Talk Your Book: What Is Private Credit?

0:00Today's Animal Spirits Talk Your Book is brought to you by Alternative Fund Advisors. Go to alternativefundadvisors.com to learn about the AFA Private Credit Fund. That's alternativefundadvisors.com. 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.

0:34Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:42Welcome to Animal Spirits with Michael and Ben. This was an interesting discussion. We haven't had anybody from the private credit space on the show before. So Marco was generous enough to take us to school. And we spent, I don't know, the first 20 or so minutes of this conversation talking about these markets, where they came from, where the returns come from. Private credit is still a relatively new asset class. It is. And to the extent that there is a premium over what you can get in publicly traded credit, bonds, I think the way that he explained this is pretty simple. There's no free lunch anywhere, obviously.

1:23But the premium comes from just sourcing, just making these loans, right? Like the lender is sort of acting as a bank. Right. And a lot of it, a lot of these loans are made outside of the banking system because the bank can't make those loans anymore. Which is funny to him. I was asking who the winners and losers are. And he's like, the banks are. They would love to make these loans if they could, but they really can't anymore because of capital requirements or loan requirements, all these things that came out of the 2008 crisis. It was my understanding, and I use those words very loosely because I don't know anything about regulation, that banks weren't making these loans anymore because they couldn't.

2:00But it sounds like banks aren't making these loans anymore, not because they're not allowed to, but because of capital requirements. Is that your understanding as well? I think so. Yes. It sounds like a lot of it is regular. And this is like, there's a lot of unintended consequences that came out of the Great Depression that were like this too, like that banks couldn't do certain things and it was supposed to protect them at the time or protect consumers. I think this is an interesting one that it seems like these lending platforms and private equity shops essentially are the ones that are benefiting from it because they were able to make this market.

2:30Is private credit the new private equity? Probably. I mean, it's probably a lot, especially for advisors and family offices and even like institutional investors. It's easy to understand. You don't have as long of a lead time. If we're talking loans that are three to four years in length or whatever, that's easier to stomach than I think than like a 10 to 12 year private equity lockup. Right. So yeah, it's an interesting space. So we had Marco Hanig on, who is one of the founding principals at Alternative Fund Advisors. So here is our conversation with Marco.

3:05We're joined today by Marco Hanig. Marco is a managing and founding principal and the CEO at Alternative Fund Advisors. Marco, welcome to the show. Hi, Michael. Glad to be here. We're going to be talking today about private credit. And I think that people, investors have heard the term private equity for a long time. The idea of investing in privately held companies is not that novel, but the other side of it, the credit side of it is perhaps a little bit newer and less familiar to investors, but the popularity has certainly exploded in recent years. Maybe let's start with what is private credit?

3:47Well, private credit, in essence, is any kind of loan that is not a bond, so not publicly traded, and not issued by a bank. So there is now a large infrastructure and network of private lenders, sometimes also called alternative lenders, lend money to typically middle market or smaller companies, and they are direct loans. And if you're investing in private credit, you're basically giving money directly to a borrower. And just to cover all the basics here, who are these lenders? Where did they come from? Because it seems like it's a relatively new side of the business that was sort of sprung out of the 2008 crisis and all the regulations that came from that.

4:34Yeah. So the big driver of why there's interest and why there's been demand for private credit is that banks have stepped away from lending due to increased regulations, more requirements on their balance sheets. The lenders, they range from large names that you might have heard of, like Apollo, KKR, Carlyle, a lot of large names that you're familiar with also from the private equity space. They will raise funds to help lend money to these companies. But there are also many smaller platforms. So the fund that we run, actually, we use lending originators that play in very specialized niches, things like lending based on mining interests, litigation finance, which are loans to law firms.

5:27They are very specialized, and these are little ecosystems of firms that have an ongoing client base. They understand that market very well and can serve the needs of those borrowers. So you said that banks used to be the primary issuers of these loans. Were banks making these loans from balance sheet capital? Were they pooling the money of outside investors and then making these loans? What was the ecosystem like before these private product companies filled the void? Yeah, banking is pretty straightforward, right? You have deposits and you pay close to nothing on your deposits. And then you are allowed to lend based on those deposits.

6:13That's banking in a nutshell. And the real challenge for banks has been on the deposit side. You recently saw with SBB Bank concerns about does a bank have enough deposits to support its asset base. But there's a deposit, that's the liability, and then the asset is the loan itself. The way that these private credit funds work is that the investor simply invests in a fund. So that's where the money is coming from. Think of that as the equivalent of a deposit. And then it is being lent out at a rate and you get that return directly. So if the loan is originated at, I don't know, say it's a 12 % loan, the manager and the fund might take out several percent of that and you earn whatever is left over.

