How To Generate 6% Yield In A Volatile World

May 22 2015 | 6:41am ET

By Greg Silberman
Chief Investment Officer,
Atlanta Capital Group

On December 26, 1991 the USSR officially dissolved, breaking up into fifteen separate nations, thus ending the 44-year Cold War.

At that time I had recently completed my first year of university. I was miserable. I felt like I was on a pre-packaged conveyor belt to hell.

It was 1992 and I was the princely age of 19. I decided to take gap year -- a self-guided tour through Eastern Europe.

Poland was nice but the concentration camps were depressing.

Prague was beautiful and I must have stumbled around for days thanks to the cheap Pilsner Urquell.

But I wanted to go deeper into the former Soviet Empire. I decided to visit my great, great grandfather’s hometown of Vilnius, Lithuania. The fact that he had run away under threat of Pogrom didn’t deter me.

The train from Poland to Lithuania goes through Belarus. At the Belarus border town of Grodno a young Russian soldier got onboard to check visas. What? Visa? I didn’t have one. I was overcome with anxiety.

I was put in a holding room for four hours until the train back to Warsaw arrived.

Many years later a person familiar with the area said to me all it would have taken to get through was a crisp $100 bill tucked in the pages of my passport.

The Great Russian Bear - Today

Far be it for me to prognosticate, but I am now feeling that same sense of unease that I had when confronted by the Russian soldier on the train.

The Great Russian Bear is spoiling for a fight.

Russia has been flexing its muscles in the Crimea under the guise of unifying Russian speakers with the motherland – similar to Hitler’s annexation of the Sudetenland and later the Austrian Anschluss under the same pretext.

They say if you press the Russians into a corner, Putin is going to bite you – I believe it!

Similarly, distant and forgotten is the pre-World War II deflation, something we are now grappling with, albeit in our own unique  version of the beast.

With short term interest rates nailed to the floor for the last seven years and seemingly, the only way to go when they do is up, investors are left scrambling for both income and capital preservation as their primary investment goals

Lucky for us the same government that has suppressed interest rates has provided (paradoxically) a way out through regulation such as Dodd-Frank/Volcker and Basel III.

Enter Private Credit

This Bloomberg Interview with Len Tannenbaum of Fifth Street at the 2015 SALT Conference describes the opportunity set better than I can (the essence is that banks have either dramatically reduced or no longer lend in many situations opening up opportunities for private capital).

Private Credit aka Asset Based Lending comes in many different flavors, all with the common themes of over-collateralization (remember 2008?), a higher coupon than public markets (LIBOR + 6%+ but really does vary) and normally a Variable Rate.

  • US Performing Credit
  • Structured Credit – mortgages and collateralizes obligations
  • Opportunistic Credit – Bridge Loans, convertibles other non-standard loans
  • Non-performing loans – distressed
  • European Credit
  • License & Royalties e.g. Film, Patents, Mineral Rights

The beauty of private credit is that each transaction can be tailored to a specific investment outcome. Take for example a hypothetical structured late-stage VC company called XYZ Inc. in the medical devices industry.

  • Funding commitment of $3MM to XYZ Inc.
  • The first tranche will be funded at close in the amount of $2MM and the second tranche can be called by the Company in the amount of $1MM. 
  • The term on the note would be 18 months and the note can convert into equity at a 15% discount to a subsequent round. 
  • The first tranche carries an 18% interest rate (non-current pay). If the second tranche is called, then the outstanding principal balance goes to 20%. 
  • In addition to the interest rate and conversion discount, [Lender] will also receive .70 bps of stock in XYZ Inc. for the first tranche and an additional 100bps for the second tranche. 
  • Earlier this year, stock was granted in the Company at nearly $100MM valuation, so the equity ownership could be economically meaningful. 
  • Noteholder will be senior to all debt and other securities in the company, save for a loan with ABC Trust Co. which we will have an intercreditor agreement with, acknowledging that it is pari pasu. 
  • [Lender] will have a board seat at the Company and strong negative controls.
  • [Lender] will receive a 2 point origination fee on each funded tranche.

The above hypothetical deal protects on the downside, has a high coupon and upside participation.

Sourcing and Structuring a deal such as the above is time consuming and I believe it is only fair that the asset manager earns a decent fee.

Credit giants such as Apollo or Blackstone have the benefit of accessing a select deal flow based on their size and speed of funding.

However, don’t overlook smaller managers – providing their credit analysis process is robust – they may have access to credit opportunities the larger players would forego due to their size.

The benefit for the investor is higher yields than public markets and lower volatility (valuations usually monthly or quarterly), however, there is a sacrifice on liquidity – 18 months up to 5 years.

So there you have it; a quick tour of private credit and the opportunity … I expect it will become a bigger feature of client portfolios in the future.

In my next article I will discuss how to protect your private credit portfolio further on the downside and how to create equity-like returns on the upside.

Pour Conclure

According to the International Institute for Strategic Studies, there are 41 active conflicts in the world at this time (3 of which involve Russia) … and that potentially does not include numerous non-state armed groups. Is it possible these wars are in some way connected, in a way we cannot yet recognize, as a World War III of sorts?

Perhaps.

I don’t know.

But I do know war causes surprises and surprises cause volatility and volatility causes havoc on clients portfolios.

Spasibo,
Greg

Greg Silberman is the Chief Investment Officer of Atlanta Capital Group. Atlanta Capital Group specializes in creating custom private market solutions for RIA/Family Office clients and is an active acquirer of independent wealth management practices. Mr. Silberman regularly writes about private market opportunities and trends. If you would like to read his regular posts, please connect on Linkedin, Twitter or via Atlanta Capital Group.


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