¶ Intro / Opening
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¶ Introduction: Private Credit Concerns
Hello and welcome to another episode of the Audults podcast. I'm Tracy Alloway.
And I'm Joe Wisenthal.
Joe, I think it's fair to say that if we didn't have the situation with Iran, we would be talking a lot more about private credit.
Yeah, yeah, for sure, Jamie Diamond, you talk about the cockroaches. We keep getting these headlines over the last several weeks, maybe months, various mini you know, not blow ups per se, but many something between a hiccup and a blow up. In some cases you hear about redemptions being slowed down, et cetera. Not great headlines and not great charts often too, when you look at the various publicly traded instruments that one would associate with private credit.
Right, So, I love that you said something between a hiccup and a blow up, because this is the difficulty I have in talking about the private credit space at the moment, which is, you either find people who are often very close to the private credit industry or in it, who will argue that this is just you know, a tiny bump in the road, This is maybe a few cockroaches, like nothing to worry about, although a single cockroach would
worry me in my own household. But anyway, or you get doomsayers who are like, this is financial crisis two point zero, right, and it's very difficult to find nuanced commentary in between.
Yeah, and we were always looking for nuanced commentary. So this is a problem for the Odd Launch podcast.
That's right, Okay, So we're trying to rise to the occasion with some nuanced commentary on private credit. And trust me, I have watched and seen and read a lot of things on this topic. And one thing that stood out in particular to me was a particular seminar or lecture that came out from a firm called Osterwise recently, and we had a couple of old school bond hands talking about the rise of private credit and how to think about it in the context of the history of the
bond market. And this is something that I think has often missed, is what exactly is private credits role when you think about overall corporate credit.
That's a good way to put it right, because we can look at the various funds, et cetera. But within the broad history of the evolution of the bond market and within the current just sort of landscape of fixed income, Like what is private credit? The way I like to frame a lot of questions is from the perspective of the investor, what problem does the existence of private credits solve for their portfolio needs?
Right?
Because that is the consistent thing we talked to endowment managers, we talked to investors, et cetera. Every instrument in theory, like it solves some sort of problem. Maybe you have a lot of money, that's a lot for a long time. It's like, okay, you're willing to try raid that way for some extra premium, etcetera. What problem does private credit solve?
Well, I was going to say, also from the perspective of the issuer and from the issue, right, because the issuer, if you're a company looking for financing, you have a bunch of different choices, and one of the ones that has become very popular in recent years is private credit. And in fact, you could I mean, there's a dynamic here where both investors are demanding it, but issuers are also very very happy to lend into that market for
various reasons that we are about to get into. Let's do it all, right, So we do, in fact, have the perfect guests. We're going to be speaking with John Sheen, he is a portfolio manager for the Strategic Income Fund at austur Weis and Craig Manchuk he is also a portfolio manager at the Strategic Income Fund. So thank you so much, John and Craig for coming on all.
Thoughts, thank you for having thanks for having us.
¶ Osterweis Capital's Fixed Income Strategy
So maybe just to begin with, how long have you guys been in the bond space.
The firm has had a fixed income strategy for twenty coming up on twenty four years. Actually started by our one of our other partners, Carl Kaufman. Originally the firm here was started as an equity only firm, and as the firm's client started to get older, founder John oster Weiss wanted to expand into the fixed income space, brought Carl in and the fund has been in operation since April of two thousand and two.
What kind of fund is it? When we're talking about it is tell us about the general, the mandate and the structure of the fund and who is like the sort of like the modal client for whom this would be a vehicle that they would put their money in.
Sure, So the fund was set up to be the only fixed income fund that our private clients needed. So we have an extremely broad mandate. We can go anywhere, and so it was a very very early, unconstrained bond fund, which has some distinct advantages and some distinct disadvantages are we get to go where we see the best opportunities. Our mantra is to look for the most attractive parts of the market and then we look for the least risky ways to play those most attractive parts at any
given time. And so the as the cycle changes. As business cycles are stronger, we would gravitate more towards credit, and as it weakens, we could gravitate more towards treasury. So the fund has over its life cycle moved back and forth, but by and large sense of financial crisis, we've been largely in high yield ig and convertible bonds. Our client base has predominantly been rias and wealth management firms and individuals. Some of those are existing private clients
of the firm. Right now, so fund is about five point eight billion dollars and it is structured as a forty act open.
End mutual fund.
