Odd Lots Podcast – What's Actually Going On With Private Credit

Tracy Alloway: We hear these stories about 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 literally pounding down the door to get in on a particular loan. Was that accurate in the past?

John Sheehan: No, I think even the managers of private credit would tell you in 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 10X over the last five, 10 years, I don't think that they have grown their sourcing abilities by five to 10X. So if you contrast 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're under much more pressure to find investments, which creates this competitive environment that you alluded to. Some of the issuers 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 covenants, or a combination of the both.

Tracy Alloway: Hello and welcome to another episode of The Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal: And I'm Joe Weisenthal.

Tracy Alloway: Joe, I think it's fair to say that if we didn't have the situation with Iran,

Joe Weisenthal: Yeah

Tracy Alloway: Would be talking a lot more about private credit.

Joe Weisenthal: Yeah, for sure. Jamie Dimon, he's talking about the cockroaches. We keep getting these headlines over the last several weeks, maybe months, various mini, not blowups per se, but something between a hiccup and a blowup. 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.

Tracy Alloway: Right. So I love that you said something between a hiccup and a blowup, 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 a tiny bump in the road. This is maybe a few cockroaches, 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 2.0." And it's very difficult to find nuanced commentary in between.

Joe Weisenthal: Yeah. And we're always looking for nuanced commentary. So this is a problem for the Odd Lotts podcast.

Tracy Alloway: 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 Osterweis, recently.

And we had a couple of sort 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 is often missed is what exactly is private credit's role when you think about overall corporate credit?

Joe Weisenthal: 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, 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 trying to credit solve for their portfolio needs? Because that is the consistent thing. We talked to endowment managers, we talked to investors, et cetera. Every instrument, in theory, it solves some sort of problem. Maybe you have a lot of money that's locked up for a long time. It's like, okay, you're willing to trade that away for some extra premium, et cetera. What problem does private credit solve?

Tracy Alloway: Well, I was going to say also from the perspective of the issuer. And from the issuer. 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, I mean, there's a dynamic here where both investors are demanding it, but issuers are also very, very happy to blend into that market for various reasons that we are about to get into.

Joe Weisenthal: Let's do it.

Tracy Alloway: All right. So we do in fact have the perfect guests. We're going to be speaking with John Sheehan. He is a portfolio manager for the Strategic Income Fund at Osterweis. And Craig Manchuck, he's also a portfolio manager at the Strategic Income Fund. So thank you so much, John and Craig, for coming on Odd Lots. So maybe just to begin with, how long have you guys been in the bond space?

Craig Manchuck: The firm has had a fixed income strategy for coming up on 24 years, actually. Started by one of our other partners, Carl Kaufman. Originally, the firm here was started as an equity only firm. And as the firm's clients started to get older, founder John Osterweis wanted to expand into the fixed income space, brought Carl in, and the fund has been in operation since April of 2002.

Joe Weisenthal: What kind of fund is it when we're talking about it? Tell us about the general, the mandate and the structure of the fund, and maybe who is the modal client for whom this would be a vehicle that they would put their money in.

Craig Manchuck: 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. The advantages are we get to go where we see the best opportunities. And 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 as the cycle changes, as business cycles are stronger, we would gravitate more towards credit, and as it weakens, we could gravitate more towards Treasuries. So the fund has, over its lifecycle, moved back and forth. But by and large, since the 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 $5.8 billion and it is structured as a 40 Act open-end mutual fund.

Tracy Alloway: So once upon a time, if you were looking to invest in credit, say in 2002, you would've 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 2008 financial crisis. That's basically a long-winded way of me saying, where does private credit come from?

John Sheehan: Private credit had been in existence prior to the financial crisis, but really saw explosive growth after the financial crisis. So if you go back into even the '80s 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 Milken, it allowed more companies, more highly levered companies to access public markets. That evolved into the leveraged loan market, the leveraged 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 CLO market where the banks could take those loans, put them into a securitized structure, which became CLOs, which led to the growth there.

But then after the financial crisis, the bank regulators really did not want banks lending to highly levered and/or risky entities, both corporations and individuals. So you saw pretty strict capital requirements. There was an explicit prevention from banks lending to companies with greater than six times leverage. So 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 BDC fund structure had been around prior to the financial crisis, but these dedicated private credit funds really began to proliferate after the financial crisis.

