#105 - Josh Baumgarten: Credit Investing Across Firm Sizes

29:37So for example, in the public corporate markets, CLOs in the loan market are the biggest driver of demand for the leveraged loan asset class. And for a variety of reasons, they don't want to touch things that are going to be downgraded, especially low single B and God forbid, triple C risk. Like that just does not work largely for the CLO structure, which means there is an entire wasteland of not all good companies, but some that are OK, that might be single B rated or even triple C rated that they trade artificially wide because the biggest fire of the universe won't touch that cohort, which creates a really interesting playground for people like us who are not looking for broadly beta, but looking for rifle shot opportunities within that pile.

30:27Josh Baumgarten:So you've obviously navigated multiple credit cycles in your career thus far. Are there any signals that you watch most closely to anticipate potential shifts in the market? It's a great question. The answer is a little bit of everything. obviously what you're looking to do is to try to look for what the conditions are that are going to make capital scarce. And the way to think about that is a little bit more, what has created the distress cycles of the past? Historically, there are the opportunities where there is slow growth, capital is leaving the system, therefore the cost of capital goes up.

31:10And as a result, borrowers either can't find financing to mature your own patients or they can't afford it based on cash flow being less. That's a more traditional economic default cycle. I would tell you we haven't seen one of those in quite some time. And then there are industry micro cycles, which is where you want to be able to identify exuberance in some kind of particular sector where the cost of capital goes far lower than what is appropriate for the risk in that capital. And that's something we've seen and I've seen a number of times in my career. It was starting in the late 90s and early 2000s when cost of capital for companies that were building the pipes for what would become the internet and telecom changed overnight and led to a much broader economic slowdown as a result of the dot-com bubble.

32:13We saw that when the cost of capital became artificially very low for also bad underwriting, primarily in the residential mortgage space, which became the global financial crisis. We saw that in the mid-2010s when fracking became this amazing technology for extracting hydrocarbons. Cost of capital got way too low relative to the risk of those cash flows, and that led to dislocations in the commodity space. So the question is, where are those conditions today? Obviously, there's an exuberance in the sector of technology, and there's probably business plans and different companies getting either financing outright or a cost of that financing, which isn't relatively appropriate to the risk of the cash flows or the future cash flows of that company.

33:08We're obviously watching that area with a lot of thermos and trying to be very close. There's also lastly, you know, in areas that I always look for in markets, which I can't tell you it's perfectly defined as saying, well, the price of a commodity goes down and therefore, you know, commodity, so companies are at risk, but it's asset liability mismatches. You know, I think it's really interesting to identify where in the markets is an asset liability match. Doesn't mean they're always going to be exploited or challenged, but when they are, it usually does lead to a very significant dislocation.

33:47We saw that in the early 2020s, where a lot of get-liquid loans were funded by, in this case, short-term deposits. In the case of Silicon Valley Bank and First Republic, that created really interesting opportunity in private markets. And I'm just saying more broadly, in terms of risk-off parts of the market, that could be the case that's brewing today in private credit markets, I would just say the good news of private credit is that the asset liability match between the assets and the structures holding those assets, I would say, is very sound. And that's very different from when I started in the hedge fund industry in 2007, where everybody put illiquid assets in illiquid structures.

34:37I actually feel that that's absolutely not the case today. But when you go under the hood a little bit, a lot of those strategies require financing. And you really want to make sure that the financing that these different businesses are using is appropriate from a turn mark to market perspective. A lot of the mega banks out there that are very large in terms of providing capital to the private credit markets and very much understand these markets. are not necessarily willing to provide term non-market to market financing. And that's absolutely critical from an asset liability match. It doesn't mean that those banks are going to pull the plug because spreads will add 100 basis points or 200 basis points.

35:24But why put yourself in that situation if you can pay up a little bit for the right term and non-market to market financing that's really required for liquid assets?

