Ep. 5 Why Invest in Short Term Senior Secured Private Debt?

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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 short term senior secured private debt.

Today's Expert Guest

Sean Rogister
Chief Executive Officer
Cortland Credit

Today's Questions of Interest

Can you share your remarkable journey from your early days to becoming one of Canada's premier private lenders?
What is Short Term Senior Secured Private Debt?
8:04 Is a first mortgage a senior loan?
And if you're doing receivables would that be 30 to 45 days?
Do you use credit insurance to protect a layer of the portfolio?
10:40 What is the process when deciding on a loan opportunity for a corporation?
If you're going to put money out how do you measure the risk for your capital?
How have your portfolios done in comparison to the bond market?
What kind of spreads are you lending over the prime rate?
Why are borrowers turning towards private lenders versus traditional banks?
How would you recommend using a short term senior secured private debt?
25:18 Could you give our listeners more details about the Short Term Senior Secured Private Debt concept?


Bob Simpson: Welcome everyone to another episode of My Private Network. Today we have a special guest, Sean Rogister, an esteemed figure in the world of private lending. And I think Sean's laughing in the background when he hears the word esteemed. But before we delve into our discussion on Short Term Senior Secured Private Debt, let's take a moment to reflect on a previous episode.

Now, back in episode one, we interviewed five prominent members of the private debt community, asking the question, "Why allocate funds to private debt?". One of our guests was Sean, a seasoned professional with extensive experience managing investments in private debt for a Canadian pension fund.

Now we explored why pension funds have been increasingly investing in private debt and why individual investors have been somewhat hesitant to include private debt in their portfolio. You know, feel free to go back and look at episode one and see what Sean was saying back then. But today Sean's back. So welcome Sean to my private network podcast.

Sean Rogister: Thanks very much, Bob.

Bob Simpson: Yeah. So before we dive into the specifics, let's allow our listeners a little bit of time to get to know you better. Now, I have a question for you here. Is it true? Because I heard the story from somebody and I just want to know if it's true or not. Is it true that you and your partner began your journey working out of a bike store?

Maybe you can share part of this journey from those early days to becoming one of Canada's premier private lenders.

Sean Rogister: It's an interesting introduction. You know, the background that comes to the bike store is that I was running fixed income at Ontario Teachers Pension Plan and my Co-Founder, Bruce Shirk, was running a private debt investment management business that teachers allocated a significant amount of money to. And in order to support that allocation, we had to buy equity in the firm because that's what our board required back then. It was one of several investments that we tried to develop and it was very successful. But probably about five in the short term secured debt markets. And Bruce and I got to know each other then when we were both available and really wanted to build this business, we set ourselves up as Cortland Credit Group.

We thought we had the ideal group. You know, from my institutional background, I knew this had an area that had very strong risk adjusted returns, but it was also a floating rate based asset. Which means that it offers great diversification. It's conservative because it's got real assets supporting it.

But at the same time it's floating. So it's a great component of a fixed income portfolio where most of the assets are the fixed pay that will have the challenge of, in a rising rate environment, they'll have negative performance.

So this is an asset that has strong performance in a positive rate environment So we had this great idea of adding great value for institutional investors. And at the same time, we had the background that my partner Bruce had on lending money in this space and knew there's a huge sector. Over 98 percent of the businesses in canada are under 100 employees, which means they can have trouble raising capital from traditional banks.

So we knew we had a great space to go into and put our money. The fact that it took three years before we actually got our portfolio up to about 50 million, where we could start to take a paycheck and afford to move to a new office was a little bit surprising. Because for the first three years we were there above the bike store, the gears bike store at Trafalgar road and the QEW working in basically very tight quarters was Bruce and I, and we slowly added one or two people on the operations and bookkeeping side.

But, it did take a little while to get the business to that scalable level where we could move to a new office.

Bob Simpson: Yeah, so do you, uh, do you ride a bike to work right now?

Sean Rogister: I didn't. That was a, I'm downtown now. So, it's a bit rough riding a bike. I probably should the way all the bike lanes are changing in Toronto, but that's a separate discussion.

Bob Simpson: So you've kind of talked a little bit about Short Term Senior Secured Private Debt, Sean, maybe take a few minutes, just to add a bit more, like explain to everybody, what is Senior Secured Private Debt?

