Photo illustration by The Globe and Mail/iStockPhoto / Getty Images
Fifteen years ago, Barbara Tate was lucky enough to inherit some money from her parents. But as an English teacher who, by her own admission, was not the most financially savvy investor, she didn’t quite know what to do with it. To keep it simple, she spread the money around some mutual funds and kept her eye on an intriguing private investment fund that advertised in one of her community newspapers.
Founded in the 1960s, Romspen Investment Corp. had blossomed into one of Canada’s largest non-bank lenders, often underwriting short-term commercial mortgages. By 2011, it had reported positive investor returns every single month for a decade straight, and its flagship fund targeted a 10-per-cent annual yield at a time when benchmark interest rates were close to zero.
Encouraged, Ms. Tate rolled the dice and put in $50,000. It turned out to be a rock-solid investment. Private debt funds are known for paying monthly distributions, and for more than a decade she received roughly $300 every month, money that helped pay for her daughter’s university education.
In early 2023, however, Ms. Tate got quite a shock. Retired and in need of a new car, she hoped to pay for one by cashing out her investment. Yet when she called Romspen, she was told that wouldn’t be possible. The company had frozen redemptions on its $2.8-billion fund two months earlier.
Ms. Tate scoured the internet looking for more information, hoping there’d be a Facebook page or some other forum where investors had weighed in, but came up short. “I couldn’t find anything,” she says. “I felt very much alone.”
Because Romspen is a private lender, it was hard to tell how its fund was performing. Unlike mutual funds, which go up and down in value daily, private debt funds alter their valuations much less frequently. The whole point of being private is to ride out short-term volatility. It was also hard to know how Romspen’s borrowers were faring, because private debt managers limit disclosure about their holdings – for competitive reasons and for client confidentially.
Ms. Tate’s experience grew more nerve-racking as the year progressed. With major pockets of the commercial real estate market buckling under higher interest rates and rising costs, development projects kept collapsing. Last April, The Globe and Mail reported that Romspen was locked in a court battle with its largest borrower after loan defaults that totalled $333-million.
With cash flow getting tight, Romspen cut the fund’s distribution multiple times. Ms. Tate now receives about $100 each month, roughly half of what a guaranteed investment certificate pays at current market rates.
And she still can’t get her money out. No one can.
Private debt managers have been scrutinized in Canada ever since Bridging Finance Inc. was put under the control of a court-appointed receiver in 2021. The company managed $2.1-billion, mainly for retail investors, and its collapse was so swift that people questioned whether rival managers could implode just as quickly.
Husband and wife duo David and Natasha Sharpe, Bridging Finance’s top two leaders, are alleged to have committed fraud by the Ontario Securities Commission (OSC).Fred Lum
What’s playing out now is quite different. At Bridging Finance, the Ontario Securities Commission (OSC) alleged the firm’s top two leaders, a husband-and-wife duo, committed fraud. Rival private debt funds, meanwhile, are grappling with market forces such as cost inflation, which makes it harder for businesses to repay their loans, and higher interest rates, which make retail investors reconsider whether the investment risk is worth the current returns. What used to be 8-per-cent to 10-per-cent annual yields can now be in the low single digits – and are sometimes even negative.
Because the market dynamics are changing, more investors have been asking for their money back. Hazelview Investments, which specializes in commercial real estate, has halted redemptions on its $1.3-billion Four Quadrant fund, just like Romspen. And Ninepoint Partners LP, which lends to mid-sized companies across several industries, has at different points over the past two years limited redemptions, halted redemptions and restructured some funds so investors had a way to cash out.
In other cases, there can be trouble brewing just below the surface. Cortland Credit Group Inc. manages a $1.2-billion private debt fund, and The Globe has reported that its largest borrower has been sold after defaulting on its debt and filing for creditor protection. The timeline for repayment remains unclear under the borrower’s new owner.
