Speaker 1: Hello, and welcome to another episode of the All Thoughts Podcast.
Speaker 1: I'm Tracy Alloway.
Speaker 2: And I'm Joe Wisenthal.
Speaker 1: Joe, what do you know about private credit?
Speaker 2: I know it's grown a lot. I know it's pretty good.
Speaker 1: That's I mean, that's the important thing.
Speaker 2: It's private and there's credit involved. Okay, I think that's
Speaker 2: about and I know it's grown, and I think that's
Speaker 2: about the extent of it.
Speaker 1: Yeah, all right, No, I actually.
Speaker 2: Wait, can I just add a little more?
Speaker 1: Maybe?
Speaker 2: No, I get the My sense is that for whatever reason,
Speaker 2: and this I don't know, people perceive there to be
Speaker 2: opportunities in private like you know, there's private equity buying mistakes,
Speaker 2: there's VC, et cetera. But people see an opportunity in
Speaker 2: pools of capital that are then lent out another lending
Speaker 2: that's not through banks.
Speaker 1: That's it. That's the episode.
Speaker 3: We're done.
Speaker 1: No, I mean you hit upon the most striking thing
Speaker 1: at the moment, which is that this is a market
Speaker 1: that has grown remarkably over the years. And I've seen
Speaker 1: various estimates. I think people calculate what counts as private
Speaker 1: credit somewhat differently, but I've seen estimates of about one
Speaker 1: point three trillion to one point six trillion outstanding, and
Speaker 1: if you think about the publicly traded bond market or
Speaker 1: the publicly issued bond market, So if you look at
Speaker 1: junk created corporate bonds, I think it's like one point
Speaker 1: three or one point four trillion outstanding, which means that
Speaker 1: the private credit market is now as big as the
Speaker 1: more broadly syndicated junk bond market, which is pretty stunning.
Speaker 1: And you also hit upon something really interesting that's happening
Speaker 1: right now, which is that the conventional line of thinking
Speaker 1: was that as interest rates go up, this was going
Speaker 1: to be bad for private credit. You were going to
Speaker 1: see more financial stress, maybe funding for private credit was
Speaker 1: going to be more difficult to come by, And instead
Speaker 1: the market has boomed, an appetite for these deals remains
Speaker 1: pretty strong.
Speaker 2: Yeah, it's sort of a subset, I guess of the
Speaker 2: surprising resilience of credit in general. But absolutely you would think, okay,
Speaker 2: here's this rapidly growing asset class. They're booming, and the
Speaker 2: zerp era and twenty and twenty twenty one, you think, okay,
Speaker 2: well this comes to an end now, right In other
Speaker 2: parts of private markets have gotten a lot of trouble
Speaker 2: you know, you know, I think about VC and how
Speaker 2: much slow down there has been there, and yet as
Speaker 2: far as I know, as far as we can tell,
Speaker 2: and everything that we've heard in sort of snippets from
Speaker 2: other conversations, that has not been the case in the
Speaker 2: private credit space. I gotta say, I'm surprised when we
Speaker 2: were about to say how big the junk bond market was,
Speaker 2: I thought you were going to say something much bigger
Speaker 2: than private credit. Still, so the fact that it's caught
Speaker 2: up is pretty striking.
Speaker 1: Yeah, it really is. So We've been meaning to do
Speaker 1: this for a while, but I think we need to
Speaker 1: dive into this market. I expect we're going to do
Speaker 1: more over time, but to begin with, we need to
Speaker 1: figure out how these deals are structured, how they're different
Speaker 1: to broadly syndication to debt, so stuff like corporate bonds
Speaker 1: or leverage loans, what higher interest rates actually mean for
Speaker 1: this asset class, and maybe even what private credits impact
Speaker 1: could be on the broader economy. And I'm very pleased
Speaker 1: to say we do have the perfect guest. We're going
Speaker 1: to be speaking with, Laura Holsen. She is a managing
Speaker 1: director at New Mountain Capital. She is also COO of
Speaker 1: New Mountain's Credit platform, which manages nearly nine billion dollars
Speaker 1: across private credit, So everything from private funds to publicly
Speaker 1: traded business development companies or BDC's. You might remember them
Speaker 1: from our interview with Dan Swarren way back in the day.
Speaker 1: I think that was like seven or.
Speaker 2: Eight years all odd loge heads, remember the dins were
Speaker 2: on interview.
Speaker 1: Well, this was when we still referred to private credit
Speaker 1: as shadow banking, which I don't see as much anymore.
Speaker 1: It's sort of this more accepted part of the market.
Speaker 1: But Okay, on that note, Laura, thank you so much
Speaker 1: for joining Odd Lots.
Speaker 3: Thanks for having me.
Speaker 1: So maybe I could begin with a very simple question,
Speaker 1: which Joe kind of alluded to in the intro, but
Speaker 1: what exactly counts as private credit nowadays?
Speaker 4: Yeah, So, the way I think about private credit is
Speaker 4: that it's debt that is privately originated and Joe, as
Speaker 4: you said, meaning not intermediated by a bank, but that's
Speaker 4: also not traded on any kind of public market. And
Speaker 4: the term private credit is pretty all encompassing. There's everything
Speaker 4: from direct lending, which is probably the largest element of
Speaker 4: private credit, but there's also opportunistic debt, there's distressed there's
Speaker 4: real estate financing. There's a pretty wide range of things.
Speaker 4: I think that counts as private credit. And it can
Speaker 4: be up and down the capital structure. So you could
Speaker 4: be senior in the capital structure, you could be junior, subordinated.
Speaker 4: It's pretty all encompassing.
Speaker 1: It also tends to be unrated as well. Right, It
Speaker 1: seems to me like this is the big difference. So
Speaker 1: you'll get you know, a corporate bond that is rated
Speaker 1: by a Moody's or a standard im Pores, but a
Speaker 1: direct loan or something like that would be unrated.
Speaker 5: Correct, DA, It's typically not rated.
Speaker 2: I ask another detail about what private credit is? What
Speaker 2: is Why don't you tell us what New Mountain Capital
Speaker 2: is and what you do there?
Speaker 5: Sure?
Speaker 4: So, New Mountain Capital we're an alternative asset management firm.