Sean Rogister: Well, I think short term is an important term as well, because in the institutional world, when you're looking at carving up your portfolio into long term and general fixed income strategies, they kind of skip over the short term, which is generally perceived to be two years term to maturity and under.

And where Cortland operates is primarily one year and under. We have a few loans out to one and a half years, and I think one or two longer, but 80 percent of the portfolio is targeted to be under one year.

So, very much a short term book, but the senior secured part is something to consider in the corporate world when you do a mortgage on your home, if you have one, you have to register the home as collateral for that loan and no one else has a senior claim on it above the bank.

If there's anything happen with your debt servicing capability and they call that loan, then you have to hand over your house as the underlying collateral.

That is the same strategy, effectively, that Cortland uses. We generally look to the liquid working capital that make up a significant part of our borrowing base. So it'll be the accounts receivable, sometimes inventory, that would make up the working capital of the borrower. And that accounts receivables, in a way a hard asset because it's a clear contractual claim that the borrower has on the people they've sold a good or service to, that that end client of theirs has to pay them back within 45 to 90 days. We have a claim on that if the borrower is enabled to service their debt with us.

And it's a great exit strategy because all you do is stop financing, collect on that accounts receivable and you're out of your loan. It's much different than being forced to foreclose on a house and then sell the assets in the market. That is a strategy we used when we do short term loans.

So probably 65 to 75%, call it two thirds to three quarters of our book is those revolving working capital, assets as the collateral. For the remainder it will be fixed term could be property plant and equipment. Sometimes it actually does include land but anything whether it's property or equipment we will always get appraisals on that at the liquidation value because we want the borrower to repay us but if something happens and anything goes wrong and we have to get to a default scenario, then we are going to have a claim on those assets and we have to sell them at what we can liquidate them at.

So that model is pervasive across the Cortland strategy. That's short term senior secured lending.

Bob Simpson: Yeah. So everybody understands the short term. And I, I think really what you're saying that people could grasp the concept of if you're going to do a, let's say you're going to invest in a mortgage in somebody's mortgage, you want to, you primarily want to be in a first mortgage, not the second or the third mortgage. The risk gets higher as you go down the list. So a first mortgage would be a senior loan in that example.


Sean Rogister: But it's short term because a mortgage might be a five year mortgage that would not fit with our model. We're looking for one year and under generally for most of the portfolio.

Bob Simpson: Yeah. And if you're doing receivables are probably 30 to 45 days. Is that not the case?

Sean Rogister: Yeah, 45 to 90 would be a good general statement.

Bob Simpson: Is that a big part of your portfolio?

Sean Rogister: It's going to be two thirds to three quarters of it. Yeah.

Bob Simpson: So really when you lend against receivables, you're really taking on the risk of the company to whom the receivables made out. Right. Let's say if somebody has an opportunity to sell to Costco, but they don't have funds to produce that deal, then you would take over that receivable. So it would really depend on Costco's ability to pay on that.

Sean Rogister: And that's exactly it and just add one other item. And that is that basically all of our borrowers have more than one entity that they're selling their good or service to and so the portfolio of, say, 40 different borrowers have many thousands of underlying accounts, receivable counterparties. So it's actually highly diversified well beyond those 40 borrowers.

Bob Simpson: Right. And one of the things that you look at there is what's the credit quality of the company to whom the invoice is made out to, right? So you can kind of pick and choose based on that. You know, in a previous life, and I don't think I ever actually told you this, that I worked for a firm that did credit insurance.

And I think you use credit insurance a little bit.

Sean Rogister: We do.

Bob Simpson: Protect a layer of the portfolio. Is that right?

Sean Rogister: There are groups that we fund on the financial side where they in turn do what's called factoring, where they buy the accounts receivable from the underlying borrowers. And that's how the borrowers pay for their working capital.

But on those where it's factoring, they always have a hundred percent insurance on that underlying accounts receivable. They're just a little too small for us to fund their underlying borrowers, but they'll have eight or 10 different borrowers that they're factoring their accounts receivable for and those are all insured.

We do have that within the portfolio as well.

