Hi, I'm Murdoch Gaddi and thanks for listening to the Rate of Change with York Wealth Management.
Hi, I'm Murdoch Gaddi and welcome back to the Rate of Change.
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.
In today's Rockcast, I'm speaking with Joe Milwood, a founding partner and portfolio manager for Epsilon Direct Lending.
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.
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.
Epsilon targets an income return of 8.5% and as of 31 August, the monthly return was 86 basis points.
The fund has a 90-day duration, current liquidity is at 20 months and according to Moody's, the credit rating is double B.
I think you will really enjoy the discussion with Joe.
You may find his thoughts on lending for growth purposes and how this differs to other private credit lending very insightful.
If you like what you hear, please reach out to me with your thoughts and questions at mgaddy at ywm.com.au.
Before considering any investments, we encourage you to both listen to the disclaimer at the end of the Rockcast and seek professional advice.
We would like to reiterate that this Rockcast isn't designed nor is it intended to be specific advice.
I hope you enjoy the discussion with Joe as much as I did.
Joe Millwood, welcome to The Rate of Change.
Thanks for having me, Modo.
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.
All right. So first of all, I've got to declare I'm English, I'm a POM.
I've been in the country for about 12 years.
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.
And I thought that was super cool that he was actually flying back from a foreign country.
I thought, wow, finance must be the place to be.
That's where I got my passion for finance very early on. It's just through school and career mentors and so on.
I got into banking in the UK, pivoted into funds management.
So I ran about a three billion euro private credit fund through the GFC 08, 09.
I decided to start a family in Australia.
So that's when I moved here about 12 years ago to start a family, to start a new life and never looked back.
I worked at a bank for a number of years upon arriving here.
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.
And I'm happy to kind of unpack that a little bit more.
But yeah, two fellows in Melbourne, Mick Wright Smith and Paul Nagy decided to join me and start Epsilon.
And we did it as a number of reasons, but primarily it was a customer led thing.
We weren't giving our customers the outcomes that they had from us and that they expected from us in the past.
And so we left to give them what they wanted, which is a great service, speed, certainty, flexibility and supporting their growth aspirations.
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?
I don't know if you can say like specifically what bank was that and what were you actually doing for that bank?
Yeah, sure, sure. So I mean, you know, I think what I've talked through is probably generic to banks.
And where were we? We were in the mid-market division of the bank that we worked out as Commonwealth Bank.
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.
So we worked in the mid-market part of the bank.
Banks are normally structured along the lines of an institutional team, a business or private bank maybe, corporate lending, SME lending,
and then your retail division and maybe other bits and pieces that are bolted on.
But it's normally kind of three tiers of service that are provided to corporate Australia.
And we're in the medium sized business part of it.
So I think customers, businesses that have turnover between $25 million and $500 million, that kind of size.
And normally the lending book is split 50-50 between real estate development, investment lending,
and then going concern lending to companies that produce something or provide some kind of service.
They're the dividing lines. And so we ran the corporate finance team at the Commonwealth Bank.
What we did was support customers with more complex lending transactions, normally involving some kind of event like a merger and acquisition,
expansionary capex, management buyout by private equity group, stuff where there's a bit more complexity to it.
But importantly, and this leads on to answer your question Murdoch, when you're undertaking these kind of events,
they're normally quite time sensitive.
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.
It's not like you could just drag these things on.
There are normally deposits paid that are non-refundable.
There's normally pretty strict timelines. And if they drag on, you know, the advisory, illegal bills, they start building up.
So when you're borrowing in order to support an acquisition, you need financing certainty.
You need to know that if somebody says they're going to be good for it, that they're actually good for it.
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
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.
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.
And the credit department comes along at the last minute and changes their mind.
Or maybe the credit person that supported the idea in the first place goes on holiday.
Someone else comes in and they don't like it and you're stuffed.
Relationship managers, credit people come and go, so there's no kind of longevity and continuity of relationship at times.
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,
the certainty of financing and the flexibility and responsibility that you need in order to act on the opportunity.
And so when you're in a fund, you can do that because you're the decision maker.
The business owners are normally the investment committee within a fund.
And you can make the decisions that lead to the better outcomes for the customers a lot quicker, provide more certainty.
So many questions there, Arne Park. I really want to hit on the regulatory side because I'm hearing as well.
We just spoke to a hotel group the other day and they were saying the exact same thing as in it was quite frustrating
that some of their clients go through all this work only for right at the end then to go,
we have to do the process again or instead of we're needing a particular amount, we need to double that.