7:02So it's a very different model than the banking system. I guess just said differently. So banks in 2023, they're still making loans. They're just not making loans to this segment of the marketplace. And I guess maybe a good starting point is why. This was a regulatory shift that no longer allowed banks to make loans to which type of companies are we talking about? It's a question of both size and type of loans. So banks are still lending. There's no question that banks are still making loans. But the requirements on their balance sheet and the regulatory capital ratios that they need to maintain is such that many of those loans are no longer economical for them.

7:44For example, think of a credit line. Suppose that you're somebody who wants to have a credit line that you draw on periodically. If you get charged by the bank regulator almost as much in capital requirement as if the loan was made permanently, it's no longer economic for you, right? You're earning money on a small balance, but you have a large credit line out there. So those are the kinds of reasons that have led banks to step away from certain segments of the market. Now, the investment grade segment of the market, large companies continue to issue regular bonds in the public markets, right?

8:23Then there are also large, large borrowers that borrow from banks and those large loans get syndicated. That market still exists. It's really the lower end of the market where there's less and less desire by banks to lend. Before we get into the investment implications, we surely want to do that. Who is benefiting from this change and who was hurt by this change? Because obviously there have to be winners and losers from this new market developing. Yeah, the benefit is to borrowers that can now do things that continue to have access to credit, right? In many cases for them, it's a difference between being able to get loans or not get loans at all, right, and getting them faster.

9:04So the borrowers are definitely better off by having a new channel that provides them with loans. The people that are hurt are banks, quite honestly. And then the big benefit, of course, is to the investors, because if you invest in a bank and you're giving a bank your deposits, you're not making very much in terms of interest on that. But if you are really lending during a private loan, you are earning rates that are in the high single digits, low double digits. So it's really the investors that really have benefited from being able to make these loans directly. What's the difference between a loan and a bond?

9:43Are they the same thing with different names or are there substantial differences between the two? Bond, by definition, is just something that's publicly traded. So, I mean, there's a whole process, an underwriting process. But bond, once it's issued, you know, it gets traded, you can buy it and it can get bought and sold. A loan, once you've made that loan, there is no market for it. So it is issued and, you know, it's then on your books until the loan gets paid back. When you say that, you said earlier that these are for lower players, I can't remember the exact words that you use, boat. Do you mean lower as in smaller or lower as in lower credit quality or both?

10:22That can be both. So these are firms that might be called double B, B credits from a credit worthiness. And some of them can be large and some of them can be small. So there is a wide spectrum. And in some cases, at the very large end of the market, some of those companies are also thinking about, is this something that I should be issuing in the public market or through one of these syndicated loans or from a private lender? So that end of the market is actually quite competitive and heavily competed. The more you go into smaller and smaller loan sizes, the less competed. Marco, how did you end up getting into this space?

11:04What's your background here? Yeah. So my background is I've been in the funds business for my entire career, first with a company called William Blair & Company in Chicago, and then with a company called AQR Capital, which is a large quantitative hedge fund in Greenwich, Connecticut. And at AQR, I was fortunate to be responsible for launching their mutual funds business. And really, we created what became known as the liquid alternatives business. The idea of having hedge fund strategies in a mutual fund format was pretty novel at the time. Towards the end of my tenure at AQR, I started to realize that we were doing liquid alternative strategies, but there was increasing interest in illiquid or private strategies, things like private equity, but also private credit, private real estate, and asset classes that you cannot just access by buying bonds or stocks.

11:57There was another innovation that happened at the same time, which was interval funds, which make it much more easy for advisors to access these vehicles. Traditionally, private credit, in order to invest in private credit, you would invest with the manager through limited partnership. And it would be a fund that would have a typical structure of maybe a three year duration, four year duration. You invest in the fund, the fund would call your capital, invest it over time, and then would give it back to you at the tail end. It'd be a subscription document, it'd be a K-1 investment. Interval funds, in contrast, basically look, taste, and smell just like a regular mutual fund.

12:40So they have a ticker. They don't have a subscription document. They have a 1099. You can typically invest in them on a daily basis. There's one important difference, though, versus a mutual fund. You can only get out your money quarterly, and there's a limitation on how much of the fund's assets can be redeemed at that time. So it's a 5 % limitation every quarter. If only the total redemption requests in that quarter add up to 3%, then everybody gets 100 % of their money back. If 7 % of the investors want to redeem their assets, the limit is 5%, everybody gets back 5 cents. These aren't draconian limits here.

13:22These are private loans with no market. And so if everybody wants their money back, that's just not possible. Correct. Right. Yeah. And so if you think about the reason why people are interested in investing in private credit is because the return of private credit is higher than that of public credit. Right. Well, and why is that? There are two reasons why you would expect there to be a premium. One has to do with this liquidity aspect. Right. In a bond, it can be publicly traded. It's you know, you get compensated for, in essence, being locked up for some period of time. So that's the liquidity premium.

