The Case for Australian Private Debt

The Case for Australian Private Debt Whitepaper prepared for Connexus February 2017

2 The Case for Australian Private Debt Contents 1. Executive Summary... 3 2. What is Australia Private Debt (Senior Secured Loans)?... 4 3. The Case for Australian Private Debt... 5 4. Does it make sense for investors to allocate capital to Australian loans?... 7 Disclaimer... 10

3 Executive Summary In this paper we seek to lay out an argument for why an allocation to Australian private debt (senior secured loans) is a compelling opportunity. Specifically, why is Australian private debt compelling at this point in the economic cycle given the current macroeconomic outlook and how does it stack up in a portfolio context relative to other asset classes. The strong returns of global equity markets fuelled by central bank liquidity over the past 5-6 years coupled with the market volatility in Q1 2016, has raised investor concerns over what the next three to five years of equity returns might look like. This is compounded by the fact that extremely low interest rates has meant there are not many defensive investment alternatives that offer a positive real return after inflation and tax in the current environment. These above points make a strong argument for an allocation to Australian private debt in the current environment and have led to a significant relative value opportunity in the space compared to other defensive assets both domestically and globally. Take for example an investment into high grade (A or AA) Australian Corporate bonds, which offer on average (itraxx) a total return of roughly 3.00% 3.50% as of February 2017. In comparison, for a moderate increase in risk profile an investment into AUS private debt (senior only) currently offers a return of 2.5-3.0 times greater with total returns in the range of 7.00 9.00% on an IRR basis (gross) and 6.50% - 7.50% on an annualized running cash yield basis (gross). From a portfolio perspective private debt / senior secured loans offer low correlation to equities as well as traditional fixed income. In addition, investors are higher up the capital structure with more protections than traditional bonds and certainly equity as well as gaining exposure to defensive industries, which can weather tough economic times (e.g. healthcare, essential business services, consumer goods, etc). History also shows that senior debt as an asset class fares well in times of economic slowdown. This is because while growth rates may be lower compared to history companies of good credit quality, a strong market position and a sound capital structure can continue to service interest payments to senior lenders. While many market pundits expect a low interest rate environment for some time to come rates will eventually rise again. The floating rate nature of Australian private debt means that investors don t have to worry about the risk of rising interest rates. It also means that there is some natural in-built protection against eventual inflation. In conclusion, we believe for a variety of reasons e.g. high relative income, no currency risk, defensive qualities, diversification, little to no interest rate risk and a degree of inflation protection that Australian private debt serves as an excellent portfolio addition.

4 What is Australian Private Debt? Australian private debt obligations are senior secured loans between a company, as the borrower, and a creditor. The creditors have historically been a group of lenders including banks and institutional investors (such as insurance companies and Super Funds). The loans are used to finance the general operations of companies, in addition to finance capital expenditure, mergers and acquisitions, leveraged buyouts and recapitalisations. The loans are called senior because of their position in the capital structure of the borrower, ranking ahead of all other creditors and equity. Lenders typically have the benefit of first ranking security over the assets of the borrower as well as a package of other protections, which further strengthens the position of the lenders recovering their money in the event of a possible default. The strong capital preservation mechanics (e.g. covenants, security and priority ranking) mean that senior secured loans have the highest recovery rate of any class of investment within the sub-investment grade space. Furthermore, unlike equities, the loans are structured so that the borrower pays a regular cash coupon to the lenders, with the loan being repayable at par. Senior secured loans are negotiated on a deal-by-deal basis between lenders and borrowers and are entered into through the execution of loan instruments. Loan instruments are negotiated specifically for each deal to address any particular risks identified in due diligence, with packages of maintenance covenants to control the borrower s behaviour, strong information rights and regular financial covenant testing to allow the lenders to closely monitor performance of the business and to take action quickly if necessary. Typical features include: Established borrowers with substantial existing businesses (no start-ups or venture capital); Credit spread agreed upfront to reflect the credit risk of the borrower; Final maturity of 3-7 years; Repayable at par and can be redeemed early (lenders typically repay after 3-4 years on average); Scheduled repayments during the life of the loan or bullet repayment at final maturity; Interest payable quarterly based on a credit spread (cash margin) paid over a short-term reference rate (e.g. 3 month Bank Bill Swap Rate, BBSW); Interest rate resets quarterly to reflect movements in interest rates; First ranking security over the assets of the borrower, along with guarantees and other credit enhancements; Repayment priority over all other unsecured creditors and equity; and Extensive package of maintenance covenants and undertakings designed to keep borrowers disciplined and protect lenders against credit deterioration. Example borrowers that have been in the local market include:

5 The Case for Australian Private Debt The Australian loan market has been dominated by a concentrated group of local and international bank lenders. As demonstrated in Figure 1, it is estimated that banks accounted for c.95% of the lending volume in Australia in 2013, compared to only 32% and 80% in the US and European markets. While institutional lenders have increased their share in Australia over the past several years the big four banks still dominate the market accounting for at least of 80% of the lending volume. Figure 1: Non-bank lenders in the Australian loan market These banks have been protected by a number of barriers to entry, including: Banks have extensive relationships with market participants, which are necessary to source and originate transactions; Local knowledge of the Australian loan market; The high fixed costs for a new entrant during the start-up phase; The significant levels of capital and time required to build a diversified portfolio; Overseas investors appetite for AUD-denominated assets; High level of expertise required to negotiate and tailor the bespoke loan documentation for each individual transaction in the private debt market; and Extensive due diligence to understand the business and its capital requirements, which consequently is often more time consuming than for investment grade investors who place significant reliance on the public rating. These barriers to entry have led to a more tightly held market than in the US or Europe. As a result, the Australian market has benefitted from more conservative loan structures, higher pricing and better credit discipline compared to equivalent overseas markets. Furthermore, the absence of fast money from hedge funds, excessive leverage or relaxation of credit standards means that the credit performance of Australian loans has remained strong and defaults low, even through the Global Financial Crisis ( GFC ). However, it is important to note that since the GFC, European banks have withdrawn to their home territories and sharply reduced lending capacity overseas. In addition, new regulations concerning capital rules for banks (e.g. Basel II and Basel III) have increased the risk-adjusted returns hurdle on bank capital, meaning that banks are lending less, and expect to be paid more when they do lend. Although there have been some new entrants

