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Private Credit 

Owen Sanderson

Quebec’s vast pension fund CDPQ ($391bn under management at end-June) is one of the world’s best known strategic investors, with an $80bn private equity portfolio, and investments in marquee assets like Heathrow Airport and Eurostar, as well as a diverse array of portfolio companies worldwide.

In 2020, it established the “Capital Solutions” unit within its broader fixed income operations, with a flexible mandate to invest in specialty finance assets, subordinated capital, opportunistic credit and special situations. The group has done complex transactions involving aircraft leasing, insurance, mining royalties, recurring revenue lending, mortgage portfolios, and music royalties — and it still has capital to deploy.

9fin caught up with James Ruane, a London-based managing director in the group since January 2022 to discuss the strategy, markets in 2022, opportunities in specialty finance, the cost of living crisis. Ruane develops the international strategy for the unit across Europe, Asia and South America, and is responsible for business development related to North American transportation and finance.

Ruane was formerly head of European special situations at Bayview Asset Management, and before that worked at Deutsche Bank and Apax Partners.

How has 2022 affected the opportunity set in specialty finance/capital solutions?

I’d almost break the year into three parts. The first part was really before the Russian invasion of Ukraine, when you still had relatively robust capital markets, securitisations were getting done, there was extensive activity. And if capital markets are functioning well that can be a pretty big competitor for us. Then there was a period after war broke out when there was very little happening, things went into a period of hibernation as everyone was trying to assess what it meant. That persisted into June or July when we saw companies asking themselves what they needed for their business. Whether you’re a company that needs working capital or a lender that needs to refinance its book, you can’t stay in hibernation forever. So our pipeline filled up pretty rapidly at that point and that’s kept us very busy through to now.

We’re seeing extensive opportunities to invest at attractive levels with anyone who’s dependent on capital markets access. There are frequent securitisation issuers, non-banks that typically issue a securitisation every three to six months. They’ll often have a warehouse line or lines from an investment bank….so if the warehouse is filling up, what do they do? They might get a privately placed securitisation done with a small number of investors, or they might come to us and say “would you like to buy a portfolio from us to clear out your warehouse, or enter a forward flow agreement to buy newly originated loans from us”?

Working capital deals can also be attractive. In the US we recently did a receivables finance transaction for a business supplying retail chains. Companies are asking how they find extra sources of liquidity. The traditional way of just going out and issuing a public bond is more difficult today.

The final area that we've seen quite a bit of activity has been the tech space, where equity market conditions have been relatively difficult, and tech firms are asking themselves what alternative capital sources are available. Could that be some sort of a credit product with stapled warrants? Do I have a contract or their IP that I can monetise?

We did a transaction in the US recently, financing a SaaS business with several hundred million in revenue. It was a good business with great customer acceptance, it’s really well liked by its customers. The company had the opportunity to grow, to scale through increasing its spend on online marketing, and it felt it had a opportunity to keep up its growth momentum.

So what we ended up doing is funding a portion of their customer acquisition costs in return for what’s effectively a loan product, but which is paid back through a fixed proportion of the revenue they receive every month. So it’s nicely secured, because the revenue share pays you back quite quickly, and you can look over six or seven years of data to see the stability of the customer acquisition trends. This kind of structure isn’t for everyone, because it requires cross-discipline thinking, whereas a lot of investors are more siloed or not set up to think in that way.

What impact will recession/cost of living have on consumer / SME / corporate credit — is it possible to structure around these issues and stay protected?

We've got to be cautious in this environment. Our focus has been very much on investment with high quality partners as well as high quality underlying assets. What's the quality of the collateral? How will it perform in a downturn? If anything goes wrong, how quickly can it be realised? There's a high degree of scrutiny on that both at the deal team level and in the Investment Committee discussions.

To me the question of protection comes asset class by asset class — it’s not just a case of doing mortgage rather than credit cards or something like that. If we’re doing consumer credit, should it be something with a lot of credit risk and a lot of spread, or something targeting prime borrowers?

So question one is: within an asset class, am I picking good spots?

The second question is: where am I in the structure? You might move up the capital stack to give yourself protection. In the mortgage space we’ve been looking at lower LTV products which give you a little bit more protection should anything go wrong.

And of course there’s also price. There’s an opportunity in some markets to buy portfolios at a discount which helps: even when you’ve picked what you think is the right asset class, making sure that the structure and entry price provides protection is an important part of the investment decision.

How does the opportunity set differ in Europe / UK vs North America?

We run Capital Solutions as a fully integrated platform across North America and Europe. We have people in New York, in London, and most importantly in Montreal.

But in terms of the differences we see, Europe still remains more bank-dominated. If you look at the percentage of non-bank financing overall, it’s probably around half the level in Europe compared to the United States. So you see a bigger spectrum of opportunities in North America just reflecting that difference in market penetration.

