1 00:00:00,000 --> 00:00:07,000 Hi, I'm Murdoch Gaddi and thanks for listening to the Rate of Change with York Wealth Management. 2 00:00:21,000 --> 00:00:24,000 Hi, I'm Murdoch Gaddi and welcome back to the Rate of Change. 3 00:00:24,000 --> 00:00:31,000 The Rate of Change is a podcast which explores the ever-shifting momentum of financial markets through the eyes of the leading managers in wealth management. 4 00:00:33,000 --> 00:00:40,000 In today's Rockcast, I'm speaking with Joe Milwood, a founding partner and portfolio manager for Epsilon Direct Lending. 5 00:00:40,000 --> 00:00:49,000 Joe joins us to discuss the origins and nuances of the strategy, the corporate lending environment and the impact of rising rates on private credit markets. 6 00:00:49,000 --> 00:01:03,000 The fund is an Australian-based non-bank corporate lender and private credit manager which specialises in providing loans of $10-50 million to Australian mid-market corporates for growth-based purposes. 7 00:01:03,000 --> 00:01:13,000 Epsilon targets an income return of 8.5% and as of 31 August, the monthly return was 86 basis points. 8 00:01:13,000 --> 00:01:21,000 The fund has a 90-day duration, current liquidity is at 20 months and according to Moody's, the credit rating is double B. 9 00:01:21,000 --> 00:01:24,000 I think you will really enjoy the discussion with Joe. 10 00:01:24,000 --> 00:01:33,000 You may find his thoughts on lending for growth purposes and how this differs to other private credit lending very insightful. 11 00:01:33,000 --> 00:01:43,000 If you like what you hear, please reach out to me with your thoughts and questions at mgaddy at ywm.com.au. 12 00:01:43,000 --> 00:01:50,000 Before considering any investments, we encourage you to both listen to the disclaimer at the end of the Rockcast and seek professional advice. 13 00:01:50,000 --> 00:01:56,000 We would like to reiterate that this Rockcast isn't designed nor is it intended to be specific advice. 14 00:01:56,000 --> 00:02:03,000 I hope you enjoy the discussion with Joe as much as I did. 15 00:02:03,000 --> 00:02:06,000 Joe Millwood, welcome to The Rate of Change. 16 00:02:06,000 --> 00:02:08,000 Thanks for having me, Modo. 17 00:02:08,000 --> 00:02:21,000 Why don't we start by telling our listeners a little bit about yourself, how you got into financial markets, your journey and a little bit about how you got into Epsilon and the strategy. 18 00:02:21,000 --> 00:02:26,000 All right. So first of all, I've got to declare I'm English, I'm a POM. 19 00:02:26,000 --> 00:02:28,000 I've been in the country for about 12 years. 20 00:02:28,000 --> 00:02:37,000 I started my career in the UK and it all came about through going to a careers fair and wanting to see the accountant who was late because he was flying back from somewhere. 21 00:02:37,000 --> 00:02:41,000 And I thought that was super cool that he was actually flying back from a foreign country. 22 00:02:41,000 --> 00:02:44,000 I thought, wow, finance must be the place to be. 23 00:02:44,000 --> 00:02:50,000 That's where I got my passion for finance very early on. It's just through school and career mentors and so on. 24 00:02:50,000 --> 00:02:54,000 I got into banking in the UK, pivoted into funds management. 25 00:02:54,000 --> 00:03:00,000 So I ran about a three billion euro private credit fund through the GFC 08, 09. 26 00:03:00,000 --> 00:03:04,000 I decided to start a family in Australia. 27 00:03:04,000 --> 00:03:09,000 So that's when I moved here about 12 years ago to start a family, to start a new life and never looked back. 28 00:03:09,000 --> 00:03:13,000 I worked at a bank for a number of years upon arriving here. 29 00:03:13,000 --> 00:03:18,000 Met a couple of cracking blokes in the bank and we figured that we could do a better job outside the bank than in it. 30 00:03:18,000 --> 00:03:21,000 And I'm happy to kind of unpack that a little bit more. 31 00:03:21,000 --> 00:03:29,000 But yeah, two fellows in Melbourne, Mick Wright Smith and Paul Nagy decided to join me and start Epsilon. 32 00:03:29,000 --> 00:03:35,000 And we did it as a number of reasons, but primarily it was a customer led thing. 33 00:03:35,000 --> 00:03:42,000 We weren't giving our customers the outcomes that they had from us and that they expected from us in the past. 34 00:03:42,000 --> 00:03:51,000 And so we left to give them what they wanted, which is a great service, speed, certainty, flexibility and supporting their growth aspirations. 35 00:03:51,000 --> 00:04:00,000 So when you say you left a bank and there was something you couldn't provide your clients that your clients exactly wanted, can you go into that in a bit more detail? 36 00:04:00,000 --> 00:04:06,000 I don't know if you can say like specifically what bank was that and what were you actually doing for that bank? 37 00:04:06,000 --> 00:04:16,000 Yeah, sure, sure. So I mean, you know, I think what I've talked through is probably generic to banks. 38 00:04:16,000 --> 00:04:23,000 And where were we? We were in the mid-market division of the bank that we worked out as Commonwealth Bank. 39 00:04:23,000 --> 00:04:30,000 But as I said, you know, the challenges that we face, the headwinds that banks are facing in general, I think are generic in nature. 40 00:04:30,000 --> 00:04:33,000 So we worked in the mid-market part of the bank. 41 00:04:33,000 --> 00:04:41,000 Banks are normally structured along the lines of an institutional team, a business or private bank maybe, corporate lending, SME lending, 42 00:04:41,000 --> 00:04:44,000 and then your retail division and maybe other bits and pieces that are bolted on. 43 00:04:44,000 --> 00:04:49,000 But it's normally kind of three tiers of service that are provided to corporate Australia. 44 00:04:49,000 --> 00:04:51,000 And we're in the medium sized business part of it. 45 00:04:51,000 --> 00:04:58,000 So I think customers, businesses that have turnover between $25 million and $500 million, that kind of size. 46 00:04:58,000 --> 00:05:05,000 And normally the lending book is split 50-50 between real estate development, investment lending, 47 00:05:05,000 --> 00:05:10,000 and then going concern lending to companies that produce something or provide some kind of service. 48 00:05:10,000 --> 00:05:17,000 They're the dividing lines. And so we ran the corporate finance team at the Commonwealth Bank. 49 00:05:17,000 --> 00:05:26,000 What we did was support customers with more complex lending transactions, normally involving some kind of event like a merger and acquisition, 50 00:05:26,000 --> 00:05:33,000 expansionary capex, management buyout by private equity group, stuff where there's a bit more complexity to it. 51 00:05:33,000 --> 00:05:42,000 But importantly, and this leads on to answer your question Murdoch, when you're undertaking these kind of events, 52 00:05:42,000 --> 00:05:44,000 they're normally quite time sensitive. 53 00:05:44,000 --> 00:05:49,000 If I'm buying your business off you, you want to know that I'm good for it and you want to know when you're going to get your money by. 54 00:05:49,000 --> 00:05:51,000 It's not like you could just drag these things on. 55 00:05:51,000 --> 00:05:53,000 There are normally deposits paid that are non-refundable. 56 00:05:53,000 --> 00:05:59,000 There's normally pretty strict timelines. And if they drag on, you know, the advisory, illegal bills, they start building up. 57 00:05:59,000 --> 00:06:04,000 So when you're borrowing in order to support an acquisition, you need financing certainty. 58 00:06:04,000 --> 00:06:07,000 You need to know that if somebody says they're going to be good for it, that they're actually good for it. 59 00:06:07,000 --> 00:06:18,000 And, you know, we can debate till the cows come home whether it's a good thing or a bad thing that APRA has decided to have a separate credit decisioning team 60 00:06:18,000 --> 00:06:26,000 from the origination or relationship teams within banks. But what happens is the relationship teams might think it's a great idea to lend the business money. 61 00:06:26,000 --> 00:06:33,000 They talk to the customer about it. They get them warm and, you know, think that they're going to get a product, a loan delivered. 62 00:06:33,000 --> 00:06:36,000 And the credit department comes along at the last minute and changes their mind. 63 00:06:36,000 --> 00:06:39,000 Or maybe the credit person that supported the idea in the first place goes on holiday. 