Talk Your Book: A $20 Trillion Dollar Market Opportunity

0:00Today's Animal Spirits Talk Your Book is brought to you by Stepstone Group. Go to stepstonegroup.com to learn more about their brand new StepStone private credit income fund, Credex. That's stepstonegroup.com.

0:33upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:44Welcome to Animal Spirits with Michael and Ben. Michael, we're hitting on the fads. I guess not fads. Fads is too strong of a word, but the trends. And this is a trend that it just seems like it's been growing and growing and growing. You mean the soup du jour? And yes, we've had more conversations about this with private credit. And it's certainly not going away, this asset class or strategy, whatever you want to call it. Yeah. I think this is timely because there's a lot of articles in the media about private credit and what's going on there. And being able to have a 40-minute conversation and really drill down and ask follow-ups, I think is helpful to bring context to this.

1:25it's certainly, it's far from a new asset class, but it is certainly the one that is, it is probably the balance between like popularity and familiarity is one-sided. So I think this conversation helps to level that. And I think it's important to have a nuanced discussion, especially for advisors between like, look at the yield. Oh my gosh, this is amazing. Versus what happens when this calamity blows up or whatever. And those are the two sides that you're hearing now. It's good to have you have more nuanced, context-based, thinking through the risks, thinking through the returns, thinking through the structures.

1:59I think that's helpful. So we talked to Bob Long, who is the CEO at StepZone Private Wealth. We've talked to Bob before about different alternative asset classes, although he did say he does not consider private credit an alternative asset class. I wish we double-clicked on that, as they say in the podcast business. Yes, he set us up, and we didn't take it. But Bob gives a deep dive. We push back a little bit. There's back and forth. I think this is a great conversation. So here's our talk with Bob Long from Stepstone.

2:29Bob, welcome back on Animal Spirits. Thanks for coming on. My pleasure. All right. Today, we're going to be talking about the hottest topic on Wall Street. That is private credit. For those who maybe are outside the industry that aren't seeing a flurry of emails hit their inbox like I am, introduce the concept. I think a lot of people are familiar with private equity, but what is this private credit that we keep hearing about? First of all, I got to start by thanking you guys for having me on for a fourth time. You know, this is the fourth. We could be brought by the number four, if you will. It's four years, four billion of AUM and fourth fund.

3:04I'm keen to get a fifth fund because I assume you're like SNL and then I get a fifth fund jacket. But we'll see there when we get there. I think Steve Martin was the first one who got it. He was. There's a long list of people that I'm generally compared to, you know, like Steve Martin, and Scarlett Johansson, Tina Fey, but we'll get to that. Private credit. So private credit is the least alternative of the alternative assets. In fact, I could argue you shouldn't even put it in the alternative assets bucket, but we're a private market specialist. We do private equity, private credit, private real estate, private credit.

3:42And it's grown dramatically recently as you envisioned. But what it really is, is today's version of lending. So a direct and private credit's a big term. And within that, there's a smaller subset that's most of private credit. And we'll talk about the other subsets, which is direct lending. And direct lending is simply a private equity company. Private equity fund buys a company, puts down 50 or 60 percent equity and borrows the rest. Historically, they often borrowed that from banks who syndicated that loan. That market is smaller today because private credit funds or direct lending funds, like Credex, have filled that gap as banks have become more in the distribution business and less actual investors.

4:27Or some people would say they're in the moving business, not the storage business. Private credit has filled that gap. These loans are generally floating rate loans with a five to seven-year tenure. They generally have covenants. And they're today at call it a 50 % loan to value. So it's just another source of income for investors that we seek to provide in the way we provide access to other asset classes for individuals on the same terms as institutions. The way that people think about private credit, depending on which side of the eye you stand, some people are like, this is amazing. We can get higher yields and it's lovely.

