Talk Your Book: Public and Private Market Credit Opportunities

0:00Today's Animal Spirits Talkie Books brought to you by the Poland Capital Credit Opportunity Interval Fund, PCOFX. Go to polencapital.com. That's P-O-L-E-N capital.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:43On today's show, we spoke with Ben Santinelli. Ben is the lead portfolio manager of Poland Capital's Credit Opportunity Strategy. He's also a co-portfolio manager of the U.S. Opportunistic High Yield and assistant portfolio manager of the Bankland Strategy. Ben, we've been speaking over the past couple of months a lot about private credit. It's been one of the hottest asset classes of the last couple of years for sure. One thing that's interesting about the conversation that we had today is that this strategy is a go anywhere. Is it go anywhere? I said strategy, I was about to say strategy again.

1:16All right, let's just go with it. It's a go anywhere strategy. It's a go anywhere strategy. So it could invest not just in private credit, but also in public credit. And I thought that was an interesting crossover. Yes, and the fact that he's saying the spreads in private credit have compressed so much that public is actually looking better by comparison. It's kind of like when VC and tech went through their little mini recession there, and people were saying, wait, it makes more sense for me to invest in the public companies down 70 % or 80 % than the private companies, which is interesting. It's also what I was thinking when we were having this conversation is, think about how dire things were for the credit space just a few years ago.

1:54I mean, generationally low yields. There was just, I mean, things were bleak. And then we had to go through this rough patch of rising rates. But now that rates have risen and that baseline rate, as he called it, is higher. There's a lot of attractive opportunities in this space. The credit cycle was weird because, or the rate cycle. Yeah, but it was more of a rate cycle than a credit cycle. That's the interesting thing. Yeah, treasuries got destroyed compared to junk bonds in 2022, right? Which is very unusual to see in a risk-off environment. Yeah, yeah. So yeah, it has been, so we haven't had to deal with the credit side of the situation, which meant that those yields have come up, but they didn't have any blowout and spread.

2:36So things are looking pretty attractive there. At least, I guess, people were until the recession hits. But this was a really interesting talk. So we talked to Ben Santanelli again from Poland Capital about all the different places they're looking for opportunities, the difference between public and private credit and all these things. So here's our talk with Ben.

2:58So Ben, welcome to the show. Your credit opportunities fund is relatively new. I'm curious, was this created because there was demand from clients? Was there a growing opportunity set because rates are higher, some other reason, a little bit of everything? What's the reason for rolling this fund out in recent years? Yeah, sure. So this is a strategy that we've had around since 2010. We have nearly$300 million in that strategy. But the idea behind rolling out the interval funds specifically was to really bring an institutionalized product to a different market, and that's the retail channel. With where base rates are today, when you can get double-digit yields, regardless of where spreads are, that's something that our clients have said they're looking for.

3:46So for the retail channel, it's an opportunity for them to get access to a strategy that we've run for nearly 15 years with some pretty good success. We'll talk about the opportunity set today. You mentioned rates, and obviously that's a big component of the story. But what type of vehicle is the$300 million comprised of? Yeah, so the$300 million vehicle is based on a separate account. We have two separate accounts, and then we obviously have the Interval Fund. All three of them are managed by me. They're the same strategy. And the Interval Fund, obviously, is just a different vehicle for somebody to access that strategy.

4:25For the people who are unaware, and some of our listeners might be, how does an interval fund work? What's the difference? How does that fund structure set up? Yeah, sure. So really the interval fund is just a vehicle for retail investors to get access to illiquid investments that were previously the domain of only institutional clients. So our interval fund, PCOFX, has about$30 million in it. Again, daily subscriptions, quarterly liquidity, or quarterly redemptions capped at 5 % of the NAV. And again, to us, it's no different than managing any of the other accounts in this strategy. It's really just a vehicle.

