Listen as they discuss:

• Why private markets investing is so attractive in the current environment.
• How Metrics Credit Partners identifies lucrative investment opportunities in private debt and private equity.
• The strategies leveraged to mitigate market risks.
• How to best position private debt in an investment portfolio.

Transcript

Welcome to Relative Return, get closer to the people, products and strategies shaping Australia's financial services industry. Hello and welcome to the Relative Return podcast. I'm your host for today, Keith Ford, and I am joined by Andrew Lockhart, who's the managing partner of Metrix Credit Partners.

Welcome to the show, Andrew.

Thanks very much, Keith. Thanks for having me.

Not a problem. Great to have you on the show. What we're here to talk about today is essentially what Metrix Credit Partners does, which is essentially private debt, private equity, you know, providing investment opportunities across those spaces, primarily through the use of managed funds. But I thought before we kind of jump into everything, if you would be able to give a little bit of a rundown on what Metrix does.

Yeah, sure. We primarily are focused on direct origination and direct lending to Australian and New Zealand based companies. There are probably three key limbs to our business, and one is obviously private debt, which is the ability to originate, to structure and to provide debt financing to companies and projects that we're involved in in providing financing to. Secondary of activity is private equity and real estate transactions. And we also have the capacity or capability to provide investors with exposure to non-control minority private equity investments that we also hold across some of our funds.

Right. And so looking at that private market perspective, what do you feel makes private market investing an attractive opportunity for investors?

Well, I think a lot of our investment activities really come down to the ability to source and originate directly with the company or the party you're dealing with rather than buying and selling over an exchange. And so what comes to this is the ability to source attractive opportunities to be able to then undertake a detailed assessment of the opportunity and to price the transaction according to the value that you deliver to the company in terms of the capital that's delivered. And so, you know, I think for a lot of investors, the ability to gain access to what is very much a bank dominated market without losing part of the economics or the return because it's going off to bank shareholders or to others delivers a slightly better return outcome for investors. So our role is to originate those transactions directly with the companies to structure the transaction, to seek to mitigate the risk of loss using access to private confidential information that our borrowers and others provide to us to be able to assess the opportunity and the risk and to really drill down into a deep understanding of what drives the cash flows of the company or the project that we're providing financing to and to ensure that we've taken action to mitigate any potential risk of loss for our investors. So that's quite different to, say, a public market investor that might be trading security for us. The underlying assets that we hold are less liquid. And there's not a market that allows you to trade in and trade out. And so as a result of that, you have to make a very deep, fundamental decision as to the attractiveness or the inappropriateness of a transaction and then to make sure that you've taken all the necessary steps to not only secure the opportunity, but to then also take steps to negotiate the appropriate pricing, but also to negotiate the appropriate terms to mitigate risk. Absolutely. So in it for a bit of a longer period than just straight up trading. Yeah. And that's, I think, one of the differences. If you think about somebody that invests in a bond, the issuer never knows or the company that issues the bond never knows who's going to be the investor. Bonds can be freely traded. And so as a result of that, the company will then try to negotiate looser terms and conditions because the investor is free to manage their risk through the trading of that instrument. In a loan, it's much more difficult to trade in and out. And so the borrower restricts who lenders might be. And so the tradeoff that a lender then seeks to ensure that they get in place is the ability to gain access to information, to be able to assess and monitor the risk on an ongoing basis because you've effectively taken away one of the ways in which you might manage risk, being the ability to trade in and out. But the quid pro quo is I want tighter terms, conditions and covenants to control the operations of the borrower in a more meaningful way. That means that, you know, you can hold the investment for the full term without being subjected to changing business or the circumstances of the company that may adversely impact your investment. Right. And so looking at some of the specifics, what are some of the areas of the market that you lend to? And are there any, I suppose, particular sectors that are appealing to Metrix, like at this moment? Our lending activity and our investment activity in general tends to be more at the large scale corporate and institutional part of the market. So we're not tending to lend for small or medium sized business purposes, and we're not lending in our funds currently to consumers. So our lending activity is primarily focused on providing debt, financing or capital to companies or to projects. And a big driver of the demand for capital is really, you know, we see opportunities across a broad range of sectors. But what we are looking for are companies or projects that give us a greater degree of the certainty around their cash flows that can be generated to service and repay the debt. So that tends to see us stay away from more cyclical industries where you've got more volatility around, say, it's an agricultural