5:02And other people on the other side are saying, no, no, no, wait, wait, wait. When a recession hits, this is all going to blow up and just wait, it's going to happen. Where do you fall in the lines of this is the greatest thing in the world or no, this is going to be the next big subprime lending? He's asking the barber if he needs a haircut. True. He's asking. Michael doesn't need one. The title is Talk My Book, as I recall, but I'm not going to do that because you guys know me. Every investment has risk. Plenty of capital has flowed to this sector. A couple of observations. Most of my career in private equity, private markets, which is pretty long here at age 62, the equity check put in, therefore, the amount of equity that a private equity sponsor puts in a deal is quite high by historical standards now.

5:50It's 50, 60 % of the deal. I very much remember the days when it was 20 or 30%. So less leverage, de-risked. much less leverage. And therefore, that is a margin of safety or protection for lenders, the industrial logic of which is frankly hard to argue. I think the underlying your point is that a lot of money has flowed to private credit. And that's true, but that's because a lot of bank money has left. So banks were historically 70 plus percent of this market. Today, they're 20 plus percent of this market. Plus, private equity has grown dramatically as it has reached further corners of the private markets.

6:31And frankly, it's a whole other conversation. Being public is just not as necessary today. There's more need for private equity-backed companies, create more need for private debt. We think the market is, call it$3 trillion for private debt, and there's about a billion six, a trillion six or a trillion seven, 50 or 60 % of that market today is served by dedicated funds. So yes, a lot of capital has been raised, but we believe there's substantial space to grow and the loan to values are a very strong protection. So more equity, less debt, less leverage. I know we're going to talk about the credit side, but on the equity side, while you're having less debt, which is theoretically a good thing, the valuations has also been floating higher over time.

7:16So part of the arguments for private equity success back in the 80s and 90s is that they were getting much lower multiples for these deals. And as you mentioned, as capital has come flooding in, a natural byproduct of that is valuations rising with the infusion of capital. Can you talk about that side of it? Well, we need charts and graphs and a whole conversation, I think, to go through that. But But overall, multiple levels are not at highest today. They are not at all time highest today. And when you look at certain sectors in the technology sector, for example, that dominates the public markets, you will often see valuations in the public markets materially higher, materially higher than the private markets.

7:58And it's not just tech. I'm thinking about an insurance company that we own that happens to be based here in Charlotte, where I am. and its key public insurance brokerage firm. Its key peer is a public company that is valued significantly differently. I like the private asset in that example. But we're getting into a broad macro. I think the big takeaway is private credit has grown, but it has covenants, it has a reasonable loan to value, and it has a piece we haven't talked about. Private credit lenders are generally principals, not just agents. And investors see the benefit of investing along someone who's going to hold the loan through the maturity, someone who has expertise in the individual sector.

8:45So we've got a team of 65 plus people. And within that, we've got sector specialists in technology, industrials, pick your sector. So when the general partner comes to us with a loan, with a proposal to buy a company, we understand that space. We understand what can go wrong. We understand what can go right. We understand the valuations. And we're going to hold that loan. So that's really beneficial, I think, to the whole ecosystem. So money coming in is not just from investors that are attracted by the higher coupon payments, although that's certainly part of it. It's also to fill the need for capital.

9:23Ben, what was that stat from Torsten Slock? Was it 85 % of companies that generate$100 million in revenue are private? Am I getting that right? Close enough. Yeah, you're in the ballpark. It's in our deck. I can quote it for you. It's 87%. And here's the number. 87 % of companies of size and scale, 100 million of revenue. So we're cutting out all the mom and pop businesses. 100 million of revenue are private. Wow. Half the number. If you're only selecting from public stocks today, you have half the choices you had 10 or 15 years ago. And that trend is not going in your direction. So the private markets have just substituted for the public markets in ways that I think we've talked about before and direct lending as a follow on trend of that.

10:13So why can't these companies just call JP Morgan and ask for a loan? They can. They're going to pay a very high price. And JP Morgan's not going to respond as a principal with committed terms quickly. So the bank market still exists. Those deals will get a little technical here. Those deals will tend to have market flex. Trust you guys are familiar with that. I'll explain that to the audience, the bank. All right. I'm a stranger to the gym, Bob. I flex all the time. Yeah, we're in SNL world, so we could have some Hans and Franz jokes here. My two favorite characters from SNL. All right, market flex.