¶ Private Credit's Historical Origins
So once upon a time, if you are looking to invest in credit say in two thousand and two, you would have had a limited set of options, so you basically had investment grade, which are bonds issued by people always use the word blue chip companies, which sounds so old fashioned to me nowadays, but companies with relatively strong balance sheets that are rated by the rating agencies as investment grade, or you would have the option of bonds
in the high yield market aka junk. So companies with weaker balance sheets and weaker credit ratings tell us about how the sort of I guess menu of credit options has expanded post the two thousand and eight financial crisis. That's basically a long winded way of me saying where does private credit come from?
So private credit had been in existence prior to the financial crisis, but really saw expect growth after the financial crisis. So if you go back into even the eighties, with the growth of the high yield market, prior to that, highly levered companies companies that didn't have investment grade balance sheets couldn't really borrow much in the public markets, so either they financed internally or relied much more heavily on
the bank market. As the high yield market grew famously with the help of milk, and it allowed more companies, more highly levered companies to access public markets.
That evolved into the leverage loan market.
The leverage loan market once upon a time used to be held on the bank balance sheets. They began to syndicate those loans and what was really the step function there was the evolution of the COLO market where the banks could take those loans put them into a securitized structure which became colos, which led to the growth there.
¶ Post-2008 Growth and Drivers
Then after the financial crisis, the bank regulators really did not want banks lending to highly levered and or risky entities, both corporated and individuals, so you saw pretty strict capital requirements. There is an explicit prevention from banks lending to companies with greater than six times leverage. That created this need for lending outside of the bank market. Those companies didn't go away, their borrowing needs didn't end, so that vacuum was created.
By private credit.
So you saw many of the same entities that were lending in the private credit market previously in the private equity market, so they also saw a need to finance their LBOs that was no longer able to be done at the banks. So they started a number of different fund structures. The BBC fund structure had been around prior to the Financial crisis, but these dedicated private credit funds really began to proliferate after the financial crisis.
Can I just add something to that, just from a historical perspective, I also think that we've been talking about private credit as it stands today, but it started so much earlier, and it started in an area that I think most people will tend to forget about, which is ge Capital was one of the largest providers of private credit under the GE umbrella for many, many, many years.
They were financing lots of different things though they were financing railcars, they were financing aircraft engines, they were financing the purchase of MRIs and other healthcare equipment, and they were extraordinarily successful and really largely responsible for a big chunk of the profits that came in underneath the GE
umbrella for many years. But what it did is it created a large body of really experienced lenders who ultimately splintered off and went into different areas and the businesses.
And one of the businesses that started from them was a company called Heller Financial, which had been around for a while, but they hired some GE Capital guys to come in and they really kind of took the original Heller business, which was financing yellow equipment and railcars and things, into the middle market LBO space, So they became critical providers of financing for that space at a time when there really weren't many away from the banks. So a lot of this has been around for a long time.
People just forget about it because there's not as many people out there that are as old as we are that remember those guys from the eighties and nineties.
We saw that with a lot of the consolidation of the financial institution, so away from GE you know, ciit was a big lender in that space. Even in the aircraft lending space, an organization ILFC was owned by AIG, and the regulators wanted that highly levered, riskier financing out of the systematically important financial institutions.
Well, speaking of people not realizing some of the history here, it took me an embarrassingly long amount of time to realize that all the stories that I'd written about shadow banking in the aftermath of the two thousand and eight financial crisis were basically for the credit.
Yeah, It's interesting to think about, Like I'm familiar to some extent. I don't know the full history of like GE Capital, but I had certainly heard of it. I knew that it became a big profit center for GE itself. And it would make sense that a company like GE or GM even but GE would have its own lending arm and then like do its own financing on the side. But I'd never really thought of it as like private
credit per se. But it's interesting to hear that, Yeah, like this was like an origin that a lot of the lending form types, etc. That were sort of emerged out of these practices in house. Then where did it go from there? So you mentioned, okay, like real asset invested in maybe it's like aircraft blending or you know, aircraft finance, etc. How did it splinter off into all of these different fields and areas beyond just the sort of like the tangible goods financing.