5:09All right. So just to sum up, you can buy whenever you want, like any mutual fund. Yep. You can get liquidity on a quarterly basis and you can potentially, and correct me if I'm wrong, take out 100 % of your investment, assuming that things are fine and there's no sort of run on the strategy. As long as no more than 5 % of the overall assets wants their money back, you'll get your money back on a 90-day basis. That would be correct. So with the throat clearing setup for the structure out of the way, let's talk about the current environment. You have a couple of really great charts in your brochure talking about the opportunity set today versus where we were in 2021.

5:53And I remember, because it wasn't that long ago, talking about high yield bonds when they were earning, like literally when they were yielding 4%, 4.5%. And it was just like, who is the buyer of this? Unbelievable. Now, obviously, we didn't know what inflation was going to do and what was going to happen to the price of these. But the environment today looks a lot different. So we actually do have high yield and high yield, which is nice. Direct lending as well. You've got a big premium over where we were just a couple of years ago. So why don't we start with the different slices of the private credit market that you all are investing in?

6:28What's the biggest piece? Is it the direct lending? Is it the leveraged loans? Is it something else? Yeah, sure. So in this, you're exactly right. First of all, I'll just hit on this. Two years ago, we were getting paid 5%. Today, for the same quality, same credit quality, we're getting paid 9.5%. So we've been huge beneficiaries of the underlying move in base rates. And that's not just our strategy, but all lenders have benefited from where base rates are. So in this strategy, we have the ability to go up to 50 % in illiquids. But really, what we're trying to do is just find the best relative value in the marketplace, whether it be in bonds, whether it be in loans, whether it be in public credit or in private credit.

7:12And it's that flexibility to be able to toggle between asset classes to find what is the truly the best relative value in the marketplace that's really led to some of the competitive advantages that we have. We're not just dedicated private lending. We're not just strictly high yield bonds or levered loans. I like to hear from portfolio managers talk about going through difficult times. So I'm just curious before we get into today's opportunity set, how did you navigate that environment when high yield bonds were yielding such low levels historically? And I think high yield did okay because spreads never really blew out, but a rising rate environment obviously is bad for bonds.

7:49So how did things shake out with you in the last, call it 18 to 24 months? Yeah. So one of the nice things about that flexibility that I mentioned is we can buy bonds and loans. So we've historically had anywhere from 20 % to 40 % of the portfolio in loans, which are obviously floating rate. So that adjusted effective duration on that portion of the portfolio is muted. It's effectively zero. Wait, Ben, sorry to cut you off, but it's obvious to you. It's not obvious to the listener, maybe. Can you just explain what's the difference between a bond and a loan? Yeah, sure. So a bond is a fixed rate contract.

8:25And generically speaking, a loan is a floating rate contract. So when you're floating rate, you're resetting the interest rate on that security every three months or six months, most of them are three months. So the impact of moves in interest rates on your overall return profile are very muted. And there's a large difference between the credit quality of companies that issue bonds versus companies that take out loans? You know, I think that would probably be a fair statement for the marketplace in general. The way we're looking at credit, you know, it doesn't matter if we're buying a loan or a bond.

9:05What we're trying to do is underwrite high quality businesses at loan to values that are, you know, 50%, 60%. So there's a big equity cushion behind us. And, you know, so the security classification doesn't have nearly the impact or the restrictions on us. We're just looking to find good quality businesses that can generate cash, whether it's a loan, whether it's a bond, again, whether it's public or private, really doesn't make a difference for our strategy. So at what point did you feel comfortable saying, all right, those loans that reset so quickly were great while they worked during the resume environment, now it's time to extend our duration or risk or however you want to put it.

9:47When did that happen for you? Yeah. So Ben, the other thing that I think is important is where we focus the strategy. The strategy is on the lower tier in the middle market. So when you're investing in the lower tier of the middle market, your coupon tends to be higher than the overall market. Today, the coupon on the interval fund is just under 10%. So another impact to that duration move is the fact that when you have a coupon of 10%, 25, 50 basis point moves in underlying rates, they're going to hurt investment grade. They're going to hurt long duration assets. Generically, lower tier middle market is not a long duration asset.