35:35Josh Baumgarten:You brought up a point that I think is really insightful, which is this notion of what is the expected return for the risk that you're taking. Expect to return is easier to underwrite. Risk can be challenging because in the rearview mirror, there may have appeared to be no risk because nothing bad happened. And so you almost have to think about what is the risk that could surprise you in the future. And oftentimes you get this risk creep where the longer you go without bad things happening, the less risk is perceived, but in reality it's probably riskier. And the expected return comes down because there's more demand for that capital.

36:12Josh Baumgarten:And it's really interesting how those cycles can turn very quickly. So I think the way you described it is very thoughtful. Yeah, obviously. And there's one good thing about being in a firm like Beach Point or frankly, the other firms I was at, you probably noticed I don't have hair. And not all these things, these dislocations, risks in the market are exactly the same, but they run. And to your point and your question, what are the things you look for? I look for asset liability mismatches. They might persist for decades, but you want to know where they are and you want to be prepared because if and when those things get exploited, it usually results in massive risk-off periods, depending on the size of that asset liability in this match.

37:01So to your point, you have certain things you look for, certain things you price for and surround yourself with people who've been there. And you challenge each other to your point, which is avoid the inertia of where the market is, because markets will do what they will do. It's more always test yourself on the downside and things that have gotten bad once before, they can get bad at things.

37:26Josh Baumgarten:And at the same time, you want to be careful about making those big macro calls in terms of when that inflection point will come. So I guess you think about it, you're just mindful of the underlying risks without necessarily making a timing call. You're just positioning yourself, waiting for that opportunity. Absolutely, and that's what you do. So you invest around catalysts and being a credit investor. The fun part about being a credit investor is you always have a tether. That tether is a coupon payment. That tether is a maturity. So it can persist. A company's always got to come back to you.

38:01So it's kind of the benefit of, of course, focusing on catalysts, events that will substantiate your view of investing. but in credit, again, with coupons and maturities, you always have a reason for that company to have to come back.

38:18Josh Baumgarten:Would you give us a brief overview of BeachPoint and what distinguishes the firm? I know you touched on some of the areas already, but if you can talk about that a little bit more. Absolutely. You would love to. So BeachPoint really started as one of the, I'd say, one of the early pioneers in the world of alternative credit. I started about 20 years ago, again, we're 20 plus billion dollars in terms of assets and management, 180 professionals. Like I mentioned, importantly, and the fun part about my job is we have a breadth of capabilities where we try to be really a one-stop shop solution provider for our LPs who are living to invest in credit markets.

39:02So, you know, whereas a lot of people I'm sure you talk to have the, you know, the canvas that goes equities, private equity, real estate, credit, we really try to be specialists in credit to try to be broad in the world of credit. So we try to do is really make sure to be agnostic, like I mentioned before, in terms of cost of capital. We try to be agnostic, whether that's going to be kind of forward-based solutions or HACCP-based solutions. We try to also be agnostic with respect to the liquidity profile. So we traffic in public markets and private markets and in many of our funds and our individual accounts in both, where clients are really looking for us to determine what's the appropriate pivot between those different markets.

39:52So I think it's critical to be able to walk in with that breadth of capabilities. Like I mentioned before, we are a middle market specialist. So we have all the capabilities, the insights. And when I say capabilities, it's not just on the investment side. It's the operations, the legal parts of our platform, because while we make investments, we are running a business here. We think it's absolutely critical to be able to provide our borrowers and our LPs with the ability to bring large scale, large capitalization type of infrastructure and solutions, but with the ability to pivot between large cap opportunities and more likely those mid cap opportunities, which we think, again, we are far more differentiated in that world, providing our LPs with a differentiated offer.

