Private Credit SDCERA Board of Retirement Meeting November 21, 2013 Lee Partridge, CFA Bill Enszer November 2013
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Private Credit Discussion Summary Macro Drivers of Growth Asset Classes Valuations and Returns Public Equities and Public Credit What is Private Credit? Definition Opportunity set Examples Risks Private Credit Portfolio Overview Portfolio fit and objectives Implementation plan Integrity Capital, LLC 2013 3
Gross Public Debt/GDP (13 Largest Economies) Many sources of returns look to be operating in a low return/ new normal world Countries with 90% or greater public debt-to-gdp tend to experience about half the GDP growth compared to those with 30% or less (~4% vs ~2% annual growth) 1 Global Weight 2013 IMF Estimated GDP (Billions USD) Country 2012 2013 22.8% 16,724 United States 103% 106% 107% 107% 106% 106% 106% 12.2% 8,939 China 26% 23% 21% 19% 18% 16% 13% 6.8% 5,007 Japan 238% 244% 242% 242% 242% 241% 241% 4.9% 3,593 Germany 82% 80% 78% 75% 72% 70% 68% 3.7% 2,739 France 90% 93% 95% 95% 94% 92% 89% 3.4% 2,490 United Kingdom 89% 92% 95% 98% 99% 98% 97% 3.0% 2,190 Brazil 68% 68% 69% 69% 68% 68% 67% 2.9% 2,118 Russia 12% 14% 15% 15% 15% 15% 15% 2.8% 2,068 Italy 127% 132% 133% 132% 129% 126% 123% 2.5% 1,825 Canada 85% 87% 86% 85% 84% 83% 82% 2.4% 1,758 India 67% 67% 68% 68% 67% 67% 67% 2.0% 1,488 Australia 28% 29% 29% 28% 27% 25% 22% 1.8% 1,356 Spain 86% 94% 99% 103% 105% 105% 105% 71.2% $ 52,296 Top 13 100.0% $ 73,455 World IMF Estimates 2014 2015 2016 2017 2018 For illustrative purposes only 1 Reinhart, Carmen, and Kenneth Rogoff. Errata: Growth in a Time of Debt. May 5, 2013 Table Data Source: IMF 4
Cyclically Adjusted P/E ratio (CAPE) Rolling 10 Yr Returns 25% When PE ratios increase, subsequent 10 year equity returns have historically tended to decrease 25% 20% 13% 15% 6% 10% 5% 3% 2% Cyclically Adjusted Earnings Yield (LHS) Forward 10 Yr Returns (RHS) Forecasted 10 Yr Returns (RHS) 10 Yr Treasury Yield (RHS) 1904 1909 1914 1919 1924 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 For illustrative purposes only. Past performance is not indicative of future results Data Source: Yale Department of Economics Website, 2013 Data used from January 1900 October 2003 rolling 10 year returns based on monthly observations 0% -5% -10% 5
Cyclically Adjusted Earnings Yield Rolling 10 Yr Returns 25% Forward Looking 10 Year Returns (S&P 500 TR) 20% 15% 10% 5% 0% -5% -10% 0% 5% 10% 15% 20% 25% Cyclically Adjusted Earnings Yield For illustrative purposes only. Past performance is not indicative of future results Data Source: Yale Department of Economics Website, 2013 Data used from January 1881 October 2003 rolling 10 year returns based on monthly observations 6
10 Year Forward Looking Equity Returns Since January 1881 Cyclically Adjusted Earnings Yield Cyclically Adjusted P/E Average Realized 10-Yr Worst Realized 10-Yr Best Realized 10-Yr Decile Low High Low High Return Return Return 1 2.3% 4.4% 22.5 44.2 3.5% -4.0% 10.2% 2 4.4% 5.0% 19.9 22.5 6.3% -2.6% 12.0% 3 5.0% 5.5% 18.1 19.9 7.5% -1.1% 15.0% 4 5.5% 5.9% 16.8 18.1 8.4% 0.0% 18.5% 5 5.9% 6.5% 15.4 16.8 8.9% 1.5% 19.0% 6 6.5% 7.2% 13.9 15.4 8.5% 0.7% 19.3% 7 7.2% 8.2% 12.1 13.9 9.9% 2.6% 17.7% 8 8.2% 9.2% 10.8 12.1 12.7% 4.3% 18.9% 9 9.2% 11.1% 9.0 10.8 14.0% 3.3% 21.2% 10 11.1% 20.9% 4.8 9.0 13.1% -0.3% 19.6% Current Cyclically Adjusted Earnings Yield: 4.1% Current CAPE: 24.4 For illustrative purposes only. Past performance is not indicative of future results Data Source: Yale Department of Economics Website, 2013 Data used from January 1881 October 2003 rolling 10 year returns based on monthly observations 7
Public Credit Public bond market yields have recovered to pre-crisis levels Private credit (ABX AAA CDSI s6-2) has recovered, but not to the same degree as public markets 22.5% 20.0% 17.5% 15.0% CSFB High Yield Index II BAML US Corporate Master 120 100 80 Yield 12.5% 10.0% Index Value 60 7.5% 5.0% 2.5% 40 20 CSFB High Yield Index II ABX AAA CDSI S6-2 0.0% 1997 2000 2003 2006 2009 2012 0 Oct-06 Feb-08 Jul-09 Nov-10 Apr-12 Aug-13 Dec-14 For illustrative purposes only Source: FRED Economic Data, St. Louis Fed, & Bloomberg, www.markit.com. CSFB High Yield Index II Yield-to-Worst and Price Index and BAML US Corporate Master Effective Yield, 2013 The ABX AAA CDSI s6-2 is one of the vintages of the Markit ABX Index, which is The Markit ABX index is a synthetic tradable index referencing a basket of 20 subprime mortgage-backed securities. 8
Private Credit Overview What is Private Credit? Provides credit outside of traditional financing channels (i.e. Banks) Serves as a mechanism for cleaning up debt in non-performing and/or distressed situations Returns driven by Yield component Complexity Illiquidity Asset discounts Integrity Capital, LLC 2013 9
Private Credit Overview Potential Opportunity The 2008 financial crisis caused substantial regulatory change, contraction of securitization and a fundamental shift in banking Secular and cyclical change drive opportunities by creating supply/demand imbalances Regulatory (i.e. Basel III) Higher capital requirements and increased liquidity requirements reducing the supply of private credit capital from banks European banks have not delevered as much as US banks, implying future asset sale opportunities Asset-backed securities and collateralized loan obligation (CLO) issuance remains low compared to pre-2008 highs Increased demand for liquidity provides potential opportunities for higher returns in more illiquid and less followed issuers Integrity Capital, LLC 2013 10
