#52 - David Chene: Non-Sponsor Backed Private Credit

27:59And so you can see the scalability aspect here. So as much as you see a lot of headlines around fundraising, there's still a substantial number of U.S. institutional LPs as well as Middle Eastern LPs, Asian LPs that have very little exposure to private credit as an asset class. so i think you'll you'll continue to likely see even within the fixed income sort of allocation buckets for large institutional lps a more differentiated approach to credit which would be sponsor backed non-sponsor backed you know mezzanine distressed i mean it's getting much more sophisticated in terms of allocation approaches by large institutional lps And for us, that's good because it does show that there's a diversifying aspect to having a non-sponsor strategy in the portfolio.

28:54And LPs are always interested in relative value and how we can, again, create a differentiated return profile that's maybe a little bit more idiosyncratic or less correlated to what's going on in private equity. Yeah. And it's interesting going back to this boom in private credit. In some ways, it's playing catch up, right? Because there's a few things that have aligned that has allowed this growth to occur. One is banks are having a harder time and are facing some constraints in lending. There's obviously a need for lending. So private credit steps in to fill that gap. And then from an asset manager side or an asset allocator side, their returns have been pretty compelling.

29:40You have yields that are double digits. That asset class held up reasonably well in 2022 when public bonds were down pretty significantly. And so you could see why all eyes have turned into that. And at the same time as there is a need for it, you could see why you've had this big boom in asset growth. That's exactly right. Base rates, where they are today versus a couple of years ago, you know, has obviously helped the return profile a lot. It doesn't mean that there's not more risk. I would say that companies that were used to five, six times leverage at SOFR or LIBOR plus 350 in today's environment, that's a very different cost of capital.

30:27So I think below the surface, there's likely a little bit more stress in the system than maybe what meets the eye. But for sure, it's for fresh underwriting and for fresh deployment opportunities where you can see how the impact of higher rates has influenced a company's cash flow profile or position in their particular industry. There are good opportunities where you can get double-digit returns and still feel like your principal is really well protected. protected. Yeah, and you can look at that as an equity-like return, and obviously you're higher up in the capital structure. Now you're giving up some liquidity to get that, but from a return risk standpoint, it looks relatively attractive.

31:15That's exactly right. When we compared in the early days, and we still look at this as an organization, if you look at private credit as an industry and multiple investment capital for private credit relative to even private equity, okay, sure, it's a little bit lower, but it's not dramatically lower. And on a risk-adjusted basis, knowing that you're top of the capital structure, or if there's a problem, you have claims on collateral, et cetera, that's our pitch. Effectively, we think that's a good position to be in, and it's a good exposure to have if you're a large-scale allocator across multiple alternative asset classes.

31:50So why has Kennedy Lewis opted to search for opportunities outside of sponsored back lending? You've mentioned that a few times, but let's zoom in a little bit as to why you look there. In the early days, if one of the big banks was calling us for financing, it's because they got to the end of the phone book, right? I mean, you know, we were a small firm and we're constantly trying to think about how we can create a differentiated portfolio. And, you know, so we undertake this process of looking at, you know, the various sectors in leveraged finance and dynamics around venture and what those companies are doing.

32:28And broadly speaking, just getting away from your classic sort of box, if you will, in terms of the opportunity set in front of you, which is publicly traded opportunities or sponsor backed opportunities. And so it really started in the beginning with this idea that, okay, let's identify, okay, so we think there's a great opportunity in power because it's been underinvested in across the country, you know, supply dynamics are relatively constrained because of permitting, because of connections to the grids, okay? Like there's all these, you know, complications around in terms of getting new kind of reliable supply into a particular, you know, geographic area.

33:09And many of those companies or power generation plants are not necessarily sponsor-backed and have, So we look at that and say, okay, well, that's a huge opportunity because you look at the electrification of everything. You look at the impact of renewables and how that's creating volatility in power prices for certain regions. There's got to be a way to sort of wedge ourself into a few opportunities where we can see kind of supply demand coming into balance. We could see the market recognizing that there's more intrinsic value to those particular plants or in that particular area, just because you have electricity demand that continues to hit new all-time highs in virtually every market.

