The hunt for alpha
As an investor you seek an “alpha return,” in essence you seek a premium return above the risk adjusted rate. However, achieving alpha usually requires market inefficiencies to occur or unique strategies to be developed, which are harder to find in public markets.
Private investments on the other hand offer an abundance of market inefficiencies and in specific in private credit.
In this article you’ll learn what an alpha return is, how fund managers use “alpha” as a sales pitch, what effects pricing and returns, and how to achieve an alpha return in private credit using our unique real-world strategies.
Private investments offer higher chances of alpha
Public markets operate by virtue of the fact that most information is publicly known, which means they are more likely to follow an efficient market hypothesis.
Private market transactions on the other hand do not follow efficient market hypotheses. Not all players have the same information, resources, skills, types of capital and networks. Because of this market inefficiencies occur more often and thus unique investment opportunities. It is for this reason that so many family offices have made their wealth via the creation and investment in private businesses.
Extracting opportunities from the private market requires skilled investment managers that can extract unique opportunities tailored to your individual portfolio objectives. For example, family offices use us to originate high yielding sub $5M direct lending private credit opportunities for them. Simultaneously, they will invest in other private credit funds that can deploy capital at volume but with lower yields. Additionally, they will also use other specialist private equity fund managers, that specialise in certain industries that they are familiar with.
What is an alpha return and why is it so important?
Depending on the model used to calculate an alpha return (advanced models take into consideration the risk profile and volatility (beta)), alpha is generally seen as the premium return an investment can generate compared to another investment / fund / index.
More advanced model incorporate risk, and alpha is considered to be when an investment can produce a premium return compared with another investment / index, that has a similar risk profile. In other words, the investor did not have to take on additional risk, to generate the higher return.
You can read the technical definition here of an alpha return.
Alpha returns / premium returns as a marketing tool
All too often investment managers will state their fund generated an alpha return and beat some type of market index to win investors over. The problem arises, when their fund holds riskier assets than the index they are comparing themselves to. In other words, they’ve taken on more risk, and compared themselves against a market index with a lower risk / return profile.
Private credit fund managers also attempt to do this at times (but less likely) by claiming their first mortgage fund achieved an “alpha” or “premium return” compared to other funds. When in reality the securities they took held a higher risk profile (higher LVRs, rural land instead of metro and riskier sponsors).
In effect, what you need to be aware of is that in most cases, alpha is not actually an alpha return or premium return for a similar level of risk, It simply a sales pitch.
What effects private credit returns and pricing
When it comes to generating returns for private credit, several things come into play that effect pricing and returns to investors. There are 3 main factors as listed below.
Supply factors effecting private credit
- The type of product, its uniqueness and risk (first mortgage, second mortgage, alternative asset loan, warehouse facility etc). The more unique, the more of a premium that can be generated.
- The capital available to fund that product (is there sufficient capital from to fund that product or is there a shortage of capital). Which effects the premium investors can ask for if there is shortage of capital.
- The ability of private credit providers to rapidly solve the inconveniences of borrowers. Speed to market can command a premium.
- The ability of private credit providers to offer blended end to end solutions.
Demand factors effecting private credit
- The demand for that product (how much does the market want it).
- The level of inconvenience the borrower is facing if they do not find a solution. The more urgent the borrower needs funds, the more of a premium they will have to pay for capital.
Regulatory factors effecting private credit
- Regulatory requirements that effect private credit providers
- Regulatory requirements that effect the broader lending market, that in turn effects demand for private credit.
How to achieve an alpha / premium return in private credit
With businesses having a myriad of funding options from non-traditional banks, investment banks, private credit funds and individual investors, achieving alpha also becomes harder as market terms tighten.
With the below examples, the inherent way a premium return is achieved in most cases, is by solving the inconveniences of borrowers who are willing to pay a premium above the risk adjusted rate to have their problems solved.
Developing unique financial products few offer
Developing unique financial products that cannot easily be replicated, allows a premium return to be made above the risk adjusted rate, because there are very providers of credit. In other words, a premium fee is being charged for solving the inconvenience of the borrower not being able to get credit elsewhere.