Speaker 4: We have kind of three pillars to our strategy. We
Speaker 4: have private equity, we have credit, and we have a
Speaker 4: net least strategy. And the way to think about New
Speaker 4: Mountain is that we're focused on what we call defensive
Speaker 4: growth sectors. So those are sectors of the economy that
Speaker 4: we think are going to perform well regardless of what
Speaker 4: kind of macroeconomic environment we're in. So whether we're in inflation, deflation,
Speaker 4: boom or bust, we want to invest in very resilient
Speaker 4: acyclical sectors and we apply that strategy across all of
Speaker 4: our products. And importantly, we use the knowledge that we've
Speaker 4: built up over our nearly twenty five year history as
Speaker 4: a firm and apply that same mentality and the same
Speaker 4: underrating knowledge and intellectual capabilities that we have to credit
Speaker 4: to net least and obviously to our core private equity strategy.
Speaker 1: Okay, so here's my other question. You know, we were
Speaker 1: talking about how big this asset class has actually gotten,
Speaker 1: how old is it actually? Because I hear different things.
Speaker 1: I hear people express concern for private debt because they'll say, well,
Speaker 1: we don't actually have that much historical data about defaults
Speaker 1: and things like that. But I also imagine there were
Speaker 1: private debt deals being done, you know, decades ago. Maybe
Speaker 1: not in the same format, certainly not to the same extent,
Speaker 1: but we must have some historical basis for comparison.
Speaker 5: Yeah, no, it's a fair question.
Speaker 4: I mean, the reality is the asset class has grown
Speaker 4: tremendously over the last you know, ten to fifteen years,
Speaker 4: but New Mountain's credit business. For example, we've been around
Speaker 4: since two thousand and eight, and we got our start
Speaker 4: by buying debt on the secondary market, debt that was
Speaker 4: trading at distressed levels, not because those companies were fundamentally impaired,
Speaker 4: but just because of the technical reasons in the marketplace that.
Speaker 1: Drove because it was two thousand and eight, exactly because it.
Speaker 5: Was two thousand and eight.
Speaker 4: And so as a result, we've seen our own track
Speaker 4: record and we you know, so we feel like we
Speaker 4: have been cycle tested, right, We've gone through COVID, We've
Speaker 4: gone through you know, the Silicon Valley Bank, We've gone
Speaker 4: through you know, definitely a pretty crazy period from an
Speaker 4: inflation standpoint. So there's been a lot of elements that
Speaker 4: we feel like we've kind of cycle tested our portfolio.
Speaker 4: But you're right, I think it's a little bit of
Speaker 4: a different form today than maybe private credit was, you
Speaker 4: know fifteen twenty years ago, what.
Speaker 1: Happened to private debt during the big COVID market route.
Speaker 1: And you know, you can look at proxies, you can
Speaker 1: look at publicly listed BDCs. I think New Mountain has
Speaker 1: one of those, and you can see certainly, like the
Speaker 1: share price went down quite a lot, but like what
Speaker 1: happened in more opaque corners of the market.
Speaker 4: Yeah, so I think, you know, during COVID, private credit,
Speaker 4: I would argue, held up better than you know, the
Speaker 4: broadly syndicated market. You saw the debt and the broadly
Speaker 4: syndicated market from a trading level perspective trade down pretty meaningfully.
Speaker 4: But from a default perspective, actually, private credit turned out
Speaker 4: to be more resilient during COVID, and I think it's
Speaker 4: a function of how these deals are set up, because
Speaker 4: they are meant to be a little bit more bespoke,
Speaker 4: more relationship oriented, and so private equity sponsors were able
Speaker 4: to have direct dialogue with the lenders and talk through Okay,
Speaker 4: here's what we're seeing in these underlying companies, here's what
Speaker 4: we're doing about it.
Speaker 5: Let's talk. It's not a group.
Speaker 4: Of fifty years or so syndicated investors that they have
Speaker 4: no relationship with. And as a result, I think we
Speaker 4: saw better outcomes in terms of just actual default losses
Speaker 4: during that period.
Speaker 2: Okay, to help understand this market, what would be the
Speaker 2: modal or typical borrowing entity for whom private credit is
Speaker 2: a more attractive lending option. Than say going to the
Speaker 2: bond market and or going to a bank.
Speaker 4: Yes, So the way I think about it, and again
Speaker 4: from where I said, at New Mountain, we focus primarily
Speaker 4: on what I call sponsor back direct lending, so direct
Speaker 4: lending to private companies that are owned by private equity firms,
Speaker 4: and the private equity firms need to make a decisions,
Speaker 4: as you said, do they want to go to the
Speaker 4: syndicated market or do they want to tap the direct
Speaker 4: lending market for their financing. And there's a bunch of
Speaker 4: things to consider. But the way I think about the
Speaker 4: benefits of direct lending are number one, you have more
Speaker 4: certain execution because when you're doing a syndicated deal, that's
Speaker 4: a deal that you're getting intermediated by a bank. They're
Speaker 4: underwriting it at a certain pricing level, but then they
Speaker 4: have the ability to flex that pricing level wider or
Speaker 4: tighter depending on market conditions at the time. And you're
Speaker 4: in market for I don't know, maybe four weeks, and
Speaker 4: so you're taking a lot of market risk, particularly during
Speaker 4: times like we're in today where there's a lot of
Speaker 4: market volatility. So that's one thing, is just a certainty
Speaker 4: of execution because a direct lending deal. You commit from
Speaker 4: a pricing perspective, and then you stick to that price
Speaker 4: throughout the rest of the negotiation, so you know what
Speaker 4: terms you're getting from the sponsor perspective. The second thing
Speaker 4: is it also can be a little bit of an
Speaker 4: easier execution because in a syndicated market, if a sponsor
Speaker 4: wants to get a first lean and second lean financing done,
Speaker 4: that's two different credit agreements, a first line credit agreement,
Speaker 4: a second lean credit agreement, and an inter creditor agreement.
Speaker 4: As to how those two tranches interact with each other. Again,
Speaker 4: you can trast that to a direct lending solution where
Speaker 4: you have a unitron structure with just one credit agreement,
Speaker 4: so it's also easier. You also don't need to go
Speaker 4: through the rating agency process, which also just saves time.
Speaker 4: And as I said, it's more relationship oriented. It could
Speaker 4: be more flexible and more bespoke to what the sponsors
Speaker 4: are looking for.
Speaker 2: Real quickly for the listeners. And also me what is
Speaker 2: first and second lean mean?
