Speaker 1: Hello, and welcome to another episode of the Odd Lots podcast.
Speaker 1: I'm Tracy Alloway.
Speaker 2: And I'm Joe.
Speaker 3: Why isn't thal Joe.
Speaker 1: It's a new year, Happy New Year, Happy New Year.
Speaker 1: This is our first podcast recording of the year, and
Speaker 1: I think it's fair to say that we are going
Speaker 1: into a different environment in terms of sentiment than we
Speaker 1: were going into twenty twenty three. So this time last year,
Speaker 1: everything was very pessimistic. Lots of people were expecting recession.
Speaker 1: The hills were alive with the sounds of inverted yield
Speaker 1: curves and things like that. This year feels a little
Speaker 1: bit better. Stalks are up, lots of talk about a
Speaker 1: soft landing. Of course, the irony is that if there
Speaker 1: is going to be a recession, and you know one
Speaker 1: hundred percent chance there will be a recession in the future,
Speaker 1: it's closer than ever, and yet we feel a lot
Speaker 1: better about it.
Speaker 3: Yeah, it is.
Speaker 2: It's funny the optimism that we really felt in December
Speaker 2: about soft landings and bull markets and raids coming down
Speaker 2: in normalization. Interestingly enough, we're recording this January third so far,
Speaker 2: I guess this is we're looking at. We've had a
Speaker 2: few down days but you know whatever, a few days
Speaker 2: here there, it doesn't make a big difference.
Speaker 1: I call it profit taking Joe profit But anyway, you know,
Speaker 1: New Year, New Themes to discuss.
Speaker 3: Taking profits, I wish.
Speaker 1: But one of the things that's still with us is
Speaker 1: this concern about whether or not the economy can escape
Speaker 1: the full force of these very dramatic interest rate hikes
Speaker 1: that we've seen over the past couple of years, whether
Speaker 1: or not there's still a shoe to drop.
Speaker 2: Basically, yeah, you know, it gets to the lags debate.
Speaker 2: We talked about it with Anna Wong at the end
Speaker 2: of twenty twenty three. The market expects rate cuts, obviously,
Speaker 2: some people think as soon as March. Unclear when or
Speaker 2: if that will be. That theoretically is taking off some
Speaker 2: of the pressure from markets, particularly credit markets. But yeah,
Speaker 2: we had this really big rise in raids. Some people
Speaker 2: think that the lagged effect still has yet to come,
Speaker 2: and so sort of trying to understand what's changed from
Speaker 2: when we were etserped to when we're at five percent,
Speaker 2: I think is still an important conversation to.
Speaker 1: Have, absolutely, and in my mind one of the big
Speaker 1: areas of concerns, And it also goes to the idea
Speaker 1: of what's changed over the past few years has to
Speaker 1: be private credit. Ye. Right, We've seen this absolute swelling
Speaker 1: of this particular asset class at a time when interest
Speaker 1: rates have been going up, and there's still lots of
Speaker 1: concern over whether or not this new source of funding
Speaker 1: basically knows what it's doing right, Like are these managers,
Speaker 1: are these investors like getting it right? But then the
Speaker 1: other thing I keep thinking about, and we've sort of
Speaker 1: talked a little bit about this, but this idea of
Speaker 1: the macro impact of private credit. If you have a
Speaker 1: body of money that is now one point three trillion
Speaker 1: or one point six trillion outstanding, depending on which estimate
Speaker 1: you're looking at, that is more or equivalent to the
Speaker 1: size of the entire junk created corporate bond market. So
Speaker 1: there's basically this like new pool of money in the
Speaker 1: economic system at a time when interest rates are going
Speaker 1: up and we're not really sure what impact it's having.
Speaker 2: And I'll just add on to that. Part of the
Speaker 2: interest obviously is Okay, what does it mean for this
Speaker 2: cycle a higher rates, et cetera. But this acid class
Speaker 2: that's exploded, it's not going to go away regardless. And
Speaker 2: the expectation is that it's going to overtime continue to grow.
Speaker 2: So I think there was just a lot of need
Speaker 2: and interest, but I would say need to sort of understand,
Speaker 2: as you say, the macro impacts from this space. I'm
Speaker 2: also curious about the source of excess returns. We talked
Speaker 2: about it a little bit, but it's always sort of
Speaker 2: important when thinking about an asset classes, like, Okay, what
Speaker 2: is it specifically that's being exploited here for above average returns?
Speaker 2: How correlated uncorrelated is I think it's still worth trying
Speaker 2: to untangle the impact and the role of this asset class.
Speaker 1: Absolutely so. We've done one episode on this topic. Previously,
Speaker 1: we spoke with Laura Holsen from New Mountain and she
Speaker 1: basically gave us the elevator pitch for why this asset
Speaker 1: class has been growing so dramatically in recent years. But
Speaker 1: in this particular episode, we're going to dig a little
Speaker 1: bit more into the macro impact of private credit, how
Speaker 1: it competes with other types of funding, and per Joe's point,
Speaker 1: where the source of those excess returns is actually coming from.
Speaker 1: And I'm very pleased to say we have the perfect guest.
Speaker 1: We're going to be speaking with Ben Emmons. He's a
Speaker 1: senior portfolio manager at New Edge twelf. Some of you
Speaker 1: might remember that we spoke to him last year about
Speaker 1: the contraction in bank lending after the collapse of Silicon
Speaker 1: Valley Bank and a few others. He's had a very
Speaker 1: wide ranging career. He was at PIMCO for a long time.
Speaker 1: A great person to give us an overview of how
Speaker 1: private credit is interacting with the rest of the financial
Speaker 1: system and the economy. So Ben, thank you so much
Speaker 1: for coming back on all thoughts.
