E289: The Evolution of Private Credit and What Comes Next

0:00Thanks for coming on. So Rick, you're the global head of private credit at Pantheon, overseeing one of the largest private credit secondary platforms in the entire world, with over$12 billion raised from 250 institutions. When you look back across your chapters in your career, what were the first principles, lessons that shaped how you think about a private credit business inside a global alternatives platform like Pantheon? We really started with a kind of a really modest, modest beginnings. We had a couple of investors and a first close in a fund. But I think it really starts with kind of formulating what the value proposition is for investors.

0:41As leadership, what we were trying to figure out was with our team and with our platform, what's our edge? What's our angle in the marketplace? And what problem are we really solving for clients? So we figured out what the value proposition was for credit secondaries. It was then from there figuring out how do we develop and communicate what the investment process should really look like when you're going after a market opportunity that's very nascent and very new to a lot of different people. So we spent a lot of time developing the investment process and the underwriting philosophy. And then you bookend that on both ends, one with how do you originate those types of assets?

1:19And then at the final part of it, the other bookend is how do you portfolio manage that? So once you have origination, investment process, and philosophy plus portfolio management set up, you then figure out how do you scale? How do you scale to become a trusted liquidity solution provider in that market? That's where team, technology, operations, and everything else come to the forefront. So that allowed us to be an early entrant and innovator in credit secondaries. And it really set the base for us trying to build, you know, the type of platform that we have today with our immense size and scale and depth and breadth.

1:54But it really starts off with that. How do you figure out what's good for investors? What problem are you really solving? And then figuring out the different elements along the way to make it make it achievable. And why does the market need a secondaries fund within credit? It's a bit counterintuitive. Absolutely. So I think what we realized a long time ago was that the credit markets on a primary basis had gotten so large, call it around$1.7,$1.8 trillion in size, with so many different types of investors, whether they're institutional, insurance and pension to high net worth to family offices and the like, plus the immense number of managers that had been created over the last decade.

2:41When you have a lot of managers with a lot of vehicles, a lot of investors and a lot of capital, you fundamentally need the ability to tactically reallocate and rebalance those exposures if you're a holder of those exposures. And we as Pantheon saw this evolve in other asset classes like private equity 35 years ago and infrastructure 15 to 20 years ago. Each of these private markets asset classes have varying degrees of liquidity and duration. And we realized that private credit didn't have that. And the real big bang moment was when we, again, back in 2018, created this fund focused on Europe initially for credit secondaries with the right cost of capital and the right go to market.

3:27That really created the impetus for this market and where we are today. So we looked at client innovation in that regard and then figured out that's how we need to address the market needs for liquidity. Said another way, a secondary solves a problem which solves liquidity for the investor and they have entire portfolio. You could have a venture secondary, you could have a private equity secondary. Why can't you have a credit secondary? And your answer is, yes, we can do that. And that's what you created. Absolutely. And it's a bit different in that credit secondaries and private equity secondaries, you're buying out some kind of discount and then it might be undervalued or overvalued depending on the intrinsic value of the equity.

4:14In credit secondaries, it's whether or not the credit instruments pays off. It's whether your loan is repaid. There's a lot of different value drivers in credit secondaries. You've alluded to this correctly, which is we're trying to figure out what the asset is worth and what kind of risk adjusted return are we getting on that asset. So the way we think about credit secondaries is you're providing a liquidity solution. There's a cost related to that. That cost in the form of discount and potentially portfolio selection helps cushion you against some level of expected loss that will manifest itself in those portfolios over time.

4:57And then as a buyer, we can do other things. We can get the dynamics of a pull to par in a portfolio. As an example, a portfolio might be marked at 95 and it could repay back at 99 or 100. We'll get some call protection, maybe some equity upside in some of these portfolios. So there's a lot of different drivers of value in a credit secondaries book of loans versus just simply buying it, you know, as an example, in the private equity market, an asset at a headline discount. So the dynamics are much more complex, much more nuanced. And that's what makes it, I think, a pretty interesting place to spend time in.

5:37and the underlying loans what's the quantum within your fund and how do you think about diversification and exposure to different market cycles so we we've been in this market a long time so we have exposure to over 5 000 loans on a look-through basis we have relationships with over 100 GPs globally. We are spread primarily between North America, primarily the U.S. and Western Europe. And we span a whole range of different underlying credit strategies. They could be on the senior side, middle market direct lending. But we do participate in lower middle market and upper middle market parts of the direct lending market.

