Dear investors, borrowers, partners and friends,
Thank you to those who have reached out over the last few weeks. I have appreciated the communication and apologise for not responding to each of you sooner.
Since March, we have been working to prioritise the safety of our staff, with all staff now working from home, and conducting detailed reviews of each investment held by the firm to understand our positions and how they may be affected by COVID-19.
In light of recent events, I felt it appropriate to reach out to those we have built close relationships with to share our views on the impact of, and likely impending recession caused by COVID-19. In particular, I believe it’s important to highlight how this is impacting the strategies for our investments and funds.
I commenced my career in the mid-1980s, following the economic liberalisation and deregulation of the Australian economy. Since then, I have had the opportunity to experience each stage of the economic cycle on numerous occasions with three notable crashes – firstly, the international recession in 1991, secondly, the bursting of the ‘dot-com bubble’ in 2000, and thirdly, the global financial crisis in 2008. I recently reflected on these events and their lasting impact on my approach to assessing investments.
During the 1991 recession (which feels like yesterday), my banking experience was dominated by a period of low liquidity. Foreign banks who had gained licences following deregulation in the 1980s cut ties to Australia, causing loans to be rapidly called in and assets sold out underneath borrowers. There were no sizeable superannuation funds, hedge funds or distressed debt funds and the Australian banks could not absorb the loans being exited by those foreign banks. Australian banks were also treading on eggshells, many speculating on their own solvency.
This period was grim. At the time, I worked for a government organisation, focusing on asset management and workouts to help borrowers stay afloat. We assumed forecasts would not be achieved, asset values would fall and businesses would fail. More times than not, these assumptions were correct. However, my boss at that time taught me that if you can apply an equity lens to debt positions, then the creation of at least $1 of equity will ensure your loan is not impaired, and will subsequently enable recovery.
The experience impacted and shaped my decision making throughout my career. I always considered the worst – what would happen in a default situation? How would the parties behave? How could we position ourselves to avoid the worst? Progressively over time, the importance of counterparty risk and obtaining quality sponsors was ingrained into me.
Over the last few years, which has seen one of the highest asset booms in recent history, I wondered whether my experience in the early 1990s was an asset or liability. In particular, I think about those investments we, as a firm, could have made but deliberately did not.
We entered 2020 with considerable cash in our funds – we have over $450 million of dry powder. Staff and investors have asked me whether this was intentional, speculating on whether I predicted this turn of the economic cycle.
To be clear, no one could have predicted the COVID-19 pandemic and resulting global fallout. However, the last couple of years presented signs consistent with the late stages of an economic cycle and this altered our investment behaviour. In particular:
- Our rejection rate on deals has been high, both at the origination level and at the investment committee level, relative to previous periods;
- We have limited our exposure to mezzanine deals, closing our Mezzanine Fund to further investment in July of last year, as we were not satisfied with the risk and pricing presented;
- We have not made any equity investments since June of last year, including in our new Opportunity Fund II, as the risk and pricing presented has not met our criteria. Furthermore, in regards to our Opportunity Fund II, which has been able to invest since September 2019, we screened over 33 investments with total cheque sizes of $1.3 billion spread across 25 sponsors and pursued none of them. This fund has not been drawn and without a doubt will now come of age as the cycle sits squarely in its favour;
- The vast majority of our deals completed in the last eighteen months have been senior debt transactions, secured with first mortgages on real assets. We have competed on price, due to the heightened competition in the market, in order to deploy capital for our investors, but did not compete on leverage terms; and
- At our staff conference held in February of this year, staff discussed the market dynamics and it was widely held that all market indicators which we deemed important to us were implying adverse conditions for investment.
The consequence of the above is that we have significant cash in our funds.
Our current investment book is circa $2 billion. As mentioned, we have recently reviewed each investment – we are confident with the vast majority and have identified focus areas for those which need some attention. The team continually challenges one another on strategies and thinking to ensure we remain ahead of the ‘COVID curve’, to the extent possible.
Furthermore, we haven’t taken on any external debt at the Qualitas holding company level nor leveraged any of our Qualitas funds. This enables us to focus on asset quality rather than the management of liabilities. Notwithstanding this, we are continually focused with Qualitas on our revenue and expenses, ensuring our liquidity buffers as a firm are adequate for the medium term in a recessive environment.
We are still open for business, albeit our interest is limited to high quality deals. We believe the right time to invest will be when we can see the other side of COVID-19. The view is murky at the moment and it’s difficult to predict the duration of the current partial shutdown and the consequential effect on asset prices and true value.
Property takes time to adjust to new circumstances unlike equity markets which can move rapidly. It can take time for the pieces to fall into place. We remain confident that business will continue and great opportunities will appear for those who remain patient.
Thank you for your ongoing support and trust. Should you have any queries or require further information, please reach out to your relationship contact at the firm.
Stay safe and wishing you all the best,
Founder and Group Managing Director