¶ Mezzanine Finance and Market Evolution
So one of the places it went was in an area of mezzanine finance. Again, back in the early days of the LBO market, the sponsors were always looking for ways, how do we fill in the gaps? We can't get this deal quite across the finish line with the equity we want to put in. Where do we fill in the gaps? And there were mezzanine funds, and they were
hybrids somewhere between credit lenders and private equity investors. So they would take the most junior piece, typically a preferred or subordinated piece of debt, and get a little bit of equity in the form of warrant or something alongside, so that they were targeting a slightly higher return profile than the typical debt guys were, but they weren't going to get the full bang for their bucket that the
PE guys were getting. And that lasted for a number of years, but as the market matured, the sponsors found that they no longer really needed the mes guys to the same degree. They're still around, but ultimately mes funds were niche kind of product that I think over time has just kind of been squeezed out between the size and scale of the combination of leverage loans and high yield bonds and the PE firm's desires to keep as much of the equity economics themselves as the asso.
¶ Private Credit's Market Expansion
So today we're at a point where the private credit market there are all these different estimates for exactly how big it is, and you're going to get some variation because it is private, like the clue is in the name. But by most estimates, it's bigger than the junk rated market, which is kind of crazy if you think about, like how large the junk raded market has loomed in the market's collective consciousness for so long. How did we get
to that particular point? How did we get to a point where this like relatively new market, Although I take the point that it has intellectual routes before even the financial crisis, but why did it grow so quickly after two thousand and eight.
I think there's two macro influences that had a large play in that. First, if you look back after the dot com meltdown in the equity market, we had three straight years of negative returns in the S ANDP. It was the first time that happened since the Great Depression. The cumulative returns of high yield for that twenty year period nineteen ninety ninety twenty nineteen beat equities, So among investors there was a desire for something away from the
equity market. Their experience in equities was unsatisfactory, so they're looking for other alternatives.
And then in the later part of that time period we went.
Through the zero interest rate environment where you know, the Fed Treasury, etcetera. Drove interest rates to zero in response to COVID. So there was a massive desire for yield and better performing assets than they had in the early parts of the two thousands in the equity market. So that really led to the proliferation of the amount of
dollars flowing into the product. And then on the supply sid we touched on it earlier, these highly levered borrowers were basically shut out of the banking lending market, so they needed to find alternatives to fund their businesses and to refinance their debt. So those two kind of came together at the same time and really fueled the growth of the product.
And I think institutionally you had in the LBO world, sponsors were looking to have a real partner that they could go to repeatedly for all different types of transactions, go back to them again and again and develop a real relationship, and where their lender could be very expedient as well, and I think expediency mattered and provide them with sort of that guaranteed financing which the banks were providing up until they were squeezed out from a regulatory
standpoint on the most highly leveraged transactions. So I think that's what it really kind of comes down to, is the ability to provide more leverage than the banks were allowed to without running a foul of the regulators.
¶ Private Credit and Insurance Link
So one thing that comes up regularly on the podcast is the sort of natural synergy between private credit and insurance and insurance companies. They have all these assets, and they have this advantage that they know exactly when those assets will be withdrawn. It will probably be in like
forty years from now. They do not have to worry at all about you know, a quick run whatever, and so they can harvest they can harvest that illiquidity illiquidity premium but that they could be they could put their money into assets that do not trade very much. And that's very intuitive to me. Talk to us, though, you're operating an unconstrained fund that is a publicly traded forty act mutual fund, Talk to us out what it means.
You know, you say you look for opportunity. Why are there private credit assets that aren't all locked up in these long term vehicles why does it sometimes make sense for private credit assets to be in a vehicle that is just sort of more opportunistic and has a daily quote.
Potentially, we currently actually right now, don't have any private credit we were involved with. We were involved in it in the past, but I think most of those opportunities have gone to the dedicated private credit funds because there's one of the structural differences of the way they're set up versus the way we're set up, h is we
source our ideas mostly from investment banks. Now, some of those investment banks used to come to us with transactions that weren't going to fly in the public market, so they would look and say, this is a small deal. We're not going to be able to find buyers from this among our investors who are primarily benchmark high yield investors, because it would be outside the index and it would be illiquid, and there's been a lot of talk about
in problems with investing in ill liquid securities. One of the real benefits of our strategy is we always have lots of liquidity. We have historically have managed our portfolio and a short duration with a short duration focus.
That creates cash and we keep a lot of front end ballast.
So as our portfolio is always creating cash, we could invest in some pockets of less liquid strategies, but we haven't done that. But the private credit guys are set up differently. They need a team of bankers to go out and source all their deals. They have to knock on companies' doors. It's a very different way in their function of having to source their transactions to try to
fill up the asset side of their portfolios. So because of that, over time, I think there's a huge structural difference between the way they approach.