64 00:06:39,000 --> 00:06:42,000 Someone else comes in and they don't like it and you're stuffed. 65 00:06:42,000 --> 00:06:48,000 Relationship managers, credit people come and go, so there's no kind of longevity and continuity of relationship at times. 66 00:06:48,000 --> 00:06:59,000 And so all those things lead to a situation where if you're a business owner and you want to buy another company, you can't always get the speed, 67 00:06:59,000 --> 00:07:05,000 the certainty of financing and the flexibility and responsibility that you need in order to act on the opportunity. 68 00:07:05,000 --> 00:07:10,000 And so when you're in a fund, you can do that because you're the decision maker. 69 00:07:10,000 --> 00:07:13,000 The business owners are normally the investment committee within a fund. 70 00:07:13,000 --> 00:07:21,000 And you can make the decisions that lead to the better outcomes for the customers a lot quicker, provide more certainty. 71 00:07:21,000 --> 00:07:26,000 So many questions there, Arne Park. I really want to hit on the regulatory side because I'm hearing as well. 72 00:07:26,000 --> 00:07:32,000 We just spoke to a hotel group the other day and they were saying the exact same thing as in it was quite frustrating 73 00:07:32,000 --> 00:07:37,000 that some of their clients go through all this work only for right at the end then to go, 74 00:07:37,000 --> 00:07:41,000 we have to do the process again or instead of we're needing a particular amount, we need to double that. 75 00:07:41,000 --> 00:07:45,000 And they're like, we just did this. We need to do done. 76 00:07:45,000 --> 00:07:55,000 So the other question I had from that is how does the Australian space and regulatory environment compare to offshore? 77 00:07:55,000 --> 00:08:01,000 You said you did a lot of time in the UK, the States. Are you saying are we behind? Are we on par? Are we catching up? 78 00:08:01,000 --> 00:08:05,000 How does it look? 79 00:08:05,000 --> 00:08:16,000 OK, so compared to offshore, what played out offshore is we're basically 20 years behind the US in terms of the evolution of non-bank lending. 80 00:08:16,000 --> 00:08:25,000 If you look at the US leveraged loan market, M&A financing market right now, 90% of funding is provided by non-banks. 81 00:08:25,000 --> 00:08:30,000 So the market's completely transitioned, whereas 20 years ago would have been about 10%, 90% banks. 82 00:08:30,000 --> 00:08:35,000 And Australia's at the start of that journey. So why is it that we're lagging so much? 83 00:08:35,000 --> 00:08:40,000 And it's not that the regulatory regimes are materially different. 84 00:08:40,000 --> 00:08:43,000 It's largely because Australia didn't really have a GFC. 85 00:08:43,000 --> 00:08:46,000 It's a very mild version of the pain that was suffered offshore. 86 00:08:46,000 --> 00:08:52,000 We had defaults, insolvency events were far greater in the US and in Europe. 87 00:08:52,000 --> 00:08:59,000 And so the regulators went pretty hard on the banks in those markets and the regulators didn't go as bad as hard here. 88 00:08:59,000 --> 00:09:04,000 And the banks were a lot more conservative in Australia relative to offshore. 89 00:09:04,000 --> 00:09:12,000 So not only did we, of course, the two things are tied together, but not only did we not suffer as bad a general recession as the offshore markets, 90 00:09:12,000 --> 00:09:20,000 but the banks were actually better capitalised and had more conservative lending books, which meant they had the licence to continue to operate as they have been for a long time, 91 00:09:20,000 --> 00:09:25,000 which meant that the barriers to entry remain quite high for non-banks to come into this market. 92 00:09:25,000 --> 00:09:30,000 So it's a bit of a kind of, you know, it's not a final frontier from offshore, but it's bloody far away. 93 00:09:30,000 --> 00:09:40,000 And so the prospect of a US loan fund, yes, setting up shop here, it's probably low down their list in terms of priority for expansion. 94 00:09:40,000 --> 00:09:49,000 It's a common, I wouldn't say it's a misconception, but it's a common focal point to hone in on regulatory capital expenses, 95 00:09:49,000 --> 00:09:53,000 the reason for the transition away from banks to non-banks. 96 00:09:53,000 --> 00:10:03,000 Now, don't get me wrong, APRA does require banks to set aside more capital when banks are lending to businesses that don't have real assets, say a property to lend against. 97 00:10:03,000 --> 00:10:11,000 APRA prefers banks to lend against real assets and they afford them greater or lower cost of capital when they do so. 98 00:10:11,000 --> 00:10:18,000 So there is definitely a bias there. But, you know, let me, let me, I'll unpack some of the real drivers in a second. 99 00:10:18,000 --> 00:10:27,000 But let me give you a few examples. When we were at the bank, as the relationship team, not the credit team, you know, whilst there were delegations in place, 100 00:10:27,000 --> 00:10:35,000 it was very rare that we didn't hit our hurdle return when providing a cash flow loan and a loan that isn't secured against property. 101 00:10:35,000 --> 00:10:41,000 And so we didn't find that it was the capital charge that was causing us to lose deals. 102 00:10:41,000 --> 00:10:44,000 What caused us to lose deals is the stuff that I've already discussed. 103 00:10:44,000 --> 00:10:51,000 And so what is it that drives the kind of lethargy in decision making? 104 00:10:51,000 --> 00:10:57,000 What is it that drives the lack of focus on supporting M&A financing within banks? 105 00:10:57,000 --> 00:10:59,000 There's a couple of things and they're tied together. 106 00:10:59,000 --> 00:11:07,000 Firstly, banks have to simplify their products because what you're dealing with isn't just this little specialist corporate finance team in the mid-market part of the bank. 107 00:11:07,000 --> 00:11:10,000 You're dealing with a thousand staff, you know, more, right? 108 00:11:10,000 --> 00:11:16,000 And all of them are meant to do the same job, deliver a standardised home loan, deliver a standardised overdraft product. 109 00:11:16,000 --> 00:11:25,000 And so if banks want to scale and improve their cost income ratio, which is a massive focus, and deliver to the masses, 110 00:11:25,000 --> 00:11:34,000 are they going to let a small team that might be highly specialised kind of go off and do their own thing, which introduces operational risk, potential heightened credit risk? 111 00:11:34,000 --> 00:11:42,000 No, they're going to kind of not resource that team as well and probably put blockages in the way that make it harder to deliver for customers. 112 00:11:42,000 --> 00:11:43,000 So that's the first thing. 113 00:11:43,000 --> 00:11:47,000 The other thing is that banks are pushing towards automated decisioning. 114 00:11:47,000 --> 00:11:51,000 So it happens today. 115 00:11:51,000 --> 00:11:55,000 You need a $10,000 credit card, you key your details in, you get a decision back very quickly. 116 00:11:55,000 --> 00:11:57,000 That's not a human making that decision. 117 00:11:57,000 --> 00:12:03,000 And when I was at the bank, they're pushing towards automating decisioning of $1 million business loans. 118 00:12:03,000 --> 00:12:10,000 So when certain conditions are met, if you can automate decisioning, you can standardise products a lot more efficiently, 119 00:12:10,000 --> 00:12:13,000 come back to the first point and lower your cost to serve customers. 120 00:12:13,000 --> 00:12:16,000 So all of a sudden, you're kind of ticking a lot of boxes. 121 00:12:16,000 --> 00:12:27,000 It's very hard to standardise, to automate the decisioning for a leveraged loan, a loan that's funding a management buyout by a private equity group, 122 00:12:27,000 --> 00:12:33,000 all those transactions are very different. The loan documentation is customised for that particular deal. 123 00:12:33,000 --> 00:12:37,000 It's not just an off the shelf agreement that you can take. So you can't really automate decisioning. 124 00:12:37,000 --> 00:12:42,000 They're the two main drivers. The regulatory capital thing is a bit of a red herring. 125 00:12:42,000 --> 00:12:49,000 So let's actually translate that and get into the actual detail of the fund. 126 00:12:49,000 --> 00:12:55,000 So I want to talk about, I want to get a better understanding of the types of loans that you have done, like a couple of examples. 