And they're like, we just did this. We need to do done.
So the other question I had from that is how does the Australian space and regulatory environment compare to offshore?
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?
How does it look?
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.
If you look at the US leveraged loan market, M&A financing market right now, 90% of funding is provided by non-banks.
So the market's completely transitioned, whereas 20 years ago would have been about 10%, 90% banks.
And Australia's at the start of that journey. So why is it that we're lagging so much?
And it's not that the regulatory regimes are materially different.
It's largely because Australia didn't really have a GFC.
It's a very mild version of the pain that was suffered offshore.
We had defaults, insolvency events were far greater in the US and in Europe.
And so the regulators went pretty hard on the banks in those markets and the regulators didn't go as bad as hard here.
And the banks were a lot more conservative in Australia relative to offshore.
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,
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,
which meant that the barriers to entry remain quite high for non-banks to come into this market.
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.
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.
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,
the reason for the transition away from banks to non-banks.
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.
APRA prefers banks to lend against real assets and they afford them greater or lower cost of capital when they do so.
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.
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,
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.
And so we didn't find that it was the capital charge that was causing us to lose deals.
What caused us to lose deals is the stuff that I've already discussed.
And so what is it that drives the kind of lethargy in decision making?
What is it that drives the lack of focus on supporting M&A financing within banks?
There's a couple of things and they're tied together.
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.
You're dealing with a thousand staff, you know, more, right?
And all of them are meant to do the same job, deliver a standardised home loan, deliver a standardised overdraft product.
And so if banks want to scale and improve their cost income ratio, which is a massive focus, and deliver to the masses,
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?
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.
So that's the first thing.
The other thing is that banks are pushing towards automated decisioning.
So it happens today.
You need a $10,000 credit card, you key your details in, you get a decision back very quickly.
That's not a human making that decision.
And when I was at the bank, they're pushing towards automating decisioning of $1 million business loans.
So when certain conditions are met, if you can automate decisioning, you can standardise products a lot more efficiently,
come back to the first point and lower your cost to serve customers.
So all of a sudden, you're kind of ticking a lot of boxes.
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,
all those transactions are very different. The loan documentation is customised for that particular deal.
It's not just an off the shelf agreement that you can take. So you can't really automate decisioning.
They're the two main drivers. The regulatory capital thing is a bit of a red herring.
So let's actually translate that and get into the actual detail of the fund.
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.
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,
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.
Yeah, sure, sure. So it's an Australian unregistered managed investment scheme to pulse our lonely investors through a unit trust structure.
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.
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.
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.
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.
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.
This causes a bunch of volatility linked to duration. We are whole to maturity investors. The fund is 15 months old.
It's currently largely fully ramped up. So we had fully paid up capital on our first close. It is now deployed.
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.
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.
The loan portfolio is double B in terms of credit risk. So it's kind of on the cusp investment grade.
Some loans are one of them actually is triple B minus and all loans are senior secured.
The types of loans in the portfolio, what we focus on at Epsilon is sustainable, predictable cash flow lending.
So we look at the sustainability and predictability of the EBITDA or the earnings that a company makes and we lend against that.
We take a view on what could cause that number to bounce around. That's our kind of risk analysis. We heavily focus on.
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.
So right now in the portfolio, 100 percent of exposure is to non cyclical industry. So we're lending to two health care companies.
One's a medical devices business. The other one is a services provider in the medical field.
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.
We've got a fixed wireless telco business in the portfolio.
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.
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.
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.
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?
Yeah, sure. So one business I didn't just mention is one of the largest coffee roasters in Australia.
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.
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
that he's reporting into in a vertical structure. He wanted to slowly exit from the business.
He was looking for a partner that could help him transition on a staged basis.
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.
And when Livable Partners decided to buy the business, a valuation was struck between the willing buyer and seller.
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.
So that's buy out financing by private equity group. That's an example of the type of lending that we do.
A couple of other snippets of examples. We've recently provided a loan to a listed company called Somnamed. It's on the ASX.
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.
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.
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.
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.
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.
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?
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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?
You know, how do you create a default unless there's an actual insolvency or bankruptcy event where the companies run out of money?
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.
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?
You've seen share prices, P multiples blow out. You've seen property prices blow out. Okay, all that stuff has played out.
What we haven't witnessed though, in the middle market in corporate Australia, is the purchase prices of businesses have barely gone up.
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.
That's about the average, you know, seven and a half times EBITDA is the typical purchase price multiple. That's not changed.
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.
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.
