March 17, 2023

The advantage of unlevered capital in times of crisis…


The collapse of Silicon Valley Bank (SVB) last week sent a wake-up call to global markets about the compounding risk of aggressive rate hikes.  
The US government bailed out depositors to prevent a deeper banking crisis. Equity holders of the bank will likely be wiped out and the risk of contagion in regional banks has been exposed.  
The need for governments and central banks to underwrite banks in crisis is likely to drive increased regulation for banks around the world. 
The ever-increasing regulation to protect depositors and the health of the financial system is likely to force more borrowers out of the banking system to source capital from alternative lenders. It could be said banks no longer have patient capital to offer.  
Private credit asset managers such as Merricks Capital have unlevered patient capital. This allows us to lend where there is deep asset protection but also requires unique structuring which a bank cannot offer when having to also manage its own highly leveraged balance sheet.  

Merricks Capital had no direct or indirect exposure to the past week’s US banking events.

As part of our portfolio risk management process, we conducted the following evaluations: 

Duration risk 

The mismatched duration between assets and liabilities and the concentration of hold-to-maturity securities led to large mark-to-market losses for SVB and similar banks. 
Approximately two thirds of the loans in the Merricks Capital Partners Fund and Agriculture Credit Fund have floating reference rates, while fixed loans are priced on upward sloping forward interest rate curve. 
Both funds have short portfolio term to maturity profiles of 10 months which allows for regular risk and return repricing. 

Liquidity risk 

The “bank run” on SVB exposed the high liquidity risk in highly levered banks, forcing the US government to set up an emergency lending program to restore confidence in the US banking system. 
We believe that banking standards will likely be tightened further as a result of this event, which will further draw liquidity out of capital markets on top of the ongoing quantitative tightening programs by central banks. 
Merricks Capital Partners Fund and Agriculture Credit Fund both have redemption clauses and processes designed to protect their investments and investors against unpredictable capital flight. 
Merricks Capital manages liquidity risk proactively through robust cash flow forecasting and asset monitoring processes.   

Default risk 

Loans in the Merricks Capital Partner Fund and Agriculture Credit Fund are all secured against real assets and rank senior with a weighted average portfolio LVR of 63% and 57% respectively. 
The Merricks Capital Partners Fund also holds Credit Default Swaps (CDS) for crisis protection, with Australian CDS spreads widening 5-15bps over the past week. We increased our CDS protection by 10% in February at lower spreads with a view that credit insurance has been cheap compared to the payoff. 

Valuation risk 

Rapidly rising interest rates have translated into high mark-to-market losses for bond holders and brought adverse impact to asset valuations. Unpredicted margin calls from the wild swing in the yield curve almost crippled the UK pension system last year. 
While further growth is expected in rental yields due to inflationary pressures, it is our view that cap rates are likely to move higher with bond yields and property valuations have room to fall another 10-20%. This has been stress tested against our portfolios and the pullback in valuations will be buffered by 65% portfolio LVRs.   
All our loans have independent valuation assessments prior to settlement, and site visits are conducted regularly. All of our derivative positions (FX and CDS) are fully collateralised bilaterally. 
All our funds maintain conservative collateral buffers which are consistently adjusted to volatility.  

Merricks Capital announced this week a new loan facility with the Milligan Group for the acquisition of one of Sydney’s last remaining major CBD sites. The $465m facility funded the aggregation of properties located on the corner of Pitt and Hunter Streets in central Sydney and has a clear path to repayment over the next 16 months.

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