Speaker 1: Hello, Welcome to the Credit Edge, a weekly markets podcast.
Speaker 1: My name is James Crombie. I'm a senior editor at Bloomberg.
Speaker 2: And i am Ruder Backman, chief structured finance strategist at
Speaker 2: Bloomberg Intelligence. This week, we are very pleased to welcome
Speaker 2: Tom Moyevsky, a founder of Eagle Point Credit, their fourteen
Speaker 2: billion dollar pride credit manager. How are you, Tom?
Speaker 3: Doing very well? Thank you.
Speaker 2: Tom set up Eagle Point in twenty twelve, turning it
Speaker 2: into one of the world's largest coo Ikady investors. The
Speaker 2: film has also explained to special definance, significant brisk transfers,
Speaker 2: and infrastructure credit, as well as other opportunities.
Speaker 1: So lots to discuss there. Let's start with software. You
Speaker 1: buy loans to software companies. That sector is under a
Speaker 1: lot of pressure. The fear is that a lot of
Speaker 1: the businesses will be replaced by AI and that the
Speaker 1: assets underlying the debt are actually worthless. Loan prices fell
Speaker 1: a lot at the start of the year as the
Speaker 1: AI story really took off. They've recovered a little bit,
Speaker 1: but the debt market still seems to be telling us
Speaker 1: that there's a big problem. Where do we go from here?
Speaker 3: The concerns are fair, the timing may be subject to question.
Speaker 3: In my opinion, I'll draw an analogy back to a
Speaker 3: little ipo I think in nineteen ninety seven Amazon dot Com.
Speaker 3: It's all worked out for them. Today you could read
Speaker 3: on Bloomberg probably every day six months after that IPO
Speaker 3: of the death of retail. I'm sure there was some
Speaker 3: story or something that talked about how retail was over.
Speaker 3: And indeed Amazon's just their retail revenue was over two
Speaker 3: hundred billion dollars last year, a lot of money. It
Speaker 3: fundamentally changed retail, but it didn't end it. And if
Speaker 3: you look across many CMBs transactions, the lowest vacancy rate
Speaker 3: is actually in the retail sector compared to US industrial
Speaker 3: or other things like that. That's from twenty nine years ago.
Speaker 3: Just to kind of put in context another significant shift
Speaker 3: in an ecosystem. Bring forward today to the rollout of
Speaker 3: AI for businesses like ours. Unfortunately, AI is still an
Speaker 3: additional cost. We're hopeful it'll be a savings over time,
Speaker 3: and that's what we're telling ourselves as we spend a
Speaker 3: lot of money and we see checks going out to
Speaker 3: all these different AI providers. When we think about software
Speaker 3: and its potential obsolescence or software as we knew it
Speaker 3: proverbially yesterday. I think answers very based on quite a
Speaker 3: number of things. First, how essential is the software picture
Speaker 3: a company like American Airlines, They're probably not going to
Speaker 3: have a clawed app replace their central reservation system. I'll
Speaker 3: go so far as to say there's probably some green
Speaker 3: screens somewhere still involved in their reservation system. On the
Speaker 3: other hand, a company like us, in our vacation tracking tool,
Speaker 3: should we have a little clawed app that can gin
Speaker 3: that up very quickly?
Speaker 2: Yes?
Speaker 3: Our order management and portfolio management system. Is that going
Speaker 3: to be replaced by some sort of AI developed app
Speaker 3: anytime soon? Probably not. That's the DNA of the lungs
Speaker 3: and heart and nervous system of our company. So when
Speaker 3: you look at the impact of AI, both on software
Speaker 3: and more broadly, you have to think of the essentialness
Speaker 3: of that software, that legacy software tool and I'm sorry
Speaker 3: to use the word legacy to describe most software those
Speaker 3: designed proverbally yesterday. How important is it? How critical is
Speaker 3: it to a business? Every company wants to save money,
Speaker 3: Every company wants to use AI to do better. Whether
Speaker 3: you're in the software business or otherwise. I think the
Speaker 3: market has the trend right the direction, but in my
Speaker 3: experience the slope is far less steep in the beginning years,
Speaker 3: but may ultimately be more severe even than people are predicting.
Speaker 3: But I think of that as worst case five potentially
Speaker 3: fifteen years out in the future. To frame it in
Speaker 3: the I guess I joined a large bank in two thousand,
Speaker 3: you still had to apply to get an email account.
Speaker 3: Unthinkable today, but back you know, that was twenty five
Speaker 3: years ago. Those were still things that we were getting
Speaker 3: rolled out, even though email had widely been around. So
Speaker 3: when we look when we're looking at any software credit
Speaker 3: or any credit, frankly, one of the things is impact.
Speaker 3: Assessing the potential impact of AI. I think it's real.
Speaker 3: I think it will happen, but I do not think
Speaker 3: it happens overnight.
Speaker 1: So what does that mean for the loans? So for
Speaker 1: those who don't know, you know, duration, the maturity schedule
Speaker 1: of a lot of these things. You know, why is
Speaker 1: the length of time important in this context?
Speaker 3: Sure so, most syndicated loans and even private credit loans
Speaker 3: typically have maturities six seven, eight years. We can move
Speaker 3: around a little bit from there that said, I don't
Speaker 3: remember the last loan that paid off at maturity, and
Speaker 3: that very few companies want to have their long term
Speaker 3: debt move to the current portion of their balance sheet.
Speaker 3: I'm sure it's happened once or twice, but typically you'd
Speaker 3: expect to see a syndicated or private credit loan refinance
Speaker 3: sometime between two and four years after it's originated. And
Speaker 3: what that means is quite a few companies that our
Speaker 3: borrowers are debtors at the market today probably have one
Speaker 3: more bite at the apple to refinance before they face
Speaker 3: a real problem. That's not one hundred percent the rule,
Speaker 3: but I think it's significantly the case. One of the
Speaker 3: things we like in the market, and we've certainly you know,
Speaker 3: you've talked about and others others here have written about
Speaker 3: the give or take two trillion dollars private credit market,
Speaker 3: and for a while there were some articles getting written.
