SKYBOUND rises to the challange of real returns in inflationary conditions
HedgeNews Africa sits down with Caroline Fuchsloch to discuss the investment outlook and the types of strategies Skybound is offering its clients.
Skybound Capital’s investment team has been together since the mid-1990s, initially landing one of the first fund of hedge funds in South Africa. Founded by Clifford Warren, Skybound has since grown into a global wealth management business, offering a unique range of alternative investment products for family offices, private clients, advisers, and institutions around the world. Skybound now has offices in the United Kingdom, South Africa, Mauritius, Australia, and Hong Kong.
What is your investment outlook at present and how are you directing clients in a Covid-hit world?
Our investment outlook, for now, is one of fast growth spearheaded by a highly successful – if not distorted – vaccine rollout across the globe. The latter is giving rise to a strong resurgence in consumer-led demand. A substantial rise in savings as well as lower expenditures (for example low transport costs because of individuals working from home) means there will be a continued shift towards value/cyclicals. The remaining sectors to beneﬁt are travel, hospitality, entertainment, restaurants and beverages. These will return to pre-pandemic levels as soon as ﬁnal lockdowns have been removed across the globe.
The consequences of the above will be a higher inﬂationary environment. While the debate between whether this inﬂation is transitory versus longer term continues, our view is it will be longer-lasting than most predict. The impact of both the above will be higher Government bond yields, higher inﬂation, and higher volatility.
Therefore, the challenge facing any client is how to maintain positive, real returns. Remaining in cash can be destructive for clients who may, unknowingly, see their real wealth erode over time. Furthermore, the traditional asset allocation mix of say 60% equities, 40% ﬁxed income is not an effective preserver of value as higher yields will drag down the value of earnings further out. Therefore, (1) real earnings power, (2)inﬂation-indexed and (3) volatility-reducing strategies (such as alternatives) are key to preserving real value while also reducing volatility.
Our strategy of capital protection remains, and we believe that maintaining positive, real returns through funds which provide stable, consistent, positive monthly returns is the best strategy in this environment.
Adopting a long-term investment mind set is an important factor in achieving attractive compounding returns. It requires us as wealth managers to focus solely on generating long-term alpha for our clients.
Our South African funds have been in the alternative space for the past three years and investors have reaped the beneﬁts with our QIHF having outperformed the SA listed equity market on an annualised basis. As the vaccine roll-out continues across the globe, there seems to be light at the end of the tunnel, but the journey ahead for investors in the listed equity market could be a bumpy one. Investors should remain resilient and ignore the noise; a balanced approach in low-volatility funds and staying invested remains key.
What are the primary concerns your clients have in this environment and are they responding appropriately?
By and large they are responding appro privately, yes, but this of course depends on where they are. For example, across developed markets, the switch to value/cyclicals in the equity market has been more rapid. That said, the choice of investments is more diverse too. In emerging markets, it has been less but then the yields being offered are also
higher in real terms so the value of cash in local currency has been better preserved.
Certain emerging markets (South Africa being a case in point) offer a beta play to the upside where equities are concerned.
Therefore, when risk-on returns (as we are seeing currently), South Africa is a natural choice for increasing emerging market exposure by developed market allocators given its good liquidity and FX convertibility.
The same is not necessarily true of local SA investors. Our clients have been concerned about the low yield and negative growth environment that South Africa ﬁnds itself in. They have been using the recent rand strength to take funds offshore and increase their hard-currency holdings, as well as allocating to our rand-denominated funds with offshore exposure.
Over the years, your focus has widened from fund of hedge funds to other alternatives, including private equity and debt. What brought about this change?
Quite simply put, you can’t ﬁght a battle unless you have the full range of weapons at your disposal. Wealth management is no different. It is a continuously changing battleground and competent wealth managers must adapt quickly. We live in a world that is very different to the one pre-pandemic –and to think the latter was only over a year ago. However, even before that, demographics have been changing the landscape.