40:47Josh Baumgarten:Obviously, many investors shy away from complexity. I know BeachPoint leans into it, but what attracts you to complex structures and strategies? That's what you have to do if your goal is to provide something differentiated to your clients. So, yes, our job is to traffic across these broad credit markets, which represent trillions of of tangible raw material for us to deal with doesn't mean that if there is a dislocation in public markets, we're not going to pivot our capital base to take advantage of great total return opportunities in liquid markets that aren't quite as sophisticated. But as you know, that doesn't exist all the time.

41:33In fact, that exists the minority of the time. So the majority of time, you're going to be looking across, like I said, different sectors, different sectors going through change, micro cycles within those sectors, businesses that are going through change, and trying to apply, whether it be legal complexity, structural complexity, in order to help be a partner to those borrowers and get paid to provide differentiated solutions to meet their needs. So frankly, I think that's what allows you to get paid more and create alpha is to identify complexity and liquidity premium. It also enables us to be, I'd say, much more differentiated partners to our limited partners who want to invest with us.

42:22Josh Baumgarten:How do you think about opportunities in areas where EBITDA isn't the driver, but hard assets are? It's a great question, probably more relevant today than it's ever been. So the early parts of the hedge fund world were really dominated by corporate borrowers and distressed corporate lending. I mean, that was the, like I said, the beginning and more nascent part of the hedge fund evolution. Post-GFC, all of a sudden you saw an expertise in an asset class being asset-based finance or structured credit markets that were principally the domain of banks. Because a lot of banks got themselves in certain challenges, you saw a transformation of sell-side professionals going into buy-side, kind of taking advantage of the dislocation many of those banks actually created.

43:18It turned from one of the most challenging episodes to one of the best long-term investment opportunities that our industry has ever had. And following that time, it led to the growth of a smaller than the EBITDA world, but a growing part of the universe focused on structured credit and asset-based finance, which is a discipline that I think they do exceptionally well. A pitch point, the difference being is that to be good at it, I think in both EBITDA corporate or asset-based finance, you need to be able to underwrite the underlying data. assets. You need to be a fundamental focused investor that really understands the assets inside and out and have a very good understanding.

44:06It's a little bit different, right? In terms of the asset-based world, you might be lending to a particular asset or a collection of many, many different loans that make up that asset. You run analytics that would get you to underwrite and better understand that pool that you're buying into. But at the end of the day, you've got to be a master of whether it's residential mortgages or a company that makes bridges. Beyond that, there's a number of different layers that I think are unique to the asset-based finance world that actually adds layers of complexity and therefore, I would say, is alpha to that part of the market.

44:47On the one hand, you have to be able to underwrite the origination plot. Like, who is that management team and the quality of that management team of operating business that is making loans, that is creating a pool that you are buying into? What is their alignment of incentives? What is your ability via structure to maybe stop or slow the underwriting of a certain type of collateral if you don't like what you're seeing? So there's an underwrite and an understanding of an operating business that is making loans. There is, again, the structural underwrite of that relationship between you and the origination platform.

45:31Then there's an underwrite of a servicing layer, which is there's typically a independent business. Maybe it's owned by the GP, maybe it's outsourced, where loans are actually being serviced by an external partner. Again, you need to underwrite the quality of that servicer, the alignment of incentives for that servicer. And again, via a structural underwrite, what's the relationship that you have with that servicer? Can you move servicing? How easy is it if something goes wrong to move that servicing? So I think it's very different. And then lastly, it's the capital markets overlay, which is I might buy a portfolio of loans.

46:14The ideal outcome might be to hold those as the raw portfolio of loans. It might be to go to a bank or insurance company to lever those. It might be to go access the securitization markets and actually create a structure whereby I'm optimizing the financing by finding a higher attachment point that will go to a bank, an insurance company, and will provide a barren cost of capital for what I own, which is the lower part of the capital structure. So I think what's interesting is the different layers that you need to underwrite poses, of course, additional risk, but for something that I think we're great at provides a lot more opportunity to extract alpha along the way.

46:58And I also think it creates an opportunity that because there's so many different layers, there's a lot less competition.

