Washington H. Soul Pattinson and Company Limited (SOL) Earnings Call Transcript

Thank you. Please go ahead.

Good morning, and thank you for joining us. I'm Todd Barlow, and with me is Dean Price, who leads the investment team as Soul Patts, and has run our credit strategy since it started. Credit is a growing segment of our portfolio, and we get a lot of questions from shareholders about the strategy. It's also one of the best illustrations of how our flexible mandate lets us invest right across the capital stack. At the full year presentation, we don't have the time to go into a huge amount of detail on each and every asset class. So in response to ongoing interest about credit, we thought we would host this web now. Our aim today is to give you insights and information about the way we think about credit, including our views on the market generally and why we like credit for its downside protecting qualities, our approach and how we generate returns, the book itself and how we value it and finally, our share strategies and deployment outlook. We have time for questions at the end, feel free to submit at any time in the question box at the bottom of the screen. Let's kick off with why do we invest in credit and what role does it play in our portfolio. If we start by thinking about the typical risk and return trade-off, obviously, the lower the risk, the lower the return. We are trying to construct a portfolio that has a range of different risk and return profiles that act in different ways through the cycle. What we are seeing at the moment is the returns from fixed income and credit are increasing in line with increases in the base interest rates. That has the effect of lifting those left-hand boxes at the expense of the right-hand boxes. Equities are impacted by higher funding costs higher cost of equity and any attempt to slow the economy should impact on general profitability. Through increased exposure to credit instruments, we are trying to shield the portfolio from lower equity returns and derisk the portfolio as a whole. We see credit as a derisking strategy. Credit reduces risk because it has the structural protection from being paid back ahead of equity. Lenders to a company have contractual rights that shareholders do not have. In the event that the company experiences challenges, lenders are paid back first and equity is paid last. But it's also an opportunity for us to earn outsized returns. In fact, our credit portfolio has been returning greater than 14% consistently for the last 5 years. That is well in excess of the total return from ASX equities. Equity is our margin of safety and we utilize our skills in valuing equities to assess the value of that buffer. We are still undertaking analysis on the underlying quality of the business and would be happy to own the equity. And in some cases, we already do. However, credit provides us with an alternative structure, which may be useful in certain situations, particularly where our fast and flexible solution is required. For us, we get to limit our downside risk and gain contractual cash flow above the yield on most equities. When we talk about downside protection, we ask ourselves if things go badly wrong, what will it actually cost? The answer starts with where we sit in the capital structure. Most of our book is senior secured or pay first, and we have security over company's assets. As I mentioned on the previous slide, we see the equity as our buffer or our margin of safety. The right-hand side of this slide puts historical context into that protection. Let's take 2009, the depth of the global financial crisis, as an example. That year, about 1 in 10 borrowers in the U.S. where the GFC hit hardest, defaulted on speculative grade loans. Speculative grade means loans below investment grade, which are rated BB+ and below. However, just because the loan defaults doesn't mean credit loses all of its money. On those defaulted loans, lenders lost $0.37 in every dollar. Multiply those together, and in the worst year in recent memory, lenders lost less than $4 for every $100 of loans. That is far less than the interest and fees that would have been earned in that year. Every loan we write, we expect to get our money back. However, we make a provision upfront for the possibility that we don't. This provision is called an expected credit loss. We'll talk a little bit more about how we arrive at that provision when we get to that valuation. But right now, we are carrying an expected credit loss of 4.5% across the book which is higher than the worst year during the GFC. However, due to our selectivity in our book, we would hope the actual losses to be less than the entire market. First point, I'll make you is that we are investing in our own balance sheet. We have not raised third-party funds that we have to deploy. We will only make new loans if we believe that provide superior risk-adjusted returns to anything else we could be doing. We do not have a predetermined allocation to a credit bucket that we have to fill. That means we can maintain the quality of what we do without having to chase deals. Our credit book is primarily in Australia and that is about $1 billion. The Australian market is estimated to be about $200 billion and has been growing rapidly and continues to see growth of around 13% despite what you might read in the papers. Large institutions are continuing to allocate to this asset class, and private credit in Australia is only about 3% of the entire banking system. So there continues to be opportunity for growth. Private credit in the U.S. is approaching $2 trillion and growing at a similarly strong rate to Australia. These are much more established market, and there are lots of good opportunities for us to deploy through partnerships. However, as money has been pouring into private credit, the large fund managers who have been given the capital need to deploy it. And if you want to deploy a lot of money, you have to go to the areas of the market that provides you with the most scale. In Australia, that largely means real estate development. Around 50% of the market is this segment where the banks have pulled back in recent years. We have typically avoided this segment because we felt it was overserviced require specialist skills in the event that something goes wrong and is also the asset class that typically see defaults in downturns. In the U.S., the scale product is leveraged finance to private equity sponsors which accounts for more than 70% of private credit deals. These are loans to private equity-owned companies where there is typically a high amount of leverage that adds risk. In addition, the terms that a highly sophisticated private equity borrower can extract are often very unfavorable to the lender. These are broadly marketed term sheets that get passed around town, where lots of capital forces faster deployment, sharper pricing and looser structures. Our bigger concern is the ownership model, a private equity firm with dozens of companies can treat each one like an option. We prefer borrowers whose owners stand behind the business and have the capability to inject capital in views of distress. What we do look for are discrete deals where we can provide bespoke solutions. We built a relationship so that we can understand the needs of the borrower and design a solution around it. We are seeking to earn a premium for our flexibility, ability to move quickly in the work we put into the design of the solutions. Our preference is to negotiate bilaterally where we set the price and terms. Trade-off is that there are only so many of these opportunities in the Australian market. Origination, not capital is our constraint, which is one of the reasons why we are growing this asset strategy offshore. Apart from the relative attraction of credit in the portfolio, we also see credit as a natural extension of what we already do. Our equity skill set, picking quality businesses is rewarded even better when applied through structured lending, and it diversifies how the portfolio generates cash. We scaled this strategy following the Milton merger around the start of financial year 2022. Our larger balance sheet scale made a direct lending book attractive. That balance sheet or what we call permanent capital is one of the biggest structural differences between Soul Patts and the credit funds in the headlines. We have no fund structure, no duration mismatch, no redemption pressure, no pressure to deploy. Borrowers we back are typically businesses with a strong asset base that may be looking for an alternative solution to raising equity. For example, a growing company may see us as a bridge to a higher equity value where they can raise capital on better terms at a later date. By targeting good quality companies, this provides us with structural downside protection. The origination diligence, structuring and decision-making is not vastly different from our approach to making equity investments. Our preferred sourcing is proprietary through our network. We conduct due diligence on the company and determine the credit score in-house. Approval runs through 3 gates where a deal is debated with our Specialist Advisory Committee that is scrutinized by the investment committee and larger investments require approval by the Board. Another point of differentiation is that we maintain active monitoring of each position, and we are often proactive about where we can play a role in the future funding needs of our counterparty. I'll now hand over to Dean.