It and the way we approach it.
But going just going back briefly to the insurance company side, insurance companies have long been investors in private assets, and they used to have large teams of private debt investors, and ultimately, over time what they've done is they've shrunken those teams and just said, here, you guys source the transactions for us, and then we'll give you guys the money and you can go do it yourselves, sort of
on an outsourced basis. So naturally it is a very good fit for them because they do have long duration assets and there's generally not a rush for those assets.
¶ Sourcing Deals and Underwriting Issues
Could you say a little bit more about how competitive it's been in the past to source private credit deals. If you're on the investor side, we hear these stories about you know, basically private companies can kind of dictate the terms of the deals because there's so much overwhelming investor demand, and you get this vision of people like literally pounding down the door to get in on a particular loan. Is that was that accurate in the past. No.
I think even the managers of private credit would tell you, and honesty maybe not on the record, that they're surprised how quickly this has grown. So if you look at some of these funds that have grown ten x over the last five ten years, I don't think that they have grown their sourcing abilities by.
Five to ten x.
So if you can trast it to say private equity, the way a private equity fund works is they find the investment opportunity and then they go call the funds.
From their LPs.
Private credit, most of these funds work where they've taken the money first and then they go out and find the investments. So they are under much more crushure to find investments, which creates this competitive environment that you alluded to some of the issues that we talked to that may have been in the public markets in the past, tell us that when they go to the private credit market, it's just a competition for who will jump the highest
for the piece of meat. And what that translates to in the credit world is either lower interest rate, weaker covenance, or a combination of the both. And that's really what you've seen with private credit in this hyper competitive environment that we're in.
Now.
¶ Retail Funds and Liquidity Structures
Another thing that John mentioned which is actually really important here, so the structural side, this is what liability side of the balance sheet for private credit guys is kind.
Of critically important here.
So if you're out there and you're raising an institutional fund, those institutional funds are generally DRAWDOUN funds, so they're allowed to go out market and say, okay, we've raised commitments for five or ten billion dollars. We're going to go out now and source our investments, which is the assets side. The LP commitments are the liability side. So they will take on those liabilities as they find the assets and
they end up being matched. And this is in a structure that's typically got a term and it's locked up money that they will not be providing liquidity for those institutional investors. The problem, and this is where we've run into the big problems, and this is what is really circulating in around them, is more recently, when we've gone and taken this out into these private BBC structures to
market them to the retail or private wealth world. In order to raise the money, they've needed to offer some concessions on the liquidity right, because it makes it easier to raise money if you're going to allow people or going to tell them that you're going to allow them to redeem at least somewhat periodically. That has allowed them to raise money really fast. It's a little bit piggy because they've just said, Okay, we can raise a lot of money. Let's just raise the money when we can.
The difference is when those dollars come in, they come into the fund on a subscription basis and need to be invested quickly, and that's what's really created a lot of the problems and what's really led to the degradation of credit underwriting because if you don't invest those dollars quickly, it creates the lag on performance in the fund. A minute that dollar comes in, it's part of your nav Therefore it needs to be invested rapidly in an income
earning investment. So that's what's happened, and you really saw a huge proliferation of this. I mean the most obvious and visible of these you could see on there would be the cliff Water Corporate Lending Fund, which is CCLFX on your Bloomberg. If you look that up, you can look at the asset growth in that, and it really
has taken off in the last five years. In twenty twenty two, we would speak to our wealth management advisors who are investors in our fund and ask them about what's working for them, because in twenty twenty two rates are going up. Investment grade bond funds are trading off sharply because people didn't understand the duration risk that they were carrying. High yield funds were weaker, but nowhere near as bad as IG and I'd.
Say, what's working. They said, oh, gosh, private credit's been working great.
I would say, well, that's wonderful, but that's because they're not taking their marks, and so they became very very comfortable because they didn't have to turn around talk to their existing investors and say here you lost a lot of money in this fund. It looks like you've just earned your yield and your NAV has been very, very stable. So as a result, their clients were happy. They were happy,
and what happened money poured in. So as that money poured in, it led to I think more bad actors is too strong work, but really more bad underwriting, weaker underwriting, more aggressive underwriting, because they needed to get that money put to work so they would provide more leverage at weaker terms.
