The Evolution of Private Credit - [Business Breakdowns, EP.163]

26:00I think that's a big area of growth. I don't know that the structure per se is going to be as detailed as something like a life sciences deal would be, but there certainly is a need there, a use case there for more capital, more private credit capital to fill that void. And then rescue lending. It's not really answering your question, Matt. I mean, you're asking about sectors, but a type of lending that structure matters a lot is rescue lending because these are challenging situations. You want to be able to protect your position and still provide capital to a company to kind of weather a difficult period.

26:33So every one of those types of situations is bespoke. The conditions surrounding that particular company's issues are usually different from one borrower to the next. So I think structure matters a lot there, too. Unifying theme across the board there is a need from capital. You see it in the digital infrastructure, these CapEx budgets that are coming out. and you know it has to come from somewhere, rescue lending would be potentially a similar need for capital. So certainly can see how that would tie together. One of the things we haven't touched on yet is the size and the importance of the size of a fund or a strategy in private credit.

27:09We had Mark Lazzari on one of our other podcasts this week, and he mentioned he was allocating to credit. It pains him to say, but he would want to make sure that the size of the fund was large. And that's absolutely important to compete now. I think for public investors, that usually gets tougher the bigger you get to compete. But in the private markets, it makes a lot of sense. Can you talk about those dynamics and how important a role they play just strategically? Bigger generally is better in the private market, but I would provide a few notes of caution. So I would separate the answer between performing private credit and opportunistic private credit.

27:44Mark Lassery might be talking about opportunistic. I'm not sure. Mark obviously does a lot in opportunistic investing himself. But in opportunistic credit, bigger size is a huge advantage. The reason is, especially in something like rescue lending, and if you think about the size of LBOs that have been done in the last five or six years, there's a multi -billion dollar LBOs with multi -billion dollar publicly traded bank loans out there. So if you're a private equity firm that needs a $700 million solution, you don't want to have to go out and talk to 30 counterparties. You really want to talk to one or two, and you want them to write a $700 million check quietly and quickly.

28:23And in exchange, the lender gets the terms that they want. So size, speed, and certainty matters. If you're able to deliver size, speed, and certainty, then you're able to get the legal and economic terms that you want as a lender. So that's for sure an advantage. Now, in the public markets, especially something like distressed debt, a lot of investors said, well, or would say, well, bigger is probably not better because that means you just have to get more and more exposed to a company by the time you're able to exercise your will in a restructuring. And maybe it's better to be nimble, get in and out of a capital structure quickly.

28:58So I could understand that. But in terms of opportunistic rescue lending size, bigger size matters a lot. Now in the performing private credit area, bigger generally is better too. However, there is sort of a natural limit. And the reason is this, a private equity firm doing a $2 billion LBO, a billion dollar term loan facility. Well, there are probably five lenders, six lenders that could write a billion dollar check on their own. But a private equity firm doesn't want a single lender in a billion dollar facility. They want maybe three. And so yes, having a big fund and being able to write that billion dollar check or to commit to the billion dollar check gets you a very important seat at the table, but you don't get the full billion dollar check.

29:42And so there is sort of an upper end of the fund size where you just find it hard to fill the boat because the private equity firms are generally not doing $10 billion LBOs with $5 billion private financings. The fund sizes may exhaust the capacity at the moment. But size, it is certainly better to be bigger in private credit so that you can speak for that certainty on a $500 million deal, a billion dollar deal. And knowing that you might not get that full allocation, but speaking for the size and the certainty certainly is an advantage. We appreciate the nuance, which is usually the case with most of these things.

30:22There's nuance to it. You tapped into some of the different instruments that are in the market. And I'd love to hear from Oak Tree's perspective, how you think about the suite of different private credit products that you have, whether it's a BDC product, traditional private credit funds, we have COLOs that are in the market. When you think about all the different instruments and how they work together, maybe just from a business perspective, how do you think about Oak Tree's own offering and any dynamics that come into play with those? So we have a very large private credit team. We have people that are entirely sourcing oriented.

31:00We have some people that are sector specialists. Actually, most of our analysts specialize by sector. So the way we view it is we have a lot of capabilities in terms of just breadth of capabilities and depth. And then the containers that we have, the vehicles that we have sort of sit on top of this big pool of people that could deliver. Now, one of the things that we find to be really great risk -adjusted return is large cap first lien sponsor lending. It is a huge market. It's the market that was dislocated when the bank stepped away 18 months ago. We think that when we look at these structures where private equity firms are writing 60 % plus equity checks and the spreads that we're earning are 500 to 550 over in the current market environment for large deals.