Bob Simpson: Yeah. So one of the examples, so you're using accounts receivable as the collateral on this, maybe just spend a second and talk about, how you look at an opportunity to make a loan to a corporation and what's the process that you go through? Maybe an example of a type of loan that you've made and what's the process that you go through to, to get that thing done?

Sean Rogister: Yeah, a big part of our portfolio is a pretty good fit for your question. And that is, the I. T. area where we're funding companies that are in the I. T. Space. Sometimes it's providing cloud storage facilities to big municipalities and big corporations. Sometimes it's cyber security services. Sometimes it's a little bit more about selling servers to the big universities where they're constantly buying more computers, but they have to have those servers configured to fit the university's model.

So they buy the server from an IT firm that in turn buys it from HP or IBM. But that I. T. firm does the configuring of the system. So it fits with the end users model. That's called a value added reseller. And in any case, those I. T. firms, there's over 30 of them that we funded in the last five years. And those firms are all looking to provide us with a claim on their accounts receivable from their institutional clients, primarily.

Could be big corporations, but a lot of them are the municipalities, the universities, the hospitals, all the people that have big data requirements that are regularly buying those servers. So those make up a big part of the portfolio. When we look at them, we look for a three to five year history of clients that they've been selling that good or service to in this case, the I.T. Equipment too.

We like the repeat buyers, cause then we don't have to do a lot of work on doing credit checks on their underlying buyers, but we always do a weekly review of that borrowing base that the borrower comes to us with and we constantly check that pool of accounts receivable to make sure it matches with what we have agreed to in the overall funding commitment and we approve those borrowers. If there's a borrower that has a history of not paying its accounts payable to the borrower then we'll say that's not approved in the borrowing base.

We check the borrowing base as it comes to us against their online bank statements to say if the borrower says to us, I just collected on 2 million of accounts receivable, then we'll look at the bank statement and say, well, that didn't show up. When is that expected to come in? And we would allow it to be included in the borrowing base when it comes in.

And I think that's a very unique feature that Cortland has developed. And it was to Bruce's credit, it was a model he developed in his prior role. But what I really liked about his platform, and we do that at Cortland, and it's a very strong part of our overall credit management that we can oversee and kind of reinvent our lending arrangement with the borrowers on a weekly basis.

Bob Simpson: Yeah, Sean, one thing that I've always said, you know, having a fairly extensive fixed income background myself is, you know, if you're going to put money out, you're going to get, you know, four or five, six, and, you know, in this case, numbers up into, you know, the high single low double digits that for that kind of return, you don't really want to risk your capital.

Sean Rogister: Right.

Bob Simpson: So, you know, One of the things that you said in episode one was that, you know, for being a bond manager is pretty easy. You just look at the credit rating agencies. You can read the report, see it's a double A, single A or whatever. You can make judgments based on that. You don't get that. Do you, when you're doing private?

Sean Rogister: No, you're right. And a good institutional investor can't really advocate all responsibility to the rating agencies. But the role of the rating agency plays is a third party assessment of the credit quality of that borrower, and we don't have that. We do use an independent review committee that reviews our processes, and they'll go and pick our three to five largest loans and go through the credit analysis we did of the ongoing borrowing based review that we have to see if we've stuck to our process. Absolutely.

But the actual due diligence on that borrower, the review of the credit quality of their underlying accounts receivable and the liquidation value of their assets, we use third parties to do that for anything that's a fixed asset, like a piece of property or equipment. But the actual accounts receivable, we do the due diligence on their underlying portfolio and it's ongoing and it's required that we do that carefully on our side.

Bob Simpson: And that's a big part of your focus, isn't it? You know, it's almost more important that you look at the asset against which you've written a loan as opposed to even the cash flow. Or it's I know it's a combination of the two, but do you slant one way or the other in that regard?

Sean Rogister: The way I would characterize it is we always look to the borrower to be responsible for repaying us. But if anything goes wrong we have an exit, which is the underlying collateral. If it's accounts receivable, we just stop funding and collect on it. If it's equipment or property we foreclose and then we'll liquidate those assets in a normal market process, which we hope is quick. But it's not as quite as clean as accounts receivable.

And that's why we really like and the majority of our portfolio is based on, that accounts receivable type of collateral, the liquid working capital collateral as our borrowing base.