We are all living longer, and this is creating huge challenges for generating sustain able income. To meet these challenges, one must reconsider time horizons and invest longer term. The latter gave rise to a big push towards private capital, especially private debt. Our foray into this space was as far back as 2009 when it was not in vogue. However, today it is a key source of income generation and portfolio diversiﬁcation. The absence of traditional mark to market valuation in this space means a very different risk proﬁle while offering an excellent risk diversiﬁer in portfolios. The reasonable liquidity terms mean the sacriﬁce to liquidity is modest.
In South Africa, the reasoning behind the shift from fund of hedge funds was a natural progression. The opportunity we had in the offshore private debt space was too obvious to ignore and contributed to us exploring new avenues and investment strategies for investors in search of performance and uncorrelated returns.
With Skybound’s ﬂagship offshore private debt fund having generated annualised returns of around 8% per annum in US dollars for the past 12 years, we had the potential to combine this with currency futures to create a low volatility, rand-denominated fund. The opportunity was to take advantage of both the consistent return of our off shore private debt fund and the interest rate differential between the rand and the various currencies in which our private debt fund was denominated. Globally, Skybound offers investors the opportunity to beneﬁt from private capital investments, sourced from its extensive network, providing a unique range of alternative investment products.
Private debt has been a fast-growing asset class post-2008 as banks have retracted from certain areas of the market. What are the risks and what types of returns can be achieved?
Well, this depends on what segment of the market one would like to focus on. The bulk of money that has ﬂowed in private debt has become concentrated amongst the larger private debt funds. It is not easy deploying billions of dollars of capital and, as a result, they ﬁnd themselves sitting on large cash piles. The considerations that need to be taken into account range from pure private debt models to hybrid private debt/private equity models, size of market cap(small, mid, large), debt tranches (investment grade, hybrid, mezzanine, junior), concentration risk, liquidity risk, sector risk and security.
Timing is also key – the reason we launched post-2008 is because that’s when demand for debt capital was at its highest and the cost of that same debt was most at tractive. Over time as risk subsided and capital became plentiful, naturally rates began to decline.
Since Covid struck, this opportunity set has re-emerged, especially as governments are looking to withdraw ﬁnancial support as soon as possible. Banks are no longer the traditional lenders they once were – this leaves the market wide open for specialist funders.
The types of returns to be made are entirely a function of the above factors. Large private debt funds with billions to deploy focusing on, say, investment-grade loans with little/no hybrid structures, will generate, net of fees, around 3% to 5%.
By contrast, we too focus on senior debt and investment-grade loans but with a smaller-cap focus. This allows us to control our risk by having full transparency in to the underlying investments, monitoring changes in key ﬁnancial ratios. As a result throughout the live track record of our off shore private debt fund, we have delivered8% CAGR in US dollars since 2009, net of all fees.
Direct lending is now a primary component of well-diversiﬁed investment portfolios. In considering an allocation to a private debt fund, the fund manager’s ability to originate transactions is a crucial factor in their strategy to ensure that they are able to take advantage of the best opportunities available and create a diversiﬁed portfolio with low correlation to traditional asset classes, offering a signiﬁcant degree of structural protection.
It is crucial that detailed due diligence processes are undertaken prior to any form of loans being made, and that various scenarios are tested and an evaluation made as to how a counterparty may perform in various market conditions to ensure that they would still be able to fulﬁl all ﬁnancial obligations. The access that a fund manager must have to counterparty management and information are crucial decision-making components in assessing the credit risk of counterparties.
The actual loans being made by a private debt manager will have tailored terms and covenants depending on the counterparty in question and it is crucial that investors are conﬁdent that they are protected, with the fund manager ensuring that all loans have a charge over the counterparty’s assets, providing protection from the risk of loss with priority over other lenders and investors.
Another notable consideration is that of security, where analysts in the private debt space need to have the aptitude to understand the legal documentation in question – and in-country legal consultation is crucial here. Valuations in the space are also analyst-driven, and there needs to be a sound understanding of corporate ﬁnance theory, thorough analysis of ﬁnancial statements and disclosures and modelling skills to ensure that these are captured in line with international valuation guidelines from inception and through the life of a loan to assess and correctly account for any potential degradation of counterparty performance. This requires signiﬁcant access to the correct market data, model infrastructure, people, and control oversight.
The increasing number of opportunities in the private debt market have been driven in part by a tightening of traditional bank ﬁnancing, with increasingly stringent capital-adequacy requirements in the form of regulations such as Basel III making it harder for banks to lend.