33:57Now you have the AI and data centers, which is a huge driver of long-term electricity demand. And so, again, that's just one theme, but it's kind of consistent with how we think about deploying capital. and you don't necessarily see a lot of sponsors in that space it's a very complex space we've been investing in it for over 20 years you know there's seven different markets all different regulatory regimes and it requires a real specialization to to identify opportunities where you know maybe the market's just not paying attention and there's a growth opportunity or there's a new lending opportunity or whatever what have you so that for us you know as we as we think about that being one sleeve of the portfolio, a lot of our investors, they like to have that kind of exposure.

34:46It's not, you know, it's not 30 % of the fund, but it's enough where it's like, okay, you know, if this theme is working, right, it's a good kind of ballasty return profile for the portfolio that we can depend on. And then relative to say, you know, healthcare or land banking or TMT, we have the flexibility to kind of change our allocations across those sectors, depending on kind of best relative value, best, you know, opportunity set, et cetera. So it's, again, it's not levered to sponsor activity in a way where we're going to have 30 % of our books going to be in one particular sector because that's what all the sponsors are doing.

35:27And then I think the biggest thing for us is, you know, when we, when every company has, like us, you know, we have situations that need extra work. We don't feel like if there's a covenant breach or there's something that happens, we don't feel pressured to do something that would be otherwise uneconomic for our clients. We can enforce, we can get extra economics, and then you're not necessarily biting the hand that feeds you. And I think that's maybe one of the challenges that, as much as it's maybe not popular to say, but it's one of those things that, you know, maybe to some of the direct lenders because there's so much deal flow is dependent upon the sponsors that when you actually have challenges in the portfolio, you might be a little reticent to really drive the best economic deal for clients.

36:15We have the flexibility to, you know, at times we've done sponsor deals when they call us and say, we need a bespoke solution and we'll structure our own document or our own kind of collateral package or what have you. But it's not something that we go out every day making phone calls. And a lot of that, so I think it really kind of, for us, it's more of a, it gives a lot more flexibility and making sure that no matter when, if there's ever a problem, we can really maximize our leverage to create a better solution for, hopefully for the company, but also for our clients. And then do you find when you are sourcing deals that are not sponsored back, that there's less competition, generally speaking, and as a result, you tend to get better terms?

36:58Yeah, for sure. They're not that easy to find. It's, you know, this has been years, we have, you know, 40, 45 investment professionals that we say part of their, part of their responsibilities day to day are, are sourcing deals and focusing on their sectors. I would say large, larger deals, you know, are always going to have maybe one or one or two other firms around it, but it's rare. I mean, for us, we probably just wouldn't even participate if we felt like this was an auction or something that was highly competitive and it was all just based on terms. We want access to management. We want access to monthly information.

37:40We want access, you know, we're going to be partners and we underwrite these like they're private equity positions. If they don't go right, you're going to own it. What are you going to do with it? Right. So we have to know that up front. What's our exit strategy before we put$1 in. We want to know that. So that is a much more iterative process than what you might get with a typical kind of sponsor process. And it gives us a level of comfort that we're actually lending to somebody who we feel like has a deep sense of responsibility to pay us back. And that's not to say other people don't, but I think for us, that's just that access to information is a key piece of what we do.

38:20So it's less competitive, but it's also, you know, you got to be careful as well. You know, I think we're pretty good at figuring out very quickly if the stars align, if you will, and what we can do in terms of greater credit protections, greater covenants, board level influence. We're not trying to micromanage, but we just want to make sure that we're up to speed on a monthly basis. And we have on the side, we have a team of operating executives that we have kind of on retainer. You know, so whenever there's an opportunity to either upgrade or take advantage of an opportunity, we're as a lender, we're pretty proactive about trying to offer resources that will, again, augment the profile of the business.

