The Evolution of Private Credit: Part 2 - [Business Breakdowns, EP.164]

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1:55This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. And we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

2:37This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Welcome back for part two of this business breakdown on the private credit markets. Again, I am now joined by Josh Clarkson, Managing Director at ProSec Partners. While our discussion with Armin was really focused on the supply and demand dynamics of private credit, where the public markets have played a role, where regulatory markets have played a role, that certainty and speed of getting deals done, and how that has proved to be an advantage for private credit versus the traditional solutions.

3:12In our conversation with Josh, we transition a bit into some broader takeaways, the history of the private credit markets, some of the wrappers and what they have meant to the private credit markets. You will often hear about BDCs, business development companies. We get into exactly how they are differentiated versus traditional solutions, and even differentiation within that own subsegment, the public BDCs versus the private BDCs, what has happened in times of stress, and what the fundraising environment has been like, and what the market looks like in the future. Please enjoy part two of our discussion on private credit.

3:50All right, Josh, I want to get to a lot of the broader private credit topics with you, but I thought it would be good to just segue off of some of the things that Armin said to start and a few of the things that stood out to me and would love to just get your perspective on those. You have such an interesting vantage point in terms of where you sit in the industry. And one of the first things is just the point on where banks and private credit funds sit in terms of being competition, which is not something that I actually really considered that much, even though we've seen a shift in market share.

4:22But can you just talk about that relationship and how you see it from your perspective? Yeah, definitely. So as you said, that competitive dynamic between them, it does certainly exist, especially on a deal by deal basis of a certain LBO or a certain transaction and which market is that going to be financed in and how relatively open or closed is the syndicated loan market, which is fairly directly related to what type of spreads can private credit charge. And sometimes the headlines can focus on that dynamic a little bit since that competition and conflict is the kind of thing that seems interesting.

4:55That said, more broadly, in terms of how the ecosystems interact, there is much more of a partnership and a collaboration dynamic, especially more recently. That manifests through several ways. One of the most classic ways is simply that many private credit funds, especially in the direct lending space, use a moderate amount of leverage, usually between 0 .75 and 1 .5 times. That leverage is very often provided by a variety of sources, but banks are usually the senior provider of leverage to a private credit fund. So that's just a very clear and direct way. And you will see some concerns and scare quotes from people about those interconnections and whether that causes systemic risk.

5:35I personally do not believe it does. But more recently, you've seen an increasing pace of and increasing attention on some really interesting ways the two are partnering. Two of them that spring to mind are what are called synthetic risk transfer, significant risk transfer, credit risk transfer deals, or other types of transactions where a private credit firm is coming in and either taking some loans directly off a bank's balance sheet. You've seen this recently with some credit card portfolios, mobile home loan portfolios, or doing one of these SRT transactions, which is where a private lender essentially takes a first loss position on a defined pool of bank collateral.

6:13And those are also called reg cap trades because these trades are usually done in a way that allows the bank to get regulatory capital relief, which needs to be signed off by the Fed or whoever their relevant banking regulator is. So this is all done within that systemic supervision world. But it's very useful for the banks because the banks, very often, they will have a portfolio of loans or a portfolio of assets that either they're no longer super directly or super focused on that area of the market. It's now a non -corp business. And that might be a situation where they just want to sell the loans.

6:47But there may be other situations where it's an area they want to continue growing, but they've been growing very fast. Or it's something like a bridge loan that normally they would offload or refi, and that hasn't happened as quickly as usual. But they don't want to give up that customer relationship. They don't want any disruption to the customer's engagement. They still want to provide that customer with currency, treasury, banking services. But they do need to reduce their risk in this area. And by selling a first loss position on that to an experienced private credit lender, their regulator will give them some relief there.

7:16These have been relatively common in Europe. They've been getting more common in the U .S. recently. Very interesting area that's very fast growing. There are firms that are very specialized in that area and have been doing it for a long time. There are very large -scaled firms that are standing that capability up more quickly now, given its popularity. And the third area of collaboration, which is somewhat similar to the previous one, is ones where a bank and a private credit firm will set up some type of joint venture where generally at a very high level, the bank is originating many of the assets.

7:49But they are going on to an off -balance sheet vehicle where the capital is mostly provided by that private credit firm. Now, each of those partnerships will be structured in different ways, whether it's a joint venture that they both own equity in with the private firm owning the majority of the equity, the bank owning, I think it's 12 .5 % very often in the US, and then providing senior leverage on top. And exactly who will have what level of veto power, that will all vary, but you've seen quite a few of those come to market. AGL and Barclays did a very interesting one recently, Wells Fargo, Center Bridge.