Speaker 4: Tracy Joe, it's great to be back. Happy New Year,
Speaker 4: Thank you for having.
Speaker 2: Me, Happy New Year, Thank you for coming back.
Speaker 1: Yeah, So maybe to begin with tell us, what's your
Speaker 1: particular interest in private credit? You know, sitting at New Edge,
Speaker 1: you're a portfolio manager. What is the offering posed by
Speaker 1: private credit?
Speaker 4: Yeah, it's driven much by clients interest in demand for
Speaker 4: this asset class, you know, in part maybe because the
Speaker 4: type of clients at New Edge in this case services
Speaker 4: are working in the private credit industry themselves ironically, so
Speaker 4: they're interested in investing out of private credit strategies. But
Speaker 4: it's also i think born out of clients who have
Speaker 4: connection with the companies that these private credit lenders are
Speaker 4: lending to or have some sort of involvement in that,
Speaker 4: and are interested and allocating the effort to this as
Speaker 4: a class as opposed to you know, let's say the
Speaker 4: retail approach of like, well, okay, I heard about private credit.
Speaker 4: There may be an ETF on it, like you know,
Speaker 4: and so let's buy this ETF and and now I
Speaker 4: go to a wealth man's perform like new Egine and
Speaker 4: they will help me with that. That's far less. So
Speaker 4: the investors that we talk to are very involved in
Speaker 4: private credit themselves, So it gives you an interesting angle
Speaker 4: on it because once you are starting to talk to
Speaker 4: these clients, you know, you have to really learn about
Speaker 4: what this aesca class truly is about. You know, it's
Speaker 4: far less an asked class about the way we're trading
Speaker 4: public markets. You know, if you look at treasury bonds,
Speaker 4: that's not what private credit is really, how it is
Speaker 4: traded or how it is functioning. So I find it
Speaker 4: a really interesting different alternative way of investing as something
Speaker 4: I had not looked at in my career previously, you know,
Speaker 4: until I really started to get into the Vegisa's investment
Speaker 4: advisory business and so interesting the watches to see this unfold.
Speaker 2: So what is it for an investor? You know, you
Speaker 2: think about overall portfolio. People have some equity, and they
Speaker 2: have some maybe risk free government debt, et cetera, and
Speaker 2: whatever it is. What is it about private credit? What
Speaker 2: does it deliver for a portfolio?
Speaker 4: So the one it is truly diversification, and it is
Speaker 4: an asset class that's traditionally non correlated to equity or
Speaker 4: fixed income, even though you know all of the loans
Speaker 4: that are in the devocredit funds are off based off
Speaker 4: the secured overnight funding rate, that's the self rate, right,
Speaker 4: So there's there is obviously a connection with interest rates,
Speaker 4: but it has been long term uncorrelated based upon how
Speaker 4: the returns have behaved relative to returns and equities and
Speaker 4: fixed income. I think what the tracks people is that
Speaker 4: the loans that are being issued by those private lenders,
Speaker 4: you know, they have been at extreme low default rates
Speaker 4: for a really long period of time. Now, I always
Speaker 4: talk to the private credit managers with a bit of
Speaker 4: a caution here because coming from a world of total
Speaker 4: return and fixed income training, you take immediately set back well, okay,
Speaker 4: load the faults. Really, I mean so.
Speaker 1: I yesh, it's sort of true of every new asset class, right, like, oh,
Speaker 1: the history is limited, so there aren't many defaults exactly.
Speaker 4: So that's exactly a very good point. That's one reason.
Speaker 4: On the other hand, it's about you know, okay, the
Speaker 4: individual companies that they lend to have had a good
Speaker 4: credit history so far, at least in many of the funds.
Speaker 4: If we looked at that's been the case. Very little
Speaker 4: impairments that have happened. Second, the private lenders are in control,
Speaker 4: so they set the covenance. It's not like a bank
Speaker 4: involved or another intermediary that is controlling the contract. It's
Speaker 4: really Blue Out Blackstone KKR. Those companies. They set the
Speaker 4: terms and they also are very good at enforcing those terms.
Speaker 4: And think it gives clients a confidence that these loans
Speaker 4: are staying current and we're not get any major impairments
Speaker 4: of anything. Now, what I think otherwise is I think
Speaker 4: of attraction to clients is that you know, it is
Speaker 4: an astraclass that is not out on the screen. It
Speaker 4: is privately managed and traded. Private credit funds are nothing
Speaker 4: like a mutual fund of etfor or hedgephone manager they
Speaker 4: are very selective in how they pick their different companies
Speaker 4: to lend to. I think all of those things play
Speaker 4: a role in why investors are interested in this aska class.
Speaker 1: So a lot of this reminds me of the debate
Speaker 1: around cove Light in sort of like the middle twenty tens,
Speaker 1: when there was an explosion in cove Light bonds or
Speaker 1: a dramatic deterioration in the amount of protections that investors
Speaker 1: were demanding in order to lend to companies. And I
Speaker 1: remember that time. There was an argument sort of for
Speaker 1: and against. So you know, some people were arguing, this
Speaker 1: is terrible. This is the result of the search for yield.
Speaker 1: It basically means people will lend to anywhere they can
Speaker 1: get a return, and they're not going to ask for
Speaker 1: any protections because they're just desperate to get any sort
Speaker 1: of yield. But then the offsetting argument was that, well,
Speaker 1: actually it sounds bad. Cove Light sounds bad. The idea
Speaker 1: of investors giving up protections sounds bad. But if something
Speaker 1: were to happen, if there were a recession, then it
Speaker 1: could end up being a good thing because it means
Speaker 1: companies have more flexibility to refinance. They don't have as
Speaker 1: many restrictions around what they can do. So I always
Speaker 1: remember there were sort of pros and cons to the
Speaker 1: cove light argument, and it feels similar in private credit,
Speaker 1: maybe to.
