The Duke of Wellington once said: “All the business of war, and indeed all the business of life, is to endeavour to find out what you don't know from what you do.” As in war, so too in business. Accessing and developing market intelligence and, more importantly, withholding it from your rivals therefore is a key element of success.
For a private debt fund (including real estate) looking to put capital to work, the odds are stacked heavily against them, at least according to one guest at the launch party of PERE’s sister title Private Debt Investor on Wednesday evening in London. The reason? Banks typically are the repositories of a vast amount of knowledge regarding the assets they loan to and service and therefore are in a much better position to judge their credit worthiness.
There is a suggestion here that when invited to underwrite loans against an asset, a private debt fund might just be picking up a credit that the bank itself has passed on. “Debt funds face an adverse selection risk, which can be quite humbling,” the launch party guest insisted.
Some firms we've spoken to make this a virtue. For those willing and able to take on 'stressed' credits or assets that because of an element of complexity make them unpalatable to increasingly risk-averse credit committees, there are strong returns to be made. This is particularly the case for teams with a strong record of working with sponsors or with a strong restructuring pedigree.
The skill is in judging which assets are simply problem children with the potential to shine and which are irredeemably delinquent. As one debt fund/credit provider said, it is imperative as an investor that you understand the ‘value proposition’ of the underlying real estate and the related structure. He is surely right.
It is unsatisfactory to rely on ‘data’ from a bank. And anyway, a market such as UK real estate is extremely transparent so any competitive advantage is diluted. Not only that but, even with a data advantage, banks made massive mistakes in their underwriting in the run-up to the 2008 global financial crisis, so just how much of an advantage is it?
The industry, including ratings agencies, has a role to play in this as well. With public assets or public debt instruments, data has to be made widely available, and maybe that should be extended to UK real estate via some kind of shared loan information in a centralized database to reduce risk in the system.
Still, with private assets underpinned by private debt, effective due diligence is an absolute prerequisite for success. Primary origination of deals is the Holy Grail for most firms – disintermediate the banks and find a strong, growing company that has drawn a blank with the banks or can be persuaded via pricing or flexibility to shun them. It's extremely resource-intensive, however, and it's here where debt advisory groups and boutique investment banks have sought to shoulder some of the burden.
One attendee on Wednesday asked whether there were sufficient deals to match the capital raised by private debt funds. The answer was a resounding yes – the key is simply cherry-picking the best ones, utilizing effective due diligence and risk management to make sure the opportunity isn’t presenting itself only because better-informed banks already have rejected it. Getting this wrong means the battle is likely to be lost.
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