Speaker 5: Yeah, no, it's a good question.
Speaker 4: So it's depends where you are in the capital structure.
Speaker 4: So first lean means you have the first claim or
Speaker 4: the first priority on the assets, and the second lean
Speaker 4: would be junior to them.
Speaker 1: I think we're kind of getting to the heart of
Speaker 1: why this asset class has been booming, because I hear
Speaker 1: this a lot from market participants, this idea that like, well,
Speaker 1: maybe the deals are structured in a way that makes
Speaker 1: them more appealing to investors versus the broadly syndicated stuff. So,
Speaker 1: you know, you mentioned that sponsors can get more definitive terms.
Speaker 1: You know, maybe the issuer doesn't have to go through
Speaker 1: the hassle of getting a rating and that sort of thing.
Speaker 1: And then you mentioned the first lean and second lean issue.
Speaker 1: And I've seen this come up in various ways. The
Speaker 1: idea of a preferential treatment in the payment waterfall is
Speaker 1: that the right way to think about it. So, if
Speaker 1: you're in a private debt deal, can you structure it
Speaker 1: such that maybe you're closer to the issuer than anyone else,
Speaker 1: maybe you get more insight into potential credit challenges before others.
Speaker 1: And maybe also you can enforce remedy payments that make
Speaker 1: you come out on top in the event of a default.
Speaker 1: So preferential treatment versus other creditors.
Speaker 4: Yeah, I mean, I think that is a fair way
Speaker 4: to think about it. When I think about again the
Speaker 4: purpose of a direct lending solution, right, it's a lot
Speaker 4: simpler of a capital structure, right, so you don't get
Speaker 4: into a situation where maybe you're fighting between the first
Speaker 4: lean and the second lean creditors for example.
Speaker 1: Which we've seen recently.
Speaker 2: Yeah.
Speaker 4: Absolutely, And to your point about just being closer to
Speaker 4: the borrow or and closer to the company, the way
Speaker 4: most direct lending deals work is it's a club of
Speaker 4: direct lenders. So you don't typically have one direct lender
Speaker 4: that's underwriting and holding the whole tranch, but you have
Speaker 4: a club, meaning you might have I don't know, anywhere
Speaker 4: from three to ten direct lenders in a deal. And
Speaker 4: there's real benefits to having that diversification from the sponsor perspective,
Speaker 4: because you have more dry powder, meaning you have the
Speaker 4: ability to go back to that same group and upsize
Speaker 4: and do incrementals or follow on deals for that same company.
Speaker 4: But you're also not beholden to any one lender because
Speaker 4: one thing you could say is, oh, well, in a
Speaker 4: direct lending deal, if you have more if you have
Speaker 4: fewer lenders in the group, maybe those lenders have more
Speaker 4: power over the company or the private equity firm. And
Speaker 4: again I think that really speaks to the benefit of
Speaker 4: having a small club. But you can trast that to
Speaker 4: a bank, send a kit which might have thirty fifty
Speaker 4: one hundred lenders in it, and inevitably, you know when
Speaker 4: you have a club of three, that those three lenders
Speaker 4: are all going to have more access, They're going to
Speaker 4: have more conversations with the sponsor, They're going to be
Speaker 4: able to call and have more of a direct dialogue
Speaker 4: with the management team as compared to you know, if
Speaker 4: you're one of one hundred.
Speaker 2: So I think I understand to some extent the appeal
Speaker 2: of direct lending. What is the pitch, you know, let's
Speaker 2: say I'm an ultra high net worth individual or family
Speaker 2: and my advisory oh, we want to you should have
Speaker 2: allocate some to private credit. What is the pitch to
Speaker 2: limited partners or investors for why this is an appealing
Speaker 2: asset class.
Speaker 4: Yeah, So, the way I think about it is private
Speaker 4: credit and direct lending specifically offers very attractive and consistent yield,
Speaker 4: and it's I think a very good thing to allocate
Speaker 4: as part of your fixed income portfolio. I think number one,
Speaker 4: it's floating rate typically, so we move up and down
Speaker 4: with interest rates. So in this period where we've had
Speaker 4: a significant run up, that has helped increase the yield
Speaker 4: of direct lending funds because the way the coupon is
Speaker 4: structured is you're tied to a base rate plus a spread,
Speaker 4: and so as that base rate has gone up, the
Speaker 4: overall interest rate that the investors end up earning has
Speaker 4: gone up pretty meaningfully. And it also provides some interest
Speaker 4: rate protection because valuation, for example, for a fixed rate
Speaker 4: bond has come down very meaningfully as rates have risen.
Speaker 4: So I think that's one thing to highlight. The second
Speaker 4: thing would just be that the higher spread compared to
Speaker 4: a broadly syndicated load, and part of that is an
Speaker 4: illiquidity premium because it's not traded. You can't you know,
Speaker 4: necessarily get out as easily, but you need to get
Speaker 4: paid for that, so you do get some extra spread
Speaker 4: from that. And then I think the there's been good
Speaker 4: data showing lower loss ratios also of direct lending, again
Speaker 4: compared to a broadly syndicated fund or a high yield fund,
Speaker 4: and so I think generally speaking it's kind of that all,
Speaker 4: you know, all of those things combined end up with
Speaker 4: a higher, more stable, more consistent yield, which I think
Speaker 4: is very attractive for you know, an ultra net worth.
Speaker 4: And the other thing I would just say is it
Speaker 4: does provide some diversification because it's not quite as correlated
Speaker 4: with all the other public markets as maybe you know,
Speaker 4: high yield or broadly syndicated loans are just.
Speaker 1: On the yield and spread point. I mean, it is
Speaker 1: true that we have seen both yields and spreads start
Speaker 1: to pick up in the broadly syndicated market recently, and
Speaker 1: I've seen some people making the argument that like, well
Speaker 1: maybe now, maybe not right now, maybe a week ago
Speaker 1: was the time to sort of pick up some exposure
Speaker 1: in the corporate bond market and things like that. But
Speaker 1: do you see, you know, when yields and spreads start
Speaker 1: to move around in the broadly syndicated market, do you
Speaker 1: typically see investors start to make that relative value judgment,
Speaker 1: Like will they sit there and think, well, I could
Speaker 1: either have this private debt deal or I could buy
Speaker 1: this in the publicly traded market.
