Private Credit Megatrends

[music] Okay, good afternoon. Um, I'm Cindy Ma with Holan Loki. Um, our conversation today is actually going to be quite broad covering how macroeconomic and geopolitical trends are shaping the diverse opportunity set in private credit, the implication of technological developments and how realization fits in this broader context. I think we're very lucky today is because we actually have a panel of titans. The reason I said that is each one of them could be a keynote speaker uh uh um by themselves for the for this 30 minute sessions.

So with that I'm going to like cut all the small talk because we need to go right into the substance. Oh again it's like I mean I think this is the first time this panel titans will be restricted by like the mean the length of uh of the response because I calcul I'm a math person. We got 30 minutes. I'm I will only take two minutes. So we got 28 minutes left.

Each of them will have seven minutes. I'm going to let them decide how they spend that at seven minutes. So okay with that is like I mean is the first question is like I mean not all private credit is created equal right for the purpose of setting the stage for the audience today. How would you define private credit in the context of your firm's history fund strategy and areas of expertise? So for the first question let's go alphabetical.

We start with uh Brian and then Paul Steve Tac.

Thank you. Uh private credit uh we are core distressed investor. So from the beginning we've always looked at uh credit curation as the most important thing and being a solutions provider and so looking at our broader syndicated loan business through our CLLO long credit business operatistic credit and that's really encompasses private credit. So public or private we're indifferent because many public credit situations going to financial difficulties there comes out of that on the back end many times a private credit security that we would own and we'll look at these opportunities throughout credit throughout the world up and down capital structure and now it might be in real estate credit might be assetbased lending uh might be structured credit however it's always looking at where can we look at the downside valuation and get comfortable there.

Hi. Um, so here's what we are. We are indeed a private credit manager, but here's what we're not. We're not direct lenders. He's a direct lender.

He's a good direct lender. That's not who we are. What we do is we team up with banks. We team up with banks in our co- lending. We team up with our banks um in our uh SRT or uh we're one of the founders indeed of the uh credit relief capital arbitrage.

We team up with banks in our credit derivatives business and we team up with our banks in in structure credit. Why do we do that? Banks are not bad people. We don't see the need to disintermediate them. They're just regulated differently.

Banks can bring something to the trade. We can bring something to the trade. And so the little position, the little corner of the market that we possess is team up with the banks, get an arbitrage by working with the banks and that's how we deliver on private credit.

Uh thank you uh and thanks for having us. The um it's a great question because I think the the term private credit gets conflated with middle market lending too often. So defining it is important. Private credit broadly is a$50 trillion dollar market. Most of it is IG.

A lot of us here are spending time on non-investment grade. But for soundpoint, private credit comes in four flavors. We have core middle market lending which is sponsorback lend lending companies with 20 to call it 70 million of IBIDA. Um we have our specially finance business which is really buying packages of consumer loans from uh lendingree and lending club and fintech companies and originators that are competing with the banks. We have a capital solutions business where the job is to go plug a hole in a balance sheet um usually for two or three years.

It's a mid- teens type return. And then we have our commercial real estate credit business where we're originating transitional mortgages. So we we do performing credit and private credit. We think about the private credit business as our manufacturing business. We originate, structure, document, underwrite, monitor.

Thanks. So, we're the vanilla player, I think, in the uh in the ice cream shop here today. We do direct lending, private credit, middle market focused. So, um think of the world as uh first, second, third generation companies that are being bought and sold by private equity firms. We finance the private equity firms buying US-based companies.

We uh we've got 520 companies in our portfolio. uh we look at 2,000 transactions a year and uh we'll finance about a hundred. So we've been doing this 25 years. We do the same thing year in year out about a hundred deals a year. We put about10 billion dollars in the ground and um uh middle market private credits been a business that the banks used to do years ago when I started 25 years ago in this business and because of regulatory capital challenges um most of that business is done today outside of the regulated financial system by asset management firms.