6:21Within other credit strategies, We have exposure to mezzanine and subordinated debt. We've done some things in real estate credit, structured credit, capital solutions, special situations. We've even done some things in royalties and film finance, music royalties and film finance. What we're trying to build are, depending on the various components of assets, diversification across many different matrices. Diversification can come through individual company, obviously, where we really limit the look through exposure. It can come through vintage year, sector exposure, those sub strategies, as well as duration and credit quality.

7:00So what we're really trying to do for clients is deliver an access point for them that they might otherwise not able to get themselves in a significant way. And they're able to get it at a discount or attractive pricing with much shorter duration and potentially even better credit quality than they might get on a new origination basis. That's the real beauty of the strategy in a nutshell. One of the hardest things of investing is seeing what's shifting before everyone else does. For decades, only the largest hedge funds could afford extensive channel research programs to spot inflection points before earnings and to stay ahead of consensus.

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8:51Is the product supposed to encapsulate an end investor's entire credit portfolio? Is it intended to do that or should it be part of a broader credit portfolio? And talk to me about that. Great, great question. I think the use case is very, depending on who you are as an investor, we found that a number of institutional investors are looking at credit secondaries as a very attractive complement to what they already do in private credit. So they, in many cases, are looking for alpha, they're looking for a differentiated way to get access to many of the assets that they're familiar with, particularly in direct lending.

9:32So that could be a use case for many investors. They want to get access to alpha, a premium return, a better risk-adjusted return by investing in fully funded, diversified portfolios. We have some clients who are insurance companies, and their real attraction to this space is that they can invest in a very capital-efficient way because many of these portfolios have a diversification and cash flow profile that allow them to be rated attractively on an IG basis. And so for them, that's incredibly attractive. What a lot of investors have also realized is that the benefits of credit secondaries are such that you can reduce the dispersion of returns that exist in private credit if you were otherwise investing on a blind pool basis in a new portfolio.

10:20And again, that's where the benefits, again, of investing in fully funded portfolios and attractive pricing come into play. For a lot of high net worth investors who otherwise can't access closed end funds because of minimums or they want some sort of periodic liquidity. Again, we created access points for private wealth, both in the U.S. as well as internationally, to get access to credit secondaries. Again, solving some of those same needs around getting alpha, getting, interestingly, access to strategies and assets and other types of portfolios they might not otherwise get access to. The fund invests through LPs and through GP-led portfolios.

11:02Tell me about that rationale and what are the pros and cons of that strategy versus going out and buying direct loans yourself? So our market sources opportunities through those two channels. So we simply look at the market as one where we are trying to buy seasoned performing credit with top tier managers by providing solutions around liquidity to the holders of those assets. The holders of those assets can sometimes be in the form of an LP interest where you're simply transacting on those particular portfolios. The benefits for us are that you're investing in a set portfolio. You can't really change the composition of that portfolio or the structure or the terms of it.

11:47So very simply, you're providing a point of view on price and execution to deliver that liquidity. What's really growing in our part of the market is what we call kind of these GP liquidity solutions, which are often in the form of what we call continuation vehicles. And what we're really doing there is we're buying a select portfolio that we curate based on our views of credit quality, the attractiveness of pricing, and how it fits in our overall portfolios. And those assets may be held by one vehicle, one investor, or across many different vehicles. And we're often partnering with the GPs. The benefit for us is we can often get very detailed diligence on each of the underlying assets in a greater way than we otherwise would on the LP side, even though we do underwrite line by line and bottoms up on the LP side as well.

12:41But what we can also do in terms of picking the portfolio is we can also dictate the structure in terms of what the ultimate fees, expenses, recycling, if any, might be on that portfolio, what kind of leverage structure might be on it. And then finally, we can also dictate what the alignment might be on that portfolio, which is really important. Obviously, as an investor, you want to make sure your GP is aligned on that portfolio and shoulder to shoulder with you with their capital as well. So the benefits can often be much more downside protective in a GP liquidity solution because you can eliminate potentially problem assets.

13:19You can lower the overall risk profile. But very simply, they are just two different channels to get access to the same types of assets. The way in which you can do it can be a little bit different. The timeline in prosecuting them can be very different. We are seeing almost a very significant sea change on the GP side. We've executed over 45 of these types of transactions in our history. We did over 20 of them by 2022. So what's often viewed as kind of a new development in our market is certainly something that we've been very familiar with for the last six or seven years. And we see the growth of that continuing for the foreseeable future.

