#114 - Michael Gross: Private Credit Crowding, Complexity Alpha

0:05Michael Gross:Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, a leading investment advisory firm. Learn more about our show at insightfulinvestor.org.

0:38Michael Gross:My guest today is Michael Gross, co-founder of SLR Capital Partners. Michael is also a founding partner of Apollo Capital Management and one of the pioneers of modern private credit. He later co-founded SLR, which today advises on roughly$13 billion in total available capital as of September 2025. The firm is focused on senior secured and specialty finance lending to middle market companies. Michael brings more than 30 years of experience across multiple credit cycles. Thank you for joining us today, Michael. Thank you for having me, Alex. I look forward to this. I do as well. Well, you were one of the founding partners at Apollo and later went on to build a major private credit platform.

1:21Michael Gross:What do you feel are the most enduring lessons from that experience that may still shape how you think today? So I started my career at Drexel in the late 80s, working under Mike Milken, who really kind of created the high yield bond, which became the lifeblood of the LBO market. And then I co-founded Apollo in 1990 with several other of my Drexel partners. And I was there about 16 years before I left to create SLR. During those first 13 years, I was in the private equity business. That's what the firm did. And we actually cut our teeth by first pursuing acquisitions of companies through distressed debt, which is a phenomenal learning experience.

2:03I think that taught me, as I think about my career today, that taught me how to be a skeptic. When you're buying distressed debt, nothing ever appears as it is. And be willing to kind of take on complex situations to get to where you want to. But I think the biggest lasting thing that I took from my experience in private equity that then translate over into private credit was that I got spoiled as an investor because in private equity, you get to spend three to six months analyzing coming from the inside before you decide whether to buy it or not. And so when I made the transition to Credit Apollo and began to build out their business by creating their business development company, I wanted to bring kind of a private equity focus to private credit, which means having the ability to direct underwriting all the time.

2:50And that's kind of the hallmark of our firm here at SLR. Everything that we do is directly underwritten, directly originated, and directly monitored. Those were kind of critical lessons I learned. I think the last kind of enduring thing I took from it was the whole issue of having alignment of interest with investors, having real skin in the game as investors alongside of our investors. And I felt that that was particularly important when I made the transition from private equity to private credit, because you really need to create a different kind of culture to do credit investing versus private equity investing.

3:25And what I mean by that is in private equity, you can be a successful investor and be right three quarters of the time. Why? Because your 40 % return deals offset your bagels. In private credit or any kind of credit, you got to be right 99.9 % of the time because you don't have any upside to offset your losses. And so we needed to create and have done here at SLR, and I did during my latter years at Apollo, the environment where there was literally no tolerance for losses, which means not being willing to take any risk because we don't get paid to take risk.

3:56Michael Gross:And those are things we're going to spend a lot of time talking about today. But just taking a step back, you've lived in both worlds, a massive multi-strategy platform and also a more focused credit firm. What advantages do you feel genuinely improve underwriting at scale? And what are the hidden costs that come with size? It's a great question, especially because we're in an environment today where a lot of the managers have gotten so huge that they're focusing on having$1 trillion,$2 trillion of assets under management, which is all well and good. There are clearly benefits of scale. You need to attract the right talent, you need to be able to have enough capital to provide the solution that you want to for your counterparty, and you need to have a low cost of capital.

4:38Those all come with having a certain scale. But I would argue also that there's also a disadvantage of scale. By being too large, you begin to be in a situation where you kind of lose control of the investment process. You're relying on professional teams of investors as opposed to kind of the founders and principals to manage it. And you can't have that same touch as you will. So we can talk about it later, but I kind of believe that when you think about this kind of scale, it ultimately leads to potentially lower returns and taking on more risk to put capital to work in an inefficient basis.

5:13Michael Gross:And there's probably a sweet spot where you're big enough to have scale to be able to pay for talent and have the infrastructure and not so big where you're, you have some of those other issues that you described. What I like to always say is that as an investor manager, you should not let your fundraising success drive your investment strategy. It should be the reverse. You should raise the amount of capital you need to be successful and relevant in your fundraising, in your investment strategy. You touched on this a little bit just now, but we've seen that as firms grow, the business can drift from investing toward asset gathering.

5:48Michael Gross:What do you feel are the early warning signs that a credit platform is heading in that direction? What's happened is with the advent of these liquid public alternative asset managers who have aspirations of reaching$1 trillion, $2 trillion of AUM, the focus becomes more on growth as opposed to returns. And when I'm on panels, I like to kind of pose the question to the audience is, you know, who are the true beneficiaries of the rapid growth we've seen in private credit with billions and billions of dollars in raises? There are a few constituencies. There's the investors. There's the asset managers or the public shareholders of those asset managers.

