Sculptor Sees Opportunity in Busted Capital Structures

back on the show Stefan Koba, chef from Bloomberg Intelligence. Hello, Stefan. Hi, James, and from Bloomberg News, Renne Garthia Perez, who covers distressed debt and of course football from London. How are you Rene?

a lot more debt issuance. Companies are taking advantage of very strong investor demand for corporate bonds and loans, with yields at historically high levels, and September is typically a heavy month for bond isshuents. We are off to a record start today, but there's still a lot more demand than net supply of corporate debt, which is a technical boost. Credit markets are supported by resilience in the economy and investors are betting on a soft blanding. However, there is

a lot to worry about in debt markets. We're seeing more creditor on creditor violence, aggressive liability management exercises, and cooperation agreements, as well as defaults and bankruptcies. Then there's commercial real estate stress war, the US election, global geopolitics plus recession risk hasn't really gone away. So Jimmy, what's your take? Are you bullet for the rest of twenty twenty four?

and today's no different. There are some tailwinds, there are some headwinds, but I think to set the stage for credit investing more broadly, you've heard, whether it's from US firms like ours, you've heard talk over the last couple of years that it's a great time to be a credit investor. You've probably heard that over and over again, and it always has a different phrase. Sometimes it's equity like returns for credit like risk or some derivative of

that sort of concept. Golden age, Yeah, golden age. You know, we've heard them all. So let's start with what is that backdrop and why is everybody saying that? And from our perspective, we try to frame it as the perspective, returns on offering credit come from the risk free rate, the i'll call it generic non investment grade credit spread, and then the complexity premium, and people call that last bucket. Sometimes that's called alpha, sometimes that's called excess return, excess spread.

But it's those three pieces. And so if you take those three pieces today, and this has kind of been true for the last couple of years, moving around up and down for each of the three, but the risk free part, depending on your rate view, it's in the four or five range. The non investment grade credit spread it's in the three four five range, and that complexity

premium is also in the three four five range. So depending on which where we pick in these different ranges, you're getting to a load to mid teens gross on levered rate of return to generally take pretty reasonable credit risk. So before we talk about anything else, we kind of pause there if returns on offer are in the low amid double digits to take reasonable credit risk. And we're on radio, so you can't say you can't see the reasonable in air quotes, right, Everyone's got their own version

of reasonable. But to take pretty reasonable credit risk and make that kind of return, that generally counts as a good time to be investing. Right, even at the simplest level, Compare that to a few years ago. Risk free was zero or one, and the credit spread component was two or three or four, and that complexity premium was one or two or three. And so the Old World's six, seven, eight became the New World's eleven, twelve, thirteen, fourteen, fifteen.

And I think that generically is what have what has credit market investors excited before we even talk about what's what and what are the categories?

the market wants it to be. So again, if we think about the last couple of years where interest rates have been topics number one, two, three, four, and five on everyone's list. For every conversation, there have been moments in time where the market moves to and I'm exaggerating, you know, one hundred percent probability of rates staying high forever, and then it moves to a one hundred percent probability of rates being dramatically cut instantly, and it oscillates back

and forth between those. I think what's realistic is rates are pretty high right now. They're generically in the restrictive zone, and they're going to go from that to something more normal over a couple of years. And I know that's a cop out answer, but I think it's not really

possible to predict. And I also think it doesn't hugely matter for being a credit investor, Meaning if one is doing a type of fundamental credit investing today, that works out fabulously if there's six cuts, but it's a disaster. If there's three cuts and it's the greatest thing of all time. If it's the opposite, something's gone wrong already. We shouldn't be that sensitive to that level of granularity. But inflation is largely gotten under control and rates are

likely to come down over time. There is always a risk of a reacceleration of inflation. Do we have an ability to predict that better than the market, probably.

what's your take on these normalizing rates? Will they help us avoid our recession in the US?

we see that with recession talk as well. And I found last month the beginning of August during that selloff, to be a bit of a head scratcher. Essentially, there was a technical event in the Japanese market overnight and by I don't know, five or six or seven am New York time, there was there were calls for an emergency FED meeting to make a cut to avoid this impending recession. That seemed a little extreme. So I don't think the probability moves as quickly like rates. It's this

is a slower moving machine. The economy has been growing really well, both nominally and real. The rate of that growth is slowing, which is what the FED and other central banks have been trying to achieve for the last couple of years. So it's not a surprise that the rate of growth is slowing down. That's been the goal, that's the point of the restrictive monetary policy. So we are getting that slowing in growth so far, and again this is not incredibly insightful. It's backward looking. So far,

so good. It's worked, inflation is kind of moderating. The economy remains fairly strong, albeit slightly less strong. So we are definitively on the soft landing path. Can we be derailed? Absolutely, And again it could sound like a cop out, but this is the beauty of being a credit investor, Especially if you're a credit investor at a time where low double digit or low to mid teens rates of return are on offer. Credit investments shouldn't be that sensitive to this.