6 into the Australian loan market in recent years, notably the Asian banks, this has not been sufficient to replace the withdrawal of capital from the European banks. According to the Australian Private Equity and Venture Capital Association ( AVCAL ), the volume of private equity transactions increased from A$2.1bn in FY14 to A$3.3bn in both FY15 and FY16, reversing the downward trend post the GFC and signalling a pick-up in private equity activity going forward. ICG believes that as the global economy continues to recover and confidence returns, there will be further recovery in LBO deal volumes. Australian private equity funds continue to grow their available investment capacity and it is estimated by AVCAL that current dry powder for the region is c.a$6bn. Indeed, per AVCAL, private equity fundraising in Australia for FY16 was A$2.2bn, down slightly from FY15 (A$2.5bn) but significantly up on FY14 (A$0.9bn), and approaching the levels last seen four years ago when A$3.0bn was raised in FY12. Given the size of the market, combined with the withdrawal of European banks and increase in regulation, there is considerable opportunity for institutional investors - that is, non-bank lenders - to act in this market alongside the traditional lending banks. Indeed, over the past 18-24 months a number of institutional investors, such as insurance companies and Super Funds, have begun to embrace the market through experienced global private debt managers, such as ICG, who have overcome the barriers to entry by recruiting experienced local on-theground teams, allocating significant balance sheet funds and building seed portfolios. Furthermore, ICG believes that this disintermediation in Australia (where the banks are playing a lesser role in providing capital) will continue in the medium to long term as the gradual shift to a less bank-dependent model continues to evolve. From the borrowers perspective, the supply of capital for loans not only replenishes the loan supply. In fact, current information from Moody s suggests that non-bank lenders are perceived to be more attractive than traditional bank lenders partly because they have a greater degree of flexibility in their financing solutions. Meanwhile, from the banks perspective, institutional investors provide liquidity to the market without threatening the banks full service business models, including the provision of services such as investment banking, transactional banking etc. to the borrowers. Looking forward, ICG believes that the demand for new senior secured loans will increase significantly, driven by the following themes: Continued buyout activity: A number of the leading financial sponsors in Australia have recently announced the completion of new fundraising activity, providing further impetus to drive the volume of buyouts in the Australian markets. It is estimated by AVCAL that current private equity dry powder for the region now totals A$6bn (source: AVCAL, November 2016); and The substantial financing needs of Australian corporates (both private equity and non-private equity owned) for growth and refinancing: Historically private equity owned companies have been the primary users of senior loans (including direct lending) but as the direct lending market matures, we expect the interest from non-private equity owned companies, who are looking at institutional lenders as an alternative source of long term debt capital, to increase. ICG views the Australian senior secured loan market as an attractive investment opportunity and this view is supported by the following: Australian senior secured loans offer stable, frequent AUD cash returns with strong capital preservation mechanics and minimal duration risk; Given the above mentioned barriers to entry and the fact that the loans are held tightly by bank lenders, the pricing and terms deliver attractive risk-adjusted returns for investors; The requirement for private debt expertise creates a further barrier to entry for potential new market participants and therefore makes it more challenging for ordinary non-bank lenders to destabilise the pricing and terms of the senior secured loan market; and The private nature of senior secured loans limits market participants to bank lenders and private debt specialists, such as ICG, who have strong relationships with the issuers and sponsors, a global network, and significant local on-the-ground presence through a highly experienced team.

7 Key takeaways: The Australian senior secured loan market is dominated by bank lenders and requires private debt expertise to assess the underlying investments. The high barriers to entry are beneficial to those investors who can successfully tap into the market as it offers attractive risk-adjusted AUD cash returns with strong capital preservation mechanics and minimal duration risk. Does it make sense for investors to allocate capital to Australian loans? We consider the major global economies, including Australia, to be in either low growth or recovery phases of the economic cycle. This suggests that central banks, including the Reserve Bank of Australia, will seek to maintain their highly accommodative monetary policies of recent years through holding interest rates at historic low levels. Under such conditions, it is clearly challenging for investors to generate positive real returns without taking on additional risks. We believe it is a good time for investors to include Australian loans as a regular cash income generator in their portfolio. Our view is supported by the following key points: Australian loans provide an attractive risk/return profile for investors in their hunt for yield ; Loan investments offer regular cash income streams which are contractual obligations; and Loan investments offer diversification benefits having historically demonstrated low correlations with equity markets. Figure 2: Private debt provides attractive risk/return profile for investors in the hunt for yield Source: CapitalIQ; Bloomberg; ABS; ICG Analysis, as of March 2016 Figure 2 illustrates the challenge facing Australian investors to generate positive real returns from their investments, particularly given that the traditional defensive options of term deposits and government bonds currently only offer returns that are broadly in line with the core inflation rate in Australia. In fact, the Reserve Bank of Australia s chart (Figure 3), clearly demonstrates that real cash returns in Australia are now actually negative for only the second time in the past twenty years, highlighting the considerable issues facing investors reliant on their investments to provide a meaningful income stream.