6:27And then there's the borrowers. Well, clearly, the borrowers are benefiting because they're getting more access to capital on a cheaper basis with more competition. the investment manager and their shareholders are benefiting because they're getting more and more management fees but i question whether the investor is benefiting from this huge growth that we've seen are they getting better returns because of it it's debatable and so when i think about you know what i look for in terms of risks of people getting too big it's you know expanding into adjacent strategies that they don't have the experience in by hiring new teams to do it so They don't have the track record.

7:00Beginning to see kind of returns come down, beginning to see the size of companies that want its financing change as a result of that capital raising success. To me, those are all kind of yellow warning signals of growth for growth's sake as opposed to for investment's sake.

7:17Michael Gross:I think one thing that's very interesting about what you just said is, and maybe the investors are not the ones that benefit. The investors are the ones funding all of this, right? If it wasn't for the investors, you wouldn't have the big asset growth and you wouldn't have the borrowers getting better terms. So it is interesting how that exists. Yeah. And we can talk about later, I think, that that's kind of been exasperated by the sheer growth that we've seen in these non-listed evergreen BDCs with how much capital has been raised and the effect kind of on the institutional investors who've been kind of funding that growth, as you mentioned, as a result of that.

7:51Michael Gross:And one of the potential challenges in this massive growth is the underlying risk that's taken. Because risk is one of those things you may not see until bad things happen. So it can go kind of just beneath the surface for an extended period of time until it surprises everyone. So if you could sit down with your 30-year-old self, what's one counterintuitive lesson about risk you'd emphasize? What I would emphasize is to not shy away from complexity. Complexity doesn't necessarily mean more risk. Complexity means that you're pursuing investment strategies in areas that require significant diligence, significant documentation, significant structuring, significant monitoring.

8:37and as a result, it's focused on businesses that are less competitive because there's less capital pursuing them. It's easy to say, I want to grow a cash flow portfolio of direct lending that's extremely scalable rapidly. But if you want to grow a factoring business or an inventory financing business, it takes a lot of people who've been doing it for a long period of time and a lot of infrastructure to do that. But what comes with that complexity is higher returns because there's less competition. And importantly, the complexity also brings much tighter documentation, which leads to more downside protection in those investments.

9:10So kind of the young Michael Gross would say, hey, let's go grow for growth stake. How quickly can we scale? The more mature Michael Gross, looking back at that man, would say, hey, take your time, build out strategies and infrastructure that allow you to access investments that aren't available to every other manager and focus on those and try to grow those.

9:31Michael Gross:So obviously private credit has gone through a pretty major evolution during your career and you've been involved in multiple eras of private credit. When you tell the story of the asset class, what are the key inflection points that you feel mattered most? When I created Apollo's BDC back in 2004, the intent was to kind of launch Apollo's credit business. And for me, it was to launch kind of a private credit business of direct lending. back during that time period and before then the only place that a private credit investor lender could participate was really mezzanine financing all the commercial banks pre-gfc provided very low cost bank financing for lbos and there was no ability for private credit to compete with that the cost of cowboys was way too high well when the when the gfc hit everyone kind of saw a light bulb go off.

10:24And the light bulb was really twofold. One was that, oh, commercial banks were forced to exit attractive direct lending businesses. And that opened up an area for people led by Aries who ran into that quickly. But the other light bulb that went off is one of risk reward. We quickly realized that you could lend on a senior security basis at maybe four to five times debt to EBITDA, put a little bit of leverage against those loans, and you would get far superior returns than you would lending on a mezzanine or second lien basis with a lot less risk. So pretty much everybody within private credit switched and went from being a mezzanine lender, second lien lender, to becoming a first lien lender.

11:04And that really created beginnings of the growth of the private credit space, financing middle market LBOs. We then entered a period of time when rates went to close to zero. And so from 2012 to 2021, we're in a zero internet environment, which was really a heyday period for private equity because they could borrow money extremely cheaply. A result paid very high prices, which they did, but also created huge demand for private credit as an asset class and a financing source. And so we saw continued growth within private credit at that time. Then we entered a period of time when rates started to go up and they went up quickly 22 to 24 23 to 24 22 23 and we saw that it became what was known as the golden age of private credit yields went up they became double digit and private credit took on really a more dominant role that because the syndicated low markets are pretty much closed during that period of time and private credit filled the void and it was the first time you saw mega deals being done of$1 billion,$2 billion,$3 billion led by people like Blackstone and others, which basically fueled the growth for private equity.

