Why Private Credit's Been Booming Even as Interest Rates Go Up

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1:15Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, what do you know about private credit? I know it's grown a lot. I know it's - That's pretty good. I mean, that's the important thing. It's private and there's credit involved. Okay. I think that's about, and I know it's grown, and I think that's about the extent of it. Yeah, all right. No, I actually, wait, can I just add a little more? Maybe. No, I get the, my sense is that for whatever reason, and this I don't know, people perceive there to be opportunities in private, like, you know, there's private equity, buying stakes, there's VC, et cetera, but people see an opportunity in pools of capital that are then lent out.

1:58Another lending that's not through banks. That's it. That's the episode. We're done. No, I mean, you hit upon the most striking thing at the moment, which is that this is a market that has grown remarkably over the years. And I've seen various estimates. I think people calculate what counts as private credit somewhat differently. But I've seen estimates of about$1.3 trillion to$1.6 trillion outstanding. And if you think about the publicly traded bond market or the publicly issued bond market, so if you look at junk rated corporate bonds, I think it's like 1.3 or 1.4 trillion outstanding, which means that the private credit market is now as big as the more broadly syndicated junk bond market, which is pretty stunning.

2:44And you also hit upon something really interesting that's happening right now, which is that the conventional line of thinking was that as interest rates go up, this was going to be bad for private credit. You were going to see more financial stress. Maybe funding for private credit was going to be more difficult to come by. And instead, the market has boomed. And appetite for these deals remains pretty strong. Yeah, it's sort of a subset, I guess, of the surprising resilience of credit in general. but absolutely you would think okay here's this rapidly growing asset class that is booming in the zerp era in 2020 and 2021 you think okay well this comes to an end now right it's in other parts of private markets have gotten a lot of trouble you know you know i think about vc and how much slowdown there has been uh there and yet as far as i know as far as we can tell and everything that we've heard in sort of snippets from other conversations that has not been the case in the private credit space.

3:41I got to say, I'm surprised when you were about to say how big the junk bond market was, I thought you were going to say something much bigger than private credit still. So the fact that it's caught up is pretty striking. Yeah, it really is. So we've been meaning to do this for a while, but I think we need to dive into this market. I expect we're going to do more over time. But to begin with, we need to figure out how these deals are structured, how they're different to broadly syndicated debt. So stuff like corporate bonds or leveraged loans, what higher interest rates actually mean for this asset class, and maybe even what private credit's impact could be on the broader economy.

4:17And I'm very pleased to say we do have the perfect guest. We're going to be speaking with Laura Holson. She is a managing director at New Mountain Capital. She is also COO of New Mountain's credit platform, which manages nearly$9 billion across private credit. So everything from private funds to publicly traded business development companies or BDCs. You might remember them from our interview with Dan Zworn way back in the day. I think that was like seven or eight years ago. The real OddLots heads remember the Dan Zworn interview. Well, this was when we still referred to private credit as shadow banking, which I don't see as much anymore.

4:57It's sort of this more accepted part of the market. But OK, on that note, Laura, thank you so much for joining OddLots. Thanks for having me. So maybe I could begin with a very simple question, which Joe kind of alluded to in the intro, but what exactly counts as private credit nowadays? Yeah, so the way I think about private credit is that it's debt that is privately originated, and Joe, as you said, meaning not intermediated by a bank, but that's also not traded on any kind of public market. And the term private credit is pretty all-encompassing. There's everything from direct lending, which is probably the largest element of private credit, but there's also opportunistic debt.

5:36There's distressed. There's real estate financing. There's a pretty wide range of things, I think, that counts as private credit. And it can be up and down the capital structure. So you could be senior in the capital structure. You could be junior subordinated. It's pretty all-encompassing. It also tends to be unrated as well, right? It seems to me like this is the big difference. So you'll get a corporate bond that is rated by a Moody's or a Standard & Poor's, but a direct loan or something like that would be unrated. Correct. Yeah, it's typically not rated. Before I ask another detail about what private credit is, why don't you tell us what New Mountain Capital is and what you do there?

6:10Sure. So New Mountain Capital, we're an alternative asset management firm. We have kind of three pillars to our strategy. We have private equity, we have credit, and we have a net lease strategy. And the way to think about New Mountain is that we're focused on what we call defensive growth sectors. So those are sectors of the economy that we think are going to perform well, regardless of what kind of macroeconomic environment we're in. So whether we're in inflation, deflation, boom or bust, we want to invest in very resilient, acyclical sectors. And we apply that strategy across all of our products.

