By: Chad Valerio, Managing Director and Portfolio Manager of Opportunistic Credit.
If you ask ten investors how they define Opportunistic Credit, you will likely get ten different answers. Typically, the common characteristics include targeting a higher return than traditional credit strategies by employing a more flexible mandate that allows managers to shift to where they see the best risk-adjusted returns. This flexibility is designed to capture the return potential that is created by the artificial silos and barriers that arise in financial markets.
For many Opportunistic Credit strategies, that has meant investing in companies facing some degree of stress since many performing credit strategies have limitations on their ability to invest in lower-rated credit or in companies that are in bankruptcy. However, to truly be opportunistic, investors need to broaden their target markets to include new asset classes and new points on the credit spectrum.
One of the biggest opportunities for this expansion today is growth debt. In the world of venture capital, investors distinguish between venture and growth equity based on where the subject company is in its life cycle. Venture capital is typically used to describe investments in companies that are more speculative and earlier in their development, whereas growth equity refers to capital used to accelerate a business that has already proven concept and gained significant traction.
Similarly, we define venture lending as providing loans to earlier stage businesses, often secured by hard assets such as equipment or receivables, while growth debt is defined as lending to more developed, yet still quickly growing companies with creditors relying more on substantial and proven enterprise value rather than tangible collateral for their downside protection.
For Opportunistic Credit investors, growth debt is an attractive way to diversify risk and inject significant upside potential into a portfolio. Since many of these borrowers have never had debt in their capital structures, growth debt is very often in the senior-most position. Typical loan-to-value ratios in the 10-20% context are quite low compared to traditional credit strategies, yet because of the limited lender base, target returns are significantly higher. Furthermore, these loans almost always come with warrants that allow lenders to participate in the future growth and success of these businesses.
Opportunistic Credit strategies are well positioned to provide this capital given the significant degree of underwriting and structuring that is required. Because these borrowers are continuing to invest in their growth through research, marketing, and personnel, they sometimes lack the standard credit metrics that go into a classic underwriting model. For investors willing to truly develop their own view of value, this creates an incredible opportunity. Historically, growth companies have been conditioned to think that debt would constrain their business development and that their capital structures should be fully equity financed.
This has resulted in high quality businesses continuing to raise expensive equity capital even as their inherent risk has significantly decreased. Opportunistic Credit strategies are disrupting this status quo by providing less dilutive growth debt that can supplement an equity raise and reduce the overall equity required. By pairing lenders, who place a premium on downside protection, with equity investors, who are focused on upside potential, each party achieves their desired objective, and the underlying companies receive a lower overall cost of capital.
Ultimately, in any of its forms, Opportunistic Credit is about providing capital to companies that have strong inherent value yet lack access to traditional capital providers. In the case of growth debt, investors are identifying a new market to enhance and diversify returns, while borrowers are finding access to lower cost capital to help grow their businesses.