13:59But the other big one is that for private credit, you can't go out and invest in private credit. You don't even know where the credits are. Bonds you can invest in easily, right? You just go and you look on Bloomberg and you can find the bond that you want to invest in. Private credits need to be originated. And so we call that the sourcing premium or origination premium. You get compensated for actually finding the underlying borrower, structuring the loan, monitoring the loan, processing the payments. So you're really investing in a lending business to some extent. So dumb question here, but the companies that are borrowing money, why are they deciding to borrow money instead just to sell some of their equity?

14:48The answer is pretty simple. If you can borrow at less than what you think your cost of capital is, you will always borrow, right? Look, I'll give you an example of the things that we tend to lend on. The private credit space is really composed of, we like to think of it as four different segments. Private credit can be cash flow-based lending or asset-based lending, and it can be to large companies or it can be to small companies. So think of it as four quadrants. Cash flow-based lending basically means I'm lending you money and the repayment is predicated upon you being able to meet your interest payments.

15:23And so the typical way that you underwrite that is through some cash flow multiple, right, where you make sure that the interest payments are only a fraction of what your cash flow is. Asset-based lending is different in that for asset-based lending, you actually require collateral. For example, you might have aircraft as collateral. You might have cars as collateral. In our case, you might have real estate as collateral. You might have mining as interest as collateral. You might have equipment, inventory. Basically, you have something tangible. So when a loan gets in trouble, in one case, you basically need to work out some sort of a restructuring of the loan if it's a cash flow-based loan.

16:02For asset-based loans, you actually have the real collateral there. So if things really go wrong, you can tap the collateral for repayment. So is that your niche, the asset-backed market? Yes. So we focus on the asset-based market. market. We focus on asset-based lending because of these repayment characteristics. The other thing to know about the asset-based market is typically the kinds of loans that I was talking about for equipment, inventory, or receivables is another big one. They are really working capital loans. So if you are a mining company that has to drill something, you know, the deposits are there, but you need to invest in the project to drill.

16:42You have a very short duration loan that covers that project. That's a typical asset-based loan. Another example would be for real estate. Suppose you're a real estate developer and you're doing a project where you have, you're trying to buy the land and you're going to go through a permitting process that might take 12 to 18 months before you can actually get a real construction loan. So there's a period where you get some bridge loan financing, and that's the kind of thing that we would be investing. I'm curious about the rates, the interest rates that investors receive or that lenders demand for these type of loans.

17:22I guess interest rates are gravity, whether it be Fed funds or the 10-year, obviously these things have to trade off on a spread like every other or like publicly traded bonds. Can you just talk about how that works in your world? Yeah. Loans can either be fixed rate or floating rate. Many of the loans in the space are floating rate. They can be SOFR plus six, SOFR plus seven. I mean, we're talking about, you know, very nice spreads over, you know, over the risk-free rate. And in some cases, if it's more of a complicated story, the coupons and the yields can be in the mid-teens. So not, you know, not every loan is a mid-teens loan.

18:04But these days, low to mid-teens is completely normal in the market segment where we play. And how much does this market follow the general marketplace of interest? Well, they're talking about the credit space or high yield or treasury bonds. Is there some sort of spread that you're following there? Or is it more easy and credit than that, depending on the asset or the lender or that sort of thing? Yeah, so this is one of the things about private credit that really is attractive to financial advisors. Private credit does not mark to market with the same velocity as bonds. Of course, private credit is affected by interest rates in the longer term.

18:44But think about the difference between investing in real estate and your own house versus the REIT market. The REIT market, those rates can be jumping up and down on a daily basis and can be quite volatile. I think what we all know is if you're trying to sell an illiquid asset like your home, you have an idea of prices in the neighborhood moving up gradually or moving down gradually. But it's a very slow moving, smooth process. You certainly don't reprice your house every day that market rates move around. So the same thing is true for private credit. Over time, it is susceptible to markups or markdowns based on rates, but it's a very slow-moving adjustment.

19:34And so the volatility for private credit is just a fraction of what it is for public. So I don't know if it's your former boss or the head of your former firm, Cliff Asness, has spilled a lot of ink about this, and he called it volatility laundering. Do you even care? Because obviously, you're right. There's less volatility, but if it's not being marked, it's like Schrodinger's cat kind of deal. Does that even matter? Or do you think because there's more of a lockup that it's like out of sight, out of mind for your investors and it doesn't really matter? Because I can see it both ways. It seems like the fact that these funds are liquid and they're locked up longer, it doesn't really matter because they're not trading on a minute-to-minute or daily basis.