Thanks, Todd. Our returns are the result of strong relationship-led origination, thoughtful and sometimes complex structuring and deep underwriting. We are not taking excessive risk to determine predetermined hurdles. Starting with sourcing. Our deals come through reputation and relationships, not marketed processes. Of the $1.1 billion we originated in FY '26, half of this was directly sourced, negotiated and structured by our team. Senior secured loans are the largest part of the book with tight covenants, information rights and active oversight. We get paid for this hard work with around $86 million of fees generated from these investments over the last 5 years. Realization happens quickly because the book is short and self-liquidating. Borrowers often repay us early. In FY '26, this amounted to about $1.2 billion. This is healthy, but it means we have to work very hard to constantly originate new ideas to remain invested in this portfolio. A quick realization is healthy and leads to higher rates of investment return, but there's also a natural tension where we want to hold on to our investments for longer and not be repaid. Putting all this together explains how we have delivered 14.3% per annum for 5 years. These returns have been generated in a lower but rising rate environment. And as rates increase, so do our returns from this portfolio. Whilst we've been writing loans for a longer period, we now have 5 years of this particular strategy behind us, having deployed $3.7 billion and being repaid about $2 billion. Over that period, 23 positions have been repaid and every single one repaid in full with no capital losses. Internal rate of return across this portfolio is 14.3% per annum. Today, the book stands at $1.9 billion of net asset value, which is around 13% of the total Sol Pats portfolio. The chart here illustrates how that capital has moved each year. You will see that repayments have grown every year. And for the first time in FY '26, we were repaid more than we deployed. This is a sign of good health and good discipline for our portfolio. With an average tenure of about 3 years, there is significant turnover in this portfolio with a meaningful share of investments coming back to us every year. Again, it takes a lot of hard work to keep finding new and quality investments. This is one of the reasons we're building our offshore partnerships to supplement what we're doing domestically, but without lowering the quality of our portfolio. This is a slide showing the direct book summarized by where we rank in the capital structure. You can see that the book is predominantly senior secured and anchoring around a mid-teen IRR. This is the margin of safety we described earlier, represented in numbers. We earn an average IRR of about 13% with senior security. This is why we don't need to get down the capital stack or take excessive risk to generate strong returns. The portfolio turns over quickly and means we're constantly re-underwriting at the current market conditions. How we value the book is important. The majority of our direct positions are held at amortized costs less an expected credit loss provision as the accounting standards require. That provision currently stands at around 4.5% of the book. As Todd said earlier, the GFC costs senior lenders 3.7% of their capital. We're currently provisioned above the GSE scale loss year, whilst our realized losses to date are 0. The right-hand chart demonstrates how this provision is set. It is built bottom up from a credit rating review of each borrower with market and country risk factors overlay. Our investment team sets this revision and it's challenged in 3 ways. First, the ratings are independently reviewed externally by consultants and it's reported internally to audit and risk committees and to the Board. And finally, it's tested through our external audit and the financial statements. And this team of 8 investment professionals averaging about 15 years across credit and restructuring. This is the same team running the same process onshore as offshore. A $100 million fund allocation gets the same diligence and thought process, structuring and relationship development as a $100 million direct loan in Australia. Let me demonstrate our approach and how we source these investments using 4 examples. The first slide uses Electrooptic Systems and ERA Resources, both examples of where we are both a lender and an existing equity holder. EOS is a 9-year relationship that helped form the proof of concept for our portfolio. Our relationship started many years ago as an equity holder in 2017. Our credit relationship started more recently through an emergency requirement of $70 million provided by us as a loan. The company's Board did not want to dilute shareholders with a discounted equity rates. As we knew the business very well, we were able to move at a speed no other capital provider could. This relationship continues. As EOS' largest shareholder, we've been approached by them multiple times since and most recently for a $100 million bridge loan facility to help them finance their latest acquisition. This is a great demonstration of our relationships and reputation helping our origination. Aeris Resources is another long-term investment where we held an equity holding first, and we knew the assets very well. The company needed $40 million to fund the closure of the zinc mine after a seismic event, an unusual and time critical need that we built the facility around. We secured our facility against assets worth in our view, multiples in our loan Again, this is a proprietary relationship store deal. The loan was repaid years later following an equity raise by Aeris. The bank guarantees we provide still remain in place today. The company's equity raise was conducted at a time of its choosing and as price higher than loan was initiated that's a win for the company's shareholders to avoid share count dilution. Next slide shows 2 examples of deals that show our willingness to lend into complexity where security protects our downside. Star was a widely covered restructuring. We participated for around $200 million in a $400 million secured over real assets worth well in excess of the loan with structural protection negotiated at entry and improve by us along the way. We were eventually repaid in full with an IRR