Alt Thinking Podcast - Private Debt: More Than Just Lending

Many small businesses have trouble getting financing while institutional and high-net-worth investors have difficulty finding an investment similar to fixed income that provides a high return in a low interest rate environment. Fortunately, they can both benefit from private debt.

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

Michael Hainsworth:
Many small businesses have trouble getting financing, while institutional and high net worth investors have difficulty finding an investment similar to fixed income, one that provides a high return in a low interest rate environment. Fortunately, they can both benefit from private debt. Arif Bhalwani is the CEO and Managing Director of Third Eye Capital. He says that while a conservative underwriting approach from Canada's big banks has contributed to a stable financial system in Canada, he adds it's also impairing innovation.

Arif Bhalwani:
It's a complicated question, because it encompasses so many factors. I mean, we have the banks here that have a concentration in credit because it is their primary function, that intermediary function of making sure that money comes and goes from depositors to investors. But what's happened in Canada is that you've had a loan structuring process that's become very standardized, I guess very mechanical. And you automatically get a rationing out where borrowers that don't meet that criteria, which is looked at quite strictly because of the ratio of accounts on loan applications that any given bank employee would have to assess.
And when we look at Canada and contrast that with the rest of the world, we do see the benefits that the Canadian financial system gained in the last crisis because this conservatism, of course, contributed to the stability of the entire financial system and our country was lauded for surviving the GFC without any significant pressure from governments to provide bank support and come up with regimes to better balance sheets within the banks.

But there's ample evidence out there from multiple sources that show Canada’s innovation performance, let's call it, is very weak when we compare that to other developed economies. And so, you know, a large part of our role in the Canadian economy is helping to close our country's innovation gap and making sure that good, productive, companies are not forsaken. This is why private debt, direct lending, all the various terms that you want to describe this alternative form of lending, it’s why this is a change that's going to be secular, structural, and cannot be just relegated as being a fad that's been perpetuated by very low yields over the last decade and a bit. It's going to be, and remain, an essential permanent part of our financial system.

Michael Hainsworth:
When it comes to business formation in Canada, the rates are pretty much on par with the United States, but we can't say the same when it comes to financing. The World Economic Forum ranks us 27th for financing SMEs, 25 spots behind her biggest trading partner.

Arif Bhalwani:
Yeah, that's shocking. It's actually easier for businesses to get financing in Azerbaijan and West Africa than it is in Canada. And so, we have a lot of work to do. My view is that a large part of the solution is about loosening the financial intermediation channels. The banks have dominance and they protect that. I think one of the ways that that we can improve these channels of financial intermediation, is by loosening certain aspects of regulation that have been set up to protect and serve banks.

Michael Hainsworth:
So, there are viable solutions. It sounds like there's an awful lot of money being left on the financing table.

Arif Bhalwani:
Yeah, I think that's true. It means that the Canadian economy has had to come up with other sources of capital and sources of capital that are not necessarily optimal for the capital structures of these most vibrant businesses. You see companies rushing to go public in Canada, probably premature to where they are in their development cycle. A good avenue in which companies end up resorting, is through our venture public markets, so if you think of the Toronto Venture Exchange for example, you'll see capital pool company formations, you'll see reverse takeovers happening with shell companies, all in an effort for companies that need growth capital entering into less favorable arrangements that require a great deal of dilution of their equity, but thinking of it as having a smaller piece of a larger pie.

Michael Hainsworth:
Well, tell me about where these companies are in that journey. You mentioned IPOs can come to a market really before they should, but companies that require debt financing tend to be later stage. That makes investing in debt less risky than an IPO, it seems.

Arif Bhalwani:
When companies are looking for debt, market theory will tell you that financing should be independent of whether they're debt or equity as far as the firm's future earning powers are concerned. Capital structure should be independent of growth and how you achieve it. But when companies are looking for debt, for the most part, they want to acquire debt so that it matches best with either their cash conversion cycle, and I'll explain that in a little bit, and with long lived assets that will depreciate in line with the amortization of their debt.

So, let's talk about the cash conversion cycle. The cash conversion cycle is where we have a company that is producing goods, they need to acquire inventory, so there's a cash outlay, they then sell those goods and when they sell those goods, typically, they sell those on certain terms, so that inventory and the channel of those goods becomes an accounts receivable. They then essentially have an amount owing to them from their customer, but they need capital to purchase that inventory. They need capital to make sure that their operations are continuing to run and service their overhead and pay their people. And then they’ve got to wait a certain period of time until that receivable is collected, so the monies are then paid by their customer, and then that gets deposited into their bank accounts, and the cash conversion cycle repeats.

So that cycle should be bridged by debt, because the debt, you know, as I said, has a self-liquidating form of repayment. The debt is used to buy the inventory. The debt will be repaid when the receivable that that inventory becomes gets collected. You wouldn't want to raise equity every time you had to buy some inventory, giving away big chunks of your company every time you need to buy inventory, and then you've got cash that's probably sitting on your balance sheet in an inefficient way and it's the most expensive form of capital.

Michael Hainsworth:
So then how do we as end investors determine what is an enviable cash conversion cycle?