127 00:12:55,000 --> 00:13:02,000 But why don't we start before we get there. Do you want to give our listeners a bit of an understanding of the structure of the fund, the performance, 128 00:13:02,000 --> 00:13:10,000 you know, how it's kind of going? Is there a lock in? How long has that been? Just an overall understanding would be great. 129 00:13:10,000 --> 00:13:19,000 Yeah, sure, sure. So it's an Australian unregistered managed investment scheme to pulse our lonely investors through a unit trust structure. 130 00:13:19,000 --> 00:13:29,000 Perpetual is the trustee and custodian. We're the investment manager to that fund. It's open ended. We strike our unit price every month and we pay distributions on a quarterly basis. 131 00:13:29,000 --> 00:13:39,000 Our target distribution is the swap, which is BBSW for us, which is as at today, it's a 90 day interest duration. It's sitting at about two and a half percent. 132 00:13:39,000 --> 00:13:46,000 So it's two and a half percent swap plus. So it's all floating rate. Two and a half percent plus six percent is our target net return. 133 00:13:46,000 --> 00:13:55,000 So right now we're delivering to investors around eight and a half percent cash income per annum. The product is a stable NAV product. 134 00:13:55,000 --> 00:14:01,000 So you don't see the unit price bounce around. It's not a mark to market fund that's referencing some bond fund in the US. 135 00:14:01,000 --> 00:14:10,000 This causes a bunch of volatility linked to duration. We are whole to maturity investors. The fund is 15 months old. 136 00:14:10,000 --> 00:14:16,000 It's currently largely fully ramped up. So we had fully paid up capital on our first close. It is now deployed. 137 00:14:16,000 --> 00:14:30,000 We have a an 80 million dollar loan portfolio. And as we sit today, we've got about 108 million of committed capital, five loans in the portfolio across the 80 million dollars. 138 00:14:30,000 --> 00:14:42,000 In credit risk terms, we use a product called Moody's Risk Calc, which is a shadow rating version of the public ratings tools that Moody's themselves use is a Moody's product. 139 00:14:42,000 --> 00:14:48,000 The loan portfolio is double B in terms of credit risk. So it's kind of on the cusp investment grade. 140 00:14:48,000 --> 00:14:54,000 Some loans are one of them actually is triple B minus and all loans are senior secured. 141 00:14:54,000 --> 00:15:02,000 The types of loans in the portfolio, what we focus on at Epsilon is sustainable, predictable cash flow lending. 142 00:15:02,000 --> 00:15:09,000 So we look at the sustainability and predictability of the EBITDA or the earnings that a company makes and we lend against that. 143 00:15:09,000 --> 00:15:19,000 We take a view on what could cause that number to bounce around. That's our kind of risk analysis. We heavily focus on. 144 00:15:19,000 --> 00:15:28,000 And because we focus on that, we've got sort of strong bias, not an absolute focus, but a strong bias towards non cyclical industry lending. 145 00:15:28,000 --> 00:15:35,000 So right now in the portfolio, 100 percent of exposure is to non cyclical industry. So we're lending to two health care companies. 146 00:15:35,000 --> 00:15:41,000 One's a medical devices business. The other one is a services provider in the medical field. 147 00:15:41,000 --> 00:15:53,000 We've got an education business in there, Australia's largest provider of IT professional education. So I think, you know, high end transformation style systems, not Microsoft Excel. 148 00:15:53,000 --> 00:15:57,000 We've got a fixed wireless telco business in the portfolio. 149 00:15:57,000 --> 00:16:10,000 And so we've got a really good kind of spread of companies in different non cyclical sectors, which we think sets us well up, which we think sets us up well for what the outlook holds. 150 00:16:10,000 --> 00:16:20,000 All right. So let's talk about one of those specific companies. Right. So and for a lot of listeners out there, they might have a very good grasp on this or they might just be coming up on the journey, getting in the head around it. 151 00:16:20,000 --> 00:16:28,000 So how exactly would you help one of these companies? So one of these companies comes to you and says, look, we want to merge by business. 152 00:16:28,000 --> 00:16:38,000 We want to vertically integrate. We want to expand. Right. So how does the loan that you give them help them get to their their particular goal? 153 00:16:38,000 --> 00:16:45,000 Yeah, sure. So one business I didn't just mention is one of the largest coffee roasters in Australia. 154 00:16:45,000 --> 00:16:53,000 And so there's a chap that's owned that business for a long, long time. He's getting to the age and stage where he wants to take a step back. 155 00:16:53,000 --> 00:17:07,000 And so he ran a process to find buyers for the business, but he didn't want to sell the whole thing outright to one of the global mega brand managers and have a three year lock up as an employee with some hundred thousand people 156 00:17:07,000 --> 00:17:11,000 that he's reporting into in a vertical structure. He wanted to slowly exit from the business. 157 00:17:11,000 --> 00:17:15,000 He was looking for a partner that could help him transition on a staged basis. 158 00:17:15,000 --> 00:17:27,000 He ended up finding a private equity group called Livable Partners to buy out a chunk of his shareholding and then have an agreement in place to buy his remaining shareholding in the future. 159 00:17:27,000 --> 00:17:33,000 And when Livable Partners decided to buy the business, a valuation was struck between the willing buyer and seller. 160 00:17:33,000 --> 00:17:45,000 Livable Partners partly funded that purchase of the gentleman's shares with equity from their own fund, and they decided to borrow from Epsilon for the remaining portion of the money they needed to support that acquisition. 161 00:17:45,000 --> 00:17:51,000 So that's buy out financing by private equity group. That's an example of the type of lending that we do. 162 00:17:51,000 --> 00:17:59,000 A couple of other snippets of examples. We've recently provided a loan to a listed company called Somnamed. It's on the ASX. 163 00:17:59,000 --> 00:18:10,000 They're about a 110-wheel market cap. They're the largest manufacturer and wholesaler of oral devices that help prevent and manage sleep apnea. 164 00:18:10,000 --> 00:18:25,000 So real kind of lending with a cause. Our money is going towards the expansion of the business, their sales force, and the finalization of a product that's being developed, which will be a real game changer in the industry. 165 00:18:25,000 --> 00:18:35,000 Thank you very much for that. The reason I want to get a better understanding of specifically what's the loans is there's a lot of talk right now about rising interest rates environments. 166 00:18:35,000 --> 00:18:47,000 Like how much cheap money has just been pumped in with COVID times. Valuations have just gone nuts. A lot of friends of mine, a large number of colleagues that have been in this space. 167 00:18:47,000 --> 00:19:09,000 As you said, you saw the GIF. So you've seen a number of crashes occur, specifically credit crashes. So one thing we're discussing off air is if you look at a number of other private lenders or funds that are lending in this currently space, you're saying that your fund is different in the sense you have a bit of a moat. 168 00:19:09,000 --> 00:19:30,000 That this may not impact you as much because you're looking at growth based lending. So I suppose my question is, what's the impact of inflation in the space that you're lending to and why just growth based lending may not have as big a, I suppose, an impact on the companies you're lending to? 169 00:19:30,000 --> 00:19:46,000 Yeah, sure. I probably wouldn't say that all lending to support a growth event such as an acquisition would be insulated from an economic downturn. That would be too broad a generalisation. 170 00:19:46,000 --> 00:20:04,000 But I will talk to what it is that we do that probably does create that moat that you mentioned. Taking a step back, I've recently done a bit of a data study on the lending market in the US. 171 00:20:04,000 --> 00:20:18,000 And just to kind of point something out, I know it's bloody obvious, but I still think people forget this. When you pump money into equities, the price goes up, right? Generally, you know, more buyers and sellers, share price goes up. That's great. Everyone's happy. 