Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
‘Top Gun’ pays off for Northleaf
It seems that the spirit of the 1980s are alive and well in 2022. Inflationary pressures have forced Jerome Powell’s Federal Reserve to start acting a lot like Paul Volcker’s Federal Reserve; two commodity producing countries are at war with each other; and the maximalist spirit of that decade has been revived at the box office, where legacy sequel ‘Top Gun: Maverick’ has already taken more than a billion dollars.
While the big winners here are Paramount and wildly bankable movie star Tom Cruise, there are winners behind the scenes too – including investors of Northleaf Capital Partners. The firm owns the royalty rights to the song “Won’t Get Fooled Again” by British rock band The Who, which plays during one of the film’s numerous montages.
“Music royalties are an area that has fantastic underlying demand characteristics,” says David Ross, Northleaf managing director and head of private credit. “We just purchased one of the largest diversified pools of music royalties – close to half a billion dollars, hundreds of thousands of underlying songs… Historically, musicians or writers would own these royalty streams and pass them on through trusts to future generations.”
“Through our purchases, they’re able to monetise those assets today, while we are focused on optimizing the music royalty assets to make sure those songs continue to get played on the radio and pushed into Netflix or movie rights – which effectively broadens the scope of those royalties.”
The possibilities there are endless, Ross says; it seems that everything now has access to music streaming, from Apple Watches to Peloton bikes (or, as they’re known in the post-Covid era, very expensive clotheslines). Northleaf started reviewing the asset class three years ago, and closed its first investment in early 2021.
“It’s been a really attractive investment opportunity so far, but it’s still early days; there are three or four transactions we’re working on today, and we see the opportunity to continue to build that exposure in all our funds, both on a levered and unlevered basis,” Ross said.
Closer to home – and earth – Northleaf’s private credit team has undertaken a variety of specialty finance activities, including investments in litigation financers Litigation Capital Management and Omni Bridgeway, and QuickFee, an Australia-based provider of lending and payment solutions to accounting and law firms. Like other private credit managers, Northleaf has exploited the retreat of big banks from the sector, and the pipeline is “pretty robust”; the team is reviewing a dozen more specialty finance deals with litigation funders and small business lenders, and is looking to leverage its global footprint to partner with the country’s big super funds.
“The super funds are demonstrating good interest, but they’re building very large investment platforms of their own,” Ross said. “Many of them are building direct teams, which is a great extension of the scale they bring into the market – but we can provide them global access to the midmarket, which tends to be highly complementary to what they’re already doing.”
Private credit tends to perform well through periods of public market volatility, Ross says; but while Northleaf has only ever invested in politically stable geographies like North America, Europe, and Australia, there is a “heightened risk” from industries exposed to the second- and third-order impacts of geopolitical and economic upheaval. Northleaf doesn’t shop in cyclical industries like storefront retail, restaurants, travel and leisure or commodity-driven energy businesses, or ones with historically higher default rates.
In Europe, it observes a divide between the “beer drinking countries and the wine drinking countries”; the beer drinking countries – the UK, Germany, the Nordics – tend to have better credit protection and a better investment environment. Its private credit portfolio is weighted approximately 70 per cent to North America, 25 per cent to Europe and 5 per cent to Australia.
“As an asset class, private credit has consistently delivered high single digit returns with muted volatility. If you look back over the last 30 years, the return stream provided to investors has been very stable. Market default rates aren’t tracked well in private markets, but we have pretty good data over the last decade and loss rates for senior loans have generally averaged around 65 basis points, with a peak of 120 basis points during the GFC.
“That’s pretty attractive performance… and now is a particularly attractive time. Our asset class is largely floating rate loans, so you get the benefit from higher returns in a rising interest rate environment.”