31:45These are companies that are worth at least a billion dollars or have 100 million of EBITDA or more. So these are really large businesses, important businesses to get paid 10 to 12 % to provide first lien lending in that type of category, we think it's great risk -adjusted return. So we have something called Oak Tree Lending Partners that is a fund managed by this big pool of private credit investors, but with that very narrow focus in a big market opportunity. Similarly, we have other vehicles that tap into the breadth of the capabilities that'll do some rescue lending, maybe some mezzanine finance, maybe some first lien on a best ideas basis.

32:22So we look at relative value between life sciences and mezzanine and sponsored lending and rescue lending. And we'll say, well, what's the best idea we have at this point in time? And so we have these sort of best ideas types of funds, which include our BDC vehicles. We have a publicly traded BDC. We have a semi -liquid BDC as well that take a best ideas approach to both the public and the private markets, actually. When the public markets dislocate, but if the private markets are not dislocating, we say, well, that really doesn't make much sense. Why don't we lean into the public side, which we did in early 2022 when the public market was dislocating and the private wasn't.

32:56So that's the way we think about it. We don't have people necessarily tied to vehicles. We have this big private credit platform that services all of our private credit vehicles. And we try to deliver products to investors, both retail and institutional, that we think are differentiated and have the ability to sort of supply them with something that they need in their portfolios. Internally, you mentioned that you have people that are essentially working across the strategies. How does that work? Just an example of a deal, is it allocated across funds? If you have a large, sizable deal, what goes into that decision making?

33:32And where does that even sit? Is there a role that's played in terms of deciding that syndication, essentially? We have an investment committee for Oak Tree Direct Lending. And there are four of us on that investment committee and we decide, A, is this good risk at the right price or not? And B, we have operational folks that sit alongside the investment committee that help us determine where do we have the need for that type of exposure. It's a cash management exercise as well as a portfolio management exercise. So for example, if we have cash available in a fund and we have room for that particular industry, we're not overexposed from a portfolio management perspective, we say, okay, we'd like it for one fund.

34:14We'd like it for every fund. That's kind of our starting point. We'd like it for one fund. We'd like it for every fund. And then we overlay, well, do we already have too much exposure to this industry? Do we already have too much exposure to this sponsor? Is this loan accretive to the portfolio based on its vintage? Should we reserve their last remaining bit of cash for something else? Maybe a rescue loan that we know is coming in three weeks. But I think the starting point is the same, which is if we had our druthers and And if we didn't have investment guidelines in any particular account, if we like it for one account, we like it for every account.

34:47Now, there are also times where we work with our opportunistic credit strategy and we do a big loan together. So for example, in the middle of COVID, we did a one and a quarter billion dollar dip loan to LATAM Airlines. Now, that's a big loan. We moved very, very quickly. We were able to write that check with the combined power of both performing private credit and opportunistic private credit. And we even put that in our BDCs. Now, it's an emerging market loan, which typically you don't see in a BDC. But we really liked the risk -adjusted return. It was a rescue loan and a differentiated position or investment that we think was very well protected from a downside perspective.

35:26And our performing private credit team worked with our emerging markets team and we worked with our opportunistic credit team to drill down on LATAM and I think unearthed an opportunity that we think was outsized in terms of return versus the risk that we were taking on. And was that a single loan given or was there separate tranches within the loan between the two strategies? We all participated in the same tranche. We typically do not participate in different tranches of the same capital structure. We have a compliance function at Oak Tree that really, we just don't want inter -fund conflicts generally.

36:02Conflict of interest makes a lot of sense. Talking a little bit about risk management, I think the first portion of risk management comes before something comes into the books. But once it's in the books for private credit deals, I would imagine when there's challenges, it's not something you just sell into the market where there's a liquidity on the other side. Can you talk a bit about those dynamics and what it's like to manage that book of risk? Well, we try to head them off to begin with. First of all, we try to make no one position large enough that it's that damaging. So highly diversified portfolio.