Bob Simpson: So changing directions a little bit over the last year or so, we've seen pretty significant negative movements in the bond market, mostly due to rising interest rates. And I think a lot of investors got caught a little bit.

They didn't realize that when rates were zero and they're paying a manager as much as the return on the bonds that they were purchasing, that they were going to be in trouble when rates when rates rose. And I don't think anybody thought they might rise as much as they did.

But you know, during that negative period where things like XBB, the benchmark ETF, I think was down 11 percent total return over that year, how have your portfolios done in comparison?

Sean Rogister: You know, it is interesting that the worst year in the history of the capital markets for that traditional 60, 40 equity fixed income mix happened last year.

And it was rough on a lot of investors, but, pardon me if I look at it as interesting, but the interesting part for us was that that was the best year in Cortland's history and this year is going to be better.

And we didn't do anything different we didn't do a punt on what's going on in the market. We just continued our lending model. But that is as a floating rate asset where we lend to our borrowers at a spread over bank prime. And bank prime was 245 two years ago I know that overnight rates were basically zero but banks would lend at a minimum of 245 their prime lending rate Now it's 720.

So it's up about you know 465 or so. And our yields went from 5-5.5 to 9%. So we're up almost exactly the same amount. Which really reflects the fact that we've got a portfolio that hasn't changed its model. But it's a floating rate portfolio and very good spread over traditional fixed income assets while being pretty well collateralized.

So it's actually more collateral support than you get with traditional bonds. They're what they call limited recourse or unsecured promise to pay by the borrowers in traditional corporate bonds.

In our environment, we have real short term and senior secured status on the collateral and that has made for a much more reliable and conservative portfolio with a better consistency and returns. And because it's private debt, it gets a big bump in what I call the alpha, the excess return over the traditional index. And that is the result of that ability to provide capital where traditional banks don't want to go. But for investors, it means significantly better value for your investment dollar.

Bob Simpson: Yeah. So what kind of spreads are you lending over the prime rate?

Sean Rogister: So we lend at prime plus call it 4-8 or 9%. And off of that, we take the underwriting cost or expense of rolling the assets over every week. That's a 1. 7%. And then there's a management fee that I think is small at 45 basis points. But all in about 2.15 percent of economics. So, we're lending at call it 10 to 11 or 12 percent and our net yield for our investors is in the 8 to 10 percent in the return they're seeing in this environment.

Bob Simpson: So I guess the question that people who are listening to us might ask is why would people borrow from you at those rates when they could potentially borrow from a bank at a much lower rate.

So really, why are borrowers turning towards private lenders instead of working with the traditional banks?

Sean Rogister: Well, just imagine that you had a project that you wanted to, you know, establish a new building because you've got a whole bunch of new sales coming in, you got to set up the oversight of that or the production facility to do it. Or If it's a private equity manager buying another company , that they want to make sure they can fund that acquisition and look to the collateral of that borrower as a part of the funding cost.

So they would come to us and say, "Hey, can you look at the collateral of this underlying borrower? Would you provide us some capital with that as collateral?". And if they took that to a bank, the bank would say, well, let us take six months to a year and go through that. And it might be a no. We can give them feedback within two to three weeks.

We think this fits well. And then we'll do the ongoing deep dive due diligence on everything component of it. But they have a good indicator and we have a long track record of being reliable in that indicator. But we do the final commitment six to eight weeks later. But that's a very short turnaround for them for working with us as compared to a bank's financing model.

And I can tell you there's lots of examples. So we do lending occasionally in the U. S.. A U. S. bank will only lend against U. S. assets. But you have a borrower that has got, you know, they're selling I. T. equipment in the U. S., but also they're selling I. T. equipment to the Canadian government. And those U. S. banks won't take that as collateral. Whereas we can provide that funding, we can hedge the U. S. dollar risk, but we can provide the funding to them, we can take all the components of that as collateral.

Bob Simpson: So it's really, you're talking about flexibility and businesses, I'm sure, find it pretty difficult with the bureaucratic nature of working with the banks. That by working with somebody, maybe it's worth a bit more money to get your hands on the money when you need it, as opposed to waiting six months to a year.