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.
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.
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.
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.
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.
So 19 percent LVR in kind of property talk is really conservative.
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.
On net debt to EBITDA ratio on a weighted average basis in the book is one point three times.
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,
maybe the gross margins and the net margins will come under pressure, you know, as tight labor markets cause wage prices to inflate.
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.
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.
Because I'm hearing there's what? 50 percent of companies in the market right now potentially trading a zombie company.
Something nuts like that. Like, it's just, you know, but of course, you know, nothing happens in a straight line.
There's a lot of people out there saying, Mockleberry got it right. You know, he called it how many months ago?
This needs to all come off. But at the end of the day, there's no such thing as a straight line.
I think we saw you see some of the biggest bear car bounces, you know, on the way down.
Right. I think I heard the other day from another gentleman saying it's going to be a three stage affair.
Thirty five percent down, 20 percent rally, which has just occurred.
I think it's all being driven by the Fed. Right. You know, the Fed talks and, you know, butterfly flaps his wings.
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.
So what are your thoughts around that?
Is there opportunities in this or is it best selling just to steer clear of or and how will that impact you?
Yeah, sure. I'll give the crystal ball a go.
The crystal ball.
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.
So I'll throw it out there.
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.
What do you need to cause a default to occur?
First of all, you've got those documentary triggers that are kind of called soft defaults, a covenant breach.
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.
There's a bunch of early negotiation normally happens at this point in the cycle.
But all these businesses that have covenants and strong protection.
So that kind of early intervention that you'd normally see won't play out to the magnitude we've seen historically.
So what I think will occur is you'll have a stronger and harsher wave of real defaults, monetary defaults that will occur.
And when you have a monetary default, effectively the company can't afford to pay its liabilities they ford you.
It's failure to pay interest or principal.
So why would they fail to pay interest?
Well, here's why.
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.
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.
OK, so you think, well, is that good? Right.
Two and a half times. It's quite a big number, right?
That doesn't include any repayment of the debt.
First of all, that's just paying the interest.
And then let's unpack that further.
That two and a half times was done at a time when the rates were zero.
You know, the swap, the BBSW or the US LIBOR, whatever reference rate is used, was zero.
OK, so let's make that three percent, which is the current six month swap.
Then all of a sudden, what's that two and a half go to?
It kind of goes to two, maybe one point eight.
And then you say, OK, what EBITDA, what earnings number was used?
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,
dreamt up by a bunch of private equity and investment bankers to act as a bad proxy for cash,
it's further from the truth that it's ever been, it's further from real cash than it's ever been.
And so when you pay interest, that's real cash. EBITDA ain't real cash.
It's very far from real cash.
And so then you kind of got interest cover under current rate environments of maybe two times.
What's your real interest cover?
And the EBITDA number is at the highest, right?
You know, there's no inflationary issues fed into that EBITDA yet.
There's no recession issues fed into that EBITDA yet.
So what I think will happen is you'll have the wall of defaults occurring because companies can't pay the bloody interest bill.
And that's not happened before.
The last GFC was a lot less about monetary defaults.
It certainly was in some instances, but a lot more about a wave of covenant breaches and early intervention
and people scrambling to restructure loans proactively in most cases with private equity.
This time around, I think it will be a lot worse.
But here's the interesting kind of dynamic.
What people have the option to do, which you mentioned, is just turn them into a zombie company.
I don't need that interest. Let's capitalise it.
Let's do a debt for equity swap. Let's pretend there aren't any defaults.
OK, so you can structure your way through this.
You can sit on your hands and just hope that things come back, right, and not put a company into VA.
And as long as it's kind of breakeven before the interest is payable,
as long as it's generating positive cash flow before the interest bill is payable,
then you might be able to muddle through.
But I think you'll see a bunch of lenders say, no, we're not going to go for that.
You'll see a bunch of directors say, well, I'm not going to sit there and pretend that there isn't a problem.
I'll appoint an administrator.
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.
If that event occurs, will that have a material impact on the companies which you're lending to
since they are companies?
Another way of looking at it is, is there a drag net approach?
So there's a number of insurance companies in Japan, as an example, right?
Earthquake hits. They all sink because they're all the earthquake insurance.
But then you look closely, two of them don't actually do earthquake insurance.
So is it going to be a situation where all equities potentially come off and they will get hit and have impact?
How the deals have been structured internally, they're good companies, they're good loans, they should be fine.
Like how should investors think about it?
Yeah, here's the thing.
I think we get a lot of properties, great asset class.