39:03I imagine a lender that's focused on sponsor backed companies is going to argue that it's a safer loan because they're ahead in line of the PE firm that has deep pockets. And as a result, maybe it justifies lower yields and weaker covenants. How do you think about that? Yeah, I would probably make that argument too. I think one of the things that also influenced our decision to create these non-sponsor focused kind of sourcing channels in the early days was a function of just the proliferation of Covenant Lite deals. the market. And so we know what that looks like. You know, you get quarterly information if you want access to management, kind of get in line.

39:51And when there's a problem, the documents are such that there's enough flexibility for the sponsors to, in some ways, allow for certain creditors that were otherwise peripassue with others to be treated worse. and so you never want to be on the outside looking in when that happens and because then you can have a binary a binary outcome and that's not really the intention obviously when you do a secured loan you know you think the odds of me not getting paid back are hopefully less than five percent and so i think for us we look at it and say yes there's there's there's truth to that statement around having true institutional private equity behind you and feeling good about it.

40:39But you definitely will get put in competition with other lenders that might be willing to do it for lower rates, for weaker covenants. And I think part of our risk mitigation strategy here at Kennedy Lewis is we want to take control of the top of the stack. And none of these games get played. and our intention is to again set a company up to succeed we'd love to get refinanced early we get some back-ended fees redeploy that capital and and then be viewed as a really a really high quality lending partner in the marketplace so that you know because in the non-sponsor world that really you know you need references you want people to to speak on your behalf and recommend us as an organization that's good to do business with.

41:28And that's really super important to us. So as we've kind of, this flywheel has sort of taken effect over the last eight years, I think the strategies, it's proving out, which is nice. But we certainly feel like, again, sponsor lending, not bad at all. There's a great place for it in everybody's portfolio. We haven't seen a cycle in a while. So maybe we're just, you know, because of our distressed backgrounds. We're always a little bit scared of what's coming. And so we just want to be well-positioned across the portfolio broadly that if we have a massive dislocation or, God forbid, something geopolitical happens, we're feeling okay about the deals that we're in.

42:12So tell me if this is a fair summary. So with the non-sponsor-backed loans, you may get a higher yield relative to the sponsor-backed loans. And maybe there's more risk, but you have more flexibility and you have potentially a greater ability to work out problems and more control to do so. That's right. And I think risk is all relative to what you think your LTVs are, your loan to values are, and relative to your information rights and your ability to step in. We have, in a lot of deals, we'll have kind of what we'll call creeping governance rights. They missed numbers one quarter, okay? They missed numbers the second quarter.

42:53We're parachuting people in to help operationally early, you know, before problems really exist. And, you know, what we have seen in our past from prior to KL days is that when things go wrong, sometimes sponsors can be even more aggressive about doing things, okay, to change the trajectory of the business that if it doesn't work, by the time you're left holding the keys, you're dealing with something that's actually worse than what it would have been if you kind of figured it out sooner. So I would say it's a much more active strategy to non-sponsor. We think it gives us the right setup in terms of really protecting capital, but generating a little bit better returns.

43:38Is there a risk of adverse selection with non-sponsor back loans since the borrowers we're not able to secure a PE sponsor? I think there's always a little bit of that risk. We're pretty good at identifying it. We can look for audited financials. We can look at how organized is something. I think for us, there's always a size threshold where we're not going to go below, right? So it's not like we're doing a$10 million EBITDA business. Those businesses, it's the same amount of work to structure a deal. And it's 10 times harder to figure out what to do with that if it goes wrong. and and so you know you want something that has real intrinsic enterprise value and so we can we can figure out very quickly how organized a particular company management team etc and what the story is because again we're focused on our sector so if we see a random deal with a random opportunity they want capital for some random you know you're like okay this isn't This isn't organized to execute on a particular strategy where that company is known to have a competitive advantage and it makes sense as to why they want capital.