36:35We look for diversity by region. So for example, I mean, we have private equity funds that invest globally. We have private equity funds right now that have investments in the US, Europe, and India in the same fund. So as we think about diversity, we look at foreign borrowers. We look at currency risk, vintage risk, our expectations around refinancing, access to the capital markets in that particular, for that industry or for that particular region. We want portfolio diversification by sector. And we're largely first lien in our accounts, but we do very closely monitor how much sort of junior exposures we might have in those accounts that allow for junior exposures.

37:13Now, obviously, once in a while, you will have a tough situation. Oak Tree, across all of our strategies, have strong restructuring expertise. Even within our performing private credit business, several of our team members are former distressed debt investors. And we have the ability to kind of work things out on our own within the team. But we also have people down the hall in our opportunistic credit strategy that are restructuring experts. And that's what they do day in and day out. So it's easy to walk down the hall and say, hey, here's a situation. Who's the right advisor for this? Do you know somebody at this other shop?

37:49We hear that they're around the situation or want to be involved in this situation. So there are considerable resources that we have. There isn't really a playbook per se, but we do know that we have tremendous resources. Oak Tree was founded in 1995, so we're almost at our 30 -year anniversary. But even before that, we launched our distressed debt strategy in 1988. And so just kind of having that longevity, the reputation in the market, the relationships, it helps for all of our strategies at Oak Tree in the unlikely event that we have a challenging situation to get through. Very much in the DNA.

38:25I would imagine there are funds out there, well, I know there are funds out there that don't have those same type of resources. Is there any type of secondary market for direct lending, private loans that are out there? Is it a meaningful size? And from your perspective, is the risk reward ever there of stepping into something else that somebody has underwritten? There really isn't a market per se. I think that's the short of it. However, there are situations where you might be in a private loan with a few other lenders. One lender, for one reason or another, wants to get out. For example, it might be a hedge fund that is experiencing redemptions and wants to get out.

39:05Oftentimes the trading of that position is monitored or traffic copped by the private equity firm that owns the business. They say, okay, you want to sell, go sell, but you have to sell it to one of the other folks in the consortium. And so it's not a market process. It's a negotiated process and it's a very inefficiently negotiated process. So if you did find yourself in a position where you want to sell, it's generally not a good outcome. Now, there are situations where there have been portfolios sold or LP interests and credit funds sold. And it depends on what's happening in the markets overall.

39:44If it's a clean portfolio and it needs to be sold for some liquidity reasons, well, there may be buyers for it who have had inflows into their direct lending funds. And they say, I just want to get exposure. We've seen trades like that at the portfolio level over the last few years in healthy markets where the average dollar price has been near par. It's really just because there's just been inflows into the market and a manager needs to get exposure. But if you have a challenging position or if you have a portfolio that's kind of at the end of its life and it's just got five troubled positions in it, it's really tough to get that sold at any sort of reasonable price.

40:20The market is just not efficient enough and transparent enough. Yeah, on both sides, it feels like it would be difficult to get a deal done. Going back to the distressed market, there's Oak Tree's DNA has been there for a very, very long time. In my own experience, it felt like the distressed market that I read about was much different than the distressed market that I experienced, where it was large players, it was very proactive. Oftentimes, if something did get to restructuring, it had already gone through so many additional financing that there was a one and a half lean tranche and all types of things mixed in there.

40:55Just over the course of your career, how much has that market changed? Am I way over -exaggerating the dynamics? Is this more of a cyclical situation? What would you point to there just in terms of the distressed market? So the market has changed. During the financial crisis, it was largely a marketable securities opportunity. So you'd identify the companies you want to invest in, you'd sort of have a price, target price in mind that you want to create your position at, you would endeavor to buy a third or more of the bond tranche or of debt of the business so that you could control or at least block a restructuring.

41:35And that was facilitated through big bank trading desk operations, as well as levered vehicles that blew up during the financial crisis. These special investment vehicles or sieves that had mismatched assets and liabilities. Today, you don't really have that. The owners of debt are long -term owners. So in the case of CLOs or collateralized loan obligations, they're holders of that debt. They don't need to sell, even if it defaults or if there's a triple C, they don't actually need to sell it. There are bad things that may happen within the CLO, but the CLOs are self -regulating mechanisms. The only place where you sometimes see selling pressure is if you see a sudden institutional or retail withdrawal from a vehicle or a market where all of a sudden there's a bunch of selling pressure.

