Understanding the debt capital stack and where private investors can generate risk adjusted returns

Our next presenter is Lauren Ryan, Business Development Manager for Investments at Think Tank Property Finance.

Today, she'll discuss how investors can achieve equity-like returns for by investing in debt within the current interest rate environment.

Please join me in welcoming Lauren.

Thanks, Angelina.

And thank you everyone for joining us today.

So my name's Lauren Ryan and I'm representing Think Tank Property Finance here today.

Just a quick disclaimer that everything that we're discussing today is general, as I don't know you or your personal circumstances.

A little bit about Think Tank for those of you who haven't heard of us, we are a non-bank property lender.

We lend money to SMEs, SMSFs, business owners,

borrowers looking to purchase small ticket commercial or residential property existing residential and commercial small ticket property either through their their own name through a business through a super fund through a company or through a trust.

We started the business in 2006 we've originated over 10 billion in lending since that time and we

We're very heavy in the borrower and broker and small business and SMSF market.

So that's sort of our niche play there.

As a non-bank lender, we don't hold a banking license and any investments that investors, institutional private investors make into Think Tank is an investment.

We don't have that to 50K government guarantee.

We only do mortgages, so we don't participate in other kinds of finance that you might find with other

Banks or non-bank lenders out there and the non-bank lending and private credit space is probably not unfamiliar to many of you There are quite a few of us out there who who operate in this space and like in the equities market there are there everyone's got their own unique value proposition and their own sector of the market that they play in so that's sort of what we're going to talk about today is a

with the current interest rate environment.

Investors are able to take debt risk and earn pretty similar returns to what you might in an equities portfolio, again provided that you're comfortable with the risk profile of the investment.

Just a little bit of info here about Think Tank and I believe these slides will be available for you later in the presentation.

So, how do we achieve debt equity-like returns whilst investing in debt?

As a non-bank lender, we take security over the property that we lend against.

And being a SME, SMSF, small business lender, the margins on that kind of lending are

always going to be slightly higher than if you borrowed money from the bank.

And because a lot of our businesses, our investors, borrowers, sorry, are small businesses or they're looking to purchase property through entities, they've got very long term time horizons and they're not as rate sensitive as a PAYG borrower might be.

So we're able to generate quite attractive returns for our investors and for the business by taking debt risk.

So many of you will be familiar with the capital stack.

You have debt that sits at the top and equity that sits at the bottom when the borrower disposes of an asset.

the debt gets repaid first before the equity does.

The equity generally has much higher upside because there's higher risk.

The debt is generally at a predetermined rate of return or rate of interest that the borrower pays and investors in the debt are able to generate a relatively consistent income return from investing in those assets.

and that's what we do at Think Tank.

So being a mortgage lender we originate lots and lots and lots of small mortgages which you can see on this slide here.

All of our assets, all of our products are pooled mortgage funds so investors are exposed to the assets within the fund so we're able to provide quite granular data on the assets within the fund so that investors can see how well diversified they are.

And as many of you know, diversification really is key when you're investing through different economic cycles, especially one that we're experiencing right now.

With interest rates being where they are at 4.35%, all debt will have a margin slightly above that cash rate.

And that's how we're able to generate those seven plus returns whilst by taking on the debt risk here.

and again these are just some slides to show you the composition of the portfolio and the diversification again these slides will be available to you.

Many of you will be familiar with this style of structure either from investing in it yourselves or if you've held a mortgage.

The black box there is the debt that's the mortgage that's owned by the bank or think tank in this case and then the yellow is the owner's equity there.

So if there are capital if an asset gets sold

at a higher capital value, which is always what we're hoping for, then the owner receives an increased equity upside once the debt has been repaid.

But of course, if a downside scenario occurs where the asset is disposed at a lower

price than what it was originally purchased for, that owner's equity is at risk first.

So by investing in the debt, you are secured by the owner's equity that sits underneath the pool of loans.

And just going back to that first portfolio slide for the income trust here, with an average LBR of 71%, you're looking at $29,000.

percent worth of borrower's equity that sits underneath quite a large pool of loans.

So that's the security for investors like yourselves.