20:12But how do you think of that volatility effect of this space? Well, I won't pick a fight with Cliff on this podcast. We'll take that up separately. No, it's a topic that AQR has written about a lot, and Cliff has written about it, particularly in the context of private equity. Right. You're not in his crosshairs yet. Just wait. Yeah, after this podcast, I'm sure I'll be getting a call. But in the case of private credit, really, it's a question of those are much, much shorter duration assets, right? They're three-year, four-year duration assets. and what I was saying in terms of how fast they move, they do get mark to market.

20:54It's just that the movement is slower. And this is not a fictitious thing. It's just, I use the housing analogy, they just don't move on a daily basis in terms of the negotiation between two private parties. I don't know if Cliff has said this exactly, but wouldn't it stand to reason that behaviorally, investors would be willing to pay for that volatility laundering, as he calls it, because it's very nice to not see the prices jump around on the screen every day. So that illiquidity premium, is there any danger of that turning into a discount that investors would happily pay for the comfort of not being marked and therefore they're not going to get the returns that they did in the past?

21:35I honestly don't think that's the case. Remember that the supply demand dynamics on that are really, the rates are determined between the supply of the lender and the borrower, right? Those are the supply and demand dynamics. That's one part of the market. And then there's the question of the investor giving money to the lender, right? So the lending platform stands between the borrower on one side and the investor on the other side. Actually, I'm going to tell you something that relates to Cliff. In addition to writing about volatility laundering, he had a piece on pet peeves many years ago. One of his best.

22:20Yes. One of the many classics. And it talked about also the question of laddered portfolios versus bonds. Individual bonds versus bond funds. Correct. Individual bonds versus bond funds. And Cliff will jump up and down and say, well, academically, the bond that you hold in your brokerage statement, in theory, it should be marked up or down every day. The reality is it is not marked up or down on your brokerage statement every day. And investors feel better about not seeing that movement. Now, if you had to sell it during the holding period, of course, the mark to market would be what would apply.

23:07But you need to think about this marking also in the context of what is your holding horizon. If you know that you are going to own this bond or you are committed somehow to owning something for five years, then you don't really much care about the volatility in between. Is that typically the holding period you tell for your clients? And it sounds like to me, you said this is an attractive asset class for advisors. Is that who most of your clients are? Yeah. Our fund is only distributed through advisors, basically RAs, private banks, and family offices. Okay. And you typically tell them, listen, this is a three to five year asset class, not something you're holding for six months or 12 months or whatever?

23:49Yeah. I think if you're investing in this, you should not be thinking about this as something that you move in and out of. There's a tendency a lot of times to saying, well, we're going to rebalance the portfolio and tweak it around the edges, and we're going to allocate a little bit more here or there. No, this needs to be sized in such a manner that you can say, this can be a permanent allocation in my portfolio. If it goes up a little bit, the percentage or so in value or not, it's not going to be that big a number that I would need to touch it and rebalance it. So looking at a chart of the cumulative performance since inception, there is no denying that this is a much smoother ride than anything that is publicly traded.

24:32We've been through that already. So my question is, where do the actual daily marks come from? Because of course, the loans don't trade. So I'm just ignorant to that. I honestly don't know. How How does the price get set on a daily basis if somebody's looking to buy either today versus a month from now versus two months from now? Where do those markets come from? Okay, so that's a two-part answer. We are structured as a fund of funds, and we get a monthly statement from each of the underlying funds. And each one of these funds has its own valuation policy that takes into account changes in yield or any potential defaults or changes in the overall market.

25:12And then our fund takes these monthly statements, and that's how we value the loans on a monthly basis. For the in-between days, we have a fair value process that interpolates on a daily basis between those month ends. What does this look like? Is this a concentrated portfolio to try to spread your bets, leg into positions, take big positions? How does that whole process work? Yeah, so we have about 570 positions, underlying positions within our portfolio, originated from 15 different lending platforms. So we select managers that have expertise in certain market segments. I think I mentioned mining as one, and I mentioned litigation finance as another, real estate, bridge loans would be a third.

26:04So what we do is we don't necessarily think about diversifying across geographies, for example. What we do is we try to diversify against different collateral types. So, for example, you don't want to have too much of your collateral tied up to the real estate market or to the auto or retail or whatever. So you try to spread your collateral. And then, of course, you try to have a very good loan-to-value coverage as much as possible. So you're doing a risk-return trade-off on saying, how safe an investment can I get relative to the yield that it's providing? So when you say that you're investing through a loan platform, what exactly does that mean?

26:48We operate as a fund of funds. Okay, got it. So we're investing through 15 different funds, and each one of those funds is a loan origination platform. So the funds that your investors are ultimately investing in, those are the companies that are making the direct loans? Absolutely. Yes. So you can look on our balance sheet. You can see the names of each one of the individual lending platforms. Those are the people that are responsible for originating the loans and for doing all of the underwriting and all of the processing of the loans. What does the default rate look like in private credit versus public credit?