of around 23% over 3 years. We weren't taking equity risk. We had security the whole way through, which we continue to improve, and we bought when others were forced to sell. A final example is of a global online shopping retailer, a more recent investment that was sourced fire on of our offshore partners. We are part of a broader package that is financing this retailers exit from a restructuring. It is a revolving loan secured against short-term receivables. Receivables turn to cash in short order a matter of weeks. Lending against receivables, not the business's success. This investment was sourced by one of our global partners, a specialist in their situations off the back of our relationship. This is a low-risk loan investment secured by receivables and the receivables are well in excess of our loan. This investment has a projected 13% plus IRR, and it demonstrates the partnership flywheel working, which now takes us to the following slides on our global partnerships. Thanks, Dean. As we said earlier, there's only so many opportunities in Australia for our direct book. We are picking discrete opportunities where we can be relevant to a borrower. Borrower needs to meet our quality requirements and the loan needs to achieve our hurdle rates. However, globally, the pool is very deep, and that's where we are seeing opportunities for growth. And we started looking at ways that we could get more exposure globally to what we like in Australia were blown away by the quality and depth of opportunities. We currently made $1.5 billion in commitments across 19 positions to offshore partners. $854 million remains undrawn, and we expect it to be called upon over the next 3 years rather than deployed all at once. Discipline is in our selection process. Each manager we partner with runs a distinct strategy with a strong track record through more than 1 credit cycle. I think and act like us with strong reputations and networks in their regions. And there are 2 additional features making these economics even better for Soul Patts. First, co-investments. We have access to deals alongside our partners on preferential terms, and this increases our deal sourcing capability. We already hold 2 positions on this basis. And secondly, franking. Due to the nature of these investments offshore, income comes back to Australia are able to be -- were able to attach franking credits from our existing $1 billion of franking credits. That means a 10% net return offshore is worth roughly the same to shareholders as a 14% pretax return domestically. And importantly, the target returns we have shown you exclude this benefit. This is all additional upside to shareholders. We're often asked who the partners are. We don't think naming them gives much insight to shareholders and the way we source these relationships is our own the strategies are outlined here. I'll draw out the top 3 where we have the most exposure. Opportunity credit is our largest allocation at around 30%. And this is flexible capital that buys good loans at discount prices when others are forced sellers. As an example, we talked earlier about the actual losses incurred in the GFC. But at that time, many lanes could have been bought for much larger discounts. It's our countercyclical strategy, meaning he does its best work when markets are stressed. We've allocated around 20% of our commitments to asset-backed lending. This strategy involves lower risk loans secured against real assets that the borrower owns, for example, property, equipment, inventory or invoices. We've also allocated around 20% to special situations, which describes lending to companies working through complexity or restructuring. This is something we are comfortable doing in Australia. Our EOS and Star loans that Dean spoke about earlier are local examples of this. The 4 smaller strategies are deliberate diversifiers, generating return streams that don't depend on the credit cycle moving one way. One note on the returns column. These are historical ranges for these strategies and are shown to give you a sense of the expectations, they do not describe current returns of our existing commitments which I've all recently made and most of this capital is still being done. As our positions mature, we will have more share on actual performance. To close, we are answering the question, is there a ceiling before deployment dilutes returns? Domestically, our deployment capability and capacity is constrained by the availability of quality opportunities. This is why a chart deliberately holds the domestic book flat. We're not forced deployment to hit the NAV number and permanent capital means we don't have to. However, last year was a large year for deployment. So we would expect to have the benefit of those loans for a couple of years. The average is to maturity on the direct book is around 3 years. Offshore is where the committed growth sits. The $854 million of undrawn commitments will be called over the next 3 years. The chart shows an illustrative drawdown profile However, the actual timing is set by our managers as they find opportunities. We think dislocation is working in our favor. Historically, tight spreads are repricing wider and some of the largest funds are in outflows. For sellers and constrained competitors are a good backdrop for flexible patient capital. And higher base rates are helpful. Our book has averaged over 14% since inception during a low rate environment. Higher base rates makes us more competitive. However, we probably compete with equity markets more than we compete with other credit providers. If equity markets are volatile and uncertain, our ability to provide a structured solution is strengthening. To finish, I'd like to summarize the key points. We believe credit is a downside protected asset, and we have provisioned above the worst year on record, and we've experienced 0 losses since inception. We have a funded path to growth and the environment is becoming more favorable. And with a strong history of solid yield, Soul Patt's credit strategy provides excellent risk-adjusted returns and placed important role in the portfolio. Thank you for attending today. Happy to move on to questions. And just as a reminder, you can type your question into the question box below, and we've got some that are already starting to come through.