14:01secondaries always sound great you're getting in private equity secondaries you're getting 10 15 20 discount ventures sometimes you could get 30 40 and the number one thing to always look out for is why is this person selling also known as adverse selection potentially how do you know that your portfolios are not adversely selected and how do you do the diligence to make sure that that's not the case great question what our view is that adverse selection can come in any market And it really depends. The way to mitigate adverse selection is having a really wide origination funnel. So as I mentioned at the beginning, we've spent a lot of time cultivating relationships directly with GPs, directly with LPs, with intermediaries.

14:45We created a funnel that was broad geographically and by strategy. So we've sourced somewhere on an annualized basis, somewhere between 50 to$55 billion of deals this year. That compares to something close to around 36 billion last year and almost six or seven years ago, around$5 billion a year. So that gives you a sense of the growth. So the way to mitigate that adverse selection is having a wide funnel, but it's also having access to tremendous amounts of information. So having all of those incumbent relationships in private credit, as well as a very large portfolio and a$2 billion primary program in private credit just gives us unique insight, incredible vantage point, both on a micro level and macro level around what's happening in private credit and with specific companies.

15:34So that allows us to identify things that are problem assets. Obviously, they might be marked already in the 70s or 80 cents on the dollar. That's obviously a red flag. But even more importantly is the red flag around an asset that's marked at 98 or 99 and is potentially underperforming. So we are in the midst today at the end of October of a lot of talk in our market around idiosyncratic risks that have happened, generating losses in the credit universe, not necessarily private credit, but companies like First Brands and others that looked seemingly performing from a valuation perspective, but were clearly underperforming from an operating perspective.

16:20So having that information, having those relationships and just having a team of credit experts that have been doing this for a long time with decades of experience, analyzing direct credit and all of these different end markets. We have specialists who've done both sponsored and non-sponsored direct lending, asset-based lending, European lending, special sets. So when you put that all together, that's a good recipe for being, I think, very confident in terms of being able to vet credit and make sure you're not stepping into someone else's problems. Fundamentally for us, for me, when you talked about first principles around investment philosophy, you really want to be focused on performing credit and performing assets.

17:05Buying someone else's problems is really much more of an equity risk. And that's not what our investors are looking for. They're generally looking for consistency, predictability, and stability. Those are really important attributes around credit investing. Protect your capital at all costs, first and foremost. principles of investing in our asset loss. So said another way, if it's performing, that's a good thing. If it's not performing, it's very difficult to tell to the extent that's not going to perform. You're going to discount it, right? So if something's a problem asset and you have to take it, then you're going to mark it down.

17:43So a good example of this more recently was we bought a portfolio, an LP interest with a very high quality manager that had a line item in it. that recently hit the news, we knew it was a problem asset. And during the course of our diligence, we realized and noticed that it got marked to zero in the portfolio. So even though it was a problem asset in the portfolio, we didn't have to worry about it because we weren't paying anything for it. The GP proactively decided that that asset was going to be worth zero. So for us to take it as part of the portfolio didn't impact how we thought about overall pricing or return.

18:19But it's important to identify those things as part of your diligence process. so you know that you're not stepping into other situations that might have similar characteristics to them. I want to have you take off the hat of private credit investor and put on the hat of private credit and finance entrepreneur. You built this$12 billion franchise within Pantheon. How does one go about building such a franchise? What is the first step? What is the second step? And what are some principles that you use to build out such a franchise? We are in the human capital business. So I think first and foremost, you have to look around and look at the kindling that you have.

18:57And I think the first thing that we gathered was putting together a great team. So we put together a team where we had expertise in direct credit. We had expertise in secondary solutions, fund finance, M &A. These are all important skill sets to have to bring together in one place. And then finding people who are really interested in building a business and growing an asset class. So I think early on, we discovered a common thread among people we were talking to who also felt uncomfortable about kind of the risks and challenges that were existing in the primary market of private credit. And we're looking to exercise their investment muscles effectively in a place where they could be creative, solve complex problems, and be part of something that could have a real future and change our industry, particularly in credit and in secondaries more broadly.

20:01So it really started with a culture of those types of attributes and team expertise, and then leveraging our strengths as a firm, right? We've really been innovative in other parts of the secondaries market over our four decade history. And then obviously leveraging a lot of our personal connectivity and relationships as individuals. I think one of the things I really like about our business is that we are real partners to GPs. We're not competitive to them. We help them with references. We help them think about the market. We help them with investor introductions. We help them think through fund structures.

20:38So we're trying to be not just capital. I realized early on when I was involved in building other credit businesses, you know, your capital is a commodity, but who you are as an individual and your relationship and where you can be constructive to somebody, whether it's someone that you're interacting with on a transaction, you're trying to buy something from them, you should try to be constructive and value added. or whether we're partnering with a GP who's going to be stewarding a lot of our assets on a go-forward basis, that's important to be value-added to them too. So those are all, I think, the most important elements of how you build something from the ground up.

