#95 - Howard Levkowitz: The Past, Present, and Future of Private Credit

0:05Welcome 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.

0:38I'm excited to have Howard Lefkowitz join us today. Howard is a leader in private credit and alternative asset management. He co-founded Tenenbaum Capital Partners in 1997 and helped build the firm as chairman of its management committee ahead of its acquisition by BlackRock in 2018. He served as chairman and CEO of BlackRock TCP Capital and chairman of U.S. private capital business, and recently launched Signal Hill Holdings to provide growth capital to companies. Throughout his career, Howard has been recognized for bringing fresh thinking and navigating complex market opportunities. Howard, thank you for joining us today.

1:19Alex, thank you for the invitation, and thank you to your listeners for joining us as well. Great. Why don't we go back a few years? What originally drew you from a career in law into the world of investing? And how do you think that journey ultimately led to launching and scaling one of the early influential firms in private credit? I think it would be fair to say that my career was characterized by both a fair amount of intentionality and also quite a bit of serendipity. I grew up in Tucson, Arizona. I didn't have a lot of exposure to sophisticated business models and platforms, certainly not the investment management business.

2:04I was fortunate enough to go to school at the University of Pennsylvania where I got a broad exposure. I had two degrees for the price of one. I studied history, which was something I'm passionate about, and in the business school in Wharton because it was something I was really interested in learning about. and that taught me a lot, substantively introduced me to a lot of people. And in one of those situations, I met several MBA students who had concluded that the banking services for students in Philadelphia were woefully inadequate and wanted to start a student credit union. And I joined them.

2:43So I got some experience starting a new business, dealing with regulators, being in the lending business, dealing with customers. and I was the first president, second CEO, and I'm pleased to say that the University of Pennsylvania Student Federal Credit Union is still in existence today. I had planned to go to law school, which I did because I thought it would enhance my knowledge of complex business issues and transactions. I went into real estate. I was interested in it. At the time, almost all in the early 90s, almost all real estate was in bankruptcy, which was fine with me because I liked bankruptcy.

3:18It's one of the few areas in a sophisticated law firm practice where you can still be a jack of all trades and learn about a lot of things. And I was going along my planned career path of practicing law for three or four years and negotiating to go to a real estate firm. And here's where the serendipity comes in. I read an article in the Wall Street Journal about somebody who seemed really interesting to me, a gentleman named Michael Tenenbaum. He left Bear Stearns after 31 years and was starting a new investment firm. And on a whim, I decided to reach out to him and contact him. And we hit it off.

3:53He recruited one other person. So that was how the three of us began at Tenenbaum Capital Partners. Well, that goes back almost 30 years. So you started in private credit in 1997. And at that time, the asset class was barely defined. Would you walk us through what it was like building something from scratch without a pre-existing playbook to follow? It was hard. Our business model changed a fair amount in the beginning. What didn't change was we were focused on doing complex transactions, investing capital in good companies with difficult business complexity or strong asset bases. And what we discovered was it was a great idea, but it was so complicated that the people we thought who would invest with us always took longer than we thought to get up to speed.

4:45And we realized that we needed to raise a fund. And it's like anything else before you've done it. Raising a first fund is hard. Michael Tenenbaum had an extensive background as an investment banker, but no track record as a money manager. Neither my other partner, Mark Goldsworth, nor I did either. And so we were basically three guys in a flip book running around trying to raise money. And I still have a lot of scar tissue on my knees from those original meetings. We were delighted when we scraped together$54 million of equity and$126 million of really expensive debt. And we had$180 million of long-term committed capital to launch our business.

5:28Our first deal was interesting. We found a specialty retailer that had a good business model, but lousy financial management. They couldn't get their financial statements done. In fact, it took 18 months after we closed to get them done. It was a public company. Their banks had cut them off. They were going to file for bankruptcy. Nobody could figure out how to save them. And we did extensive diligence. And we really dug in and concluded there were assets to pay us back. There was a business there. The vendors wanted to save them. And they joined us. And then a firm that at least people had heard of called Goldman Sachs also thought it was a good idea.

6:04So they joined our little group. And that's how we established ourselves with our first deal and our first fund as being people who would do rescue financings or to get done financings that others couldn't. And so we put ourselves on the map as being a group that would do difficult transactions. And we also bought a lot of debt in the secondary markets, both bonds and then later over time, bank loans. It's interesting. We started our conversation with you describing your passion and interest in complexity. And your first deal was relatively complex. Well, what do you think it is about complexity that draws you in?