Private Debt Universe Private Lending Middle Market Lending Mezzanine Unitranche SBIC Real Estate Whole Loans Structured Credit Asset Backed NPLs CLOs/CDOs Bank Trust Preferreds TARP Preferreds CMO, Pass-Thrus, CDOs Aircraft Trade Claims Receivables Pharma/Energy/Music Royalties Loan to Own Strategies Restructurings Non Performing Assets Shipping Railcar/Aircraft VPPs Mortgage Servicing Rights Ag Working Capital Loans Opportunistic Managers Event Driven Rescue Financing DIP Loans Liquidations Bank Capital Integrity Capital, LLC 2013 11
Private Credit Examples Direct Lending Background Pre-2008, banks began to pull back from traditional lending in middle market space Specialty finance (CIT, GE) and CLOs filled in the void by supplying loans to this space Opportunity Hire funds that will provide loans to middle market companies Coupon/Cash Flow Spread above levered loans Floating Rate Prudent use of leverage Loan Spread Today Specialty Finance and CLO are limited Regulation makes it expensive to hold loans on balance sheet The result is a lack of financing to middle market and lower middle market companies For illustrative purposes only Chart Source: Hewitt Ennis Knupp Data Source: S&P CLO collateralize loan obligation 12
Private Credit Examples Regulatory Capital Relief Background Rating and yield sensitive investors drove the demand for synthetic CDOs (CSOs) Profitable business for banks Created portfolios of legacy risks on balance sheets Opportunity Opportunity to provide capital relief through complex structure: Insurance on a portion of the portfolio of assets Yield on portion of the portfolio Today Synthetic CDO business is largely extinct Portfolios of legacy risk on balance sheets are hedged, but capital intensive Under Basel III, banks must hold significantly more capital against these portfolios Through Q3 2013 Total For illustrative purposes only Integrity Capital, LLC 2013 Synthetic CDO Collateralized Debt Obligation comprised of underlying CDS (credit default swap) contracts 13
Private Credit Examples Distressed Corporate Background Increased issuance of lower rated securities often leads to periods of high default rates Opportunity Higher default rates indicate an increased amount of financially stressed businesses Opportunities arise to finance and restructure these businesses at higher rates of return with strict covenants in place Distressed opportunities can be attractive to those with the expertise and resources to unlock value Today Capital needs to be ready to take advantage of the next cycle of defaults Opportunities exist now to take advantage of the lack of capital supply to small and middle market companies who might have difficulty refinancing existing debt For illustrative purposes only Source: JPMorgan and Apollo. Lower-rated issuance includes bonds rated Split B or lower. 14
Private Credit Examples Non Performing Loans (NPLs) Background European NPL market estimated to be 1.3T (~2-3x the size of the US market) 1 Due to regulation, banks will need to sell assets as there is not time to outgrow losses European banks still levered compared to US banks Today Pressure on European Banks to sell NPLs Basel III makes holding NPLs cost-prohibitive Bank capital has grown signifcantly since 2009, making charge-offs more palatable Very little in-house expertise to work-out No income generation Opportunity Buy diversified pool of loans at distressed prices Requires expertise and resources to service and work-out loans Integrity Capital, LLC 2013 1 Price Waterhouse Coopers (7/2012) 15
Potential Risks of Private Credit Market Risk: beta to the credit markets Distressed Investment Strategy Companies may be levered with limited cash flow Risk of default or credit impairment Potential for Headline Risk Non-US Investments Subject to international law and regulations Illiquidity There are no secondary markets for some private credit markets (i.e. direct lending) Integrity Capital, LLC 2013 16
Private Credit Portfolio Fit & Objectives Credit Outperforms During Certain Periods of the Business Cycle Low growth environments favor Credit s superior position in the capital structure especially true after deleveraging Credit dominated equity during the last major deleveraging of the late 30 s and uncertainty of the early 40 s For illustrative purposes only. Past performance is not indicative of future results Source: St. Louis Fed, Ken French, 2012 17
Private Credit Portfolio Fit & Objectives Low but positive growth has traditionally been a better environment for credit vs. equities We believe the dearth of financing in the global economy will provide outsized returns to non-traditional sources of capital similar to other cycles Potential investment opportunities will be considered based upon an evaluation of several key issues Fees and cost of implementation Transparency and control Return potential Degree of difficulty complexity of the opportunity Potential for low double digit net returns Lower fees (based on invested capital), higher hurdles and less J-Curve effect vs. Private Equity Classified as opportunistic within the current IPS Integrity Capital, LLC 2013 18
Portfolio Structure Core/Satellite Investment Approach Core manager(s) to opportunistically allocate capital and access multiple opportunities Compliment core with targeted allocations to specific opportunities Lower overall cost of implementation through coinvestment and secondary purchases Integrity Capital, LLC 2013 19
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