Sean Rogister: Plus these smaller firms, the banks get a little bit nervous that they don't understand all the collateral. They got to do a ton of research on it. And then they've got to do the ongoing tracking. For a small firm it may not justify that weekly, well, it won't justify a weekly borrowing base review. They may get comfortable with monthly or quarterly borrowing base, but that's generally for larger firms.

The smaller firms that we deal with, you've got to do an ongoing and deeper dive into the, the ongoing development of their revenue. What is their accounts receivable that is turning over in that? And I can tell you that we have, on our revolving loans, you can have 20 to 30 percent of the portfolio turning over every month.

It's a lot of monitoring work.

Bob Simpson: Yeah. Sounds like you're earning your fees on this as opposed to a bond manager where all they have to do is go out and figure out the duration of the bond and the credit quality and make a call, right?

Sean Rogister: I was on the other side of that conversation quite a bit. You know, that it's, uh, sometimes a directional bet on interest rates and that can take a lot of work, but the actual execution could be just a bond and it could be the five year versus the 10 year or something like that. But yeah, there's a different set of decision parameters.

Bob Simpson: Yeah, a little easier. Now for the individual investor or maybe a family office who's looking to diversify their portfolio, how would you recommend using a Short Term Senior Secured Private Debt in a portfolio? Now, is it a viable alternative to both growth investments such as stocks and or income investments, things like bonds and GIC's?

Sean Rogister: Yeah, I really recommend that people look at this as a conservative fixed income portfolio because it's going to generate a very consistent performance and return. It'll be the thing in the corner of your portfolio generating that return through thick and thin.

But it's never going to give you 15 or 20 percent return in one month over others because you make a good call on individual stocks that have a lot of potential growth. This is more of a consistent conservative allocation and can be a long term allocation within a strategic portfolio investment plan.

Bob Simpson: Yeah. But even for an investor who is maybe getting weary of the rollercoaster ride of equities over the last few years, one of the numbers I follow really closely is that if you bought the S& P 500 back in December of 1999, that you would have received a total return of about six and a half percent per year over that period.

Your thinking is with the spreads over things like bonds and GIC's over prime especially, that you could probably come pretty close to getting equity performance without that risk or volatility.

Sean Rogister: Yeah, that is my view as well. A lot of people will look for equity returns to be higher because they're taking a lot more risk with it.

But If you look at that historical data, you can get a sense that it's actually hard to actually deliver that. Whereas our strategy has been, you know, quite reliable.

Bob Simpson: Now, one thing that I've heard from people in your firm is that you're working on a new concept that we're hoping to list on PD&E as well.

Can you give maybe give our listeners a bit of a sneak peek as to what you have in mind there?

Sean Rogister: Yep. Thanks, Bob. Keep in mind that my background is very heavy on the derivative side over, over the course of my career. And so we did identify that there's an opportunity right now to participate in bank stocks with the upside only.

And without the downside risk by buying options on the bank index. Now we can pay for that option with the alpha, the excess return that Cortland generates. And so you get access to only the upside on equities. And even if equities do nothing, you still make 5 percent return on the Cortland strategy over the three year term of this investment.

We can't do it forever, but we can do a three year option on the underlying equities that get you that return.

And because we are doing a different model, we don't participate in the management fees in this model. We only participate in a portion. I think we set it at 10 percent of the upside in the equities. But we don't have a management fee. So if nothing happens, investors are much better off than they would be just investing in Cortland or in this strategy on its own.

And if the market goes up, they're still going to get all the unlimited upside that you can get with equities if they really do deliver strong returns. And we picked the bank side because historically banks have done very well for investors.

The challenge of course is that there's a lot of uncertainty in the market right now as to whether or not banks will be able to deal with more requirements for regulatory capital or will they be able to come out of this as they have in the past to help investors with that uncertainty?

They can get access to this where the cost of that option is covered by the alpha from Cortland strategy.

Bob Simpson: So I want to just extend a big thank you, Sean, for you spending your time with us today and sharing your valuable insights.

Sean Rogister: Thanks very much, Bob. Very thoughtful questions.

Bob Simpson: This podcast episode will be available on privatedebtandequity.ca as educational content for Short Term Senior Secured Private Debt. Please don't forget to follow us on your favorite podcast platform. Subscribe to our YouTube channel now before making any investment decisions, it's essential to consult a. professional financial advisor to determine suitability.

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