Just can you clarify? Sorry, I think you explained it, but why is it that with the traditional private asset not private private asset model that they only call on the capital once it's needed, Because what you explained is okay, once you take into the capital, if it's not being invested, it's a drag on NAV. Very intuitive. Just explain why is that? Why is the other parts of the private
capital world able to do the thing. You only call up the LPs when you have a deal, whereas that's not the case with private credit where you're taken the money upfront.
I just think it's what people are used to and they've gotten used to on that model over the years. As an institution. Hey, I'll commit to your fund, tell me when you need the money, and we'll send it in. And I think that's the way they do it now, exactly how they do Yeah. I don't know if that's a dollar for dollar thing or if they'll do it in just installments over time, but it does help to provide.
It gives them the ability to have less drag by having you go out and raise a five billion dollar fund day one.
That money's going to sit there if you.
No, no, I mean it makes it. I guess what I'm trying to establish is why couldn't private credit work the same way where it's like, Okay, I go out and raise five billion dollars worth of commitment, and then as I get a lending opportunity, and when then I call up my LPs and say, okay, you needed to phone you up that fifty million to us that you've committed and whatever. Why couldn't have worked that way?
It could? I think it's the nature of the investment.
So the traditional structure that Craig described as private equity, right, So if you think about an equity investment, you go out, you buy a company, you take over management, retool operations, you merge, you do whatever you do in private equity to increase value, and then in three five years you want to turn around and realize that investment where a lending business is more of a kind of balance sheet perpetual business where you're finding new loans all the time
and you have loans maturing, redeploying the money. So the evergreen structure of an integral fund.
Makes more makes sense.
Yeah, so you typically have bigger bite sizes in private equity. You know, it's more heavily concentrated portfolio with a finite timeframe.
Where it's credit, it's like a if you take a.
Bank balance right, this was finding that used to be funded by deposits.
In perpose, it is balance here by a time.
I think the fact you have a much smaller number of investments many many small. I mean a typical private equity fund can have five to twenty five investments depending on its size, whereas the typical private credit fund is going to have hundreds, if not thousands, of So imagine having to make to call fifty dollars four times, four times a week from your investor each of your one hundreds of thousands of it.
It would be really cumbersome.
And I think that also goes to the logic around the gates. That's been a pretty controversial topic. But think about a five year loan, right, You probably have twenty percent of your loans come and do every year.
That's five percent a quarter.
So the gates were put in there to address the fact that we have maturities every quarter that could be there to meet redemptions, where some of the five percent logic came from.
¶ Impact of Redemption Gates
Actually, we should talk about the gates because one of the sort of defenses that you sometimes hear about private credit is this idea that, well, even if you get a spike in defaults and all these companies start failing, it's not necessarily a huge problem for private credit because we've set up these limitations on redemption so you can't get this rapid run for the exit because the amount of money that can be taken out of each fund is capped at you know, five percent or something like that.
My inclination when I hear stuff like that is to think, like, Okay, well you've capped the amount of money that can exit the fund, but that doesn't mean that you've stopped people from wanting to exit the fund, it's just a slower run than it would be otherwise, So you're sort of building up that pressure. But then again the response to that is, well, you know, you're giving investors time to see their marks build back up or whatever, but like,
does that selling pressure go away at all? How helpful are the gates when it comes to managing stress in private credit?
I think they're critical actually in the retail channel, because you're protecting both sets of investors. It's not the asset side of the equation. It's not the loans that they're making that or the problem. It's the other side. So if you go back and just think about what happened at First Republic Bank, they were owning treasuries and they had forty billion dollars of redemption requests for their demand deposits go out the door in a few days and.
The business was sunk.
So if you didn't have the gates up and you had to run on the private credit funds because people were unhappy, they got nervous, they got scared, you sink funds very very easily that way. But what's important about it, and this is where we're going to get into a potentially thorny period as we move down the road is these funds will either need to do one of two things.
They'll either need to sell assets to meet their redemptions, or they'll have to finance the redemption requests, provided that the inflows that they've been seeing slow down.
Now.
