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Private Credit – a Shelter from the Storm?

Investors who allocated to and rebalanced into Private Credit / Direct Lending have found one of the few bright spots this year. Public equities and public fixed income have declined in tandem leaving investors battered. Low correlation private credit looks to continue its recent performance for three reasons: Firstly, large asset managers are rebalancing their portfolios back to their target allocations which means away from alternative assets and into more public debt and equities. Secondly, central banks continue to run off their balance sheets or engage in quantitative tightening (QT). Thirdly, the rising interest rate environment will improve private credit returns as they are largely floating-rate loans benefitting from higher reference rates. We know that private credit strategies enhance fixed income, provide diversification benefits with low correlations, and offer a reliable income stream with capital preservation. What is unusual about recent returns is that they have also been strong when compared to public equity returns.

Large asset managers tend to have target asset allocations. For example, CalPERS, one of the largest US public pension funds, has the following target allocation:

77.6% of CalPERS assets are in public bonds and equities which have fallen significantly. To maintain their target asset mix they will have to sell other assets which increased in value to rebalance their positions to their target. In essence, their asset base has fallen, and they will have to sell other assets including private debt to rebalance. This will lead to a shortage of private debt, reducing competition in private credit, and enhancing returns therein. As the pandemic started central banks sought to stimulate the economy with capital by keeping interest rates low and by buying financial assets through a process called quantitative easing (QE). This forced financial institutions and investors to invest in riskier assets to see competitive returns.

Now that central banks are increasing interest rates, they are beginning to reverse QE–through QT. QT will reverse the effects of QE, which inflated the value of risk assets. Financial institutions such as banks will look to safer assets to meet regulations, or they will hold higher-cost capital to offset risk and deflated asset values. A reduction in the availability of credit will affect Small and Medium Sized Enterprises (SMEs) more acutely than those who have access to public capital markets. Lastly, private debt typically has an attractive credit risk profile due to the credit enhancements negotiated in each custom transaction. Private debt minimizes the risk of rising rates as returns are primarily based on a floating reference rate plus a spread. Additionally, unlike traditional public market bonds, private debt can negotiate credit enhancements like positive covenants and interest rate minimums (also known as floors) to further mitigate risk. These features enhance its attractiveness as an asset should market conditions change. Increasing interest rates coupled with a lower supply and muted competition in the market indicate continued outperformance for private credit.

About Bond Capital
Bond Capital is an award-winning private credit fund. As a direct lender, Bond Capital provides advice and money across the entire risk curve. Bond Capital structured credit financing enables business owners to maintain control ownership in exchange for yield and capital preservation. Across multiple cycles and for over 20 years, Bond Capital has advanced secured investment quality credit to lower middle market companies throughout North America.

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2022 Summer Book Review

The Goal
by Eliyahu M. Goldratt, North River, 1984

Don’t let its publication date fool you The Goal has long been, and remains to this day, one of the 25 most influential business management books according to Time.

Most interesting is that Goldratt was a physicist and not from the normal circles of business book authors. As such he writes The Goal in the style of a novel that was both refreshing and, for me at least, quite captivating. As an entrepreneur I found this book both foundational and influential towards my own thinking on how to go about running a better business and fixing a broken one.

The book’s main character is Alex Rogo a production manager with a scant three-month turnaround time frame for an unprofitable manufacturing plant with the added complexity of a failing marriage. The Goal explains the “Theory of Constraints,” and the thought that, “a chain is only as strong as its weakest link”. Rogo focuses on removing one productivity bottleneck after another. I think you’ll also enjoy meeting Herbie who at first looked like a problem constraint until he became the solution as an exploited constraint. Herbie acts as a memorable metaphor that the job of all non-constraints is to subordinate their decisions to the constraint’s needs.

The Goal was written at a time when outsourcing (the precursor to offshoring) was the current of the day. While the novel is true to the period and before the digital era, it still has lessons for entrepreneurs. Some of these include the lesson that you can’t reach your goal unless it’s clearly defined and articulated for everyone. A second lesson was to optimize systematically, not departmentally. On this point even if you don’t work in manufacturing, the factory analogy still applies. In every business work originates somewhere in your company, moves through a process, and eventually get received by a customer. The takeaway is that you can’t optimize a single part of a business without factoring in how it may affect the other parts. A third lesson is that the process of continuing and ongoing optimization (continuous improvement) is the key to profit and whole life balance.

While not every lesson is relevant in today’s digital world it’s a light and captivating read that will help you grow your business management toolbox. A true classic, I hope you enjoy reading, or in my case re-reading, it as much as I did.

Have a great summer and I hope you get to enjoy a much-deserved break with friends and family. We’ll look forward to reconnecting with you soon.

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Private Credit – Inflation Antidote?

Private Credit – an Inflation Antidote?

So far this year many investment classes have suffered sustained losses. Inflation has risen to cycle highs and the S&P 500 is down nearly 20% while the Bloomberg Global Aggregate Bond Index has lost $2.6 trillion, a record slide from its high in 2021. The last time a drop of this magnitude occurred was 2008. A traditional 60/40 equity and bond portfolio, which is supposed to buffer investors when either bonds or equity decline, has not worked as both have declined in tandem. A couple bright spots have been cash and private credit.

The S&P 500 index has declined 18% year to date while the Bond market has lost trillions of dollars in value.

Every bond class has suffered with longer duration suffering the most.