Speaker 4: An extent ration. But I would say the managers that
Speaker 4: we've spoken with, and you know, we talked to over
Speaker 4: one hundred managers in that space, what we've read from
Speaker 4: most of those governance they're not lights. They're actually stricter,
Speaker 4: and I think it is because of the personal relationships
Speaker 4: that these private lenders have of the company that they're
Speaker 4: lending to. And they told us that we've actually got
Speaker 4: an examples they've shown also, you know, uh, a presentation
Speaker 4: of the different companies that are actually we are in
Speaker 4: the fund right who are basically let's say, long term
Speaker 4: standing relationship between say a Blackstone and that company itself.
Speaker 4: So I'm trying to get us that the covenants are
Speaker 4: sort of maybe like customized governance. They certainly don't do
Speaker 4: to us as light. You know, there's a very strict
Speaker 4: control on payments of interest and it's about trying to
Speaker 4: you know, really help the company move ahead. So there's
Speaker 4: much of a i think also a private equity aspect
Speaker 4: to this, and that's typical in private credit anyway, where
Speaker 4: you have a sponsor that it's involved in the structure
Speaker 4: of private credit fund. But having that private equity approach
Speaker 4: gives these companies that sort of, let's say, empower those
Speaker 4: companies to do the right thing with that money and
Speaker 4: invest in the right way. And therefore the governance, although
Speaker 4: they look really strict, are not necessarily going to be
Speaker 4: at some moment like, Okay, you can't pay off those loans,
Speaker 4: We're going to, you know, really put the screws on
Speaker 4: this company if we're going to take the keys right
Speaker 4: at lily and and therefore the company becomes totally impaired
Speaker 4: and dysfunctional. That doesn't seem to be the case so far,
Speaker 4: even though from what I read, those governants there are
Speaker 4: strict compared to say, clos where that governant light showed
Speaker 4: up in the mid to twenty.
Speaker 1: TENHS for now, So what what cause a company to
Speaker 1: decide to go the private route versus you know, either
Speaker 1: issue a bond or take out a loan from a
Speaker 1: bank in the public market.
Speaker 4: So I did announcers on the b credit fund, for example,
Speaker 4: from Blackstone, and all those are in there are non listed.
Speaker 4: All of those companies have what we from our conversations
Speaker 4: with them, have no interest in going public at all.
Speaker 4: And Thirdly, what I did find, and I did say
Speaker 4: that to Blackstone, about ten percent or so of that pool,
Speaker 4: there's very little information I can find on these companies,
Speaker 4: and I go online, I don't see much of any
Speaker 4: kind of information. So some of our really really private,
Speaker 4: private type companies we talk about literally like services companies
Speaker 4: a car wash or some technology services company like that
Speaker 4: you've never heard of before. And so these companies I
Speaker 4: think are no also not in the position to just
Speaker 4: go to the public markets unless there's a bank that
Speaker 4: is really that easy in terms of his lending standards,
Speaker 4: that is willing to give these companies money or allow
Speaker 4: them to come to market. On the other hand, I mean,
Speaker 4: some of these companies may be in a position where
Speaker 4: they get better and better revenues, they get more traction,
Speaker 4: get more attention to their business model, and at some
Speaker 4: point some big investor compans like, hey, look, you know,
Speaker 4: we can help you go public and raise equity. We've
Speaker 4: not found those examples in these pools so far.
Speaker 2: How much of the rise of this acid class, in
Speaker 2: your view, is simply about scale and capacity within the banks,
Speaker 2: or maybe lack thereof, because if the story is right,
Speaker 2: the companies are not listed, they're not particularly well known, so,
Speaker 2: like you know, you're sort of starting from scratch on
Speaker 2: due diligence or familiarity. Perhaps the covenants are bespoke. In
Speaker 2: many cases, as you've described, they're tailored, so that obviously
Speaker 2: takes legwork on the part of whoever is making lending decisions.
Speaker 2: So is this like a story of like essentially going
Speaker 2: to post Dodd Frank world where like banks are constrained,
Speaker 2: et cetera, that essentially it just makes more sense for
Speaker 2: in many cases for a third parties who have the
Speaker 2: capacity and scale to specialize and find in creating that relationship.
Speaker 4: That's spot on, Joe. I think the outer part of
Speaker 4: that story is that as banks have skilled back ye
Speaker 4: dedicated market, that created a void, and I think that
Speaker 4: was part of the story too, of these companies automatically
Speaker 4: getting towards a private lender as supposed to going to
Speaker 4: it let's say mid size or smaller bank trying to
Speaker 4: get a loan or business loan. But as I mentioned,
Speaker 4: the personal aspect that found really fascinating of how personal
Speaker 4: relationships they've had. Now, any private banker has this right
Speaker 4: if you go to I don't think of any of
Speaker 4: the major banks there's a personal relationship. But I think
Speaker 4: in this case it's very driven by personal long term relationships.
Speaker 4: So that void of the banks, not you know, lendings
Speaker 4: as much in that syndicated loan channel, is one reason
Speaker 4: why there is a lot of demand for private lending.
Speaker 4: On the other hand, it's really the personal relationships. I
Speaker 4: think that's driving it.