Speaker 3: Is the private credit market eating the syndicated market's lunch?
Speaker 3: And for listeners, the syndicated credit market is going to
Speaker 3: be larger companies. This is going to be Hilton Hotels,
Speaker 3: Dell computer companies of that size and scale. Private credit
Speaker 3: typically smaller, but not always and there were a number
Speaker 3: of companies maybe a year or two ago that were
Speaker 3: in the syndicated market that refinanced their debt into the
Speaker 3: private credit market. In many cases they paid, greed to
Speaker 3: pay a higher spread over base rates. And why did
Speaker 3: they do that. Their revenues or EBADA had fallen twenty
Speaker 3: to thirty percent. They needed to be more levered. There
Speaker 3: were aggressive firms, maybe even vultures, buying up their debt
Speaker 3: in the syndicated market, and they just wanted to get
Speaker 3: to a spot where they could work things out privately
Speaker 3: with two or three lenders who would hopefully be more understanding,
Speaker 3: but they'd have to pay them more. At the same time,
Speaker 3: as companies do better, private credit companies all want to
Speaker 3: graduate to the syndicated market because your cost of debt
Speaker 3: is lower. If private credits five hundred or six hundred
Speaker 3: over syndicated credits in action directionally three hundred bases points over.
Speaker 3: There's no one in the world who wouldn't like lower
Speaker 3: debt costs. So what we see is, even if it's
Speaker 3: a large cap company that might be facing some AI headwinds,
Speaker 3: I see the potential for the private credit market to
Speaker 3: refinance them out and other companies will probably achieve some
Speaker 3: significant cost savings and might be able to move from
Speaker 3: private credit up to the syndicated credit market. That companies
Speaker 3: have a couple of years of runway on their debt.
Speaker 3: We look across and we publish this and are on
Speaker 3: our website of all the loans we have exposure to
Speaker 3: in our syndicated programs, I'm going to say less than
Speaker 3: two or three percent mature in the next eighteen months.
Speaker 3: So companies in general have a good bit of runway
Speaker 3: on their debt. They might not like the terms they
Speaker 3: have to refinance that, but in general, I believe there'll
Speaker 3: be a market for most, if not all companies to
Speaker 3: continue refinancwer.
Speaker 1: So it's a company that's kind of in long term declimb,
Speaker 1: but short term there's an opportunity on the debt.
Speaker 2: Yes, yeah, what are you describing with your exposures. That's
Speaker 2: actually very common across CROs. You do find that when
Speaker 2: you look at klatropool and you track it over time,
Speaker 2: the maturity is the new maturities. They'll always disappear from
Speaker 2: the pools several years, sometimes ahead of the time before
Speaker 2: they actually come due. So there's sort of their wave
Speaker 2: of maturities in the collateral pool that moves forward in
Speaker 2: time as we move forward in times, so we never
Speaker 2: actually get to the point where we have a wall
Speaker 2: of maturities hitting the CLO market all at the same
Speaker 2: time in the collateral pools. I think the difficulty with
Speaker 2: the AI exposure of SAS companies is that AI is
Speaker 2: fairly new, so I think a lot of people are
Speaker 2: trying to figure out what exactly the scenario is that
Speaker 2: will play out, and different people have different concerns in mind.
Speaker 2: I mean, some people have the concern or have the
Speaker 2: concern that the pricing models that the SaaS companies are
Speaker 2: using it's no longer going to work because currently their
Speaker 2: pricing proceed and if you have an AI like a
Speaker 2: cloud Cowork, then you might have far fewer employees as
Speaker 2: a result of fewer seats, and so for the SaaS companies,
Speaker 2: the seat pricing is so long ago going to work.
Speaker 2: Other companies then, or other investors have the concern that
Speaker 2: we may see a situation where people who currently buy
Speaker 2: software will just build it internally, which you alluded to before,
Speaker 2: which might happen for smaller applications. Another concern is that
Speaker 2: it might actually be very easy and cheap and quick,
Speaker 2: using AI to replicate some of the largest SaaS companies offerings,
Speaker 2: and that in turn would result in an increased competition
Speaker 2: that in turn would put pressure on margins as SaaS companies.
Speaker 2: So there's a variety of concerns and it's difficult to
Speaker 2: figure out what exactly this scenario is going to be
Speaker 2: that will end up in I think it's difficult to
Speaker 2: make a great assessment as earlier as now because the
Speaker 2: field that's just so wide open with AI, because it's
Speaker 2: so new, and because the improvements in in AI are
Speaker 2: so fast.
Speaker 3: I think what you're saying is fair direction. I agree
Speaker 3: with the sentiments you've shared. That maturity wallpoint is actually
Speaker 3: very very true. If you look at our public filings
Speaker 3: over the last ten years, the maturity wall chart basically
Speaker 3: looks the same every single year. We just changed the
Speaker 3: dates one year. I'm sure we actually recalculated, but we
Speaker 3: probably don't have to and could convey the same message broadly. Though,
Speaker 3: what you're talking about is in line with what I'm
Speaker 3: talking about of we need a little more time to
Speaker 3: see the real impact of this. We know there will
Speaker 3: be an impact. I actually think it will be more
Speaker 3: severe than maybe many of the naysayer say. However, I
Speaker 3: think it will be later. The pace of innovation or
Speaker 3: the implementation of innovation just takes longer. I saw a
Speaker 3: stat recently, and I don't remember the source, but it
Speaker 3: was it was something on the lines of seventy percent
Speaker 3: of Fortune five hundred companies still use mainframes for calculations.