44:45Again, most of our senior leadership here, you know, 11 partners will have 25 years experience investing. And you figure out very quickly if something has been shopped and now they're calling us. You know, sometimes there's opportunities there, though. We generally won't throw things out right away, but we'll figure out very quickly what the setup is. And so it's rare that something will end up in the portfolio that maybe shouldn't have. So you alluded to this a little bit earlier, but how can non-sponsored private credit help diversify a portfolio even within private credit? Well, I guess it's a couple of things.

45:25So I look at kind of correlation between credit portfolios and equity portfolios. Okay, so that's one. So if you have non-sponsor that is, they're doing deals across diversified set of sectors, you're going to get less correlation in your, you know, that non-sponsor portfolio than what you might get in your, you know, in your sponsor-backed direct lending portfolio. Just from the sector diversification. Correct. Right. So it's a kind of irregardless of what sponsors are doing at that point in time, there's deal flow happening in other sectors. So you get kind of that diversification. That's my opinion there.

46:02And some of the large cap, you're seeing a lot of overlap exposure between GPs, between managers, large, large scale managers. So there's 25 % to 30 % overlap. And what I mean by overlap is there's a large deal that comes to market. Your very large direct lending platforms all want exposure to it. And so they just carve it up across three or four different large cap. So, again, you're getting diversification away from that, right, because of, you know, the non-sponsor approach and because of the, you know, the more concentrated top of the stack, you know, kind of exposure and posture that we have.

46:47So again, it doesn't mean that either are bad, but it does give you a flavor for how to get some diversification with a yield profile that's going to be similar, if not a little bit, maybe a little bit better. So obviously, a big impact on future returns is how the economic environment transpires. And I know you kind of have a top-down view as well when you're sourcing deals. would you talk through your big picture expectations and how that impacts the sourcing yeah i think you know our house view so i want to say in late i think it was mid mid to late 21 we had a view that we were going to see very sticky and higher inflation for a long period of time.

47:38And so for us, anything that had relatively long duration, you know, where you're, maybe you're hoping spreads compress a little bit and you make a little bit more money on your return profile, we got rid of that. And we moved as much as we could in the portfolio to more floating rate risk. You know, because of our, kind of the target returns where we try and seek, we don't really have much what we'll call kind of rate risk. So if rates move up or down 50 basis points or 100 basis points, is it really going to change the return profile of what we're doing? Not really. But we certainly, in an environment where if rates do go dramatically lower, I think, number one, if they go lower in a rapid fashion, it's probably a bad sign for the economy.

48:27Something's happening when the Fed feels like they need to stimulate. But as you see a normalization through that process, you do want to be protected from getting refinanced out of everything much lower. And so we'll have call protection or we'll have features in these deals where if they're going to take us out early, we get extra fees for that. And so we're somewhat protected if the rates go down and then if rates kind of go up, we're already there. I don't think the, I think our house view is that rates are probably where they're going to stay for some period of time as much as maybe the Fed takes rates down.

49:04There's a lot of reshoring, unemployment's low, you know, the economy's doing fine right now. But there is a tremendous amount. And I think you saw it, you know, I guess yesterday, I mean, $100 billion plus commitment for, you know, infrastructure projects back in the US by, you know, by SoftBank. So the more that you see, and we've seen it through manufacturing capacity, utilization start to pick up. And so again, that will just continue to stimulate the market in a way where it could be inflationary, particularly with deficit spending and whatnot. So as diversification of supply chains, reshoring, fiscal stimulus, et cetera, it just feels to us like rates are going to continue to be kind of where they are for a while.

49:53So when we underwrite deals, we're certainly not underwriting anything where the return profile is dependent upon rates going down. If they do, great, we'll try and make sure we're protected. But if they don't, well, then we're not surprised. And how do you mitigate the risk that your predictions about the economic environment might be off? A lot of that's position sizes. When we underwrite deals, we generally, we like to take anywhere from like three to kind of 6 % position size, depending on what we think the downside protection is depending on the level of conviction we have in something. But if we're wrong, we're always calculating that this particular business might need a little bit more money.

