Welcome to the My Private Network Podcast!
Interested in learning about private market investing concepts and opportunities available to you?
This week's episode features our co-founder and host, Bob Simpson, who gives you, the investor, a chance to hear from industry experts about why you should consider investing in purpose built student accomodations.
Today's Expert Guest
Rob Anton
President and Partner
Next Edge Capital
Today's Questions of Interest
1:44 What are you seeing with equities and bonds in the current financial landscape?
5:13 Could you explain the returns you're seeing in private lending?
12:41 What can investors expect when it comes to fees?
13:55 How do you go about assessing return of capital?
19:27 Are most private lenders floaters?
23:08 Does the combination of higher interest rates plus a recession impact your borrowers?
26:28 You measure withe the Cliffwater indicies?
27:25 During the negative years, what were the size of the losses?
28:07 Is private lending an alternative to bonds in a portfolio?
Transcript
Bob Simpson: Welcome back to the latest edition of my private network podcast. I'm Bob Simpson, your host, opening another door to my private network. Today's guest is Rob Anton. Rob's firm is a private lending firm. Rob is president founding partner of next edge capital. He has been active in the financial services industry for over 25 years.
Hey, Rob, thanks for being with us here today.
Rob Anton: Yeah. Thanks for having me, Bob. You know, I must say that, you know, over the past 30 years, I've been a pretty big advocate of education in the financial business and, uh, very much appreciate, you know, what you're doing here.
Bob Simpson: Yeah, no, it's the whole goal is education today.
I want to focus the attention on trying to help investors to find some answers as to why their investment returns are falling short of the returns that they need to achieve their financial or income goals. So Rob, do you think you can help me with that today?
Rob Anton: A hundred percent. Let's do this.
Bob Simpson: Let's do this. So as I look at the landscape here, I see that we really live in the investment world now in a cookie cutter world, where if you go to a financial advisor, they're going to give you a couple options. Let's do a 60 percent equity, 40 percent bonds. Or if you want to be more conservative, let's do 40 percent equities and 60 percent bonds.
But you must own equities and you must own bonds. Those are really the two asset classes. That they're shown, right? Are you seeing much the same in your world?
Rob Anton: Yeah, it's a good point. My personal thoughts on it are, you know, for most investors, the volatility associated with equities is typically more than they can stand.
And in many cases, you know, a lot of these investors tend to exit at the wrong time and miss out on the longterm benefits of equities. But investors need them in order to achieve enough return. Although I do believe that there are some other alternatives that can aid within portfolio solutions. With regards to bonds they're definitely considered a safe haven, although they tend not to achieve enough return in order to meet investors targets that they need in order to achieve a happy and healthy retirement. In fact many people, such as advisors, are typically recommending bond funds instead of bonds.
And with coming off historical low interest rates over the past decades and additional fees from these management fees that have eaten up a fair bit of investor returns, coupled with, we ran into some periods where both bonds and equities were moving in the same direction down, such as in 2022. For the most part, they really just haven't done the job that a lot of people are utilizing them for.
And, I truly believe that you need more in your portfolio than just stocks and bonds.
Bob Simpson: Yeah. You know, I'm a stats guy. If I took a look at the S&P 500. If you take it back to, uh, 2000 to, you know, let's party like it's 1999 December of, um, the return since December, 1999 is 7.2% annualized over that period.
But you had a period where you actually made no money in equities between 2000 and 2011. And then you had great returns since 2011. They've just absolutely been shooting the lights out, but over time, 7 percent is a, probably a reasonable return for equities. And I think we've been experiencing much better than that over the last little while. You know, when I look at the bonds, the stats that I saw is that 160 Canadian bond funds that were set up as F class, where the advisor fee is over and above the fees charged by the fund manager, the average annualized five year return on those 160 on average 0. 7%. So you learned less than 1 percent in bonds. But the crazy number is, you know what the management fee was? 0.6. So it's kind of like, yeah, give us your money, we'll share the returns between fees and what you get, and you really don't end up with anything. But, you know, as you said, when rates were zero, it was a bad asset class.
I think equities are a good asset class. They're not for everybody. Some people just can't stand the heat and the volatility that's there and it's been quite bad. We've seen declines of 25 percent down to 55 percent over the last couple of decades. But let's look at bonds.
And I think you have some ideas that you could share with us about some alternatives to investing in bonds. Think that's where we're going to go today. So returns from private lending, the area that you've been involved in, they've been quite attractive historically relative to traditional and fixed income and even parallel that is equities, right?
The returns are almost equity like sometimes, aren't they? So what are some reasons why these attractive yields exist today?