6:46It's more interesting. For one, it's more intellectually challenging. And I think there's also room for outperformance. When you think about some of the original business principles we developed, and I should say, you know, this probably applies to anybody, regardless of what you're doing. It starts with integrity and reputation. So that was at the top of the list. But I think it's even more important when you're providing capital to complicated companies, because people have to trust you and know that you're going to do what you say and do the right thing. But we liked finding deals that weren't so easy to do with a Bloomberg, a keyboard, and a phone.

7:27We liked things that we could really roll up our sleeves, do unique structured transactions. So a lot of the rest of the business during this time, people who were doing these kinds of loans and rescue finance things often had a high yield business or a bank loan business. And they came from that standpoint. And we made the conscious decision that we wanted to be a boutique. We wanted to be specialized investment managers focusing on more complex, interesting, higher yielding situations. We weren't trying to become an asset manager that was doing all things and adding a more commoditized product to it.

8:09And how did you and your co-founders evaluate risk and opportunity when there was no clear industry template? It starts with companies themselves. I think certainly when you're a credit investor, first and foremost, you're looking at the business, the industry, its management. The macro is important and you can't ignore that, particularly in a volatile environment. But we're really focused on being a business analyst. One of the nice things about doing private transactions is you get to spend time with management, see the company's books, talk to suppliers, customers, competitors, really analyze the business itself.

8:53We realized early on that we weren't going to be experts in all industries or frankly most. And so we created a situation where we had advisors that were specialists in each of the businesses we sought to invest in. And these were industry players, not investors. They were where people had spent their entire career in senior positions in the industries and had a history of good judgment because you can be a great business analyst, but if you haven't been in a business your whole life, you're going to miss things. So we did that. We structured things with downside protection. We stress tested them.

9:34And maybe most importantly, we learned from our mistakes. Our investment checklist kept growing. Anytime we'd miss something, we added it or We noticed if somebody else missed it and a deal, we'd add it. And it was very organic and we're very self-critical, I think, as part of our process. Our podcast is called The Insightful Investor. And one of the insights that I feel like I'm hearing from you is maybe more broadly applicable beyond just private credit is this notion of if the thing you're investing in is really easy to understand. There's less opportunity to generate a skill-based return and asymmetry.

10:18Whereas if you're pursuing a situation that is complex, and you're highly skilled relative to your peers, then maybe you can extract extra alpha or some opportunity excess return that others cannot. And I could see why if you feel like you can play in that game, that you'd be attracted to that space. Well said. That's exactly the thesis. Looking back, what are some of the surprises you encountered as private credit gradually evolved from a niche to one of the most sought after and influential sectors within private markets? That's a great question. And I think you kind of led with the answer. Lending is one of the oldest human-to-human transactions in history.

11:05You go back in any society and there's some form of, with any degree of advancement, there's some form of lending going on. But it has evolved tremendously from a niche that didn't have a good name to a major asset class. And it's understandable because if you look at private lending, it encompasses many areas. But if you look at sort of the easiest to understand, corporate direct lending, and you compare it to traded bank loans, there's maybe 200 to 400 basis points of outperformance over the long term. And if you add some judicious leverage, you can increase it. One of the things we discovered when we were starting, though, was it was really hard to explain to people what we were doing, because we'd go to the debt investors, credit investors, and say, well, we've got this long term seven to 10 year lockup fund.

11:53And they'd say, wait a second, just stop, go talk to the private equity people. That's private equity style. So then we go to talk to the private equity people. And they say, oh, no, oh, no, you got credit in there. Go talk to the debt people. And so one of our early challenges when this was a niche without a name. And in fact, if you went back, you'd see we kept changing the name, trying to figure out how to describe what we're doing in the very earliest days, is that there weren't a lot of people who were set up to invest in absolute return inflexibly. Now, today, that's changed a lot. But that was certainly the case when we started.

12:30Yeah, basically didn't fit cleanly into a box until gradually became apparent that it should be its own box. And then eventually that box was created. Yeah. And I think what people discovered was regular distributions are great. When we first started, it was during the dot-com boom. And everybody thought they could make 20, 30 % a year on their money and nobody wanted distributions back. Everybody was awash with money and we were paying quarterly distributions because we're taxpayers and we thought it was nice and we had these leveraged funds. And people said, why are you doing this? And then after the dot-com blow up, a bunch of those same investors started calling saying, when is the quarterly distribution and how much is it going to be?

13:11And so I think the investors discovered that getting really nice, consistent cash flow returns is good for spending policy and reallocation. And for the managers, It's a very consistent business. But the real breakthrough came after the GFC. And I think that was probably a seminal event for the industry itself. It was for us because we had these commingled funds where we'd invest up and down the capital structure with a heavy emphasis on credit and making loans. But we did all kinds of things. So you eventually sold the firm to BlackRock. What lessons would you take from that experience? and how did it shape your view on scale, culture, and innovation in private markets?