Speaker 3: I'm not in data and operations. I'm sure they're not
Speaker 3: using punch cards and real to real tapes that you
Speaker 3: might have seen in a nineteen sixties James Bond movie
Speaker 3: or something like that. But that's still technology that's used,
Speaker 3: and certainly there's more efficient ways to do things. And
Speaker 3: you know, probably my iPhone has more computing power than
Speaker 3: mainframes did ten or twenty years ago. So I agree
Speaker 3: with the sentiment you're sharing. I think we have a
Speaker 3: longer runway than the market predicts. It doesn't mean it's
Speaker 3: smooth sailing for the next few years, but it's also
Speaker 3: not armageddon. One of the other things we've seen in
Speaker 3: AI or the AI threat coming around a one particular
Speaker 3: loan an insurance broker called Alliant, which is principally a
Speaker 3: high net worth of property and casualty insurance broker. Back
Speaker 3: in January February of this year, there was an article
Speaker 3: went around or some chatter in the market that AI
Speaker 3: is going to cost them their business, and the loan
Speaker 3: traded down three points and you know, in a very
Speaker 3: short period of time it rebounded those in three points
Speaker 3: and probably a very similar period of time, and it
Speaker 3: was a missing opportunity.
Speaker 2: Frankly, I want to come at this point. I think
Speaker 2: you have sort of alluded to it already twice, which
Speaker 2: is not so much a fundamental point which we addressed before,
Speaker 2: but the sentiment important, and one concern I would have
Speaker 2: is that we are in a situation where, because it's
Speaker 2: so uncertain what will happen, these companies will post decent
Speaker 2: results fundamentally the current contracts are currently have, they're still running,
Speaker 2: the financials will look fine, but a lot of investors
Speaker 2: will start to worry that in future they will not
Speaker 2: be fine, and at that point it will become very
Speaker 2: difficult for them to refinance make during that. So you
Speaker 2: sort of alluded to that before when you said, well,
Speaker 2: you know, some of these companies may have to get
Speaker 2: refinanced from a different investor base than from their current
Speaker 2: investor base. But this crazy situation where we might end
Speaker 2: up in a with a self fulfilling prophecy. Yes, currently
Speaker 2: things look fine. Yes, eventually thinks might go wrong, be
Speaker 2: not sure, but that will take time, but the impact
Speaker 2: on the businesses will materialize earlier simply through the funding market,
Speaker 2: and we may have the self fulfilling prophecy where the
Speaker 2: current investor base says, well, I think these businesses could
Speaker 2: too poorly. I think all the other investors that I
Speaker 2: know in my market think the same thing. So I'm
Speaker 2: not going to refinance this company because I'm afraid no
Speaker 2: one else I know will do and tends the company
Speaker 2: will go bust, even though different fundamentals currently still look good.
Speaker 2: And then comes the question of can the company actually
Speaker 2: find someone else to fund them?
Speaker 3: And some non AI examples of that. There was a
Speaker 3: company in the syndicated loan market called Outer Wall which owned,
Speaker 3: among other things, red Box, which were in supermarket DVD rentals,
Speaker 3: which was in the state of the art twenty years
Speaker 3: ago I'm now laughable, but multiple times, even in their decline,
Speaker 3: they able to refinance another company, am General, that makes
Speaker 3: hummers for the military and maybe even the commercial ones.
Speaker 3: I forget similar thing of trend very much in the
Speaker 3: wrong direction, but able to continue to access the capital
Speaker 3: markets as long as they have some degree of revenue
Speaker 3: and EBITDA. That said, there will be a day of
Speaker 3: reckoning for any of these declining companies. But the mitigant
Speaker 3: that we see is time is your friend as a lender,
Speaker 3: even if they have to take their SOFUR plus three
Speaker 3: hundred loan and refinance at private credit at SOFA plus
Speaker 3: six hundred and then three years later refinance it into
Speaker 3: a distress lender at SOFA plus eight hundred. If it's
Speaker 3: that or default, you're going to you know, you're going
Speaker 3: to pay up on the debt versus lose all your equity.
Speaker 3: So it's it's maybe even analogous to real estate when
Speaker 3: you interest rates moved up, many would have called that
Speaker 3: a slow moving train wreck. You know, if you have
Speaker 3: a three percent mortgage and all of a sudden, you know,
Speaker 3: mortgages are now seven percent and you own a you know,
Speaker 3: not so fancy office building in midtown, you're fine until
Speaker 3: you get to your maturity date on your loan. And
Speaker 3: we could see you know, similar things like that. Not necessarily,
Speaker 3: that's the corporate owners are going to get to the
Speaker 3: maturity date, but it will take a long It will
Speaker 3: take multiple years for all of this to flesh out.
Speaker 3: And what we're seeing in the credit markets, both the
Speaker 3: CLO market and actually the BBC market where we're a
Speaker 3: very large investor in the private credit market in terms
Speaker 3: of fun financing, we're seeing the baby thrown out with
Speaker 3: the bathwater, by and large when we look at this,
Speaker 3: and we have, in addition to our COLO equity position,
Speaker 3: and we believe we're one of the largest holders of
Speaker 3: COLO equity in the world, which gives us insight into
Speaker 3: thousands of different credits all around the world, both in
Speaker 3: the US and Europe. We're also, we believe, one of
Speaker 3: the largest at eagle point one of the largest non
Speaker 3: bank financiers of BDCs and private credit funds. And this
Speaker 3: is a strategy we set up six or seven years ago.
Speaker 3: We actually call it our defensive income strategy. And the
Speaker 3: genesis of it, we were talking about bubbles and private
Speaker 3: credit long before the headlines were getting written, back when
Speaker 3: private credit was a one trillion dollar market. Now it's
Speaker 3: a two or three trillion depending on who's counting, but
Speaker 3: lots and lots of money what's going on here and
Speaker 3: what we saw. If memory serves from like twenty fifteen
Speaker 3: to twenty nineteen, a period when there weren't a lot
Speaker 3: of credit losses, BDC debt outperformed BDC equity. I might
Speaker 3: be slightly off on my date on that, but directionally,
Speaker 3: even if it's the same, if you're the creditor and
Speaker 3: you're making the same as the shareholder, obviously you're taking
Speaker 3: less risk as the creditor. And we started looking at this,
Speaker 3: and we started looking at the BDC market, which is issued.