In all, private debt funds that manage nearly $10-billion have struggled with elevated redemption requests or major defaults, and close to two-thirds of these assets are now trapped in funds that have halted redemptions.
Despite the pain, new private debt funds keep launching in Canada because the sector is exploding in popularity around the world, with US$1.7-trillion now invested globally, according to Preqin. Even BlackRock Inc., which used to swear by passive investing in low-cost exchange-traded funds (ETFs), has launched a private credit arm.
Historically, the money invested in private debt usually came from sophisticated institutional investors who commit their capital for multiple years. Over the past decade, however, more retail investors have bought in – particularly in Canada, where there is a national obsession with yield. Now, even more funds are catering to this demographic, with managers such as Mackenzie Investments, AGF Management Ltd. and Brookfield Asset Management all targeting retail clients with new funds. The marketing pitch: Retail investors are getting better access to a sector that mostly served the biggest and the brightest. Sometimes it is described as the democratization of finance.
The question is whether retail investors are well served by these funds. Some buyers are not financially sophisticated enough to understand the ins and outs of private debt – including a fund’s right to halt redemptions – and those that are may not have enough information to properly assess their risk. The sector’s fund managers aren’t always required to report major developments, such as a leading borrower’s bankruptcy.
Put together, it means Canadians are often flying blind when they invest in private debt funds, and when things go bad, there aren’t many safeguards to protect them.
The New Age hedge funds
In many ways, Romspen embodies the evolution of private debt in Canada. In the 1960s, the company started making loans funded by sophisticated individual investors, and in 2005 its flagship fund was modified to make it easier for retail buyers to invest. At the time, Romspen managed roughly $170-million; today, its Mortgage Investment Fund manages $2.8-billion and lends across Canada and the United States.
The 2008-09 global financial crisis was a major catalyst for the sector’s growth. Before the crash, there were plenty of other ways to find yield, such as bonds and income trusts. But after 2008, central banks cut interest rates to near zero and kept them there for years. To adjust, retail investors – and baby boomers in particular – went hunting for higher-yielding securities.
It wasn’t until 2015, though, that private debt really took off, driven by two additional forces.
Around this time, low-cost ETFs had become quite popular, so investors were demanding more from money managers who wanted to charge high fees. For many fund companies, the answer was adding a suite of “alternative investment” funds that specialized in sectors such as infrastructure assets, private equity and private debt, which used to be reserved for big institutions.
Mid-sized companies were also starved of capital, because banks shrank their loan books after the financial crisis and focused on blue chip borrowers. Private debt managers could raise money from retail investors, lend it out – often for one to three years – and charge borrowers 10 to 12 per cent annually in interest. To comfort retail investors, private debt managers usually focused on senior debt, so that they would be paid back first if borrowers had financial trouble. They also kept loan maturities short, so there would a constant churn of cash to pay investors who wanted to redeem, and they emphasized loans that came with good collateral, so that there was a solid backstop.
With the money pouring in, private debt managers had the potential to make big profits. Unlike mutual funds or ETFs that charge a fixed percentage as an annual management fee, many private debt funds copied the hedge fund model that exploded in popularity the decade prior and took an annual management fee – usually 1.5 to 2 per cent, some of which went to investment advisers who put their clients in these funds – as well as an annual incentive fee, usually worth 20 per cent of profit above a certain threshold.
Because these funds are private, investors and their financial advisers rarely get a glimpse of the profits being made, but Bridging Finance’s collapse provided some insight into the sums involved. In 2016, the company’s earnings before interest, taxes, depreciation and amortization (EBITDA) were $2-million. By 2019, that jumped to $43-million, according to internal figures obtained by The Globe.
After so many consecutive years of solid returns, it was easy for investors to think private debt wasn’t all that risky. Not even the COVID-19 pandemic slowed the funds down, because central banks slashed interest rates back to near zero.
And when interest rates finally started rising in early 2022, private debt managers argued this would also be good for investors, because most of their loans have floating rates that rise just like variable-rate mortgages, so investor yields would also climb higher with no additional risk.