13:58What we noticed starting about eight years ago was what had been a niche was becoming an asset class. And a lot of the private equity firms that hadn't had any interest in our business were piling in and creating big teams. Traditional asset managers were coming into the business. and a number of these farms were much larger than we were, much better resourced, global in scale. And we realized that as the business itself was growing, the size of the deals was growing, more better capitalized people were coming in and that if we wanted to keep our position, we were going to need a step function in growth that was going to be hard to do organically.

14:41And we decided that we would talk with a couple of large players that might be able to help us get there. We were honored when the world's largest asset manager, which had a small business doing what we were doing, concluded that we were the right growth solution for them. They had more people doing due diligence on us than we had in our whole firm. And I think that enabled us to solve for the issue we'd identified, which has become even more pronounced today. What do you feel is the biggest mistake investors make in private credit today, especially as the market has clearly become more crowded and competitive.

15:19Let me bifurcate that. I think when we talk about investors, we'll first talk about professional investors. I think the biggest mistake people have are aggressive lending structures. Usually when you have a credit problem, it's a liquidity crisis or a confidence crisis. It's not a balance sheet crisis. And you can think even to like the last few weeks when we've seen some headlines about bank issues. When somebody is concerned at a bank, the stock gets sold. If it's a real problem, depositors pool and the regulators come in and start putting pressure on the lender. And so although the banking system is designed for long-term stability, it actually has a fair degree of vulnerability.

16:11And the same thing I think is true when you look at mutual funds and some of the other vehicles that are out there. So one of the mistakes that I think professional investors make is having structures, financing structures that are vulnerable, short term, subject to triggers. That's how the investors get in trouble. I think one of the other things is that as the industry has involved many of the large players and small players also, either do exclusively deals with private equity or mostly deals with private equity. And that has a lot of advantages. It's easier to run your business that way. Private equity has lots of resources.

16:53They're active. They're prolific. They're generally smart. They invest a bunch of equity and they can replace management. They can merge in other companies. that can do all kinds of things that are good for the business. But on the flip side, they have different math. They are looking for doubles, triples, higher returns. And if occasionally investment goes bad, none of them want that, but it doesn't kill their economics and their fund if they've got enough winners. If you're a credit investor, you can't withstand those kinds of numbers. You can't withstand losses because you're funding at par or maybe 98 cents on the dollar.

17:29Maybe you get a little prepayment premium, but a loss is really painful. And so there's sometimes a disconnect there because the private equity people want their good relationships to finance everything. And not everything that's a good private equity investment is good debt investment. And I think you see this through many periods of time. Now you're seeing it with some consumer durables and some healthcare areas of professional services where the business models are not so robust for the lenders. and they're taking hits. When we talk about mistakes for the underlying investors themselves, I think sometimes people go into lending vehicles that are publicly traded, don't think about or don't realize how volatile those can be.

18:19The underlying instruments may be credit, but they trade like equities, albeit maybe with a little less volatility. I think people going into private funds sometimes underestimate how long it's going to take to get their money back. They hear that an average loan is three years duration. They look at the investment period. They do some math and they figure they're going to have most of their money back. And the reality is the average duration may be three years, but that's because a lot of things prepaid quickly. And there are always some loans that are in there in long-term vehicles that stick around for a long time.

18:53And maybe the final issue there is, I think people tend to focus a lot on the firms. And ultimately, all of these businesses are comprised of people. The success is only as good as the managers themselves. And you've got some terrific firms who are really good at a lot of things that are not as good at direct lending and private credit and just haven't been able to build those teams. And sometimes there are changes in the teams and people may not focus as much as they should on who's actually doing the underlying work. Well, we've seen a surge of capital and activity in private credit relatively recently.

19:34Do you feel like this represents a bubble or is it simply the market catching up? In other words, closing and inefficiency that existed for years as banks pulled back from lending? I do not think it's a bubble. And the reason I don't think it's a bubble is because of the structures. Usually for a bubble, things need to fall a lot. And there may be defaults and default rates may pick up. But private credit in general has been pretty clever, certainly in the last decade, about how they've structured most of their vehicles. You have the traditional long-term locked-up funds. You have permanent capital vehicles, public and private.

20:20You do have these vehicles that provide some liquidity interval funds that may have some exposure, but they can limit how much comes out. And so if you have significant credit issues, the industry isn't going to fall. It doesn't have the risk we're talking about in sort of in the banking system or in funds that are subject to quick-term redemption where prices are going to fall. Things may get marked down. There may be defaults, but I don't think that's actually the popping of a bubble. I think also you're seeing an evolution in the industry as people do more in different kinds of financings. If we would have had this conversation 20 years ago, we probably would have been talking about 20 to 50 million, maybe$100 million deals.