I think, because of all the noise out there that we see in the media, people's confidence in the private credit space, certainly the retail investor's confidence, the wealth manager's confidence has been shaken. So it wouldn't surprise me at all if we see those flows slow down. If that happens, then the net outflows will be potentially greater and they'll build. That means that these private credit managers will have to
finance those or they'll have to sell assets. And the assets they sell are the ones that are probably the easiest to sell, which generally are the highest quality. So the concern here and really where when people are worried about the contagion. The concern is you are left with a fund that has raised more debt to meet some redemptions, then been forced to redeem to sell more positions, and
some of those are your better positions. So now you've got a more levered fund with horror overall investment quality. Where does that stop and at what point does that potentially blow up? Because candidly, the private credit guys may sell the early sales there were from we heard from
a blue owl into an insurance company. Okay, that's great, but I will argue that we're just seeing the beginnings of the pools of assets being created that are going to take on some of the stressed or distress loans in that space, and those loans are not going to be as easy to move. You'll find somebody like an oak Tree who typically does this. At points of stress or distress. They'll go to their lkpi's and say, hey,
we have a great opportunity. We want to raise ten billion dollars, and because over the years they've been really really savvy about that, they're able to raise that money.
So they'll create a.
Special Opportunities Fund to go out and buy these particular private credit loans that are stressed or distressed. You need the expertise to go in and work out those loans and potentially either take and run the company from an equity standpoint, or kick the can down the road and hopefully restructure and revise those loans. So I think that's
where it really starts to get thorny. If we get into a protracted redemption cycle, the financing runs out and they have to start selling things, it starts to really cut into the bone.
We do have a precedent for how the gates of interval funds have behaved over time. So if you go back to the commercial real estate market, after Value Bank and First Republic Bank, everyone was trying to pull their money out of large real estate interval funds. There's one famously that hit the gates and prevented redemptions. That fund now has kind of gotten to the other side. It actually had a better return than its credit fund last year.
And people tend not to panic for longer than three six months, right human nature crisis is a day, a week, a month. But if it just stays there long enough, people tend to get.
Cooler heads and it works itself out. But as Craik said, that'll help on the liability management side of these fund structures, it's not going to help on the asset side.
So if the default rates start hitting some of these levels that people fear and or predict, it's not going to save you on the asset side of the equation.
¶ Recovery Values: Software Company Debt
And then maybe.
To open up another topic, there's two parts of a default, right, there's when the company actually took player's default, and then what the credit recover in bankruptcy. I think there's big fears around some of these recovery values that will be seeing. Some of these are very highly levered companies with very few hard assets. So that's going to be the next test when we start getting it to work out of some of these loans, what do the creditors really have to protect them.
I'm glad you said this because this is a perfect seg into the question I was going to go to next, which is, Okay, we trace the history of private credit to physical things, the type of things that a ge would sell, maybe like a wind turbine or you know, get natural gas turbine, whatever it is, et cetera. And we were talking about the big mega trends of the twenty tens, and one of them was the regulatory push
of loans off banks. Another one reserve, but another one was the emergence of these predictable payment streams called software as a service subscriptions. This is the area in which you could really have zeros, a natural gas turbine is going to be worth something at the end. A obsolete software company is not going to be worth anything if
the business has been destroyed thanks to AI. But what was the moment in which the credit guy suddenly realized that, essentially, here's this business that we used to never think of high tech. It used to be when when I was a kid, Tech and debt didn't go together. What was the moment that the credit guys sort of realized that these are financiable assets, so to speak, that could come into the debt world.
Joe, you hit the nail on the head here, because this is the spot where really the high yield market and the private credit market started to diverge the most. There have been issuers in the tech space and in the software space into high yield, but it's definitely been
a more recent phenomenon. If you go back ten years, there were not a lot of software issuers in the high yield space, largely because of that, because people couldn't get their arms around the typical okay, I need to have two times asset coverage or two and a half times asset coverage. We just never saw that. So those companies financed themselves either in the equity market where they
financed themselves in the convertible bond market. So we used to see a lot of that in the convertible bond market because these are growth companies, and so the convert market would say, Okay, I'll accept a low coupon because I'm going to have equity participation on the upside, and so my upside isn't capped at whatever my coupon is. And I think that that's actually really been the area where it's diverged the most.
How exactly did we get here?
I think it was a willingness of these sponsors to come in and say, all right, I'm going to pay sixteen or seventeen times enterprise value to EBITDA for this business, and I'm going to put in an unusually large check. Let's say forty percent of that I will put in in equity instead of the typical twenty percent. So historically people have in the LBO space, they were coming to the highal market saying we put twenty percent down, finance
the other eighty percent. If they go to the private credit guys and say, well we'll put forty percent down if you'll lend to us on the balance, we love this business at sixteen times, And I think they potentially just persuaded a lot of these lenders to get a little bit too far out over their skis in terms of the amount of leverage that they were willing to extend. And as a private credit lender, if it's just you, or if it's just you and one other, you can
be a lot more creative in terms of structure. And I think they also took on this willingness to say, Okay, well, you can't afford to pay me this interest, so how about if.