10:51Bank writes you a commitment letter and says, yes, I'll provide this loan to you at X terms. But if the market isn't there for me to lay it off, well, I need this flexibility to do X and Y. And of course, it's subject to credit committee, et cetera, et cetera. So direct lenders like ourselves benefit from speed, certainty, expertise and deep relationships. And what we've seen is even in a competitive market, and I don't want to pretend it's not, or that the general partners don't have very sharp pencils when pricing this debt. They do. They value speed, certainty, relationships, expertise, being able to deal with one or two parties, not a syndicate, who will have to approve any covenant waiver or any amendment or any tweak.

11:40They value those things. And thus today they're paying base rates, which today is SOFR as opposed to LIBOR. These are floating rate loans, if I wasn't clear on that. Base rate plus five to seven hundred basis points. and they are submitting themselves to covenants and sometimes prepayment fees and that sort of thing too. So these are very attractively priced, we believe, in terms of the risk. And that, of course, is an attractive investor. The yields look amazing to investors. So you said plus five to 700 basis points. We're talking, I guess, I don't know, eight to 12 % yields or something like this.

12:16So my question is that yield for the investor is also the debt burden for the company. So how are companies managing to pay double-deed interest rates on their debt? How do they survive that? Jim O' Importantly, higher cost of debt has flushed out marginal private equity deals. That's the first thing to understand. So that higher hurdle rate has made it so they're a little more selective is what you're saying? Jim O' They have been much more selective. And I think net-net for the industry, that's a very good thing. But clearly, the deals have to pencil out, right? Companies have to. Private equity firms are still seeking to hit their historical rates of return, and they can do it with this cost of debt if they achieve the operational improvements they seek to with those companies.

13:01Do you think that, so Jamie Dimon was talking last week, and there was a quote about something going to hell that was severely, severely taken out of context and made it appear much worse than it actually was. That's really not what he was saying. But what I gathered from his comments, and I don't know if you heard them or not, was it sounds like he's a little bit jealous that JP Morgan is not in this business in the way that they might want to be, given the capital requirements of these giant financial institutions. They just can't move as quickly. They don't have the flexibility. Do you think that's some of what's going on from the bank's point of view?

13:33Absolutely. The Dodd-Frank and the other capital regulations that have been imposed on banks make it harder for them to do more leveraged transactions. Also, just think about the way banks are staffed, right? It is an agent mentality, not a principal mentality. And this is an asset class that's better suited to a principal mentality, to buy and hold, to be accountable and responsible for the outcome of that loan, whether it pays back on time and in full. And so banks are just not in that position today. They don't have five and six and seven year compensation plans the way we do and private equity firms do.

14:07So it's just different. And by the way, what we're talking about here is a minor part of the shift that I've seen over 30 or 40 years away from banks as principals to banks as agents. This is just a part of it. How much of this too was just the regulations after the 2008 crisis that banks got pushed out of this? How big of a part of it is that? Very meaningful, Ben. Very meaningful. Older news, if you will. So not something people talk about as much. But sort of the base bump that sort of came in that 12, 13, 14 time frame was largely driven by that. And many of these firms got into the direct lending business at that time or since then.

14:49One of the things I'm proud to say about us is we've been in the direct lending business much longer for more than 15 years. and have a very deep track record with people who've been investing together for that and have actually seen a cycle. So I would encourage your listeners, whether it's our fund, any fund, any credit fund, make sure you're looking at the tenure of the senior leaders, the decision makers, have they invested through a cycle? You know, we're living in a world today, it's not brand new, you know, two or three years ago when rates, two years ago, rates started increasing. You had many, many investment professionals, certainly most, maybe not most senior, but most bodies who never seen rising rates.