company or a natural resources company. You've got a range of factors, be it commodity prices, production volumes. You can have weather, you know, foreign currency issues. You can have trade disputes between governments. All of those things can mean that the company's earnings can be quite volatile. They present a different risk profile to, say, a company that's got a more certain or more stable cash flow. So we tend to prefer companies that have got more stable stability to their business model and their cash flows, where some of those external risks that you're exposed to in some other industries are not there. So, for instance, big area of focus for us is obviously in commercial real estate financing, and we're very active primarily in short term development funding for residential and industrial development activity. So if you think about large scale land subdivisions or large scale residential high density apartment complexes and those sorts of things, we're involved in financing of those. And we think that it can be an attractive lending proposition because as a lender, you can take appropriate security. You can mitigate your risk. You're releasing funds as the project is being completed and you've got a known source of repayment on completion of the project from the sale of the asset, the sale of the property on completion, which is often subject to a presale agreement with a purchaser. And so, again, quite different in terms of understanding the nuances. But the real lending decisions that we make is how do we get a high degree of certainty and confidence that the company is going to generate sufficient cash flow to be able to service its debt? And then what are the multiple ways in which we can get our money back if circumstances don't play out the way? So we want multiple exit opportunities for us as well. So as you mentioned, private markets, this is something that can be quite challenging for retail investors to get involved with. I'm sure part of that is just not quite understanding the idea of the private markets. Can you give us a bit of an outline of some of the private debt instrument investment opportunities that providers like yourself make available to investors? You're 100% right. A lot of retail or even high net worth and other investors don't necessarily gain access to private credit investments. The asset class is an asset class that is predominantly held on bank balance sheets. So if you think about Australia as an example, most Australian companies don't have credit ratings by S&P or Moody's. We don't have a big bond market where Australian companies can go and raise debt capital efficiently. And so most companies are heavily reliant on banks for funding. So our role is to seek to provide a means for companies to diversify their funding sources. So importantly, what we do is seek to originate those lending opportunities to source the transactions, to structure and negotiate the terms, conditions and the terms of the funding and the pricing, and then provide investors with access to that risk and return and the profile of a direct loan that's made to a company in a fund format. And so, you know, we were the first group to establish an ASX listed fund where investors could buy and sell units in a fund on the stock exchange that gave them exposure to a portfolio of corporate loan assets. And so, again, you know, the way in which you create product and opportunities to allow investors to invest in the asset class is quite different to some other funds, but primarily the ability to pool capital and to use that pool of capital to then lend to companies is important. And so we offer a range of both listed and unlisted funds, some for institutional investors, some for retail investors. But the intent is to really allow an investor to determine what is their return objective, because investing in credit, you can invest in low yielding, low risk investments. Equally, you can move through the capital structure and through the risk profile to generate a higher return. Some investors are looking for higher returns and they have to recognise that to generate the higher return, they might be taking higher risk. And so what we've sought to do is to structure funds that have got different return objectives, which then imply a different risk profile of the fund. And then each of the funds have different liquidity mechanisms that allow an investor to determine how and when they want to invest or not invest and get their money back. And so there's a range of investment products that really cater to those three key objectives of an investor. And then equally, what we think about as well as where does it sit from an investor's portfolio perspective? Some investors are looking for more of a defensive, more traditional alternative, you know, a more capital stable type option, defensive in terms of the features of the product. Others are looking for more of an equity market replacement. And so the beauty of private debt, I think, is it can play dual roles in investor portfolios. At one end of the spectrum, it certainly delivers the stability of capital and attractive income that makes it an attractive alternative to traditional fixed income. So in Australia, we often see investors hold hybrids or bonds as a fixed income investment and investment in a private credit fund can be an alternative solution for that fixed income allocation. The other end of the spectrum, we see a lot of Australian investors, for instance, hold portfolios of equities, and they hold those because they're looking for the dividends that come from the shares that they hold. But often they're subjected to greater bouts of volatility from public market equities. And so, again, recognising the return profile and the risk profile, you can actually structure opportunities in high yielding debt that could present an opportunity for investors to downweight or replace their equity market allocation and allocate to private debt. Again, it's just for investors to understand how it fits in terms of their overall