Uh we will do performing credit. Um, we'll do alternative credit, we'll do real estate credit, we'll do sponsor uh finance credit, we'll do non-sponsor credit, but most of our transactions are transactions. They're buyout, change of control transactions. They're not trades. We want continuing ongoing relationships with our companies and our private equity firm clients.

Great. Let's like go to look at the market dynamics topic. Um the question is how is the global macroeconomic and geopolitical environment impacting the opportunities set in private credit and each of our panelists here sit actually in a different corners of the private credit market? So from your perspective where are the most attractive opportunity emerging? So this time we start with Steve and go down to Ted, Paul and Brian.

Yeah. Well, just to your first point, I I do think the the most important trend in private credit continues to be the title wave of capital that's moving off bank balance sheets to our funds or the funds or balance sheets of our customers. And I think if broadly speaking, if regulators or internal risk managers at banks are concerned about uh macroeconomic issues, then that only benefits us. It creates more opportunity for us. And the one, you know, there are probably people that are sitting in the audience who wonder if there's a bubble in private credit because it does feel like there's been growth.

Um, and I will say that when you think about how we manage private credit, we tend to manage it in vehicles with either no leverage or lightly levered. Whereas before the great financial crisis, banks held the preponderance of of credit um at 20 or 25 times leverage. So in terms of systemic risk, I think you didn't ask the question, but I do think that the that the trend is a positive trend broadly speaking and I do think to the extent that LPs and investors are concerned about geopolitics or the effect of geopolitics or macroeconomic issues or they're concerned that we're moving towards a credit cycle or a default cycle where where we are seeing interest is in AVL and accounts receivable. Why? because it has low correlation or no correlation to um more cash flow-based lending.

So that's where we see investors leaning in. We've been doing uh accounts receivable and asset back in our capital solutions business for for 10 years now. And it was a quiet interesting workmanlike product for years and now it's uh it's the the sexiest or one of the sexiest private credit products.

It's an interesting time. We've got the highest PE ratio today in the S&P that I can ever remember. It's almost 30 times today. We've got the highest um non-standard uh auto loan defaults. We got the highest credit card consumer defaults and the highest subprime mortgage defaults.

So, we really have a a a dual um economic situation in the US. We have very healthy corporate um S&P the stock market but the consumer is not good. Uh we're seeing very high inflation and we're seeing high unemployment. Uh normally when the stock market is is high and trading very well, the economy is on a straight line up. I'm concerned that the consumer is not on a line up but on a line down.

So as a lender, we've got to be cognizant of that and we have to be very focused on where we want to invest. So as a company, our 520 companies are spread across mostly uh business services, software, technology, health care. Where they're not involved is in consumer goods products, um hospitality, restaurants, and things um that are very cyclical in nature. And anytime we go into credit cycles, uh, the consumer generally leads into a down cycle and leads us out of a down cycle. So, uh, we're very heightened aware today of the potential risks.

Now, it's been masked somewhat by interest rates. short-term interest rates keep coming down and I think we're going to see it again here tomorrow where the US Fed reduces interest rates by another 25 basis points. The interesting thing is that long-term rates aren't coming down. Long-term rates are holding. So that tells you that we're very concerned about deficits.

We're concerned about unemployment. We're concerned about inflation. So, I think that we're going into a time period where there's going to be some volatility and it's going to be good for private credit players because private credit players tend to be niche players that embrace volatility and that can underwrite volatility irrespective of which side of the ice cream um we focus on. We are all very focused on strong underwriting and focused on collecting um our debt. As the last panel said, with assetbased lending, you have to be very focused on the assets.

If you take your eyes off the assets, you end up in a first brands or aricolor situation where you're you're greatly at risk. So today, it's all about underwriting. Focus on managers that have the best underwriting uh infrastructure and you will win today in private credit. Well, your question is is always an important question, but I think it's even more important right now. Um, you know, the fundamental question we ask ourselves is where do we want to lend?

Where's the macro the best? And what kind of lending do we want to do? Different lending suits different environments. Orchard Global is truly global. So, we can invest anywhere.

