I think that there is a tendency amongst investors to view funds on very high yields with suspicion, reasoning that the opportunity is too good to be true. VPC Speciality Lending (VSL ) could have fallen into this trap. Why else would a debt fund that has delivered annualised returns of close to 12% over the past five years be trading on a 24% discount to net asset value (NAV)?

I met Gordon Watson, a partner at Victory Park Capital Advisors, LLC (the manager) recently to find out.

VSL’s returns come from the loans that it makes. Every loan must be backed by assets, which can be sold to repay the loan if the borrower runs into trouble. Assets that are easy to sell are viewed as less risky, the asset cover that VSL demands is higher on illiquid assets. Deals are priced based on value of the collateral in a default scenario. The manager is watching the portfolio carefully given the current environment.

The investment company lends by providing lines of credit, primarily to tech-enabled lenders. The loans that they make in turn must meet VSL’s lending criteria. In a situation where loans that the finance company had made ran into trouble and the assets backing the loans didn’t fetch enough to cover the repayment, it would be down to the finance company to make up the difference – providing further security to VSL. In the past, finance companies have raised fresh equity to make up shortfalls. In extremis, Victory Park is willing to take control of businesses.

VSL is a reasonable size, with a market value of £224m. However, the manager says that by itself is too small to do the sorts of lending it does; the largest line of credit in the manager’s portfolio is about $800m. Fortunately, the closed-end fund benefits from the scale of the management firm, which has assets under management of about $7.5bn.

Watson says that Victory Park has good deal flow, almost all from inbound enquiries. He thinks that this is largely due to Victory Park Capital’s long-standing relationships with founders, venture capital firms, portfolio companies, private equity firms, and investment banks, among many others.

In addition, it helps that Victory Park has a presence in six major US cities. Watson thinks that a more recessionary environment may reduce competition and allow it to improve the quality of the loan book without compromising on the 10% yield.

The manager is relatively agnostic on the nature of the underlying collateral. Victory Park has a large internal underwriting team reviewing potential investments. The portfolio is exposed to loans to consumers, small and medium sized enterprises (SMEs) and has some ecommerce exposure. The bias is to relatively liquid collateral.

It is perhaps inevitable given the state of the global economy that investors may be concerned about what happens to VSL’s portfolio in a stressed environment.

Watson points to the fund’s track record in the wake of the pandemic, saying: ‘The early days of Covid presented an unprecedented shock to the VSL portfolio and to the collateral supporting each of the investments. The strict operational controls that we structure into our investments proved to be critical to controlling the situation and the short duration of the collateral allowed for rapid cash accumulation.

‘In the end, by cutting off new collateral originations and restricting cash we saw a significant shift of our collateral mix into cash which allowed us to reduce risk and leverage at both at the investment level and at the portfolio level.’

In line with accounting rules, VSL made an IFRS9 provision against potential loan defaults in March 2020. At the end of March, it was looking at a -3% calendar year-to-date return. However, by the end of the year, these provisions had been released and the outcome was a +11% return.

I should add a caveat though because that positive outcome was undoubtedly skewed by the largesse of governments during the period. While the UK government is already splashing cash around in the face of potential recession, other governments may be more prudent.

VSL’s returns have been augmented by profits on equity stakes and warrants it received as part of the financing it provided. At the end of June 2022, about 70% of the portfolio was debt, 13% preferred stock, 7% convertible debt, 5% common stock, 4% warrants, and just 1% in cash.

Notably, two of these stakes ended up being listed via ‘Spac’ (special purpose acquisition companies) transactions and this has made the NAV more volatile as investors fell in and out of love with these deals. Lock-up periods on these investments will expire over the coming six months and the money will be recycled into new loans. Despite recent share price falls, VSL will still have made money. New loans may come with warrants/equity to refill the hopper.

VSL’s stake in Bakkt, a digital platform that merged with VPC Impact Acquisition Holdings, has driven most of the volatility; last October, its share price soared from $10 to over $42 in a couple of weeks (VSL’s NAV return was 14.4% that month), today it is trading at $2.30. Consequently, VSL’s one-year returns are not indicative of the health of the rest of the portfolio. The other SPAC is trading at half the value of the cash on its balance sheet.

Partially offsetting the fall in the SPAC investments, VSL also has a stake in wefox. After the recent 50% valuation write up, which also boosted Chrysalis’s (CHRY) NAV, this was 5.1% of VSL’s portfolio at the end of June 2022.

By contrast, VSL’s revenue has been stable. It has paid a stable 2p per quarter dividend since May 2018. Now, however, with interest rates rising, so too is VSL’s income, all of which is floating rate. It may be that the dividend will soon rise too.

The manager says that senior secured, asset backed, floating rate income is exactly what investors should be looking for in the current environment. I understand why investors would be cautious given the economic backdrop, but the discount looks too wide to me, even for a fund with a fair bit of exposure to private equity.

Stop press: Half-year results today showed a 7.6% drop in NAV to 105.51p in the six months to 30 June, although with dividends included VSL’s total underlying loss was a shade over 4%. The bulk of this came from falls in publicly quoted shares such as Bakkt. The company said it was benefiting from a rise in revenues as interest rates rose but cautioned that brought some extra credit risk, though it expected more growth companies would turn to debt financing in the bear equity market.

On another tough day for the world stock markets, VSL shares shed 1.5% to 78.8p. They have fallen 14% this year but delivered a total shareholder return of around 70% over five years.

James Carthew publishes research at QuotedData. Any opinions expressed by Citywire, its staff or columnists do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account people’s personal circumstances, objectives and attitude towards risk