One such example is the heritage plate lending solution that RSC offers. As we are the only ones in Victoria to do this, investors can secure their interests via control of the title, whilst securing double digit returns and at very conservative LVRs. Because we are the only ones that can offer this, and because borrowers may not have other collateral they can use for a loan, we can command a premium above the risk adjusted rate.
Speed to market
Borrowers are willing to pay a premium above the risk adjusted rate for certainty of quick liquidity. This could be to solve an urgent liquidity crisis or to take advantage of a market opportunity.
Whilst most private credit funds like to think they can move quickly, very few are able to settle a deal within 7 business days.
What this means is that smaller agile private credit providers (such as us) can command a premium relative to the risk for the provision of quick capital.
So, whilst a standard 70% LVR loan may be done at 11% p.a. for example, we can charge 12 % p.a. to 12.5% p.a. without taking on additional deal risk (which is a 10% to 15% premium).
Doing the work to understand the risk
All to often we have seen great opportunities get missed by 99% of other private credit providers. Typically, if a transaction doesn’t meet a vanilla set of metrics, deals can be denied when the underlying quality of the security is very good.
A good example is we had one borrower that had a 1,000 sqm factory in an inner suburban premium location. Because it was a specialised meat processing plant, other private credit providers felt the asset would be too hard to dispose of if they had to take possession, consequently rejecting the loan.
What all others failed to realise was that the asset was located in a zoned area for mid-rise developments. Meaning if the asset was to ever be put in the market, there would be strong demand for it, despite it being a specialised asset.
Because we were able to understand the inherent value of asset, we had a family office that was more than willing to fund the deal, whilst also a charging a premium relative to the risk involved as few others wanted to fund it.
The ability to offer blended solutions
Private credit funds that can offer blended end to end solutions for clients, are able to charge a premium above the risk adjusted rate.
For example, a developer may need to raise $3M to acquire a site for a petrol station.
Typically, a private credit fund may offer $2.1M (70%) LVR at 10.5% p.a, with the developer having to raise $900k in equity from their own funds or investors.
If a private credit fund has the capacity to provide a whole solution (debt and underwriting for partial equity) they are able to charge a premium. For example, they may offer the following.
- The first mortgage private loan, $2.1M at 70% LVR.
- Underwriting of a further $400k on stand bye if the developer needs it (a second mortgage priced at 18% p.a to cover the partial equity shortfall).
- A underwriting fee of 1% per month on the $400k.
- The underwriting be provided on the condition, that the first mortgage 70% LVR is done at a 12% p.a, instead of the standard market rate of 10.5%
In this example, the private credit firm is able to secure a premium return in two ways.
- They are able to secure a 1.5% premium (12% p.a. vs 10.5% p.a. if it was on the open market) on the first mortgage component of funds.
- Secondly it is able to sell a portion of the funds ($400k), at second mortgage rates even though it holds the first mortgage on the asset and is not behind another party.
The ability to underwrite risk
Private credit providers are able to make a premium return, if they have the ability to take mitigate or negate greater levels of risk whilst charging a risk premium.
A real-world example of ours is we had a client that had $50m worth of assets, and had loans with their bank of up to $35M. The client required an urgent $1M of funding for 3 months, and the bank was unwilling to provide the extra capital.
Additionally, the bank had cross securitized the asset pool, essentially having a first and second mortgages on the assets. To make matters more complex the bank was unwilling to provide a deed of priority.
Most other private credit providers had said they couldn’t do the deal due to the complexity of the banks senior position and most second mortgage lenders were unable to write the deal due to the banks position regarding the deed of priority.
In this instance a family office we work with was able to provide the $1M to the borrower, with a caveat as security, at a 36% p.a interest rate. A condition of finance was the family office had the right to pay out the bank in an event of default. In other words, the family office would have the right to hold the first mortgage across the entire security pool in an event of default.
Because the family office had the capacity to underwrite the risk, they were able to secure a a high risk caveat premium return of 36% p.a. whilst holding indirectly the security position of a first mortgage that would normally be priced at 12% p.a. In other words, they secured a 36% p.a. return, for the a risk level that would normally be priced at 12% p.a.
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