Speaker 3: They are forty AC companies that make a special BDC election,
Speaker 3: and that law became available to BDC's I believe in
Speaker 3: nineteen eighty, so we're forty six years in. While lots
Speaker 3: of BDC's, we've talked about them a little bit, the
Speaker 3: public ones, many if not most, are trading at a
Speaker 3: non trivial discount to nab the share price on the
Speaker 3: exchange less than what the books and records say the
Speaker 3: value of the equity is. On one hand, many non
Speaker 3: traded BDC's probably I had my the Bloomberg terminals not
Speaker 3: open right here, but I'm sure there's a headline about
Speaker 3: some fund that had more than five percent redemptions come
Speaker 3: in this quarter of a non traded BDC, both of
Speaker 3: those facing significant headwinds. BDCs that had historically traded at
Speaker 3: a premium now trading at a discount. Across the forty
Speaker 3: six years since the BDC laws have been in place,
Speaker 3: to the best of our knowledge, there have been two
Speaker 3: defaults ever by BDCs, Allied and ACASS and both of
Speaker 3: those were one hundred cent recovery to the creditor, even
Speaker 3: the shareholder's got some leftover value. And so when we
Speaker 3: look at what's going on in private credit, the thing
Speaker 3: that's made BDC's work is something called the asset coverage ratio.
Speaker 3: In our opinion, has been the number one thing, which
Speaker 3: simply it's there's three different tests. Under the forty Act
Speaker 3: one percent asset coverage. BDCs are subject to the one
Speaker 3: to fifty rule, which means there need to be for
Speaker 3: every dollar of debt one hundred and fifty dollars of
Speaker 3: assets supporting it. If they were to fail that test,
Speaker 3: the consequences are severe, but not game over. And this
Speaker 3: is very important as well. If you fail your asset
Speaker 3: coverage ratio, you can't declare any more dividends and for
Speaker 3: people in the tender offer funds or the non traded funds.
Speaker 3: No more. Forget about getting capped at five percent redemptions.
Speaker 3: The redemptions go to zero if you're failing the asset
Speaker 3: coverage ratio because they're not allowed to redeem capital below
Speaker 3: that ratio. And when we look across what we're seeing
Speaker 3: in all the different BDCs, and then we've taken that
Speaker 3: same technology, which I think is some of the most
Speaker 3: elegant financial regulation ever written, We've applied that to GPLP funds,
Speaker 3: which we think is the vast majority of the private
Speaker 3: credit market. Well XYZ non traded BDC gets the headline.
Speaker 3: We think the traded and non traded BDC universe is
Speaker 3: probably twenty thirty percent in BDC format or the private
Speaker 3: credit markets twenty to thirty percent BDC format, which suggests
Speaker 3: seventy to eighty percent in GPLP format. And when we
Speaker 3: look across that, what we've begun doing, and we started
Speaker 3: this six years ago and it's actually our largest business segment.
Speaker 3: We took the forty Act rules of the asset coverage
Speaker 3: ratio and started providing long term financing to GPLP funds.
Speaker 3: And what it gives us, in addition to a very
Speaker 3: good return on our investments, it gives us insight into
Speaker 3: hundreds and thousands of private credit loans as well. In
Speaker 3: many cases, we see the financials on the underlying borrowers,
Speaker 3: We see the trends and their businesses, and indeed, you know,
Speaker 3: i'd say software companies are probably the most at risk
Speaker 3: across that universe. At the same time, well, I think
Speaker 3: my company were probably. AI is still in the cost
Speaker 3: center category. We hope it becomes a savings category. There's
Speaker 3: other companies perhaps where AI is already helping them save
Speaker 3: money and reduce staff and do things more efficient money.
Speaker 3: So invariably because of AI and its prevalence and the
Speaker 3: technology is truly amazing. And I know one one thousandth
Speaker 3: one one thousandth of a percent of what we can
Speaker 3: actually do with AI. I'm sure my team knows more.
Speaker 3: That will hurt some, but it'll actually help others and
Speaker 3: lower costs and lower prices and increase profits for many businesses.
Speaker 1: So it comes always back to the software point, and
Speaker 1: to kind of circle out to something that Reto said,
Speaker 1: I mean, you know, there is this kind of uncertainty
Speaker 1: no one really knows so you know, you could be
Speaker 1: wrong about some of your assumptions. What stops the companies,
Speaker 1: you know, they face an existential risk? What stops them
Speaker 1: doing something desperate? You know, they don't pay you back,
Speaker 1: they just go off and try and save themselves instead.
Speaker 1: You know, is that not something you see as a scenario.
Speaker 3: Well, thankfully we do have contract law in the United States,
Speaker 3: so their ability just to renounce their debt. One or
Speaker 3: two companies have tried that over my career. A company
Speaker 3: a long time ago laid law my recollection tried to
Speaker 3: say this was not valid indebtedness to the syndicated market.
Speaker 3: That didn't work out for them, But in general, companies
Speaker 3: have to pay. However, what's another trend in the loan
Speaker 3: market the default rate? If you were to look up
Speaker 3: on any of the major publishers corporate loan default rate,
Speaker 3: you'd probably saye, it's around one percent right now for
Speaker 3: below investment great credit, well below the long term average. Frankly, wow,
Speaker 3: that sounds great. What could possibly be going wrong? The
Speaker 3: little secret of the market, and you've covered it once
Speaker 3: or twice on this podcast fairly recently, is what i'll
Speaker 3: call lender on lender violence or liability management exercises or
Speaker 3: out of court restructurings might be the least salacious way
Speaker 3: to put it, but it really is a lender on
Speaker 3: lender of violence and something that's crept certainly well into
Speaker 3: the syndicated loan market and even somewhat into the private
Speaker 3: credit market. Are provisions that say fifty one percent of
Speaker 3: the lenders can pretty much agree to anything. That's a
Speaker 3: pretty good that's a very very powerful provision, and over
Speaker 3: the last eighteen months or so, we've seen well over
Speaker 3: one hundred liability management exercises or out of court restructurings
Speaker 3: of companies that we're facing. The problems that you're facing.
Speaker 1: The CLO trade generally, we've had a lot of people
Speaker 1: talk about it as a big opportunity, but there is
Speaker 1: a fear about the underlying loans in terms of defaults.