Speaker 2: Tracy, it still strikes me as perverse that the banks
Speaker 2: that failed in twenty twenty three were like the banks
Speaker 2: where they actually took like private relationships seriously. Like it
Speaker 2: sort of bothered me. It's like, oh, this is like
Speaker 2: what I think like bankers should be, like really getting
Speaker 2: to know the clients, bespoke offerings that isn't just like
Speaker 2: some generic website.
Speaker 1: There's a difference between getting to know the clients and
Speaker 1: doing whatever they want you to do.
Speaker 2: I guess that's it, but it still feels like man like,
Speaker 2: I think that's what bankers should be doing, but I
Speaker 2: guess apparently not, that's not what the market said.
Speaker 1: Well, I mean, just going back to the regulation, I
Speaker 1: mean a lot of this was by design. I remember
Speaker 1: when the leverage lending guidelines came out again in the
Speaker 1: mid twenty tens. That was back when the market was
Speaker 1: going absolutely haywire, and the regulators came out and said,
Speaker 1: hold on, you guys have to like take a breath
Speaker 1: here and stop doing so many things that are risky,
Speaker 1: basically forcing that activity into what we used to refer
Speaker 1: to as the shadow banking system. I don't see that
Speaker 1: term as much as I used to, but that is
Speaker 1: exactly what private credit is, of course. But just on
Speaker 1: this note, I remember there was a really interesting chart.
Speaker 1: I think I put it in one of the All
Speaker 1: Thoughts newsletters maybe a couple months back, but it showed
Speaker 1: commercial and industrial bank lending in the US versus USGDP,
Speaker 1: and for most of the history of that time series,
Speaker 1: they pretty much moved together. So if there are more
Speaker 1: commercial and industrial loans, then GDP tends to be growing.
Speaker 1: But over the past couple of years they've kind of decoupled,
Speaker 1: and in my mind, it really raises the question of, like,
Speaker 1: what is driving GDP growth. If it isn't bank lending,
Speaker 1: you know, maybe it's government funding. We've seen a lot
Speaker 1: of infrastructure spending and things like that, but maybe it
Speaker 1: is also the more than one trillion dollars of private
Speaker 1: credit that now exists.
Speaker 4: I think that's right, because you know the fact that
Speaker 4: it is one point three trillion dollars going to lily
Speaker 4: companies that making twenty five to fifty one hundred million
Speaker 4: dollars of gross revenues a year. That's part of the
Speaker 4: really the small mid size backbone of America that's driving
Speaker 4: GDP and again doing reach own these companies. From the
Speaker 4: information that I've found on it is, you can really
Speaker 4: tell like their business models have expanded very rapidly of
Speaker 4: last several years. In part I think is the infusion
Speaker 4: of private credit and the availability of private credit. Again
Speaker 4: to that question of Joe like that if the availability
Speaker 4: is from private lenders not from banks, it does eventually
Speaker 4: do show up in GDP, maybe not because of the
Speaker 4: commercial and industrial loan contractions you're see in there, but
Speaker 4: through the other channel of private credit extension. I think
Speaker 4: also that the impact in itself of leveraging gearing in
Speaker 4: the financial markets is actually none by from private credit.
Speaker 4: There has been one colo now issues of Blackstone's bi
Speaker 4: credit fund that was very very recently. It was about
Speaker 4: a five hundred million dollar deal. They took the most
Speaker 4: I think that the best loans that they had in
Speaker 4: their fund and bundled them together and sold them to
Speaker 4: investors at a very i think, very tight spread compared
Speaker 4: to where high yielders and anything else, so very conservative.
Speaker 4: But as not much more of that is happening yet.
Speaker 4: So if you think of impact from private credit on
Speaker 4: the economy, we go through leverage and securitization as an example,
Speaker 4: so that maybe the next stage in the future, as
Speaker 4: Blackstone sort of tipped the waters there and figured out, hey,
Speaker 4: there is investor demand instead of direct into our fund,
Speaker 4: we can securitize. If that were to pick up that securitization,
Speaker 4: I would think you're going to get an even more
Speaker 4: compounded effect from this, and then maybe the fears about
Speaker 4: the risk of private credit will become more justified. Right
Speaker 4: because I'm maybe jumping ahead of another question, but you
Speaker 4: know the risk if you think of macro impact on
Speaker 4: the economy and you think of risk, I would think
Speaker 4: the real risk of private credit is that the leverage,
Speaker 4: yeah that's in these funds, which tends to be about
Speaker 4: one and a half two times is sort of most
Speaker 4: of the funds that have that sort of leverage that
Speaker 4: that gets compounded by securitization the loans in the funds,
Speaker 4: and we haven't gotten to that stage yet. So the
Speaker 4: actual leverage itself, I think relatively low. If you compare
Speaker 4: it to the public markets take investment grade leverage is
Speaker 4: still three four times. Yeah, earnings is supposed to one
Speaker 4: or two times.
Speaker 2: I've brought this up in a few different conversations, but
Speaker 2: always blows my mind. So I keep asking the same question.
Speaker 2: But people like the fact that it's not on a screen.
Speaker 2: You mentioned that, And so there's this attraction to prices
Speaker 2: that I guess you don't have to look at every day.
Speaker 2: And if the market's read one day and the stock
Speaker 2: market's down two percent, but you look at your privacy easy.
Speaker 1: To be diversified if you're not traded.
Speaker 2: Yeah, there's like, oh, hey, my credit exposure was totally fat,
Speaker 2: even though like implicitly like that's a lie. I mean,
Speaker 2: we all know, but like, here's what I don't get
Speaker 2: about that. So A, like, is that real like that
Speaker 2: premium that people pay for the appearance of non diversification,
Speaker 2: And b it seems to me that the people who
Speaker 2: should really like pay up for the privilege of not
Speaker 2: having to look at their quotes. Are like individual retail
Speaker 2: investors who are like prone to panic and selling it
Speaker 2: the worst time and buying at the top, et cetera.
