How structured debt offers exciting opportunities now
The current economic environment both exciting and challenging, the softening inflation is a respite, but businesses are stifled by higher interest rates
image for illustrative purpose
Most of the times, I’m quizzed if a particular product or opportunity is good or not but rarely do they explain their situation and ask for a suitable product or opportunity. In the investment world, usually there’s no good or bad investment. The moot point, however, is and should be whether it’s suitable or not for those investing in such an opportunity. I would say all products are good but not many or suitable to all.
While evaluating a product or an investment opportunity, investors tend to employ the perspective of their return on the investment (RoI in terms of IRR/CAGR) but rarely compare them based on the risk. Also, the allure of the possibilities masks the probabilities of the risk. This possibly is the biggest challenge for an investor to overcome in decision making.
The current economic environment is both exciting (of future) and challenging (present). The softening inflation (and possible further cooling) is a respite, but businesses are stifled with higher interest rates. Not all businesses are attracting investments while many are still paying for their past deeds (for accessing cheaper capital to be returned) and in some cases the business opportunity itself is weakened (due to the cyclicality of the business, at times). As long as the capital raised by the businesses is towards the business expansion, the fund outcomes would be profitable.
So, attractive and innovative opportunities are also cropping up to address this landscape.
Private debt or venture debt is one such. The risk spectrum, however, not simple as it may seem. These funds raise capital from interested public and provide (loans) to the businesses. Of course, these deals are underwritten i.e., insured through asset collaterals, etc. so that the capital is protected, at least technically. The business risks remain, and the debt serviceability is still a concern. The good practices of the fund might reduce the risk by releasing the capital in tranches with track of fund flows to the desired business activities.
The fund might dictate terms which restrict the business to allow the flows into those activities which would help the businesses to prosper, as envisaged by the lender. This ensures any chances of pilferages that promoters could resort to. This enables the lender to extract the interest to be serviced and as the prospered business to repay the capital. This is the underlying assumption of both the parties and is what the investor into these funds also wish for. This is an ideal situation and the reality is much more dynamic, though. Of course, that’s where the opportunity lies to generate better returns.
These credit opportunity funds structure the investment philosophy based on this and to reduce these possible risks they resort to not just the underwriting practices but also through diversification of the businesses considered. As Per the SEBI (Securities Exchange Board of India) guidelines they would be categorized into AIF (Alternate Investment Funds) so that legality of operations is achieved. The structure also keeps the option of raising or accepting more capital through a Green Shoe option while the tenure of the fund is usually 3-5 years with a possibility to extend for up to two years, with consent (from the investors).
These funds provide a fixed, if not a guaranteed, income periodically i.e., monthly or quarterly depending on the debt service agreements. In some cases, a combination of both these periods depending on the instruments/securities (loans) have the repayment schedules. So, the investor enjoys a fixed income through this tenor. The current elevated interest rate scenario allows the investor to lock-in at higher interest rates and enjoy over the next 3-4 year period. The assumption is that there could be a pivot from the high interest rate regime in the coming quarters. Investors would end up with relatively higher interest rates at that point of time. If the tenor (tenure) of the loan is shorter and closes, the reinvestment options might be slimmed as optimal risk-reward opportunities tend to be reduced.
These funds usually charge a catch-up (like a performance fee) above a hurdle (a defined benchmark) which could be in the range of 15 per cent-20 per cent. It means, if the IRR or return is generated over the defined rate, the fund would deduct the catch-up for the investor and the net of it is paid. Investors who have a higher risk appetite and capital to be deployed could explore this option in case they are also looking for a regular income.
(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at knk@ wealocity.com)