Big operations in Asia. We have presence here. Our biggest office is in London and our headquarters is in Houston, Texas. Now, back when we were teaming up with TED 10 years ago, the US was a great place to lend. Actually, and I got to thanks for setting me up, but for all the reasons that Ted just said, the US great economy may be great for private equity or or equity or VC or Magnificent 7, but as lenders, we don't have a lot of conviction in the US right now.

We have a lot of conviction as lenders into Europe. Not because Europe is solving all their problems. In fact, because we think that Europe has so many demographic, regulatory, energy cost headwinds, that's exactly when we want to be lending. We actually think in in in um you know [clears throat] single B doubleB kind of credit risk which what which TED does also for a living we think that you can get 125 to 150 basis points more in Europe than in the US um for the same risk. Why is that?

The US has a BDC market. The US has a more developed uh ABS market, AL market, CLLO market. They have, you know, stronger banks, more competition. Europe, you have Brexit, you have del globalization, you didn't have capital markets union, you didn't have banking union. So, where do we want to invest?

Europe. What kind of lending do we want to do? We've done in the past sponsored lending, you know, LBO's, buyouts that a lot of the other people in this panel do, and that's great. Right now we're not doing that because of those high PES. We think that's a little bit too leveraged.

We like to be in fact I probably should have sat in the last panel much more assetbased much more car parks, airports, aircraft engines, uh you know pipelines, frack sand, you know that type of thing. So right now the answer to your question is geopolitically and macro in Europe and less leverage finance and more assetbased. The the [clears throat] word we use today is dispersion. So if you look at the IG and high yield market, they're at uh all-time tight levels or decades tight levels. As mentioned earlier, you have a steep yield curve.

So duration is going to be more costly. You look at the secular issue from 2020 and the and the rates have gone up and private equity and other companies have borrowed with floating rate debt. They're now suffering because they haven't been able to grow. The inflation uh for some is causing some margin erosion and so looking at the K-shaped recovery as again as was mentioned that is giving a lot of uh companies issues. So you you have a lot of this driven by liquidity by the magnificent seven very high PE ratios and that obfuscates some of the uh underlying issues.

There's a lot of companies that are pick there's many of those uh pick uh bonds that are private credit. Uh you look at the broader syndicated loan market. We have the CLO business. We see a window into those that are are struggling uh and they can't write a check. So, we're able to go in and what we call liability management exercises and write a check to a private equity sponsors companies that has a private e private credit existing where there might be either weak covenants for a broad syndicated loan or an ability to come in and layer on a very senior level and get paid an extra 3 400 basis points uh on what would be traditional private credit.

And so going top of the capital structure which is important as we go into this credit cycle there's been as many uh rate lowerings has gone around the world and back in the GFC however that steep yield curve I think is worrying about the inflationary pressures which is caused in that margin erosion now there's still the reshoring there's still the AI infrastructure and all these trends that are going on which is going to be three four five trillion dollars uh that's going to be problematic now the banks uh Wells Fargo had their asset cap removed. So the banks in 2013 were basically told, hey, six times leverage you can't do, which really created the private credit market as we know today. That's been recently reversed by the Fed and the other regulators and giving the the banks the ability to come back into that market. Uh Wells Fargo has a trillion dollars that they want to extend. You saw them just write a $30 billion check for uh the Netflix transaction.

And so I think there will be interesting as that new flood of capital comes in but I think they've gotten used to a better uh originate distribute model. Now the US is 30% bank dominated places like Middle East it's 95 plus%. And so I think there'll be opportunities in places like the Middle East. I think there's opportunities uh obviously in Europe but fragmented uh and certainly as we're global. I think Asia is difficult.

You know you have a couple of the markets which we've been able to be successful in. uh but the US given the amount of low DPI and the need for liquidity and particularly from a restructuring operatives to credit standpoint uh we see this trend that will continue for some time as we go into this uh new cyclical uh transformation.

Well, given the quality of responses we're hearing, we may have to cut some questions. But let's go to the next questions. um as private credit continues to grow and how do you uh ensure that scale doesn't come at the expense of underwriting diligence and credit quality especially in a more volatile and increasingly competitive credit environment. Why don't we start with Steve and then we go down Ted and Paul and Brian? Yeah, I I think um look part part of part of the ethos of soundpoint is uh it's better to have more ideas than capital.