12:17But what happened was that as soon as rates began to stabilize and come down, the private equity firms were smart enough to know that the minute the spreads came down, they can go force the private credit community to reprice those loans. Because the alternative was either reprice them or they'll go to the syndicated loan market and redistribute them? Well, the response from the vast majority of private credit investors was to reprice when holding those loans. So we then entered a period when we saw rates started to come down, spreads come down, and you can track private credit portfolios yields from the end of 2023 through today going down 25 basis points a quarter.

12:59Why? Because there's been this massive refinancing wave that private credit has fed into because they've raised so much money, they have nothing else to do with it. And so when I talk about pressure on returns, we're beginning to see the pressure on returns as a result of that. It's really kind of supply and demand driven. During that same period of time, we've seen the explosion of non-listed BDCs, which have a business model that require you to invest that capital when it's invested. And so that, again, creates more supply to fund all this demand that private equity has.

13:32Michael Gross:Yeah, that was a great summary of the last about 20 plus years. Thank you for that. One observation is cash flow lending has become commoditized in many ways. It's obviously better for borrowers, but potentially less attractive for lenders. Where does commoditization show up? Is that pricing? Is it terms or somewhere else? All the above. And the way you can see it evidenced is if you look at the portfolios of the public BDCs, which are disclosed every quarter by statute, you have to. you can look and see how much overlap there is amongst BDCs. There's one or two BDCs that are as high as 80 % overlap.

14:13There's others that go all the way down to 50, 60, 70%. But there's a tremendous lot of overlap because everyone's doing the same deals. That's commoditization. As a result of that commoditization, which is driven by the amount of capital devoted to private credit today, it has done two things. It's driven down yields because people are extremely competitive to put assets on their books because managers get paid on assets under management. And it's also driven up risk because two things have happened. Leverage ratios have gone back to peak levels. You're back to six to eight times on basic industry companies.

14:46And structures have gotten compromised because the other way the private credit firms compete to get business from the PE firms is to offer attractive covenant package, which often means no covenants. And so I would argue that the vintage that we're in today carries more risk because they're higher levered companies with lower yields and worse structures.

15:06Michael Gross:One other observation is historically private credit existed because smaller companies couldn't access public markets and lenders earned a meaningful liquidity premium. And now more recently, we've seen private credit moving up market into larger loans and sometimes even competing directly with public markets. What does that shift do to yields and to lender leverage in negotiations? You're hitting on a critical point, something that I'm personally critical of, of our industry is, back to an earlier comment, people have allowed their fundraising success to drive their investment strategy. So what's happened is when all these non-investment BDCs have exploded in size, and this is the mega ones, I'm not talking about people have raised one or two billion, people have raised 10, 20, 30,$80 billion for these structures.

15:54it changed kind of the investment dynamic in a big way. Historically, private credit was based upon having drawdown fund structures where the investment manager said, okay, there's a good time to invest. I'm going to call capital for my LPs and now I'm going to lend it out. The non-listed BDCs are such that it's more like a mutual fund. When the money comes in, it's got to get invested a month because all the cash is coming in. And if they don't invest it, the yield goes down. And so it means that the investment manager no longer has the ability to judge and say, what is a good time to invest and when a bad time to invest is.

16:29And so we become more of a supply demand market. When money flows into these funds, rates come down and structures get worse. It's also allowed people to change where they invest. So one particular very successful asset manager, if you look back at their private credit portfolio five years ago, their average EBITDA was$110 million. At$110 million, at five times leverage, which is a 550 million credit facility, you're firmly in the middle market still. You're not big enough for the syndicated middle market. If you fast forward to today, because of how much capital that they've raised over the last five years, their average EBITDA has tripled.

17:10It's$330 million. So at five times, that's a$1.65 billion credit facility. In a reasonable market, that's a syndicated loan. So now you have these private credit funds competing with the syndicated loan market, which allows the privately sponsored to play everyone off of each other and get to better yields. And so it's a long-winded way of saying that the illiquidity premium that used to exist in the larger space has come down dramatically. And so I do believe, it's back to my comments earlier about the benefits and the detriments of scale is one of the issues of being too large is you're becoming the market and you're not getting the illiquidity payment anymore.

17:51You're forced to go to the larger companies and put on assets on your books, which will drive down yields.

