans are an area of the credit markets often overlooked by investors but can provide very favorable total returns, risk protection, and substantial yield.   Everyone has heard of consumer debt, but what many don’t know is that there is a buyer’s market behind it.  Even with stricter regulations on lending, financial institutions will always have consumer delinquencies.  Their need to create additional cash flow and improve their bottom line is the reason purchasers of distressed receivables exist.

Returns from this strategy are essentially driven by the difference between what an investor can purchase these loan portfolios for, and what they can ultimately collect from consumers.   For example, we can purchase a $4 million portfolio from a financial institution (made up of thousands of loans with average balances of $1,500) for substantial discounts of six to eight cents on the dollar, or approximately $250,000.  Using our established collection infrastructure, we can collect 10-12% of the debt before selling it, which pencils to ROI’s of ~20%.  This is typically collected over a 12–14-month period, and is a very favorable return profile relative to other credit investments of similar duration.

The consumer debt market has a long history, is very large, and continues to experience robust growth.  The Federal Reserve has been tracking consumer debt since January 1943  (this is debt from revolving debt – credit cards, and non-revolving debt – installment loans).  At that time, the total non-revolving debt market was $6.6 billion and there was no revolving debut reported until January 1968, with $1.3 trillion revolving and $105.5 billion in non-revolving debt.  Fast forward to January 2021, and total outstanding consumer debt hit $4.2 trillion with $965 billion of revolving debt and $3.2 trillion in non-revolving debt, down slightly from the all-time peak in December 2020.

Even though the pandemic has sent balances falling for the first time in years, personal loans aren’t going anywhere.  They’re more widely available than ever, and that’s generally a good thing, because they can be an effective tool for borrowers looking to consolidate debt, refinance other loans at lower rates, or finance big-ticket purchases such as a home remodel or a wedding.  In addition, their fixed monthly payments make them simpler and more predictable than a credit card or some other types of loans.

The key to being successful in navigating this market is (1) having the connections to buy the debt, (2) the knowledge and infrastructure to analyze portfolios for potential successful collecting, and (3) maintaining the portfolios while going through the collection process.  There are a number of buyers of defaulted consumer debt, from one-man bands, to larger companies.  However, many are focused on building scale and as such focus on the higher ticket student loans, credit cards, and automobiles, for which it can take several years to get paid off.  However, focusing on smaller loans with balances averaging $1,500 can be less competitive and a more rewarding area to participate in, which is exactly where Longhorn Debt Recovery Management’s core expertise lies.

About

Michael Scarangella
Michael has focused on corporate credit for over twenty-five years.  He is the Founder and Managing Partner of Private Capital Advisory LLC, a private debt placement firm.  In his prior experience, Michael was a Managing Director at Morgan Stanley, where he co-founded and was a senior investment team member of a $2B+ private credit investment platform.  As part of the Investment Committee, Michael oversaw the deployment of capital in approximately 65 transactions.  Previously, Michael served as Senior Director, High Yield Research at Merrill Lynch.  While at Merrill Lynch, he was ranked as one of the top sell side high-yield healthcare analysts, achieving the #2 ranking by Institutional Investor.  Earlier in his career, Michael served as Vice President, Healthcare Investment Banking with JP Morgan.

Michael earned a BS in Finance from Bentley University and an MBA from Columbia University.  He is a FINRA-registered representative with Pickwick Capital Partners.  Michael lives in New York with his wife and two children.

Daniel Rubin
Daniel Rubin has over 22 years of principal investing, investment banking, restructuring and operational experience.  Throughout his career, Mr. Rubin has held a number of leadership positions.  Currently, Mr. Rubin is the co-founder and Managing Partner of YAD Capital, a New York-based alternative asset management firm that opportunistically invests in private credit opportunities.

Prior to YAD Capital, Mr. Rubin was the COO & CFO of Halpern Real Estate Ventures where he assumed a strategic role in the overall management of the firm.  During that time, Mr. Rubin executed and managed over $650 million of real estate transactions. Prior to that, Mr. Rubin invested in and advised several real estate operating companies, REITs and private equity real estate firms on more than $4.5 billion of complex corporate finance and strategic transactions at various organizations including CW Capital, EdgeRock Realty Advisors, JEN Partners and Lehman Brothers.  Mr. Rubin started his career at Deloitte as a turnaround consultant in their Restructuring group.

Mr. Rubin holds an MBA degree in Finance from New York University Leonard N. Stern School of Business, a Master of Science degree in Financial Engineering from IAE Gustave Eiffel University, France, and a BS degree in Accounting, Finance, and Corporate Taxation from University of Paris Dauphine.

Christopher Winkler
Mr. Winkler has eleven years’ experience buying, working out, and mediating bad debt, and is currently the President of Silverwood Capital, a Texas based real estate investment firm specializing in buying heavily discounted residential and light commercial distressed notes and toxic assets since 2013. 

Mr. Winkler has thirty years of experience in raising venture capital, sales, marketing, negotiation, investor acquisition and retention, debt mediation, and collection practices.

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