So obviously certain credit investments are. And I'm speaking very generically now, if if one is investing in a zero to fifty percent LTV loan, whether the economy grows at three or shrinks at one, sure it's going to feel better growing at three than shrinking at one. But that loan ought to be protected. So as credit investors, we don't have to be as precise.

remains in effect. So the smoother the landing, the better the narrative, and the longer it persists for allows the market to take some return out of the market. So would credit investors rather be investing against fifteen than against twelve? Sure, but twelve works works nicely as well.

return environment that we're in. But to your point, if it's a quarter and then a year and then two years where it turns out the economy grew really nicely and earnings have growth has been strong, and inflation got back to target, then yeah, the returns on offer to be a credit investor probably won't be as good then as they are.

the US consumer. I cover container shipping, which is very much driven by consumer demand and by the number of containers filled with goods bit clothing, shoes, furniture shipped from Asia to the US personally, with interest rates going from zero to five percent, I'm rather surprised that the consumer demand seems to be holding on at least for now, and this is what container shipping companies that I cover

tail investors. But I was curious to hear your views on the state of the UNS consumer going into Q four and next year as well.

the opportunity to spend as much. Employment stayed really good, and so the consumer came into this period of time with a better financial position than it had had in a really long time. And again on this the real world moves more slowly than the Bloomberg screen we all stare at all day. Takes a while for that to

burn off. But you see it in particularly in consumer credit, within asset based finance, you see that that excess has started to burn off, and like it does historically, it starts at the most challenged consumer at the lowest end and then kind of slowly works its way up. But you've seen that in consumer lending delinquencies, You've seen that in subprime audo versus prime auto. So yeah, some of the air is coming out of the ball, and again that shouldn't be a surprise because that's how this all

was designed. It was designed to take air out of the ball. And there was a period time at the beginning of the inflation rate period that we're in where inflation was in excess of wage growth, and now you're kind of seeing that catchup. So you're getting the wage growth in excess of the now moderating inflation. And again maybe that's just kind kind of getting back to new.

to speak. And maybe it's worth for a second just laying out the three categories of the credit world that we try to invest in, or the way we define it. There's the corporate credit market. I'll say everyone knows that one. It's when companies are money more or less. There's the real estate credit market, which is think of that as loans on a building or loans on a real estate asset. It's conceptually similar to corporate credit in that it's a

single name underwriting. And then there's asset based finance, which is the hardest to define. It's probably the most topical today and maybe the easiest way to start with the definition is asset based finance is everything else so it's all types of credit risk that aren't corporate credit and aren't single name real estate credit. So that includes generally pooled assets or pooled cash flows, or pooled loans of residential real estate, commercial real estate, consumer credit, auto loans,

credit card loans, student loans, transportation, aviation, infrastructure. Those are all the underlying feedstock for this asset based finance market. And it includes taking that feedstock or those pools of assets and turning them into securitized products, or turning them

into SRTs or CRTs or even unlevered asset pools. So there's the type of risk, which is all those categories I laid out, and then there's the structure of that risk, which can be varied again cash synthetic, thicknches, thin tronches, safe trunches, risky tranches. But it's pooling all those underlying risks into pools that can then be analyzed and assessed.

That's what we call asset based finance. I'd say the words it used to be called would include securitized products, structured credit, principal finance, specialty finance, acid based finance reg CAP. All that today we'll put into that ABF bucket.

is probably not the world's most efficient asset class. So because there's so much different collateral and so much different structure, and so many different forms of origination, it's an imperfect market. It's a market that's nowhere near as mature as the corporate credit market, and so the opera ortunity comes by waiting for what falls through the cracks. Now, at different points within the last couple of years, has there have

there been more distinct themes. Yes, you know, at the beginning of the rate rise, it was, well, home prices must be going down, so you know, anything residential real estate related could be an opportunity. And then at some point it was, you know, commercial real estate is crashing and there's a regional bank crisis, and so anything related

to commercial real estate must be the opportunity. And I could kind of keep going with each one, but there isn't a specific dislocation that The prevailing principle across the board in all of asset based finance is that it's generally a wholesale funded market. So when rates go from low to high and spreads go from tight to wide,

it's disruptive to a wholesale funded market. And so it doesn't matter if the underlying asset classes a non QM loan or a single family rental pool, or a portfolio of aircraft, whatever it is at that moment in time.