47:05Josh Baumgarten:How do you see private credit evolving over, let's say, the next decade, especially as more institutional and private wealth capital flows in? I mean, you just mentioned it. It's capital that's going to continue to flow in. In this case, it's going to be coming from areas like retail that have been a part of the alts landscape, but is becoming the absolute focus for every mega alternative asset manager. Right now, they are all explicit by saying, we need to target the retail investors. So I think you put it aside, you rightly assume that capital is going to continue to come to the asset class.

47:46With that, I think as a result, the cost of capital should actually come down. For private capital, you've seen it. You've seen it in the early evolution of private capital was really corporate private lending. And you've seen as that has matured, the allocation that LPs have made has matured, and a lot of competition has existed. So therefore, the cost of capital to those borrowers has come down. But I would tell you that those markets grow and they're seeing it a little bit more in a different part of the market, which would be private equity, real estate. Investors, sometimes even though that they're underwriting an asset class that is not liquid might want liquidity.

48:30And so I think there's going to be increasing ways and opportunity where liquidity will be introduced to the private credit asset class in the form of secondaries businesses, which are amazing businesses that haven't been as focused yet on credit. They absolutely will be. It wouldn't shock me that the large banks try to find ways to generate market-making activities. And by the way, that might be some of the large mega alt managers as well, creating markets in what would otherwise be less liquid assets. That sounds like a great thing, but keep in mind, everyone's going to need to be prepared for an asset class that everyone loves, the limited volatility.

49:17What happens if liquidity is introduced. Do you have to follow the marks? Are those marks just day-to-day marks or is it representing any liquidity bid? Do I need to mark my assets to those? So I think the changes are fairly vanilla in the sense of what capital coming in and more liquidity coming in. I think the impact might be more profound and that's what makes our job really interesting.

49:43Josh Baumgarten:And what you just described sounds like just a natural evolution of the growth in private markets and the blurring of the line between public and private. Absolutely. I think that's a huge advantage sitting here at Beach Point to be able to do both. I think it's going to become, frankly, increasingly challenging to just be a public alts manager or a private alts manager. you're going to want to be able to do both. And that's going to lead to probably some businesses that exist today that will not exist in the future. And others, like you saw in the case of my previous firm, Consolidation, where you're trying to get capabilities that I think largely will be asset class or private and public related.

50:31Josh Baumgarten:What do you feel like are the biggest risks in today's credit markets? And how do you think about mitigating them? Look, I see there are risks that exist, like I said, in terms of certain sectors that have become a bit more exuberant in terms of cost of capital and then the risk around the cash flow showing up. So technology is one area that might be the greatest opportunity, might also be the greatest risk. By definition, when these sectors and the exuberance shows, they tend to become the bigger drivers of sort of size in those markets. Technology has become north of 20 % of the kind of leveraged finance market and growing.

51:18And that's not just in the below investment grade markets that I focus on every day. That's also touching investment grade parts of the ecosystem as well. When those changes happen, the ripple effects will be significant and some of the businesses I've talked about that got financing won't get financing. Some of the businesses that may have been too focused on financing those businesses might have issues. So it's a cascading effect that might occur as a result of changes in the largest sector of the market. Like I mentioned before, the asset liability match that exists and underpins some parts of the private credit universe.

51:57Again, I'm not predicting that we're going to have a washout in terms of banks all of a sudden deciding to mark private assets lower and as a result demanding liquidity and posting margin, but it's something that bears watching. And then the last thing I would say, which again, might never come to fruition, but there's a really interesting underlying dynamic going on as a result of a certain buyer base in our markets being insurance companies. Insurance companies are becoming larger players in our markets, larger LPs to the GPs that you talk to. And they invest their balance sheet. like a lot of other large institutions.

