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A Galaxy Far, Far Away

October 1st, 2017

Market Views

When Star Wars: The Last Jedi opens on December 15, hordes of fans will flock to theaters to see the latest chapter of this modern classic and to learn what Luke Skywalker has been up to in his galaxy far, far away.

Similarly, in the universe of private debt, in our opinion, allocators race from theater to theater hoping for a seat with seemingly little concern for what’s playing. Direct lending funds, public and private BDCs, and sponsored and non-sponsored deal funds are all playing to packed houses, and lines continue to form before new shows are even announced. According to Preqin, ten direct lending funds closed in the third quarter, having raised more than $10 billion, bringing the total raised to $28 billion year-to-date.

While HCG operates in this red-hot private debt universe, we observe the frenzy from a galaxy far, far away: the cooler outpost of digital finance we call home. And, despite the consistent performance and superior risk and time-adjusted returns achievable in our digital finance world, the bulk of assets being raised for private debt are not destined for our relatively small corner. As of 3Q17, we estimate that digital finance assets represented less than $10 billion of a private debt universe of more than $1.4 trillion
(Sources: Preqin, J.P. Morgan, Bloomberg, Thomson Reuters).

We believe that managing digital finance assets in our galaxy requires a skill set not possessed by every Jedi wannabe. In our view, survival and success depend on foresight, clear investment objectives, experience with public and private markets, and a focused, thoughtful and disciplined investment process. At HCG, we seek to combine these skills with bespoke technological innovation, cohesive risk management, and optimized and agile portfolio construction across multiple disciplines and diversified over thousands of small-balance loans. We also believe that familiarity with the neighborhood and its residents is paramount. The Force alone will not get it done.

Guided by the right Jedi master, we think the digital finance galaxy is a pretty good place to invest. As for the hordes, back in the private debt frenzy, we turn to Obi Wan for guidance1.


Industry Update

Macro: For those of us in a secure orbit, these are good times. According to the latest macroeconomic gauges, the US economy is healthy: unemployment is at 4.1%2 and third quarter GDP came in at 3%3. Not surprisingly, consumer confidence has reached its highest level since 20004, and in October, the Non-Manufacturing ISM index, a monthly leading indicator, hit its highest level since the composite’s inception in 2008 and the highest level since 2005 when considering the pre-2008 composite index5.

Credit: Against this healthy macro backdrop, most segments of consumer and small business credit continue to perform in line with our expectations. Revolving consumer credit loss rates have trended slightly upwards, from excellent to just very good. In the chart, we highlight the six largest credit card issuers in the U.S. and their net charge-off (“NCO”) rates since 2007, noting that loss rates on credit cards are still well below levels from early 2007. On average, NCO rates were ~3% in 3Q17, in line with expectations of a normalizing credit environment (Source: Company data).



Aggregate housing debt (mortgages and home equity loans) is at $9.2 trillion of the $13 trillion U.S. household credit stack per the New York Fed6. A sub-segment, 12-month term “fix-to-flip” and rehabilitation business purpose residential real-estate mortgages, is, in our opinion, also exhibiting steady traction and favorable loss experience.

Within consumer credit, auto and student loans represent areas of caution, and while we do not participate in the former, we have identified a platform that we believe will allow us to participate in the latter in a way that is consistent with our investment process and our commitment to risk management.

Small businesses in the U.S. remain optimistic about future growth prospects according to the latest NFIB Index of Small Business Optimism report.7 While the index declined in September, the overall level of optimism remains high, in-line with levels last seen between 2004 and 2006 – a period of robust economic expansion. Additionally, the Thomson Reuters/PayNet Small Business Delinquency Index shows stable credit conditions across small business loans. The chart below highlights that only 1.35% of small business loans and leases tracked by Paynet were “31 to 90 days” delinquent through September.