We pick it.
Because if we pick it, my investment will grow and it'll give me sort of a quasi equity like feel because it's getting bigger. So that's kind of intriguing to me too. So I think there was a little bit of lender over zealousness. I think there was a competitive pressure. I think that they fell preyed to some of the sponsors willingness to overpay for some of these interestings.
¶ Systemic Risk and Default Forecasts
So when I hear secured credit that might not have that much security behind it, as we just discussed with the example of the software companies, and then when I hear increasing amounts of leverage on the issuer side, but also on the fund side, because you have private credit
funds that use leverage to increase their returns. And then when I hear illiquidity mismatches between a publicly traded BDC and the underlying assets, all of those sound very familiar from financial crisis history and have certain, you know, negative connotations around them. How worried should we be about the future of private credit at this point and the idea that is it going to be a systemic issue for the financial system.
I think the liability structure that we've discussed numerous times is dramatically different than what we saw in the financial crisis. So most financial institutions that we fail because of their liability structure. They're built to realize losses over extended periods of time, which I think many of these credit funds will be able to do. But I do think that we are going to enter into a period where we're going to see significant dispersion among credit fund managers or
private credit managers. We've been lulled into uniformity of returns right if you look in the public markets, it's been a huge trend towards indexation, so most people own spy or QQQ or whatever form you want to pick. So equity returns all look very similar. And that's what happened in the early days of private credit, where everything was marked a par you had an eight, nine, ten percent coupon. It looked great, so you couldn't really see some of
the cracks below the surface. As Craig alluded to earlier, there have been managers who've been doing this for twenty five thirty years and they are very new recent entrance into it, who've seen st andro growth in their assets that they had to invest. So I think that's probably the first leg that we'll see, is that you're going to start to see real dispersion of returns from manager
or manager. But you know, they have a good head start where they have coupons and they have returns built in that they can absorb higher default rates than they are now. It's just the question of how high do those default rates get relative to the coupons that they're earning.
And we've heard some numbers from some of the cell side Wall Street analysts that suggests that we could see fifteen percent of faults in private credit seems a little high, but it doesn't it's not so far out of the realm of possibility, because we've just seen the practice of extending more leverage to companies that probably shouldn't have that
much leverage. On many many years ago, a good friend of mine who was doing this for a long long time, told me, company gets to six times levered, it's very, very difficult to get out from under that.
And this is back in the early two thousands. We were in a normal rate.
Environment that went by the wayside when we went through this period of extraordinarily low rates for many many years post financial crisis. Now that we're back where we are today, we're back into that environment where six seven times leverage, all of a sudden, at the current borrowing rates becomes
a real strain on most companies balance sheets. So again, if you think about the legacy businesses, some of these software companies that were in these portfolios, they might be twenty twenty or twenty twenty one vintage LBOs that haven't monetized yet. They were borrowing versus a eight and historically
low treasury rate. Once we raise rates in twenty twenty two, all of a sudden, the resets on these loans because they are floating rate have gone up, so it's chewing into the equity value these businesses, and it's putting an increasing amount of strain on the companies to have to cover their interest expenses. So I think that all these things filter into more and more pressure on these companies, which could lead us to a spot where we do
get to fifteen percent dems. I'm not saying that the probability is very very high, but if it happened, I wouldn't be shocked.
¶ Osterweis's Current Market Stance
And can I just ask you said earlier that you don't have any private credit exposure in your fund at the moment. Is that right or that's correct? Okay? What made you take that decision because you said you'd been involved a little bit earlier. And then secondly, what would you need to see in the market to potentially get back in.
I think the reason that we don't is because we were financed out over time and it was never a core part of what we did. It was a more ancillary part of our business. There were a few individual opportunities that came along with companies that needed money for a particular reason, or it was a business that people I don't think widely understood, or it was the size of the re borrowing requirement. One of the companies took the money that we lent them and kept the money
on their balance sheet the whole time. They just had it as a safety net. It was less than one and a half times levered for the entire time. They no longer needed it. They paid us off and moved on and went to the next thing. So other times we were financed out by the leverage loan market or the private credit market, where they were going to be much more aggressive on the terms than the ones that
we were willing to provide. And that's typically we're a bunch of old guys, and we have our ways of doing things that have been developed over thirty or forty years. We're not likely to change approach to providing credit just because the market now all of a sudden wants to get more aggressive and look past some of the obvious things, particularly as it comes to structure and covenant protections and
amounts of leverage. We'd look at the business and say, Okay, this business is worth seven times I'm not going to give them six and a half times leverage. Do something just doesn't make sense.