52:44But as you know, they are ratings driven. And there is a significant ratings arbitrage where GPs and investors of all different types are looking to get things rated in order to appeal to this buyer universe that needs things to be rated a certain way for them to buy. Importantly, the insurance cost of capital tends to be a lower cost of capital. So if you can solve the ratings aspect, you can sell some piece of that capital structure to a very willing insurance company because it meets their needs. They have the direct duration of capital to hold those investments. Of course, as long as these things don't get down with it.

53:27So there's like an arbitrage, a massive arbitrage that exists if you have the ability to access ratings markets and find the right collateral, get a rated and find that next buyer for you as someone who's going to own probably the backing of that potential securitization. The risk, of course, becomes, in a world of ratings, downgrades. Well, who's the buyer of that wrong cost of capital, that rated asset that shouldn't have been maybe rated AAA, AA in the first place? And not to compare this to the global financial crisis, but at the time, if you recall, there was a massive push to try to get anything rated in order to appeal to a certain buyer base.

54:13And when that got downrated, buying bases disappeared pretty quickly. So again, I'm not tying the two, but I'm just pointing out when there are ratings arbitrages of which exist today, you need to be mindful. Is it appropriate? Is there a risk of that unwinding? And if so, where do you want to be both to protect yourself, but maybe also to take advantage?

54:36Josh Baumgarten:When you look across the competitive landscape, what do you feel differentiates the firms that thrive versus those that struggle in credit investing? You talked about middle markets and large cap, but are there other factors? Yeah. So on the asset side, look, I think because of what we mentioned before, it's rare that markets provide cheap beta on an ongoing basis. So you need to really find firms that are specialists in terms of underwriting particular areas in the market, specialists in terms of underwriting certain sectors. You need to be focused on managers who can provide a solution. So again, what is the alpha that I'm providing?

55:23Can't just be capital because if it's just capital, then the winner is going to be whoever provides the lowest cost of capital. So can I provide capital with greater flexibility? Do I understand the borrower, understand the business? So there's got to be alpha and bring, whether it be legal, structural, or liquidity, because you've got to be rifle shot. And then, like I mentioned, you've got to have the ability to pivot between, I think, public markets, private markets, corporate markets, structured credit markets. The ones that are going to make it are going to have that kind of flexibility. Importantly, there's also the dynamic of, as someone who invested in alternative firms, you're not just investing in a fund and the assets you're investing in a business right you are also taking business risks so i think what's also of absolute paramount importance to sit across from a business where they recognize the importance of the right side and the left side of their balance sheet and making sure that their funds are structured appropriately it's making sure that they have teams around them that allow them to cover a lot of ground, that they have a very specific process that allows them to debate, challenge each other, and get to the right answer.

56:44And then, of course, all the things that you don't see but exist behind the wall, which is back office, legal, infrastructure-related. Because again, And I'm already taking enough risk investing in the asset side. I don't want to take that business risk. So it's making sure you're surrounded by a firm that understands it's a lot more than just the investment side of the house. It's also the back office and infrastructure, making sure there are career paths, appropriate alignment. Like there's a lot that goes in to managing an alts firm. And I think it's all table stakes when you're looking to invest in one and think about who's going to be the future survivors.

57:25Josh Baumgarten:Josh, this has been great. I appreciate you taking the time to share insights. Thank you for joining us today. Alex, thank you for the opportunity. Appreciate your time. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes. And don't forget to forward today's conversation to others you think would enjoy listening.

58:02Josh Baumgarten:Important information. This podcast is provided for informational purposes only and should not be considered legal, tax, investment, or business advice. It is not a solicitation, recommendation, or endorsement. All opinions expressed by participants are their own and do not necessarily reflect the views of the Evoque Advisors Division of MAI Capital Management, LLC, or Evoque, its affiliates, or any companies mentioned. Information shared has not been independently verified by MAI or its affiliates. MAI Capital Management, LLC, or MAI, is registered with the U.S. Securities and Exchange Commission, SEC, which does not imply any particular level of skill or training.

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