Again, most of you are probably quite familiar with this structure.

The next slide and the next structure that I'm going to talk about might be a little bit new to you and it is a little bit more complicated so we'll take a little bit of time explaining all of that.

And it's called the debt capital stack.

So if you imagine this entire slide here, this graph,

is equivalent to the black box in this graph.

So instead of one investor owning the entire first mortgage debt it gets tranched and it gets split up into different investment tranches.

They have slightly different risk profiles and slightly different return profiles.

Many of at think tank, we operate in the debt capital markets, many of much the majority of our funding comes from domestic and global banks.

And they're able to provide that funding to us at a relatively tight margin over over the BBSW 30 or over cash.

They won't fund the entire first mortgages that we originate.

Those senior funders, they require subordination, which is investors who sit underneath them in terms of priority, and that's a capital loss protection mechanism there.

So think tank will have a relationship with a senior funder who might fund 85% of our funding needs.

So at the moment the loan books $5.8 billion.

So 85% of that funding will come from our senior funders generally being domestic and global banks.

And then we will go and have relationships with third party credit managers, some of which you might have come across in the past or other institutions who are

willing to take a slightly higher level of risk for a slightly higher level of return.

And they sit in the, I'm going to call it pink or salmon box on this diagram.

They sit underneath the senior funders in terms of priority, and they will absorb risks, any capital losses first, should they occur.

And then underneath that, the issuer has to own what's called the equity tranche.

So in this diagram, we're talking about an entire, this is all the first mortgage,

piece of the pie and think tank as the issuer we own the equity tranche that sits underneath so our capital is at risk first we've got skin in the game and that's required by the senior funders.

Now where investors can generate equity like returns by investing in the debt you'll see on this screen there's a black subordinated bonds box and that's called the high yield trust so think tank has a vehicle

that allows investors to get direct exposure to our institutionally funded debt warehouse through this high yield trust and you're able to earn quite attractive returns by investing in slightly lower down the debt capital stack.

These next few slides just look at the the pool of loans that sit underneath

these mortgage structures here and again you'll see that you're very well diversified.

Think Tank runs a commercial mortgage backed program and a residential mortgage backed program so the commercial mortgage backed is a CMBS and the residential mortgage backed is an RMBS and you can see here that in within the CMBS we're looking at 2.1 billion

of funds under management.

So investors are getting great diversification which is very difficult to achieve on your own and very expensive to achieve on your own and from the previous slide the majority of our funding comes from institutions.

It's quite difficult for individual investors such as yourselves to actually get access directly to this kind of asset class.

So we're looking at 2.1 billion for the commercial mortgage backed portfolio exposure.

Again you can see very well diversified across

different states, different borrower types, different uses and on the right hand side where it says documentation that's the the amount of credit that refers to the credit underwriting.

So a full doc they provide us with much more information and they get a lower price for that.

Mid-doc they provide us with a couple of years worth of their financials and they have to pay a slightly higher rate

SMSF as well generally incurs a slightly higher cost which some of you might be aware of if you've ever borrowed through a self-managed super fund.

And then the next slides we're looking at the RMBS the residential mortgage backed portfolio.

So borrowers sorry investors are exposed to both residential and commercial underlying mortgages.

Our resi portfolio is 2.4

almost 2.5% at the moment.

And again, you're very well diversified here.

So by investing in pools, you are able to gain exposure to lots of different borrowers, lots of different asset classes, lots of different types of businesses, because the income that the borrower is deriving generally comes from their business.

Lots of different locations all across the country.

We are predominantly on the East Coast.

So you're very well diversified in that respect.

And these are just some characteristics about the fund.

So the income and high yield trust, the product to investors actually, it's a bond.

So your return is linked to the, it's linked to the BBSW 30, the bank will separate 30, which generally tracks in line with the cash rate.

And the return for the income trust is a 3.6% fixed margin plus the BBSW 30.

This gets reset every month.

So your return is linked to that BBSW 30 there.

There's no manipulation on think tank side, there's no volatility or variation of the return in that respect because it's a bond.