Rob Anton: To us, it really comes down to certain inefficiencies that we think exist in the marketplace prior to, building a whole private lending business in a fund to capture this opportunity.
We spent a fair bit of time looking at the marketplace and trying to really figure out why these returns existed on a risk adjusted basis as well as on an absolute basis. And what we uncovered was various different, what we believe, are risk premiums or yield premiums that exist in the marketplace.
And we actually designed, our business in order to try and capture some of these. So a few of these in academia world, most people would consider some of the premium returns that are attached to both private debt as well as private equity attributed to what's called an illiquidity premium. Which is that you should be compensated.
With an extra return for the give up in liquidity that you're giving up, I believe that's one of many reasons, you know, as far as an explanation of yield premium. But I believe that there's actually more so for us, some of these other yield premiums that we think are attached to private lending.
One would be a regulatory premium, which is kind of attached somewhat to scarcity. And a few ways to explain this would be in 2008, 2009, when we went through the financial and banking crisis, many rules were enacted shortly thereafter, which put capital constraints on the banks, which really meant that they had to de lever their balance sheets significantly.
Which meant that a lot of loans or companies that used to get financing from the banks had to seek other avenues. However, the private lending business wasn't as robust as it is today. So there was this very big void created in the marketplace, which private lenders kind of had to fill. Those regulatory changes continue.
We have the entrance of Basel three coming very soon, which is requiring once again, the banks to reshuffle their balance sheets of the loan pools, which creates a lot of opportunities for private lenders. It creates inefficiencies in the marketplace, which are opportunities for private lenders, but attached with that are, are excess yields.
We believe that there is a size premium attached to private loans. When you look at statistics over, say, the last 3 to 5 years, I would say that 5 private lending firms or maybe 5 to 10 of the thousands of private lending firms globally are capturing probably 75 to 85 percent of all the capital raised in the industry because they're raising so much capital in order to move the needle for their businesses.
They really aren't getting involved in loans under say 30 million, 40 million in size, which creates a very large opportunity for loan sizes under that. When you are competing on a loan, that's of a large size with these big players that have massive pools of capital, it really just means that the competition in those larger loans tends to be higher, meaning that the yields that you can charge these end debtors or the people that are borrowing the money tends to be a little bit less.
So we feel that there's an inverse relationship between the size of a loan and the rate that you can charge to a degree. So the size of transaction premium definitely exists. We believe that there's just inefficient price discovery. There's no public pricing mechanism like a stock market in order to achieve pricing.
Not that I'm saying stock markets are efficient somewhat either, but vastly more efficient than price discovery or the rate of return discovery for private loans. And therefore pricing is fairly inefficient and subject to somewhat of a premium, definitely in certain areas for most people that go to the bank.
And when the bank says no, and they can't get a loan from their bank, most people don't know where to turn to. They don't know where to start to actually try and get money from other avenues. And that venture can be quite taxing on a lot of people. And a lot of non bank lenders really focus on certain verticals and are not a catch all for all different types of lending.
So that journey for many people can be very inefficient and it can lead into inefficiencies as far as like what we call price discovery or yield discovery, which can relate to excess yield from the lending transactions. We believe there's a premium attached to a superior origination activity, meaning the more deals you see, the more likelihood you are one doing deals that more fit your box, which could lead into less loan losses, which, you know, helps net yield, which is gross yield net of losses.
But we also believe that the more deals you see, the more opportunities you have. And sometimes especially in areas that are maybe outside of major metropolitan areas there's less competition there, which can aid in higher yields as well.
And kind of lastly, and this is more of a structural point, it relates to the cost of capital. The bank's cost of capital is what they're paying you on your deposits, what they're paying you on, your GICs and what they're raising bond capital at. And then if they're paying you 3%, you know, on that money, then they might go out and lend it to someone else at 5 or 6 percent and they make that spread.
No different than non bank lenders. The amount that non bank lenders charge is really a function of their cost of capital. And for non bank lenders, the cost of capital is higher. We have to pay investors a higher rate of return than the banks do in order to access that capital. And then a spread has to be put attached to that.
So, that really factors into the equation as well. So there's various different factors that relate to this and hopefully I gave you a little bit of insight into how our mind works at, on what we look for, how we run our business in order to try and capture some of these.
Bob Simpson: Yeah, but just to put a different spin on cost of capital is you have a cost of capital, which is what investors require as a return But in a way. It's not really a cost. It's really you're providing a service to investors. Getting them, what we call be the bank kind of returns, maybe a different way of looking at it.