Speaker 1: As the US phonomy maybe gets more challenged in the
Speaker 1: second half, the rates maybe they go higher. That puts companies,
Speaker 1: you know, at risk maybe not being able to pay back,
Speaker 1: but also the risky trunche that you're in. I mean,
Speaker 1: that seems to be the most exposed. We've just had
Speaker 1: a default in Europe, part of European CLO managed by
Speaker 1: Bain failed to repay investors in full. That's the first
Speaker 1: such defaults since an overhaul of the market more than
Speaker 1: a decade ago. Is this a sign of things to come?
Speaker 3: There's always outliers. And even if you look back to
Speaker 3: the CLO one point zero era, ninety six percent of
Speaker 3: clos had a positive return to the equity class and
Speaker 3: the media and IRR was well in excess of the
Speaker 3: base case that was marketed. Frankly in the mid two thousands,
Speaker 3: there are two principal risks that we think of as
Speaker 3: a CLO equity investor. Oddly, defaults is the second of them.
Speaker 3: The first one is what we saw a lot of
Speaker 3: in twenty two twenty five. A research report that I
Speaker 3: saw by Nomura suggested that COLO Equity had a negative
Speaker 3: fifteen percent total return last year. That's one person's judgmental opinion,
Speaker 3: probably directionally accurate. It was less to do with defaults
Speaker 3: and more to do with the bull market and credit
Speaker 3: and spread compression. And what that means is that the
Speaker 3: spreads on loans were getting repriced tighter and tighter and tighter. Alone,
Speaker 3: that was three seventy five over got repriced to three
Speaker 3: twenty five and across many of the colos we've invested in,
Speaker 3: we saw the spreads come down significantly on the assets,
Speaker 3: so now we have less money coming into the system.
Speaker 3: Things we can do as a majority equity investor are
Speaker 3: proactively resetting and refinancing the right side of our liability
Speaker 3: of the COLO balance, directing refis and resets, and I'm
Speaker 3: going to go so far, sos Had, I don't believe
Speaker 3: anyone's done more than us in the last year in
Speaker 3: that space, and where we have such a larg portfolio,
Speaker 3: there's always something to do. There's not enough banks to
Speaker 3: get one typically what we want to do. That said,
Speaker 3: the spread tightening on the COLO debt side was nowhere
Speaker 3: near as much as on the asset side, and so you,
Speaker 3: despite our best efforts, the NIM or the difference between
Speaker 3: the spread and the assets and liabilities just fell significantly
Speaker 3: last year. While there were some credit problems, oddly the
Speaker 3: bigger issue was bull market and repricing of loans, and
Speaker 3: no one really asked us that when we're talking to investors, well,
Speaker 3: what if loans rally hard? Is not a question we
Speaker 3: often get. But when we look at what's gone wrong
Speaker 3: with colos, typically that's been the biggest thing the flip side.
Speaker 3: When we look at the faults. Let's say we have
Speaker 3: a ten percent de fault rate over the next twelve months.
Speaker 3: Not a prediction from me by any stretch, but it's
Speaker 3: always a possibility. If we were to have ten percent
Speaker 3: of faults, James, where would you think loans are trading it?
Speaker 1: Does the index? Yes, probably below ninety.
Speaker 3: Certainly greater than more than a ten percent discount would
Speaker 3: be my expectation. I'd probably put it somewhere in the
Speaker 3: seventy to eighty context to frame it. During COVID, when
Speaker 3: we had five six percent of faults, the loan index
Speaker 3: fell to eighty, and when we saw in the financial
Speaker 3: crisis ten to eleven percent of faults, loans actually fell
Speaker 3: to as low as sixty, give or take on the index. Importantly,
Speaker 3: every loan that doesn't default pays off at par. Just
Speaker 3: because the index is at sixty of ten percent default,
Speaker 3: that means all the others paid off at one hundred.
Speaker 3: Colos typically do the best, and I look at our
Speaker 3: performance across our different portfolios. We do the best when
Speaker 3: there's actually periods of high default because in my opinion,
Speaker 3: in my experience. Price volatility in the loan market is
Speaker 3: always greater than actual credit expense.
Speaker 2: So it's true a course various credit astic classes that
Speaker 2: the spreads are there low at the moment, and that
Speaker 2: brings me to a number of questions around turns. So
Speaker 2: one thing that comes up in that context is the
Speaker 2: value of the call option that the that the equity has.
Speaker 2: And of course now we've spread so low, and having
Speaker 2: having been low or as low as maybe two years ago,
Speaker 2: it seems to me like the value of the call
Speaker 2: option is is reduced in terms of what it can
Speaker 2: offer the equity, and so maybe the equity returns that
Speaker 2: we can expect the lowered to that extent. So before
Speaker 2: you comment on that, one thing I've come across again
Speaker 2: and again is that investors who look at colo equity
Speaker 2: investments people haven't done that kind of investment before. They
Speaker 2: actually find it very difficult to find reliable data on
Speaker 2: what the historical performance of equity investments has actually been.
Speaker 2: And I think it might actually be help for the
Speaker 2: entire asset class if that data was more wide available,
Speaker 2: but at the moment it seems to me it's mostly
Speaker 2: private data not very available, and maybe that even keeps
Speaker 2: people who have a long history in equity investments, uh
Speaker 2: a leg up. So so I guess the first point
Speaker 2: was more about what's the current situation in terms of
Speaker 2: expected returns in equity and the second point was more
Speaker 2: how can we back up claims about the value of
Speaker 2: equity investments more generally?
Speaker 3: Well, James could have seen me smiling when he said
Speaker 3: that information about equity values is not broadly available. It's available,
Speaker 3: but you have to have largely created it yourself as
Speaker 3: a general rule to just complete on that second point.
Speaker 3: So the data does exist, it's not published. There's not
Speaker 3: much in the way of a CLO equity index. You know,
Speaker 3: there's a number of bags have debt in that indices,
Speaker 3: but I can't point to a published CLO equity And
Speaker 3: that said, a number of large banks publish annual or
Speaker 3: semi annual total return numbers for the COLO equity asset class.