Craig Manchuck: 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 rail cars. They were financing aircraft engines. They were financing the purchase of MRIs and other health care equipment, and they were extraordinarily successful. And what it did is it created a large body of really experienced lenders who ultimately splintered off and went into different areas in the businesses. And one of the areas, 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 rail cars 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 bank. 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 80s and 90s.

John Sheehan: Yeah. And you saw that with a lot of the consolidation of the financial institutions away from GE. CIT 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.

Tracy Alloway: 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 2008 financial crisis were basically private credit.

Joe Weisenthal: Yeah. It's interesting to think about ... Yeah, I'm familiar to some extent. I don't know the full history of 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 a GE would have its own lending arm and then do its own financing on the side. But I never really thought of it as private credit per se, but it's interesting to hear that this was an origin, that a lot of the lending form types, et cetera that were sort of emerged out of these practices in-house. Then where did it go from there? So you mentioned, okay, real asset investing, maybe it's like aircraft blending or aircraft finance, et cetera. How did it splinter off into all of these different fields and areas beyond just the tangible goods financing?

Craig Manchuck: One of the places it went was in an area of mezzanine finance. And 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 warrants 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 buck 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 mezz guys to the same degree.

They're still around, but ultimately mezz funds were nichey kind of product that I think over time has just kind of been squeezed out between the size and scale of the combination of leveraged loans and high yield bonds and the PE firm's desires to keep as much of the equity economics themselves as they possibly could.

Tracy Alloway: 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 how large the junk-rated 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 relatively new market, although I take the point that it has intellectual roots before even the financial crisis, but why did it grow so quickly after 2008?

John Sheehan: 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&P. It was the first time that happened since the Great Depression. The cumulative returns of high yield for that 20-year period, 1999 to 2019 beat equities[MS1]. So among investors, there was a desire for something away from the equity market. Their experience in equities was unsatisfactory, so they were looking for other alternatives. And then in the later part of that time period, we went through the zero interest rate environment where the fed, Treasury, et cetera, 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 2000s 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 side, 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.

Craig Manchuck: Yeah. 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 levered 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 afoul of the regulators.

Joe Weisenthal: 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'll probably be in like 40 years from now. They do not have to worry at all about a quick run, whatever. And so they can harvest that illiquidity premium. 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 40 Act mutual fund. Talk to us about what it means. 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?

Craig Manchuck: We currently actually right now don't have any private credit. We were involved in it in the past, but I think most of those opportunities have gone to the dedicated private credit funds, because one of the structural differences of the way they're set up versus the way we're set up 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, and problems with, investing in illiquid securities. One of the real benefits of our strategy is we always have lots of liquidity. We historically have managed our portfolio in 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.

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 or 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. And 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 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 shrunk in 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 outsource 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.

Tracy Alloway: Could you say a little bit more about how competitive it's been in the past to source private credit deals if you are on the investor side? We hear these stories about 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 literally pounding down the door to get in on a particular loan. Was that accurate in the past?

John Sheehan: No, I think even the managers of private credit would tell you in 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 10x over the last five, ten years, I don't think that they have grown their sourcing abilities by 5 to 10x. So if you contrast 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 take in the money first and then they go out and find the investments. So they're under much more pressure to find investments, which creates this competitive environment that you alluded to. Some of the issuers 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 covenants, 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.

Craig Manchuck: Yeah. One of the thing that John mentioned, which is actually really important here. So the structural side, this is what I'll call the 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 drawdown funds. So they're allowed to go out market and say, "Okay, we've raised commitments for five or $10 billion. We're going to go out now and source our investments, which is the asset 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 and around the media, is more recently when we've gone and taken this out into these private BDC 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, because it makes it easier to raise money if you're going to allow people or you're 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. The 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 what you had in, 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 Cliffwater 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 2022, 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 2022, 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?" And 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, 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.

Joe Weisenthal: Can you clarify again, why is it that with the traditional private asset model that they only call on the capital once it's needed? Because what you explained is, okay, once you take in the capital, if it's not being invested, it's a drag on NAV, very intuitive. Just explain, why is the other parts of the private capital world able to do the thing where you only call up the LPs when you have a deal, whereas that's not the case with private credit where you're taking the money upfront?