And if you go back to the point you make to begin the podcast, how private credit in the proliferation of the loan market has impacted the high yielded investment grade market. You know, what was once a two tiered market of investment grade non investment grade has really become a four tier market investment grade, high yield, leverage, loans, private credit in that order of credit quality. Most of the credits that do not meet our underwriting standards have
fallen into leverage loan and private credit. So the high yield market is substantially higher quality now than it was before. The double B portion of the market is approaching sixty percent that used to be about thirty five percent, and the riskiest segment, the triple cs, is now about nine percent that used to be over twenty percent. So just by our underwriting process, we kick out a lot of the highly leveraged companies, kick out a lot of the companies that do not.
Have the interest coverage that we're looking for.
And so there's a function of our under adding process, but also where the more risky companies are financing themselves these days.
All right, well, I think we could talk about this even more. We're going to have to leave it there, John and Craig, Thank you so much for coming on our thoughts. Really appreciate it.
Thanks so much. Nice being with you.
That was great.
Thank you so much.
¶ Reflections on Private Credit's Future
So, Joe, I found that conversation super helpful just to sort of again contextualize private credit in the history of the bomb market. I do think, setting aside whether or not this is like a systemic issue, and I do think we're probably not even close to two thousand and eight style crisis right like it just can't be, but there are probably some hidden issues within there that are
going to start to appear. But setting all of that aside, I think one of the challenges of credit having these continued crises, or at least being in the headlines all the time, is it is going to have a macroeconomic impact. Sure if you think of it as this market that is now bigger than the junk bond market, Like the junk bond market is an important source of financing for
companies all around America, and so is private credit. So if you start to see that particular asset class slow down, like at a minimum, that's basically a credit crunch for a bunch of companies totally.
And you can see like how there's like this path dependency. And again that doesn't mean it has to be like systemic, but you can see how there's this path dependency. Where as you mentioned, you get the headlines about with the draws, there are more withdraws. These sponsors have to sell good assets, they might have to take on credit borrowing of their own in order to meet those redemptions and so forth.
You could see how that really spirals. I just really like their situation situation, how well they situated the whole conversation, situationship, their situationship, the way they could situate in the history of credit. Yeah, and there like look like if we're talking about ge credit financing, jet engine deals, et cetera,
that's private credit. Yeah, it's expanded beyond that, but it's basically all sort of versions, you know, various flavors of a kind of financing that is quite old and non exotic at all.
Absolutely, But I do think the sequencing also matters when it comes to raising money because, as they pointed out, this idea that like you're going to start a fund and you immediately have to start like going out and sourcing stuff to buy with that money, and it puts pressure on you to get like what you can get.
That was very interesting, the difference between fund structure of a private equity fund versus a private credit fund, which I had never really thought of. Right, So VC in PE you're like hunting around for deals and so forth that you're like, all right, we got a deal. Then you call up all the LPs will give you commitments and say, while you're sad cash that you promised to now where is in the financing realm? You know, you just always have the cash on hand. It's always coming
in and out and then coming in and out. Part also help clarify something for me, which is that, unlike with say a VC investment or a PE investment, where you put the money in and it's sort of indeterminate when you get the money back, right, you don't know when the company's gonna IPO, you don't know it's going to sell, et cetera. With lending, you do have that schedule from day one of when the money is supposed
to come back in. And therefore the idea of gates and redemption schedules in the first place makes more sense because when you have this sort of pre understood timing of when the money comes back in. You can understand why you have a mechanism in place right to schedule and regulate when the money is allowed to go back out to the LPs.
Right, but you still need to get back to some form of normalcy. Yeah, yeah, yeah, but like it's obviously incredibly helpful.
Well, this gets to a thing you know, I've wondered about, which is like, well, okay, as part of the issue here with some of the more retail oriented private credit, which is education or lack of sophistication, where you have entities putting money into private credit that hadn't really appreciated that this is an element of it, which maybe.
But on the other dating itself, but on the.
Other hand, like the industry wouldn't be as big as it is today were you not going out to these less sophisticated investors. So yeah, two sides of the same. Colindre, all right, shall we.
Leave it there.
Let's leave it there.
This has been another episode of the Authoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.
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