investment objectives. Absolutely. And so private debt, recent years, particularly in 2023, we've been seeing it gain a lot of momentum, essentially. Are there any particular reasons that you're seeing that are causing that kind of increase in momentum? Yeah, look, I think investors are probably experiencing a bit of a shock in terms of when interest rates have risen, as they have over the course of the last 18 months or so. Some asset classes have not delivered the stability or the protection that investors are looking for, and the returns then don't look terribly attractive in a rising rate environment. So generally, in a rising interest rate environment, investments that are, say, traditional bonds where you've got interest rate risk, people have locked in fixed rates and those sorts of things. Some of those investors have lost money as a result of rising interest rates or in some investments, some companies or in property, stabilised property investments, increasing interest rates can impact the valuation. And so as a result of that, what people have looked for is where can you go in an asset class that provides for benefits in terms of higher total returns as interest rates rise? And that's what private credit has delivered over the course of this 2023 period. Interest rates have risen, the total return for investors has increased. Now, people will always look at that and say, well, rising interest rates may adversely impact the credit quality of the companies that you lend to. And it's important then to be able to show and demonstrate to investors that the quality of the loans that you have made and the company's performances have not adversely impacted their capital. And so the combination of low loss rates, low default rates, together with rising real income that's keeping pace with inflation has presented a pretty attractive investment proposition in comparison to some other asset classes that are perhaps more volatile or potential risk to the downside in terms of valuations. So I think those are the features that have driven investor interest in private credit as people have sort of moved away from some of the more traditional fixed income allocations. If you think about investments in hybrids or an investment in cash deposits, those investments have struggled to keep up with the inflation that's passed through the economy. And so as a result of that, rising inflationary pressures, rising cost pressures have forced investors to think about how do you generate a real return. And private credit has been one of those asset classes that's demonstrated the ability to deliver a real return. Right. And that does lead in pretty nicely to my next question for you, which I'm wanting to know, I guess, how private debt's being used in portfolios and by the sounds of it, certainly as a bit of a way to offset some of the poor performance in some other asset classes that people might've been exposed to. Seems like that might be one of the ways. Yeah. Look, it's been an interesting period, right? Because for instance, we are seeing and have raised capital from offshore investors that would ordinarily have invested in real estate equity globally, have made a decision to reduce their exposure to say real estate equity and invest in real estate debt because it presents a lower risk part of the capital structure, benefits from security, but the income that's being generated is attractive in comparison to say, holding a stabilised commercial office building for rental when you've got potential risk around valuation. So it's been interesting to see where demand from investors has come from. Certainly domestically in Australia, we see a lot of demand from retail and high net worth and institutional investors looking for a higher yielding income generating asset cost and the returns that are being generated really reflect in some ways the pullback in terms of market competition as the banks have been focused on repayment of the reserve bank term funding facilities. So you've sort of seen a reduction in competition. You saw a lot of volatility in the early part of 2023 that reduced bank lending appetite around the time you had the SVB bank collapse and those sorts of things. So investors have sort of seen the asset class deliver on what we've sort of said, which is it provides for protection of capital through appropriate terms, conditions, covenants and security, and you can generate a pretty attractive return. So for a lot of investors, it's played a role of reducing exposure to some underperforming asset classes and we've seen a reallocation. So real estate equity into real estate debt has been a feature, particularly those that have had core or core plus type property investments looking for an alternative. So we've seen a bit of a flow from commercial real estate equity products for those that might be owning commercial offices and industrial or retail property assets as interest rates have risen and potentially impacts valuation. But equally, we've seen pretty strong interest from people that have just got savings that they're looking to allocate to generate a higher return, but are looking for an alternative, say, to a bond or a hybrid. Equally, I think that given some of our funds also provide investors with the participation or the right to participate in sort of equity-like investments, we have funds where, for instance, we might have negotiated options or warrants or we've taken an equity stake in a project or a company that we've lent to, that also delivers investors with an attractive income from the debt, but also the rights to participate if the company is successful or the project is successful, then hopefully the investor will also participate in capital gains as well. Right. And so you mentioned a little bit earlier that Metrix has been in the market for a while in terms of private debt within Australia, probably one of the earlier adopters within the space. So leading the way a little bit there, a bit of a leader. Where do you see the difference between Metrix and