Arif Bhalwani:
There are different considerations there because it depends what type of a debt investment that you are contemplating to make. If you’re an end investor, you want to find out where your lending manager (that's who you're investing in, that fund that you're investing in, managed by the lending manager), you want to find out where on the balance sheet they invest. Are they on the current side or the long-term side? So, if they're on the current side, that's when you're really interested in looking at the cash conversion cycle, because that conversion from inventory to accounts receivable to cash, is a cycle that, depending on the industry, will, in the majority of cases happen in a self-liquidating way within a year.

We're very collateral dependent, so we are deliberate about whether we're investing short term against the cash conversion cycle of the business, or long term against the fixed assets of the business, which are generally intended to increase production capacity of a particular firm.

Michael Hainsworth:
Tell me about Third Eye. If I buy a share in Amazon.com, my advisor is not working side by side with Jeff Bezos. But at Third Eye, you call yourself a business problem solver, not a lender. So can you quantify the benefit of building a relationship with a management team?

Arif Bhalwani:
It's a great question and it really comes down to what makes us unique and differentiates us from a lot of other lenders, is that we're not just there lending our capital, but we're also lending our expertise. We get into the trenches, we examine the business, we help set out the structural changes and the operational changes that are necessary to maximize a company's profit potential. And that does require, to your point, building very strong partnerships with management teams and their stakeholders.

And the benefits to us are obvious, we see a lot of recurring business. And the benefits to the company, particularly entrepreneurially driven ones, is that now they have a business coach. So, we work really closely with management, we’re going to formulate a very strategic financial and business plan and then we're going to monitor the execution of that plan and we’re going to help management teams actually blueprint their business.

Michael Hainsworth:
How much power do you have in a lender relationship compared to a VC firm that's taking a stake in a startup or a growth stage company? They've got a seat at the table. Companies typically turn to debt financing when they don't want another long-term investor on the board.

Arif Bhalwani:
As a debt investor, we structure our loans that so they're senior secured, which means that we're at the top of the stack. In the capital structure, we are the we are the party that is looked after first if there is a sale of the business, liquidation of the business, if there is a restructuring, our interests are served first if we are senior secured. Another way of looking at it, I guess, is the losses first accrue to those below us.

So, before we would suffer a single dollar of loss, the equity would have to get wiped out, all the junior creditors would have to get wiped out, all the suppliers would have to get have to get wiped out. So, an important underwriting characteristic that you'll see in loans, particularly asset-based lenders like ourselves and collateral dependent lenders like ourselves, is you will see a large amount of cushion between our exposure and what the value of the firm and the value of the assets underlying our exposure are worth.
Now in terms of controls. The best way to look at it is, we’re not there to institute a new order, we’re not there to take over management. But what our controls are intended to do, and they come in the from various covenants and conditions before we even get involved. But covenants, undertakings, and ongoing representations that are about making sure that the company does not shrink its assets without coming to us, it does not change its business intentions, it does not all make large material alterations to what actually has made the business worthwhile in the first place.

Michael Hainsworth:
Private debt is proprietary in nature. It is exclusive to the asset manager. What's the benefit of that propriety and exclusivity?

Arif Bhalwani:
For investors, when you have something in your portfolio, which is a result of your investment in a fund that’s not available anywhere else, the benefit of course is diversification. You have less correlation within your portfolio between assets, because you’re holding an asset that is unlikely to be anywhere else in your portfolio. So, when we make a loan, that loan is exclusively ours in the sense that we are typically the sole senior lender, we don’t do split lien financings typically (a split lien financing would be where a bank is in there, lending against the cash conversion cycle, and they’ll typically do that in the form of a revolving credit facility), so we don’t do a deal where the bank is looking at one set of assets and we’re involved in another set of assets. Typically, we like to have all of the assets and then provide the company with a full solution.

The benefits of having that exclusive relationship between us and a borrower, is that when a borrower needs to take, let's say, a defining action with respect to its business strategy that perhaps involves an acquisition, we can move much quicker in adjudicating that that opportunity.

And the benefit to the borrower of this exclusivity is that they can deal with a single partner, and make decisions quickly and efficiently for the mutual interests of all stakeholders. We’re very growth oriented in how we invest, and so our objectives are to make the companies better off because of us. We share in some of that growth, so in our lending model we're not just providing capital, but layers of advice, expertise, and consulting. We will share and align ourselves with our borrowers in the achievement of those outcomes for the future.

Michael Hainsworth:
So, I can see the key benefits in private debt. You’ve got the low volatility, the default and loss rates are lower than high yield bonds, and you're collateralized by assets. But I never make an investment decision without understanding the counterargument. What's the risk to investing in private debt?

Arif Bhalwani:
One of the major risks that any investor has to consider in the in the private debt space is the fact that you are dealing with liquid assets that are not readily tradeable, there's no exchange in which a price can be easily, or even at all, attained. And so, when you're thinking about investing in private debt, if you're someone that looks at their statement every month, and you open your statement, you're going to have a value there that you can't independently look up.

You know, you’ve got your Apple stock, you can you can look on any standard quotation service and find out what your Apple stock is worth. The value of a lending investment, you've got to be comfortable that those values are reflective of all of the material factors that can affect the value of a lending investment. And for the most part that means: how well is that underlying loan performing? And so, as an investor in private debt, you certainly have to get a lot more transparency from your manager of your fund that you would otherwise expect from making an investment in a publicly listed stock or even a publicly listed bond in order to make your own assessment of what that asset is worth.

Michael Hainsworth:
Arif Bhalwani is the CEO and Managing Director of Third Eye Capital.

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.