Q1: Your recent report on Real Estate Credit Investments sits behind a disclaimer. What can you tell us about that?
A1: It is just the standard disclaimer that many investment companies have. In essence, for regulatory reasons, there are some countries (like the US) where the report should not be read. It is not a simple asset class, and the report should only be looked at by professional/qualified investors.
Q2: Your recent report reviewed RECI’s sensitivity to rising rates. What can you tell us about it?
A2: In this note, we explore RECI’s low sensitivity to a rising rate environment by analysing i) borrower revenue sensitivity, ii) borrower debt sensitivity, iii) RECI’s portfolio risk mitigation techniques, iv) the MTM on the bond portfolio, v) the impact of RECI’s own funding mix, vi) international diversification), vii) previous share price experience, viii) sentiment to the stock, and ix) potential opportunities that may arise.
This reinforces the message in our last two notes that RECI’s business has shown limited downside during the COVID-19 crisis. We use a case study of a hotel exposure to illustrate how Cheyne’s management of challenging relationships materially reduces the final loss.
Q3: You talk of the borrower sensitivity to both revenue and debt. What exposures did you find there?
A3: Interest rates are most likely to be increased to take some heat out of the economy, and so dampen inflation. This will affect borrowers to varying degrees, with the biggest impact on those who are dependent on discretionary spend.
As at October 2021, nearly 50% of the book was Core/Core+, which means that it is steadily income-generating. Where an exposure is higher-risk, the lending criteria are tighter (by way of example, as at October 2021, the average LTV for development exposures in the top 10 was c.10% lower than the portfolio as a whole).
In some of the sectors, which may be regarded as having above-average borrower earnings risk, slides 17-20 of RECI’s October update provide useful and detailed information on why its specific exposures are not as bad as the sector exposure as a whole, and we review those in the note.
Q4: And how does RECI mitigate the risk of rising rates?
A4: Firstly, its high yields reflect intellectual capital, as well as risk. It is much easier to pass on a 50bp increase in benchmark rates if you are charging 8%-9% than if you are charging 2%-3% – so having a high-yielding book makes it less sensitive to market rate increases.
Second, the duration of lending is short – the average life of the loan book (£298m) at end-September was just 1.5 years.
Third, we have previously outlined the key cultural difference, whereby RECI staff “own” their loans, and are not employees of a large, faceless organisation, who might be likely to move on before problems emerge from their lending decisions.
Fourth, the turndown rate is high, at c.90%.
Fifth, the trend to covenant-lite lending seen in many larger corporate markets has not been prevalent in RECI’s markets.
Sixth, Cheyne typically does deals of between £50m and £200m (or currency-equivalent), so the equity contributor is usually a professional investor likely to take rate sensitivity into account.
Finally, we highlight the geographical diversity of RECI’s exposure, with the UK now accounting for 56% of funded fair value.
Q5: Your report also included an interesting case study of how Real Estate Credit Investments managed a hotel exposure through COVID-19. Can you elaborate on this?
A5: When COVID-19 struck, Cheyne immediately determined that risk was difficult to price, and paused all new deals. In the UK, it focused on its existing book of around 30 positions, and relatively quickly identified that a key risk lay in hotel exposure. Cheyne had closed the case study hotel deal a year earlier, but it was a complex situation, with 10 interested parties (each with different interests, jurisdictions of the parties, security, etc). It is testament to Cheyne’s expertise and reputation that it was chosen to lead the restructuring negotiations. Inter alia, these included taking control of the equity and re-financing all the senior debt, restructuring the parental support and equity, partially paying down the existing senior debt, and discussions with other operators in case the existing tenant failed.
After six months of intensive negotiations, in December 2020, a deal was struck, which saw the economic loss from COVID-19 spread between all parties and a financing package agreed on which the business could proceed. For RECI, it added some time to the duration of the loan, and saw a small reduction in effective spread, but it also saw an IRR at c.1.5x the dividend cost. Since the restructuring, trading has been better than planned. In our note, we go into why Cheyne was uniquely placed, resourced and skilled to manage the restructuring.