Thanks, Todd. Thanks, Dean. The first question just relates to the offshore partners. The question is, do you have high transparency with global credit partners and the loans you are making to global companies? How often is Soul Patts' updated if loan repayments are not made or are nonperforming?

There's a fairly high level of transparency, they're reporting to us periodically on how the portfolio is performing. But one of the things that I should have said in the presentation about each of our allocations to offshore managers is that they are in themselves as a diversified portfolio. So we would not expect any of our allocations to any of the managers to be seriously impacted by any 1 or 2 defaults. What we should see is a portfolio that is diversified across a number of positions and the same principles that we talked about applying to our own portfolio in terms of downside protection should apply to each of the managers that we allocate to.

Thank you. And a question now on returns, will you be getting the same returns, assuming the 13% IRR by using offshore funds?

The returns I think it could be higher than what we see domestically. But there's a fair amount of spread in terms of what we're targeting. So we've got some asset-backed strategies, which are lower turning than what we do domestically. But then there's some special situations type returns that we would expect to be higher than what we do domestically. But on average, I would say that we would expect to be coming out at a similar level of returns to what we see in Australia. However, there is a material difference from a tax perspective. So the 14% that we earn domestically, we have to pay full tax on. The rates that we are getting or the returns that we're getting from offshore are net of fees, net of taxes. And so if we receive a 14% net return from offshore, that is equivalent to 20% domestically. So it's not like-for-like. If we're getting 14% globally, that's equivalent to 20% domestically. And for that reason, the global opportunity actually looks better in aggregate than the domestic opportunities.

Another return question. If Soul Patts are achieving plus 14% per annum, how much are the investors inside the credit fund receiving?

That is -- we are just investing in our balance sheet. So we don't have funds that we're managing. So we're just investing our balance sheet. And if we're receiving 14%, shareholders are getting the benefit of that 14%. There's no management leakage on that. That is the predominantly cash return that we are getting across our direct credit book. If I'm talking about offshore funds, the returns we talk about are net of fees that the manager charges us. So whatever we're talking about today is the amount that shareholders are earning from those investments.