Deals themselves also tend to be smaller. Often a borrower is focused on a single European jurisdiction, and consumer credit products are defined by national consumer protection law. The loan agreement for a mortgage in Germany is a German law document enforceable in Germany. In the securitisation world, you're not normally going to be commingling loans that originated by a single originator in two or three countries into a single trade.

Something like 80% of mortgages in the US are originated by non-banks. I don’t know what the overall figure is for Europe, but in some countries like Spain or Italy, the percentage is close to zero. There’s essentially no non-bank origination of certain products. So you always have to be mindful of this dynamic, and bear in mind that you’ll be looking at the products where they’re not playing for whatever reason.

What’s a characteristic CDPQ trade? What’s the secret sauce?

Our biggest single transaction in Capital Solutions, and one which explains what makes CDPQ different is our joint venture with Aercap, one of the Irish leasing companies. We invest predominantly in young, new generation short haul aircraft -- like the A320neo. It’s an example of being able to partner up with a best-in-class operator in a sector we like, and then do two things.

The first is commit capital in size, so we committed to investing half a billion a year over four years. And the second is that we did that with no capital markets dependency. This is a big differentiator for CDPQ — other investors might require bank financing or securitisation to make their investment work, but given the nature of our capital, we can do without. We can simply commit that money on an unlevered basis, so if you’re partnering with us you know we can provide committed capital independent of market fluctuations.

Are there any worthwhile opportunities through public markets?

Across CDPQ we’ve seen that the liquid credit markets have repriced more quickly than some private markets. It’s not universal but in general there’s been a fairly rapid repricing in liquid credit. And in some cases we’ve deployed quite actively into those markets, reflecting what we think are attractive return prospects.

But equally you can't simply build a long-term business around just opportunistically buying liquid credit. If you're not out there, engaging with partners and borrowers, if you just suddenly disappear that's actually quite damaging to your franchise. So you've got to be doing both because markets are cyclical, and while there might be great opportunities in one market at this point in time, you know markets won’t be stable on a five year view. All credit assets have a finite life so you’re always going to get repaid and have to reinvest.

At least in our business, we’ve seen an ability to get transactions done at attractive premia to liquid credit. So although liquid credit is attractive, some of that pricing is getting reflected into private markets. Some pockets haven’t repriced, but some have repriced quite significantly, and if you can find these, yields can be quite attractive.

Is it better to invest through asset portfolios or through ownership of origination platforms? Does the determination vary by asset class/sector niche?

Well….it depends! We have the ability to do both within our mandate. We can buy a stake in an originator, equally we can buy asset portfolios, and portfolios have been our focus to date. But there can be times when alignment of interest is really valuable and having that seat at the table with an originator is important. We're pretty close to finalising a deal in the US, where we’ll have an option to acquire equity in the platform, which is a really nice way of cementing what we think could be quite an interesting long-term relationship.

We’re a three-year old team within CDPQ, so we’re still relatively new in the journey. As we go forward, it’s nice to have the option to invest in platforms in the toolkit. We’re in a cyclical industry, and the right tools can depend on the point in the cycle. Right now, we’re in a phase where everyone needs access to capital and to liquidity, so if you have that available, it’s you can see a lot of investment opportunities.

At other points in the cycle, the challenge can be the reverse — there’s lot of capital and liquidity available and the challenge is guaranteeing your access to assets. At that point in the cycle, that’s often where a form of long term relationship or platform ownership becomes really valuable.

To what extent has the growth in specialty finance sectors been enabled by bank regulation? Will the pendulum swing back towards the banks at some point?

There’s two elements here. There’s regulation, which has made some products less attractive from a capital perspective for banks. But the second element is that banks have been forced to critically assess their business models. I spent many years at Deutsche Bank, and it used to describe itself as a global universal bank. Every product to every customer everywhere in the world was the strategy. That strategy has changed for Deutsche and other banks – now it’s important to pick your spots and be only in the areas where you're really competitive. This has driven banks towards products which are standardised and can be easily scaled. So that has often opened up products that are more bespoke, more complex, that need a little bit more manual underwriting, or aren’t as suited to being pushed through a volume process to the non-banks.

What’s the difference between a FinTech lender and a lender?

Let me let me flip it around. I don't think you can be competitive in the modern world running a lending business with no tech in it, right? So the “tech” is simply the price of entry in terms of efficiency, controls and business processes. Every lender is going to be pretty heavily tech enabled at this point.

But I do think there are some areas where you can't rely fully on technology. So you will see in the specialist lending sector, products with a little bit of complexity, which earns you a premium in terms of return, but which needs a human in the process to actually do the underwrite and review it. So you add a lot of tech around the process to make it more efficient. In mortgages, for example, you upload all of your documents and your application online, but then you have a skilled mortgage underwriter who can make a judgement call on some of the most difficult cases. So that’s a long-winded way of saying you need tech, but there's often areas where being a bit traditional can be quite valuable.

9Questions — James Ruane, MD Capital Solutions at CDPQ

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9Questions — James Ruane, MD Capital Solutions at CDPQ

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