42:23But since the global financial crisis, those periods have been very short. Even if you think about COVID, the depth of the buying opportunity was only about two or three months from March to maybe June. That's really when you saw most of the paper actually trade. And so on the public side, as a distressed debt investor, you have to be very nimble. You have to have a lot of conviction and be willing to move quickly in those short periods of time. So as a result, distressed debt has become more of a private credit oriented exercise where you're looking for consensual rescue loans, working in partnership with the private equity firms that own these businesses.

43:00It's a very different mentality these days versus before. And what you described as kind of the layered caking of capital structures, that certainly happens for sure. And it's probably going to continue to happen, I think, with rescue loans that are probably going to kind of roll through over the next two or three years as maturities happen. what you'll probably see is some number of them resulting in rescue loans that are first lien, but then grabbing collateral that hasn't been pledged to the existing loan. So that's a little bit of a layer caking that occurs. And then there'll be other situations where there's a hold coat pref rescue loan that comes in that delevers the first lien and makes it refinanceable.

43:40That's probably a little bit of a healthier situation in terms of clarity in the capital structure that so -and -so coming in is clearly junior, but ahead of the equity and earning equity -like returns for taking on that type of subordinated risk. It's hard to predict exactly how that all turns out. But I think the biggest change in the distressed debt market is the drying up of liquidity in the tradable credit market. One of the other dynamics about private credit, which can sometimes attract the cynics, is the marking of the books. And I think you referenced a very interesting period of time there with COVID, where you had this moment, quarterly mark, which was right in the heat of things.

44:22And fast forward just a few months later, and everything had snapped back, essentially to par and beyond that in the future. Can you talk a little bit about anything that you would say in response to whether it's the volatility and the difference in terms of private credit versus public credit, or just the practice of bookmarking in private markets, whether there's any pushback that you would have on the cynical approach to it? It's easy to be cynical about it. Because if you look at that period of time, COVID was sort of early March, mid -March 2020 is when everybody went home. And then the marks for the March 31 book came out in late April, mid -May kind of thing.

45:03So when you looked at those marks, and you looked at the public marks, there was a big delta. This is very high level and generic, but I would say private credit books generally mark down six to nine points for that quarter. Public credit, especially bank loans, probably mark down 18 to 20 points. I think if you looked at the bank loan market on average, the index was probably low 80s -ish by mid -April or late April. A lot of folks, the skeptics, would say, well, is private credit really that much better? I mean, in terms of credit quality versus where the market is telling you this type of credit should be marked.

45:46It turns out that private credit was probably right in its marks in the following sense. Private credit marks its books based on fundamental performance of businesses. But secondarily, they also market based on a change in market spreads. Now, at that point in time, yes, there was a change in spreads. but it gets impacted by expected duration of the asset as well. Having roughly a third of the markdown, a third to half of the markdown that you see in the public markets, felt kind of healthy because on a fundamental side, there was no way to know what any one of these businesses would end up performing like.

46:24Nobody knew whether company A in the private market or company B in the public market was going to implode or be just fine. Nobody knew what the stimulus would look like. It was sort of the best guess that the private credit market can make. And frankly, with all the stimulus, most everything snapped back pretty quickly within 12 months. So I think that that also leads to a little bit of a misconception about the private credit market, which is, this is just really opaque and people are playing with the marks. While I understand that skepticism, I think that there is a fair bit of transparency in private credit.

46:58And a lot of these private credit positions are held across multiple BDCs. But if you look at the 40 act regulated private credit vehicles, they do mark their books to fundamental performance every quarter. They do provide information on their calls about things like fixed charge coverages and what their leverage ratios look like across the portfolio. You could compare those marks to other publicly traded BDCs as well. So while you don't have company by company performance disclosed with that level of specificity, you can get pretty comfortable that if a BDC has a mark of X, you can get comfortable that there's a real basis for that mark based on performance.

47:39And it is supported oftentimes by third -party valuation agents that are employed by these BDCs. And those valuation agents work across BDCs. So they know what someone else is marking the same position at and what sort of fundamental drivers, both positive and negative, another manager may be assuming and coming up with that mark or advising what that mark could be. We'll start to wind down this conversation. It's been absolutely excellent. You mentioned before the power of Oak Tree's platform and being able to pull off something like the LATAM Airlines deal. You've combined with Brookfield, there was the Brookfield acquisition.