172 00:20:18,000 --> 00:20:32,000 Right? Until they're not. But, you know, generally drives up price. When you pump more credit into a system, when you have a ton of money that's trying to find a home, trying to find somebody to borrow it, that doesn't result in prices going. That's not a good thing. 173 00:20:32,000 --> 00:20:44,000 What happens is you have more lenders competing for the same deals. And if they can't compete on price because they have a hurdle return to meet for their fund, which has been the case in the US, pricing hasn't really suffered too much. 174 00:20:44,000 --> 00:20:53,000 What are you competing on? How are you winning those deals? It's terms and conditions. You know, I'll let that covenant go. Here comes covenant-like lending. I'll let the undertakings go. 175 00:20:53,000 --> 00:21:04,000 Okay, so now if a new company buys the one that I'm lending to, I don't have a say. No change of control provisions. And I can go on and on and on. You end up with a lot more leverage in these companies. 176 00:21:04,000 --> 00:21:18,000 So right now in the States, or certainly true, I think the market's got a little bit more cautious as things have played out, but certainly kind of, you know, as recent as four or five months ago, the average loan to enterprise value ratio. 177 00:21:18,000 --> 00:21:30,000 So that is the amount of gearing that companies or credit funds are providing to companies. It's around two thirds of the capital structure. So you've got an imbalance there, right? Straight away, the equity providers are only providing a third. 178 00:21:30,000 --> 00:21:40,000 So they stand to lose less if the company goes bad. Yes, you're secured, but that's quite a lot of leverage for an operating company where there's no fixed assets that you're lending against. 179 00:21:40,000 --> 00:21:53,000 And those conditions are very similar to what I saw in 2008. You know, same kind of gearing levels, same kind of average rating, the origination of the deal, worsening of terms and conditions, very few covenants. 180 00:21:53,000 --> 00:22:04,000 Okay, so the conditions offshore are pretty dicey right now. And so if you're hearing people say, I'm nervous about credit, it's with good cause because the bulk of the global credit market is very hot at the moment. 181 00:22:04,000 --> 00:22:13,000 And whilst you might not see an immediate material uptick in defaults because they're in a covenants to act upon as a long term lag effect here, right? 182 00:22:13,000 --> 00:22:19,000 You know, how do you create a default unless there's an actual insolvency or bankruptcy event where the companies run out of money? 183 00:22:19,000 --> 00:22:26,000 So you've got a bit of a lag between rates going up and defaults occurring. You've got good reason to be a bit concerned. 184 00:22:26,000 --> 00:22:38,000 Okay. Why are things different in Australia and in our market, our target market? Well, first of all, what's happened to all that cash that's been pushed into the system? 185 00:22:38,000 --> 00:22:45,000 You've seen share prices, P multiples blow out. You've seen property prices blow out. Okay, all that stuff has played out. 186 00:22:45,000 --> 00:22:54,000 What we haven't witnessed though, in the middle market in corporate Australia, is the purchase prices of businesses have barely gone up. 187 00:22:54,000 --> 00:23:05,000 Okay, so normally a business that we'd lend to is being purchased by a private equity group or an individual shareholder or a high net worth family office for seven times earnings. 188 00:23:05,000 --> 00:23:13,000 That's about the average, you know, seven and a half times EBITDA is the typical purchase price multiple. That's not changed. 189 00:23:13,000 --> 00:23:21,000 And so the beauty about our strategy is it is within the confines of the Australian market, which has an imbalance between supply and demand of debt. 190 00:23:21,000 --> 00:23:28,000 There's not enough debt to provide into the system. There isn't enough of it to cause the deterioration that we've seen offshore. 191 00:23:28,000 --> 00:23:34,000 And there's not a massive wall of equity money sat there as well. There's a reasonable amount of dry prouder and private equity. 192 00:23:34,000 --> 00:23:43,000 But you haven't seen that kind of purchase price multiple in the mid market blow out. So we're lending against quite stable asset prices. So there's your number one protection. 193 00:23:43,000 --> 00:23:51,000 Secondly, we're lending at quite low levels as well. You know, Aussie buyers are businesses, they're not that aggressive in the use of leverage. 194 00:23:51,000 --> 00:24:01,000 It's not that, you know, the cost of debt here is higher. It's actually lower than offshore. So they could afford to put more leverage into businesses. 195 00:24:01,000 --> 00:24:10,000 We've got really conservative capital structures. Right now in the Epsilon portfolio, the ratio of the loan to the enterprise value of the companies is 19 percent. 196 00:24:10,000 --> 00:24:14,000 So 19 percent LVR in kind of property talk is really conservative. 197 00:24:14,000 --> 00:24:23,000 The ratio of net debt to EBITDA, which is another metric that's used in our world, you know, typically it's kind of six times net debt to EBITDA in the US. 198 00:24:23,000 --> 00:24:28,000 On net debt to EBITDA ratio on a weighted average basis in the book is one point three times. 199 00:24:28,000 --> 00:24:37,000 And so we sit there and go, yeah, sure. Yeah. If there's a recession, top lines will come under pressure, inflationary pressures, you know, 200 00:24:37,000 --> 00:24:45,000 maybe the gross margins and the net margins will come under pressure, you know, as tight labor markets cause wage prices to inflate. 201 00:24:45,000 --> 00:24:55,000 So maybe earnings will come off. But we think we've structured our loans to non-cyclical businesses on quite a conservative basis against uninflated asset prices. 202 00:24:55,000 --> 00:25:02,000 So we think we've got a hell of a lot of buffer before we see anywhere near what I'm expecting to see in terms of default rates offshore. 203 00:25:02,000 --> 00:25:09,000 Because I'm hearing there's what? 50 percent of companies in the market right now potentially trading a zombie company. 204 00:25:09,000 --> 00:25:15,000 Something nuts like that. Like, it's just, you know, but of course, you know, nothing happens in a straight line. 205 00:25:15,000 --> 00:25:20,000 There's a lot of people out there saying, Mockleberry got it right. You know, he called it how many months ago? 206 00:25:20,000 --> 00:25:24,000 This needs to all come off. But at the end of the day, there's no such thing as a straight line. 207 00:25:24,000 --> 00:25:29,000 I think we saw you see some of the biggest bear car bounces, you know, on the way down. 208 00:25:29,000 --> 00:25:33,000 Right. I think I heard the other day from another gentleman saying it's going to be a three stage affair. 209 00:25:33,000 --> 00:25:36,000 Thirty five percent down, 20 percent rally, which has just occurred. 210 00:25:36,000 --> 00:25:41,000 I think it's all being driven by the Fed. Right. You know, the Fed talks and, you know, butterfly flaps his wings. 211 00:25:41,000 --> 00:25:49,000 And but it's down then up again and then potentially a lot of people are saying that sometime next year potentially maybe the big one. 212 00:25:49,000 --> 00:25:51,000 So what are your thoughts around that? 213 00:25:51,000 --> 00:25:59,000 Is there opportunities in this or is it best selling just to steer clear of or and how will that impact you? 214 00:25:59,000 --> 00:26:03,000 Yeah, sure. I'll give the crystal ball a go. 215 00:26:03,000 --> 00:26:05,000 The crystal ball. 216 00:26:05,000 --> 00:26:13,000 I mean, and I'll qualify this by saying I'm very far from being qualified in this field, but, you know, I've got an opinion. 217 00:26:13,000 --> 00:26:16,000 So I'll throw it out there. 218 00:26:16,000 --> 00:26:33,000 I think confining my commentary to the space that I understand the leverage line markets and what I think could play out in the offshore markets from a default company default and recovery rate experience. 219 00:26:33,000 --> 00:26:36,000 What do you need to cause a default to occur? 220 00:26:36,000 --> 00:26:41,000 First of all, you've got those documentary triggers that are kind of called soft defaults, a covenant breach. 221 00:26:41,000 --> 00:26:55,000 Right. And normally that then leads to a wave of restructuring activity, a lot of positioning, maybe, you know, companies are willing to buy tenor, you know, pay a higher margin with a bunch of interest being capitalised to buy them some cash flow relief. 