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Today, we will learn more about:

1. Alternative Financing

2. Oaktree Quarterly Letter

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Alternative Financing

Alternative financing is non-traditional methods of capital raising for a litany of purposes. Unlike conventional approaches, such as bank loans or venture capital, alternative financing explores innovative ways to support individuals or businesses that might have difficulty accessing traditional financial channels. Examples of alternative financing include crowdfunding platforms, where many people contribute small amounts to fund a project or business. This is the most popular form of alternative financing for early-stage, high growth startups looking for early development capital. Peer-to-peer lending is another method, where individuals borrow directly from others without involving a financial institution. Also, alternative financing may involve angel investors, who invest their own money in startups or small businesses in exchange for equity or ownership stakes. Moreover, there are various grant programs and competitions that provide funding to innovative projects and social enterprises. Crypto and blockchain technology have also opened new possibilities for alternative financing, with Initial Coin Offerings (ICOs) and Security Token Offerings (STOs) enabling businesses to raise funds by issuing digital tokens.

Common categories include P2P/Marketplace lending, which is individuals or investors providing a debt-based loan to consumer borrowers. A specific form of P2P/Marketplace lending is Property lending, where the loans are secured against a type of property. Along with P2P, there is Business Lending, where the intermediaries facilitating peer-to-business lending enable small and medium-sized enterprises (SMEs) to access loans from a pool of online investors quickly, bypassing the complex process of traditional bank lending. This rapid funding process makes this approach much more appealing to many companies compared to conventional banking methods. Additionally, peer-to-business loans generally show lower default rates compared to those seen in commercial banks, indicating the crowd of investors' ability to identify and support high-quality businesses. Other popular categories include Balance Sheet Lending and Invoice Trading (IT). IT is a model which allows SMEs to sell or auction off their invoices and receivables to institutional investors. In return, they drive down their cost of funding from external sources.

Using Alternative Finance for funding purposes has grown in relevance particularly in the United Kingdom and the US. The market has seen exponential growth, tripling from £309mm in 2011 to £939 million in 2013. Even looking at a decade ago, the share of alternative financing in UK is similar to what it is today. The highest transaction volume is made up of donation-based crowdfunding, the second highest is peer to peer/business lending, and the smallest volumes yet highest growth rates were debt-based securities, revenue/profit sharing, and microfinance. In the United States, alternative finance activity grew by 45% from 2018 to 2020, and they make up 65% of the current volume globally.

Overall, the most common and important form of alternative finance is crowdfunding. Simply put, it is the financing of a project by a conglomerate of individual investors, rather than a bank or established VC fund. Crowdfunding has been largely made public over the past decade; think of websites like GoFundMe, Kickstarter, and Patreon. Entrepreneurs look to capitalize on individuals rather than professional entities. Crowdfunding has three main avenues for investment: donation, passive investment, and active investment.

• Donation investments are typically seen from non-profit organizations, where they are detached from offering financial returns or recognition to investors.

• Passive investments are strictly returns in recognition and financial; being a passive Crowdfunder provides no involvement such as voting rights or capabilities on final products. Think of this as being a minority stakeholder in any organization.

• Active investments are derived from entrepreneurs being open to allowing investors to have a tangible role within a company. Most often, this involves allowing investors to have a say when it comes to product development routines, such as wanted features and feedback. In other situations, this enables profit-sharing for investors.

The original nomenclature for crowdfunding used to be crowdsourcing. In 2006, Wired Magazine defined it as a function that “takes place when a profit-oriented firm outsources specific tasks essential for the making or sale of its product to the general public (the crowd) in the form of an open call over the Internet, with the intention of animating individuals to make a [voluntary] contribution to the firm's production process for free or for significantly less than that contribution is worth to the firm.” At the time, using customers as “volunteers” was an innovative idea pioneered by the development of Web 2.0 and democratization of the internet. This shortly evolved into companies employing customers to provide product designs, open troubleshooting tickets, create customer-customer support networks, etc.

