The Business Credit Market Unwrapped with Lon M Singer

29:19There are experiential retailers that are doing wonderfully in this economy. But if there is not a suitable balance between your brick and mortar presence and the expense and the labor and the cost associated with that on the one hand, and your e-commerce presence, you've got a problem. And the other characteristic that I want to add with respect to all six of these entities is these are all non-luxury, non-designer, non-upmarket businesses. So let's take a look. I have a slide and you may or may not have flashed it already. I've got two slides, actually. One reflects the fact that e-commerce business relative to brick and mortar business is obviously ascending.

30:09And there it is. And it's precipitous and significant, and it's going to continue. The other slide demonstrates the other piece of this puzzle as it relates to the entities that I listed out that have filed for bankruptcy and the retail retail market generally. And that slide shows you that more and more, a greater and greater proportion of consumer dollars is going to the LVMH, Moet, Hennessy type companies of the world. So, you know, obviously there's inelasticity of demand among by the rich, and they will continue to buy expensive goods and services, regardless of the economy we're in. And so what does this mean for retail?

31:01It means that if you're in the good group, you do a lot of e-commerce, you have a lot of fine experiential characteristics associated with your retail business, you're on the high end of the market, you're sort of a luxury brand. Again, you're somebody who can do very well with lenders. Lenders are willing to lend to you. You're going to generate plenty of working capital, and you're going to continue to borrow on pretty good terms. If you're in the other group, you're going to struggle worse in this current tight credit environment than you were even doing in prior periods. So that's notable.

31:47So let's talk about the breakdown here. Again, the menu of credit options between traditional lending. Obviously, we've talked a little bit about this revolving lines of credit with traditional financial institutions, banks, and then the non-traditional piece. What are the major buckets on the non-traditional side? I know one of the things that I'm eager to talk to you about, because I don't know a whole heck of a lot about it, but I know as an asset class, it's becoming incredibly more important with the passage of every month is the private credit markets? Yes. So the private credit markets, now there's an interesting interrelationship between the ascent of the private credit markets and the ascent of a particular type of private lending that I find myself doing at greater and greater volume.

32:33And that is something I'll call lender finance. So I doubt your audience is familiar with this. This is a very esoteric niche of the lending market, but I'll simplify it. Lender finance is basically providing a warehouse credit line to a borrower that is itself a lender. So, okay, let's slow that down. So suppose, for example, a hedge fund raises a billion dollars and it says, I'm going to use these billion dollars in a platform that I'm going to establish, which is going to be a lender, which is going to compete with the banks. It's going to lend to businesses. So I'm going to run a lender finance business.

33:23So what happens is they are going to want to leverage the money they've raised so that they can increase their IRR. And they open up a warehouse line and thereby leverage the size of their facility. And what happens, and this is kind of nuanced, is that the ultimate lender is sort of derivatively and secondarily secured by the collateral that is taken by its borrower in its own borrowers. And so it's a fairly complex debt stack, but this is a market that is increasing dramatically, lender finance. And the reason that that's happening is twofold. More and more businesses are setting up to lend to lenders.

34:20And more and more lenders who are not banks and who want to leverage their platform are growing like crazy at the moment in time when banks are making fewer loans and have more rigorous criteria attached to their loans. Well, you just made an interesting point there, which is the rigorousness of the criteria that are attached to the loans. It sounds like what essentially is happening here is it's almost a kind of regulatory arbitrage where you have less regulated entities who have greater flexibility and their ability to lend that don't have the alphabet soup of regulators scrutinizing them. And as a consequence, you see that flow of credit happening in the non-traditional lending.

35:03That's exactly the story. And so I have bank clients whose employees call me all the time and say, I'd love to do this deal. Five years ago, this was right in our sweet spot. It looks great. I can't do it. Why not? The box that we're consigned to by this alphabet soup of regulators is such right now that it doesn't look secured in exactly the proper way. It doesn't look like it's in exactly the sweet spot for us. It runs afoul of the directive that says we can only have so many borrowers in a particular industry, for example, and we already have too many borrowers engaged in this industry, notwithstanding that the industry in question may be the hottest and best place to make loans right now.