10:30And when you have a coupon that high, the impact from interest rates is very muted. Ben, when you say lower tier, do you mean in terms of the size of the borrower or the credit quality or both? It's really, look, we like to say we don't rely on ratings agencies to determine the level of risk that we're taking. But for the general market, lower quality would probably be single B, double, excuse me, single B, triple C. But those are ratings that a large ratings agency puts on them. It's not generically how we view risk. We view risk more through the lens of loan to value on the overall business, not just debt through a tranche or what the interest coverage ratio is, but really how much is in this entire enterprise worth and what are we lending against?

11:17How much of what you're doing is private versus public markets? So today in the interval fund, we have about 25 % of the account is in what we would deem illiquid investments or private markets. That has come down a little bit. I think that the biggest, there are a few reasons for that. One of them is the illiquidity premium that you're getting paid today in the marketplace. It has shrunk. the private markets have become more institutionalized. There's been a lot of money raised and they've just become more competitive. So historically, when we were getting four or 500 basis point illiquidity premium, today it's probably one to 200.

12:01So again, this is where we find the flexibility to be able to toggle between public and private very beneficial because today you can get, again, where base rates are, you can get liquid securities for relatively the same yield that you can find in the private markets at the same loan to values, and you can pick up that liquidity. So why would you want to allocate just for the sake of allocating to private credit? Volatility. With all that money rushing in though, into private credit, how quickly did that spread narrow? Did that happen really fast or did it take a while to happen? It's happened pretty fast.

12:43I mean, we've been doing private credit or direct lending since the founding of the firm in 1996. It's never been a direct strategy that we have or an independent strategy. We've always maintained that flexibility. But look, the market's grown from basically a nascent boutique into an institutionalized asset class. Today, it's over, I think, a trillion and a half dollars. that has taken less than 10 years. The rise has been pretty dramatic and everybody sees the numbers. Most of those assets are being raised by the top 10 managers. There still is an opportunity in that space for the lower tier, the middle market direct lending that we have historically done, but the 500 to a billion dollar unit tranche deals that are in the marketplace today, I mean, that's really not the market that we're targeting.

13:43Ben, I yelled at volatility and I was only sort of kidding. In fact, I actually wasn't kidding. Like if you said, why would you invest to something illiquid when you can get the same yield in a liquid market? There's an incentive to not show the marks, like the public marks on a daily basis. And you laugh, but that's a big part of the story. Yeah, it's definitely a big part of the story for institutional investors who have boards that they need to report to and want to not have to mark their book, mark to market. I think for individual investors who are sophisticated, who take a relatively long-term view, I don't know if that volatility is as much of a concern, especially when you're generating a coupon of 10 % and a yield of 11.7%.

14:30I think it's a little bit different for institutions than it is for retail. So the question that we have to ask anytime we talk to someone about a fund like this is, what's the plan for a recession? Because that's the thing everyone's waiting for is like, well, we've had this renaissance in credit and all this money's rushed in there, but what happens when the economy turns? Then what then? So how do you think about navigating that scenario whenever it might happen? Yeah, sure. I mean, I think we're preparing for that right now. I mean, we're seeing fundamentals are okay in the marketplace, but we're seeing weakening employment numbers.

15:04Inflation is more under control. And what we've done in this fund and across all of our strategies is we've really become a little bit more conservative. We're moving away from credit risk, locking in some higher quality names that might have a little bit more duration to them. But I think ultimately what it comes down to whether you're investing in public credit, private credit, regardless of the security class, it comes down to underwriting. And are you investing in businesses that generate cash through the cycle and generate enough cash in order to refinance or pay back their debts? And really, it doesn't matter what economic cycle you're in.

15:49If you don't have the right underwriting skills, you're not going to be able to do that. So we have a team that's been together for a number of years, we've worked through different economic cycles. We've worked through different rate environments. So I'm pretty positive on the quality of our portfolio and the names that we've underwritten that have gone in there. And again, this is a portfolio of 40 names. It's truly the best ideas across all of our strategies. So we don't have to pick 200 names to populate a portfolio. We have 40 names in this portfolio. You know, the top 10 names make up 50 % of the portfolio.