Um and especially in manufacturing businesses, direct lending, uh accounts receivable, AVL, etc., you need to look and and Ted talked about this um earlier. You need to have you need to have a lot of reps. You need to put things at the top of the funnel. uh if you don't have a lot of things to put at the top of the funnel, you you may be more likely to to end up executing on a transaction that isn't good for your LP.

So, more ideas, less capital. That's hugely important. Um, and how do you ensure that? Well, part of it is showing the restraint, being long-term greedy. We we were about to to do a final close for our the strategic capital fund three which is an accounts receivable fund and we did a we imposed a hard cap of 1.

5 billion and could have raised three times that much and I do think as investors you need to understand the managers with whom you work and make sure that they are being thoughtful about your capital um as opposed to being and being long-term greedy as opposed to being short-term greedy

you Cindy, that's the best question that you could possibly ask because that's what keeps me up at night. You know, what could go wrong? And in a market where we've seen a 20% growth rate in capital entering into the private asset segment, um, private lending has got a lot of capital. The only thing worse right now is private equity. There's $1.

4 4 trillion dollar of dry powder sitting in private equity asset managers waiting to deploy. Now, I have a lot of friends that are GPS in private equity. Assume they're not going to return that money to their LPs. So, assume they're going to find a way to deploy that capital. So if you assume that for every dollar of private equity that gets deployed, there's a dollar of private credit that gets deployed in some 5050 ratio.

Um we don't have nearly enough dry powder and private credit to deploy to support the amount of dry powder that's going to be invested over the next three years in private equity. So if you assume today that the private credit marketplace is about a $1.5 trillion dollar market, we're going to take that one and a half trillion dollar market to about three trillion in the next three or four years. So the key, as we just heard, is find the right opportunities. Make sure you've got a deep enough um top of the funnel flow.

We look at 2,000 investment opportunities a year. 2,000. and we do about a hundred. That's less than 5%. Now, that's because the US is a large diversified um market where there's probably 7,000 transactions a year.

Europe is about 20% the size of the US and that's the next largest market in the world. So um for us uh we've got a very large infrastructure 350 employees about 150 investment professionals and it's about underwriting goes back to the first discussion we had underwriting credit portfolio management portfolio monitoring we have to stay on top of the credits covenants are crucial today 80% of the market is covenant light in transactions because the syndicated loan market has bumped up against private credit at the upper end of the market making it one big similar market. So we like to play in the lower part of the market where there's covenants. Whether you're lending to a company the lower end of the market or the upper end of the market, the winners are going to be the asset management firms that can monitor the credits and then manage the defaults.

Yeah. Um, you know, Ted is right. Uh, uh, private credit is growing and it's whenever there's a market that's growing from 1 and a.5 trillion to 2 or 3 trillion or by 100%. You got to ask the question is is how much is too much?

It's absolutely the right question to ask, especially since, as we all agree, we're getting in especially in the US into a trickier part of the credit market. But, you know, perspective is also important. The top 20 banks control 100 over 100 trillion in lending assets. So, you know, I I was a regulator. I started at the Fed.

I was a bank regulator, albeit a junior one. Um, and in fact, the last AMS conference I spoke at, we were at the IMF, uh, where the SEC was there. And what I pointed out to them is yes, it is true it's growing, but if we're going from 1.5% of the market to 3% of the market, let's not overstate, you know, there's a stop. There's still a lot more to grow.

Now, that's why we work with banks. So, [snorts] you know, that said, as everybody else has said, you need to be careful, especially now. Number one, it's why we don't do leverage finance right now. Number two, uh we turn down about 95 to 97% of the deals that we see. But because we as I said earlier team up with banks every loan that we make or almost every loan that we make has been through our process and we have a very stringent process 95% 97% rejection rate but then it also has to go through the banks and because we know the banks so well because we are also their primary capital provider we also know which banks are good which are bad and which are ugly.