35:51So my bank clients are constrained and it's tricky for them. And let me tell you a very practical reality that goes along with this. So if you're a business development officer at a bank, your job is to go out and talk to CFOs and find loans to tell the guy, hey, I see you have a credit line with XYZ right now. Well, we here at ABC, we can give you a more flexible, more favorable credit facility. Why don't you come over and move your borrowing activity over to us? They're salesmen with accounting and economics backgrounds. That's what they are. Well, guess what? The best guys in that space, they make the best living possible for themselves when their institution is giving them the support and the flexibility to do a larger percentage of the transactions that they come in and present to a credit committee.

36:51What am I saying? The guys who are really good, they're moving over to private debt. Why? Because they can get paid. If they can't get the loans closed at the bank, they can't make the living that their expertise really merits for. So it's very interesting. Yeah. And obviously, these are very bright, sophisticated individuals who are rational actors are going to go where the cash flow is. Juan, I'm enjoying this conversation immensely because typically I talk to economists who look at these things in various sort of abstract ways, but to actually understand the microeconomic underpinning, why the agents do what the agents do from someone who's actually in the room with them, I think it's just fascinating.

37:28But I wanted to give folks just a little bit of an idea talking about the macroeconomic side, about what some of the size of this market and its growth, because it is so important, I think, for people to understand the scale of this, what we're talking about here. So the private credit market in 2020 was$875 billion. At the start of 2023, this year,$1.4 trillion. And it's predicted to essentially close to double$2.3 trillion in the next four years by the end of 2027. I did my homework last night to kept myself myself from getting left in the dust in this conversation. And these, this data is from JP, excuse me, from Morgan Stanley.

38:07So obviously folks can see rapidly, rapidly growing market. Yeah, listen, we're in an environment where technology change is everything, right? And the only way for businesses to keep pace, to stay at the front, to be agile, and all businesses learned agility during the pandemic experience. The ones that were agile were successful, and the ones that were entrenched and less agile tended to be less successful. I'll tell you something interesting. The financial institutions that I represent, they now include an analysis category for the agility of management and the agility of the infrastructure of the business as part of their underwriting process.

38:55That was never considered previously. So what does that mean, Lon? What exactly does that mean in practice? Okay, so suppose, for example, you're manufacturing something, okay? If all your manufacturing happens at one plant, you're less agile than a guy who's got plants in four jurisdictions because there could be a quarantine in two out of four, but you've still got four running. Suppose, for example, that your manufacturing input is derived from one supplier only. You are less agile than a guy who can obtain that material input from five or six different suppliers. Because your one supplier might be shut down in a regional pandemic.

39:37But the guy who's got four or five suppliers, he's going to continue motoring along. So agility means that you diversify the infrastructure of your business, number one. And also, you may have an inherent agility in that your assembly lines, if you actually produce something physical, are geared toward shifting to other product lines, again, with agility. You know, it's like a wartime mode. The people in World War II who were able to stop making, you know, Schick razors and start making, you know, canteens or something that needed to be sold to the armed forces, these guys made a fortune, you know.

40:21Some of them were criticized for how well they did during wartime. The same thing, some of the COVID success stories were criticized for how quickly they were able to make safety gear when they previously made some consumer product for which there was no demand. Yeah, they were criticized for alleged profiteering, et cetera, et cetera. One of the fascinating things about what you just said, Lon, is it represents a dramatic reversal. So I spent, you know, before journalism is my third career, my first career, I was in IT and business process reengineering. Then I worked in banking, obviously, at large banks for a long time.

40:57And now as a journalist. But what's interesting is I remember when I was a young guy in my 20s, this idea of just-in-time inventory, that you had the smallest possible inventory stack that you could possibly have, that you wanted to do the opposite of diversify your supply chain sources. You wanted to lower the cost to the greatest extent possible by, you know, going to only the cheapest supplier. It's so interesting because it's kind of the reverse of the Nassim Taleb view of anti-fragility. We created almost by financial design the most highly fragile system, and then we saw what happened during the pandemic, which was it broke.

