Short Duration, Asset Backed Lending: A Primer

Disclaimer: I have no connection to or investments currently with any of the companies mentioned in this article, although I may in the future.  Do your own due diligence before making an investment decision.  It’s your money; you’re the best person to judge what is best to do with it.

I have a confession to make: I am a big fan of credit investments.  Certain kinds of credit investments.  It goes against the grain of building a large family fortune, as investing in high quality credit investments is more about maintaining wealth than building it.  However, I hate to lose, and this goes double for losing money.  It’s why I can’t go to a casino.  I know what the odds are.  So I don’t play.  It’s why I focus so much on adding optionality to my family’s investment portfolio: limit the downside while maintaining the upside.  Credit investing seems like the opposite of that: all the downside with limited upside.  That is absolutely true, but here is one of the key points to investing:

Selling short-term downside risk in order to buy long-term downside protection makes a happy portfolio!

Many of you may be asking yourself “huh?”  It’s okay, because this key concept took me years to learn, and I’m a professional investor by trade.  Short-term downside risk tends to be overpriced, while long-term downside protection tends to be fairly priced or underpriced.  I’ll discuss this concept more broadly in future posts (this is what I consider a key insight in investing), but short duration, asset-backed credit equates nicely with selling short term downside risk.  In the case of asset-backed credit, it also tends to have very limited downside risk.  For those familiar with option trading, it is similar to a put spread, where the strikes are very near the money.

First, the Taxes

Before going any further, I have to take a detour to discuss taxes.  Remember, our goal overall is to earn a real 5% per annum return.  That’s 5% after inflation and taxes.  Frankly, this is a tough nut to crack.  I consider myself fortunate enough to be in the highest tax bracket (well, not that fortunate – nobody likes taxes!).  Sounds trite, but it means that I earn more than 95+% of taxpayers.  I am also in a fairly high income tax state, which means that my marginal tax rate on income is close to 50%.  Let’s see how the math works:

Real 5%: 5.0%

+ Inflation: 1.5%

+Taxes (50%): 6.5%

Target Return: 13%!

You can see how the government, either intentionally or not, prefers equity investments over income generating assets.  The capital gains tax for high income earners is only 20%, which combined with my state’s capital gains tax, implies a roughly 25% rate.

Real 5%: 5.0%

+ Inflation: 1.5%

+Taxes (25%): 2.17%

Target Return: 8.67%

So where does it ever make sense to add credit investments?  Obviously it has to be high yield, but you always want to be sure risk is mitigated to the downside.  Let’s take a look at some of the characteristics of a solid credit investment.

What is Short Duration?

Duration is the measure of how sensitive a fixed income investment is to changes in interest rates.  For example, if an investment has a duration of 10, then it would be reasonable to estimate that the investment will go up by 10% if interest rates drop by 1%, or it will go down by 10% if interest rates rise by 1% (remember that fixed income investments have an inverse correlation to changes in interest rates).  The goal of building a portfolio with limited short-term downside risk is to prevent it from changing in value substantially while you hold it (most professionals cannot accurately predict interest rates, let alone you or me!).  Hence, sticking with short duration assets is key.

Duration is driven by two components, how long a fixed income asset has until maturity, and how much cash flow it pays out during the life of that investment.  A zero coupon bond (pays no interest until maturity, but purchased at a discount) would have a duration equal to its maturity.  On the flip side, a high yielding, cash paying investment will have a duration substantially shorter than the stated maturity rate.  This is because those cash flows can be reinvested along the way, and as such, are less sensitive to changes in interest rates.

From our perspective, short maturities (1-4 years) and larger coupons (8% or more) would be ideal.  How can you find those?  The 2yr US Treasury is yielding 1.3%, the Vanguard Short-term Investment Grade Credit ETF is yielding 2.25% and the SPDR Short Term High Yield Bond ETF is yielding 5.5%.  You can find these higher yielding, shorter duration assets, but you must be willing to stray from the more traditional fixed income investments.

Asset-Backed Provides Downside Protection

Asset-backed loans provide downside because you have a legally specified piece of collateral that can be seized in the event of a default.  Historically, asset-backed loans have included things like auto loans, credit cards, student loans, and home equity loans.  However, those are not the same as some of the newer asset-backed loans.  After all, the Barclays 1-3 year Asset-Backed Security index is yielding only 1.5%.  Not exactly the yield we’re looking for.

In order to earn a higher yield while still maintaining downside protection, you must be willing to invest in and lend against what have been considered “alternative investments” in the past.  Below are a few asset-backed loans that provide a nice yield return with a strong asset underneath.  Note that for most of the investment platforms themselves, you must be an accredited investor before you can invest.  To be considered an accredited investor, you must have either earned over $200,000 per year ($300,000 for a couple) over the last two years with the expectation to continue earning that, or have a net worth of $1 million or more, excluding your primary residence.  Given that readers of this blog are naturally above average, many are likely to be accredited investors, or well on their way.

  1. Real Estate Bridge Lending: Real estate bridge lending has grown substantially in the last few years, and the online alternative investing platforms have really stepped up. For example, one of the biggest is Peerstreet, which provides financing to fix and flip investors.   However, this has become a very crowded space, with groups like Realtyshares, Yieldstreet and others offering bridge loans on real estate.  In other words, supply has increased, making investments easier to find, but it has also compressed yields on the loans.

A fix and flip investor will often take out a short-term loan (called a hard money loan) for repairs and upgrades, and then either refinance the property with a traditional, much cheaper lender upon completion of the project, or more likely, sell the property and repay the loan.  Hard money loans are traditionally well-secured, with loan-to-values of 40-70% of the home value.  Yields tend to fall in the 7-11% range.  The risk in these types of loans is in the ability of the fix and flip investor to execute their plan.  Taking over a project that is half completed is not the outcome that hard money lenders want.  However, the low LTV offers protection against losses in that case.  This has been one of my favorite investment ideas, but you must be ready to step in and invest when a loan becomes available.  These tend to go quickly.