And Todd, could you please explain why Soul Patts would not offer credit as a stand-alone product?

Well, I think the main reason, certainly, when we're talking about our direct opportunities. As we said in the presentation, they're quite hard to come by, and we want to allocate as much as we can these strategies because we like the risk-adjusted returns. So we don't really want to share them with outsiders. We're investing in our balance sheet that is owned by our shareholders, and we want to be greedy for our shareholders. So we don't want to share those great opportunities around because they're hard to come by. There is a deeper pool of opportunity offshore, and there might be an opportunity for us to offer co-investment with some of the investments we're making offshore. But for now, we've just been focused on maximizing the opportunity for our shareholders and investing in our own balance sheet without worrying about trying to make fees on funds.

How do you deal with currency risks?

So everything across our portfolio is hedged back into Australian dollars. So we take away currency risk, particularly with our credit because it's a little bit more certain in terms of the cash flow. So it's a lot easier for us to hedge that back to Australian dollars.

With private credit in Australia largely tied to the property market, which has taken a big hit with rate rises and tax changes in the budget, does Solpat see opportunities still in the luxury retirement villages development or more luxury apartments for downsizes. As capital is being drawn away from property development, are opportunities starting to look more attractive there?

Yes. As I said, we have typically avoided lending to real estate development. It's not our expertise. It was something that we deliberately avoided because we felt that there are a lot of other providers in the market. And it is an area where you do see a little bit more distress through the cycle. So it isn't something that we have typically done. There are increasing opportunities coming, but we will tread very cautiously because there's a lot of funds who are in outflows and they might need a solution. There's a lot of people who need to be refinanced and they might need a solution. But it is something that requires specialist knowledge and it is taking a view on the real estate market, which is a little bit more challenging to predict. What we tend to stick to is understanding the value of companies because that's what we do and that's what we know. And if we end up owning a company that is just consistent with what we do elsewhere, whereas if we end up owning residential developments, that's not something that we're particularly comfortable doing. But the question did raise the fact that we are in retirement living, which is somewhat connected to real estate residential prices. We've again been trending cautiously there. We've done one development in Crinala. That's already been sold down, and we -- that was very successful for us. We have another development which hasn't kicked off yet. But generally speaking, our exposure to residential real estate in our portfolio is very, very low.

I've got Simon Fitzgerald, the analyst at Jefferies with a few questions here. So number one, you mentioned that there have been 0 losses. Can you talk about defaults, loan extensions and if there have ever -- if there's ever been a situation whether we've needed to draw on that security? And the second question, with the external capital that is invested in third-party funds, what total percentage of that is private credit and how to manage that exposure where Soul Patts is still exposed to redemptions in those funds?

So I'll take the first one around the defaults. And so we've experienced 0 losses. We've never had to actually take security -- underlying security of any of the borrowers that we've loans to. From time to time, we do offer extensions and relief. The bilateral nature of our loans means that we can have very tight covenants so that we can have ongoing dialogue with the businesses if we ever start seeing some deterioration in the underlying performance. So it would be natural for us to be in constant dialogue with companies about how they're performing. But we've never had a situation where there's actually been a default resulting in us having to take possession of security. So that's been a positive experience. On the second point around external capital, Dean, do you want to touch on that one?

This relates to the investments we're making in third-party funds, the questions around private credit. I guess it depends on how, Simon, you define private credit. But if you're talking about direct lending to sponsors or real estate, then we have 0 of that in our allocations.

And then a third question has come through from Simon. What sectors are off the table that you would not lend to, for example, data centers that rely on AI contracts and any others?

Well, I think it's really just anything that we think has poor quality characteristics. So AI contracts would be very, very difficult because some of them are not long term in nature. We would be concerned about risk around obsolescence and things like that. So I think valuing the residual value of the equity behind that would be quite complicated for us. But we're very happy lending to data centers that are sort of cloud-based because we can see that there's underlying value in the real estate, where the real estate in those situations is a higher proportion of the valuation as compared to some new AI data centers that are heavily CapEx and chip related and things like that, which we don't understand as well. So nothing is off the table. It really is just a quality filter around what would we be happy to own equity in and what are we happy to have exposure to in our credit book.

And a question now on geographical spread. So there's a question here about the country of origin for our asset lending and how far down the capital stack we invest for these assets -- the asset back strategies are predominantly in the U.S. and the way those strategies or those loans generally made is that you've got security at the asset level. So it's not about necessarily going down the stack secure you're securitized against the particular asset.