Don't get me wrong.
You should always diversify and have that mix across your book, right?
But people do fall into the trap of saying, well, if there's not a real asset, then you're left with nothing, right?
Well, are you?
So who's going to provide all the services that you require in order to operate your business?
You know, IT help desks, cleaning companies, coffee roasting, dentists.
These are real operating businesses that have a need in society.
And in our space, where we lend to quite established businesses, normally a market leader or top three,
there's a real reason for that company to exist.
So what you're not going to see is just an overnight disappearance of all these businesses
because there is still demand, right?
The issue is the demand has gone down and the leverage is very, very high.
So there has to be a restructuring event, right?
The balance sheet is over levered.
And so I don't think what you'll see is just this disappearance of a whole bunch of companies, right?
You know, it's not like it's people say it's thin air when you lend to a company without property.
It's not thin air.
You know, society needs to function, right?
You know, I think we've seen a lot of the downstream impacts of society not functioning properly in recent times.
Yeah, shipping delays, right?
Toilet paper shortages, all these kind of crazy behavioral issues that can occur when people go to be in a state of panic.
I don't think you'll see that kind of level of disruption to the services being provided by these companies.
I think their balance sheets need to be restructured.
Now, does that have downstream impact?
Well, sure, because a whole bunch of people have allocated capital to these credit funds to lend the money.
So they're going to suffer losses.
So what happens?
The big public pension funds in the US, the insurers that are providing all this money.
I think there's a potential for a pretty meaningful write down.
So I think it pays right now to be cautious around allocating offshore, right?
Some managers will do it tremendously well because they're able to pivot, you know, become run a dislocation strategy.
Start doing distress lending, right?
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.
But I think there definitely will be a bunch of pain suffered as well.
Well, since we're on the crystal ball topic, where do you think interest rates are going to go?
This would be fun. Pick a number.
Oh, boy. What do I know?
I know that the six month swap is currently 3.1 percent.
I think I think last week's commentary at the Fed was was fascinating.
Like, you know, it's largely a statement being made that the put is gone.
Right. Don't rely on us anymore.
And so, you know, what are you left with?
You're left with what happens to inflation and then how to raise respond.
And I think inflation continues, then rates will continue to respond.
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,
but also systemically so we get a sense of where rates might go.
But, yeah, I'm terrible with a crystal ball at this.
Who knows if I if I if I had a real sense, I probably wouldn't be doing this job.
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.
But we're not overly worried at Epsilon about that.
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.
We normally lend on three year tenor three, four, five years.
Sometimes the average life in our loan portfolio is three point two years.
So we've got quite short credit duration.
So we're asking ourselves, where will rates go in the next three years?
Oh, and by the way, a chunk of that floating rate exposure we're hedging right now today anyway.
So we know what the interest cost is for our borrowers.
Our borrowers know how much cash they need to set aside in order to pay the interest bill in the future.
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,
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.
Right now, our sensitized ICR cover is about six times earnings.
So we've got a real strong buffer there and that's real earnings.
It's not the made up stuff.
So we're pretty comfortable with where we're at.
The bigger underlying concern is if rates do blow up, what does that do to consumer discretionary?
Yeah, what does that do to disposable income?
And that's a focus because we believe that all businesses suffer if consumer discretionary go down.
But we're trying to insulate by focusing more on businesses that aren't directly exposed to it by going for the non-cyclicals.
Can you talk more about you said that you're hedging it out for three years, but it's a shorter period.
And you also mentioned about is it quarterly?
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?
That's eight and a half percent, you know, average past 12 months, you know, for the next 12 months.
Right. You know, say rates do rise.
Will they benefit in that upward lift?
And exactly how does that work?
Yeah, they benefit.
Yes, a pretty good inflation hedge investing inflating rate debt with an interest duration of ours.
So we've got a 90 day interest duration. So let me clarify what I was talking about with the hedge.
We pay investors the 90 day swap plus the net interest margin and the fees that we earn in the portfolio.
Everything's passed through to our investors after our management fees.
And so our borrowers are paying us that floating rate.
But what they do behind the scenes with, you know, an investment bank is swap that floating rate for a six-frag exposure.
So they're paying us floating, but their cash flow is fixed.
OK, so they swap that floating rate cost for the fixed rate cost with the investment bank.
That floating rate is paid to the investors in the fund and our rates are reset on a quarterly basis.
So we've just, you know, our loans are documented such that the interest rollovers occur, that rate reset occurs at each quarter end.
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.