Speaker 2: But for the sophisticated investor, which I imagine most people
Speaker 2: who are like allocating to private credit, you know, they're
Speaker 2: not mom and pop. They're you know, they're people with
Speaker 2: moving serious money and sophisticated, like they're pros at this.
Speaker 2: Shouldn't they like be able to bear to look at
Speaker 2: their portfolio on a day to day basis? Why do
Speaker 2: they need to not have the screen?
Speaker 4: Yeah? I know, And that actually has happened because if
Speaker 4: it takes step back, yeah and go to the four
Speaker 4: quote of twenty twenty two, they are suddenly this news
Speaker 4: out that institutional investors in Asia were taking their money
Speaker 4: out of Beat Credit, and that was the first news
Speaker 4: of sort of this redemption starting, and that did spill
Speaker 4: over to the US and cause a little bit of
Speaker 4: a nerve, including with some of our clients that we
Speaker 4: got redemption requests. And because it's a gated fund, but
Speaker 4: they only pay out up to five percent of the
Speaker 4: total bull per cord order and it's an an auction
Speaker 4: type basis right, so you don't get your the five
Speaker 4: percent is a pro rade idea, you know, I did
Speaker 4: think made people wary of that. To your point, it's
Speaker 4: not on the screen, it's not mark the market, but
Speaker 4: there are marks clearly, and if you follow the ten
Speaker 4: Q ten K filing every quarter, you can see that
Speaker 4: the change of the value. This is what I do
Speaker 4: obviously because I have to do this for my job.
Speaker 4: And yeah, there's some stresses have built in over the
Speaker 4: last year, and you could tell us from the spreads
Speaker 4: on those loans they were when I started a new
Speaker 4: edge somewhere in the three the five hundred base points
Speaker 4: over sofa more than the fifty percent of the pools
Speaker 4: right now i'm looking at are more like five hundred
Speaker 4: to seven hundred base points over sofa, So that has
Speaker 4: a change has happened. So I think the sophisticated investor
Speaker 4: looks at this similarly, saying I'm getting wider spreads than
Speaker 4: in high almost double now Kearney, and the marks are
Speaker 4: indeed somewhat deteriorating now that the fault rates stay low.
Speaker 4: That's you know, of the total pool, that's how they
Speaker 4: present it. But if you break it out by different sectors,
Speaker 4: and a lot of these, by the way, these private
Speaker 4: credit pools are allocated significantly to software and healthcare, and
Speaker 4: that's where the weaknesses have been in the economy, so
Speaker 4: you can tell that those president only wider than they
Speaker 4: were a year ago. There's also I think from the
Speaker 4: marks on the loans from when I looked at different
Speaker 4: ten K filings, Yeah, there's some default breaters picked up
Speaker 4: there and there's some impairments have been reported. That is
Speaker 4: also showing up again to the covenant and the control
Speaker 4: that seems to be quite tight, and that I think
Speaker 4: why it hasn't been a floodgates of redemptions coming out
Speaker 4: of these funds, but that is ongoing is I think
Speaker 4: it's a sign of that people are looking at the
Speaker 4: ASKA saying we want more transparency and not so much ovagueness.
Speaker 4: I like to better understand what the liquidity truly is.
Speaker 4: And therefore I'm also reserved cautious. So it's not all
Speaker 4: in private credit and it's fantastic and you don't have
Speaker 4: to do it. I think there are just a lot
Speaker 4: of investors that have caution.
Speaker 1: What would be the proximate cause or catalyst for this
Speaker 1: might be an unfair question, but like the doomsday scenario
Speaker 1: in private credit, because I keep thinking, like, okay, one
Speaker 1: of the strengths of the asset class is that in
Speaker 1: some respects it's very liquid and you don't have to
Speaker 1: mark to market on a daily basis, and so you
Speaker 1: can kind of withstand short lived down cycles. But at
Speaker 1: the same time, you know, I imagine if those pressures were
Speaker 1: to build up enough at some point you would have
Speaker 1: to crystallize losses. At some point you would have investors
Speaker 1: running for the gates, per your example. So what would
Speaker 1: be the sort of trigger for that to actually happen.
Speaker 4: That's the burning question on the mind of every client
Speaker 4: I talked to about. And there's different ways to analyze that,
Speaker 4: I think, because on the one hand, it's just as
Speaker 4: I described, there's some level of stresses building into these pulls,
Speaker 4: and in a way you would think that maybe just
Speaker 4: simply how the economy is evolving, it gets overtime software
Speaker 4: and weaker, and you get some impairments, there will be
Speaker 4: some companies that will be behind in payments. On the
Speaker 4: other hand, it's about the liquidity aspect that yes, people
Speaker 4: have tied it up there. Liquidity in that vehicle and
Speaker 4: wanted out. And so that big credit example is one
Speaker 4: example of people trying to maneuver the liquidity out and
Speaker 4: keep redeeming from it with the good news that there's
Speaker 4: all these funds are gated so you don't get a
Speaker 4: run on those funds, because that would be the normal
Speaker 4: financial trigger, right right, I have an edge on a
Speaker 4: ETF out there, and people, Okay, this is wrong, I'm
Speaker 4: pulling all my money out, and that effect on that
Speaker 4: they could have on broader markets. It's not the case
Speaker 4: with private credit funds. But I think that what people
Speaker 4: will look at carefully as the realization that the loans
Speaker 4: that they've extended to these companies, if there are issues
Speaker 4: with fraud cases or other types of issues, that that
Speaker 4: will become a trigger of realization of hey, there's actually
Speaker 4: been some deterioration of lending standards have actually taken place,
Speaker 4: and as a result, invest started to react like they
Speaker 4: started to look at Okay, I'm going to start redeeming
Speaker 4: more from these funds. Now there's little evidence of this curny,
Speaker 4: I think really because of the state of the economy
Speaker 4: where we are, or there's not been much report on
Speaker 4: this yet. I want to mention this because as this
Speaker 4: podcast gets out there, the private credit fundman as will
Speaker 4: listen to this. One of the complaints I had was
Speaker 4: that the vakeness of the funds is also expressing that
Speaker 4: some of these companies very little information available. So as
Speaker 4: an investor would I would want to know, like if
Speaker 4: I put one dollar in that funds and you're going
Speaker 4: to lend that out to company XYZ that I cannot
Speaker 4: find any information on, I at least want to know
Speaker 4: what that company is really about. So I've been kind
Speaker 4: of messaging this to different managers, but I think this
Speaker 4: is a concern expressly for other investors too, and probably
Speaker 4: is one of those where you say trigger ideas of
Speaker 4: like if it shows up more and more of like
Speaker 4: we're lending to companies that we can find little information on,
Speaker 4: that will be in concerned, right.