So, we work with the best banks and their best origination and their best credit departments. We don't rubber stamp that. We have our own separate ones. And we actually did a deal um way back when um where Ted's team would underwrite and our team would underwrite. And then my favorite thing to do is watching my credit team disagree with his credit team.

And it was a great partnership. Worked out well for us. But that's the way that you lend in a market that is, as Ted said, more risky than none.

I think it's it's always incumbent upon the lender, the investor to do their work. I think as I was said earlier, uh we want to have more opportunities than capital. We've always operated in markets. That's why we are global. That's why we're big enough to be relevant in all the different verticals and markets we operate in, but not too big where we have to do everything.

You know, one of the big large investors goes around and tells everyone, "Yeah, we see everything." And the counter to that is yes, but you have to do everything, too. And so I think that's the uh most important thing from our perspective is right sizing your capital to be able to take advantage of of the opportunities but able to be a uh very selective as has been said uh here I think again given that perspective from a bankruptcy distress investor that's our core competency always what can go wrong always looking at seeing so many different restructurings where investors bond you know bond holders have been screwed or bank lenders have been screwed. You know, what are the different covenants? So, we have a a very uh seasoned and deep bench on our legal team which is uh able to go through and this is not something you can use jet GPT to figure out.

It is something that you need decades of experience to understand you know the different ways that that companies uh can maneuver or sponsors can maneuver around their creditors. Uh, and so that's that's sort of how we look at things. Want to make sure that we're always able to be on our front foot in terms of pricing and to be able to solutions provider. I think if you're a solutions provider, many times we'll reverse into companies that we see them going into into trouble and that has been a interesting solution because then we're not waiting to see what's shown us. Many times if you get seen something, it's it's kind of uh not the greatest opportunity.

However, if you're able to, you know, reverse your inquiry in, those have been our best investments.

Well, as I watch the clock, my mind keep recalibrating the outlines of questions. What should I ask? What should I not ask? So, we only have two minutes left. What I would like to do is each of you have 30 seconds to cover things that you have not covered.

This time, I will really have to cut you off within like hopefully 25 seconds. Start with Steve.

Yes. So let everyone wants to talk about AI and and we don't none of the people on this panel except for perhaps in our PA are buying Nvidia stock and so I think about how AI can affect our business. AI um what AI does extremely well is they do the drudgery that human beings don't like to do. They do it in a better way. So we've applied AI to our middle back office IR accounting etc.

We also use a um uh something called Hebia to help us write memos, do models, help us streamline and focus our people on using their judgment as [clears throat] opposed to doing drug.

Okay, now each of you only have 20 seconds because it takes more time. So much

time. Sorry, guys.

I'm going to say uh two words. Data centers. Everyone talks about data centers. The last guy up here talked about how much data centers he's doing. There's going to be a few winners and a lot of losers in data centers.

Be careful. The world doesn't have enough power. We don't have enough water. Data centers are going to be a disappointment to many investors. And I'm concerned the retail investors are going to be the ones that could hit the worst.

So, be careful.

20 seconds.

Yeah. Uh, two things. Now is the time to be a conservative lender. Ask for more covenants. Take um less spread if you need to, but really protect yourself.

Number one. Number two, um, now is the time to be long volatility. In our derivatives funds, we're long V. You want to be long V. What I can guarantee you is when we meet next next year and the year after that, we are going we are entering a much more volatile period.

So be defensive.

So you're you're over. So if you if you think about the liquidity is the most important thing. That's what we focus on. Liquidity in the in the framework, you look at DPI lowered. You look at the fact that there is uh many companies that are are struggling with liquidity on the data center.

We have a non- evaporative cooling liquid cooling. So it's no water issues. Uh certainly AI ecosystem three four five trillion dollars of it's going to crowd out a lot of the borrowers. So that is something uh to be mindful but certainly appreciate uh all the comments.

Well with them uh panel of titans I failed the job as a moderator because they basically say you need to end on time. I know we're well on deficit and sorry about that. I know Amos is not going to invite me back but thank you everybody.

Thank you.