It's more that the market structure has been disrupted, and it's disrupted today cyclically, meaning the high rates and the inflationary environment and the regional bank consequences over the subsequent couple of years, and it's disrupted secularly, which is the twenty year trend of more and more regulation on both big banks and small banks.

goes with logic that that market's now more efficient. When a financial sponsor buys a company and they want to borrow the first sixty percent of the capital structure, they can go to the investment banks that have been doing it for eternity. They can now go to the direct lending market, which has trillions of dollars and growing by the day, with I don't know dozens or hundreds of players and so there's going to be some efficiency to

that market. Well, the private ABF market today is deminimus, and so it looks a lot from an efficiency standpoint, or from a falling through the crack standpoint, it looks a lot like the direct lending market looked fifteen years ago. It's niche, it's smaller, there are less players, every deal is different, relationships matter, all of that. It's the direct lending from fifteen years ago.

these are all widely quoted numbers now. But if you take the direct lending market, the high yield market, and the bronze syndicated loan market and you get to five or six trillion, do that same math on REZI, consumer, commercial, corporate, hard asset, infra, etc. And that five or six is more like twenty five or thirty trillion. And that's what kind of creates some of these eye popping figures as

far as predictions for the future. But to be clear, that's happening with or without us, with any of us. It's not a path. What we're focused on is when you start with that market that's five or seven times the size of the corporate market that doesn't yet really have an established private credit market, and you're in an environment where the base rates four or five and credit spreads are four or five and complexity premiums four or five.

We think we've got a good few years ahead of us to go after that opportunity and create some return.

opportunistic bucket of an allocator. It wasn't an official allocation in the world, It wasn't in a consultant model, it wasn't anywhere. What you're seeing today is that it's starting to make its way again. It's at the leading edge, but it's making its way into the mainstream allocation model.

are out there. We were involved in a transaction where a bank had been providing warehouse financing for an aggregation of single family rental properties that were meant to be aggregated until they got large enough to securitize. And as the securitization market became disrupted by rates going up and spreads going up and the world becoming less comfortable with warehouse financing and banks becoming less comfortable with holding risk against that, the bank decided that it would like to

have less of that risk. And so the bank said, Okay, if we're lending the first seventy five percent against the value of these homes, let's lay off the bottom ten points of that. But that sort of transaction is so customized that it can't be done in one of these broadly syndicated SRTs or CRTs that again we read about we hear covered kind of every day. That's a bespoke transaction, and so that means the bank can really only call a handful of players because it's just too cumbersome to

do it broadly. And so step number one be one of a handful. Step number two be able to be flexible, to structure, to work quickly through that collateral. The punchline is that for doing all that, we can create what we think is safe risk against a portfolio of homes with plenty of enhancement by the way. As it turns out, home prices didn't go down, they actually kind of kept going up and do that for that kind of load to mid teens rate of return.

and slicing it. And so they're as a in this case a smaller scale auto finance platform. Again, if you're a huge auto finance platform, you can do a big, syndicated, transparent deal that you know, sort of cookie cutter, and

you're going to get better execution as an issuer. If you're smaller and you have this pool of auto loans, and maybe they're kind of unique because you're a lender that does something a little different, and you don't have the kind of balance sheetter financial wherewithal to access capital more cheaply, but you still need to accomplish the same objective. What does that mean You're going into that bespoke ABF market.

You're having a handful of conversations to say, how can I get capital relief as an issuer or get liquidity as an issuer. We look at that and say, Okay, we know where double B auto abs ought to be, or we know where triple B auto abs ought to be. If we can do something private, bespoke, highly structured, sometimes that means less liquid sometimes it doesn't. If we can create that same risk, but do it for hundreds of basis points wider than what exists in the market, that's

that last four. I keep talking about the four plus four plus four. That last four comes from what I just described. And again we've done it in various parts of REZI and various parts of auto, and various parts of consumer, in various parts of the aviation market. All of those are are in play.