16:30It is, again, it's a best ideas portfolio. So that's why I'm pretty confident that those names will be able to see through, you know, whatever type of slowdown or recession is on the horizon. All right, we'll get into portfolio construction in a minute. But before we do, I don't want to leave the topic of the compression in yields. Undoubtedly, it's a function of so much money coming into the market. But do you think that there's also part of it is that just where rates are, like even if there wasn't so much money in rates, I'm sorry, in private credit, that just from rates going from from the 10 year going from 50 basis points up to four and a quarter, wherever it is, 450, that the spread would compress just because if it held constant, the rates that these companies would pay would just be punitive and they wouldn't be able to service the debt.

17:16Is that a part of it? Yeah, for sure. I mean, you've definitely seen a split between really the haves and the have-nots from a company perspective. Companies that had any touch of secular decline to them or over-levered balance sheets, those companies are really, really struggling with this rate environment. You know, then you have other businesses, leisure, capital goods, other names where, you know, they've only been strengthened in this environment because they went into it with relatively strong balance sheets. You know, they've seen a different outcome. So it really has bifurcated the market into haves and have nots.

17:55You know, I would say that when you're talking about, you know, four, four and a quarter percent base rates, you know, that is, it's going to have an impact on everybody. But again, loan issuers probably more susceptible because they have more floating rate debt than bond issuers. And the fact of the matter is we are investing in the lower tier of the high yield market. I mean, these are not the Netflixes, the Apples and Googles of the world. So what's the biggest risk there being in that lower tier? is because some people would say the risk in that entire yield as well, there's just spreads blowing out.

18:38For you, is risk also just default? What keeps you up at night? It's specific because everything that we do is bottom up on a company by company basis. It's idiosyncratic risk of 40 different businesses. There are really no universal themes of higher rates or lower rates aren't going to blow up this portfolio. Higher rates aren't. An economic slowdown, yeah, will hurt, but it's not going to materially impact. What would materially impact for performance is if one of the 40 businesses loses a major customer, has an environmental or a plant issue at one of their main manufacturing facilities. You're really taking business risk on these 40 names, and that's what's going to drive the performance.

19:20So it is truly credit risk of our underwriting. So how does that manifest itself in risk? Is it because investors could look past price volatility depending on how nasty it gets. But when you say risk to the portfolio, are you talking about risk of income not being distributed? How do you think about risk and how should your investors think about it? No, I don't think of it as income not being distributed because we have 40 names in there. And they're all, like I said, with a yield of 11.7%. Well, I mean, it's really the credit risk of those underlying businesses not being able to perform and thus there would be default risk.

20:00So, you know, credit risk goes far enough, then you hit default risk. And, you know, if we have defaults, we do have the ability to work through those defaults. I think that's an important differentiator. We do have in-house legal on our team, and we have a team that is very seasoned and working through restructurings and defaults. But, you know, look, when you have, and I hate to keep harping on it, but when you have a 10 % coupon on the portfolio, that hides a lot of price volatility. That's a massive income generator. And really to the clients that have purchased this fund and other clients in the strategy, they're really looking to this fund as an income generator.

20:45We have a lot of institutional clients who, yeah, yields are high, but when you look at the market on a spread basis, it's just not that attractive. Retail investors, from what we've seen, they're really not driven by spread. They're driven by income. Yeah, I agree. Retail yield, they just love the absolute yield level, right? Yeah. It's kind of true, isn't it? Yeah. I mean, it goes a little bit to the fact of institutions are strategic allocators. They're going to set it. And then it's going to be there for the next hundred years, or as long as that institution is there, they're going to go up and down with the market.

21:23Retail investors can be a lot more tactical. And when you have an 11.7 % yield on a portfolio, that's a pretty compelling return for a fixed income investment. How often do you pay that income out? Is it a monthly basis, quarterly? I believe it's quarterly. You might need to check that with the powers that be. It's, okay, distributions, it says monthly. At least that's for the institutional share class. So again, we could check on that. But I'm looking at the top 10 issuers, and you've got names, and these names won't mean anything to most listeners, but I want you to talk about, if not specifically these companies, but just what are these businesses?