The new strategies found in using customers to better a company strategically and financially is what catapulted the idea of crowdfunding. Acquiring investments from your consumers not only gave a way to raise capital for development but was also a key indicator of potential reception for a product in the open market.

Institutional investors play a crucial role by utilizing alternative finance as part of their investment strategies or to diversify portfolios. in 2019, institutional investors provided $28.5 billion of the alternative finance volumes, 16% of global share. In 2020, the information available from 60% of the cases indicated that institutional investors contributed $43.6 billion to the alternative finance volumes. This represented 42% of the entire global volume for that year. Notably, this signifies a significant 53% increase in funding from institutional sources from one year to the next. Crowdfunding business models showed a notable concentration of individual investors. In both 2019 and 2020, only 7% of Equity-based Crowdfunding, a mere 6% and 2% of Donation-based Crowdfunding in 2019 and 2020 respectively, and only 1% and 6% of Reward-based Crowdfunding in 2019 and 2020 respectively, were sourced from individual investors. This trend reveals the dominant profit-seeking motive of financial institutions, as they tend to prefer non-investment models. Their limited risk tolerance are evident when it comes to equity investments compared to lending. As a result, individual investors play a more substantial role in the Crowdfunding landscape, while traditional financial institutions remain relatively reserved in embracing equity-based investment opportunities.

On a global level, regulation is a key variable in alterative finance. In early 2019, researchers from CCAF conducted a focused review of Uganda's regulatory framework for capital markets and collective investment, aiming to identify obstacles hindering the development of alternative finance. The potential barriers were categorized into several types: issues related to regulatory boundaries that impede innovative financing, regulations that might be disproportionately restrictive, biases towards certain technologies in the regulations, biases within the regulatory ecosystem, and regulations with unclear application or objectives. The review revealed that technological biases were not the primary hindrance to building successful regulated alternative finance sectors in Uganda. The country's laws actually had commendable examples of technology-neutral reporting and record-keeping requirements that could be adopted in other aspects of the regulatory framework. Instead, the main regulatory barrier was found to be the regulatory perimeter. Specifically, regulating peer-to-peer (P2P) lending. A solution to this issue is regulating the P2P sector by treating it with the same standards as asset and fund managers, making them link to regulations and rules which promote clarity in investment.

Oaktree Quarterly Letter

On June 21, 2023, Oaktree released their top insights from its Quarterly Letters. Oaktree Capital Management, an investment management firm with over $164bn AUM, is the largest investor in the realm of distressed credit. In the insights, Oaktree’s leaders, including legendary investor Howard Marks, share valuable insights, outlooks, and wisdom gained through years of experience

Global Credit Outlook

Bruce Karsh, Chief Investment Officer, and David Rosenberg, Portfolio Manager of Global Credit, believe that current credit markets offer opportunities for attractive investments. The high yields available today, especially in below-investment-grade asset classes, make it possible for institutional investors to meet their return targets of 7% or 8%. For instance, U.S. and European high-yield bonds offer yields close to 9%, twice the level available in 2021. Unlike equities, fixed income investments ensure that investors will earn their contractual return regardless of short-term price volatility unless there is a default. Karsh and Rosenberg emphasize that just two years ago, achieving a similar 9.00% yield would have required taking on significant risk in the credit markets, sacrificing liquidity, or investing in equities at inflated valuations. Furthermore, the rise in yields has brought about increased opportunities for generating returns (the authors refer to this as “alpha”, a term commonly used in the investment industry). Although interest rates are not expected to rise significantly in the current economic cycle, they are unlikely to return to near-zero levels soon. This suggests that performance disparities between different issuers, sectors, and regions will continue to expand, creating a favorable environment for skilled investors who engage in bottom-up fundamental analysis.

Opportunistic Credit Outlook

Mr. Karsh joins forces with Robert O’Leary (not to be confused with Shark Tank’s Robert O’Learly), Portfolio Manager of Global Opportunities at Oaktree. Karsh and O’Leary suggest that even though there hasn't been a significant wave of credit downgrades, defaults, or spread-widening in the current economic cycle, there have been pockets of stress emerging, especially since the regional bank turmoil that started in March. Karsh and O’Leary cite the following reasons for a potential uptick in distressed credit opportunities:

1. Although default rates on U.S. high-yield bonds and leveraged loans haven't spiked, they are at a two-year high. Oaktree speculates that if these default rates continue to rise, investors may become anxious and motivated to sell, potentially leading to a surge in distressed opportunities.