other managers in the space? Is it just the time in the market or are there other things that you're doing a bit different? I think there are a range of things. I think the asset class actually benefits from one manager that's got a skill set and a track record that's worked through different cycles. And our team have worked through being lenders in the market for decades. And so we've gone through many cycles. And over the last 10 or 11 years, since we launched our first fund, we've been able to demonstrate to investors consistently the management of risk. And every single one of our funds that we operate has exceeded the minimum target returns that we've indicated. So I think credibility comes into play, but equally, we've invested substantially in building good long-term relationships with the borrowers we do business with. We want to provide a high level of service to those companies. We want to be a valued partner in terms of providing capital to them. And as a result of that, the combination of investments in long-term relationships with our borrower clients, we think delivers better outcomes for our investors. And so we're very clear about the need to ensure that we're delivering both the service to our borrower clients, and as a result of that, delivering good investment opportunities for our investors. But equally, size and scale is of material benefit. If you think about, in Australia, you've got competing private debt managers. In other asset classes, investors might think of manager diversification. They might think of asset class diversification, and they might sort of think of, particularly in equities, where you might have a star stock picker that's going to generate all this alpha and upside value for you through investing in their funds. In private debt, you want to be with a large scalable business that can deliver diversification across borrowers. What you don't want is to find out you've diversified by manager, to only find out that multiple managers have invested in the same deal, increasing your risk. So it's really important, I think, to benefit from the large size scale of the manager that gives you access to greater diversification and limits the exposure you have to any one individual borrower. And I think that's been a real feature of our activities, because we've invested substantially in building out origination capability across our team. We've got a great team that are focused on delivering outcomes for our borrowers, and as a result of that, investors get the benefit of substantial diversification. But equally, as you become large and scalable, as a lender, you become very relevant to the borrower and banks. If you think about our funds, for instance, say we're competing against a smaller manager that may have raised $100 million. And you think about it in the context of a borrower, say, wanting to borrow $50 million. $50 million in the context of our size, scale, and diversification, it fits quite neatly. So therefore, you're very relevant to that borrower. And so you're negotiating power in terms of fees and margins and the terms upon which you lend become, you've got a bit more power in that negotiation compared to, say, a manager that's got $100 million, you can't do a $50 million deal, the concentration in his portfolio would be materially greater. So therefore, the investor might miss out on that opportunity. Or if the manager was to do that, they might have to say, I can only do $10 million of the $50 million. So therefore, that manager and that fund is not relevant to the borrower. So again, missing out on the opportunity to generate or maximise the returns for the investors in that fund. So size and scale is definitely an advantage to investors. And I also believe that one of the things that we've tried to do is as our businesses got larger and our funds have grown, and we've tried to pass that through to investors in the form of lower costs. So again, delivering benefits to investors as a result of the size and scale of our business. Sure. And so just to pivot a little bit, we've been talking private debt, want to talk about private equity a little bit as well. So why do you feel that private equity within real estate is an attractive asset class for investors? Look, I think for us, we see, I guess, a broad range of transactions across the market. And our role is to really identify where we can deliver the best outcomes for our investors. Sometimes that might be in a lending transaction, sometimes it might be that there's an opportunity to participate in the equity or the profits of the project or the company. And so having the capability and the flexibility across our business and funds to be able to provide equity, but also to provide debt at appropriate times, gives us an advantage, I think, in terms of being able to access good quality transaction opportunities for investors, which again, private, they're confidential. There would be very limited ways in which retail or wholesale investors can gain access to a diversified pool of investments, say, in residential high-density apartment dwellings. They're often private developers that don't look for access to capital from broader markets. And so our relationship with our client base and borrowers gives us an opportunity to provide capital to those groups. And we're providing capital to those groups where we've seen they've got a demonstrated proven track record of delivery and performance. And so as a result of that, they represent good joint venture partners to do transactions with. Right. And so when you're looking at private equity, there's potential for some higher returns in that space. For Metrix, what are the target returns you're looking at within real estate equity and what's driving the returns? Yeah. And so the return profile can vary depending on the risks that you take. So for instance, if you were to take a planning risk, then you would want the return to be materially greater than a site that isn't subject to plenary. So a simple example, if you're investing in