41:33We saw supply chains break. We saw distribution chains break. We saw all kinds of problems in transportation, et cetera, et cetera. So it's so interesting to see that lenders are now favoring businesses that create anti-fragile and therefore agility. I mean, it's just a really interesting sort of shift. It was very revealing. And, you know, I've got another slide that feeds into what you just observed, Ash. You know, one of the interesting things is that the logistics and shipping companies, as we all know, they experienced remarkable growth during COVID. So they had tremendous success. But when markets normalized, take a look at how dramatic this chart is.

42:15When markets normalized, they basically fell off a cliff and returned to their normal. So let me tell your viewers and listeners something interesting about lending that may seem obvious. But investors like to get in when a company has struggled and it's about to improve. It's often overlooked that lenders like to do the same thing. People like to get the best possible deal. So if you're lending to a company that just got through hard times, the company's balance sheet doesn't look that great. The company can't put its best foot forward in going to the bank or other lender. So what does that mean?

42:57It's going to pay a lot for its money. It's going to be highly constrained in terms of its flexibility, the lender has the upper hand, but the lender is thinking, I'm getting terrific terms, but I'm also aware that this business is just about to turn the corner. And so an appreciation of projections is something that informs underwriting and lending strategy by all lenders. And so while lenders were delighted to make loans to people who were in the shipping and logistics business prior to and during COVID, at the moment, they're declining businesses. And so they are not favored by lenders. They're struggling.

43:43They're struggling to get borrowing on decent terms. Yeah, it's fascinating and almost counterintuitive, the idea that when there's more potential risk, if you can project going forward, you basically can get the best of both worlds. You can have a higher credit worthy entity that you're lending to while simultaneously being able to charge higher rates and therefore generate greater fees for everyone involved. And that's the lender equivalent of the stock market customer who wants to buy low and sell high. It's exactly that. You try to minimize your exposure and maximize your return. And the lenders do it.

44:16And I don't think people have a real appreciation for how thoughtful they are in doing that. Some are better than others. Yeah, it sort of reminds me when I was a young guy and talked to someone who worked in the consumer finance, was in the credit card business and said, you know, what we call people who pay off their bill at the end of the month, we call them deadbeats, right? Because you don't raise any money on you. It's kind of this kind of intuitive aspect. Correct. That's correct. Those guys are the zero IRR component of the business. And so you really don't like those guys very much. I'll tell you another interesting example.

44:50And, you know, we talked about upmarket and downmarket retailers before. Here's a corollary, almost opposite example, that feeds from the COVID, post-COVID experience. So during the COVID era, anybody who was making a consumer good, toothpaste, toilet paper, we know the answer. People weren't just buying the stuff. They were stockpiling it, right? So these guys could borrow on virtually any terms that interested them. I think there's a chart that I have coming up in a moment that talks about the fact that consumers were buying the household brands. They wanted Kleenex and Clorox and Crest toothpaste.

45:38And they were buying this stuff in sufficient quantities that they could store it in the basement like the apocalypse was coming. So now, why did that happen? You had scarcity or a perception of scarcity. And you also have the government printing money, handing people money and saying, hey, you might want to stockpile this stuff. We're not sure how much of it is going to be around. So the government was subsidizing it. You had an environment in which people were nervous. Obviously, people were buying the stuff like like hotcakes. OK, then what happens now? We find ourselves in an inflationary environment.

46:14Things are really expensive. Gasoline's a fortune. Things are expensive in the grocery store. So while you have a tremendous demand for LVMH, Moet, Hennessy, you know, branded handbags and shoes, in the grocery store, guess what's going on? The exact opposite is happening. Suddenly, the public has a tremendous appetite, no pun intended, for house brands. What does that mean? lenders and I've spoken to several clients of mine they are reluctant to lend to the company that is making its fancy name brand foodstuff product and they are very eager to lend for example to the guy who makes the generic house brand product that you see sold under the the shop right Whole Foods you know uh Kirkland uh generic brand so this is a bit counterintuitive because it essentially seems as though you have this bifurcation, the two sides of the market here.