Speaker 4: Yes, I think people definitely look at kind of the
Speaker 4: relative value versus the public benchmarks. But again, I think
Speaker 4: direct lending as an asset class has historically over now
Speaker 4: many years outperformed the public credit benchmarks. So you've seen
Speaker 4: that relative value I think always kind of shift in
Speaker 4: the favor of the direct lending funds.
Speaker 5: And again it comes back to.
Speaker 4: The spread premium compared to just a broadly syndicated loan.
Speaker 2: Can we talk about you know, you mentioned the clubs
Speaker 2: and the idea that Okay, you're not just gonna have
Speaker 2: one direct lender, you might have three, ten, whatever it is.
Speaker 2: How does deal flow typically work? How does something land
Speaker 2: on your desk in the first place, in the sort
Speaker 2: of standard mode.
Speaker 4: Yeah, so I think most credit firms the way they
Speaker 4: attack the market, most direct lending firms, they have sponsor
Speaker 4: coverage people who go out and call on a set
Speaker 4: group of private equity firms. Okay, and they call them
Speaker 4: and they say, hey, what deals are you working on
Speaker 4: on the private equity side? Can we help you finance them?
Speaker 4: So that's the typical model as to how most standalone
Speaker 4: private credit firms get deal flow. I would say New
Speaker 4: Mountain we approach things a little bit differently because we
Speaker 4: also have a private equity business. We are seeing the
Speaker 4: deal flow earlier because we're seeing it on the equity side.
Speaker 4: And what we're able to do is then triage those deals.
Speaker 4: And not all of them we're going to buy for
Speaker 4: private equity, of course, but a lot of them are
Speaker 4: really high quality, good businesses that maybe are going to
Speaker 4: trade at evaluation that we think is too high. So
Speaker 4: rather than buy the company on the private equity side,
Speaker 4: we can say, okay, well, now we know that deal
Speaker 4: is in market, let's see if we can go finance
Speaker 4: it for another private equity firm. And so we take
Speaker 4: a pretty different, i think, more proactive approach to deal
Speaker 4: sourcing because we know those deals are out there and
Speaker 4: then we just need to go find them. And again,
Speaker 4: the conversation that enables us to have with our private
Speaker 4: equity clients is, Okay, we know this deal is in market,
Speaker 4: our private equity firm is not looking at it, but
Speaker 4: we like the business, we have a view on leverage,
Speaker 4: we've already underwritten the space. Again, back to the point
Speaker 4: that I made in the beginning is to New Mountain
Speaker 4: focuses on the same industries across the board, and we
Speaker 4: have some really unique diligence angles that we could bring
Speaker 4: to bear. So that kind of conversation with our private
Speaker 4: equity clients I think gives us an edge and allows
Speaker 4: us to source very effectively.
Speaker 1: Just on this note, how sticky or reliable is this
Speaker 1: type of financing for the company itself, because again this
Speaker 1: is a place where you hear different arguments in the market.
Speaker 1: So on the one hand, you know, a lot of
Speaker 1: private equity funds have lock up periods and so people
Speaker 1: can't suddenly withdraw their money. But on the other hand,
Speaker 1: there is a concern that maybe this kind of financing
Speaker 1: is less sticky than, for instance, a bank loan, where
Speaker 1: maybe some of that is funded by deposits and things
Speaker 1: like that. So how reliable is this time of financing?
Speaker 4: Yeah, it is very reliable. When you think about the
Speaker 4: types of structures that underlie private credit funds, a lot
Speaker 4: of them are permanent capital vehicles. You mentioned business development
Speaker 4: companies or BDCs. The publicly traded ones are a form
Speaker 4: of permanent capital. So that's about as stable or as
Speaker 4: sticky as.
Speaker 5: You can get.
Speaker 4: And you also have other kinds of funds that are
Speaker 4: structured as draw down funds, which again have kind of
Speaker 4: a locked up life for a period of time. There's,
Speaker 4: of course, other types of funds that are maybe a
Speaker 4: little bit more open ended and the ability to come
Speaker 4: in and out, and so that can be where maybe
Speaker 4: you have a little bit less sticky, But I would
Speaker 4: argue that you have those dynamics kind of in all
Speaker 4: areas of credit investing, not just the direct lending market.
Speaker 4: So overall, I think it is really sticky and very
Speaker 4: reliable from the sponsor standpoint, and that's ultimately what they
Speaker 4: care about.
Speaker 2: How do you build expertise when you're walking through a
Speaker 2: whole range of industries because private equity could be literally
Speaker 2: anything thing. Do you have to build that expertise in
Speaker 2: house to be able to judge the credit quality of
Speaker 2: each type of deal that comes across your desk? How
Speaker 2: do you internally get to know whether a company is
Speaker 2: a good credit or not?
Speaker 5: Absolutely? Yeah, so skill.
Speaker 4: Yeah, So the due diligence process is incredibly important, and
Speaker 4: as you said, it takes a lot of time in
Speaker 4: many years to build so a new mountain. We proactively
Speaker 4: have come up with sectors of the economy that we
Speaker 4: think are going to be again those defensive growth sectors. Yeah,
Speaker 4: So sectors like enterprise software, right, so you have mission
Speaker 4: critical software that's deeply embedded, very sticky, very hard to
Speaker 4: rip out, high retention rates, good recurring revenue, so you know,
Speaker 4: we really like that sector. For example, we also really
Speaker 4: like tech enabled healthcare, right where you have different types
Speaker 4: of tools and both services and technology that power different
Speaker 4: healthcare providers and payers to ultimately take cost out of
Speaker 4: the system. So we kind of we get very you know,
Speaker 4: into very specific niches because it's not good enough in
Speaker 4: our mind to say, oh, yes, healthcare is a good sector,
Speaker 4: let's go invest in healthcare. We want to really narrow
Speaker 4: that down and find the sub sectors within healthcare and
Speaker 4: within enterprise software, within business services that we think will
Speaker 4: be really resilient for the long term. And then what
Speaker 4: we do is then we we staff a very full team.
