Private high yield alternatives could be the answer

If you’re relying on the traditional bond market to generate income, then you already know that today’s low interest rates make this a challenge. Even if the Bank of Canada enacts a handful of rate increases in the coming months, most investors will continue to find that rates are too low to yield sufficient income for their needs.

The question is how to earn a higher yield without assuming excess risk. To help answer this question, our clients were recently invited to a discussion on private high yield alternatives hosted by John Poulter, CFA, who is a Portfolio Manager at Cumberland Investment Counsel Inc. and a founding partner of our firm.

Private high yield alternatives, or “private alts,” have been around for decades. They are similar to bonds in that they represent debt and earn interest, but they have a number of unique attributes that enable them to generate higher levels of income.

• Specialized. Private alts tend to be highly specialized funds that originate lending where banks and other traditional lenders can’t or won’t.
• Managed. Private alt funds take advantage of the fund manager’s knowledge of the unique circumstances and risks associated with the industries where they lend.
• Diversified. Private alt funds are often very nimble and able to make many smaller loans that are diversified across many borrowers.

It’s this combination of specialized lending, active management and careful diversification that enables private alt funds to earn robust income with very attractive risk/reward profiles.

Investing in Private Alts

Last year was relatively rare in that Canadian investment grade bonds posted an overall loss of -2.8%. They were also highly volatile, with six up months and six down months throughout the year. For contrast, John and the Cumberland team shared the 2021 results of the seven private alt funds that are currently on Cumberland’s recommended list, which revealed that the average fund had less than two negative months in 2021, and positive annual returns ranging from +3.5% to +18.1%.

To be sure, investing in this space is not so simple. Just as you would carefully analyze a company before buying its shares, it is crucial to conduct due diligence on any private alts fund before committing capital to it. John and the Cumberland team have developed a recommended list based on decades of trusted relationships within the industry as well as extensive selection criteria, including compliance review, analysis of returns, individual holdings review and management team interviews.

Private lending example: Arena Investors, L.P.

As part of the discussion, the audience learned about a given loan made by one of the alternative funds – Arena Investors, L.P. (Arena)This is a US-based firm with $2.6 billion of assets under management and a lending portfolio that spans corporate credit, real estate, commercial and industrial assets, structured finance, consumer loans, and securities.

Arena’s typical loan has a two-year term and targets a 10-12% net return. To manage risk, their loans are the most senior in the capital stack, meaning that they are among the first to get paid if something goes wrong. They also typically include a 30%-40% loss cushion, which is provided by the borrower’s principals or a subordinated lender.

Arena’s employees have been involved in aviation-related investments since 2001, and one of their JV partners recently saw an opportunity to buy two commercial jets at an attractive discount to the value of the aircraft parts on a disassembled, liquidated basis.

Arena required the JV partner to contribute $3 million of his own capital, and to make his contribution subordinate to the $7 million loan that they agreed to provide. As the planes were liquidated, the equipment sales were subject to Arena’s approval, and Arena generally controlled all cash and bank accounts, including the JV’s, until the completion of the venture.

In short, Arena’s strong sourcing capabilities among its JV network unearthed the opportunity, its specialized knowledge permitted it to structure a unique deal, and its hands-on approach gave it robust controls over the life of the loan.

Reach a Cumberland Portfolio Manager to learn more

For a more detailed discussion of how our clients are seeking higher income through private high income alternative investments, a deeper look at our funds and strategies, and how they can add value to your portfolio, please reach out to us and speak with a Portfolio Manager.