And from a think tank perspective, we are required to pay all of our investors, all of our bond holders their income first before we receive any income.

the way that waterfall payment works, which I'll just go back to one of these earlier slides, all of the income that we, all the income gets aggregated at the top of the waterfall stack here and then the yellow bonds get paid first, the remaining income then goes to pay the salmon coloured bonds,

and then it goes to pay the high yield trust and then think tanks equity and then the remaining income is called the excess spread.

So if you imagine at the end of every month at the start of every month or the end of every month when you get paid you pay out all of your bills first and then the remaining income that you have left that that's that's your play money to do with what you will.

This is how you would look at that that waterfall structure.

so think tank investors in think tank in the income trust or the higher your trust they're getting paid before think tank is and then that remaining excess spread then goes to pay a staff cost business expenses rent and things like that so if there are any arrears or any capital losses during that time during that month those will come out of the excess spread first so investors are getting paid before we are

which is just an added level of security when you're investing in a in a program like this.

Think Tank is currently open to high net wealth and wholesale sophisticated investors only.

Our bonds are a minimum 12 month term so you're locked up for 12 months and so if the interest rate or the cash rate does change during that 12 months

you'll see your return vary accordingly.

Our mortgages are variable, so we very much link them to the asset and liability management of the business.

And investors can invest in either fund or one or the other, it's entirely up to them.

And that is probably where I'm going to leave you.

Thank you very much.

Thanks, Oren.

Do you have time for two questions?

Go for it.

So, why do borrowers turn to non-bank lenders for their lending needs?

Yeah it's a great question and we're seeing it more and more in the market.

The banks over the last 10 years have spent a lot of resources on building out automated credit modelling systems and many of you watching might have experienced that yourself or you might have had family members or friends who experienced that and if a borrower doesn't fit into that sort of cookie cutter bank model which generally is looking at prime residential lending by PAYG borrowers

then the non-banks are aware their lending needs are serviced.

And it's partly due to, as APRA has made changes over the years, that certain types of loans are quite expensive for banks to hold on their own balance sheet.

And also the banks have got a very, very large pool of money to allocate capital.

So businesses like Think Tank, it makes sense for the banks to say, provide us with $500 million and then we go and write lots and lots and lots of little loans rather than they go and write all of the small individual loans because the cost to write a loan

from a CBA Westpac NAB perspective is pretty similar to what it costs think tank.

However, those banks are dealing with much larger pools of capital.

So it makes more sense to allocate larger pools of capital in one investment, rather than writing lots and lots and lots.

lots of small loans and also that the banks do focus on prime residential lending.

Because our borrowers are predominantly self-employed, SME, SMSF, they're purchasing through entities, it can get quite complicated and that complexity doesn't align with the bank's credit underwriting models that they have spent the last sort of 10 years building out.

So there's many reasons as to why borrowers choose to use the non-banks, but hopefully that gives you a little bit of insight as to why they might.

Why do institutional investors invest via the debt capital markets rather than writing the loans themselves?

Yeah, it probably comes down to expertise.

So in many of those institutional investors,

Their expertise is in analyzing the underlying investment, analyzing the risk of the investment and managing the different investments that they invest in.

They probably don't have a credit or loan expertise within their businesses and they're quite expensive to set up in many respects.

think tank operates not too dissimilar to banks when it comes to net interest margins and many of you might be aware of how the net interest margin works and that's essentially the difference between on average what your borrowers pay and then on average what you pay your investors as a weighted average and in banking your net interest margin or your NIM sort of hangs around the two percent mark it's not a huge margin

So banking is a volume game and for many credit funds or third part or investors it doesn't make sense for them to open their own lending business because it is expensive to underwrite higher margin loans which is probably what they would be looking to achieve because there's a lot of competition in the prime lending market which Think Tank does operate in and we are experiencing that at the moment.

So from an investor's perspective and the institutional investor's perspective, their expertise is in analyzing the investments.

And like many of us do, we outsource to the experts.

So it's more beneficial for them to outsource the credit underwriting to a business like Think Tank, who are one of the best in what we do.

And then those institutional investors will focus on what they're really good at, which is analyzing the investment.

Thank you, Lauren.

Thanks, Angelina, and thanks Investment Markets for having us again.