15:31I had only seen a declining rate in Burma. And it's very important when you're evaluating a credit fund, because remember, with credit, your upside is you get your money back. Therefore, you get your money back plus interest. Minimizing downside, evaluating risk, and therefore we believe being extremely diversified are critically important to any credit product and particularly a direct lending product. So who is higher rates hurting? Because it's benefiting the private credit lenders. Is it hurting the private equity borrowers? Let's talk about who it benefits. I think it benefits savers. I mean, anyone who's saving, if you we lived in a world I graduated college in 1984 and basically rates more or less trended down for most of my my working career.

16:22And that hurt savers. You know, it hurt retirees. It hurt people in those categories. And while equities benefit from very, very low rates for a long period of time. So we're in a reset world. Credit is important. You can earn attractive returns with credit. I believe attractive risk adjusted returns in credit. And so it's getting a lot more attention to that. Another area that's getting attention is the structure of these funds, which if listeners take anything away from this conversation, it should be that these are long duration, for the most part, relatively illiquid assets. This is not a cash equivalent.

17:02This is not something that you can get your money back tomorrow. And there's been stories popping up in the media lately about investors wanting their money back and not being able to do so. So talk about the structure of this fund and what can potential investors or what should they know before they even think about looking at something like this? I think it's a really important question. Thank you for asking. First and foremost, we focus on educating investors and I believe our quality peers do so. I believe the mainstream press has misrepresented the understanding level of the average investor in a semi-liquid fund.

17:38And that's what we offer, our four funds, S-prime, spring structure that we've talked about on the show and now Credex. These are semi-liquid funds. They sit between your daily traded exposure that you can sell every day. And there are publicly traded credit funds. You can sell them every day, but you may not like the price because they will sell at less than net asset value frequently. With a semi-liquid fund, it's a compromise. It's a hybrid. You get most of the benefits of illiquidity and you get quarterly liquidity, generally for 5 % of the fund, not of your investment, but of the fund. And I believe, despite the press's reports, including this weekend, that the vast, vast majority of investors fully understand that.

18:26I would agree with that, by the way. They price, they size their position accordingly. They understand that to get these sorts of returns, historical returns. You do have to suffer some or deal with some illiquidity. We're not magicians. We're not alchemists. Neither are our peers. These are hybrid solutions that a vast, vast number of very sophisticated financial advisors and clients are flocking to. You can look at the numbers. We're$4 billion of AUM today. We're raising$200,$300 million a month across our four funds because investors see value in getting most of the liquidity premium and diversification benefits of private assets, getting daily and monthly valuation so they know what they have.

19:12They avoid capital calls and distributions. Talk about that some more, put that to the side for now. And they can get out quarterly at 100 % of NAF. So 5 % of the fund means most of the time, not forever, not every single quarter for the next 20 years, most of the time, most investors will be able to get out at 100 % of net asset value. And the other thing that's misrepresented by the press is that if Michael and Ben, you guys are in our private equity fund, which offers 5 % per quarter redemptions, by the way, the high has been 1 % to date in that fund, and it's several year track record. If for whatever reason, there's a war, there's an event, and we have 10 % redemptions, 10 % of our investors seek full liquidity, you would each get 50 % of your investment back at 100 % of NAV on a few days notice.

20:09Okay, 50%. And then presumably the next quarter you'd come back, presumably, and you would tender or seek to redeem again. So I think investors understand that. I think there's a high degree of industrial logic. And when you contrast semi-liquid funds with the other ways to gain exposure to these return streams and these diversification benefits, which are the traditional drawdown funds, that in the case of private equity are a 15-year experience. And in the case of private credit are somewhat shorter, probably a 10-year experience from first cash flow to last cash flow. They see value. They see value in semi-liquid, and they see value in the other piece, which is being immediately invested.

20:55In a drawdown fund, you are committed, but you are not invested. Now, you commit$250 ,000 to a private credit fund through your favorite private bank, and they draw that over three or four years. They invest it, and you get it back. With CredX, we manage the cash flows. It is difficult, by the way. We do it well. and all our other evergreen funds, Michael, if you commit today, which you can do this as a daily fund, buy it with a click through your RIA, then we take responsibility to deliver you the returns. We blend your money in with the existing money. You buy into the existing assets. And when you seek liquidity, you're exiting at a net asset value that represents all the assets.