47:14On the one side, you have the Louis Vuitton view of the world where we've seen those retailers do very well. And on the other sort of wing, you're talking about folks who are probably financially constrained who are looking to find the best value for their dollar going out and buying store brands. That's right. And the difference, of course, is that you may or may not need a handbag. You certainly don't need a$5 ,000 handbag. Everyone needs nutrition. Groceries are an absolute necessity. So people are saving money on these necessities. As I said earlier, there's a complete inelasticity of demand at the ultra high end of markets.

47:51And that's why that's a diametrically opposed dynamic. The second example seems counterintuitive, but it's actually logical. And I'm in the middle of doing a credit facility right now for one of my clients that's lending to a big house brand food manufacturer. Yeah, maybe slightly depressing about what it says about income distribution in our society, but an important point. Listen, let me just make one other point here because I think it's important. People who are interested in this conversation who find this intellectually stimulating, but trying to figure out how it applies to them, talking about private credit markets, one of the interesting things that we're seeing right now is a series of retail-oriented funds spinning up.

48:31In June, I believe, BlackRock, obviously the largest asset manager in the United States, one of the largest in the world, announced a fund for credited investors to get exposure to private credit markets. So historically, this has been something that's been these products have been purchased by institutional investors, by allocators, by pension funds, et cetera, et cetera, all the usual suspects. But now essentially you have retail investors who are getting in on this space through these funds via places like BlackRock and Blackstone. Obviously not investment advice, but important for people to understand why this is relevant, particularly as we've seen the breakdown of the 60-40 portfolio in a rising rate environment.

49:13So from an investment perspective, if you're a retail investor and you're listening to this, this is why this is relevant in your life. I think it's right. There is greater interest in having some segment of portfolios reflect lending opportunities, public and private debt, Obviously, people have always looked at banks as part of their portfolios, but there are obviously listed hedge funds in which people can invest. And they in turn, as Ash points out, are establishing new investment vehicles that are dedicated to lending money. And the lending of money is a damn good business. It can be done on a secured basis.

49:52It can be done on an unsecured basis. There's different structures, different risk and reward associated with different structures. But the lending of money is a glorious business that's been going on since the beginning of time. People want a piece of that action. And I think Ash is right there when he says that that's something people should be focused on. The other takeaway, I think, from all of what we're talking about is that it's important in evaluating equity investments, in evaluating industries, in evaluating particular companies to have something more sophisticated than a monolithic view of debt and credit availability.

50:36It's too facile to say money, as we started out talking, money is expensive and hard to come by. It's important to think with greater granularity from whom might lending be available to the company I'm interested in. Where is the company I'm evaluating being perceived by prospective lenders? Where in the business cycle are they relative to the availability of liquidity at a price from various sources? So all of that needs to be considered in a much more nuanced and narrow way than by generalizing about the state of the debt or equity or any other market. Yeah, very well said. I was going to ask this question, but Steve, one of our viewers has beat me to the punch.

51:24And the question is, what are the risks of private credit, Juan? Okay, it's interesting. So the risks of private credit will vary by the mandate of the particular private credit platform. So I know that sounds very vague, but I'm going to dig in. So if you're investing in an enterprise that has established itself as, for example, a secured asset-based lending platform, well, this is what you'd be getting. You'd be investing in loans that are secured by 100 % of the assets of the borrowers. That's a nice thing. You'd be investing in loans where the advances that are made to the borrowers are merely a percentage of certain specified assets of the borrowers in question.

52:18So let's, let's drill down on that. Sorry to bore you with all this details. So if you've invested in an asset based lending portfolio, You put in a million bucks. They're lending to companies where they do a loan. They get a lien in all the assets of the company. They're lending against certain assets of the company only, perhaps inventory and accounts receivable. They're not advancing 100 % of the value of the inventory or the accounts receivable. Maybe they're advancing 80%. So let's roll back and get a broader vision. The loan in question is dramatically what I would call oversecured. There's vastly more collateral than there ever is an outstanding debt obligation.

