Blog: Risk Management – Staying On The Front Foot.

EXECUTIVE SUMMARY

Markets are currently swallowing a bitter cocktail of significant stresses – rising inflation, volatility, and interest rates – which are being shaken and stirred vigorously by the recent pandemic and ongoing geopolitical turmoil. Authorities remain challenged by the complexities of monetary and fiscal policy and markets react with lightning speed. Such uncertain and unpredictable times highlight the primacy of a front-footed approach to risk management throughout the transaction lifecycle. Of course, navigating these markets is challenging! From a risk management point of view, there are numerous quantitative measurement metrics – no doubt many of the performance triggers are under pressure – but by their nature these measures are often backward-looking and may take time to raise the alarm. But what can be done on a qualitative, forward-thinking basis ahead of such triggers, breaches and events to preserve and enhance investments, returns and profitability? I want to highlight a more qualitative and intangible aspect of risk management: specifically, the fine art of knowing and understanding your counterparty.

KNOW AND UNDERSTAND

Effective portfolio management helps to respond quickly to unforeseen events and preserve the quality of portfolio assets. Not all market events and/or disruptions can be predicted or fully mitigated but they can be understood and managed.

The art is knowing how and when to act

Credit investments can only be properly evaluated when inherent risks are identified, understood thoroughly and analysed rigorously. The art is knowing how and when to act, possessing the judgement, skill and wisdom that comes with experience, and crucially, having a collaborative and cohesive investment team that will push and challenge constantly. Such teams are nimble. They have a broad strategic focus combined with a pragmatic approach to risk in order to safely navigate through dynamic markets and take advantage of opportunities. They also possess years of experience – both individually and collectively – a trait which is paramount when it comes to identifying, judging and weighing the intangibles (or the known unknowns).

THE BIG THREE

To elaborate, here are three core investment underwriting elements that we always reference at SCIO. Overall, our loans tend to be secured, are short-to-medium-term in duration, with direct recourse to specific asset-based pools.

• Cash flow is king: Structures may provide credit support, but SCIO’s first line of protection is net cashflow. We therefore test the collateral pool of cash-producing assets to see how they might perform under various stress scenarios.
• Alignment of interest: Does the transaction structure ensure that the sponsor is aligned, ie first in line to suffer losses? Opportunities abound, but our turndown percentage of roughly 90% reflects a cold-eyed screening and selection process. Importantly, this is a process that must be dynamic – a static screening process would inhibit adaptation to changing market conditions.
• Transparency: Transparent counterparties with whom we can build an enduring relationship based on trust are our bedrock. This approach requires SCIO to be active partners (not passive lenders) with a relentless passion to connect and understand. Intangibles, which are qualitative and difficult to measure, are a key ingredient. To identify and then monitor these, we work to strike the right balance of interaction with key counterparties and build trust-based relationships. By doing so we are better placed to know early on if a business plan is off-track – better to work together to resolve rather than remain inert and hope it will self-correct.This approach allows us to navigate safely through disruption, avoid over-reliance on periodic transaction reporting, and ultimately benefits our investors through consistent outperformance and capital preservation.

PREDOMINANTLY PRIVATE, OPPORTUNISTICALLY PUBLIC

One of SCIO’s key differentiators is its ability to seamlessly navigate between private and public credit markets in order to take advantage of market dislocations. The nature of counterparty relationships within these two markets can be very different:

• Private deals typically have fewer counterparties (single lender and single borrower) which leads to a prime seat at the table and the ability to shape and influence negotiations towards satisfactory (low volatility) outcomes.
• Public deals often have multiple counterparties which leads to differing, conflicting interests and often no straightforward and cohesive plan.

Here are two historic transaction examples where SCIO has employed a front-footed approach in order to remedy a challenging situation:

• Public: Bond backed by large pool of UK consumer loans Subpar servicing led to a breach of deal triggers which, in turn exposed investors to potential losses. SCIO became actively involved in a working group with multiple investors over several months, had the servicer replaced which stabilised the deal, allowing SCIO to exit the position at a modest premium to book value.
• Private: German residential real estate manager This investment had, on its surface, satisfactory performance. However, we grew uncomfortable with the quality of deal reporting and general lack of transparency  and engagement with the sponsor (often we were left waiting as queries remained unanswered). SCIO decided to exit the trade, again at a modest premium to book value. Wind forward a couple of years and we feel vindicated in our decision, given the recent market scrutiny of the counterparty’s corporate (accounting) governance.

TIMELY, CLEAR AND ACCURATE

Investors deserve timely, clear and accurate responses to their queries. Transparency is paramount to SCIO’s philosophy of putting investors first, and we demand the same from our investment counterparties.

Information is like market liquidity – it’s typically not available when you most need it

We observe that when times are good, counterparties tend to share an abundance of news, but this transparency tends to become cloudy when events and performance become challenging owing to cognitive biases. In this sense, information is like market liquidity – it’s typically not available when you most need it.

FINAL THOUGHTS

Long-term success in managing credit portfolios requires flexibility, both to manage investments from entry to exit as well as to adjust to dynamic, ever-evolving markets. This necessitates a prudent, front-footed and pragmatic approach to investment management in order to ensure the highest level of service to investors. Thanks for reading! Jason