the risk. So five billion portfolio, five hundred million of risk transfer. That's a big deal. And that's going to be sort of broadly syndicated or at least broadly reached out. It's going to follow a kind of standard form. By the way, even with all that still pretty attractive. Meaning when we're looking at that, we're not saying, oh my gosh, that's such a unattractive risk to take. We're saying that's

actually pretty good risk too. But then take the financial institution that has the five hundred million portfolio that needs the ten points of relief, and it's the fifty million. There's just less players because the sophistication to do that, again correlations means big firm, lots of resources, big capital. That group would probably rather work on the five hundred million dollar check than the fifty million dollar check. And again it doesn't have to be so prescriptive, and the

truth is kind of somewhere in between. But the bigger, more standardized transferences of risk, whether that's the sale of loans or an SRT or a CRT or some sort of structured financing, the really big tends to be more efficient.

they would also extend these revolvers. Revolvers, it turns out, are a tough business to make money on, right, because a bank needs to hold the capital in case it gets drawn, but they don't get paid much for that risk.

It's kind of a loss leader. And so the one of the classic forms of these transactions, a bank would say, Okay, here's a pool of ten or fifty or one hundred of these names, they you know, all started off as five year but there's some you know, some runoff in there, so it's a you know, it's a four year waited average life portfolio. When you talk about things like consumer or auto, those are much shorter. Weaightter average life that

could be one, two, three years. When we talk about capital relief transactions off of warehouse financings, those can be twelve or twenty four month maturity, So depends on the collateral. If you're talking to someone like aviation, those are seven year leases.

and you know everyone's back in the game. The financial crisis had a much more long lasting shadow overhang impact on that market, and you see it in tons of stats, and there's some of these charts kind of make their

way around over and over again. But it's bank share of securitization, bank's share of origination, it's credit stats around what is being securitized or what's being risk transferred in some way, and the the moment in time underwriting from before the financial crisis, we are at the other end of the spectrum. Maybe we're coming back towards the middle now, but we are not on that side of the pendulum swing at that era.

was leverage upon leverage upon leverage upon leverage. Both of those kind of came out of the market and went to the other extreme of the pendulum again, maybe now working back towards the middle. But today we don't see that type of head scratching behavior on the asset or the liability side.

Where we've been most active in corporate credit again, a topic probably well covered by you all, has been on the liability management exercise side of the corporate credit market. Right, That's one way of saying it. There's a more cynical way of saying it, which is the creditor on creditor violence. But the provision of new capital, new credit capital to an existing capital structure that might not be sustainable. That has been the best opportunity in the corporate credit market

over the last year or two. I'd say at the beginning of the high rates, high inflation period, it was more classic dislocation, meaning there were hung financings at banks, and there was a secondary market that was sort of crashing, and there was a primary market that was frozen and shut. And so that's more traditional dislocation. So by good bonds and loans in the secondary getting thrown out with the market, make safe loans to good companies that have to pay

up for capital because markets are shut. You know, that was maybe the parts of twenty two twenty two. That's not the case anymore. I think sometimes it still gets talked about it like it's the case, but I would say that's not really the case today. Where the opportunity set really got to from late twenty three into twenty four was more of the existing capital structure, typically in a you know, a buyout situation, meaning a leverage buyout where when rates were zero. Cash Flow was fine when

rates were five. Cash flow was not fine when the economy was sort of growing massively and margins were peak. Maybe it was okay. When the economy slowed a little and margins came off peak, maybe not okay. So you had this accumulation of cash flows not as good as everyone had hoped. Interest eating up most of free cash flow, if not more than all of free cash flow i e.

You know, companies becoming free cash flow negative. And instead of the old fashioned way to resolve this, which used to be some sort of insolvency proceeding for a whole host of reasons, the world evolved to a different way of resolving that, which is some version of an extension, some version of a moving assets around, some version of a moving the capital structure around, and so that that premium I keep talking about the third the third four,

if you will. The best place to find that third four in the corporate credit market over the last year has been from either the complexity structure sourcing alpha sort of tech wherewithal on the technology for this to participate in that amend and extent market, or that provision of new capital to a stressed capital structure.

Do you think that we're past the peak of the cycle, and would you just be maybe more defensive in your portfolios going twenty twenty five or is it a question of being more selective as you said earlier on cyclical industrial names.

to make sense. Two answers to that. One, maybe there's not an impending recession, but two, a lot of the world of credit investors are yield buyers, so spreads might be tighter than opportunistic credit investors want them to be, whether that's in European industrial names or just in aggregate.