Craig Manchuck: But what people are used to, and they've gotten used to in 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 $5 billion fund day one, that money's going to sit there if you've got more-

Joe Weisenthal: No, I mean, it makes sense. 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 $5 billion worth of commitment and then as I get a lending opportunity, then I call up my LPs and say, "Okay, you needed to pony up that 50 million to us that you've committed and whatever." Why couldn't it work that way?

John Sheehan: It could. I think it's the nature of the investment. So the traditional structure that Craig described is private equity, right? So if you think about an equity investment, you go out, you buy a company, you take over management, you 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 sense.

Joe Weisenthal: That makes sense.

John Sheehan: So you typically have bigger bite sizes in private equity, it's a more heavily concentrated portfolio with a finite timeframe, whereas credit, it's like if you think of bank balance sheet, this was a funding that used to be funded by deposits in perpetuity on a bank balance sheet upon a time.

Craig Manchuck: Yeah. I think that's the fact that you have a much smaller number of investments, many, many smaller. I mean, a typical private equity fund can have five to 25 investments depending on its size, whereas the typical private credit fund is going to have hundreds, if not thousands of. So imagine having to call $50, four times a week from your investor, each of your hundreds or thousands of investors would be really cumbersome.

John Sheehan: 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. You probably have 20% of your loans coming due every year. That's 5% 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. That's where some of the 5% logic came from.

Tracy Alloway: 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 5% 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're giving investors time to see their marks build back up or whatever. But does that selling pressure go away at all? How helpful are the gates when it comes to managing stress in private credit?

Craig Manchuck: 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 are 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 $40 billion 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'd 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 slowed 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 and 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 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 poorer 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 Blue Owl into an insurance company. Okay, that's great. But I'll 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 distressed loans in that space. And those loans are not going to be as easy to move, but you'll find somebody like an Oaktree who typically does this at points of stress or distress.

They'll go to their LPs and say, "Hey, we have a great opportunity. We want to raise $10 billion." 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.

John Sheehan: So 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 Silicon Valley 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. 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 Craig 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.

And then maybe to open up another topic, there's two parts of a default. There's when the company actually declares default and then what the creditors recover in bankruptcy, I think there's big fears around some of these recovery values that we'll 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 in bankruptcy?

Joe Weisenthal: I'm glad you said this because this is a perfect segue 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 get natural gas turbine, whatever it is, et cetera. And we were talking about the big mega trends of the 2010s, and one of them was the regulatory push of loans off banks. Another one was ZIRP. But another one was the emergence of these predictable payment streams called software as a service subscriptions. And this is the area in which you could really have zeros. A natural gas turbine's 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 guys suddenly realized that essentially, here's this business that we used to never think of high tech.

It used to be 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 financeable assets, so to speak, that could come into the debt world?

Craig Manchuck: 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 finance themselves either in the equity market or they finance 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 rate 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 16 or 17 times enterprise value to EBITDA for this business, and I'm going to put in an unusually large check. Let's say 40% of that I will put in an equity instead of the typical 20%." So historically, people have, in the LBO space, they were coming to the high yield market saying, "We'll put 20% down, finance the other 80%." If they go to the private credit guys and say, "Well, we'll put 40% down if you'll lend to us on the balance. We love this business at 16 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 PIK it? Because if we PIK 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 overzealousness. I think there was a competitive pressure, but I think that they fell prey to some of the sponsors' willingness to overpay for some of these businesses.

Tracy Alloway: 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 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?

John Sheehan: 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 fail, 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. If you look in the public markets, there'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 at par. You had a 8, 9, 10% 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 25, 30 years, and there are very new recent entrants into it who've seen substantial 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 to manager, but 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 a question of how high do those default rates get relative to the coupons that they're earning.

Craig Manchuck: And we've heard some numbers from some of the sell side Wall Street analysts that suggest that we could see 15% defaults in private credit. Seems a little high, but 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 2000s. We were in a normal rate environment. Now that went by the wayside when we went through this period of extraordinarily low rates for many, many years post-financial crisis. But 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 2020 or 2021 vintage LBOs that haven't monetized yet. They were borrowing versus an historically low Treasury rate. Once we raised rates in 2022, 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 of 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 15% defaults. I'm not saying that the probability is very, very high, but if it happened, I wouldn't be shocked.

Tracy Alloway: 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?

Craig Manchuck: That's correct.

Tracy Alloway: 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?