Speaker 1: So yeah, and also there is clearly a tension in that,
Speaker 1: Like part of the investment case of this asset class
Speaker 1: is the idea of lenders building really strong relationships with
Speaker 1: private companies doing really good due diligence and very like
Speaker 1: customized deals. But then it's weird if none of that
Speaker 1: work actually shows up for the end investor, like if
Speaker 1: there's no way for you to actually check it out,
Speaker 1: and you're sort of buying into it on blind faith.
Speaker 4: Almost yeah, you're buying into a bull of loans that
Speaker 4: is presented as this is a load of fault vehicle.
Speaker 4: It's very steady and it's yields and payout and therefore
Speaker 4: you don't need to worry about those nuances and details.
Speaker 4: And yet I think as a vestors, you should worry
Speaker 4: about that because you know, in the end, the money
Speaker 4: that you put into that fund gets to those companies,
Speaker 4: and so that due diligence should really matter. And you know,
Speaker 4: you get a lot of assurances that that due diligence
Speaker 4: process is water tight and the covenants are very strict.
Speaker 4: And I have to say, but from what I've read,
Speaker 4: that's true. But we know from subprime lending, we know
Speaker 4: from other types of lending that it could not always
Speaker 4: work out that way, especially if you have an exuberance
Speaker 4: that we're dealing with currenty. So the private credit market
Speaker 4: is in an exuberance face currenty, you know, because everybody's
Speaker 4: focused on a lot and a lot of money is
Speaker 4: being allocated to it, and a lot of nowadays mutual
Speaker 4: fun companies for example, jumping to the opportunity to coming
Speaker 4: very late in that race, and that would be to
Speaker 4: be interested to watch too, right, And how if they're
Speaker 4: starting to become private lenders, you know, what does their
Speaker 4: lending stand practices compared to the experts in that space, say,
Speaker 4: you know, well established firm side Blackstone and KKR and
Speaker 4: Blue Owl, who have years of experience with been lending
Speaker 4: to private companies.
Speaker 2: I guess on some level, this is every credit cycle, right,
Speaker 2: I mean in the sense that at some point people
Speaker 2: want to start lending money to people who can't pay
Speaker 2: it back, and then some people will make a lot
Speaker 2: of money doing that, and then someone will lose a
Speaker 2: lot of money doing that. Can you talk a little
Speaker 2: bit more about the leverage and the fund structure. So
Speaker 2: company X launches a private credit fund, how much is
Speaker 2: it like sort of like equity investors in that fund?
Speaker 2: And then how much would they theoretically like borrow from
Speaker 2: some bank or someone else to like add leverage or
Speaker 2: sort of juice the fund. Like, how does that work?
Speaker 4: Yeah, so you have to sponsor at a private equity firm. Okay,
Speaker 4: that's the main I'd say capital provider and as a
Speaker 4: fund then gets long. It literally is like, yes, they
Speaker 4: use intermediaries the fund, right, because you have ultimately, you know,
Speaker 4: the companies who borrow from that private credit fund, you
Speaker 4: know they're facing essentially a bank. Yeah, the same idea,
Speaker 4: but the private credit fund itself has gets capital backing
Speaker 4: from a private equity firm, but still has to use
Speaker 4: intermediaries to raise the funds for in order to lend.
Speaker 1: Right.
Speaker 4: So now, on the other hand, it's also about I
Speaker 4: think the combination of other types of leverage. So what
Speaker 4: I've noticed was that a lot of these funds do
Speaker 4: partially invest their pull into clos I know, that's obviously
Speaker 4: where the financial leverage to an extent comes from. I
Speaker 4: found that interesting, even though it's a very small portion
Speaker 4: of it tends to be like one to two percent
Speaker 4: of the total pool. But it's it's another, i think,
Speaker 4: another source of their their leverage of funding, if you
Speaker 4: call it. On the other hand, it's a very low
Speaker 4: leverage though I've compared to other lending vehicles that they're
Speaker 4: out there. I mean, if you talk about say the
Speaker 4: total notion of the fund is leveled one to two
Speaker 4: times max, most of them are more like one to
Speaker 4: one and.
Speaker 2: A half, So they're not going crazy.
Speaker 4: No, it's quite conservative. So that's I think, why are
Speaker 4: kinds of not a concern about the leverage unwind idea
Speaker 4: of what we've seen with SPVs during the financial crisis, right,
Speaker 4: some off bounce sheet vehicle fifty nine levers and it
Speaker 4: has to unwind and we get all the disaster that follows.