Speaker 3: And we've strung together some degree of i'll call it
Speaker 3: simulated index. We'll take as many credible data sources as
Speaker 3: we can and average them. And sometimes the numbers are
Speaker 3: all over the place. You know, one guy might say
Speaker 3: the market's up ten, the other says up fifteen. Okay,
Speaker 3: we'll take the average of the two and say twelve
Speaker 3: and a half, and it's directionally accurate, we believe, and
Speaker 3: I share with you. Last year in Amuro said the
Speaker 3: market was down fifteen percent, which feels directionally pretty accurate
Speaker 3: as well. So there are some published pieces of information,
Speaker 3: there's not specifics.
Speaker 1: So what could you make this year on CLO equity?
Speaker 1: What would the return forecast be?
Speaker 3: Banks have put out some stats for the first half
Speaker 3: that were also non trivially negative, this time a little
Speaker 3: more due to credit volve than to spread compression. Where
Speaker 3: we sit going forward, I'm a little more optimistic in
Speaker 3: that I think we've seen the significant bulk of the
Speaker 3: spread compression play out, and I think we're seeing more
Speaker 3: discipline behavior on issuance in our account. In twenty twenty five,
Speaker 3: the significant majority of the COLO market of new issue
Speaker 3: clos was sponsored by captive or controlled capital by the
Speaker 3: collateral manager, which we think of as generally analogous to
Speaker 3: unsponsored private equity. We're giving management the keys to the kingdom.
Speaker 3: Very few new colos last year were purchased by third
Speaker 3: party equity investors. We're seeing a little bit of an
Speaker 3: uptick in that I think that might increase in the
Speaker 3: second half of the year. So the things that have
Speaker 3: gone wrong last year, spread compression largely abated. It always
Speaker 3: reappear and reappear very quickly. And credit expense. I think
Speaker 3: we saw price declines and loans which adversely impact the
Speaker 3: price of COLO equity, but we haven't seen. While we
Speaker 3: did talk about l ees and modifications and things like that,
Speaker 3: the credit losses going to the things that were said
Speaker 3: earlier in this call haven't been that The realized losses
Speaker 3: haven't been that significant. So it could be a very
Speaker 3: interesting time to get into the market, probably more on
Speaker 3: the secondary side or buying into an existing portfolio than
Speaker 3: saying let's go out and create a bunch of new ones. Today.
Speaker 3: That said, there's always something interesting to be done in
Speaker 3: the market, but.
Speaker 1: It could be another negative year for an equity on the.
Speaker 3: Clos where we stand right now, it's certainly possible.
Speaker 1: Okay, So it doesn't sound so good in terms of
Speaker 1: the BDC's which he talked about. You know, you lend
Speaker 1: to BDCs, you also lend to other private funds gps
Speaker 1: and LPs. I'm interested in your view into that world
Speaker 1: because you know, we get a lot of very negative
Speaker 1: views about private credit, about the sky is falling about
Speaker 1: you know, the reckoning coming about the end of the
Speaker 1: Golden Age, all of that stuff. You've heard it. But
Speaker 1: since you have the visibility, how worried should we be
Speaker 1: about Bdcason about private credit?
Speaker 3: More generally, it's not as bad as the pace of
Speaker 3: headlines suggest in my opinion, when we look at what's
Speaker 3: going on with the underlying portfolio companies of many private
Speaker 3: credit funds, not all. In general, revenue is growing in
Speaker 3: many cases, IBIDA is flat to growing, which is good.
Speaker 3: There might not be hitting plan a fair number of cases,
Speaker 3: but it's not as if we're seeing ten other than
Speaker 3: isolated incidences. We're not seeing ten twenty thirty percent revenue
Speaker 3: declines across companies that are in these portfolios. One of
Speaker 3: the things that frustrates me, and it's gotten attention, and
Speaker 3: I certainly knew a lot of press on the terminal
Speaker 3: and from others. Loans that are marked at one hundred,
Speaker 3: one hundred, one hundred and one hundred and thirty. Yeah,
Speaker 3: that's not supposed to happen, right, you know, absent some
Speaker 3: terrible shock event happening to that company in that quarter.
Speaker 3: One of the things that that frustrates I think quite
Speaker 3: a few people is a little bit of the lack
Speaker 3: of the lack of transparency the opacity in private credit pricing.
Speaker 3: Some research analysts have looked across and said, you know,
Speaker 3: BDC one holds this loan, they've got a marked at
Speaker 3: ninety eight, b DC two holds it at ninety five.
Speaker 3: Things like that, Well, ideally they'd be the same. These
Speaker 3: are level two in level three assets within a few points.
Speaker 3: I think that's a tolerable band. What would be more alarming,
Speaker 3: And there were a few instances like this in the past.
Speaker 3: One guy's got it marked at sixty and the other
Speaker 3: guys got it marked at one hundred. That's clearly the
Speaker 3: wrong answer between two identical instruments. But when we look
Speaker 3: through the things that are bad for credit ultimately are
Speaker 3: drops in revenue and EBITDA. At the end of the day,
Speaker 3: if your EBITA and revenue are growing, it's probably going
Speaker 3: to work out for a company, And by and large
Speaker 3: we're seeing that even in the private credit world, not exclusively,
Speaker 3: but that's not the exception to have that happen. And
Speaker 3: so when we think about BBC stock in general, vast
Speaker 3: majority are trading at discounts to book. There's a couple
Speaker 3: of things going on there. There's the perception of future
Speaker 3: credit losses coming, which I think is a fair perception
Speaker 3: that's probably overpriced in the market.
Speaker 2: I wanted to ask about a third product that you
Speaker 2: seem to be involved in, which is the significant risk
Speaker 2: transfer transactions that has grown over the past few years,
Speaker 2: and I'm wondering how you started to enter that market.
Speaker 2: Was it that you mostly looked at as at transactions
Speaker 2: that are set up as a synthetic secusations? Was that
Speaker 2: the entered point that it became interested in this as
Speaker 2: a media security should optoty.
Speaker 3: So we call them regulatory capital relief. In my opinion,
Speaker 3: that sounds a lot better than significant risk transfer. Yeah,
Speaker 3: who wants to be transferred a significant amount of risks? Indeed,
Speaker 3: and I think it used to be synthetic risk transfer,
Speaker 3: but somehow it changed to significant maybe to appease some regulators.
