For Private debt managers, understanding their underwriting
process is important.
• Who is involved, from sourcing to the final decisions, and what
risk metrics are in place?
• What is the manager looking for prior to working with a
• Do they have a competitive advantage and with whom do they
• Do they use additional leverage, if so how?
• What are their Loans to Value, and how is the value measured?
• How do they rate their borrower? (prime vs. near prime vs.
• How are the loans monitored once issued and how often?
• What covenants are in place to protect the investor?
• What is the ratio of non-performing loans?
• How many loans in the Manager’s portfolio, to assess concentration?
• What is the experience and track record of their workout team
in dealing with delinquent or defaulted loans.
A private debt manager should have a good credit monitoring team,
third party experts to monitor their loans, as well as a proven team
and process to resolve issues with non-performing loans. Lastly, it
is also very important to note that since private debt managers do
not trade their securities on any markets and do not mark to market,
volatility is very low. However volatility is not a valid risk metric
as compared to publically traded equities that mark to market daily.
“Illiquidity premium”, is an important driver of returns in private
debt. Selling a private loan is a long tedious process (if it can be
done at all) since the terms and conditions of each loan is bespoke.
Some smaller, shorter duration, nimble private debt strategies can
offer monthly liquidity to investors, but many larger established
managers will have quarterly or even yearly investor liquidity, with
one to five year initial lock-ups on capital. This provides the
manager with a predictable capital base from which to properly
execute the lending strategy while allowing them to operate through
difficult market cycles without the issues faced by many publically
It is extremely important to understand and evaluate if the liquidity
terms of a fund match the underlying strategy and loans. Many
investment funds have failed because of issues that emerged from
the mismatch between liquidity to investors (too short) vs. the term
of their loans, as opposed to the failure of the loans themselves.
Furthermore, if one or a few investors that represent a significant
portion of the fund decide to redeem, the rest of the investors may
be forced into a situation where they are unable to redeem until the
fund is able to either find new investors or wind down their loans
in an orderly fashion.
• Private debt funds take advantage of regulatory conditions
preventing traditional lenders from participating, and take
credit and liquidity risk to generate returns. These strategies
are relatively new to retail investors, and have yet to be tested
through any kind of economic cycle. As such, extreme caution
is warranted, and investors should be prepared for a situation
where they are denied liquidity entirely.
• All fund types need to be reviewed for operational risk. The
departure of a key manager or failure of a service provider
could have adverse effects on the fund. A Private Debt funds
workout team, while not busy in recent years, is every bit as
important as their credit adjudication team.
Mortgage Investment Corporations (MICs)
• Though they are a form of Private Debt (mentioned previously)
MICs are deserving of their own category in Canada. All the
comments from the private debt section would apply, but
further considerations are warranted.
• MICs are an easy way for investors to gain exposure to the high
yield real-estate backed sector.
• MICs are early in their evolution for investors, and some
contain structural flaws.
MICs account for the majority of unregulated mortgage lending in
Canada. These entities typically invest in short duration, high yield
mortgages and pay out 100% of their income as distributions to
investors. This flow through structure allows them to avoid paying
corporate taxes and to maintain a constant net asset value (NAV)
assuming that interest income exceeds expense and losses. MICs
are not allowed to reinvest their earnings. As such, they are dependent on new investor funds to grow. This is fine, as long as investors
are willing to provide them with funding. In addition to the discussion concerning the three risk components that follows, we’d also
highlight that MICs are subject to regulatory/structural risk. At
present, MICs are regulated by OSFI – the bank regulator – and not
necessarily by the Ontario Securities Commission or any of the
securities regulators; however, there have been more moves recently
by the provincial regulators to remedy this.
MICs are not required to publish their NAVs, mostly because of the
nature of short-term lending, where loan values are simply their
face value unless they are impaired. MICs issue and redeem at a
fixed price. While this keeps the structure simple, the U.S. money
markets provided a good example of what could happen if those
impairments happen. In Q4/16, U.S. prime funds were required to
publish net asset values based on the current value of their assets.
Prior to the implementation of this regulatory change, prime funds
were able to preserve the value of their investments at $1 a share,
providing a certain sense of stability for investors. When that
changed, investors sold their positions. The same kind of exodus
would not be as straightforward for MICs, since their assets are
highly illiquid, but the structural/regulatory risk remains.
We should note that there are many different types if MICs with
differing risk profiles – residential, construction, commercial, etc.