222 00:26:55,000 --> 00:26:59,000 There's a bunch of early negotiation normally happens at this point in the cycle. 223 00:26:59,000 --> 00:27:02,000 But all these businesses that have covenants and strong protection. 224 00:27:02,000 --> 00:27:08,000 So that kind of early intervention that you'd normally see won't play out to the magnitude we've seen historically. 225 00:27:08,000 --> 00:27:17,000 So what I think will occur is you'll have a stronger and harsher wave of real defaults, monetary defaults that will occur. 226 00:27:17,000 --> 00:27:23,000 And when you have a monetary default, effectively the company can't afford to pay its liabilities they ford you. 227 00:27:23,000 --> 00:27:26,000 It's failure to pay interest or principal. 228 00:27:26,000 --> 00:27:28,000 So why would they fail to pay interest? 229 00:27:28,000 --> 00:27:29,000 Well, here's why. 230 00:27:29,000 --> 00:27:37,000 The average deal that's been struck in the US over the last year has been done at two and a half times interest cover. 231 00:27:37,000 --> 00:27:45,000 So what that means is the earnings of the company are two and a half times larger than the annual interest bill from the money that they've borrowed. 232 00:27:45,000 --> 00:27:47,000 OK, so you think, well, is that good? Right. 233 00:27:47,000 --> 00:27:49,000 Two and a half times. It's quite a big number, right? 234 00:27:49,000 --> 00:27:51,000 That doesn't include any repayment of the debt. 235 00:27:51,000 --> 00:27:53,000 First of all, that's just paying the interest. 236 00:27:53,000 --> 00:27:55,000 And then let's unpack that further. 237 00:27:55,000 --> 00:27:58,000 That two and a half times was done at a time when the rates were zero. 238 00:27:58,000 --> 00:28:04,000 You know, the swap, the BBSW or the US LIBOR, whatever reference rate is used, was zero. 239 00:28:04,000 --> 00:28:09,000 OK, so let's make that three percent, which is the current six month swap. 240 00:28:09,000 --> 00:28:11,000 Then all of a sudden, what's that two and a half go to? 241 00:28:11,000 --> 00:28:14,000 It kind of goes to two, maybe one point eight. 242 00:28:14,000 --> 00:28:17,000 And then you say, OK, what EBITDA, what earnings number was used? 243 00:28:17,000 --> 00:28:25,000 And in the US, Moody's have shown that the level of normalisations in these EBITDA numbers that are used for structuring, you know, this great invention EBITDA, 244 00:28:25,000 --> 00:28:30,000 dreamt up by a bunch of private equity and investment bankers to act as a bad proxy for cash, 245 00:28:30,000 --> 00:28:34,000 it's further from the truth that it's ever been, it's further from real cash than it's ever been. 246 00:28:34,000 --> 00:28:38,000 And so when you pay interest, that's real cash. EBITDA ain't real cash. 247 00:28:38,000 --> 00:28:40,000 It's very far from real cash. 248 00:28:40,000 --> 00:28:45,000 And so then you kind of got interest cover under current rate environments of maybe two times. 249 00:28:45,000 --> 00:28:48,000 What's your real interest cover? 250 00:28:48,000 --> 00:28:50,000 And the EBITDA number is at the highest, right? 251 00:28:50,000 --> 00:28:54,000 You know, there's no inflationary issues fed into that EBITDA yet. 252 00:28:54,000 --> 00:28:57,000 There's no recession issues fed into that EBITDA yet. 253 00:28:57,000 --> 00:29:04,000 So what I think will happen is you'll have the wall of defaults occurring because companies can't pay the bloody interest bill. 254 00:29:04,000 --> 00:29:06,000 And that's not happened before. 255 00:29:06,000 --> 00:29:10,000 The last GFC was a lot less about monetary defaults. 256 00:29:10,000 --> 00:29:15,000 It certainly was in some instances, but a lot more about a wave of covenant breaches and early intervention 257 00:29:15,000 --> 00:29:21,000 and people scrambling to restructure loans proactively in most cases with private equity. 258 00:29:21,000 --> 00:29:24,000 This time around, I think it will be a lot worse. 259 00:29:24,000 --> 00:29:28,000 But here's the interesting kind of dynamic. 260 00:29:28,000 --> 00:29:32,000 What people have the option to do, which you mentioned, is just turn them into a zombie company. 261 00:29:32,000 --> 00:29:35,000 I don't need that interest. Let's capitalise it. 262 00:29:35,000 --> 00:29:39,000 Let's do a debt for equity swap. Let's pretend there aren't any defaults. 263 00:29:39,000 --> 00:29:42,000 OK, so you can structure your way through this. 264 00:29:42,000 --> 00:29:48,000 You can sit on your hands and just hope that things come back, right, and not put a company into VA. 265 00:29:48,000 --> 00:29:52,000 And as long as it's kind of breakeven before the interest is payable, 266 00:29:52,000 --> 00:29:56,000 as long as it's generating positive cash flow before the interest bill is payable, 267 00:29:56,000 --> 00:29:58,000 then you might be able to muddle through. 268 00:29:58,000 --> 00:30:03,000 But I think you'll see a bunch of lenders say, no, we're not going to go for that. 269 00:30:03,000 --> 00:30:07,000 You'll see a bunch of directors say, well, I'm not going to sit there and pretend that there isn't a problem. 270 00:30:07,000 --> 00:30:08,000 I'll appoint an administrator. 271 00:30:08,000 --> 00:30:15,000 And so I think you will see a real pickup in defaults, but I think it will take quite a long time to play out. 272 00:30:15,000 --> 00:30:21,000 If that event occurs, will that have a material impact on the companies which you're lending to 273 00:30:21,000 --> 00:30:23,000 since they are companies? 274 00:30:23,000 --> 00:30:28,000 Another way of looking at it is, is there a drag net approach? 275 00:30:28,000 --> 00:30:31,000 So there's a number of insurance companies in Japan, as an example, right? 276 00:30:31,000 --> 00:30:36,000 Earthquake hits. They all sink because they're all the earthquake insurance. 277 00:30:36,000 --> 00:30:40,000 But then you look closely, two of them don't actually do earthquake insurance. 278 00:30:40,000 --> 00:30:48,000 So is it going to be a situation where all equities potentially come off and they will get hit and have impact? 279 00:30:48,000 --> 00:30:54,000 How the deals have been structured internally, they're good companies, they're good loans, they should be fine. 280 00:30:54,000 --> 00:30:56,000 Like how should investors think about it? 281 00:30:56,000 --> 00:30:57,000 Yeah, here's the thing. 282 00:30:57,000 --> 00:31:02,000 I think we get a lot of properties, great asset class. 283 00:31:02,000 --> 00:31:04,000 Don't get me wrong. 284 00:31:04,000 --> 00:31:08,000 You should always diversify and have that mix across your book, right? 285 00:31:08,000 --> 00:31:14,000 But people do fall into the trap of saying, well, if there's not a real asset, then you're left with nothing, right? 286 00:31:14,000 --> 00:31:15,000 Well, are you? 287 00:31:15,000 --> 00:31:20,000 So who's going to provide all the services that you require in order to operate your business? 288 00:31:20,000 --> 00:31:27,000 You know, IT help desks, cleaning companies, coffee roasting, dentists. 289 00:31:27,000 --> 00:31:32,000 These are real operating businesses that have a need in society. 290 00:31:32,000 --> 00:31:37,000 And in our space, where we lend to quite established businesses, normally a market leader or top three, 291 00:31:37,000 --> 00:31:40,000 there's a real reason for that company to exist. 292 00:31:40,000 --> 00:31:44,000 So what you're not going to see is just an overnight disappearance of all these businesses 293 00:31:44,000 --> 00:31:47,000 because there is still demand, right? 294 00:31:47,000 --> 00:31:50,000 The issue is the demand has gone down and the leverage is very, very high. 295 00:31:50,000 --> 00:31:53,000 So there has to be a restructuring event, right? 296 00:31:53,000 --> 00:31:55,000 The balance sheet is over levered. 297 00:31:55,000 --> 00:32:00,000 And so I don't think what you'll see is just this disappearance of a whole bunch of companies, right? 298 00:32:00,000 --> 00:32:04,000 You know, it's not like it's people say it's thin air when you lend to a company without property. 299 00:32:04,000 --> 00:32:06,000 It's not thin air. 300 00:32:06,000 --> 00:32:08,000 You know, society needs to function, right? 301 00:32:08,000 --> 00:32:16,000 You know, I think we've seen a lot of the downstream impacts of society not functioning properly in recent times. 302 00:32:16,000 --> 00:32:18,000 Yeah, shipping delays, right? 