In the first installment of our AW Outlook series, we look at the trends within private credit markets in our exclusive conversation with CEO and Founder of Flat Rock Global, Robert Grunewald.
Robert Grunewald has over 30 years of experience with middle market finance, BDCs and asset management. Within the finance industry, he has participated as a lender, investment banker, M&A advisor, private equity investor and hedge fund manager. Most recently prior to Flat Rock, he served as the president and chief investment officer of Business Development Corp. of America (BDCA). During his tenure at BDCA, Grunewald grew the company from $2.5 million of assets under management to $2.5 billion.
Flat Rock Global is an alternative credit manager investing in areas of the credit markets the firm believes are less efficient with the dual objective of preservation of capital and generation of current income. Flat Rock funds are available exclusively to RIAs, family offices and institutional investors.
Over the next 12 months, how are you preparing your portfolio for interest rate hikes and market volatility? What is top of mind?
We are well-positioned for interest rate hikes and market volatility as our two funds, Flat Rock Core Income Fund (CORFX) and Flat Rock Opportunity Fund (FROPX), are both 100% floating rate portfolios. As such, all of the underlying loans in those portfolios are floating rate, so if interest rates rise, they will in fact benefit from those increases.
We created a portfolio of 100% floating rate loans in both of our funds because we wanted to create, what at the end of the day, are zero duration assets. That means that there is no risk of a decline in value as a result of an increase in interest rates, so the only risk we’re really taking in the portfolios is credit risk, and of course, we carefully manage that credit risk through our underwriting process. We felt strongly that adding an additional risk (i.e., duration risk), that exists for example in high yield bonds or other traditional fixed-income investments, was not something that we wanted to do and not a risk that we believe investors should be taking.
As we approach the third year of the pandemic, what are your thoughts about the macroeconomic picture?
It’s an interesting question for me because I’m certainly not a macroeconomist, and at Flat Rock, the macro environment does not particularly inform our investment thesis.
In our view, investment success is built upon bottoms up underwriting. We look at investment opportunities in our core areas of expertise within credit. Let’s take for example an attractive opportunity to secure debt financing for a middle market business. When assessing the opportunity, we analyze the business nose to the grindstone, looking at the fundamentals of that business. We look at those fundamentals in light of the existing economic environment as well as how they performed over a decade or more in a variety of economic environments.
So, back to your question, when I look at the current macro environment, I see low, but rising, interest rates. We’re not naive to inflation and carefully account for what inflationary effects could have on businesses with rising input costs, and the possibility of tightening margins as a result of that. While we are cognizant of these macroeconomic factors, we believe that the key to investment success in any market environment is bottom up fundamental analysis. If you’re doing that, then you’re going to be making good decisions, no matter the market.
What role do you see private credit playing in across the alternative investment arena in years to come? Is there still room for private credit as an asset class to grow?
We have certainly seen increased investor demand for private credit, and yet, I still believe there is tremendous room to grow.
I do want to call out a word you used in the question: “alternative.” The private credit space has now become a trillion-dollar marketplace and it should now be considered a mainstream asset class, not an alternative one. Moreover, it’s a mainstream asset class that, in my opinion, every investor should want to have exposure to. It gives investors floating rate exposure with much more attractive yields than one could ever get from traditional fixed income investments today.
What are the pros and cons to managing and investing in a private credit interval fund in the current environment?
An interval fund is a very specialized mutual fund. It has a daily net asset value and you can buy it any day. Just like any other mutual fund, you can buy either of our funds using the tickers CORFX or FROPX. The only difference between an interval fund and a traditional mutual fund is that if you want to sell, you can only sell at specific intervals, therefore the name an interval fund. In our case, those intervals are once a quarter. We tender 5% of our shares a quarter and 20% a year. The reason for that reduced liquidity is because the underlying assets, in our case private credit, are not as liquid as traditional stocks and investment-grade bonds. The advantage of that lower liquidity is that investors get higher yields. Essentially, we’re capturing what I would call the illiquidity premium that exists in private credit. In order to match the fund structure with the less liquid nature of the underlying fund assets, we feel very strongly that the interval fund structure is the right structure.
So, looking at our funds specifically, the pros are simple to see: an investor in CORFX is getting a nearly 7% dividend rate and strong returns (average annual returns since inception, which is coming up to 5 years now, are 7.6%) with a standard deviation of 3.1%. That’s nearly double the returns of the Barclays Aggregate with lower volatility. And an investor in FROPX has gotten a double-digit return (15% average annual return, over what’s coming up on a 4-year history) and again with a floating rate portfolio. I think it is fairly safe to say that investors are pleased when they are receiving consistent, attractive returns.
The one con, that I’m hoping I’ve shed a bit of light on, is that many investors are unaware of what interval funds are and why investing in private credit through an interval fund structure is advantageous. We need to find ways to educate investors so that they can understand that these assets are less liquid. As I said, some of the yield we’re picking up is what I call the illiquidity premium of the assets. That’s why their house in an interval fund structure is so strong: you can invest in them any day, but if you want to sell, you can only sell once a quarter.
The truth is, we want our investors to be long-term investors, and, with lower liquidity, we can achieve that. If you need to sell for some mild liquidity or portfolio rebalancing, that’s fine, as the interval fund structure works well for that. However, if you’re trying to be a tactical investor, you should be thinking about investing in our funds over a long-term horizon.