Craig Manchuck: 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 reborrowing requirement. One of the companies had, 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 leveraged 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 30 or 40 years. We're not likely to change our credit, our 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 look at the business and say, "Okay, this business is worth 7x. I'm not going to give them six and a half times leverage to do something like that. It just doesn't make sense."

John Sheehan: And if you go back to the point you make to begin the podcast, how private credit and the proliferation of the loan market has impacted the high yield and investment grade market, what was once a two-tiered market of investment grade and non-investment grade has really become a four-tier market, investment grade, high yield, leveraged loans, private credit in that order of credit quality, most of the credits that do not meet our underwriting standards have fallen into leveraged 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 60%, that used to be about 35%, and the riskiest segment, the triple Cs is now about 9%, that used to be over 20%. [MS2]So just by our underwriting process, we kick out a lot of the highly levered companies, kick out a lot of the companies that do not have the interest coverage that we're looking for. And so it was a function of our underwriting process, but also where the more risky companies are financing themselves these days.

Tracy Alloway: All right. Well, I think we could talk about this even more, but we're going to have to leave it there. John and Craig, thank you so much for coming on Odd Lots. Really appreciate it.

Craig Manchuck: Thanks so much. Nice being with you.

John Sheehan: Thank you.

Tracy Alloway: So Joe, I found that conversation super helpful just to sort of, again, contextualize private credit in the history of the bond market. I do think setting aside whether or not this is a systemic issue, and I do think we're probably not even close to 2008 style crisis, right? 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 private credit having these continued crises, or at least being in the headlines all the time, is it is going to have a macroeconomic impact.

Tracy Alloway: If you think of it as this market that is now bigger than the junk bond market, the junk bond market is an important source of financing for companies all around America, and so is private credit. And so if you start to see that particular asset class slow down, at a minimum, that's basically a credit crunch for a bunch of companies.

Joe Weisenthal: Totally. And you can see how there's this path dependency. And again, it doesn't mean it has to be systemic, but you could see how there's this path dependency where, as you mentioned, you get the headlines about withdrawals, there are more withdrawals. 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. So you could see how that really spirals. I just really like how well they situated the whole conversation. Their

Tracy Alloway: Their situationship.

Joe Weisenthal: Their situationship. The way they could situate in the history of credit. Look, if we're talking about GE credit, financing, jet engine deals, et cetera, that's private credit. It's expanded beyond that, but it's basically all sort of versions, various flavors of a kind of financing that is quite old and non-exotic at all.

Tracy Alloway: Absolutely. But I do think the sequencing also matters when it comes to raising money because as they pointed out this idea that you're going to start a fund and you immediately have to start going out and sourcing stuff to buy with that money and it puts pressure on you to get what you can get.

Joe Weisenthal: 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. So VC in PE, you're hunting around for deals and so forth. They're like, "All right, we got a deal." Then you call up all the LPs who give you commitments and say, "Wire us that cash that you promised to now." Whereas in the financing realm, you just always have the cash on hand, it's always coming in and out. And the coming in and out part also helped 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, you don't know when the company's going to IPO, you don't know how 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 to schedule and regulate when the money is allowed to go back out to the LPs.

Tracy Alloway: Right. But you still need to get back to some form of normalcy, but it's obviously incredibly helpful.

Joe Weisenthal: Well, and this gets to a thing 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 hand- But the

Tracy Alloway: But the gating itself, you mean?

Joe Weisenthal: Yeah, the gating itself. But on the other hand, if you didn't go, the industry wouldn't be as big as it is today where you're not going out to these less sophisticated investors. So it's probably two sides of the same coin there.

Tracy Alloway: All right. Shall we leave it there?

Joe Weisenthal: Let's leave it there. Okay.

Tracy Alloway: This has been another episode of The Odd Lots Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

Joe Weisenthal: And I'm Joe Weisenthal. You can follow me at the stallwork. Follow our producers, Carmen Rodriguez at Carmen Armand-0Bennett at Dashbot, Kale Brooks at Kalebrooks and Kevin Lozano at Kevin Lloyd Lozano.

Tracy Alloway: And for more Odd Lots content, you should check out our daily newsletter. You can find that at bloomberg.com/oddlots.

Joe Weisenthal: And you can chat about all of these topics 24/7 in our discorddiscord.g/oddlots.

Tracy Alloway: And if you enjoyed this conversation, then please like the video or leave a comment or better yet, subscribe.

Joe Weisenthal: Thanks for watching.