a site that might be an existing commercial office building that needs to be repositioned, say, to residential, the risk associated with getting a rezoning to cater for a residential project is greater than buying into a site that might already accommodate for a residential development. So planning risk is one aspect. Market risk, the ability to determine whether or not there's going to be an end market for the product that you're developing. So if you're building a residential high-density apartment building, you're taking risks that people will want to buy apartments in that location and for that price point. So you're taking market risk in terms of sales price and demand. So you need to do a lot of analysis to understand the market risk you're taking. Same in industrial, same if you're building a hotel, what's the genuine demand in terms of occupancy levels and room rates that a new hotel might deliver and who's your partner that's going to operate the hotel and all of those sorts of things. If you think about then another risk component might actually be construction or delivery risk. So the risk around, can the project be delivered? Can the construction and the project costs and the financing costs be delivered within an approved budget that will deliver an acceptable margin and return? And then of course, you've got other variabilities around what happens if construction costs rise, what happens if builders fail or you've got bad weather that can extend the timetable, all of those sorts of risks. So as a result of the risk profile, the returns that you generate from individual investments need to reflect that. So if we were going to do a lower risk equity transaction, we might be looking for sort of a 15% to 20% IRR. Greater risk, we might be looking for greater than 20% IRR. So it really does vary. So in our real estate equity fund, we seek to deliver investors with a minimum IRR of 15%, net of fees and costs, and then you're targeting developments and projects that are delivering sort of 20% plus. Well, wait, that's not a bad margin. That's the kind of returns you want if you're taking some risk. I think for equity capital, you're in a different part of the capital structure compared to a debt provider or a lender. And so the return should reflect that. But the degree of certainty you've got in relation to a project that you might be financing is, I think, and the degree of control that we have over an individual project that we might be undertaking with our joint venture partners, I believe gives you a greater degree of confidence around the return profile than perhaps investing in public market equities where you don't have management control, you don't have access to information to be able to see how the company is going to perform. You don't know what products or services the company is going to deliver, how management are focused on reducing costs, management wages, remuneration structures, all of those sorts of things can impact the return a shareholder can get. If you actually look at Australia's share market, it's pretty stable and mature and not really delivering those kinds of excess returns for investors from the core of the business. And so I think investment in private equity in real estate presents a pretty attractive alternative. And so you've mentioned a few different types of real estate in there. You brought up an example of a hotel, for instance, because real estate, it's quite a broad term. It can mean a lot of things to a lot of different people. Can you elaborate a little bit on the types of real estate that Metrix looks to invest in, how you go about selecting those investments? Primarily, we're looking for value and development opportunities. We're not investing in passive investment assets that are generating income from rentals. For instance, we're heavily involved in developing a range of residential development, high density apartment buildings, for instance. So again, what we're looking for there is what's the project look like? What's the market depth? Are we confident that the market is going to be there to absorb the product? Can we deliver the product at the right price to generate a profit? We want to know that we're working with reputable and strong parties that have got experience and background in construction and project management. They've got their appropriate planning, that they've got appropriate workplace health and safety issues, that they're building a quality product. We want to make sure that our products are also strong in terms of environmental issues. ESG issues are important. That's an aspect in terms of our residential transactions. We're also involved in, we're doing a project that is a gentrification of a site in Victoria, in Melbourne. We're building townhouses in a site, medium, low density dwellings, high density dwellings. We're involved in a retail shopping centre that we've acquired that again, has future land banking and opportunities to add value and further develop the site. We're building a hotel in the centre of Sydney that's turning into an arrangement with the Marriott. There's a whole range of activities that we're involved in. Primarily what we're looking to do is to partner with good quality development partners where we can assist them with access to capital and funding. We can assess the risk to determine whether or not it's an appropriate investment opportunity for our clients. In the instance of the high density building, for instance, and you mentioned not really looking for the passive rental income, the idea there would be you build then sell the apartments off. So we're financing a project and just the same way we provide debt financing, when we're equity financing, we're financing a project. And that is, have we bought the land at the appropriate price? Have we got all of the approvals? What's the timeline between commitment of capital to exit and repayment and release of our capital from the sale of the completed product? And then what do we need to do to make sure that the project