The level of risk in the space all depends on the type of ﬁnancing being provided. We invest in the direct corporate lending space, ensuring that our loans are adequately covered by security. The beneﬁt here, especially in comparison to public markets, is that one has complete see-through on the borrower’s business, with monthly management accounts, access to board meetings and regular site visits.
In the public space, one rarely has this kind of daily access to direct management or exposure to underlying business operations. As such, we have a greater level of transparency within the direct lending space as well as security, which considerably reduces overall risk.
Success in the private debt space is reliant on good strategy and great execution. Borrowers need to undergo a signiﬁcant due diligence process to ensure that loans are only granted to corporates that will succeed and are able to afford the loan repayment and interest servicing costs.
It is possible to achieve a decent yield with low risk and favourable liquidity, but it all comes down to rigorous due diligence, structuring and ongoing monitoring.
Has the Covid pandemic and subsequent economic distress, both locally and abroad, changed the outlook for private debt?
No, in fact quite the opposite. As referred to earlier, the effect of Covid 19 has been to effectively recreate similar circumstances that existed back in 2008/2009 immediately following the GFC. Bank lending is very distorted and tends to be skewed to large companies. This leaves a swathe of mid to small-cap companies that are still starved of cash to grow their businesses. Many of these are on government health support but, sooner rather than later, this support will be withdrawn. That’s where we expect private lenders to step in and take up the slack.
We have seen data come out which demonstrates that the pandemic is disproportionately affecting the middle market, with smaller companies experiencing depressed revenue and little ability to adjust to the market conditions.
It is likely that there will be lasting ramiﬁcations as a result of Covid, but mid-market businesses coming out of the pandemic with suppressed balance sheets will also need to rely on private debt to gain access to capital and realise their growth potential. This will bring opportunity to the space, but lenders will need to be cautious and keep sustain ability at the core of their approach.
Part of one’s analysis in looking at potential borrowers will always include examining their ability to handle potential defaults, and experienced teams post-Covid will be a key differentiator.
Prudential, patient allocation of capital will be crucial to long-term success in the current environment, lending only to high-quality borrowers who put up high-quality assets as collateral.
What are the typical liquidity terms of a private debt allocation?
The critical point to understand here is the concept of weighted average duration. Liquidity terms are a triage of the company’s ability to repay and their capital requirements. Typical loan terms are between 12to 36 months, but it can stretch out to 60months. In extreme market situations (such as the GFC and March 2020), liquidity will always become severely stressed – but that is also when the opportunity set for the fund reaches a new high. Therefore, one must view the fund’s life over a “normal” market scenario. Portfolios need to be crafted with a liquidity ladder in mind so that there is always something maturing (interest and capital repayments) at the same time as new opportunities present themselves.
In our funds, we work very closely with our counter parties (borrowers) to provide capital as and when required in tranches, with each of these tranches then repay able on the above terms. This ensures that companies can then do their cashﬂow planning accordingly and are not facing are payment deadline for all capital provided at once. Regardless, a close eye is kept on the ability of the company to repay, with regular reporting requirements and ﬁnancial covenants in place that must be met for further funding to be advanced under the agreements.
What should investors be mindful of when considering an allocation to private debt?
Liquidity ﬁrst – investors must look seriously at their liquidity needs. If they absolutely need access to daily dealing investments, then they should keep away from private debt. Instead, they should look at maturity dates and carefully evaluate how these ﬁt in with their investment horizons and cash ﬂow planning.
That said, if they can afford to have money invested in longer duration (i.e. greater than daily dealing), they should consider it from the point of view of portfolio diversiﬁcation and reduced volatility. Longer duration does not mean having one’s money locked away in multi-year structures.
Skybound’s QIHFs as well as offshore private debt fund, for example, offer monthly dealing which we feel is very compatible with the types of investment opportunities in the marketplace and the environment we ﬁnd ourselves in. Consequently, the “illiquidity risk premium” is much less than structures which have multi-year redemption terms. These funds offer uncorrelated, steady and consistent returns that are independent of listed equity markets.
Article courtesy of HEDGENEWS AFRICA.