303 00:32:18,000 --> 00:32:26,000 Toilet paper shortages, all these kind of crazy behavioral issues that can occur when people go to be in a state of panic. 304 00:32:26,000 --> 00:32:33,000 I don't think you'll see that kind of level of disruption to the services being provided by these companies. 305 00:32:33,000 --> 00:32:35,000 I think their balance sheets need to be restructured. 306 00:32:35,000 --> 00:32:38,000 Now, does that have downstream impact? 307 00:32:38,000 --> 00:32:42,000 Well, sure, because a whole bunch of people have allocated capital to these credit funds to lend the money. 308 00:32:42,000 --> 00:32:44,000 So they're going to suffer losses. 309 00:32:44,000 --> 00:32:45,000 So what happens? 310 00:32:45,000 --> 00:32:49,000 The big public pension funds in the US, the insurers that are providing all this money. 311 00:32:49,000 --> 00:32:53,000 I think there's a potential for a pretty meaningful write down. 312 00:32:53,000 --> 00:32:59,000 So I think it pays right now to be cautious around allocating offshore, right? 313 00:32:59,000 --> 00:33:04,000 Some managers will do it tremendously well because they're able to pivot, you know, become run a dislocation strategy. 314 00:33:04,000 --> 00:33:07,000 Start doing distress lending, right? 315 00:33:07,000 --> 00:33:14,000 So the good managers have got the capital committed and they have the capability and teams to pivot will soak up a bunch of opportunity. 316 00:33:14,000 --> 00:33:17,000 But I think there definitely will be a bunch of pain suffered as well. 317 00:33:17,000 --> 00:33:21,000 Well, since we're on the crystal ball topic, where do you think interest rates are going to go? 318 00:33:21,000 --> 00:33:24,000 This would be fun. Pick a number. 319 00:33:24,000 --> 00:33:26,000 Oh, boy. What do I know? 320 00:33:26,000 --> 00:33:30,000 I know that the six month swap is currently 3.1 percent. 321 00:33:30,000 --> 00:33:35,000 I think I think last week's commentary at the Fed was was fascinating. 322 00:33:35,000 --> 00:33:39,000 Like, you know, it's largely a statement being made that the put is gone. 323 00:33:39,000 --> 00:33:42,000 Right. Don't rely on us anymore. 324 00:33:42,000 --> 00:33:45,000 And so, you know, what are you left with? 325 00:33:45,000 --> 00:33:49,000 You're left with what happens to inflation and then how to raise respond. 326 00:33:49,000 --> 00:33:53,000 And I think inflation continues, then rates will continue to respond. 327 00:33:53,000 --> 00:34:01,000 So what I'm focused on is and what we're focused on is trying to unpack inflationary drivers and how they impact our portfolio directly, 328 00:34:01,000 --> 00:34:06,000 but also systemically so we get a sense of where rates might go. 329 00:34:06,000 --> 00:34:08,000 But, yeah, I'm terrible with a crystal ball at this. 330 00:34:08,000 --> 00:34:13,000 Who knows if I if I if I had a real sense, I probably wouldn't be doing this job. 331 00:34:13,000 --> 00:34:24,000 Well, I think I think there's a bit more pain to come in rates like I'm probably bearish in terms of believing that rates will go higher than the market currently expects. 332 00:34:24,000 --> 00:34:27,000 But we're not overly worried at Epsilon about that. 333 00:34:27,000 --> 00:34:36,000 And the reason is because all deals that we write, we require our borrowers to hedge their floating rate exposure back to fixed for years two and three. 334 00:34:36,000 --> 00:34:39,000 We normally lend on three year tenor three, four, five years. 335 00:34:39,000 --> 00:34:43,000 Sometimes the average life in our loan portfolio is three point two years. 336 00:34:43,000 --> 00:34:46,000 So we've got quite short credit duration. 337 00:34:46,000 --> 00:34:49,000 So we're asking ourselves, where will rates go in the next three years? 338 00:34:49,000 --> 00:34:53,000 Oh, and by the way, a chunk of that floating rate exposure we're hedging right now today anyway. 339 00:34:53,000 --> 00:34:55,000 So we know what the interest cost is for our borrowers. 340 00:34:55,000 --> 00:35:00,000 Our borrowers know how much cash they need to set aside in order to pay the interest bill in the future. 341 00:35:00,000 --> 00:35:08,000 And so, of course, we're constantly having to reset that benchmark and run sensitivity analysis in our portfolio to understand what if rates did blow out to five, 342 00:35:08,000 --> 00:35:16,000 six, seven percent and we run those scenarios and we check those interest cover ratios to make sure there's a lot more buffer than the two and a half times that the states have seen. 343 00:35:16,000 --> 00:35:21,000 Right now, our sensitized ICR cover is about six times earnings. 344 00:35:21,000 --> 00:35:24,000 So we've got a real strong buffer there and that's real earnings. 345 00:35:24,000 --> 00:35:26,000 It's not the made up stuff. 346 00:35:26,000 --> 00:35:30,000 So we're pretty comfortable with where we're at. 347 00:35:30,000 --> 00:35:35,000 The bigger underlying concern is if rates do blow up, what does that do to consumer discretionary? 348 00:35:35,000 --> 00:35:38,000 Yeah, what does that do to disposable income? 349 00:35:38,000 --> 00:35:45,000 And that's a focus because we believe that all businesses suffer if consumer discretionary go down. 350 00:35:45,000 --> 00:35:52,000 But we're trying to insulate by focusing more on businesses that aren't directly exposed to it by going for the non-cyclicals. 351 00:35:52,000 --> 00:36:00,000 Can you talk more about you said that you're hedging it out for three years, but it's a shorter period. 352 00:36:00,000 --> 00:36:03,000 And you also mentioned about is it quarterly? 353 00:36:03,000 --> 00:36:12,000 So what's occurring? So can you participate if rates start to creep up and investors are looking at, you know, what am I to expect? 354 00:36:12,000 --> 00:36:16,000 That's eight and a half percent, you know, average past 12 months, you know, for the next 12 months. 355 00:36:16,000 --> 00:36:19,000 Right. You know, say rates do rise. 356 00:36:19,000 --> 00:36:21,000 Will they benefit in that upward lift? 357 00:36:21,000 --> 00:36:23,000 And exactly how does that work? 358 00:36:23,000 --> 00:36:25,000 Yeah, they benefit. 359 00:36:25,000 --> 00:36:30,000 Yes, a pretty good inflation hedge investing inflating rate debt with an interest duration of ours. 360 00:36:30,000 --> 00:36:35,000 So we've got a 90 day interest duration. So let me clarify what I was talking about with the hedge. 361 00:36:35,000 --> 00:36:43,000 We pay investors the 90 day swap plus the net interest margin and the fees that we earn in the portfolio. 362 00:36:43,000 --> 00:36:47,000 Everything's passed through to our investors after our management fees. 363 00:36:47,000 --> 00:36:52,000 And so our borrowers are paying us that floating rate. 364 00:36:52,000 --> 00:36:59,000 But what they do behind the scenes with, you know, an investment bank is swap that floating rate for a six-frag exposure. 365 00:36:59,000 --> 00:37:03,000 So they're paying us floating, but their cash flow is fixed. 366 00:37:03,000 --> 00:37:07,000 OK, so they swap that floating rate cost for the fixed rate cost with the investment bank. 367 00:37:07,000 --> 00:37:13,000 That floating rate is paid to the investors in the fund and our rates are reset on a quarterly basis. 368 00:37:13,000 --> 00:37:21,000 So we've just, you know, our loans are documented such that the interest rollovers occur, that rate reset occurs at each quarter end. 369 00:37:21,000 --> 00:37:27,000 So it's as simple as that. You know, look at the look on the ASX at the BBSW that struck on the 30th of June. 370 00:37:27,000 --> 00:37:32,000 That kind of the bid and that's the rate that our borrowers are paying. 371 00:37:32,000 --> 00:37:38,000 And that's what will then pass on at the end of that quarter when our borrower pays us that interest bill. 372 00:37:38,000 --> 00:37:46,000 That makes a lot of sense. Is there any companies you're looking at right now to lend to or is the book currently set? 373 00:37:46,000 --> 00:37:50,000 No, no, we're lending. Yeah, we're actively pursuing opportunities right now. 374 00:37:50,000 --> 00:37:55,000 How many would you say that you look at before you actually go, we want to lend to a company? 375 00:37:55,000 --> 00:37:58,000 Well, do you know what the good thing about our market is? 376 00:37:58,000 --> 00:38:07,000 And, you know, this is not to not to kind of discount other strategies, but it's a deep market. 