But a lot of the world needs a total return, needs a total yield, and so whether that part of the yield is coming from the base rate or the credit spread, maybe isn't as important to a lot of those buyers, and so the tighter spread then you'll want it to be. So to speak, is an output, not an input.

couple of years. I wanted to ask your views on cooperation agreements because here and here we're starting to see them in some situations influenced by US accounts, in situations where it's either a cross border like LDS or Altis Friends or others like Klogner Pentoplease that it's a German name but has US debt, and investors here seemed to look at those co op agreements with at least skepticism,

if not concerned. What's your view on those cope agreements that we're also seeing them being longer and longer.

become altered in any way. And then over a period of years, documents became much looser, particularly the ability to amend a document with majority as opposed to super majority or super duper majority. Market participants meaning borrowers, lenders, banks, advisors all got smarter on this technology, and all got smarter on how to optimize, and so sponsors started doing

very aggressive maneuvers. Then new lenders started to take advantage of that through the provision of new capital, and sponsors then sought a different angle, and the response to that was the co op. And so it's just it's this ping ponging of capitalism. There's old lenders, new perspective lenders, and the borrower. Those are three parties in there. Now, a typical situation is way more complex because old lenders might be five, six, seven different layers of a capital structure.

But the pingponging of trying to get an edge, get an edge, create a response, create a counter response is what led to the co op. And on a no names basis, we're in our morning meeting this morning on credit debating when a co op might break and there's going to be a splinter group off a co op that's going to create a new co op. And so this is just this is just capitalism at work. It's

neither good nor bad. It just is. And so the job of the credit investor is to make sure you can see around that corner again, not every single time, but hopefully most of the time, to avoid being on the wrong side and hopefully be on the right side.

really clever new line of attack. So co op agreements are as I shouldn't say necessary, are going to be as part of the process in Europe as they are in the US. Notwithstanding the fact that certain avenues to create pressure that are used in the US, and you alluded to it, there's fancier ways of talking about it, but it's basically the moving of assets up and out. It can be harder to do that in certain European jurisdictions due to director liability that kind of kicks in

and around this zone of insolvency concept. But someone will think of a new angle and the cop agreement will address that.

it that way. It's not going away. As long as there are contracts, and as long as contract law prevails, and as long as there is a capitalist interest on all sides amongst all constituents, there will be continued innovation

in this. So I think there are traditional lenders who say this is bad for business, and it's going to raise the cost of capital for companies, and everything should go back to the simple way it used to be, which is if you were the first in line lender, you got paid before anyone else, and then the second line, second in line lender, and then so on down the line. I don't think that's coming back. I think that is that is wishful wishful thinking.

mark to market basis. Right, So I'd argue it's it's better than the business of banking, because in the business of banking, as as people learned over the last couple of years, sometimes your funding runs out the door, and when your funding can use a mobile phone to do so, it runs out even faster. Clos are a term financed funding arbitrage. So there are times the arbitrage is wider

or narrower. There are times where we or others as manager do a better or worse job, But fundamentally it's a really great tool to extract the assets spread less the cost of funds.

There just hasn't been that much return on offer in credit. So where we have dollars that can move between asset classes, more of those dollars are deployed in credit. Where we have credit funds that can draw down capital, they draw it down even faster. Where we have evergreen credit funds, they're fully invested. So when we have the chance to make these types of returns relative to this type of risk. We want to take it.

that have multi year time horizons. So if you can take the liability side off the table, or you can reduce the risk of the liability side, now your risk is just on the asset side. And so in generally making you know, senior type of loans or taking senior type of cash flows, we can do worse than we underwrite. But it's hard to to catastrophically get that wrong in aggregate.

Things might be kind of good or might be kind of bad. And if we think we're okay either way, you know that's the goal. Where where could the unexpected

come from? If inflation were to re accelerate, that would be highly disruptive to everything, because if inflation were to re accelerate, then the entire framework of don't worry that rates are high because they're gonna come down, and that's what allows commercial real estate values to stay okay, and residential real estate values to stay okay, and corporate multiples to stay okay. If that foundational factor were to be challenged, that would seriously stir the pot Now for existing investments.

If you were right that you made a fifty LTV loan and the value goes down by fifty percent, You're still okay. You're not going to feel great while it's happening, but you're still going to be okay. But a reacceleration

of inflation, that is one of the primary risks. Again, we can always make the list of there's geopolitical risk, and there's election risk and so on and so on and so on, but and those you know, no one knew the pandemic a year before the pandemic, right, a lot of us knew it the month before, but not the year before. That would change everything.

We're on Apple, Spotify, and all other good podcast providers, including the Bloomberg Terminal at bpod Go. Give us a review, tell your friends, or email me directly at jcrombiight at Bloomberg dot net. I'm James Crombie. It's been a pleasure having you join us again next week on the Credit Edge