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21:47And the best part, you keep 100 % of your savings. Get started with Experian app today. Results will vary. Not all bills or subscriptions are eligible. Savings not guaranteed. Paid memberships with a connected payment account required. See Experian.com for details. What do you think GPs look for you from a perspective of value add? And how have you been able to add the most value? So I think GPs recognize that we are GPs ourselves. We're not just LPs. So I think first and foremost, there's that level of commonality of experience and being in the trenches and investing in different things similarly over the course of our careers.

22:29I think GPs are really looking to us as a trusted sounding board. They're looking at us for candid advice that they probably can't get from other allocators in the market or other investors that just don't bring some of those shared experiences and battle scars, having worked through different investment cycles, different investment environments, and different types of strategies. So GPs are ultimately looking to us as a solutions provider, obviously, if we're looking at a particular transaction. But when we're not working on a particular deal, they're really looking for us for knowledge, for expertise.

23:05Can people on our team help them think through how to be better in fund management? How can they better serve other LPs that we also have as part of our own ecosystem. Private credit today is somewhere around$1.7 trillion asset class, one with a T. What are some of the misunderstood risks on the asset class and what are maybe some of the headwinds? Yeah, I thought a lot about this. I think there's a number of things that I think are misunderstood. One is, you know, maybe more at a micro level, you know, valuations are always things that investors scratch their heads about, right, to our earlier discussion around if an asset is in trouble, why is it marked so highly?

23:52And I think, you know, the valuation anomalies that exist in our business are a function of just private markets, time lapses between how valuations are put together and when information is got or received. And that's just the difference between, you know, being a private market, private markets investor and a public market investor. I think other things that are misunderstood include kind of correlation risks in our business. So when I see a lot of investors getting into asset-based lending, as an example, and again, it's kind of been more in the news lately because there have been several instances of fraud or collateral that's been mispledged or not diligenced well.

24:38And I think a lot of investors tend to overestimate the non-correlation of certain types of assets when they invest. And then finally, the other thing I think is misunderstood is just alignment, right? Our industry has changed a lot. We have a lot of large asset managers in our business, and we have a lot of boutiques. And I think how GPs are incented around their portfolios to deliver performance to clients is changing a lot. There's a lot of consolidation going on in the market as well. And who is aligned against your capital, I think, is an important consideration always. But I think it's an even bigger risk today than it's ever been over the last 10 years.

25:17Conversely, what do you think the skeptics get wrong about private credit? And maybe they should be a little bit less skeptical on? there's a lot of angst about private credit, but they don't realize, and there's a lot of worry around competition. But I think for a lot of things to negatively impact private credit, a lot of other things have to go wrong in other asset classes. So we as credit investors always talk about the fact that if you're worried about credit impairments, you have to think about equity impairments first. So being first dollar at risk in many businesses fundamentally means that you are not in a first loss position, someone else is.

25:54So if you really are going to think through challenges in credit, you really have to think through challenges in other parts of your book as well. So we often see investors that are very heavily in the private equity business or heavily in equity, and they're really wringing their hands around private credit, but not understanding completely some of the connectivity in that relationship. The other thing that I think is also maybe misunderstood is just this concept of risk-adjusted return in private credit. I think it's unique to the asset class because there are many different ways to get a 9 % return, a 10 % return, or a 15 % return in private credit.

26:31Most equity investors, as an example, think about multiple of capital. They think about the specific industry exposures or style of deals that they're involved in. In private credit, because of the use of structure and leverage and different forms of duration and cash flow profiles, I think the risk adjusted nature of how you invest is really important, right? If you can get a levered 15 % return lots of different ways, but the risks involved in getting that 15 % could be markedly different. So I think those two facts, I think, are probably kind of key things to think about in private credit for the skeptics anyway.

27:08You built one of the first evergreen private credit funds aimed at private wealth. What has What surprised you the most about building an institutional grade product for the private wealth channel? It probably wasn't a complete surprise, but what surprised me is the appetite, the level of demand for clients. I think we've always viewed it being strong, but I think it's really touched a nerve with investors with respect to getting access in a diversified, low risk way, I think has really resonated with folks, particularly around credit secondaries. So we've, I think, been very careful around making sure we build it in the right way that we're finding the right types of investors and explaining from an education and suitability standpoint, the tradeoffs between investing in private wealth or retail evergreens and the tradeoffs between, you know, using leverage or having access to liquidity and the pacing of those types of investments.