8:21So that's Beach Point and KeyBank. So certainly another area where you will probably continue to see a lot of growth. Again, where in some cases, the direct lender wants that direct relationship, and that's why it's called direct lending. There's many other cases where the bank wants the relationship and the private credit firm is totally okay with that. They want the assets, and there's a very symbiotic way for them to work together there. So very long -winded way of saying that there is a competitive dynamic, but there's really so much more of a collaborative ecosystem dynamic going on in today's world.

8:50Very comprehensive overview there. I want to tap into a few of those categories just a little bit more on the leverage point in terms of giving private credit funds additional leverage. Can you just walk us through the mechanics there? Is that essentially providing leverage against a portfolio of loans? Is there something else that's going into that? Just the mechanics to, I think, separate a lot of the excitement or fear around private credit comes from this exact point. So any of the dynamics that you can share there will be helpful. Certainly. So there's something I think we'll talk about in more detail later is that lots of private credit lending happens out of what are called business development companies or BDCs, which are a statutory construct.

9:31They can be traded or non -traded. But importantly, for this conversation right now, part of that statutory creation is a limit on their leverage. Originally, it was 1x. Some changes were made so it can go up to 2x. It's very rare you'll see anybody go up to 2x, usually it's somewhere in that 0 .75 to 1 .5 range. Some of that leverage will be provided by a bank, but there would usually, especially for the larger BDCs, also be a meaningful portion of CLO and unsecured leverage under it. I say that in the context of this conversation and say that very often that bank line will have meaningful subordination under it.

10:05Also, that bank is lending, again, at a 1 to 1 .5x leverage level, as opposed to the bank's balance sheet itself, which would usually be something more like 10 to 1 lever. So it's a lower levered position. And that is being made to a diversified pool of professionally managed assets. And when you look at the loss rates for many leading BDCs and other private credit strategies, they are in the very low single digits. So you have a bank providing a senior loan against a professionally managed diversified pool of assets. And mind you, by providing that leverage, it allows that credit creation to still happen through the economy.

10:42So you're doing it in a way where the vast majority of the risk is being borne by equity investors in that private credit vehicle who are very often locked up or it's a permanent capital vehicle. So you don't have run risk the way you do on a bank balance sheet, very often with term and unsecured financing, further subordinate to the bank line. And so that bank line will be in a pretty senior position where for that bank line to be at all impaired, you would have to see a level of losses in the private credit vehicle that is far beyond anything we've ever seen historically, or could really, I don't want to say you could never envision it, but it would be tough to see that.

11:20And I do think that, as I said, that way you're still having credit creation in the economy. I think sometimes something that often gets lost in this discussion of systemic risk posed by private credit is that regulators want risk to be taken out of the risks in certain areas to be taken out of the regulated depository insured banking system. However, beyond the parochial views of bank regulators, policymakers writ large, the government writ large, I would posit does not want a massive reduction in the availability of credit to the economy. They may tighten policy, they may loosen policy, but I don't think anybody wants the economy to face a massive withdrawal of credit.

11:59So if you don't want that massive withdrawal of credit and the concomitant job creation and economic growth, somebody needs to be providing that credit. So that's where a well -managed, well -structured private credit lender working in cooperation with the banking system enables that credit creation to still happen in a much less systemically risky way. And on those loans that are made to the funds, you mentioned the leverage of one to one and a half times. What is the denominator in that case, EBITDA for a typical business? Is this just coming from the interest payments from a loan portfolio?

12:32Does that actually fall up to the higher level where you're getting management fees that could theoretically pay those loans as well? Do you have a sense for that? Oh, so it's usually one times the equity assets and just secured by the loans in the portfolio. And it is usually not... And I want to be careful here because I don't want to get too far ahead of my schemes, but you would usually not have direct recourse to the GP. I mean, there are structures where you might have a guarantee or something, but generally it is a loan just made to the fund with recourse to the assets in the fund. And whether those assets are underwritten, and I think we're going to get into this a little bit more later, but whether those assets are underwritten on an EBITDA basis, on an asset valuation basis, some kind of ARR basis, that can vary hugely by the type of private credit fund you're lending, I guess.

13:20And do you have just on rate for some of these, because I think it brings it to life a little bit if you have a private credit fund that's targeting, let's say, 10 % to 12 % yield. That's what they're underwriting. And you could be borrowing at what I assume is mid -single digits. Any context for there for what the gap is? Yeah. So generally speaking, we'll just use direct lending here as an example, since it's the largest piece of private credit and relatively easy to comprehend. The asset side of the books may be something like a base rate, which is now SOFR, used to be LIBOR, plus 500, 550, 650.