Rob Anton: Yep. For sure. We do believe that in order to attract investor capital, we need to at least strive to achieve a certain rate of return. So net of our management fee, you know, we have to charge X for a loan. So net of any fees that we might earn for running this business, we need to try and strive to achieve investors and net return of X in order to keep them in the fund in order to attract new capital.
Bob Simpson: Right. And that's when you talk about origination, you're really trying to originate loans that fit your model, that fit the requirements of your investors. So you're really working on behalf of the investors opposed to banks where let's talk fees. You put money in the bank, they give you three, they lend it out at eight, they're making 5%.
Those are fees. Those are bank fees that are being charged, right? In your case, you have smaller fees where you're. Where the bulk of the return is being directed to the investor.
Rob Anton: So our fund operates, you know, in the function that we put out money and we charge a management fee and performance fee. So our revenues attached to that and the experience that we give our investors. Whereas, how the banks make capital is more from a balance sheet standpoint. Whereby, they have a cost of capital for money that they take in from investors or from deposit holders, or people buying GICs, things like that. And then they might put it out at a significantly higher rate than that and make that spread. And then what they utilize is significant leverage in order to multiply that spread, to make a return on equity.
Bob Simpson: Okay. So at the origination level, you really have a pretty big funnel.
You look at a lot of deals that you say no to and I know that through Private Debt and Equity, we've had some people come to us and say, "Hey, we need some money", and we've shown you those deals. And you've said, no, no, that doesn't fit our model. So you really at that level, that's really where you're assessing the risk.
What is the risk of these loans? How do you go about doing that assessment to make sure that it's return of capital rather than return on capital, but you want the right combination of the two?
Rob Anton: We're strong believers that in private lending, as well as in private equity for that matter, you're only as good as the deals that you see it.
What that really means is that you need to go out there, expand your network and look at a lot of opportunities. Some opportunities we might say no to just because, you know, it doesn't fit our box, meaning, for us personally, we're collateral back lenders. And if this business doesn't have collateral that could be pledged to back the transaction.
It wouldn't be a fit for us, but even companies that might have collateral, we might stay no for various other reasons, such as their ability, why they need the money, you know, their ability to go to how that money gets them from point A to point B, various different metrics. But we're big believers that you need a large funnel.
You need to see a lot of deals in order to find the ones that are right for your business and what your skillset is. Otherwise, if all you're seeing is, inferior deals, you might end up doing those because that's all you're seeing. So we think that that's quite key.
It's quite key to, you know, one, we believe lead to a lower loss rates, which obviously has a huge impact on net returns. It also helps find some deals maybe in some less competitive markets where you can maybe achieve a little bit higher , on the opportunity as well.
I have a mentor in this business, a gentleman that used to be a colleague of mine, you know, at a prior firm. And he was very, he had a very successful career and he spent a few decades running one of the world's largest hedge fund to fund products. And in his prior career, he had been part of a research study whereby they tried to figure out. What were the key variables of what made one private equity manager outperform other private equity managers at the time?
So we're talking about private equity, but there's parallels here. And after all the research that they did, they believe that the only defining repeatable variable that differentiated one private equity manager from another as far as superior returns was actually the origination. Being invited to the table in the first part to be able to participate in a deal was the key defining variable on outperformance.
And we think that that philosophy, totally translates to private lending as well. And that's kind of the philosophy that we use in our business as well.
Bob Simpson: Right. So the importance of being shown the right deals, as opposed to going out and trying to rustle them up from the bushes, right. That, yeah, here's one.
Yeah, maybe we look at that. Maybe we don't. You want to look at superior deals, lowest risk deals, best return deals, get the right combination there.
Rob Anton: Exactly. And I must say just by putting a shingle, on the building, doesn't grant you that you do have to work at it. So it is part of properly operating a private lending .Business.
Yeah. So just from our discussions before we did this, we had a number of questions. What's the common philosophy or mentality that you see from private lenders on the street when putting out loans?
Prior to actually getting involved in the private lending business, in the way that we currently are, it's been a fair bit of time doing due diligence on the sector. And after spending a fair bit of time, you know, in the business, it's still a key variable, but I would probably say it's, it's one third of becoming a successful business.
I would say that, we just spent a little bit of time talking about origination. I would say that origination equates to probably about one third of the variable running a successful private lending business underwriting and due diligence on the file prior to approving it, I believe equates to about one third of the key variables to running, private lending business.
And then once you actually extend the loan, one third of the importance is really on monitoring and risk management. Making sure that you're talking with key management, making sure that you're watching the financial metrics of that company and making sure that they're going as to the plan. Monitoring collateral that might be pledged, backing the asset, these are all really important things. The buck doesn't stop once you give them the money and you hope it comes back. It's really a lot of work. In order to be successful in the business risk management and monitoring is probably that other third.