Source: St. Louis Fed FRED Economic Data; Board of Governors of the Federal Reserve System (US)

Bond prices may have further to fall as they have yet to react to historical relationship with inflation as shown in the chart below. Given current inflation rates, the 10-year bond yields could be 3 or 4 times higher than the current yield of about 3%.

But will bond yield rise? While currently low in relation to the last 70 years, the 10-year bond yield has retreated the last two times it has reached current levels as shown in the chart below. This time inflation is way different but a continued rise in the 10-year yield is by no means a certainty, especially if historically high levels of global debt and rising rates make debt service difficult causing a recession.

Source: 22V Research via John Roque

Private Credit Doesn’t Care
True cash has maintained its notional value relative to bonds and equities. However, despite a 50bps increase by the Fed on May 4, 2022, the real return (overnight target rate less the inflation rate) remains negative. A better alternative is private credit. Many private credit loans are variable rate at a spread above the overnight rate generating significantly higher returns. Will inflation go up or down causing the Fed to raise or lower interest rates? Private credit doesn’t care. With low volatility private credit, irrespective of current overnight interest rates, continues to generate a premium.

About Bond Capital
Bond Capital is an award-winning private credit fund. As a direct lender, Bond Capital provides advice and money across the entire risk curve. Bond Capital structured credit financing enables business owners to maintain control ownership in exchange for yield and capital preservation. Across multiple cycles and for nearly 20 years, Bond Capital has advanced secured investment quality credit to lower middle market companies throughout North America.

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What is Private Capital?

Private capital is a very old concept, having emerged during the middle ages from the Florentine merchant banking community. Of course, private capital as we know it today is a little different, and a little more refined than it was when it first began.

Hundreds of years ago, European merchant ships would travel to the Americas to gather trading goods. Outfitting a ship with crew and supplies cost money, so expeditions were made possible with an investment from a wealthy sponsor. When the sailing ship returned with its cargo, the ship’s captain would be paid a carry (or carried interest), a percentage of the cargo’s value, while their sponsor would get a larger majority percentage. Think: 20 percent to the captain, 80 percent to the sponsor.

The sponsor’s initial investment funded the ship’s expedition, and the value of the goods they received when the ship came back was their return on investment (ROI). Sponsors would fund expeditions that they thought would be profitable. The early sea trade is where the term “carry trade” is thought to have evolved from.

Over time, the practice spread from shipping to other areas of commerce, with wealthy families working with agents and investing capital in different ventures.

The practice became somewhat more formalized in the mid-20th century, after World War II. This is when we saw the emergence of the three main branches of modern private capital – venture capital, private equity, and private credit.

Venture Capital

Venture capital is a dilutive type of investment in which shareholders of companies that have no revenue seek out investors and sell shares to cover the costs of starting or growing a business. Venture capital can fund activities such as:

  • Hiring employees
  • Securing a space to do business
  • Developing internal systems and processes
  • Producing saleable goods

Once the company becomes profitable, the investors can be paid returns. In some cases, a venture capital funded company will be acquired by a larger corporation or float an IPO (Initial Public Offering) once it passes a certain threshold of revenue. Some of the proceeds of the sale may go to the initial investors.

Private Equity

Private equity is similar to venture capital in that it is also dilutive to the existing shareholders. In this case the businesses seeking funds are already established, and need the extra money not to start up operations, but to finance acquisitions, mergers, and other growth efforts.

With private equity, investors are purchasing shares in a private company, and that comes with some power over the company’s overall direction and management. Private equity investors have a say in how and when their money is put to use, and they have a carried interest motivation to grow the company to achieve a higher valuation.

Private Credit

Private credit (also known as private debt) is also used to fund mergers, acquisitions, and growth initiatives, but unlike private equity and venture capital, it is anti-dilutive for the shareholders. A private credit lender does not take on common share ownership of the company and therefore does not have any direct control over the company’s direction or growth. This can be advantageous for companies that are taking on manageable risk, have tangible enterprise value, don’t have a lot of tangible assets, and want access to capital without giving up control or bringing on a minority partner with control rights.

Of the three branches we’ve discussed, private credit is the most “DIY” – unlike with private equity or venture capital, recipients of private credit investments are independent when it comes to determining how and when to allocate the funds.

What Does Bond Capital Do?

At Bond Capital, we specialize in private debt, and alongside that private debt, private equity.

When it comes to private debt, we participate in what’s called the lower middle market, dealing with transactions between 5 and 50 million dollars and corporate revenues between 10 million and 1 billion dollars.

The types of businesses that may benefit from issuing private debt are unable to access public markets and are underserved by government relief or their existing banks. This can be for a variety of reasons.

Banks are conservative and tend to prefer hard assets when it comes to business financing. If your business’ equity value based on cash flow or intellectual property exceeds its asset or book value, it can be more difficult to get funding from banks. Individual banks also have their own regulated borrowing rules, and since it’s often a headache and time-consuming to change banks, some business owners find it easier and faster to seek out a private credit financing.

Let’s Talk Private Credit

Do you have a business in need of funding? Before you approach Bond Capital or any other private debt lender, you need to have a big dream expressed in a clear business plan. State the amount of money you require to see your plan to fruition and illustrate your ability to overcome risk factors while acting as a good partner and steward. Be prepared to explain your track record, how you’ll allocate the investment funds, and why your business will be successful.

Ready to take your business to the next level? Looking for more information? Contact us today.

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