When investing in credit, the best thing in the world is to find a company that can originate safe assets at a really high rate of return.
That means the company can afford higher-yielding debt, and even if the company’s forecasts are wrong, the net interest margin (the difference between the gross returns pre defaults, and the interest/principal rate owed to the debt provider) is high enough to incur extra defaults without raising any interest income.
But often, we talk to investors who pass on these opportunities because they find that the originator who is making the loans is making “too much compared to the debt.”
Put differently, the investor would either prefer that:
The originator was making less on a gross basis, meaning there were less net interest margin and less room for error
Getting paid a higher percentage because they want to share more evenly in the profits
The first one is irrational. You’re saying you’d rather have more risk than less. The second is just hard to achieve. I guess the point is “we’d rather make more money for the same risk?” I mean… yeah. Wouldn’t we all? But prices aren’t based on how much the originator is making. They’re based on what price other investors are willing to pay for the risk being offered, where the deal will clear.
Price is about “supply and demand” not based on “what’s fair.” The originator did something special. They found an asset no one else did. They are financing it. And they should get paid for doing all the magic and the work. But if an investor is only willing to invest in assets where they are making most of the money, then they will only invest in assets with low interest margins and more risk.
It’s just totally illogical. “It’s not fair” is not a good reason to pass.
The only reason to pass on a deal is if the returns, relative to the risk, are not high enough compared to an investor's cost of capital. But passing because the other side is "doing too well" is logic that would force investors to move almost every single "best deal.".
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Life’s not fair - sounds like there’s some participation trophy phenomenon leaking into credit markets (ego-driven? “I want the bulk of the returns just for showing up”). It’s confounding that people haven’t grasped that “fair” doesn’t necessarily mean “equal”. In this case, “fair” means the rewards match the contributions/risk taken on. On the bright side, I imagine that crowd will be pushed out at some point as more nimble investors with a co-operative disposition and sensible judgement of “fair” fills the gap.