Speaker 4: You know, we have over one hundred and fifty investment
Speaker 4: professionals at New Mountain that spend every single day you know,
Speaker 4: in some of these sectors. And then we become experts
Speaker 4: in these sectors. We look at companies that you know,
Speaker 4: are in these sectors, we map them out in a
Speaker 4: lot of detail. We hire bankers and consultants to help
Speaker 4: us map these sectors out and figure out that, you know,
Speaker 4: what's good and what's bad about these sectors. We also
Speaker 4: own companies in these sectors. Right, So we own forty
Speaker 4: five companies on our private equity side, and so we're
Speaker 4: seeing the real time trends within these sectors, and we
Speaker 4: can apply all of that, all of that knowledge, all
Speaker 4: that intellectual capital, we can apply it to the next
Speaker 4: credit deal. So we're never trying to figure out something
Speaker 4: from scratch. It's not we're not waiting for that deal
Speaker 4: to come across our desk and then say okay, let's
Speaker 4: go try to figure this out. No, if that's the case,
Speaker 4: we're just like, we're not going to look at that.
Speaker 4: That's not you know, within our scope. But what we
Speaker 4: do is we say, okay, we want to be starting
Speaker 4: from you know, the sixth, seventh or eighth inning from
Speaker 4: a diligence perspective and really just be doing bringdown work
Speaker 4: and not trying to figure something out from scratch.
Speaker 1: So I take the point about due diligence and expertise,
Speaker 1: but it has to be true that the macro environment,
Speaker 1: you know, where we have seen this very dramatic increase
Speaker 1: in interest rates is deteriorating in way. And I think
Speaker 1: if you look at leverage loans, broadly syndicated leverage loans,
Speaker 1: which would be private credits nearest competitor. I think the
Speaker 1: default rate there has increased. It's not enormous, but I
Speaker 1: think it's gone up from like one point four percent
Speaker 1: last year to four percent now. And you've also seen
Speaker 1: some ratings downgrades there, although you've seen a lot of
Speaker 1: upgrades in the junk bond market. But anyway, when you
Speaker 1: observe what's going on with defaults in the broadly syndicated market,
Speaker 1: what are you thinking about how that will feed through
Speaker 1: into the private credit market. And also, you know you
Speaker 1: mentioned illiquidity previously, is a lot of private credits resilience
Speaker 1: just down to that illiquidity Because I always think of
Speaker 1: liquidity as both a pro and a con right.
Speaker 3: You pay up, you.
Speaker 1: Pay a liquidity premium so that you can get rid
Speaker 1: of things if you need to. But on the other hand,
Speaker 1: if there is financial distress and some thing's a liquid
Speaker 1: maybe you don't have to take your on it as soon.
Speaker 1: Maybe you have more time to work something out with
Speaker 1: the issuer.
Speaker 4: Yeah, so a lot embedded in that question for sure.
Speaker 4: But you're right, so you know, with rates rising, you know,
Speaker 4: call it over five hundred basis points in eighteen months.
Speaker 4: Of course, that is going to pressure these companies right there.
Speaker 4: You know a lot of these companies were financed and
Speaker 4: the capital structures were put in place when rates were
Speaker 4: close to zero. So I think it really comes down
Speaker 4: to what does your portfolio look like from an underlying
Speaker 4: industry perspective, from a quality perspective, are these companies equipped
Speaker 4: to deal with that? And I think some are more
Speaker 4: than others. When I look again at our portfolio because
Speaker 4: of the sectors that we focus on, these sectors tend
Speaker 4: to be higher EBADAM margin businesses, So you're starting from
Speaker 4: a good place from a cash flow perspective. And again
Speaker 4: it comes back to cash flow, and so these sectors
Speaker 4: tend to be lower cap X, lower working capital from
Speaker 4: a you know, cash outflow perspective, because their asset light,
Speaker 4: they're more, they're tech, their service oriented, and so they
Speaker 4: are generating a lot of cash flow which helps them
Speaker 4: cope better with you know, the higher rate environment. All
Speaker 4: that being said, I think the other thing that we
Speaker 4: take a lot of comfort in is something that you know,
Speaker 4: we talk about a lot, which is loan to value.
Speaker 5: And so when we look at.
Speaker 4: A capital structure today or one that was put in
Speaker 4: place even a couple of years ago. The vast majority
Speaker 4: of the capital structures that our sponsor backed again are
Speaker 4: financed with equity, not debt. So if you just rewind
Speaker 4: and think about the history, right in two thousand and seven,
Speaker 4: the capital structure set up of a typical LBO was
Speaker 4: mostly debt, right, and the equity was a small portion
Speaker 4: of it, so it was really more of an equity option,
Speaker 4: whereas today equity comprises the vast majority of the capital structure,
Speaker 4: meaning that the private equity firms have a lot more
Speaker 4: at stake, right. And so when you think about what
Speaker 4: that means, you know, one percent, two percent, five percent
Speaker 4: change in interest rates, that dollar cost of supporting that
Speaker 4: company is pretty small relative to the equity dollars. And
Speaker 4: just to give an example, because I think it brings
Speaker 4: it to life a little bit, if you think about
Speaker 4: a billion dollar capital structure that's financed with three hundred
Speaker 4: million dollars of debt and seven hundred million dollars of equity,
Speaker 4: and that's a typical capital structure that we're seeing today.
Speaker 4: If you have interest rates go up by one percent,
Speaker 4: that's an extra three million dollars of interest expense, so
Speaker 4: or maybe went up five percents. That's fifteen million dollars
Speaker 4: of extra annual interest expense, but that's still such a
Speaker 4: small amount compared to that seven hundred million of equity
Speaker 4: that a private equity firm has at stake. So again,
Speaker 4: unless the business is fundamentally broken or really, you know,
Speaker 4: just a disaster, they're very inclined to feed it and
Speaker 4: support it to preserve the equity.
Speaker 5: Value that they have.
Speaker 4: And I think that speaks to the second part of
Speaker 4: your question, which is around default rates and thinking about yes,
Speaker 4: clearly defaults have picked up in the syndicated market, you
Speaker 4: haven't seen it pick up materially and the direct lending market.
Speaker 4: And I think a bit of that is what you said,
Speaker 4: which is, you know, illoquidity, and therefore it's not as
Speaker 4: much out there. That data probably isn't as strong. But
Speaker 4: I think a big piece of it, and probably the
Speaker 4: bigger piece of it, is the fact that kind of
Speaker 4: back to the dynamics that I talked about before, is
Speaker 4: that the relationship between the lenders and the sponsor, that
Speaker 4: more flexible capital structure allows people to work through things
Speaker 4: a little bit more effectively and therefore don't end up,
Speaker 4: you know, as frequently in kind of a default scenario.