377 00:38:07,000 --> 00:38:15,000 There are seven or 35,000 businesses within our target market, the mid market in going concern Australia. 378 00:38:15,000 --> 00:38:19,000 Thirty five thousand operating businesses is the engine room of the Australian economy. 379 00:38:19,000 --> 00:38:24,000 Largest employer in terms of the catchment size of businesses, largest contribution to GDP. 380 00:38:24,000 --> 00:38:26,000 But it flies under the radar. 381 00:38:26,000 --> 00:38:31,000 No one hears about it because it's not an ASX listed, you know, mega cap that gets in the AFR every single day. 382 00:38:31,000 --> 00:38:34,000 This is the engine room of the economy. 383 00:38:34,000 --> 00:38:37,000 And so we see a lot of deals. 384 00:38:37,000 --> 00:38:43,000 This isn't a kind of niche strategy that only has capacity to get to 300, 400 million before the deals really dry out. 385 00:38:43,000 --> 00:38:45,000 This isn't kind of special sits. 386 00:38:45,000 --> 00:38:50,000 12, 15 percent target return lending, right? The real racy stuff. 387 00:38:50,000 --> 00:38:54,000 This is vanilla lending. We're competing against the major banks. 388 00:38:54,000 --> 00:38:59,000 Yes, CBA's corporate lending book is 50, 55 billion dollars in size. 389 00:38:59,000 --> 00:39:03,000 Our component of that within the team that we used to run was about three billion dollars. 390 00:39:03,000 --> 00:39:10,000 And so we think our total addressable market size, corporate lending Australia, is about a trillion dollars in total. 391 00:39:10,000 --> 00:39:14,000 So that's all loans to companies in Australia, including real estate, including, you know, 392 00:39:14,000 --> 00:39:18,000 real generic overdrafts and working capital facilities, all that kind of stuff. 393 00:39:18,000 --> 00:39:23,000 Trillion dollars. We think our market is about seven percent of that or 70 billion dollars. 394 00:39:23,000 --> 00:39:25,000 So it's a bloody deep market to go for. 395 00:39:25,000 --> 00:39:34,000 In the last 15 months, we've seen 172 lending opportunities for the total value of about five point seven billion dollars. 396 00:39:34,000 --> 00:39:36,000 And we've invested 80 million. 397 00:39:36,000 --> 00:39:40,000 Gives you a sense of how selective we are. Now, we would have done more capital was a constraint, 398 00:39:40,000 --> 00:39:42,000 but we certainly wouldn't have done five point seven billion. 399 00:39:42,000 --> 00:39:51,000 Normally, we'd kind of convert one in 10, one in 15 opportunities into those opportunities into a loan. 400 00:39:51,000 --> 00:39:55,000 So right now we've got a dozen or so opportunities on the desk. 401 00:39:55,000 --> 00:39:59,000 We'll probably fund one or two of those with the capital that we've got right now. 402 00:39:59,000 --> 00:40:02,000 Deal flow isn't the issue. Capital is the issue. 403 00:40:02,000 --> 00:40:08,000 The banks have this market corner because they've got a bottomless pit of capital to put to work. 404 00:40:08,000 --> 00:40:15,000 So, you know, I talked earlier about our value proposition and why people would borrow from Epsilon. 405 00:40:15,000 --> 00:40:18,000 We charge more than a bank would. 406 00:40:18,000 --> 00:40:21,000 So people are willing to pay a bit more on the interest rate. 407 00:40:21,000 --> 00:40:24,000 It's only kind of two percent more or so than the banks charge, 408 00:40:24,000 --> 00:40:28,000 but they're willing to pay more for the service and the certainty that we provide. 409 00:40:28,000 --> 00:40:32,000 And the fact that we're a known quantity as an investment team with the decision makers. 410 00:40:32,000 --> 00:40:36,000 But there are borrowers out there that don't care about the service issues 411 00:40:36,000 --> 00:40:41,000 or might have a cracking relationship manager that delivers a good service and they get a better price. 412 00:40:41,000 --> 00:40:46,000 So, you know, there is there's competitive dynamics at play in the market. 413 00:40:46,000 --> 00:40:52,000 But we see, you know, we think a bloody good share of the market in order to maintain a high level of selectivity. 414 00:40:52,000 --> 00:40:56,000 And yes, we are actively deploying right now. 415 00:40:56,000 --> 00:40:59,000 Well, let's talk about risks then as well. 416 00:40:59,000 --> 00:41:08,000 One thing I've seen, this is just being an adviser dealing with a number of companies, lenders, COVID, all these types of situations. 417 00:41:08,000 --> 00:41:16,000 And one risk that I've personally seen has been when there's a whole lot of cash held on book and it's not deployed. 418 00:41:16,000 --> 00:41:22,000 Right. So essentially, for listeners out there, if you hold cash was not being lent out, you're not making any money. 419 00:41:22,000 --> 00:41:32,000 Put simply, right. So if an event occurs or something does occur, do you see risks that not deploying capital? 420 00:41:32,000 --> 00:41:36,000 Because there might not be a couple of opportunities around. You might have to work for 12 months. 421 00:41:36,000 --> 00:41:42,000 Is that or do you just deal is happening? Yeah, man, this deal is happening. 422 00:41:42,000 --> 00:41:48,000 So this is genuinely one of the great features of our target market is that it is an all weather strategy. 423 00:41:48,000 --> 00:41:54,000 Deals don't dry up. What happens when vows come off? Private equity is still sitting on a ton of dry powder. 424 00:41:54,000 --> 00:41:57,000 So there might be the processes might be a bit longer. 425 00:41:57,000 --> 00:42:02,000 It might be more difficult to get willing sellers across the line because they're used to the, you know, 426 00:42:02,000 --> 00:42:07,000 my mate told me my business was worth five times revenue last year type commentary. 427 00:42:07,000 --> 00:42:10,000 So you've got to get their head around that. 428 00:42:10,000 --> 00:42:14,000 But the M&A volumes are pretty stable in Australia. 429 00:42:14,000 --> 00:42:19,000 Like you don't get to a point at which, you know, that 70 billion dries up to become 10 billion. 430 00:42:19,000 --> 00:42:25,000 It's just never happened. If you look at the long term trend, both domestically, which didn't really suffer a GFC, 431 00:42:25,000 --> 00:42:34,000 but even offshore through the European and US recessions, you can see that the M&A volumes didn't ever just completely disappear. 432 00:42:34,000 --> 00:42:40,000 Fewer and far, far between. But within the mid market tends to be insulated for the reasons I explained earlier. 433 00:42:40,000 --> 00:42:46,000 Asset prices have actually been quite stable through the long term. So it's not a much of a bid offer through downturns. 434 00:42:46,000 --> 00:42:50,000 And there's still a lot of dry powder on the sidelines. Opportunistic buyers come out the woodwork. 435 00:42:50,000 --> 00:43:00,000 Forced sellers come out the woodwork. So there's an asset grab opportunity, a kind of roll up opportunity in downturns as well for people that have capital available to deploy. 436 00:43:00,000 --> 00:43:06,000 And so, yeah, we don't see things dry up. We're pretty stable in terms of deal flow. 437 00:43:06,000 --> 00:43:12,000 Like in our sleep, we would put, you know, $250, $300 million a year of lending out the door. 438 00:43:12,000 --> 00:43:17,000 That's kind of without really trying in a constrained banking environment. 439 00:43:17,000 --> 00:43:21,000 So, you know, cash drag, yes, it's something that we focus on very heavily. 440 00:43:21,000 --> 00:43:25,000 We've got through that initial ramp up period that our investors knew about. 441 00:43:25,000 --> 00:43:31,000 We've now put in place a working capital facility, a small one in the fund, to manage that as well. 442 00:43:31,000 --> 00:43:36,000 So we can minimize cash drag by utilizing the working capital facility. It's not core leverage. 443 00:43:36,000 --> 00:43:40,000 It's kind of, you know, capped at about 15 percent of NAV. 444 00:43:40,000 --> 00:43:43,000 So we're not intending to just have it sat there acting as leverage. 445 00:43:43,000 --> 00:43:50,000 It is priced at a discount to the distribution rate to our investors. So there is a slight pick up there, but we're not concerned. 446 00:43:50,000 --> 00:44:00,000 No, the reason why I ask that question is to lead into a question I should have asked a lot longer ago is always we'd love to understand how you're immunerated. 447 00:44:00,000 --> 00:44:09,000 Right. Because we find behaviorally how anyone's remunerated essentially dictates how they think about investment opportunities. 