50:36And we want to make sure that if we're asked to provide more money, number one, we're getting much better economic terms. We might get equity for that. We might get even better credit projections. We might get board seats. but we've had, I would say, half a dozen positions over the last seven or eight years where when those things occur and we've taken extra economics, having that flexibility to deploy that additional capital has created a very good outcome for the portfolio. So we look at it and kind of make sure that we always have the ability to deploy a little extra capital if we need to. We don't ever want to be full on a situation unless we feel like it's a 20 % LTV and we're getting mid-teens returns.

51:22And on a liquidation basis, we'll make a great return. Those are rare. And not to say they haven't happened, but they're very rare. So for us, it's a lot of position sizing and making sure, again, that up front we're positioned to be at the table. There's a disruption. Earlier, you mentioned a focus on industries that are in transition. Would you give us a couple examples of that? Power is definitely one of them, as I mentioned. It's a huge long-term opportunity. And I can go into more details on that. Another one is really, I would say, the home builder industry. So home builders have done very well post-GFC.

52:09They've all de-levered. And generally speaking, the larger builders have captured additional market share. When you look at the total home market in the U.S. between existing homes and new homes, the new home market, particularly with rates being where they are, has captured more market share in terms of home sales. And a lot of that is just existing homes. People have a 30-year fixed rate mortgage that's below 4%. And it's an asset now with rates where they are. So they don't want to move. They lose that. Otherwise, they get a 7 % mortgage. But the builders have become very, very high quality credit and equity stories.

52:50And what they're really trying to do now is become more asset light. And so builders historically were large land banks that had manufacturing companies sitting on top. And historically, they had land, capital tied up in land for a very long period of time. And so one of the transition sort of aspects of home builders is as much as they're in great shape from a credit and equity standpoint and generating good returns, they're still trying to become more asset light. So there's this part of the reason we got into the land banking. Darren, my co-founder, was a home builder analyst back at Goldman 25 years ago.

53:28So he's been very close to the space for a long time. But part of the reason we really got into, built kind of a franchise around land banking is because we could see that you have this, you know, this more, this opco-propco separation going on within the home builder space, which has never happened before. And it's not a risk transfer. It's that they're just trying to be more capital efficient. And they want to have, you know, financing counterparties that they trust, that know the business, that will be with them through thick and thin. they don't want to lose access to the land but they're willing to pay a fee for it to have as much as it might be a little bit of a degradation in their gross margins their return on equity in a lot of cases goes up substantially which allows them to trade better in the public markets and for us it's really just a financing vehicle and it's a you know long term you see all the builders now trying to get you know more asset like so that's that's a big transition and the way we've positioned ourselves with the builders, very trusted counterparty, but allows us to have real-time updates in terms of what's happening in the U.S.

54:33housing market and how that can inform opportunities for homebuilder suppliers and vendors and what have you. And so, again, there's kind of an ecosystem that's influencing how we're thinking about capital deployment in that space, and there'll be good opportunities to think there. Can you talk about your proactive approach to identifying lending opportunities rather than waiting for people to approach you, as is probably more common? It's more common now, but it was certainly for us, I guess. But in the early days, it was less common. I think that's where, you know, that's where, again, our DNA is, let's not wait for the phone to ring.

55:11When we look at these sectors, whether it's, you know, again, medical devices, diagnostics, tools, power, land banking, TMT, even in structure credit, where we have a sleeve that we focus on some cap relief trades, but also privately structured portfolio deals, whether it's consumer or what have you. Our view is, okay, we think the opportunity looks like this for that sector over the next five to 10 years. Let's go out and start talking to companies that we think actually could be well positioned. to take advantage of that growth or to take advantage of that disruption or that opportunity. And if you take, for example, what I talked about in homebuilders, we go to the homebuilders, we ask them, you know, who are your largest vendors?