6:42And importantly, we use the knowledge that we've built up over our nearly 25-year history as a firm and apply that same mentality and the same underwriting knowledge and intellectual capabilities that we have to credit, to net lease, and obviously to our core private equity strategy. Okay. So here's my other question. You know, we were talking about how big this asset class has actually gotten. How old is it actually? Because I hear different things. I hear people express concern for private debt because they'll say, well, we don't actually have that much historical data about defaults and things like that.

7:21But I also imagine there were private debt deals being done, you know, decades ago, maybe not in the same format, certainly not to the same extent. But we must have some historical basis for comparison. Yeah, no, it's a fair question. I mean, the reality is the asset class has grown tremendously over the last, you know, 10 to 15 years. But New Mountain's credit business, for example, we've been around since 2008. And we got our start by buying debt on the secondary market, debt that was trading at distressed levels, not because those companies were fundamentally impaired, but just because of the technical reasons in the marketplace that drove.

7:58Because it was 2008. Exactly, because it was 2008. And so as a result, we've seen our own track record. And so we feel like we have been cycle tested, right? We've gone through COVID. We've gone through the Silicon Valley bank. We've gone through definitely a pretty crazy period from an inflation standpoint. So there's been a lot of elements that we feel like we've kind of cycle tested our portfolio. But you're right. I think it's a little bit of a different form today than maybe private credit was 15, 20 years ago. What happened to private debt during the big COVID market route? And you can look at proxies.

8:36You can look at publicly listed BDCs. I think New Mountain has one of those. And you can see certainly like the share price went down quite a lot. But like what happened in more opaque corners of the market? Yeah. So I think, you know, during COVID, private credit, I would argue, held up better than, you know, the broadly syndicated market. You saw the debt and the broadly syndicated market from a trading level perspective trade down pretty meaningfully. But from a default loss perspective, actually, private credit turned out to be more resilient during COVID. And I think it's a function of how these deals are set up because they are meant to be a little bit more bespoke, more relationship oriented.

9:17And so private equity sponsors were able to have direct dialogue with the lenders and talk through, OK, here's what we're seeing in these underlying companies. Here's what we're doing about it. Let's talk. It's not a group of 50 or so syndicated investors that they have no relationship with. And as a result, I think we saw better outcomes in terms of just actual default losses during that period. OK, to help understand this market, what would be the modal or typical borrowing entity for whom private credit is a more attractive lending option than, say, going to the bond market and or going to a bank?

9:57Yes. So the way I think about it, and again, from where I sit at New Mountain, we focus primarily on what I call sponsor-backed direct lending. So direct lending to private companies that are owned by private equity firms. And the private equity firms need to make a decision, as you said, do they want to go to the syndicated market or do they want to tap the direct lending market for their financing? And there's a bunch of things to consider. But the way I think about the benefits of direct lending are, number one, you have more certain execution. Because when you're doing a syndicated deal, that's a deal that you're getting intermediated by a bank.

10:38They're underwriting it at a certain pricing level. But then they have the ability to flex that pricing level wider or tighter depending on market conditions at the time. And you're in market for, I don't know, maybe four weeks. And so you're taking a lot of market risk, particularly during times like we're in today where there's a lot of market volatility. So that's one thing is just the certainty of execution because a direct lending deal you commit from a pricing perspective and then you stick to that price throughout the rest of the negotiation. So you know what terms you're getting from the sponsor perspective.

11:14The second thing is it also can be a little bit of an easier execution because in a syndicated market, if a sponsor wants to get a first lien and second lien financing done, that's two different credit agreements, a first lien credit agreement, a second lien credit agreement, and an intercreditor agreement as to how those two tranches interact with each other. Again, you contrast that to a direct lending solution where you have a unitron structure with just one credit agreement. So it's also easier. You also don't need to go through the rating agency process, which also just saves time. And as I said, it's more relationship oriented.

11:51It could be more flexible and more bespoke to what the sponsors are looking for. Real quickly for the listeners and also me, what is first and second lien mean? Yeah, no, it's a good question. So it depends where you are in the capital structure. So first lien means you have the first claim or the first priority on the assets, and the second lien would be junior to them.

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13:42Go to public.com slash market and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash market. Paid for by Public Investing. All investing involves the risk of loss, including loss of principal. Brokered services for U.S.-listed registered securities, options, and bonds in a self-directed account are offered by Public Investing, Inc., member FINRA, and SIPC. Crypto trading provided by XeroHash. Complete disclosures available at public.com slash disclosures. I think we're kind of getting to the heart of why this asset class has been booming, because I hear this a lot from market participants, this idea that like, well, maybe the deals are structured in a way that makes them more appealing to investors versus the broadly syndicated stuff.