48:20Can you talk a little bit about that, whether it's changed the strategy at all or opened up opportunities at all, anything that you would point to there? As we've seen consolidation in the asset management space become more and more common over the years. Just curious about the experience and the strategy with Brookfield. Brookfield is an asset to Oak Tree. Brookfield has not changed anything that we do. It's, I would say, only amplified or supplemented things that we do. Brookfield has a huge balance sheet, and they move in size and conviction when they believe in the people and the strategies that are part of the Brookfield ecosystem.

48:54Brookfield doesn't do much in credit on its own. Oak Tree is really the key partner in its credit area, but they have huge businesses in private equity, renewables, real estate, and infrastructure. And the knowledge base that they have in those areas can be an asset to us as well. And when appropriate, we do sort of reach across and ask them that question. But Oak Tree is managed independently. We have an independent board. We have an information wall up between the two institutions. We have complete autonomy over our investment decision -making. And Brookfield has made it clear that they're there to help as and when needed.

49:30So it's been a fantastic partnership. It's worked really well from my perspective and from Oak Tree's perspective generally. We kind of have a lot of things, I would say, in the hopper from a growth perspective that make a lot of sense for Oak Tree to execute upon with Brookfield's help, both in terms of industry knowledge, but also in terms of balance sheet. And for the last question, I'll keep this somewhat high level in nature and allow you to answer it however you like. But we tapped on a lot of the different market dynamics as it relates to private credit today. But is there anything that we haven't talked about that you've been thinking about a lot that can be very specific, like the Fed, which we almost avoided talking about?

50:09It could be outside of private credit, like AI spend or something along those lines. But anything that you've been spending more time reading about or a market dynamic that we haven't talked about that you had mentioned? There's a lot to unpack in terms of discussion around rates as well as the election. I think the markets for a while, and maybe still, were saying, oh, look, inflation is kind of heading in the right direction. That means rates are going to come down. I never quite understood why those two statements make a lot of sense side by side. The Fed does not have a mandate just to reduce rates for the sake of reducing rates.

50:43The Fed does not have a mandate to support asset prices. It really has a mandate to support stable economic growth as well as employment. So I don't see inflation just heading in the right direction being a reason for the Fed to reduce rates unless and until there's a recession or some meaningful shock that causes a risk to stability of the economy. So I think rates stay high for an extended period of time. I think that's a good thing if you're a saver, you're a creditor or a credit investor. So I think it's a great time to be a credit investor rather than equity, at least for the medium term.

51:18But I'm also a little concerned about the rate picture with the budget deficit in the US being what it is with the cost of interest of the US economy or the US treasury now approaching something like 1 .1 or 1 .2 trillion dollars just for interest expense. You just think about the amount of debt that needs to be printed just to roll debt and pay for our own interests. And we don't have in the US the political will to change spending or to increase taxes, which just means that the Fed's balance sheet is going to have to grow and to buy up the treasuries at the treasury issues. And at some point, I'm just a little bit worried about where that breaking point is.

52:00And it's easy to craft an argument that long -term rates become unruly, which would be devastating to asset prices and asset values, and maybe even the economy overall. So that to me is a big problem. Now, when you overlay the election, I think you have candidates, both candidates that are probably just going to continue to spend. They both believe in deficit spending. So there's a lot of rate and Fed related risk, I think that could unfold over the next 12 months, depending on who becomes president. And I think it's a really serious consideration because if rates go up from here, which I don't think is an unlikely condition, But if rates do go up from here, either because of political shifts or because we just don't have a choice but to issue debt to pay for interest expense, I don't think the market's really ready for that.

52:50And I think that there could be a crisis of confidence, consumer confidence, as well as corporate confidence that could cascade into a recession if that were to occur. So that's on my mind. I don't know if that's what you're looking for, Matt. Maybe that's a little bit gloomy to end this session on, but that is what's on my mind. Well, we're talking credit, which the credit versus equity, it would fit the characteristics. But I think it's a great point. It's something that I think is in most people's in the back of their head. And they just hope that it stays in the back of their head in terms of the national debt levels and when that eventually gets addressed.

53:24It's a good thing to bring up because it's often one that we just kind of try to forget about. And the election being somewhat of a catalyst for that is a really interesting point. Thank you very much, Armin. This has been a absolute masterclass in all things private credit and credit in general. So thank you for joining us. Thank you. Thanks, Matt. I really enjoyed it. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out JoinColossus .com. That's J -O -I -N -C -O -L -O -S -S -U -S .com.