8 Figure 3: As of March 2016. As a result, some investors have been forced to increase their allocation of savings to riskier asset classes, particularly equities, in order to maintain their income levels in a hunt for yield. We view this as a risky strategy given the historic volatility of equities and current stock market valuations, potentially giving rise to capital losses for Investors should equity markets decline. From an absolute cash return perspective, Australian senior loans currently provide an annual cash yield of approximately 6-7% p.a., which is higher than the cash return offered by ASX200 dividends. Aside from the more attractive cash returns compared to the ASX200 dividends, senior loans offer an attractive and defensive alternative given that the value at which loans will be repaid is contractually agreed (typically at par), therefore loans offer clarity to investors as to the repayment value upon maturity of the loan. In addition, loans are ranked senior in the capital structure of the issuing entity, therefore benefit from a priority claim on assets ahead of equity holders. Importantly, this priority claim enables loan investors to recover a higher proportion of their principal, should the business default, than can be achieved by the subordinated claims of other investors, such as equity, in the same business. Loan investors receive further downside protection given that loans benefit from covenants (e.g. maximum leverage, minimum interest cover ratios, restricted payments to shareholders) which enable the lender to enforce and seek immediate repayment should the borrower default on its contractual obligations. Figure 4: Yield spread between Australian loans and term deposit is trending upwards Source: Bloomberg; ICG Analysis. As of February 2016 Figure 4 compares the cash return on a portfolio of Australian senior loans compared to the return offered to investors from term loan deposits. The result shows that the yield spread between Australian loans and term deposits has been trending upwards since 2013.

9 The key driver behind the trend is the strong supply of deposits which has driven down term deposit rates over the past 37 months. In contrast, whilst the supply of capital available in the Australian loan market has slowly improved since the GFC, the Australian loan market has retained considerable pricing discipline. Consequently, from a relative value perspective, we view that now is a good opportunity for investors to switch in-part from term deposits or bonds to Australian loans to take advantage of the higher spreads. Senior loans offer regular AUD income stream for investors Investors in senior loans receive a regular income stream from their investment, typically paid on a quarterly basis. Given that the margin paid to loan investors is a contractual obligation, it is not subject to the potential volatility of equity dividends which are usually discretionary (i.e BHP & WOW recent dividend cuts). Furthermore, the floating rate component of the cash coupons paid to investors in senior loans provides protection from an increase in interest rates. Indeed, given that the floating rate component typically resets every 3 months, there is low duration risk making the loan asset class particularly attractive relative to fixed income assets should we revert to a rising interest rate environment. Figure 5: Loan investments as an asset class has demonstrated a low correlation with equity markets Note: Fifteen years ended December 31 st, 2016 Source: JPMorgan 2016 Leveraged Loan Annual Review The correlation table in Figure 5 is based upon data over the last 15 years to December 2016. The results demonstrate that returns from US senior secured loan investments have historically reflected a low correlation to US equities and a lower correlation than high yield bonds, reflecting the senior position in the capital structure, covenant protection and floating rate nature of the loan asset class. In addition, there is a negative correlation with the returns of US Treasuries demonstrating the strong potential for wealth protection in a rising interest rate environment. We view the low historic correlation of returns from the US loan asset class compared to US equities, as a good correlation proxy for the equivalent Australian loan market with other asset classes. As such we expect Australian loans to be an excellent source of portfolio diversification for investors given their usual high asset allocations to equities and cash. Key takeaways: In a low interest rate environment, in order to maintain a consistent level of income, many investors have been forced to increase their investment allocation to riskier asset classes in a hunt for yield ; Australian loans as an asset class offer investors consistent and positive real cash returns paid on a quarterly basis, with considerably higher relative cash returns than are available in other popular asset classes such as equities and term deposits; The senior position of loans in the borrower s capital structure, giving lenders a priority claim on assets, together with the suite of covenants negotiated by lenders, provide investors with significant capital protection; and The low historical correlation of returns on loans relative to other asset classes such as equities and Treasury bonds demonstrates a potential opportunity for investors to diversify their portfolios given their typical portfolio concentrations of equities and cash.

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