448 00:44:09,000 --> 00:44:16,000 So how are you remunerated in the fund? And like as an example, if I don't know, you're one percent behind target. 449 00:44:16,000 --> 00:44:23,000 Does that does that impact? Would you look at a deal that you normally wouldn't look at because you're behind? 450 00:44:23,000 --> 00:44:29,000 Or how does that work? You just avoid it completely because, you know, there's a particular process. 451 00:44:29,000 --> 00:44:34,000 No, we spent so much time debating this when we set up the business, Murdoch. 452 00:44:34,000 --> 00:44:40,000 What we knew is that we hated the bank remuneration model, which was you get a reasonable salary, 453 00:44:40,000 --> 00:44:45,000 you get a bonus for earning a certain amount of revenue that year for the bank. 454 00:44:45,000 --> 00:44:49,000 And if that customer goes bust three years later, there's no impact to you. 455 00:44:49,000 --> 00:44:55,000 We hated that lack of alignment of interest. When we set up Epsilon, everything was about how do we create a sustainable business model, 456 00:44:55,000 --> 00:45:00,000 but with true alignment of interest. The outcomes of both our investors and the companies that borrow from us. 457 00:45:00,000 --> 00:45:04,000 Because two things are true, right? If you screw an investor, you're out of business. 458 00:45:04,000 --> 00:45:08,000 And if a bunch of borrowers that you lend to go out of business, you're out of business. 459 00:45:08,000 --> 00:45:16,000 So we had to avoid those things, whilst balancing the fact that we want to create a great business as well. 460 00:45:16,000 --> 00:45:22,000 And so the way we structured the way that we get paid as a manager is 50-50. 461 00:45:22,000 --> 00:45:29,000 Half of our income as a business is through management fees. And that basically pays the fixed costs. 462 00:45:29,000 --> 00:45:36,000 If you go through diligence with us, you'll see very modest salaries for the three founders of the business, 463 00:45:36,000 --> 00:45:40,000 reasonable salaries for the investment team, and then keeping the lights on stuff. 464 00:45:40,000 --> 00:45:46,000 So that kind of pays the bills, the management fee. Our management fee is 75 bits of NAV. 465 00:45:46,000 --> 00:45:53,000 And then the upside for us is the performance fee, which roughly equates if we hit our target return to the other 50%. 466 00:45:53,000 --> 00:46:00,000 So it comes out slightly lower than 75, about 65 basis points we earn if we deliver to target return. 467 00:46:00,000 --> 00:46:06,000 The way that fee is designed is it's an excess spread type calculation. 468 00:46:06,000 --> 00:46:11,000 So there's no kind of catch up in the performance fee. It's only money that we earn above our hurdle. 469 00:46:11,000 --> 00:46:18,000 Our hurdle is the swap plus 325 basis points. So as the swap rate moves up, our target return moves up. 470 00:46:18,000 --> 00:46:23,000 We're not kind of gaming the spread here in the floating rate component, which some others might be. 471 00:46:23,000 --> 00:46:36,000 And then we take 20% of excess spread over 325. So 20% of our 6% target minus 325 basis points is where we get our performance fee. 472 00:46:36,000 --> 00:46:44,000 And importantly, that performance fee, while it's accruing quarterly, it's not paid for the first three years of the life of the fund, 473 00:46:44,000 --> 00:46:47,000 because the average life of our loans are three years. 474 00:46:47,000 --> 00:46:51,000 So we wanted to demonstrate to investors that we're not in this to try and rip a bunch of money out. 475 00:46:51,000 --> 00:46:56,000 We're in this for the long run. We want to see our borrowers demonstrate an ability to repay the loans. 476 00:46:56,000 --> 00:47:02,000 And only at that point will we start to take performance fees out. And our performance fees are based on total unit return. 477 00:47:02,000 --> 00:47:06,000 So if there's volatility in the NAV price because we screw up and we have to impair a loan, 478 00:47:06,000 --> 00:47:13,000 which, by the way, we've built a lot of independence into in terms of valuations, then our performance fee will get wiped out. 479 00:47:13,000 --> 00:47:22,000 So we're highly incentivised to focus on this being a return of capital strategy, not return on capital. 480 00:47:22,000 --> 00:47:26,000 We can't afford to lose a dollar. We don't intend to take risk and lose a dollar. 481 00:47:26,000 --> 00:47:33,000 And the obvious question, which I know you're just about to ask, is what stops you trying to get, you know, 482 00:47:33,000 --> 00:47:36,000 a 10 percent return to rip a load of money out of the performance fee? 483 00:47:36,000 --> 00:47:44,000 And the beautiful thing about our market is that there's this natural tension where the people that we lend to aren't desperate. 484 00:47:44,000 --> 00:47:49,000 I don't need to pay bloody 10, 11, 12 percent. Right. That's not our target strategy. 485 00:47:49,000 --> 00:47:55,000 If I went to a private equity house looking to do a buyout and said, oh, here's a term sheet, 10 percent margin, they'd laugh us out of the room. 486 00:47:55,000 --> 00:47:58,000 You've got to be reasonably tight to where the banks are priced. 487 00:47:58,000 --> 00:48:04,000 And so we can't just by market dynamics, supply and demand, go and charge a fortune for these loans. 488 00:48:04,000 --> 00:48:12,000 Not that we want to, because if we are lending at those rates, it means the companies probably are desperate and we're targeting the wrong stuff. 489 00:48:12,000 --> 00:48:17,000 Yeah. Well, we've seen the exact same thing happen with Phaser and, you know, the advisor space in the industry. 490 00:48:17,000 --> 00:48:25,000 It's all about making sure that the advisor or the money managers interests are completely aligned with the client. 491 00:48:25,000 --> 00:48:28,000 You know, 20 years ago, that really wasn't the case. 492 00:48:28,000 --> 00:48:31,000 But it's a really good thing what happened with Phaser and also in the banking regulation. 493 00:48:31,000 --> 00:48:33,000 So it's really good to see that. See that. 494 00:48:33,000 --> 00:48:38,000 So if our listeners want to learn more about Epsilon and yourself, how do they find you? 495 00:48:38,000 --> 00:48:46,000 Yeah, we're at www.epsilon.dl.com.au. You can give me a call at any point as well. 496 00:48:46,000 --> 00:48:49,000 Our contact details are on our website. We're all on LinkedIn. 497 00:48:49,000 --> 00:48:53,000 We're trying to do a reasonable job of getting our names out there. Murdoch. 498 00:48:53,000 --> 00:48:58,000 We're on Macrap. We're on NetWealth. We're on PowerApp or Premium. 499 00:48:58,000 --> 00:49:04,000 So we're on a bunch of the platforms. So, yeah, we hope to hear from people. 500 00:49:04,000 --> 00:49:10,000 And any final thoughts you want to leave us with? 501 00:49:10,000 --> 00:49:18,000 Just probably just to reiterate that we believe that whilst, you know, 502 00:49:18,000 --> 00:49:26,000 we recognise that whilst there are, you know, there's commentary out there suggesting that credit might be a tough place to invest right now 503 00:49:26,000 --> 00:49:35,000 because the majority of the market probably is over-levered and there's potential for duration, you know, based issues, 504 00:49:35,000 --> 00:49:41,000 playing out, default-based issues. Within the mid-market in Australia, which is a deep and stable market, 505 00:49:41,000 --> 00:49:48,000 there's a tremendous investment opportunity right now. And we think we're really positioned quite well to act upon that opportunity 506 00:49:48,000 --> 00:49:51,000 and deliver great outcomes to investors. 507 00:49:51,000 --> 00:49:54,000 Excellent, Joe. Well, thank you very much for joining us on The Rate of Change. 508 00:49:54,000 --> 00:49:56,000 And I hope you have a cracking weekend. 509 00:49:56,000 --> 00:50:18,000 Thanks for having me, Murdo. 510 00:50:18,000 --> 00:50:24,000 Any views expressed in this recording do not represent the view of any other third party and other sole personal opinions of the Speaker. 511 00:50:24,000 --> 00:50:28,000 Any reference to financial product does not constitute advice or recommendation. 512 00:50:28,000 --> 00:50:32,000 And before any action, you should seek proper advice from your financial professional. 513 00:50:32,000 --> 00:50:58,000 Australian listeners should head to www.moneysmart.gov.au to find more information on the matter.