17:57Michael Gross:And one of the dynamics that I've observed is when the markets are strong, money flows in. And when markets are weak, money goes out. And that is in many ways counter to what it should be. And that also feeds into the loans that are being made. And that's true of private equity too. The irony is that the most money that's invested is when prices are the highest, not with the lowest. And the most lending credit that's invested is when yields are the tightest because that's when the money's spreading in. The more kind of flexible debt managers who have the ability to time the market and have other strategies beyond just traditional direct lending and capital lending will have the ability to outperform if they have the flexibility to move their capital within those strategies.

18:38and to your point, to not invest in the levered loans when the market floods in, but to invest instead when the capital is departing.

18:47Michael Gross:Another major evolution is that lenders once competed primarily against one another, whereas today they often collaborate through co-investments and other structures. What do you feel has changed culturally and structurally to make that cooperation possible? There's a few things. One is, we hit it earlier, it's the size of the companies being financed. If you're a$300 million e-bent company raising$1.6 billion, there are not many people who are going to write a$1.65 billion check. You're going to have to club it together with three or four other players. And at the end of the day, it's the private equity sponsor who's determining who their lenders are.

19:24And if you're a private equity sponsor, you really don't want one lender, ideally. It's too much control in one party. you're typically as a private equity investor looking to acquire a company and then probably do add-on acquisitions. So you want a lender or lender group that can grow with you. And so they'll oftentimes on a 500-million dollar deal, they'll have two rookie participants, each doing 175 or 150 and change, and allow them to club together so that when they do want to grow, they can add more capital. It also allows them, if one lender changes their mind, they can replace them with somebody else.

19:59So that's been going on for a while. don't see that changing. Where you don't see that is in more complex strategies like receivable financing, inventory financing, or lender finance, where it's typically sole managed because that lender needs to have complete control given the amount of controls they have going forward as opposed to a typical levered loan.

20:24Michael Gross:The other factor that is at play today is political and geopolitical uncertainty, which can freeze activity and reduce issuance. When deal flow slows, what actually changes for lenders first? Is it pricing, structure, or selectivity? Typically, there's a shock to the system and deal flow just stops. So, for example, when on Liberation Day, you solve for a period of time, people had a very difficult time forecasting businesses. They didn't know what the impact was. So activity literally did stop. And so the first thing that comes back is the nice thing about it as a lender is the leverage shifts back to the lenders as opposed to the borrowers.

21:04And the way the lenders kind of exert that influence is, to your earlier comment, it's in structure. They'll be allowed to kind of put covenants back in place. And the next thing that comes is yield. They'll ask for more yield. And then until things start to kind of come fully back around, you won't see leverage ratios tick up. So there's more of a conservatism put in place and the terms kind of favor the lenders more. And that's why, you know, going back to kind of my talk about the golden age of private credit, when the syndicated loan market shut down during that period of time because rates had spiked so quickly, private credit was able to move much more quickly and fill that void and get much more favorable terms.

21:45So prior to that happening, you know, you were getting 70, 80, 9 % yields. Post that happening, people were getting 11 % to 13 % of yields, and they were getting covenants. Now, it was short-lived, but private credit does have the ability to take advantage of that dislocation when the public market is shut down.

22:05Michael Gross:As a private credit lender, is there a better way for allocators to build a private credit program so you're not so dependent on one particular market environment being favorable? Definitely. I think, look, we've seen the evolution of private credit as an asset class, and I'm old enough to know because I've been doing it that long. It used to be people didn't know what private credit was, then they started to get into it. And the way everyone got into it originally was to go into the brand name, direct lenders, who are all kind of in one strategy, cash flow lending. We've talked a lot about today so far that it's become pretty homogeneous and commoditized.

22:45there's probably not a lot of return differentiation amongst those parties, given they've all been doing the same thing. And there's probably a lot of overlap. What's happened now is as this has come full circle, is that the sophisticated investors have said, I want more in private credit, but I don't want more of the same. I need to kind of diversify sources of private credit yield into other more esoteric and complex asset classes that aren't suffering for the same supply dynamics of traditional direct lending. So we've seen, and we've seen it from our LPs, much more of an open mind to looking at some of these smaller niche strategies.

23:23And they could range from drug royalty to life science, to lender finance, to receivable financing, inventory financing, equipment financing. These are all asset classes that carry a lot less competition and carry higher yields because of the complexity involved in doing it. And so we're seeing more of a desire from those who've been in the asset class for a while to not necessarily slow down what they already have in the ground, but to add to it by adding these other strategies and trying to find diversified sources of income away from traditional direct bondage.