February 2023 Newsletter
February was volatile as investors still digested inflation and the realization that higher rates are here to stay for longer than many wanted. Inflation increased month over month more than expected. CPI increased 0.5% led by strong retail sales. Consumers are very resilient in their habits regardless of higher prices across many goods. This data has strengthened the belief the Fed will follow through on their proposed 50 bps raise in March. We have always suspected this to be the case and have been dialing down on risk while capturing these higher rates for our investors.
New news has rolled out so fast I have to address the “Elephant in the Room".
Banking issues continue to unfold. Continued banking issues in the long run can be good for private lenders. For example, many private lenders in venture are looking to hopefully take on additional business that they might have never seen with Silicon Valley Bank and First Republic Bank being "Kings of the Hill". Further news regarding Signature Bank and now Credit Suisse is unfortunate, but it is not surprising that we are seeing these hardships come to light. This happens when free and easy money is taken away. Many of the investors in today’s world might not have been around the last time this happened in a major fashion. That was 2008, the liquidity dried up and the old proverb always seems to come true, “When the tide goes out, you get to see who is not wearing any clothes”. I am sure the news of market participants being under stress is not over, especially if the Fed continues to be laser focused on Inflation rather than the broad impact of higher rates.
These banking issues, in some ways, have been good for us. Just as private Venture Debt is excited to see the large bank players weakened, we have been benefiting from increased loan demand as banks have stepped away. This increased demand for private funding has continued to be strong in the first two months of the year. This occurrence is natural as banks make the decision to become more conservative. The loans that might have met conventional loan standards now do not meet the guidelines of the bank and the borrower must find a private source of funding.
Historically private debt has offered strong risk adjusted returns. Today, the risk adjusted returns of private debt in real estate are the strongest many have seen for a long time.
If you are looking to enhance the return of your fixed income allocation while offsetting risk across your portfolio, please reach out.
I want to shift gears and take an opportunity to share how many institutional investors categorize, review and rank investments funds. If you have watched any of my webinars you will hear me mention investors need to discover two key metrics, identifying the inefficiency of an investment and understand the edge of the manager. The two methods I mention next just expand out the same principles of inefficiency and edge.
The Five P’s of Investing:
People – Understand the team that manages and operates the Fund. The team’s experience and skill with regards to the investment thesis and running the business of the Fund.
Process – Understand the Fund Strategy. This is difficult as there are so many strategies. Is there a competitive advantage in their process?
Parent – Companies behind the Fund. What is the turnover at the Manager? What is the firm’s investment culture? Does it fit the investment? What are the compliance procedures and code of ethics of the company? If there is a board, then who is on the board and how do they interact and drive the management?
Performance – Tenure of the current manager and the performance created by that team. Understand the risks taken to earn the returns. If possible, benchmark the manager to determine value add above a comparable index.
Price – Fees and costs associated with the investment. Investors need to vet out what they are paying not only to the manager but fund expense, incentive fees, and if there is an introducing broker. Having an intermediary broker dealer involved in a fund offering can be surprisingly expensive.
AEIOU Method:
Alignment – Is the manager aligned with the investor? Are the internal operations of the manager aligned across all team members? Often trades require a variety of counterparties, is the manager and the process aligned with these counterparties?
Edge – This is the differentiation of investment thesis. How is the investment unique or going to produce excess return? Lastly, is the investment thesis repeatable?
Implementation – How is the fund set up to capture the return? What is the manager’s process and procedures to ensure effective execution of the investment thesis? Is the process and procedure creating efficiency in capturing the return while controlling costs?
Optimal Use of Risk – Where is the manager taking risk? Can the manager define risks in their portfolio? Are they hedging risks? Do they have process and procedure in place to limit these defined risks?
Understanding Performance – What is driving the returns? This can be difficult to ascertain and in the due diligence process you might have to request what they call performance attribution. This is a breakdown of the net performance so you can see what strategies or trades helped or hurt performance in a certain time frame. You can possibly identify if there is a cyclical nature to the investment.
Regardless of method, one can see there is a lot of overlap in the types of questions and subjects one should ask during fund due diligence. Given the time you have and the resources available to you, your due diligence might differ from others but according to institutional investors one of these two methods or a mix of them make up a core element of their fund due diligence process.