Speaker 1: Yeah, that's my impression as well, just looking at the
Speaker 1: wider market, What is your impression of how much froth
Speaker 1: is out there in private debt? Because I wouldn't expect
Speaker 1: you to say that, you know, New Mountain has underwritten
Speaker 1: a bunch of frath details or something like that. But
Speaker 1: I remember no. But seriously, I remember in the leverage
Speaker 1: loan market in like I guess this must have been
Speaker 1: circa thirteen or something. I remember going to the office
Speaker 1: of a certain Swiss bank that doesn't exist anymore. And
Speaker 1: that's one reason why I feel comfortable now telling the story.
Speaker 1: But also I think I've told it in public before.
Speaker 1: But I went to the office of this leverage loan
Speaker 1: guy and he had a shirt that was framed in
Speaker 1: his office with a little plaque that said I stole
Speaker 1: this shirt off my client's back, which is pretty amazing.
Speaker 1: But you know, this was the time when the leverage
Speaker 1: loan market was booming. There was a lot of concern
Speaker 1: about deterioration and quality more risk embedded in these deals.
Speaker 1: Have we seen a similar dynamic in the private debt market.
Speaker 4: I don't necessarily think so. I mean, if you go
Speaker 4: back just a couple of years. You know, certainly twenty
Speaker 4: twenty one probably felt a little bit more like that
Speaker 4: environment where you know, rates were low, leverage was high,
Speaker 4: it was a competitive environment for the direct lenders, and
Speaker 4: you know, spreads were a lot lower, and so you
Speaker 4: kind of had a little bit of a dynamic where
Speaker 4: everything was kind of peak peak. But I do think
Speaker 4: we've kind of come off from that quite a bit.
Speaker 4: I think, you know, just the volatility in the markets,
Speaker 4: the fact that the syndicated market had been closed for
Speaker 4: big chunks of time, and just overall deal flow had
Speaker 4: come down so much given the rise in rates, And
Speaker 4: I attribute a lot of that to just the valuation gap,
Speaker 4: you know, where people are just trying to level set
Speaker 4: as to where valuation should be in an environment where
Speaker 4: base rates are five and a half percent, and you
Speaker 4: have a dynamic where buyers don't want to pay those
Speaker 4: high prices anymore and sellers don't want to sell at
Speaker 4: prices below those peak levels. So you've definitely had a
Speaker 4: little bit more of a pause I think in the
Speaker 4: market over the list likes the housing market.
Speaker 2: Yeah, absolutely, Speaking of twenty twenty twenty twenty one. In
Speaker 2: other credit conversations, there's a lot of there's a lot
Speaker 2: of talk about firms taking out a bunch of debt,
Speaker 2: refining their own debt, terming out the debt, and we
Speaker 2: talk about this maturity wall that's coming out. But I
Speaker 2: guess in private credit, if it's all flow, that's not
Speaker 2: really the same phenomenon doesn't really exist in there. There's
Speaker 2: not going to be some day when companies that you
Speaker 2: interact with suddenly resets.
Speaker 4: Well, I would say that you know these are still
Speaker 4: you know, have a finite life on them, these underlying loans, right,
Speaker 4: so they're typically six seven year loans, and so but
Speaker 4: you're right, the maturity wall that exists on the syndicated market,
Speaker 4: there's I think almost a trillion dollars of debt coming
Speaker 4: due by the end of twenty twenty six. That's going
Speaker 4: to create in my mind, that's going to create a
Speaker 4: lot of opportunity for the private credit market because, as
Speaker 4: I talked about, the direct lending market has taken share,
Speaker 4: and so as those deals come up for refinancing, a
Speaker 4: lot of those are going to need to be get
Speaker 4: you know, taken out with a direct lending solution. And
Speaker 4: we've seen some of that happen already right, there are
Speaker 4: large syndicated loans that have been taken out with very
Speaker 4: large direct lending loans. There was a five billion dollar
Speaker 4: one earlier this year, which is huge in the realm
Speaker 4: of private credit, and so I think that, if anything,
Speaker 4: it'll create more of opportunities.
Speaker 1: That So you mentioned the maturity wall, and we are
Speaker 1: obliged to say the looming maturity wall. I feel like
Speaker 1: we cannot have a credit market discussion without mentioning the
Speaker 1: maturity wall. But also we cannot have a private debt
Speaker 1: discussion without mentioning the term dry powder, which you already have.
Speaker 1: So I guess my question is a how much dry
Speaker 1: powder is actually out there, and then be on the
Speaker 1: topic of sponsors and their behavior and their goals and
Speaker 1: targets and how those might change. Would there ever be
Speaker 1: a time where you do get this pressure where the
Speaker 1: entire industry sort of needs to get out, Maybe they're
Speaker 1: mandated to exit, maybe there's a wider macro thing happening,
Speaker 1: and you're not as able to roll all this stuff over.
Speaker 4: Yeah, so you're right, we do spend a lot of
Speaker 4: time talking about dry powder. I do think it is
Speaker 4: a tailwind for our industry. So the way I think
Speaker 4: about the numbers or maybe a little bit dated, but
Speaker 4: for private equity, I think there's about five hundred and
Speaker 4: eighty billion dollars of dry powder, the funds that they've
Speaker 4: raised that they need to deploy. And again, we're coming
Speaker 4: out of a period of time that's been relatively low
Speaker 4: from a deal volume perspective, so there is some pressure
Speaker 4: to deploy that capital. Right, they raise it and they
Speaker 4: need to deploy it and generate attractive risk adjusted returns.
Speaker 4: But I think also importantly, and something that I think
Speaker 4: gets talked about less, is the need for private equity
Speaker 4: firms to return capital to LPs. And so whether they're
Speaker 4: deploying or whether they're returning capital by selling companies, both
Speaker 4: of those events create opportunities for us as lenders to
Speaker 4: finance deals. And so when I think about credit and
Speaker 4: private credit dry powder, again there's not great data around this,
Speaker 4: but one number that I saw was there's about one
Speaker 4: hundred billion of private credit dry powder. You know, when
Speaker 4: I think about sponsor back direct lending, we're still a
Speaker 4: very small percentage of the dry powder of our clients,
Speaker 4: and they've been raising money, you know, a faster pace
Speaker 4: even than the private credit market has grown, and so
Speaker 4: I think it ultimately creates a good backdrop and a
Speaker 4: good opportunity set for us to deploy capital into this environment.