21:1010 years ago, we would have said$500 million is sort of the largest that you'll see in private credit. And today, you're regularly seeing multi-billion dollar deals getting done out there. And so there is more capital, but there are more borrowers doing different things. The capital is addressing different kinds of structures, different kinds of deals, bigger companies. What I do think you may see is a reduction in returns. Some of that is simply because the base rate, often SOFR, whatever it's tied to, is coming down. Some of that is because asset spreads, which were higher a couple of years ago, have reduced in part because of the relatively benign economic environment, in part because of competition.

21:57And so you're seeing some of the vehicles out there reduce their distributions, but I wouldn't call that a bubble. That's just the ordinary course. And interestingly, investors may not get hit as much in the near term because the way some of these vehicles are constructed, the first reduction may hit the investors, but right now we're getting pretty close for a lot of them to their hurdle rates. So the next reductions may impact the managers more than the underlying investors, depending on the structure. I ask the question because we see so much money going into private credit and new funds popping up all the time that a natural response of investors is that's too much money chasing returns.

22:40And what you're describing is looking at it just from an asset class perspective and looking at the actual loans and the structures that are set up. And from that perspective, it doesn't look like a bubble. Correct. The concern about a lot of capital going into the sector, you don't even need a Bloomberg. I think you can pick up any business publication and almost on a daily basis now, you'll see headlines on private credit, something that wasn't even an asset class. And there is a lot of money. And it is very competitive. And that is putting pressure on yields. So returns may come down. And I do think in the short term, they are headed down.

23:19for the asset class. There will always be people doing more unique things and outperforming, but that's very different than a bubble. That's simply lower returns to the asset class. Are there any attractive elements of the early no-template innovation in private credit from a couple of decades ago that are missing from today's more institutionalized market? Yes. When we started the business, as you pointed out, there were no templates. and it was harder and more differentiated. I'll go back to the first investment we did in our first fund, which I mentioned at the beginning of this conversation.

23:59It was a really troubled company. And I said to our law firm, please use as a template your toughest credit agreement with the most covenants. Then go through your other agreements and find every covenant that's not in there, put it in the document. and here's a long list of company-specific and industry-specific covenants. And I recall walking into the meeting with the management, they said, you gotta be kidding. And I said, no. And we wound up having almost all of them. And in today's world, when you talk about covenants and restrictions, you hear things like covenant light, no covenant. Is there a covenant?

24:42What does the covenant say? It's a very different process than it was. Also, the ability to do diligence has changed. There were a lot fewer rules around the process previously. Today, I would say some of this is digitization and the wider availability of information. You don't have to physically go to the company to see things, and everything can be accessed online pretty quickly. but it used to be that you would control as a lender the process however you wanted to control it. And in today's world, there's a shifting of power in many situations, not in all where the lender will limit the diligence process because it's competitive.

25:26And maybe one of the more dramatic changes is that many of the private equity firms have a function today that's called capital markets or something like it. And the job of that person is to make sure that they as borrowers are getting the best terms possible. So they will contact their closest three, five, 10, 50 or 100 friends and say, this is what we're looking for. And these are the terms. So the good news is you can get stuff done a lot faster that way. But it is certainly less friendly to the lenders. And then maybe one other thing, which is the size of the companies has tried to change dramatically.

26:09Small companies are still financed, but many of the deals done certainly by larger managers today are much larger businesses that have far more resources, particularly if something goes wrong. It sounds like part of what you described is just a natural maturation of the industry, meaning you have more lenders competing, the borrowers will naturally get better terms because there's more competition for their dollars. That has certainly happened. And the borrowers have gotten more sophisticated and there's more information available. It used to be people didn't even know what people's terms were.

26:46Today, if it doesn't get splashed in some publication, it's probably in some disclosure document somewhere. And I'm sure there's some cyclicality to the terms as well. If you go through a bad economic stretch, then the terms probably get a little bit tighter. Absolutely. Whenever you get a backing up in the capital markets, the lending terms from the perspective of the lender get more attractive. So if you were starting your investment career now, what are some of the skills, mindsets, or technological foundations that you'd focus on developing and why? Yeah. I think anybody in the investment business should have a really good foundation in understanding financial statements.

27:34Maybe that's the historian in me. I like to understand what's happened. At its simplest, I look at investing as having a rearview mirror. You've got to understand the past. And it's always interesting when companies show up and they show you the projections and they don't want to talk about what happened. Dig into the historical statements and cash flows and really pull them apart. And then when you're done with the rear view, you've got to look at the windshield and see what's in front of you. And that is a more complicated process. You need to be able to have some sense of whether management's projections are right You need to have some macro sense, some regulatory sense.