53:09Why is that important? Because the likelihood that the loan doesn't get repaid is literally infinitesimal. And as somebody who's been in this market for forever, I can tell you that the only situations in which those loans fail tend to be outright fraud. And so these investments are pretty darn secure. So, Juan, talk to us a little bit about the security interest and the priority of the creditors in the event that something goes wrong. How does that structure break down? You're talking about securing things by things like accounts receivable. So these are things that are cash assets. And therefore, if you're lending at some factor of those, it's presumably relatively secure.

53:55In most cases, obviously not investment advice, but just to try and understand the broader picture of the risk profile. Yes. So when you decide you're going to lend money to a business, you can do it in any number of ways. If you're lending to General Motors, they can walk in and say, hey, you know, I'd like a billion dollars. And the bank shakes its hand and says, okay, here's a billion dollars. I'd like it back in two years with interest. It takes a lien in absolutely no assets of General Motors. It probably negotiates a series of financial covenants with General Motors so that if its performance were to begin to deteriorate, there would be an early warning system that would let the lender, or in that case, syndicate of lenders inevitably, getting back to something else we talked about, let them get to the table with General Motors early enough to work the problem through.

54:47Now, with the non-general motors, like we're talking about, taking a lien in all assets is a legal specialty. It's one of my specialties. Those assets could be domestic or international. They're often international. And keep in mind, they include all manner of things that are rarely loaned against. So, for example, the lender has a security interest in the trademark, the name of the business. You've probably seen that the Sharper Image store doesn't exist anymore. We all used to go to the mall, sit in the Sharper Image vibrating chair, say, wow, this is really nice. I used to joke to people that they don't really have much of a business model.

55:25They should charge people a dollar to sit in the vibrating chair. They would make more money because nobody ever really walked out of there with anything. They were like four grand in the 90s. Right? It was like unbelievable. Well, the Sharper Image name is still around because in connection with the liquidation of the business, and by the way, I don't think any lender ever got hurt lending to them. In addition to selling off the fancy radios and the vibrating chairs, they sold the Sharper Image name to some private equity firm that licensed the Sharper Image name out to all sorts of makers who are providing little things that you can buy online through Amazon, chargers, earphones, this and that.

56:01There's a little secondary value associated with Sharper Image. People say, oh, it's Sharper Image, must be pretty good. It's made in China like every other piece of technology. But the Sharper Image name can generate revenue. So in my example, you've got lots of what the industry calls boot collateral. It's kind of British. It's like it's in the trunk. It's in the boot. It's extra collateral. It's not stuff we're advancing against. It's not the accounts receivable and the inventory, the quick assets, the stuff that cycles through very quickly and pays down the loan very rapidly in a deterioration.

56:30It's extra collateral. Things like real property or machinery and equipment. stuff that I can liquidate if after 60, 90, 120 days, collecting out the sale of the inventory, getting the accounts receivable repaid, I still come up a little short for my lender client. Well, now I go foreclose on some of that other stuff, sell that at market, and make them whole. So investing in completely secured loans is a very good investment, if it's managed well by people who know how to underwrite them and know how to manage the credit facilities. And obviously, you have to trust the business people you're dealing with, their business acumen, their sophistication, the kind of counsel they engage, the kind of companies they lend to, and the kind of diligence they lend to.

57:17Let me ask you this. The differences and similarities between leveraged loans and private credit, give us a little bit of a sense of those two terms because we hear them, obviously, with increasing frequency in this environment. Well, you know, the leverage loan universe really accounts for the upper market segment of the money center bank type lending. The LevFin we talk about is, you know, it's a chemical company. It's a petroleum company. Syndicate of banks are lending$2 billion. They go out and they share the risk. That's the LevFin market. They sell it down, and that's a tremendous market.