That kind of the bid and that's the rate that our borrowers are paying.
And that's what will then pass on at the end of that quarter when our borrower pays us that interest bill.
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?
No, no, we're lending. Yeah, we're actively pursuing opportunities right now.
How many would you say that you look at before you actually go, we want to lend to a company?
Well, do you know what the good thing about our market is?
And, you know, this is not to not to kind of discount other strategies, but it's a deep market.
There are seven or 35,000 businesses within our target market, the mid market in going concern Australia.
Thirty five thousand operating businesses is the engine room of the Australian economy.
Largest employer in terms of the catchment size of businesses, largest contribution to GDP.
But it flies under the radar.
No one hears about it because it's not an ASX listed, you know, mega cap that gets in the AFR every single day.
This is the engine room of the economy.
And so we see a lot of deals.
This isn't a kind of niche strategy that only has capacity to get to 300, 400 million before the deals really dry out.
This isn't kind of special sits.
12, 15 percent target return lending, right? The real racy stuff.
This is vanilla lending. We're competing against the major banks.
Yes, CBA's corporate lending book is 50, 55 billion dollars in size.
Our component of that within the team that we used to run was about three billion dollars.
And so we think our total addressable market size, corporate lending Australia, is about a trillion dollars in total.
So that's all loans to companies in Australia, including real estate, including, you know,
real generic overdrafts and working capital facilities, all that kind of stuff.
Trillion dollars. We think our market is about seven percent of that or 70 billion dollars.
So it's a bloody deep market to go for.
In the last 15 months, we've seen 172 lending opportunities for the total value of about five point seven billion dollars.
And we've invested 80 million.
Gives you a sense of how selective we are. Now, we would have done more capital was a constraint,
but we certainly wouldn't have done five point seven billion.
Normally, we'd kind of convert one in 10, one in 15 opportunities into those opportunities into a loan.
So right now we've got a dozen or so opportunities on the desk.
We'll probably fund one or two of those with the capital that we've got right now.
Deal flow isn't the issue. Capital is the issue.
The banks have this market corner because they've got a bottomless pit of capital to put to work.
So, you know, I talked earlier about our value proposition and why people would borrow from Epsilon.
We charge more than a bank would.
So people are willing to pay a bit more on the interest rate.
It's only kind of two percent more or so than the banks charge,
but they're willing to pay more for the service and the certainty that we provide.
And the fact that we're a known quantity as an investment team with the decision makers.
But there are borrowers out there that don't care about the service issues
or might have a cracking relationship manager that delivers a good service and they get a better price.
So, you know, there is there's competitive dynamics at play in the market.
But we see, you know, we think a bloody good share of the market in order to maintain a high level of selectivity.
And yes, we are actively deploying right now.
Well, let's talk about risks then as well.
One thing I've seen, this is just being an adviser dealing with a number of companies, lenders, COVID, all these types of situations.
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.
Right. So essentially, for listeners out there, if you hold cash was not being lent out, you're not making any money.
Put simply, right. So if an event occurs or something does occur, do you see risks that not deploying capital?
Because there might not be a couple of opportunities around. You might have to work for 12 months.
Is that or do you just deal is happening? Yeah, man, this deal is happening.
So this is genuinely one of the great features of our target market is that it is an all weather strategy.
Deals don't dry up. What happens when vows come off? Private equity is still sitting on a ton of dry powder.
So there might be the processes might be a bit longer.
It might be more difficult to get willing sellers across the line because they're used to the, you know,
my mate told me my business was worth five times revenue last year type commentary.
So you've got to get their head around that.
But the M&A volumes are pretty stable in Australia.
Like you don't get to a point at which, you know, that 70 billion dries up to become 10 billion.
It's just never happened. If you look at the long term trend, both domestically, which didn't really suffer a GFC,
but even offshore through the European and US recessions, you can see that the M&A volumes didn't ever just completely disappear.
Fewer and far, far between. But within the mid market tends to be insulated for the reasons I explained earlier.
Asset prices have actually been quite stable through the long term. So it's not a much of a bid offer through downturns.
And there's still a lot of dry powder on the sidelines. Opportunistic buyers come out the woodwork.
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.
And so, yeah, we don't see things dry up. We're pretty stable in terms of deal flow.
Like in our sleep, we would put, you know, $250, $300 million a year of lending out the door.
That's kind of without really trying in a constrained banking environment.
So, you know, cash drag, yes, it's something that we focus on very heavily.
We've got through that initial ramp up period that our investors knew about.