14:25So, you know, you mentioned that sponsors can get more definitive terms. You know, maybe the issuer doesn't have to go through the hassle of getting a rating and that sort of thing. And then you mentioned the first lien and second lien issue. And I've seen this come up in various ways, the idea of a preferential treatment in the payment waterfall. Is that the right way to think about it? So if you're in a private debt deal, can you structure it such that maybe you're closer to the issuer than anyone else? Maybe you get more insight into potential credit challenges before others. And maybe also you can enforce remedy payments that make you come out on top in the event of a default.

15:12So preferential treatment versus other creditors. Yeah, I mean, I think that is a fair way to think about it. When I think about, again, the purpose of a direct lending solution, it's a lot simpler of a capital structure. So you don't get into a situation where maybe you're fighting between the first lien and the second lien creditors, for example. Which we've seen recently. Yeah, absolutely. And to your point about just being closer to the borrower and closer to the company, the way most direct lending deals work is it's a club of direct lenders. So you don't typically have one direct lender that's underwriting and holding the whole tranche, but you have a club, meaning you might have, I don't know, anywhere from three to 10 direct lenders in a deal.

15:56And there's real benefits to having that diversification from the sponsor perspective because you have more dry powder, meaning you have the ability to go back to that same group and upsize and do incrementals or follow-on deals for that same company. but you're also not beholden to any one lender. Because one thing you could say is, oh, well, in a direct lending deal, if you have fewer lenders in the group, maybe those lenders have more power over the company or the private equity firm. And again, I think that really speaks to the benefit of having a small club. But you contrast that to a bank syndicate, which might have 30, 50, 100 lenders in it.

16:37And inevitably, you know, when you have a club of three, that those three lenders are all going to have more access. They're going to have more conversations with the sponsor. They're going to be able to call and have more of a direct dialogue with the management team as compared to, you know, if you're one of 100. So I think I understand to some extent the appeal of direct lending. What is the pitch? you know, let's say I'm an ultra high net worth individual or family in my advisor, oh, we want to, you should have allocate some to private credit. What is the pitch to limited partners or investors for why this is an appealing asset class?

17:12Yeah. So the way I think about it is private credit and direct lending specifically offers very attractive and consistent yield. And it's, I think, a very good thing to allocate as part of your fixed income portfolio. I think number one, it's floating rate typically. So we move up and down with interest rates. So in this period where we've had a significant run up, that has helped increase the yield of direct lending funds because the way the coupon is structured is you're tied to a base rate plus a spread. And so as that base rate has gone up, the overall interest rate that the investors end up earning has gone up pretty meaningfully.

17:53And it also provides some interest rate protection because valuation, for example, for a fixed rate bond has come down very meaningfully as rates have risen. So I think that's one thing to highlight. The second thing would just be that the higher spread compared to a broadly syndicated loan. And part of that is an illiquidity premium because it's not traded. You can't necessarily get out as easily, but you need to get paid for that. So you do get some extra spread from that. And then I think there's been good data showing lower loss ratios also of direct lending, again, compared to a broadly syndicated fund or a high yield fund.

18:33And so I think generally speaking, it's kind of that all of those things combined end up with a higher, more stable, more consistent yield, which I think is very attractive for an ultra high net worth. And the other thing I would just say is it does provide some diversification because it's not quite as correlated with all the other public markets as maybe, you know, high yield or broadly syndicated loans are. Just on the yield and spread point, I mean, it is true that we have seen both yields and spreads start to pick up in the broadly syndicated market recently. And I've seen some people making the argument that like, well, maybe now, maybe not right now, maybe a week ago, was the time to sort of pick up some exposure in the corporate bond market and things like that.

19:23But do you see, you know, when yields and spreads start to move around in the broadly syndicated market, do you typically see investors start to make that relative value judgment? Like, will they sit there and think, well, I could either have this private debt deal, or I could buy this in the publicly traded market? Yes, I think people definitely look at kind of the relative value versus the public benchmarks. But again, I think direct lending as an asset class has historically over now many years outperformed the public credit benchmarks. So you've seen that relative value, I think, always kind of shift in the favor of the direct lending funds.