Speaker 2: Is there a lot of room for private credit to expand?
Speaker 2: Is the share of credit markets absolutely? Where would where
Speaker 2: would that be?
Speaker 5: Yeah?
Speaker 4: So during COVID and during these like peak volatile moments
Speaker 4: when the syndicated markets have been closed, direct lending and
Speaker 4: private credit has gained a.
Speaker 5: Lot of market share.
Speaker 4: And that's not to say, you know, I don't expect
Speaker 4: that will have as an industry, I have one hundred
Speaker 4: percent market share forever by any stretch. But you know,
Speaker 4: one interesting way to think about it is if you
Speaker 4: look at our private equity business, because we issue a
Speaker 4: lot of debt or you know, prolific issuers of financing
Speaker 4: as part of our private equity business, we used to
Speaker 4: be one hundred percent syndicated in terms of the types
Speaker 4: of deals that we would do for our private equity deals.
Speaker 4: Then maybe five or so years ago is probably about
Speaker 4: fifty to fifty And now we're doing pretty much exclusively
Speaker 4: only direct lending deals. So we've seen that market share
Speaker 4: capture even in our own experience, and so I do
Speaker 4: think that is something that will continue and it'll ebb
Speaker 4: and flow with just you know, the overall market dynamics
Speaker 4: and how open the syndicated market is, how attractive deals
Speaker 4: are getting priced there. But right now, you know, I'd
Speaker 4: say the syndicated market is open, but it's a pretty
Speaker 4: tight box as to what can get done from a
Speaker 4: syndicated perspective. You need a certain rating in order to
Speaker 4: do it.
Speaker 5: You know, you.
Speaker 4: Need a certain credit story and loan to value to
Speaker 4: kind of access that market, and you need a certain
Speaker 4: size because liquidity is important in that market. So for
Speaker 4: all of those reasons, I think, and for the reasons
Speaker 4: that I talked about before as to the benefits of
Speaker 4: direct lending, I think that market share shift will continue
Speaker 4: to occur.
Speaker 1: Do you see banks responding to competition from the private
Speaker 1: debt market, Because if we think of leverage loans and
Speaker 1: you know, corporate bond issuance, these are extremely lucrative businesses
Speaker 1: for an investment bank. I can't imagine that they're going
Speaker 1: to sit idly by as they watch, you know, more
Speaker 1: and more issuers issue in the private market.
Speaker 4: Yeah, it's a great point. We've seen some of the banks,
Speaker 4: not all, but a good portion of them set up
Speaker 4: their own little direct lending businesses that are on their
Speaker 4: balance sheets, basically, I think, to your point, to offset
Speaker 4: some of the revenue that they've lost from syndicating loans
Speaker 4: or syndicating bonds.
Speaker 5: And so we'll.
Speaker 4: See how that evolves, because then to some extent they're
Speaker 4: competing with some of their clients, right.
Speaker 5: But I do think.
Speaker 4: They've had, to your point, address it by kind of
Speaker 4: setting up their own capabilities so that when a private
Speaker 4: equity firm approaches them and says, okay, we want to
Speaker 4: finance this, they can offer two solutions. They can offer
Speaker 4: what does the syndicated path look like and what does
Speaker 4: the direct lending path look like, and they can have
Speaker 4: confidence as to how to really show those two paths
Speaker 4: and how to price it, knowing what their own direct
Speaker 4: lending business would do.
Speaker 2: I want to come back to something you said, you know,
Speaker 2: I think it was about what is the appeal from
Speaker 2: the perspective of the investor of private credit. You mentioned
Speaker 2: in some cases lack of correlation to other markets, and
Speaker 2: this is of course Tracy sort of hit on this,
Speaker 2: but also this is sort of people get very cynical
Speaker 2: about this point when it comes to private markets, whether
Speaker 2: it's VC or PE, and they say, yeah, it's uncorrelated
Speaker 2: because they don't have to change the prices and there's
Speaker 2: no market. And of course the fundamental economics do go
Speaker 2: up and down, but there's no forcing mechanism. And some
Speaker 2: people think, well, maybe that's a future that you don't
Speaker 2: have to look at a line on a chart that
Speaker 2: went down, which is never a pleasant thing. Is that real?
Speaker 2: Do people really like private assets in general? Because they don't.
Speaker 2: On a day when you know, their stock portfolio may
Speaker 2: fall two percent, their private assets were flat on that.
Speaker 5: It's a it's a fair point.
Speaker 4: I mean, I think some of it you can just say,
Speaker 4: you know, for private assets, you're just kind.
Speaker 5: Of ignoring the endoring agnoring, So I hear you.
Speaker 4: But I do think that still, you know, the the
Speaker 4: inherent nature of it is that the direct lending market
Speaker 4: or some of these other private markets, like they don't
Speaker 4: react in as volatile of a way or as quickly. Right, So,
Speaker 4: like I think about you know, the you know, the
Speaker 4: the price for a typical unitronch loan. I'll just use
Speaker 4: this as an example, like over the past ten years,
Speaker 4: the range of price of spreads for a unitronch loan
Speaker 4: has probably been anywhere from sofur plus five twenty five
Speaker 4: to seven hundred. So it's a it's a wide range,
Speaker 4: but not not so dramatic, right, And so depending on
Speaker 4: where we are in those kind of ebbs and flows
Speaker 4: of the equity markets, of the you know, the public
Speaker 4: credit markets, you know, you're seeing a little bit of movement,
Speaker 4: but you're not seeing the same spikes or the same valleys,
Speaker 4: and so I do think it offers a little bit
Speaker 4: of inherent protection. And again I think also in terms
Speaker 4: of the lenders, you know, we continue to show up
Speaker 4: and to be there, whereas again the banks can kind
Speaker 4: of pull in and out of the market a little
Speaker 4: bit more aggressively.
Speaker 1: So just on that topic, I realized we've had this
Speaker 1: entire conversation without actually talking about regulation. And I mean,
Speaker 1: to some extent, the boom in private credit has been
Speaker 1: by design of the regulators. So post two thousand and eight,
Speaker 1: they wanted to squeeze out a lot of the riskier
Speaker 1: stuff from the banks and into the so called shadow
Speaker 1: banking market, which includes things like BBC's private credit funds.