Speaker 4: That I think is not so much to worry. It's
Speaker 4: more that opakness and the issue about lending to companies
Speaker 4: that although strict covenance, turned out to be issues with
Speaker 4: those companies and we didn't know about that, and therefore
Speaker 4: we're dealing with the deterioration of the pool and we
Speaker 4: have to reassess the risk. And as I mentioned, if
Speaker 4: you could tell from the change of the spreads on
Speaker 4: those loans over the past year, than there's some risk
Speaker 4: is creeptive. So I think that's the bigger risk. But
Speaker 4: back to your original question, I think it's really the
Speaker 4: structure of having this sponsored company providing the majority of
Speaker 4: that capital, which is I think is maybe what gives
Speaker 4: a lot of clients of confidence, like you have a
Speaker 4: private equity company involved, you know, that's that's kind of
Speaker 4: like a choke hold on a particular company, right, because
Speaker 4: private equity is very keen on we want our equity.
Speaker 4: So you're going to have to stick by these covenance
Speaker 4: that we set on these loans, and the moment that
Speaker 4: there's a change there will come in and make changes
Speaker 4: to make sure that you stay current. But there's been
Speaker 4: examples of that they actually have to take in what
Speaker 4: they call the keys of the company. They just can
Speaker 4: the company can no longer do it, and they have
Speaker 4: to take in the keys. I think that's when the
Speaker 4: online process happens and where the private equity manager then
Speaker 4: has to just divest. And I think that's the other
Speaker 4: part of this risk of that those turning in keys
Speaker 4: becomes more problematic wider than this leverage on my So
Speaker 4: the leverage is quite low.
Speaker 1: Is there any way to short private credit? Because well,
Speaker 1: if I think about, you know, like a corporate bond,
Speaker 1: and there are all sorts of ways, you know, primarily
Speaker 1: using derivatives, but I could short like a CDX index
Speaker 1: or something like that, or I could do you know,
Speaker 1: individual like CDs tied to that specific bond. Is there
Speaker 1: something similar for private credit?
Speaker 4: Well, you would have to be back to the financial engineering.
Speaker 4: I think there's three ways to do it. One is
Speaker 4: to short the stock of the company itself, which is,
Speaker 4: you know, if you have shorted the stock of Blackstone,
Speaker 4: that would have not have been a good trade. It
Speaker 4: was pretty bad. There is a there's a senior loan
Speaker 4: ETF out there, that's several of them, So those are
Speaker 4: actually loans that are very similar, if not coming out
Speaker 4: of private credit funds. You could that can be short
Speaker 4: that does. I believe even the private credit ETF in
Speaker 4: there that has invested in the different private credit funds
Speaker 4: and bundled in the ETF. So I guess that's another
Speaker 4: way of.
Speaker 2: Shorting here VPC Right, that's the one, is you private credit?
Speaker 4: But I believe I believe that's the one. But there's
Speaker 4: no derivatives on private credit or anything like that at
Speaker 4: this moment. But yeah, I think.
Speaker 1: I sent an opportunity, maybe just to bring it back
Speaker 1: to the macro impact. I mean, what does it mean
Speaker 1: for the functioning of the economy and the wider financial
Speaker 1: system if we now have this pool of money that
Speaker 1: really wasn't there before, or you know, if it was there,
Speaker 1: it was in a different form, Like what does that
Speaker 1: mean for the future.
Speaker 4: Wow. And one is positive because you know, we found
Speaker 4: an avenue to fund small mid sized companies without having
Speaker 4: banks involved in a way that you know, that could
Speaker 4: lead to more like shot prime lending and financial stresses
Speaker 4: that could ultimately end up into the negative. The detriment
Speaker 4: of those companies, those companies of the private credit markets
Speaker 4: created competition too, you know, so the regional banks are
Speaker 4: in more competition now with those funds, which lowers the
Speaker 4: cost of funding potentially. And as I mentioned, the cost
Speaker 4: of funding, I mean currently that seems quite high if
Speaker 4: you think of you're all in yield on those loans
Speaker 4: being anywhere from eight to eleven to fifteen percent, quite high.
Speaker 4: But I think the other positive of that is, though,
Speaker 4: is that as much as that's high interest, these companies
Speaker 4: have a stable source of funding and are not dealing
Speaker 4: with any other sort of restraints other than their covenant
Speaker 4: on that loan. So therefore they can go back to
Speaker 4: that same source and keep tapping it as long as
Speaker 4: they continue to perform and return the loans, pay off
Speaker 4: the loans, and make money as a company. So the
Speaker 4: macro impact I think is getting more significant. I think
Speaker 4: in that sense, it would be interesting to understand better though,
Speaker 4: of the different areas where this lending is taking place,
Speaker 4: we can think of a coastal areas as usual, just
Speaker 4: like with residential mortgages, you know, because as I mentioned,
Speaker 4: the big component in these pools is technology and software.
Speaker 4: So we know that that's obviously concentrated on east and
Speaker 4: west coast bars and maybe maybe a little bit down south.
Speaker 4: But what would be interesting is that if there's more
Speaker 4: expansion in the industrial area, manufacturing area through private credit,
Speaker 4: that would be I think meaningful in terms of the economy.
Speaker 4: So it is very much a stable source of funding.
Speaker 4: There have available credit to companies that may not be
Speaker 4: able to get that elsewhere. I think that's the macro impact.
Speaker 1: All right, Ben, thank you so much for coming back
Speaker 1: on all thoughts and talking to us. Not bank lending
Speaker 1: this time, but an alternate form of lending.