22:02So specialty steel, Baffinland iron mines, clear channel outdoor holdings, Husky injection molding systems, internet brands. How big are these companies? How do you find them? Talk about the portfolio. What's inside here? Yeah. So I will say that 75 % of the portfolio is private equity-backed businesses. A good one that you guys have probably heard of, I know not all of them are household names, but internet brands, they own WebMD. private equity-backed company. I know that one. WebMD is a huge brand out there. Like I said, most of them are private equity-backed businesses, but the universal theme of all of those businesses is they generate sustainable, predictable cash flow.

22:51That is, as debt investors, what we're craving. And, you know, we can't, you know, one of the sectors that we do not participate in almost at all is oil and gas. For the simple fact of the volatility and the lack of predictability in being able to look out three, five, seven years and predict the cash flows of that business, we find that very difficult. it's much easier and much more repeatable to find a widget manufacturer in Ohio that's made those widgets for 85 years and they've always earned a 20 % EBITDA margin and had 2 % of CapEx as a percent of sales in it. They generate 10 % of free cash flow to debt every year.

23:35That's a story that is predictable. It might not be as sexy as the oil and gas guy who's going going to go from 10 million of EBITDA to 250 million when they find the next deposit. But the fact of the matter is those companies, the predictability of the cash flows of those businesses and the repeatability of being able to do that as an investor, finding those companies is incredibly difficult. Do you place any other constraints in the portfolio other than kind of avoiding the energy and gas sector? We really don't. I mean, we've always prided ourselves as kind of a go anywhere credit shop. I think we do have some basic ground rules, and one of those is generating sustainable, predictable cash flow.

24:22I think we've historically stayed away from companies that, whether they're government contracting, whether it's biotech, Things where we don't have any real insight to predict with any level of confidence the future cash flows of those business. They can be very lumpy. They can be here one day, gone the next. Those are businesses that we want to try to avoid. And another general theme is we're really not looking at, not necessarily asset quality, but we're not looking at asset coverage as a means for recovery. You know, when we say we're lending against, you know, the total enterprise value of a business is how much is this business worth to a buyer?

25:09Not what are the assets worth? Those can fluctuate materially. It's really how much is this business worth based on the cash that it generates today? and that's the number that we're going to lend against, not how much is this deposit in the ground worth or these plants, what's the construction value of those plants. We're not really looking at asset value. We're really looking at cash flow. Do you need to be like business analyst, sector analyst, or are you allowed to just be financial analyst where you say, I don't even care what this business does, but I've got 15 years of data and I know all I need to know.

25:50What exactly do you need to say? Look, some firms do a generalist model. I think what's worked for us is having our analysts broken up by sectors because they gain that inherent knowledge of covering a sector for 5, 10, 15 years. They develop relationships with management teams. They develop contacts within that industry so that they can use their network when they're out researching these businesses. So ours are broken up by sector. It's worked for us. And we've never really seen a reason why if you cover industrials for high yield bonds, why that knowledge wouldn't translate into covering industrials for leveraged loans or for a private credit business.

26:33If you know industrials, you know industrials, it doesn't matter the type of security that you're purchasing. You need to be able to value a business and value those cash flows. And so for us, the sector model has worked very well since we've been around. Are you surprised that spreads have remained as tight as they have over the last couple of years? What are your thoughts on that? Yeah. I mean, no, I'm not. Given the underlying strength in the economy, when you look at employment over the last three years, the employment numbers have been incredibly strong. America's pastime is spending money.

27:14It's probably not baseball anymore. And when people are employed, they're going to spend money, whether it be cars, homes, cruises, whatever it may be. So when you have as strong as the consumer has been, which is really the driver of our economy today, it doesn't surprise me that spreads have been this tight. You add that into the amount of money that was pumped into the economy and the rate cuts that were taken during COVID and before COVID, capital was free effectively. So there was no incentive to not spend. There was no incentive to save, I guess, is a better way to put it. Anything else we didn't cover that you wanted to hit on today, Ben?