2. Oaktree argues that many companies did not anticipate the sharp increase in interest rates, and as a result, higher borrowing costs and unsustainable debt burdens are squeezing them. If interest rates remain elevated for a considerable period, more companies could struggle to service their debt, leading to potential defaults.

3. While default rates could be lower compared to previous recessions due to fewer debt covenants in recent years, caused by a rise of cov-lite lending, the amount of lower-rated corporate debt globally has significantly increased. Even a modest rise in default rates could result in a wide range of distressed investment opportunities.

4. Despite seemingly healthy corporate fundamentals, cash positions may be more strained than current yield spreads indicate, owing to the negative impacts of slowing growth and rising costs in various industries.

5. The current problems in the banking system, though unlikely to reach the severity of a 2008-style crisis, have caused financial conditions to tighten. As a result, investors may find opportunities to purchase loans from risk-averse banks, provide rescue financing to regional banks, buy distressed debt of both regional banks and their heavily reliant companies, and create capital solutions for businesses historically dependent on regional banks for funding.

Real Estate Credit Outlook

John Brady, Head of Global Real Estate, and Justin Guichard, Co-Portfolio Manager, Real Estate Debt and Real Estate Structured Credit, discuss how the real estate debt market has experienced a significant shift primarily due to a rapid increase in interest rates. This has led to a retreat among traditional real estate lenders, a decline in transaction volumes, decreasing property valuations, and a substantial wall of debt maturities, creating opportunities for real estate lenders to step in and fill the funding void. The Federal Reserve's hawkish interest rate policy has caused three major providers of commercial real estate debt capital - commercial mortgage-backed securities (CMBS) markets, banks, and life insurance companies - to all slow down on their lending. This retreat is evident in the substantial decrease in CMBS issuance, with issuance levels in 2022 dropping by 36% y/y. The trend has continued in 2023, with CMBS issuance in the first quarter down by 77% y/y. The situation has been further complicated by the banking cycle stresses discussed above. The commercial real estate market is now caught in a vicious cycle, as falling property valuations and increased volatility have resulted in wider bid/ask spreads between buyers and sellers. As a consequence, traditional capital providers have become more hesitant to lend. However, the demand for financing in the sector remains substantial, with ~$2.50tn in commercial real estate debt maturing by 2028. Real estate debt investors, on the other hand, stand to benefit from this situation. They now have the opportunity to lend at higher yields against high-quality assets with moderate leverage and discounted valuations. Additionally, they can negotiate lender-friendly terms that offer significant downside protection. Consequently, Oaktree considers this to be the single most attractive real estate credit environment since the GFC.

Direct Lending (Private Credit) Outlook

Armen Panossian, Head of Performing Credit, Raghav Khanna, Co-Portfolio Manager of Strategic Credit, Raj Makam, Portfolio Manager of U.S. Private Debt, and Milwood Hobbs, Jr., Head of Sourcing & Origination, discuss how the direct lending landscape has undergone a shift, as many lenders who were bullish in 2020-2021 have now adopted a more cautious approach. This change has created compelling opportunities for investors who possess the necessary skill, discipline, and capital to capitalize on this retreat. Over the past year, many direct lenders have reduced their investment pace and scaled down the size of their new investments. This is evident in middle-market direct lending volumes, which dropped by 50% q/q in Q1 2023, reaching the lowest level since Q2 2023. One reason for this decline is that sponsor-backed deals completed between 2020 and 2021 have left portfolio companies with potentially unstable capital structures due to the Fed’s rate hike cycle. Consequently, many private lenders are reserving their capital to address issues in their existing portfolios rather than deploying it into new deals. Additionally, U.S. commercial banks are also contributing to the conservative lending environment by tightening credit standards, reducing lending volumes, and charging higher interest rates with added cushion above their cost of funds (see the recent senior loan survey results in the graph below). As a result of this cautious lending environment, loans for new leveraged buyouts have become scarce and more expensive. Even the largest private equity firms are facing higher costs, paying significantly higher coupons and fees to raise enough debt capital for their buyouts. Interestingly, contrary to historical trends, larger leveraged buyouts are finding it more challenging and potentially costlier to attract sufficient lenders and capital. As a result of these challenges, direct lenders who are able to identify safe opportunities may be able to take advantage of these increased financing costs.