is built on time, on budget and with the appropriate quality to ensure that it's delivering a good end product that's saleable? Right. And so you've mentioned a couple of risks in there. So earlier, you mentioned planning risk, you've mentioned avoiding dodgy builders, that would be a risk. What are some of the other risks in the private equity real estate space? And what do you guys at Metrix do to try and mitigate the risks for investors? As you mentioned, vetting the builders is an important one. Well, good quality counterparties and joint venture partners is critical. So you're looking for groups and we do business with. And one of the things we do is we prefer to be involved at an equity level with groups that we've lent money to. So we've tested them out in terms of that relationship. But what we also, if you think about the risks, the risks are planning, planning risk, delivery risk, completion risk. They're the three key areas in development funding. And so everything we do then goes to mitigate what is the risk of the planning outcome being achieved within the time period. So you factor in a whole range of contingencies around time and costs associated with achieving a planning outcome, making sure you've got alternatives and that you're not trying to push the envelope in terms of what you're trying to achieve from a planning outcome that wouldn't be acceptable to the government or the community. And then you think about the product that you're delivering, is there demand? And so market risk is very important to overcome. So planning risk, market risk, and that comes down to ensuring that you've got a good understanding of competing sites, competing developments that might appeal if you've got a competitively priced product. What's the market depth looks like? What's it look like in terms of end buyer demand? And are they going to pay an appropriate price that delivers a profit margin? And then obviously, construction delivery risk, who's going to build the thing? Have we got confidence that it can be built on time or budget? What are the ways in which we can mitigate that risk? And then completion risk is all about making sure that on completion of the project, people settle, your property sold, and you're recovering all of your principal and profits through that process. And that you're not left with large swathes of unsold stock or inventory that you have to discount or anything like that. So management of market risk and cash flows is very important. But through that process, there's a range of... We structure and negotiate terms with our joint venture partners to ensure that this isn't just a blank check. You're providing financing on the basis of it being linked to performance outcomes that our joint venture partners need to achieve. And they're aligned with the achievement of those objectives. So financial alignment with our joint venture partners to deliver on the project objectives is very important. Absolutely. And so for investors themselves who are looking perhaps to get involved in private equity or real estate, how do they gain access to the asset class? What are they looking at typically in terms of investment size? Have you got funds that they can invest in? Or have you got others that are coming that they can invest in? We have both. We have existing real estate equity funds and a range of new and existing funds where investors can allocate and get exposure to the asset class. Importantly, we continue to originate good opportunities. So we have a very strong pipeline of future investment opportunities. And I think one of the things that appeals to us about our real estate equity fund is as it builds, a lot of people have had exposure to one single property investment. And so they don't get the benefits of diversification. Here, as our size and scale delivers increasing diversification and those investments are being made on a more frequent basis, the ability to have the fund run right at a higher total return over time, I think is pretty appealing for investors. So it's an ongoing development equity fund providing investors with diversification. So strong pipeline, existing funds, new funds coming. And certainly the way in which people can find out about that is getting contact with us directly and we're happy to help them. Of course. And so some investors, sometimes they look for stuff like single assets, syndicated offers. It's an option for some investors. What do you guys at Metrix think about the risk return profile for this kind of investment versus a diversified fund? Yeah. The benefit, I suppose, is that investors can see and understand the extent of the investments that we make. And so rather than, I guess, putting all of your capital into one project that may or may not pay off, you've got the ability to spread that capital across multiple funds but not dilute your returns. And so I think the ability to gain access to quality counterparties that we do business with, good sites, good location, diversification across industrial, residential, residential high-rise, residential land subdivisions, into retail, into hotels. I think that broad diversification of individual assets, geographic diversification, counterparty diversification managed by a quality team at Metrix I think is a superior investment proposition than going into an individual property syndicate. Yeah. I mean, look, I talk to primarily advisors when I'm reporting about stuff. They always spruik the value of diversification. It's certainly something that advisors strongly recommend is diversifying. So it's certainly in line with the things that I hear from the advice profession. Yeah. Very much so.

Well, that's all I've got for you today, Andrew. Thank you very much for joining the show. It was a pleasure having you on. Thanks very much, Keith. And thank you very much for having me. Not a problem. And so that's all we've got for today. So thank you for joining in and having a listen to Andrew Lockhart from Metrix Credit Partners. And we will see you next time. Bye for now.