The Lowdown on LVRs

Coming next, we have Patrick William from Rickson Capital.

He's just sitting next to me.

Now, Patrick is a co-founder and managing director of Rickson Capital, the investment manager of the Rickson Income Fund.

The fund is a private credit income strategy focused on institutional lending to Australian SMEs with a target return of 10% to 12% with distribution paid monthly.

Now the fund focuses on the bank, 2 million to 10 million funding niche which seeks to deliver investors a return premium for scarcity rather than risk.

The fund has delivered distribution of 0.8% to 1.8% per month since inception with a weighted average fund LVR of below 60%.

Now I'm gonna hand over the stage to you Patrick to start your presentation.

Thank you.

The purpose of my presentation is primarily education.

The goal is for investors who are listening in to be able to walk away and be able to ask educated probing questions around LVRs when they're assessing investment in credit.

So the key to building block of an LVR is the V of value.

I think we're often trapped by the fact that you see a low LVR, you assume it's attractive, you assume it's safe.

What I like to discuss is how two LVRs, while similar in number can reflect very, very different risks depending on how that V was actually derived.

And equally where you sit on the capital structure has a material impact to what the LVR means for you.

The first example, I've just got an illustrated capital stack.

So we're talking about where you rank here.

So if you're a subordinate debt holder in this scenario, you're generating an attractive return and you have what you believe is a 15 cent equity buffer ranking behind you.

So you're an 85% LBR.

But the key point to realize is when you're a debt investor, there is no upside.

The key question you've got to ask when assessing risk and return is,

Where do I stand?

How do I recover my capital if things go south?

So in this example, I very conveniently assume there's a 15 cent write-off, which means there's 185 cents of assets remaining and 85 cents of debt remaining as well, 70 cents to senior, 15 cents to subordinated shareholders.

It seems very attractive on paper until you realise that in a default scenario, both the sub and senior debt holders are accruing interest.

but the senior debt holder moves first.

They're engaging with the receiver, they're engaging with the potential buyers.

So by the time the asset's unwound, it is very unlikely that sub-debt holder is getting themselves 15 cents or 100 cents to the dollar.

So that's not to say an investment in subordinated debt isn't a good investment, but the question you've got to ask yourself as a debt holder is, are you being adequately compensated for the subordinated debt risk?

When you consider the side of the equity buffer, consider the size and timing of the underlying asset base, which you can realize to actually return your capital.

Next, I'm going to talk through three examples, three different ways with which you can calculate value and how it impacts your risk.

First example is when you use market equity as your benchmark.

In this example, I've put together an M&A funding transaction.

So the debt holders have a 75% VR.

The debt package involves buying a business for four times earnings.

Now, in the base case, everything's gone very well.

You're benefiting from multiple accretion.

So if you look at the chart now, the equity holders have doubled their investment.

It's a very, very nice return for them.

The debt holders, on the other hand, get the same return, but they benefit from deleverage.

It's now 55, 50% LBR because the business is worth more.

But again, we're debt holders, so we're not benefiting from the upside.

The question we have to ask ourselves is, what if the business becomes compromised?

So the downside scenario, you assume the business has lost your contract, lost some earnings, the earnings multiple, the valuation multiple is contracted, the debt is now impaired, the equity holders have been written off.

So again, the question here is not so much that you shouldn't fund an M&A transaction,

fairly balanced with equity holders.

Because in the base case, equity wins, debt gets the same return.

But in the downside case, both of you lose.

So the question you've got to ask is, is your return right or is your balance between debt and equity right on day one?

The second example is the use of what I call a static valuation report.

say it's March 2022, you've got a ambitious developer who's bought a piece of land for, call it a million dollars.

He's got himself his DA approval.

He's got a good valuation report.

And suddenly on an as if complete valuation, it's now worth, call it a hundred million dollars.

On the back of that, they raised $65 million of debt at a market LVR of 65% and they commenced construction.

A key point to note in this graph is most of that equity value is actually paper profits.

So it's actually the debt holder who's underwriting this project.

Again, that's fine if your return is good and your LDR is strong.

But if you take that exact same facility written in February, March 2022, and look at it today,

If you ran an updated valuation report, which you would require if that debt was coming up for refinance, there is no way you'd get 100 cents of the dollar on it.

At best, you're looking at a 70%, 80%, 85% LBR, which means that piece of construction debt, that development debt cannot be refinanced, and you're actually trapped in the facility.

So in this sort of scenario, the question you really have to ask yourself is, when was that valuation undertaken?

So if you're presented an opportunity to invest in a development loan or a construction loan today, if that valuation report was written any time before, say, January 2023, you should ask for an updated valuation because there's a good chance you're underwater from day one.

The third methodology is asset at cost.

That's the methodology that we use at Rixin Capital.

It's a tangible asset, it's done at cost, it's done at day one.

So in this example, we're assuming we're providing a receivable funding facility.

The beauty of this sort of facility is a $1 receivable reflects $1 value.

So very much aligned with the equity holders.

So in this scenario, we've sized a facility of 75% LVR, 25% equity.

And the beauty of receivable funding facilities is

self-liquidating.

So you don't have to worry about a refinance if refinance is not forthcoming because the receivables pay themselves out over the 6 to 12 month period.

It also allows you to assess risk at a very specific level.

So in this example, we assume that we have diligence to business and there's a 5% loss rate.

So we tell the lender, we're comfortable providing you debt so long as you provide us the five times buffers.

In this scenario, they've given us a 25% equity buffer, which reflects the five times cover over the five times loss.

So in the base case,

There has been a 5% loss rate, which the equity buffer has absorbed.

The equity holders don't mind because they're very well compensated.

But as a debt holder, you have two benefits.

One, your debt is still above water.

You can undertake a refinance if you want to.

But equally, if you choose not to refinance because that book is self-liquidating, you'll have 100 cents on the dollar back in your hands within 12 months.

Now the downside scenario, you know, as I said earlier, this book, when diligence had a 5% loss rate, we built a 20% loss rate.

So that loss rate has ballooned by four times, now 400% increase.

You still have that equity buffer because you've planned for this downside scenario.

And in this scenario, you're probably unable to refinance their debt up, but you haven't got much of a concern as a debt holder because you know that you hold onto that facility.

the assets realize themselves and your capital will be returned.

In our opinion, this is really the gold standard of the sort of assets you want to hold and measure in on an LVR basis.

So the RICs, to tell you a little bit about the RICs and income fund.

So we're focused on capital preservation and a regular monthly yield.

Our LVRs are rarely above 70% and we require LVRs on real assets, no valuation reports, no implied equity valuations that can move as the market moves.

We require real tangible assets, receivables, inventory, plant property equipment.

As a broader strategy, we're not permitted to have exposure to equity or property development.

We'll take a brownfields property as security, but by and large, we're finding a lot of demand in really high quality receivers.

Because we focus on the underbanked $2 to $20 million space where the large funds don't play, we will extract what I call a scarcity premium.

per annum, and the fund has delivered regular returns of between 0.8 to 1.8% per month cash.

Our March return, which will be paid in a few weeks, will be 0.87%.

Our April return, which we've already got visibility of, will be a solid 1% cash return.

We're an income only strategy, but given our focus on capital preservation, it's a very, very good risk reward proposition.

Look, I would like to thank the investment markets team for giving us the time to present.

You'll get my details or the businesses details through them.

I look forward to fielding any questions or interest in the fund.

We are open and we are accepting applications because we've got a very strong yield pipeline over the next three to six months.

Thank you.

Thank you, Patrick.

That was a wonderful presentation.