57:57The private debt market is everything, packaged and sold or not, that is undertaken by private lenders up and down the debt stack. And as I said, the private lender, they might be competing with the bank with their own private syndicate to lend a billion dollars. Or they might be lending$3 million to lubricate the wheels with respect to supply chain activity, factoring the receivables of a moderately sized business so that its cash flow is improved and enhanced. So there's a tremendous array of credit products and activities that are available up and down the debt stack. And that's the interesting thing to look at when looking at the marketplace.

58:45place, people often completely overlook the middle market and the lower middle market where a tremendous volume of lending takes place. We get a new question in this one from Ralph. It's always a sophisticated question from Ralph Humphrey. And the question is, what does Lon think of these NAV loans, net asset value loans, private equity firms are getting? You know, I'm not going to opine on that, Ralph. I hate to demur. And it is a sophisticated question, but it's not a space in which I live. And, you know, I've told people many times, a bad lawyer is one who give you advice on any question you ask him.

59:22And a good lawyer is the one who will only advise you about things he knows about. So I'm going to I'm going to tell you that's not in my sweet spot. Let me ask you this. One of the things I was I was doing a little research last night on private credit markets, because as we talked about such an incredibly rapidly growing space. One of the things that I thought was interesting is that it seems that many of these loans in the private credit space are held to maturity rather than sold or syndicated. Is that something that you have a sense of? And what are the drivers behind that type of activity?

59:54Well, I think you're absolutely right. They're largely held to maturity. They're largely three-year loans. I would say the market is such that almost every line I close is for three years. There were some points throughout my career where four years was more common, but I think three years is the right window right about now. So why are they held? They're held because in the underwriting process, projections anticipate that they will perform and pay good value throughout the term. In many cases, the borrowers have entered into the credit facility on the basis of a relationship with particular bankers or a consortium of bankers.

1:00:34They want to have a sense that that relationship is likely to maintain itself and to be preserved in place for a period of years. The CFO wants to work with the same relationship manager and loan officer at the bank or other lending institution. And so, really, the selling of these loans, the ones I'm talking about for the most part, is not the primary goal. Yes, there are businesses that package and sell them immediately, but for the most part, they're held and managed. And the other thing to keep in mind is some of these lenders, especially the banks, and this applies uniquely to the banks, they may be in a position to generate revenue from cross-selling opportunities that non-bank lenders cannot make available.

1:01:25What do I mean by that? If I'm in a three-year relationship with a borrower as a bank, I may be able to sell them credit swaps. I may be able to sell them commodity hedges. I may be able to issue a private credit card for them. I may be able to attend to all their cash management. I can earn fees doing a lot of other opening letters of credit. So I can earn a lot of fees in addition to the interest on my loans per se. And so cementing and broadening the relationship represents an economic opportunity. Interesting. Lon, this has been a spectacularly interesting conversation to me. I've enjoyed this immensely.

1:02:06It's great to just have a view from actually inside the room from someone who's advising these lenders on these activities. We tend to look at things from a macroeconomic perspective. It's so helpful to have someone who can bring the view from inside the room. I know our viewers and our listeners are enjoying this immensely. I can see the comments in the live stream. Terrific conversation. I hope you come back and join us again. Before we go, final thoughts, key takeaways that you'd like to leave our audience with. Yeah. Again, I think I alluded to it earlier and my lesson for the group, and this is a savvy, sophisticated group, and that's why I'm delighted to be here.

1:02:39My lesson is don't think of the credit market as a singular thing. Consider the various slices of the debt stack, the various lenders, the various borrowers by industry and entity within industry and try to evaluate an appropriate connecting of the dots when you consider a company, say to yourself, from whom might they borrow? Where do they stand from a credit perspective relative to their competitors? The more you know about the credit market, the more you know about the impact of the credit market on their prospective borrowers and businesses across the economy. Perfect point to end on. So much more we could explore.

1:03:24Only one solution. We're going to have to have you back again to continue this conversation. Lon Singer, thank you so much for joining us. Thanks, everyone. It's been a real pleasure. Ash, as they say, I'll see you around campus. See you around campus, Lon. Have a good weekend, everybody. Bye-bye.

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