Speaker 3: But regardless of what we call it, I'm going to
Speaker 3: call it regulatory capital relief for this purpose. We got
Speaker 3: into the market i'm going to say about five years ago,
Speaker 3: and we were intrigued by it in a number of ways.
Speaker 3: The asset pools underlying these regulatory capital transactions that bank issue,
Speaker 3: and the purpose of them is for banks to keep
Speaker 3: owning the loan but get a reduced capital charge or
Speaker 3: substantially eliminate their capital charge from holding assets whilest serving
Speaker 3: the customers being the face to their customers. And it's
Speaker 3: basically a just in time tool for banks to raise capital.
Speaker 3: And we have a team of people focused on this market,
Speaker 3: and I joke with them they could take the first
Speaker 3: forty five days of the quarter off and then work
Speaker 3: NonStop the second forty five days at the quarter because
Speaker 3: typically these issuances closed the dare you know, September twenty
Speaker 3: eighth will be a busy day in the regulatory capital
Speaker 3: market October second, they could probably take the day off
Speaker 3: and play golf if it's nice outside. So it's banks
Speaker 3: using this market to raise capital. A lot of European
Speaker 3: banks are quite active in it. The US banks have
Speaker 3: done it to some degree, but it's principally driven by
Speaker 3: the European and a lesser degree Canadian banks. It can
Speaker 3: include corporate credit, both large cap and middle market. It
Speaker 3: can include auto loans, It can include consumer loans. One
Speaker 3: large bank actually did trade finance loans, and you know
Speaker 3: they've got a business. Someone you know, a merchant, puts
Speaker 3: his goods in a box and shen zen on a boat.
Speaker 3: He wants the money. It gets off the boat in croatio.
Speaker 3: That guy doesn't want to pay, and so he opens
Speaker 3: the box and sees the goods are there. One bank
Speaker 3: is pretty good at doing that financing, and they actually
Speaker 3: do an SRT on that portfolio.
Speaker 2: And where do you take the position? Is it sort
Speaker 2: of a second loss piece because obviously to take the
Speaker 2: first loss piece in a co but do what where
Speaker 2: is your positioning?
Speaker 3: Typically a good, very good question. We're typically in the
Speaker 3: first loss piece. Once in a while the banks will
Speaker 3: keep a teeny tiny sliver beneath us, but by and
Speaker 3: large we're in the first loss piece. Now in nearly
Speaker 3: all of these the banks will also hold a portion
Speaker 3: of the loan unhedged on their balance sheets, so they're
Speaker 3: in the same loan alongside of us, but we are
Speaker 3: typically first loss. What we're looking at is banks are
Speaker 3: very very data rich, and you can see in many
Speaker 3: cases twenty thirty years of loss experience, and like even
Speaker 3: within auto loans, they might rank auto loans in fifteen
Speaker 3: different categories of risk, and you can see with a
Speaker 3: pretty they're pretty darn good at picking this kind of stuff.
Speaker 3: How their portfolios have performed historically based on the bank's
Speaker 3: internal risk category for any pool of assets. So that's
Speaker 3: the kind of stuff we can look at. It's a
Speaker 3: very data rich investment. When I think about putting it
Speaker 3: together with COLO equity, there's a couple of interesting pieces.
Speaker 3: Colo equity has NAV risk, and that when we get
Speaker 3: to the call date, typically at the end of the
Speaker 3: reinvestment period, doing whatever loans haven't defaulted, whatever's in the portfolio.
Speaker 3: If I want to liquidate the portfolio, I get the
Speaker 3: price the market will bear on that day for the
Speaker 3: remaining loans, which could be ninety eight cents on the dollar,
Speaker 3: could be ninety seven cents on the dollar, or along
Speaker 3: the way. If loans trade way down all of a sudden,
Speaker 3: the NAV could be zero in a piece of in
Speaker 3: a piece of col equity, despite still getting cash flows.
Speaker 3: In an SRT transaction or regulatory capital transaction, every loan
Speaker 3: that doesn't default is unwound from the vehicle at par
Speaker 3: in that it's a synthetic contract if it hasn't defaulted. Okay,
Speaker 3: at think you just rip up the contract. There's no
Speaker 3: mark to market on the way out. So one of
Speaker 3: the big things that drives volatility in COLO equity pricing
Speaker 3: NAV volatility is not something you face in regulatory capital
Speaker 3: relief investing, so we like that a lot. What you
Speaker 3: don't get in regulatory capital relief is the ability to
Speaker 3: reinvest cheap. So in a world where in two thousand
Speaker 3: and eight or twenty twenty, loans were trading at deep
Speaker 3: deep discounts and coelos are able to use prepayments or
Speaker 3: make relative value trades to buy things in a distressed market,
Speaker 3: the regulatory capital relief market doesn't really have that concept.
Speaker 3: Even if there's a replenishment period, which many do, where
Speaker 3: the bank can add new assets meeting subject to certain criteria,
Speaker 3: they just go into park. So you get the benefit
Speaker 3: of NAVS stability or you're isolated from NAV risk when
Speaker 3: you're in these regulatory capital pools, but you lose the
Speaker 3: ability to reinvest cheap in distress days. I said earlier,
Speaker 3: we were investing pretty aggressively in this market in twenty
Speaker 3: twenty three and twenty four. If you look at some
Speaker 3: of our public funds, which you can see our schedule
Speaker 3: of investments, and you can see where we mark everything,
Speaker 3: and you can compare it to others marks as well
Speaker 3: if you'd like. You'll see we've added relatively little in
Speaker 3: this space over the last eighteen months. It's still an
Speaker 3: attractive investment in my opinion, but the excess return maybe
Speaker 3: has been taken out of it to some degree in
Speaker 3: that several large players have gotten involved then have just
Speaker 3: gobbled things up and have actually asked for thicker equity
Speaker 3: tranches than is needed just so they can get significant
Speaker 3: sums of capital deployed. So whereas we were deploying a
Speaker 3: lot of capital at fourteen fifteen percent loss adjusted a
Speaker 3: couple of years ago, today it's going to be a
Speaker 3: couple hundred basis points tighter than that. And when I
Speaker 3: look across the ecosystem, and a number of our portfolios
Speaker 3: are are multi strategy, can put we can buy clos
Speaker 3: and then we can do fund financing. We can put
Speaker 3: private infrastructure credit, we can put equipment leasing in, we
Speaker 3: can do any number of things to put into those funds.