“That’s a huge misconception,” says Greg Obenshain, head of credit at Boston-based Verdad Advisers. Companies with good balance sheets usually secure fixed-rate loans with longer maturity dates from banks. “Why do borrowers have floating rate debt? Because they’re riskier,” he said. And as interest rates rise, at some point the burden climbs so high that it simply suffocates the borrower.
When the music stops
Five months into the interest-rate hiking cycle, Romspen made its first distribution cut. Four months later, in December, 2022, Hazelview sought $200-million in funding from a private equity firm to have a cash buffer as the commercial property market wobbled.
In some cases, changes such as these were made because borrowers were starting to struggle. In others, investors were turning skittish and asking for their money back, just to be safe, which created a cash crunch.
The difficulty for private debt managers is that their loans are illiquid and can’t be sold in a flash. For this reason, they have limits on how much can be redeemed each quarter, often around 5 per cent of total assets. Over the past two years, redemption requests have exceeded these limits at multiple Canadian funds, and the rush to exit has been so strong that they’ve had to halt or limit redemptions. A similar scenario played out at Blackstone REIT, one of the largest private real estate funds for retail investors in the world, with US$69-billion under management, in December, 2022.
The promise of continuous redemptions has long been a point of contention. In 2012, Canadian private lender ROI Capital had to freeze redemptions, and in 2019, a prominent British fund that offered daily redemptions had to freeze £3.7-billion (then about $6.3-billion) of investor money. In a parliamentary hearing at the time, then Bank of England governor Mark Carney said funds that offer this feature, yet invest in illiquid assets, are “built on a lie.” Last summer, the United Kingdom’s securities regulator issued a public warning to money management chief executives, noting that a review of their liquidity risk management was lacking, “particularly in stressed environments.”
In Canada, there’s been little public discussion of these issues by the provincial securities regulators that govern these funds, and the OSC declined to comment for this story. But there are ways to revamp the model.
One option, says Greg Racz, president of MGG Investment Group in New York, which manages private debt funds for high-net-worth investors and institutions, is to offer continuing redemptions only up to a certain dollar amount per investor – perhaps $50,000 each.
Another option is to match redemptions to repayments, meaning investors can only cash out as loans are repaid. This is the format Ninepoint used to alleviate the rush of investors who wanted out of its flagship Ninepoint-TEC Private Credit Fund in 2022. At the time, 25 per cent of clients tried to get their money out, according to a presentation Ninepoint gave.
Or, of course, retail private debt funds could be reworked so that their redemption terms mimic those often imposed on institutional investors – that is, any money invested is locked in for a minimum of three years.
In an e-mail to The Globe, Romspen managing partner Derek Jenkin said there are some drawbacks to this structure. Open-ended funds have much more flexibility and are less affected by market conditions, he wrote, because there isn’t a specific maturity date for the entire portfolio. “This is crucial in maintaining stability and avoiding the pressure to liquidate assets at suboptimal times,” he wrote.
Open-ended funds are also less likely to use additional debt within the portfolio to boost returns. “Closed-ended funds generally focus on more stabilized projects with lower interest rates, often relying on leveraged portfolios to boost their returns,” he wrote.
Disclosure is another pressing issue. By design, private debt funds are indeed private, so investors technically can’t expect much intel. But within this grey zone there is a wide range of options. Romspen, for instance, discloses what percentage of its portfolio is “non-performing,” or struggling, each quarter. Currently, that portion is around 36 per cent, higher than the historical average. Other funds do little more than list brief details of their top 10 loans.
What makes this all so challenging for investors is that there aren’t many external marks, or assessments, of a fund’s holdings. In the U.S., there is a gigantic market for publicly traded high-yield debt, and such bonds are rated by credit agencies such as S&P Global or Moody’s Investors Service. When a borrower is struggling, the bond will be downgraded. In the private debt sector, there is no such thing.