13:57Some have been coming in a little lower recently as spreads have tightened. In periods of dislocation, they get much higher, but think something in that range. And then the loans that that bank revolver line will usually be something in, as you said, the base rate plus low single digits. And then your unsecureds will obviously vary a lot on the yield curve, but one of the largest BDCs just priced unsecureds at 5 .9 yesterday, I think. So you can see a pretty nice spread there. One last thing I did want to add on that point about systemic risk and looking at it through history. During COVID, you did have situations where some vehicles fell out of compliance with some of those bank lines.

14:35They got kind of margin called by those bank lines. And what you saw happen was those vehicles did equity capital raises that were dilutive or punitive to their equity holders, which was unfortunate and people lost money, But the bank was never impaired. The bank line was never at risk. And I think that's just a really important point there is that sometimes people will conflate saying, oh, private credit's making these risky loans. They're untested. People are going to lose money with private credit poses a systemic risk. And those are two very separate conversations. And if an investor who went in eyes wide open to something paying them a low to mid double digit yield takes a loss on that because they were taking risk for that additional return, that's unfortunate for that investor.

15:18And of course, managers work very, very hard to prevent that. But that is generally speaking, the way that finance in the world works is there's more risk for more return. And I think sometimes people try to meld that into systemic risk without being very clear about the fact that those are two different types of risk. And the ability to raise equity capital, I think when I think of getting a margin call, or basically being a forced seller of something to meet some other liability that you have, oftentimes companies will not be in a place where they can raise equity. It is so punitive that it just results in a spiraling effect.

15:53And you end up seeing asset sales. In this case, that would be the loan portfolio. Sounds like recent precedent is that they were able to raise equity capital. Have we seen the need to divest large loan portfolios in similar situations? So I'd usually want to highlight those were public vehicles, so they had a public equity. I cannot think of a situation where somebody... I mean, we've had a fairly benign credit environment for some time now. So I can't think of a situation like that generally. But I think that if you were in that situation, I would think that a bank would be able to step in, take over the loans, try to resell them, work something out there.

16:29And again, you were only 1x levered on generally senior secured risk. So it's not something where the equity is going to be wiped out overnight in some kind of 10 to 1 or 20 to 1 levered structure, like pre -GFC banks. Transitioning to another interesting point that was made, and we had a little bit of discussion offline about this from Armin, was the health sciences strategy and life sciences strategy. And I think, again, we're talking a little bit about the different niches within private credit when it comes to public BDCs, private BDCs, CLOs, all these different structures. But most other asset classes, you see very dedicated funds to specific sectors.

17:14I'm wondering how popular of a theme that is in this market today, anything that you could add around that? Definitely. So the short answer is, it's certainly popular. And I think in many cases, whether it's life sciences, aviation, SRT that we were talking about, you'll very often see strategy -specific funds in the institutional context for that very sophisticated allocator that can say, I want pure exposure to this one strategy, home builder finance, things like that. Whereas the vehicles that are more often accessible to a wealth or retail audience will usually be commingled, but also very, very often And that specific strategy that a firm such as Oaktree with Life Sciences, where you have Armin and Amman with really rich medical backgrounds, that strategy will be expressed both through that dedicated vehicle and in sleeves of larger commingled funds.

18:06On the private side, it's generally more commingled, although you have seen firms like Blue Owl roll out technology lending focused, but that's still lending to a relatively diverse range of technology companies serving diverse end markets. So yes, you see them, but the majority of fundraising is still in the diversified sector wide. And it's more common to see is strategy focused in that it's direct lending, it's asset backed, it's MEZ, but across industry. And I'm curious your perspective on where private credit sits relative to private equity in this regard. With private equity, I can think of quite a few funds that have that sector specific strategy.

18:49and it might just be perspective rather than playing out in the numbers. But do you think if you look 10 years out that a more mature private credit market will be much more diversified with these sector -specific strategies? Or do you think there's something different about this market that will always keep it diversified in terms of the fund nature? That is a really, really good question that I wish I had a crystal ball better answer to. my very gut feel answer is that you will continue to see growth in the sector -specific fund area, but that the majority of it will continue to be through diversified sector -wide funds.

19:31I do think an interesting angle to that sector -specific fund point is when you think of that really deep sector growth in certain areas, in some ways, I think of it as two broad categories that drive that growth. One is sectors that have traditionally been fairly debt heavy, like LBOs, aviation, real estate, traditionally a debt finance asset class that was maybe historically financed by a bank or a capital market solution that is now financed by a private market solution. But then you also have things like life sciences, like venture debt, where you had an asset class, whether that be earlier stage life sciences companies or venture backed companies in general, that historically just did not really use debt finance.