20:03And again, it comes back to the spread premium compared to just a broadly syndicated loan. Can we talk about, you know, you mentioned the clubs and the idea that, OK, you're not just going to have one direct lender. You might have three, 10, whatever it is. How does deal flow typically work? How does something land on your desk in the first place in the sort of standard mode? Yeah. So I think most credit firms, the way they attack the market, most direct lending firms, they have sponsor coverage people who go out and call on a set group of private equity firms. OK. And they call them and they say, hey, what deals are you working on on the private equity side?

20:44Can we help you finance them? So that's the typical model as to how most standalone private credit firms get deal flow. I would say New Mountain, we approach things a little bit differently. Because we also have a private equity business, we are seeing the deal flow earlier because we're seeing it on the equity side. And what we're able to do is then triage those deals. And not all of them we're going to buy for private equity, of course, but a lot of them are really high quality, good businesses that maybe are going to trade at a valuation that we think is too high. So rather than buy the company on the private equity side, we can say, OK, well, now we know that deal is in market.

21:26Let's see if we can go finance it for another private equity firm. And so we take a pretty different, I think, more proactive approach to deal sourcing because we know those deals are out there. And then we just need to go find them. And again, the conversation that enables us to have with our private equity clients is, OK, we know this deal is in market. Our private equity firm is not looking at it. But we like the business. We have a view on leverage. We've already underwritten the space. Again, back to the point that I made in the beginning is to New Mountain focuses on the same industries across the board.

22:01And we have some really unique diligence angles that we could bring to bear. So that kind of conversation with our private equity clients, I think, gives us an edge and allows us to source very effectively. Just on this note, how sticky or reliable is this type of financing for the company itself? Because, again, this is a place where you hear different arguments in the market. So on the one hand, you know, a lot of private equity funds have lockup periods. And so people can't suddenly withdraw their money. But on the other hand, there is a concern that maybe this kind of financing is less sticky than, for instance, a bank loan, where maybe some of that is funded by deposits and things like that.

22:43So how reliable is this type of financing? Yeah, it is very reliable. When you think about the types of structures that underlie private credit funds, a lot of them are permanent capital vehicles. You mentioned business development companies or BDCs. the publicly traded ones are a form of permanent capital. So that's about as stable or as sticky as you can get. And you also have other kinds of funds that are structured as drawdown funds, which again, have kind of a locked up life for a period of time. There's of course, other types of funds that are maybe a little bit more open-ended and the ability to come in and out.

23:21And so that can be where maybe you have a little bit less sticky, but I would argue that that you have those dynamics kind of in all areas of credit investing, not just the direct lending market. So overall, I think it is really sticky and very reliable from the sponsor standpoint. And that's ultimately what they care about. How do you build expertise? When you're walking through a whole range of industries, because private equity could be literally anything, do you have to build that expertise in-house to be able to judge the credit quality of each type of deal that comes across your desk, how do you internally get to know whether a company has a good credit or not?

23:57Absolutely. Yeah. So, yeah. So the due diligence process is incredibly important. And as you said, it takes a lot of time and many years to build. So at New Mountain, we proactively have come up with sectors of the economy that we think are going to be, again, those defensive growth sectors. What are they? Yeah. So sectors like enterprise software, So you have mission-critical software that's deeply embedded, very sticky, very hard to rip out, high retention rates, good recurring revenue. So we really like that sector, for example. We also really like tech-enabled healthcare, where you have different types of tools and both services and technology that power different healthcare providers and payers to ultimately take cost out of the system.

24:45So we get into very specific niches because it's not good enough in our mind to say, oh, yes, healthcare is a good sector. Let's go invest in healthcare. We want to really narrow that down and find the subsectors within healthcare and within enterprise software, within business services that we think will be really resilient for the long term. And then what we do is that we staff a very full team. We have over 150 investment professionals at New Mountain that spend every single day in some of these sectors. And then we become experts in these sectors. We look at companies that are in these sectors.

25:24We map them out in a lot of detail. We hire bankers and consultants to help us map these sectors out and figure out what's good and what's bad about these sectors. We also own companies in these sectors, right? So we own 45 companies on our private equity side. And so we're seeing the real time trends within these sectors. And we can apply all of that, all of that knowledge, all that intellectual capital, we can apply it to the next credit deal. So we're never trying to figure out something from scratch. It's not we're not waiting for that deal to come across our desk and then say, OK, like, let's go try to figure this out.

25:58No, if that's the case, we're just like, we're not going to look at that. That's not, you know, within our scope. But what we do is we say, OK, we want to be starting from, you know, the sixth, seventh or eighth inning from a diligence perspective and really just be doing bring down work and not trying to figure something out from scratch. Thank you.