Complicating matters, private debt borrowers have more leeway than they used to. “Lenders have stopped putting tight restrictions on borrowers,” Mr. Racz said. “The credit agreement is filled with Swiss cheese loopholes.” For one, borrowers that pay cash interest are sometimes granted the opportunity to flip to a “PIK loan,” short for payment-in-kind, in which interest is accumulated and added to the total debt. As Mr. Racz describes it, borrowers can say, “Put it on my tab; I’ll pay you in three or four or five years.”
While the practice is a common feature of private debt funds, there is a saying in the industry for fund managers who push the limits: “Extend and pretend.” In Bridging Finance’s case, it was only after a court-appointed receiver took over in 2021 that investors learned that a large portion of its portfolio was comprised of PIK loans. The receiver has since estimated that investors will lose $1.3-billion, close to two-thirds of the money they put in.
While the composition of Bridging Finance’s loan portfolio is quite possibly far from the industry norm, the sector’s limited disclosure means investors and their financial advisers often have no way of knowing. To deal with this uncertainty, fund managers are usually audited by an external party. However, even the audit practice has some leeway. If someone wants to argue a loan will be repaid, there’s usually a way to justify it. “Valuations of illiquid assets are much more art than science” says Daniel Bach, a partner at Siskinds LLP who specializes in securities class actions.
As it stands, Canadian regulators and private debt fund managers have some cover whenever the sector faces scrutiny. Although these funds are available to retail buyers, in most cases only a certain type of investor can put money in – they must be “accredited investors.”
How someone becomes accredited is a bit complicated because there is a long – and growing – list of ways to qualify, but the requirements mostly boil down to one thing: If someone has enough wealth, they either have the financial acumen to understand these funds, or they at least have the financial wherewithal to absorb losses. Examples include earning more than $200,000 annually before taxes, or having household financial assets exceeding $1-million.
What rarely gets debated is whether these thresholds fit the bill any more. For one, the income and financial assets requirements haven’t changed in 20 years. But there is also a question of whether wealth equates to financial sophistication. Someone might have simply inherited their money. The average home price in the Greater Toronto Area is now $1.1-million, and if your parents die, you might become a millionaire overnight. Regulators, though, must also weigh the global push into private assets. By restricting access, it is possible they will keep Canadians away from lucrative returns.
But even if the accredited investor criteria was tightened, it wouldn’t change the fact that many of these buyers often fly blind when investing in private debt funds. The level of discretion afforded to fund managers makes it tough for investors to track the ins and outs.
Scott Stacey, a manufacturing executive, invested in multiple private debt funds, and he readily acknowledges investors bear some responsibility for tracking their money. “It’s on everyone to educate themselves as much as they can,” he said. Yet he also argues it simply isn’t possible to scrutinize every single investment he makes. “It’s not reasonable,” he said. At some point, investors should be able to rely on the portfolio summaries provided to them.
To this end, Cortland’s largest borrower filed for creditor protection, yet investors reading a two-page quarterly summary in January probably wouldn’t know. The unnamed borrower’s debt was also split into three separate buckets in a table of top 10 loans. An investor may think the three loans are unrelated, when in reality, they’re all made to the same company – and one is a financing Cortland provided to help keep the lights on during creditor protection proceedings.
Ten largest loans in Cortland's flagship fund
As of Jan. 31, 2024
Rank
Type
Industry
Area
Weight
Senior Secured
Energy
Sask.
14%
Short Term Loan
Senior Secured
Information
U.S.
6%
Revolver
Technology
Senior Secured
Information
Britain
5%
Revolver
Technology
Senior Secured
5%
Financials
Ontario
Revolver
Super Priority
5%
Energy
Sask.
Revolver
Senior Secured
Consumer
5%
Britain
Revolver
Discretionary
Senior Secured
Energy
Sask.