20:13It was traditionally a purely equity capital stack until you were probably public, or maybe you had a very small bank line or something like that. And the rise of private credit and the ability to craft more bespoke structures has allowed some of these other industries to prudently use well -tailored debt solutions in a way that's beneficial for the company and works for the lender. Because again, a lot of of times that type of lending would just never really work for a bank balance sheet or often for a capital market solution either. It's an interesting question. And I can see from the credit side, you're much more managing the downside risk.

20:50And by definition, allocating to a specific strategy is different than diversifying. In private equity, you could be a little bit more thematic with the investments. But at the very least, to your point, where you have industries where you're seeing a shift in terms of where capital is coming from, why it should come from certain sources versus others plays into it. It brings up one of the broader questions in terms of the history of private credit. I started with Arvin around the financial crisis and seeing the shift from bank balance sheets, but I think it probably starts earlier than that. What would you point to as defining moments over time for this industry?

21:25Definitely. So I'll spare everyone going back to the first caveman who decided to lend somebody some mammoth jerky in exchange for a wool coat or something. Oh, I'll start somewhere. Yeah. But I do think this is interesting to me, especially because today, tons of the growth of private credit is happening in the life insurance space. And as you have this closer nexus between alternative asset managers and life insurers, and life insurers and other kinds of insurers, but especially long tail life insurers looking to bring more private credit on their balance sheet so that they can get additional yield per unit of risk and often an IG rate structure.

21:59Going back hundreds of years though, life insurance companies directly wrote loans against buildings and against assets and were in many ways the original private credit providers. In fact, the New York Times was bought by the Ox family with basically, I believe, all debt financing from, I think it was New York Life. It was definitely a large life insurer in the hopes that they would be more favorable to business in the era of William Jennings Bryan and the Cross of Gold and all of that. So these things all come full circle, fast forwarding greatly. And again, we'll view this through the lens of that BDC construct that much of this lending happens through.

22:37It was created in 1980, actually in response to similar dynamics to what you see today in terms of banks not being in a position to lend as much to small and mid -sized businesses as the government would like. That was really high interest rates, stagflation, regulation queue, huge wave of bank deregulation happened then that's far beyond the remit of this conversation. And BDC's muddled along for a little while. There were certain additional regulatory hurdles that had to be cleared, such as getting them passed through status to avoid corporate taxation, which a very important part of the BDC construct is that as long as you pay out 90 % of your taxable income on an annual basis, there's no corporate taxation, similar to a REIT.

23:13And then you had this first wave of internally managed BDCs, but you're limited in how much you can grow in internally managed BDCs since you can't have other vehicles that the manager is running. And then you saw a wave of externally managed ones before the financial crisis. Some of those did well. Some of them struggled a little bit. Many of them still exist. But then the financial crisis, as Armin pointed out, was really a light switch moment, watershed moment, whatever analogy you want to use, where you really saw private credit and direct lending especially begin to shift from something that was really a small, mid -sized option for somebody that really never could have of access the capital markets and maybe would have been working with a community bank otherwise, really begin to compete directly with that syndicated loan or in some cases, even high yield bond solution for larger and larger deals and just put numbers around that.

24:07So a unit tranche is a very common construct of direct lending loan. It basically combines a 1L and a 2L into a single loan as the name unit tranche confers, might go to like 6 to 7X leverage instead of a 1L that goes 4 to 5 and a 2L that takes you from 5 to 7. So in 2016, you saw the first billion -dollar unit tranche, which is a very pun intended big deal. And now, billion -dollar unit tranches are common. 2 to 3 billion are common. I think you've had some cross -five depending exactly on how you count it and if you count the DDTL and the RCF piece with it. And that number is only going to continue to grow as you have more capital allocated to the space and as more borrowers see benefits to the private credit construct, even in a market where you can access the syndicated market, where you could access a bond solution, private credit will have certain solutions, privacy with certainty.

25:00And then also with the ability to have what's called a delayed draw term loan, which especially if you're a sponsor who's having a buy and build platform strategy, the ability to access incremental capital without doing an entirely new loan offering, but also not paying interest on a lot of capital that you're not immediately using is very attractive. Now, certainly the spreads that private credit can command over liquid solutions will vary based on the openness or lack thereof of the liquid market. But there's certainly now an acceptance that there are advantages to the private credit solution over a syndicated solution, irrespective of market environment.