Almost 40 per cent of the loans in a private debt fund run by Ninepoint Partners LP and Third Eye Capital Management Inc. have not required cash interest payments since their inception – and have not paid them – while another 25 per cent have the option to defer their cash interest payments, according to a document reviewed by The Globe and Mail.
The figures reviewed are from September, the last quarterly data available, and Third Eye told The Globe that some of the percentages are “erroneous” but would not provide new numbers.
Loans that do not pay cash interest are known as PIK loans, short for “payment in kind,” and are similar to IOUs that defer cash interest until the total debt comes due. These loans can reward investors with more interest when they mature, because the borrowers typically pay a higher interest rate in a lump sum.
However, PIK loans can also be riskier debts because no income is promised until maturity, which can be years out.
Asset manager Ninepoint proposes deal to unfreeze investor redemptions for largest private debt fund
The fund in question, the Ninepoint-TEC Private Credit Fund II, is managed day to day by Third Eye and marketed to investors by Ninepoint. Both companies are based in Toronto. In total the fund has $1.3-billion in assets, including roughly $200-million in cash and equity investments, and its size and decade-plus history make it one of the best-known private debt funds in Canada.
The fund’s percentage of PIK loans was communicated by Ninepoint to a Canadian bank that previously sold the fund through its adviser network. These figures were then relayed to bank advisers in a confidential memo, a copy of which was reviewed by The Globe.
Although Ninepoint and Third Eye have not widely disclosed what percentage of loans in the fund do not pay cash interest, their latest public investor update said three borrowers comprised 55 per cent of its $1.1-billion loan portfolio as of Oct. 31. Concentration risk of that sort means investors could suffer large losses if even one or two of those borrowers struggle. It is not clear if those three loans are deferring cash interest payments.
Private debt funds raise money from investors, then lend that money to higher-risk borrowers who can’t access traditional bank financing. These funds became popular with retail investors over the past decade by paying hefty yields at a time when many fixed-income investments paid next to nothing. Over the past 12 years the Ninepoint-TEC fund, which is sold to accredited retail investors in Canada, delivered a 10.45-per-cent average annual return.
Lately, though, private debt funds have lost some of their lustre because rising interest rates have made their yields look much less appealing relative to other fixed-income investments. The funds’ 8-per-cent to 10-per-cent annual returns used to compensate investors for the risk they were taking on, but their risk premium, as it is known, may not be enough any more, considering some guaranteed investment certificates pay more than 5 per cent annually. The economic outlook is much less rosy today, and riskier borrowers are more likely to default in tough times.
Over the past year a growing number of investors have been pulling money from private lenders. In February, 2022, Ninepoint suspended redemptions on four of its credit funds, including the Third Eye fund, which had $1.4-billion in assets at the time. Ninepoint cited a spike in payout requests related to the collapse of Bridging Finance Inc. and the resulting tension in private debt markets.
With $2.09-billion in assets, Bridging was one of Canada’s largest private debt managers, but the company was put into receivership in April, 2021. Its top officials, David and Natasha Sharpe, have since been accused of fraud by the Ontario Securities Commission, and Bridging Finance is under investigation by the RCMP, The Globe has reported. The receiver has estimated that investors will lose an average of two-thirds of their money.
Shortly after Ninepoint froze redemptions, the company disclosed that 25 per cent of investors in the Third Eye fund had tried to redeem their money. Ninepoint ended up restructuring the fund in September to assuage disgruntled investors, and ultimately just 10 per cent of them formally requested to take their money out.
Romspen, one of Canada’s biggest private mortgage lenders, with $3.2-billion in assets under management, also froze its own investor redemptions last fall, citing some trouble with loan repayments. The company’s portfolio largely comprises construction and predevelopment loans, and it lends to borrowers across the United States and Canada.
Redemption requests can be problematic for private debt managers because loans to higher-risk companies often cannot be recalled or sold on a moment’s notice, which makes it harder to come up with the cash to fund a surge in redemptions.
Lately redemptions have even been troublesome for private investment vehicles that aren’t necessarily as risky. Private equity giant Blackstone Inc. runs a private real estate investment trust for high-net-worth customers, known as BREIT, and in December Blackstone announced it had to limit redemptions on the fund because too many clients were asking for their money back.
Despite these developments, more asset managers are launching private debt funds that target retail investors in Canada, including Brookfield Asset Management Inc., another industry giant. What was once sold as a way to earn decent yields in an era of ultralow rates is now often marketed as a form of inflation protection. Private debt often charges a floating interest rate, so, much like variable-rate mortgages, borrowing costs rise whenever central banks hike their benchmark rates. This money can be passed on to fund investors in the form of higher yields.
Yet each product in the private debt sector carries a different level of risk. The proportion of PIK loans in the Ninepoint-TEC fund, for instance, can mean there isn’t as much inflation protection in the portfolio. Third Eye also specializes in distressed debt and special situations, such as lending to borrowers who have filed for creditor protection, so it is less inclined to make short-term, floating-rate loans that last one to three years. Third Eye’s loans often last two to five years.
“Part of our core expertise is in restructuring and business turnaround,” Arif Bhalwani, Third Eye’s chief executive officer, said in an interview. “We are the risky component” of a private debt portfolio.
Ninepoint says the fund is only sold to accredited investors, who typically must meet certain criteria, such as having an annual income of more than $200,000 or possessing financial assets worth $1-million or more. Ninepoint also says investment decisions should be made in consultation with an investment adviser who is obligated to determine whether an investment product aligns with a client’s suitability and risk appetite. Ninepoint’s private debt products are sold exclusively through registered investment advisers.
As well, Ninepoint co-chief executive John Wilson wrote in an e-mail that Ninepoint has added precautions to its website. In order to access marketing materials for private credit funds, an individual must accept or decline a warning pop-up window that advises of the risks of private credit investing. “We were an early adopter of this practice because we thought it prudent and transparent for investors,” he wrote.
But Ninepoint’s marketing materials still contain some contradictory information. The company, for instance, offers a private debt explainer that says there are “two distinct approaches to private debt investing”: “return maximizing,” which focuses on distressed debt and structured equity, and “capital preservation,” which focuses on direct loans. Ninepoint then explicitly states that its private debt strategy is the latter.
In the same marketing document, Ninepoint outlines some benefits of investing in private debt, including “an innovative way to generate income” and “typically floating rate loans.”
Its largest private debt fund, however, is the Ninepoint-TEC fund, and 38 per cent of the fund’s loan portfolio defers cash interest payments from the time the loans are made. Another 25 per cent permit switching from cash payments to deferred, or PIK, payments.
Mr. Bhalwani’s description of Third Eye’s investment strategy also differed from Ninepoint’s stated focus on capital preservation. “You’re going to see very complex situations, highly structured transactions,” he said in the interview. “We’re trying to generate private equity-type returns with better downside risk protection.”
Ninepoint also says the same in one of its own marketing documents, referring to its fund with Third Eye as deploying a “private equity approach to debt.”
Asked about the difference between Ninepoint’s stated private-debt strategy and the investment agenda for its largest fund, Mr. Wilson wrote: “We believe [the] Ninepoint-TEC fund is consistent with capital preservation goals because its investments are primarily senior secured loans, which are at the top of a company’s capital structure. In the event of bankruptcy or liquidation, senior secured creditors, including the fund, have priority on recovery proceeds.”
Third Eye’s Mr. Bhalwani added that his firm specializes in lending against assets, not cash flows, and that PIK loans can generate some income before they mature. Such income can be earned when a borrower sells an asset, for instance, because proceeds from the sale flow to the lender.