Life Sciences Lending

Armen Panossian, Head of Performing Credit, and Aman Kumar, Co-Portfolio Manager of Life Sciences Lending, discuss how opportunities in the sector have significantly expanded in the last year, primarily due to the notable volatility experienced by biotech companies in the public markets. The S&P Biotechnology Select Industry Index saw a substantial decline of 26.00% y/y in 2022 and fell 48.00% below its peak in 2021, though it rose in 2023. This market turbulence has led many life sciences companies to seek financing in the private markets instead. However, private capital has mostly been directed towards a select few life sciences companies, leaving many others behind. As a result, there has been a growing demand for capital from a broad range of biotech firms, including larger publicly traded companies looking to fund product commercialization. These market dynamics have created attractive opportunities for life sciences lenders, particularly in opportunities involving companies with innovative therapies that are in the later stages of development, rather than just offering minor modifications to existing medications. Despite the possibility of economic slowdown, the outlook for the life sciences sector remains positive, as life-saving or life-extending therapies are typically purchased by insurance companies or state healthcare systems. As a result, sales in this sector are not as closely correlated with economic activity.

Senior Loans

Ronald Kaplan, Portfolio Manager of U.S. Senior Loans, discusses senior loan investors facing a tough decision due to elevated interest rates. On one hand, higher rates make loans more attractive to investors because of the increased coupon payments. However, elevated rates can also negatively impact credit quality, as borrowers may find it challenging to manage higher interest payments. In H1 2023, retail investors' concerns about deteriorating credit quality in the loan market seemed to outweigh the appeal of rising yields, which are now averaging over 10%. As a result, loan mutual funds and loan ETFs have experienced net outflows of $16.50bn in H1 2023, following the $12.80bn in net outflows in 2022. According to Kaplan, there is a growing perception of credit risk in the loan market. While the default rate for the loans was low at 2.50% as of May 31, 2023, it remains below the long-term historical average of 3.10%. However, downgrades in the U.S. have surpassed upgrades by $110bn in volume y/y. Kaplan warns that even if default rates do not reach recessionary levels, there may be a decline in recovery rates due to the prevalence of cov-lite structures and loan-only borrowers. The competing dynamics of rising yields and concerns about credit quality create challenges for investors, but it may be possible to find opportunities to purchase loans at low prices and benefit from elevated yields while waiting to see how the market deals with the tough decision.

Emerging Markets

Julio Herrera, Portfolio Manager of Emerging Markets Debt, and Pedro Sanchez-Mejorada, Co-Portfolio Manager of Emerging Markets Debt, discuss the high risks involved in investing in current emerging markets credit. Currently, the EM HY index shows yields above 10%. However, despite the elevated yield, Oaktree believes spreads do not fully reflect the increased risk in EM debt markets, as the index's yield spread remains near its historical average. Oaktree notes that optimism surrounding EM recovery in H2 2023 is primarily driven by the expected rebound in China after a subdued 2022, as most other EM countries are projected to experience slower growth compared to the previous year. Additionally, capital scarcity continues to be a significant headwind. In the previous year, EM companies paid $480bn in debt servicing costs, but only issued $220bn in bonds. On top of this, geopolitical tensions in EM remain high, including the war in Ukraine, worsening China-U.S. relations, populism in Latin America, and macroeconomic instability in Turkey, which could erode investors' confidence and lead to further capital outflows after significant outflows, compounding on top of the challenges noted above.

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