21:39Can you see during the next financial crisis, other private credit structures, if there's something bad happens and there's a flood run rush for the excess for whatever reason that one of these funds is going to be gated and the financial media is going to lose their mind that's probably gonna happen correct first and foremost the word gated is inappropriate it's proration that's what we talked about a gate is when michael runs a hedge fund he tells people that they can get all their money back in a given quarter and then when they all seek to he says ah but look at the footnote where I said I could do a side pocket, right?

22:12Our funds and our peers, including those that have been written up in the press extensively, prorate. You do get your money back in proration. So certainly in the event of a severe crisis, and we've seen this with some real estate funds, but let's remember a big difference between real estate and the other asset classes that we deal with within Steps to Private Wealth. Real estate has publicly traded comparables, or at least the investors believe that they can buy apartments and warehouses in a publicly traded format. They see a certain price, a certain cap rate, and they read across to a private fund, and they believe those are out of sync.

22:57So they see a carry trade. They sell one and buy the other. In the case of venture capital, in the case of private equity, in the case of private infrastructure, that does not exist. In the case of private credit, there are openly traded funds, but I would point you to the frequency with which they trade at less than net asset value, their fee structures, and other features where we believe a private fund makes the most sense or makes sense. I wouldn't say there's no place for the others, but we believe and we're seeing demand for the semi-liquid fund in private credit. I just want to comment that I would agree with you that the way that it is portrayed in the media is obviously hyperbolic.

23:39And it's not to say that the issues that they're talking about are not real issues. Absolutely. But I would agree that most investors, not all, but the vast majority understand what they're signing up for. What they're signing up for is semi-liquidity. And so with that, I'm just curious, let's just assume that in the example you gave, there's 5 % liquidity in any given quarter and 10 % does want the money back. Where does the actual liquidity come from? Because if there's more demand for funds than exists, well, then you have to sell. Ostensibly, if there's a high demand for liquidity, it's probably because something isn't great going on in the economy or specific to your fund.

24:18and in which case you would have to sell at a discount to the prior nav. Can you walk through some of those dynamics? So in the case of a private credit fund, all your assets are generating yield and they have a maturity date, unlike a private equity asset, which in the case of a tough market just gets held longer. So a private credit fund, and specifically one that focuses primarily on direct loans, which is what we're doing, the average repayment on those loans is three years. So you're generating organic liquidity in a private credit fund. You also have a credit facility in a private credit fund.

24:55So you have liquidity from repayments, liquidity from quarterly coupon, and you have a credit facility, all of which make managing liquidity in a private credit fund much, much easier. and to that point, contrast with our venture capital fund, where we only offer 2.5 % per quarter liquidity, because that's what makes sense. Right. So forgive me for focusing so much on the risk side of it, but I think that the returns, the rewards are well known, right? Everybody understands the coupon, the benefits of private credit are very apparent. So in the event, listen, the economy is doing very well by almost any measure.

25:35Companies are healthy, Things are going well. If there were to be a downturn, how would those risks manifest themselves potentially in a private credit type of structure? You would see loans go on watch lists and eventually loans become non-performing. One benefit of a semi-liquid fund that quotes a price daily is that you would see those marks flow through immediately on a daily basis into our net asset value, which also affects our fees, by the way, as it should. And so those adjustments to valuations are where that starts. Over time, in your example, covenants get tripped, deals get restructured, but particularly in a world where the private equity sponsor has put 50 or 60 % equity in a deal, the private equity sponsor is much less likely to walk away.

26:27So Bob, this is the part that I think is really important because this is where some of the arguments happen is that private credit funds would say, we have a much lower default than our publicly traded counterparts. And the public investors would say, come on, what really is happening is the deals are getting restructured. So yeah, they technically might not be a default, but the terms of the original deal are getting extended, which I'm not saying that's a bad thing. It just might not be the whole truth and nothing but the truth. So can you talk about what that part of it looks like? Yes. So recognize today that I am not the portfolio manager and in the weeds on doing individual private credit deals.