Speaker 3: Appreciate it.
Speaker 4: Thank you, Tracy, Joe, it's great to be on.
Speaker 3: Thanks for coming back, Joe.
Speaker 1: That was really interesting. There was so much to pick
Speaker 1: out there. One of the things I keep coming back
Speaker 1: to is this idea of like outsourcing the due diligence
Speaker 1: to a private equity company or a sponsor or something
Speaker 1: like that, and it's a bit of a cliche to
Speaker 1: reach for subprime, but Ben did mention it, and it
Speaker 1: sounds a lot like the rating agencies, right, Like you're
Speaker 1: kind of relying on an entity to do that due
Speaker 1: diligence for you, and maybe it'll work out, maybe it'll
Speaker 1: all be fine, but seems like there's a big question
Speaker 1: mark there.
Speaker 2: Yeah, I mean it kind of makes sense to me,
Speaker 2: just intuitively. The banks only have so much scale, right
Speaker 2: and like obviously there's only so much balance sheet that
Speaker 2: banks can allocate, you know, how much they can lend out,
Speaker 2: but there's also like going to just be a constraint
Speaker 2: on how much due diligence and how many relationships they
Speaker 2: can build, and the types of industries that the individual
Speaker 2: bankers at the banks like truly become familiar with enough
Speaker 2: to lend, and particular for smaller companies that may not
Speaker 2: be like you know, megafeed generators or whatever. So I
Speaker 2: guess like intuitively it makes sense that we sort of
Speaker 2: see like the sort of like breakup of the bank
Speaker 2: and that more and more of the credit extension part
Speaker 2: would essentially be from individual specialist companies of various sorts.
Speaker 1: Well, and also going back to the regulation I mean
Speaker 1: again by design.
Speaker 2: Yeah, by design, by design exactly.
Speaker 1: Regulators decided they didn't want banks to take so many
Speaker 1: risks in the aftermath of the two thousand and eight crisis,
Speaker 1: and so they put in restrictions on various types of lending,
Speaker 1: and a lot of that activity got squeezed to private credit,
Speaker 1: business development companies, that type of thing. So it makes
Speaker 1: some sense. And to Ben's point, if we have basically
Speaker 1: established a way for small to medium sized companies to
Speaker 1: get stable funding. This was always a concern in the
Speaker 1: public markets, right that if you're a smaller medium sized company,
Speaker 1: you are probably not going to be issuing a massive
Speaker 1: leverage loan in the same way mega corporation can do it.
Speaker 1: So if there is an alternative, that seems like a
Speaker 1: good thing. However, I still kind of wonder about that,
Speaker 1: like cataclysmic trigger, because it seems like the incentives are
Speaker 1: all really well aligned for the time being. So if
Speaker 1: you're the lender, you can keep blending money because you
Speaker 1: don't want to crystallize a loss and take a default,
Speaker 1: and you have that relationship with the company. But if
Speaker 1: that ever changes, Yeah, and we're talking about companies that
Speaker 1: don't have access to alternative forms of funding. You know,
Speaker 1: they can't go to a bank and get a loan.
Speaker 1: Often that's why they're knocking at private credit store.
Speaker 3: I don't know.
Speaker 1: No, maybe I shouldn't worry about the worst case scenario,
Speaker 1: but no.
Speaker 2: I mean I guess the way I would just sort
Speaker 2: of like I said, and I would maybe like sort
Speaker 2: of go down the middle on this question, which is
Speaker 2: that like the worst case scenario will happen, in other words,
Speaker 2: at some point, because this is like, you know, there
Speaker 2: have been banking cycles and credit cycles and people wearing
Speaker 2: the rose colored goggles probably since the first loan was made. Yeah,
Speaker 2: none of us like really know the timing, but we
Speaker 2: definitely know that there will be some point in which
Speaker 2: lenders basically lend to bad credits make loans. Maybe the
Speaker 2: terms are too nice, maybe the spreads are too narrow,
Speaker 2: Maybe the conditions that no big legs. I mean, we
Speaker 2: know this is a phenomenon, right, I mean, like maybe
Speaker 2: the terms in the conditions, the covenants are solid now,
Speaker 2: but it's only a matter of time before that deteriors
Speaker 2: the longer you go without defaults. This is how it's
Speaker 2: going to work. We don't know the timing, But it
Speaker 2: just seems like no matter what the lending category, at
Speaker 2: some point, someone is going to come along and lend
Speaker 2: to bad borrowers at two favorable prices.
Speaker 1: Well, I guess the thing to watch out for is
Speaker 1: the leverage question, like whether or not you start to
Speaker 1: see leverage bills, yeah, on private credit, at which point
Speaker 1: it would become a systemic.
Speaker 2: Securitization allowing end investors, has been said, securitization allowing them
Speaker 2: to sort of lay on to their own credit. This
Speaker 2: will happen. It will happen. We don't know when it'll happen, eventually,
Speaker 2: because this is what humans do.
Speaker 1: Very philosophical start to the new year. It is true,
Speaker 1: all right, I am just going to say that we
Speaker 1: are going to talk more about private credit, and we
Speaker 1: actually have a really interesting guest lined up, something we've
Speaker 1: never done before. So that ohtally yeah. Hopefully that will
Speaker 1: be out relatively soon after this one. But in the meantime,
Speaker 1: shall we leave it there.
Speaker 2: Let's leave it there.
Speaker 1: This has been another episode of the Odd Thoughts podcast.
Speaker 1: I'm Tracy Alloway. You can follow me at Tracy Alloway
Speaker 1: and I'm Jill Wisenthal.
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