From a lending company standpoint, I'd say, uh, you know, a solid source of capital is also important, but the, the first three are the most important from an investor standpoint. It really takes all three in order to be successful.
Bob Simpson: Yeah, one of the things that we've seen on the private lending side is that.
Most of the private lenders are floaters, right? They're floating rate and investments as opposed to bonds that are fixed rate investments. So the bonds all got hit because you essentially lent money out to somebody at 1 percent when rates go up to 3 or 4 then now you're in trouble, right? You're going to lose some of your capital.
So talk a bit about the importance of, you know, what you see moving forward in a floating rate environment for investors.
Rob Anton: Yeah, I think it's best if we break it down into maybe returns, how it impacts returns and then talk kind of more so from the risk side. You know, with regards to returns from private lenders, I kind of break it down into shorter term lenders and longer term lenders.
But, as a whole, many private lenders do put out floating rate loans, meaning that as interest rates have increased, the cost to the end borrowers has increased, which means that the private lenders are making more money from their loans. I would say that the shorter term lenders, it's a mixture of maybe some fixed rate loans as well as floating depending on how short of the curve that they're on.
One key difference over the past few years has been that if you're a short term lender, meaning on average, shorter term duration of your loans, meaning one or two years or less, I would say that as these loans have matured, there's still a fair bit of competition on refinancing good loans that some of that benefit of the increase in interest rates were negated somewhat when they got renegotiated.
So, I would say that the people that benefited the most from rising interest rates from a return standpoint are more of the longer term lenders, those that are 3, 5, 7 year loans, whereby those, rates of returns went up in lockstep. Whereby they're shorter end of the lending spectrum as far as duration didn't benefit as much.
From a risk standpoint, higher interest rates being charged on the borrowers really mean that you need to monitor how this impacts the end debtor. And for existing lender clients, we might look at things such as their ability to service the debt from simplistic standpoint. But monitoring their operating margins, their interest rate coverage, their ability to pass on maybe higher rates to their customers in order to make up for this higher cost.
When we put on new loan opportunities, we can take this into consideration and I would tell you that not unlike many people that are trying to get a mortgage on their house, whereby, you know, the amount that they can qualify for today versus two years ago is dramatically different. It's similar when you're lending to businesses out there. And I would say that in some instances, our ability to pass on three, four, 5 percent increase in interest rates really hasn't been there because it just doesn't work for these businesses.
And unless you offer them rates that make sense for their business, they're just not going to take the money, or they'll just not do what they originally planned to utilize the money for. That's had somewhat of an impact on the private lending business as a whole and passing on all that rate increase that we've seen over the last three to five years.
I know in our shorter term lending space, maybe we're picking up an extra 100, 150 basis points on new deals, maybe up to 200 basis points from two years ago. But, our ability to charge four or 500 basis points more from two years ago to these businesses is just not in the cards. It just doesn't work.
Bob Simpson: Yeah. So the combination of higher interest rates and. Last Wednesday, we did an event, Outlook 2024, and one of the speakers, Bill Chinnery, was saying, you know, was talking about recession. He said, I don't believe there's going to be a recession. Does the combination of higher interest rates plus a recession, is that, what impact is that going to have on your borrowers?
Rob Anton: Yeah, and that whole recession talk, I think it depends on the month because we've been back and forth quite a bit over the last year, year and a half as to whether we think we'll go into a recession regardless. I think discussing how private lenders have fared during weakness in the markets as a whole or weaknesses in.
The economy, I think is a worthwhile discussion. First off I'm the first person to tell you that private debt investing is not a foolproof way of investing. So please take that into consideration. You know, however, we got involved in the game because we think it offers exceptional risk adjusted returns historically as well as go forward.
So, I'm obviously a huge fan. I think part of it really depends on the area of private lending that you're involved in, there's various different ways that private lenders operate with various different degrees of risk reward.
On one side, you might have senior loans versus junior loans.
Senior meaning that they have a higher claim in any value of that business versus junior, meaning they have less claim and are down that, that totem pole as far as their claim on value of a business if things go wrong. You have say secured loans, versus unsecured, secured or obviously have a higher claim on any value that that business has, if things go awry, you have, you know loans that are maybe collateral backed by assets, such as real estate, equipment, inventory, things like that.
And you have loans that might have no collateral backing it. These various different things, and I could go on and on, but they define kind of the level of risk of which that private lender is, iinvolved in. For example, senior first lien loans backed by collateral, historically net of recoveries, historically of the lowest lost rates, versus any other forms of lending.