We've now put in place a working capital facility, a small one in the fund, to manage that as well.
So we can minimize cash drag by utilizing the working capital facility. It's not core leverage.
It's kind of, you know, capped at about 15 percent of NAV.
So we're not intending to just have it sat there acting as leverage.
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.
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.
Right. Because we find behaviorally how anyone's remunerated essentially dictates how they think about investment opportunities.
So how are you remunerated in the fund? And like as an example, if I don't know, you're one percent behind target.
Does that does that impact? Would you look at a deal that you normally wouldn't look at because you're behind?
Or how does that work? You just avoid it completely because, you know, there's a particular process.
No, we spent so much time debating this when we set up the business, Murdoch.
What we knew is that we hated the bank remuneration model, which was you get a reasonable salary,
you get a bonus for earning a certain amount of revenue that year for the bank.
And if that customer goes bust three years later, there's no impact to you.
We hated that lack of alignment of interest. When we set up Epsilon, everything was about how do we create a sustainable business model,
but with true alignment of interest. The outcomes of both our investors and the companies that borrow from us.
Because two things are true, right? If you screw an investor, you're out of business.
And if a bunch of borrowers that you lend to go out of business, you're out of business.
So we had to avoid those things, whilst balancing the fact that we want to create a great business as well.
And so the way we structured the way that we get paid as a manager is 50-50.
Half of our income as a business is through management fees. And that basically pays the fixed costs.
If you go through diligence with us, you'll see very modest salaries for the three founders of the business,
reasonable salaries for the investment team, and then keeping the lights on stuff.
So that kind of pays the bills, the management fee. Our management fee is 75 bits of NAV.
And then the upside for us is the performance fee, which roughly equates if we hit our target return to the other 50%.
So it comes out slightly lower than 75, about 65 basis points we earn if we deliver to target return.
The way that fee is designed is it's an excess spread type calculation.
So there's no kind of catch up in the performance fee. It's only money that we earn above our hurdle.
Our hurdle is the swap plus 325 basis points. So as the swap rate moves up, our target return moves up.
We're not kind of gaming the spread here in the floating rate component, which some others might be.
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.
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,
because the average life of our loans are three years.
So we wanted to demonstrate to investors that we're not in this to try and rip a bunch of money out.
We're in this for the long run. We want to see our borrowers demonstrate an ability to repay the loans.
And only at that point will we start to take performance fees out. And our performance fees are based on total unit return.
So if there's volatility in the NAV price because we screw up and we have to impair a loan,
which, by the way, we've built a lot of independence into in terms of valuations, then our performance fee will get wiped out.
So we're highly incentivised to focus on this being a return of capital strategy, not return on capital.
We can't afford to lose a dollar. We don't intend to take risk and lose a dollar.
And the obvious question, which I know you're just about to ask, is what stops you trying to get, you know,
a 10 percent return to rip a load of money out of the performance fee?
And the beautiful thing about our market is that there's this natural tension where the people that we lend to aren't desperate.
I don't need to pay bloody 10, 11, 12 percent. Right. That's not our target strategy.
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.
You've got to be reasonably tight to where the banks are priced.
And so we can't just by market dynamics, supply and demand, go and charge a fortune for these loans.
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.
Yeah. Well, we've seen the exact same thing happen with Phaser and, you know, the advisor space in the industry.
It's all about making sure that the advisor or the money managers interests are completely aligned with the client.
You know, 20 years ago, that really wasn't the case.
But it's a really good thing what happened with Phaser and also in the banking regulation.
So it's really good to see that. See that.
So if our listeners want to learn more about Epsilon and yourself, how do they find you?
Yeah, we're at www.epsilon.dl.com.au. You can give me a call at any point as well.
Our contact details are on our website. We're all on LinkedIn.
We're trying to do a reasonable job of getting our names out there. Murdoch.
We're on Macrap. We're on NetWealth. We're on PowerApp or Premium.
So we're on a bunch of the platforms. So, yeah, we hope to hear from people.
And any final thoughts you want to leave us with?
Just probably just to reiterate that we believe that whilst, you know,
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
because the majority of the market probably is over-levered and there's potential for duration, you know, based issues,
playing out, default-based issues. Within the mid-market in Australia, which is a deep and stable market,
there's a tremendous investment opportunity right now. And we think we're really positioned quite well to act upon that opportunity
and deliver great outcomes to investors.
Excellent, Joe. Well, thank you very much for joining us on The Rate of Change.
And I hope you have a cracking weekend.
Thanks for having me, Murdo.
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