Speaker 3: What I'm seeing is, in general, although there's exceptions, regulatory
Speaker 3: capital today is less compelling to deploy capital into, not
Speaker 3: necessarily because of future credit risk that we see, although
Speaker 3: that's a factor more just in terms of the yields
Speaker 3: that other investors are bidding today. No, it's hard to
Speaker 3: say the market's cheap. I think it's still attractive, but
Speaker 3: it's certainly not cheap.
Speaker 1: Briefly because they're almost out of time, tom where do
Speaker 1: you see the best relative value right now? Because you know,
Speaker 1: you describe yourself as the biggest coelo equity investor that
Speaker 1: you expect potential loss this year following a loss last year,
Speaker 1: So you know, how.
Speaker 3: Do you make your money the old fashioned way of
Speaker 3: hopefully picking the best investments. And even if you look
Speaker 3: at our public COLO funds, there's plenty of things that
Speaker 3: are not clos in those funds today, and that's an
Speaker 3: important part of delivering value for our shareholders in those vehicles.
Speaker 3: Across the strategies and across the areas where we're investing today,
Speaker 3: what I think of as the two most attractive things
Speaker 3: that are getting the most excitement are middle market infrastructure lending,
Speaker 3: and we have a dedicated team focused on that. Where
Speaker 3: we're not coming in lending on Heathrow Airport or you know,
Speaker 3: these ginormous projects we're coming in at the one hundred
Speaker 3: million couple hundred million dollar financing size, so smaller than
Speaker 3: the but the gigantic groups are going after. We've been
Speaker 3: able to get some very attractive investments done there where
Speaker 3: we're providing i'll call it bespoke solutions for folks. We
Speaker 3: can speak for the whole facility ourselves, but it's not
Speaker 3: big enough to attract the gigantic funds, and it's also
Speaker 3: probably seeing one little tweak to make it bank eligible
Speaker 3: for the project finance market, which is by far one
Speaker 3: of the cheapest markets. So we've deployed probably over a
Speaker 3: billion dollars in infrastructure middle market private credit over the
Speaker 3: last year, and our pipeline there is very robust. We
Speaker 3: also have a joint venture with a large one hundred
Speaker 3: plus year old bank here in New York City for
Speaker 3: equipment financing. And when we think about serving middle market companies,
Speaker 3: many of these are the companies that are borrowing at
Speaker 3: SOFA plus five hundred from these BDCs facing redemptions. In
Speaker 3: many cases, we've been able to go to companies when
Speaker 3: we've seen them issue alone and say would you also
Speaker 3: be interested in doing a sale lease back on some
Speaker 3: of your essential equipment. And we have a dedicated program
Speaker 3: where with outbound calling where we're going and we're actually
Speaker 3: doing sale leasebacks on like a good example of essential
Speaker 3: manufacturing equipment. And what makes that very good In a
Speaker 3: lease the less or you're the owner of the equipment.
Speaker 3: It's good to be a secured lender is great. It's
Speaker 3: better to own the equipment. And the course of a
Speaker 3: bankruptcy and if a company doesn't pay or it goes bankrupt,
Speaker 3: they either reaffirm the lease and keep paying, or you
Speaker 3: go and take your equipment. You've got the title, you
Speaker 3: take the sheriff, and you get your stuff. What's important
Speaker 3: in that strategy is focusing on the most essential equipment.
Speaker 3: There's one company we're involved in that owns a large
Speaker 3: portfolio of gas stations or petrol stations. We own the
Speaker 3: gas pumps and least them back. If they're going to
Speaker 3: be a business, they're going to have these, and if not,
Speaker 3: there's actually a secondary market for used gas pumps, believe
Speaker 3: it or not. A and then be The other thing
Speaker 3: I like about it is knowing not a lot of
Speaker 3: people are sitting here saying inflation's going down, and probably
Speaker 3: inflation's trending up over the long term, we've got more
Speaker 3: geopolitical uncertainty in the world. Commodity and energy inputs are
Speaker 3: you know, probably keep going up, not down. Inflation is
Speaker 3: a G eight factor for equipment financing in that we
Speaker 3: own the equipment at the end of the lease, and
Speaker 3: to the extent inflation is high, residual values will typically
Speaker 3: be higher, and there's a path for significant gain. Of
Speaker 3: some of our earliest leases that have gone full cycle,
Speaker 3: we've actually really crystallized very nice gains at the tail
Speaker 3: end of that. I'm leasing as a specialized market. There's
Speaker 3: other quirks to it, not just straight up corporate lending,
Speaker 3: and we have a dedicated team focused on that. So
Speaker 3: when I think of the things that are exciting us
Speaker 3: that typically move to the top of the pile when
Speaker 3: we're looking at investments, a middle market infrastructure credit is
Speaker 3: one for sure, equipment finance certainly another, and then I'll
Speaker 3: call it esoteric specialty finance. Things that might just fall
Speaker 3: through the cracks where we can apply a little bit
Speaker 3: of abs knowledge and a little bit of structured product
Speaker 3: knowledge and some corporate credit finding things like that, they're
Speaker 3: typically going to be over ten percent type returns. Not
Speaker 3: the kind of thing where we're going to be competing
Speaker 3: with a BBC. Might need a little extra brain power
Speaker 3: to to kind of figure it out and structure it.
Speaker 3: But those are the kind of things that do excite us.
Speaker 1: Great stuff. Tom Yeski, found managing partner at Eagle Point Credit,
Speaker 1: Thank you so much for joining us on the Credit Edge.
Speaker 3: Great, thank you so much for having me, and.
Speaker 1: Of course very grateful to Retto Bachman with Bloomberg Intelligence.
Speaker 1: Thank you very much. Pleasure for more credit market analysis
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