Hence, the net returns of the gross yields tend to be still quite positive during poorer periods in the economy. Junior unsecured loans that are not backed by collateral tend to have higher loss rates on their loans, whereby the returns may swing a little bit more. So understanding the various different risk rewards is fairly important.
Some recent examples of performance during stress periods we've had a few not that long ago, although a lot of people forget very shortly. But in 2020 the start of COVID, it was a very stressed environment. The economy had a significant downturn, equity sold off.
And in that year, most private lending funds made money they were a very good balance for your portfolio and a bright spot. And one of the many reasons at which to hold them, 2022 is another, you know, good, very recent example [00:26:00] that we can point towards when both stocks and bonds in general sold off and had negative years.
And for the most part the private lending funds in general had good returns in 2022. You know, I, I believe that one of the best proxies for private lending, returns in the business is, something called the Cliffwater indices. Um, you know, due to...
Bob Simpson: The old Cliffwater indices, yeah.
Rob Anton: I like it due to the methodology of which they use in order to calculate the index, very different than any other indices I've seen out there.
It's a U.S. Based or U.S. Centric so take that into consideration. But you know, in their direct lending index, which has been around since 2005. So, you know, 18 years, it's only in 2008 that they actually have a negative year. So we're talking one negative year out of 18. For their senior direct lending index, which just focuses on more higher in the capital stock type loans,
which began in 2010, it hasn't actually shown a down calendar year thus far. So I think these are good proxies. I think that the private lending industry as a whole over the past number of decades has shown what makes them quite attractive. So like I say, not foolproof, but superiorly, attractive.
Bob Simpson: But even during the negative years, what were the size of the losses?
Rob Anton: The cliff water index showed a loss that year of six and a half percent, during 2008. So obviously significantly less than the equity losses of what, 30 to 50 percent or something. Yeah.
Bob Simpson: 55. Yeah. 55. I think. Yeah. So just to close the loop, you know, what we were talking about as we started this, Rob when we started this discussion, we really talked about bonds, can we find an alternative to bonds. Private lending as an alternative to bonds in a portfolio, what do you believe?
Rob Anton: Yeah. So right now we see the opportunity set quite strong. We relate opportunity set somewhat to. The economic environment, but also to the amount of opportunities that we see coming across our desk that are superior quality in nature. And I would say that over the last year, year plus, we've definitely seen the banks becoming more risk adverse saying no to a lot of loans that they used to say yes to moving some loans out in various different sectors based on, some of the decisions that they're making.
So the opportunity set from that has been very strong. We see the new changes coming in shortly with regards to Basel three. We're seeing banks reshuffling their loan books and balance sheets in accordance with that moving out of certain areas that's created some opportunity. And I know this seems like, or to me anyways, it seems somewhat long ago, but it really is.
It was less than a year ago that we've seen some severe problems happen in the U.S. And the regional bank environment, whereby, you know, some regional banks went insolvent some of the bigger ones that we've seen historically and you know, that created a mass exodus of deposit capital out of not just those regional banks that went bankrupt, but out of a lot of regional banks in the U.S., that's created a lot of opportunity. I know with our business, we focus a lot on small and read small and mid sized companies throughout North America. And the regional banks in the U.S. are competition for us. Not only do they have a lot less capital to deploy, but at the same time over the past year, they've been actually dialing back their risk.
So it's been a double whammy for them and that's created a lot more opportunities to see deals, outside of what we were seeing prior. So we're, pretty optimistic about, go forward in the business, at least for our business.
Bob Simpson: Yep. So as an alternative to fixed income, traditional fixed income, this is an area that investors should spend some time and, we're here to educate, and I know I've talked to some people recently where they said, yeah, that seems a bit complicated.
I said, yeah, but you know, don't invest in things till you understand them. And that's what we're here to do. And I appreciate Rob that you've spent the time with us this morning, time to kind of wrap this up a little bit, but thanks for coming out, thanks for sharing your thoughts with us today.
We appreciate it.
Rob Anton: Thank you.
Bob Simpson: So I want to really thank, thank you, Rob, for the time that you've spent with us sharing your invaluable insights today. A podcast episode will be available on privatedebtandequity.Ca as educational content for your specific, channel. Now, before making investment decisions, it is crucial to consult a professional financial advisor to determine suitability.
Full disclaimers are available on private debt and equity. ca. Now don't forget to follow us on your preferred podcast platform and subscribe to our YouTube channel to stay updated. In closing, I'm Bob Simpson. It has been my pleasure to guide you through this conversation today. Thank you Remember that knowledge empowers you to make well informed investment decisions and progress towards your financial objectives.
Until we meet again, stay focused and disciplined on your financial journey. We'll catch up with you next time.