56:05Are they, how are they doing? Labor inflation, okay, has impacted virtually every company. Do they need financing? knowing that they are a counterparty of yours helps us from a credit standpoint because we obviously understand the builders and how high quality they are in today's environment and so the sourcing approach is okay we do a deal with the business who are your top vendors do they need capital would you be a reference for us and again try and create that connectivity around a particular opportunity that will create more deal flow for us. And so it generally works pretty well, but it's totally separate and independent of what might be happening in the capital markets on a day-to-day basis.

56:58Would you elaborate on your all-weather approach to investing? So I think that's when we say all-weather, for us it's really in reference to the ability to take advantage of public market dislocations. And so when we think about the deployment, when we speak to our investors, they want capital deployed. They don't want to sit on a contingent liability to fund capital over time where they don't have at least some visibility on when that capital is going to get called from them and actually deployed in the market. And so we try and be very thoughtful about our deployment pace, certainly relative to the pipeline, but we also make sure we keep a little dry powder at all times for public market opportunities.

57:47and so if there's nothing to do you know spreads today are super tight you know the tightest they've been in a couple years not much to do in public markets well doesn't concern me i don't lose sleep over that because we have the you know the private pipeline where we're able to you know prudently in a disciplined way you know put capital work in the private opportunities knowing that we still have some dry powder if if we need to for a dislocation you know in 25 And as an extreme example, I'll say, you know, we raised our second fund. It was right when COVID started. And we had raised about half the fund, I guess, when COVID started.

58:28And 90 % of that capital was invested in public market securities in April of 2020. And so as much as we came out as this private credit firm and this is what we're doing, it was like, okay, you can't even price a private deal in that environment. because spreads are at 650, and you want a premium on top of that for the illiquidity in a private deal, and companies can't even afford that. At the top of the stack, you can't grow out of that cost of debt. So focused 100 % in public market opportunities. It was a great investing environment. We looked at the playbook that the Fed ran back in 08. It looked very similar, and as much as it was uncomfortable for that short period of time, it was a great opportunity.

59:18And by the end of 2020, we were 90 % back into private. It's not always easy if you're mostly in private to flip back to public, but that's why we keep a little dry powder. But to the extent that we have opportunities through an investment period in the public markets, we will definitely spend some time there. And again, it's not overly complicated. It's more, We know what private companies exist in that industry. We also know where public companies exist. And so we always have a watch list and we're always kind of paying attention. And, you know, if there's dislocations or opportunities, we'll spend some time there.

59:53But that way we're not all over the map and we're still consistent with our thematic approach, you know, which our investors have signed off on. Are there any particular sectors where you're currently finding disruption and potential lending opportunities? There's a lot going on in aerospace and defense, which between supply chains, post-COVID, between Boeing, obviously the geopolitical issues globally are having an impact on current inventory levels and how inventory levels need to kind of ramp back up. So there's working capital requirements. But yeah, that's a space that we're seeing more and more in.

1:00:39I would say, as it relates to LNG and midstream opportunities, we'll see what happens with this current administration. But for sure, gas is a transitionary fuel and will be helpful in terms of carbon footprint. Ultimately, the goal is to get to a complementary, reliable gas fire plus renewables. but there's just a tremendous amount of infrastructure that's required to get it there you know and in the meantime until there's large-scale economic battery storage it's going to be somewhat challenged so we're seeing a lot in energy transition energy infrastructure you know which you know will probably show up in the portfolio and then as i mentioned you know land banking you know where where there's that's just a you know when you look at the the size and scale of land on, you know, builder balance sheets, it's$150 to$200 billion kind of land opportunity over time.

1:01:41So it's, yeah, it's, it's put us in a position where we, we can be very selective about the areas that we actually want to own land and make sure it's entitled, zoned, permitted, et cetera, what's the best counterparties and allow the business to flourish from a sourcing standpoint as it relates to, you know, the kind of the housing complex broadly. That's great. Well, David, we've reached the finish line of our mini triathlon. And so I appreciate you spending some time with us and sharing your insights. Absolutely. No, I really appreciate being invited on. And thank you very much. If there's ever any time that I can clarify anything or be of service, please feel free.

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