Platforms: In our opinion, the following platforms continue to report good results and to provide us foresight into emerging economic trends. Just as we saw the general strengthening of the US economy in growing loan demand and steady loss performance, we now see yet greater confidence as businesses and individuals turn to these platforms in increasing numbers. LendingClub and Square, Inc. (“Square”) posted strong results with notable year-over-year growth in originations, revenues and operating cash flows. Please see each company’s release for details (click here for LendingClub8, here for Square9).

At Square, higher gross payment volumes and new product initiatives resulted in management raising 2017 adjusted EBITDA guidance by 8% to a range of $132-$135 million. Square Capital originations grew 45% yoy with over 47,000 new business loans totaling approximately $303 million in the quarter.

At LendingClub, the company posted record quarterly revenues on the back of $2.4 billion in originations, which were up 24% yoy. Profitability jumped, as measured on an adjusted EBITDA basis, to $20 million vs. $4 million in the second quarter. Operationally, LendingClub introduced their 5th generation credit model in an effort to continuously improve underwriting across all grades, and in particular their higher risk standard program loans (e.g. Prime F & G).

Both LendingClub and Square ended the third quarter with $790 million and $848 million, respectively, in cash and cash equivalents.

Regulatory: We observe that the legal and regulatory community associated with the digital finance space is the most optimistic it has been regarding the regulatory outlook since 2013. In our opinion, the confusion and conflict we have witnessed is being replaced with clarity. While legal challenges will likely continue to arise in the short run, directionally, the trajectory towards regulatory clarity appears favorable. For example, Congress continues to make steady progress on the passage of laws that will likely repeal the impact of the Madden v. Midland case that questioned “valid when made” loans (click here10), and the House of Representatives is working on a few bills that should allow digital finance originators to pursue their corporate missions with clear legal guidance. The House’s legislative initiative is bolstered by government-sponsored research highlighting the positive community and economic impact digital finance platforms are having on the country, highlighted by the Philly Fed’s working paper on the impact of digital loans in its district (click here11).

Confidentiality and Non-solicitation: No information herein constitutes an offer or a solicitation to buy or sell any securities or any interests in any product or investment strategy managed by HCG Fund Management LP (“HCG”).  Any offer or solicitation relating to any such investment will be made only by means of confidential offering documents relating to a particular fund  or investment contract and only in those jurisdictions where permitted by law.
Reliance: This information may not be relied upon for investment decision-making purposes. It does not contain all the information necessary to make an investment decision, including the risks, fees, and investment strategies of investment products advised by HCG. Eligible investors are described in official offering documents, all of which must be read in their entirety and will supersede the information contained herein.  No offer to purchase any securities or interests by a prospective investor will be made prior to receipt of all official documents, and no offer to purchase any securities or interests will be accepted without receipt of all official documentation that has been completed to HCG’s satisfaction.
Opinions — No obligation to update:  The information contained herein represents the views and opinions of HCG.  It is intended solely for informational purposes and is not intended to constitute investment, legal, tax or accounting advice.  The views about digital finance investing and estimated future investment opportunities expressed herein reflect those of HCG management as of the date herein and are a reflection of our best judgment at the time.  They are subject to change based on market and other conditions, and we have no obligation to update.  Actual results, however, may prove to be different from our expectations.  No warranty is given to the completeness or the accuracy of the information contained herein.
Suitability and Risks:  Any investment in products managed by HCG is appropriate only for financially sophisticated investors capable of analyzing and assessing the associated risks fully disclosed in the Private Placement and/or Information Memoranda. Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The Private Placement and/or Information Memoranda contain this and other information about the investment. A prospective investor should have no need for liquidity with respect to its investment and should view it as long-term and not a trading vehicle.  Additional risks are disclosed in the Private Placement and/or Information Memorandum including, including, limited liquidity and restrictions on transfer of the securities, dependence on HCG’s principals, and short operating history of certain productsAs with all private investment funds, investments are deemed speculative and involve risk of loss.
Third Party Data: We do not verify third party data used in certain calculated metrics shown here.