4%
Short Term Loan
Senior Secured
Information
Ontario
4%
Revolver
Technology
Senior Secured
Revolver
Industrials
Germany
4%
Senior Secured
Consumer
U.S.
10
3%
Revolver
Discretionary
the globe and mail, source: cortland credit
Ten largest loans in Cortland's flagship fund
As of Jan. 31, 2024
Rank
Type
Industry
Area
Weight
Senior Secured
Energy
Sask.
14%
Short Term Loan
Senior Secured
Information
U.S.
6%
Revolver
Technology
Senior Secured
Information
Britain
5%
Revolver
Technology
Senior Secured
5%
Financials
Ontario
Revolver
Super Priority
5%
Energy
Sask.
Revolver
Senior Secured
Consumer
5%
Britain
Revolver
Discretionary
Senior Secured
Energy
Sask.
4%
Short Term Loan
Senior Secured
Information
Ontario
4%
Revolver
Technology
Senior Secured
Revolver
Industrials
Germany
4%
Senior Secured
Consumer
U.S.
10
3%
Revolver
Discretionary
the globe and mail, source: cortland credit
Ten largest loans in Cortland's flagship fund
As of Jan. 31, 2024
Rank
Type
Industry
Area
Weight
Senior Secured
Energy
Sask.
14%
Short Term Loan
Senior Secured
Information
U.S.
6%
Technology
Revolver
Senior Secured
Information
Britain
5%
Technology
Revolver
Senior Secured
5%
Financials
Ontario
Revolver
Super Priority
5%
Energy
Sask.
Revolver
Senior Secured
Consumer
5%
Britain
Revolver
Discretionary
Senior Secured
Energy
Sask.
4%
Short Term Loan
Senior Secured
Information
Ontario
4%
Revolver
Technology
Senior Secured
Revolver
Industrials
Germany
4%
Senior Secured
Consumer
U.S.
10
3%
Discretionary
Revolver
the globe and mail, source: cortland credit
In an e-mail to The Globe, Cortland chief executive Sean Rogister said the company is limited in what it can disclose because of confidentiality agreements with borrowers, but added that Cortland keeps a credit reserve that is updated monthly and is used to cushion against bad loans. “We are confident that our reserve is sufficient,” he wrote, adding that it is supported by regular site visits, weekly reviews of loan collateral and regular appraisals of fixed assets, “generally by third-party professional appraisers.”
Another instance of the grey area came to light late last year when The Globe reported that the $200-million Hazelview raised from a private equity firm involved creating a new class of preferred share units. Unlike the fund’s ordinary units, the preferred units promise Ares Capital a 7.95-per-cent annual return for three years, and Ares ranks senior to all other unitholders – yet the other unitholders weren’t told about this feature.
In an e-mailed statement to The Globe at the time, Hazelview said no vote was required because the fund’s limited partnership agreement allows it to create new classes of units without the prior approval of the limited partners – that is, the retail investors.
Because there is so much leeway, one option is to institute hard and fast disclosure rules for the sector. Has a loan stopped paying cash interest for more than a year? That has to be clearly disclosed. Has a fund brought in a new investor that ranks senior to existing unitholders? That has to be clearly disclosed.
Better protection may simply be necessary because retail investors have little recourse when a private debt fund struggles. With other types of funds, investors usually have the option to collectively launch a lawsuit, but many private debt products “are just not big enough, or not solvent enough, to do a class action,” said Mr. Bach, the lawyer from Siskinds. Class actions are predicated on recovering money by selling off assets or clawing it back from fund manager fees, but Bridging Finance illustrates just how fraught the prospects can be.
It is very possible, of course, that the current fund woes will subside if interest rates fall. In that environment, elevated private debt yields could look enticing once again. But at this point no one knows if the investors who once chased these returns will stick around for that moment to come. Interest rates are expected to remain higher for longer, and less risky options are readily available. Private debt may be Bay Street’s favourite fund flavour, but retail buyers will have the ultimate say.
Tim Kiladze