  1. Litigation Finance: Litigation finance is the process of investing or lending money to law firms based on the cases that they are currently working on. Litigation finance may get you out of your comfort zone, because looking at a law firm’s case load as an asset is not the norm.  Even law firms themselves often do not recognize that they’ve created an asset based on the work they’ve done for a case.  From what I’ve been able to find, only YieldStreet offers litigation finance investments, although I’m sure that there are others out there.  You can also invest directly with companies that invest in these types of litigation finance investments, such as Burford Capital.  Think of Burford Capital as a business development company (BDC) for litigation finance.

Litigation finance can be broken down into two primary categories:

  • Pre-Settlement: These are cases that are still working their way through the legal system and the outcome is still unknown. Investing in pre-settlement cases is the equivalent of taking an equity position in a legal case: potential for large upside but also the potential for a zero.  These can be interesting if you know what to look for (you have to understand the legal nuances, which I personally do not), but this is definitely not a lending transaction.  If you are only interested in lending transactions, this would cause you to exclude the legal BDCs like Burford Capital.
  • Post-Settlement: Post-settlement investments are the act of advancing the legal fee from a settlement or award before the lawyers are paid. Law firms that rely on contingent payments (paid only when they win) are normally in a fairly precarious cash flow position much of the time.  Generally speaking, their fees are not received until they win a case or settle, and everything is processed through the courts.  At the same time, they have a staff of high-priced professionals that expect to get paid on an ongoing basis as well as costs related to case work.

A law firm will often take a short term loan (12-24 months) at a fairly high rate (12% or higher) in order to help even out that cash flow.  In most cases, the partners of the law firm all provide personal guarantees as well.  Banks do not like to finance law firms because of the way their revenue structure is so uneven.   This opens up the opportunity to more savvy investors.

  1. Factoring: Factoring is a form of financing that is often used by small and medium-sized businesses. There are two main types of factoring: accounts receivable (less risky) and inventory factoring (more risky).  Let’s use a small consumer manufacturer that sells to a big box retailer such as Wal-Mart as an example.

Wal-Mart orders their product on a regular basis, so the manufacturer must hold both raw material inventory and finished product inventory.  For inventory factoring, a loan is made and secured by the inventory based on the expected fire sale value of the inventory (normally 70% or less of the fire sale inventory value).  The loan is paid off as the product is sold and Wal-Mart makes payments.  Because inventory tends to turn over so quickly, these loans are often made as a line of credit to recognize the up and down nature of inventory, but each individual draw tends to be a very short duration.  The liquidation value of inventory is difficult to determine in advance, which makes inventory factoring riskier than accounts receivable factoring below.

Now let’s assume that Wal-Mart has taken the finished product and put it in their store.  Our small manufacturer bills Wal-Mart, but because Wal-Mart is the big dog on the street, they don’t pay for 120-180 days.  However, this manufacturer needs to pay its employees, buy new materials, and keep the lights on.  So that manufacturer can either outright sell the invoice to an investor at a discount, or take out a loan against the value of the invoice.  Investors can offer these types of solutions and in effect, you now have Wal-Mart credit backing a high yield loan with the corresponding high return.  The biggest risk here tends to be fraud, given that factoring is used mainly by small and mid-sized companies.

P2BInvestor and Kickfurther are two companies that provide these types of financing.

Overall, do your due diligence, but do not be afraid to think differently about what constitutes an asset.  I’ve seen loans made to professional athletes based on their contracts as well as financing equipment for medical clinics.  All of these loans can have solid collateral coverage, but do not fit in the standard investing box.

Adverse Selection

Adverse selection is one of my biggest fears in investing in these types of products.  I have a somewhat unique perspective, because I have also invested in some of these products in my professional life.  There, I can write a check of $10-50 million and hire some of the best managers to do the underlying due diligence.  Part of me always thinks about why a company would borrow through an alternative investment platform when they could get a loan through one of the managers that I use at the endowment.

To get comfortable, first, you must always do your own due diligence.  If you are not 100% comfortable, don’t make the investment.  It’s as simple as that.  Sometimes the best action is to take no action.  Second, remember that many of these alternative lending platforms were started by individuals that broke off from the professional money managers to form their own firms.  Always check the backstory of the company and its founders.  Using the marketplace lending concept is just a way to raise capital, as opposed to the traditional route of going on the road and visiting with the likes of pension plan managers and endowment managers like me.  Sometimes, it’s easier to raise money through an online platform, as there is a huge pent up demand for these types of investments from individuals who would normally not have access.

Portfolio Construction

Building out a well-diversified pool of these investments is important.  Hard money fix and flip loans have far different risk characteristics than post-settlement litigation finance loans and accounts receivable factoring.  Diversifying the downside risk is key.

Using short duration loans also allows you to be more reactive.  Many of these loans have limited to no secondary liquidity, meaning once you make them, you are stuck with them.  However, the fact that the average loan is often paid back within 12-18 months should provide comfort.  Giving up a little liquidity for a year to earn a 10% yield or more is often worth the tradeoff.

Combining these short duration, asset-backed lending investments with upside optionality can provide an incredibly strong portfolio.  The downside risk protection of asset-backed loans will help prevent a large loss in a bear market.  On the other hand, using yield earned on these short duration loans to purchase things like call options allows you to participate in the upside.  Limiting drawdown while preserving upside growth should be the focus of every investor.

Keep building my friends.

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