Speaker 1: Do you worry at all that they'll maybe start to
Speaker 1: take a closer look at the private debt market, and
Speaker 1: I think there have been some sort of rumblings around this,
Speaker 1: But how are you thinking about the sort of I guess,
Speaker 1: regulatory arbitrage question between the banks and private credit.
Speaker 4: Yeah, so, I mean you're right that I think a
Speaker 4: lot of the growth of the industry has somewhat stemmed from,
Speaker 4: you know, just the change in regulation and the fact
Speaker 4: that the banks kind of were somewhat prohibited from maybe
Speaker 4: doing some of the things that they used to be doing.
Speaker 4: But at the same time, I think there's a lot
Speaker 4: of other reasons for the growth of the private credit
Speaker 4: asset class. When I think about the inherent riskiness of
Speaker 4: the asset class, I think it's a very different story
Speaker 4: than you know, the banks or some of these other
Speaker 4: more higher levered structures, right because as a BDC, for example,
Speaker 4: we're limited as to how much leverage we can incur,
Speaker 4: so we can be max. Two times debt for every
Speaker 4: one part equity. So that's not very levered in the
Speaker 4: scheme of things, and most BDCs, including ourselves, run way
Speaker 4: below that. So you compare that to you know, other
Speaker 4: again financial instruments where you're ten times levered or forty
Speaker 4: times levered.
Speaker 5: That's just a lot less risk in the system.
Speaker 4: And as a result, you know, sure there might be
Speaker 4: more regulation or there might be more focus around it,
Speaker 4: just as the ass that class becomes a little bit
Speaker 4: more institutionalized. But it's hard to attack of underlying fundamentals
Speaker 4: necessarily because you know, we're lower levered. You know, we're
Speaker 4: pretty matched from an asset and liability standpoint, from a
Speaker 4: term point of view. You know, again, we're also largely
Speaker 4: matched from a floating rate perspective. A lot of our
Speaker 4: liabilities are floating rate, so there's a lot of inherent
Speaker 4: safety I think in a lot of the structures of
Speaker 4: the private credit market. So it is a little bit different,
Speaker 4: But that's not to say, you know, we won't see
Speaker 4: more regulations. I can definitely imagine that we will.
Speaker 1: Yeah, I'm getting I'm getting flashbacks to covering BDC's for
Speaker 1: the ft, and I think there was a discussion about
Speaker 1: raising the leverage limits and maybe they did it.
Speaker 4: They did, they did exactly, Yeah, but raising it from
Speaker 4: one time's debt equity to to two times, right, so
Speaker 4: it's just still not very highly levered.
Speaker 1: All right, Well, Laura, that was an incredible conversation, a
Speaker 1: really good entry point to the private credit market. As
Speaker 1: I said before, I suspect we're going to be doing
Speaker 1: more on this, but appreciate you coming on all thoughts
Speaker 1: and explaining the market to us.
Speaker 2: Of course, that was great. That's exactly what we needed. Yeah,
Speaker 2: that was exactly the conversation we need.
Speaker 3: Thank you so much, Thank you, guys, Joe.
Speaker 1: I feel like we should go out to the private
Speaker 1: debt market and raise some capital. How much was the
Speaker 1: dry powder? Like five hundred and eighty.
Speaker 3: Billion, Yeah, let's do it.
Speaker 1: Yeah, it seems like there's a lot of money out there.
Speaker 1: But I thought that was a really interesting conversation, a
Speaker 1: good introduction to the market. There are a couple things
Speaker 1: that stood out to me. So one thing I've been
Speaker 1: thinking about a lot recently. I think everyone's been thinking
Speaker 1: about this, but to what degree the economic landscape has
Speaker 1: changed in recent years? And I think maybe the evolution
Speaker 1: of the debt market, which includes this boom in private credit,
Speaker 1: is an underappreciated one. And if you think that, sodly
Speaker 1: you have this market that's the same size as the
Speaker 1: junk rated bond market, but is more able to be
Speaker 1: flexible with issuers you know, has more of a tendency
Speaker 1: towards workouts and things like that. Then maybe it explains
Speaker 1: some of the reason why we haven't seen such a
Speaker 1: huge impact from interest rate hikes just yet, Like maybe
Speaker 1: that resiliency is coming from not just the workouts, but
Speaker 1: also maybe some of the illiquidity that Laura mentioned. You know,
Speaker 1: this idea that you're not under as much pressure as
Speaker 1: maybe a public vehicle.
Speaker 2: My mind went to the same place with the workout.
Speaker 2: I guess we also talked about this in housing, although
Speaker 2: there's been no housing distress in a long time, but
Speaker 2: of course there's that infrastructure that got built up after
Speaker 2: the Great Financial Crisis to work out mortgages. So it
Speaker 2: made me wonder if just the credit industry in general,
Speaker 2: after the credit crisis, after the crisis in two thousand
Speaker 2: and eight two thousand and nine, just has deeper in
Speaker 2: its DNA ability to avoid foreclosures or avoid defaults of reasons.
Speaker 1: Well, I guess we'll find out, right.
Speaker 2: Yeah, well when though I don't know, Yeah.
Speaker 1: That's the question. One other thing I would say, just
Speaker 1: on the ill liquidity point is I think it was
Speaker 1: Perry Merling's quote, but this idea that you know, liquidity
Speaker 1: can be your friend until it kills you. Yeah, and
Speaker 1: then it kills you pretty quick. Oh yeah, And so
Speaker 1: I guess like that's the sort of doom scenario for
Speaker 1: private credit. Although again, you know, five hundred eighty billion
Speaker 1: of dry powder sounds like a pretty big cushion to
Speaker 1: prevent that from happening. So I guess we'll see.
Speaker 2: We'll see. No, that was great, And now when I
Speaker 2: follow it, or now when I read about it, I
Speaker 2: feel I can at least attempt to track the trajectory
Speaker 2: of this space.
Speaker 3: Excellent.
Speaker 1: Don't go chasing a payment waterfalls, Joe.
Speaker 2: That's a good one. You just make that up.
Speaker 5: I did.
Speaker 1: Yeah, I don't know why. All right, shall we leave
Speaker 1: it there?
Speaker 2: Let's leave it there.
Speaker 3: Okay.
Speaker 1: This has been another episode of the ad Thoughts podcast.
Speaker 1: I'm Tracy Alloway. You can follow me at Tracy Alloway.
Speaker 2: And I'm Jill Wisenthal. You can follow me at the Stalwart.
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