Private debt emerged as an asset class for both institutional and retail investors when banking regulations were toughened up considerably following the 2008-09 financial crisis. The regulations forced many medium- and smaller-sized enterprises to turn to non-bank lenders. Today, the Canadian retail market for debt is estimated to be around $2 billion in size, compared to $200 million in 2010. In the U.S., there is an estimated US$650 billion, held mostly by institutional clients.
"It's a growing asset class and one of the big drivers has been the changing regulatory landscape for banks," says Scott Colbourne, co-chief investment officer at Toronto-based Sprott Asset Management LP. A 26-year industry veteran who joined Sprott in 2010, Colbourne is part of the team that oversees the $23-million Sprott Alternative Income. The co-manager is Ramesh Kashyap, senior vice-president, alternative-income group.
"In many cases, banks have focused more on what makes sense on their balance sheets, so many borrowers no longer make the cut," says Colbourne. "It's not that these borrowers are bad, but from a holistic view it may not make sense for the bank to complete the transaction. The new world of financial regulations makes it much tougher for borrowers."
Among the new regulations that have forced borrowers to turn to non-bank lenders are the Inter-agency Guidelines in Leveraged Lending established in the U.S. in 2013 and the anticipated implementation of the Basel III guidelines in 2018.
"Borrowers are not getting the underwriting that they need and the leverage they were used to a decade ago. And banks are too slow to close on the loan, as it can take many weeks to close," says Colbourne. "The opportunity in private debt is an outcome driven by policy-makers."
One of the largest private-debt players in Canada, Sprott has close to $760 million in private-debt assets under management, all in the form of senior secured direct lending. Launched in August 2016, Sprott Alternative Income is sold through offering memorandum, rather than via prospectus, and is aimed at accredited investors. "The fund is a one-ticket solution for investors who want a diversified approach to private debt," Colbourne says.
It's comprised of four underlying funds: one third is held in Sprott Bridging Income LP, one-third in Sprott Private Credit Trust II, one-sixth in Sprott Credit Income Opportunities and one sixth in Sprott Diversified Bond.
Introduced in 2013, Sprott Bridging Income holds a portfolio of direct lending and factoring investments in private Canadian debt. Launched in 2010, Sprott Private Credit Trust II invests in asset-backed loans of Canadian companies. Launched in 2015, Sprott Credit Income Opportunities invests in corporate credits with a low-duration profile.
Sprott Diversified Bond, offered by prospectus, is a short-duration mutual fund that provides greater liquidity for the overall fund. "Private debt offers investors very attractive returns, but one of the things you give up is daily liquidity," says Colbourne. Redemptions of Sprott Alternative Income units are permitted on a monthly basis. Since its inception last fall, the fund has returned 3.3%, net of fees, as of April 30.
Sprott and its sub-advisors conduct a rigorous process to ensure qualified borrowers deliver on their loans. Between the two private-debt pools there are about 250 loans, of varying sizes. To date, no debts have soured.
Sprott focuses solely on so-called direct loans that are also known as senior secured loans. "It's at the top of the capital structure," says Colbourne. "And typically, the collateral-to-loan ratio is two to one. Another benefit of private debt is the yield pick-up. You're getting better than the yield in a traditional fixed-income product -- about 450 to 600 basis points higher."
In addition, the loans are floating-rate, which means they track short-term interest rates. "There is no interest-rate risk," says Colbourne. Moreover, the fund also gives investors exposure to an asset class that is not marked to market, as are money-market funds. "Because the deals are proprietary in nature, you will never see these deals anywhere else. In addition, we require extensive documentation which allows a deal to be renegotiated, if necessary." For every 100 potential borrowers, less than five deals are closed.
Colbourne and Kashyap are mindful that central banks are in a tightening mode, but are confident that private debt will be resilient. "As a lender you will benefit when rates rise. But this asset class has been steady through a variety of cycles. People borrow through good times and bad," says Colbourne, noting that the loans are structured in a way so that Sprott can exit if conditions become extremely challenging.
"The underlying focus of the fund is to lend to companies that have good collateral, good management and a generally good business. So you can invest when times are tough, and when times are good."
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