InvestmentNews: John Sheehan Breaks Down the Cracks in Private Credit

Gregg Greenberg: John, where are we in the credit cycle right now? And which economic indicators are you watching?

John Sheehan: It's certainly mature. The last real reset that we've had in the credit market was in '22 around the Fed rate cuts, maybe even earlier than that in 2020 with the Covid shutdown. So if we were to use a baseball analogy, I wouldn't say we're in extra innings, but certainly feels like we're in the seventh or eighth inning.

In terms of economic indicators, we look at the two primary that the Fed looks at, inflation data, employment data. But for our fund, we're really a bottoms up fund. So we spend as much time, if not more, looking at our individual companies, their earnings releases, changes to their leverage, what they're doing with their free cash flow.

So that's a good insight into the economy, but is really the main driver for how our companies are going to behave.

Gregg Greenberg: Well, are those companies telling you that we're in a K-shaped economy? Because that's what everyone else is saying.

John Sheehan: There's some element of that. Yeah. I mean, we're almost through earnings season for our portfolio companies and they've done well. So despite all the headlines and legitimate concerns in the market, corporations are still doing well. I think something like 75% of the S&P 500 have exceeded expectations this earnings season.

Gregg Greenberg: Not software companies though. So is that affecting your portfolio, and does that have the capacity to drag down a lot more of the market?

John Sheehan: We have a relatively light exposure to software, so it hasn't really been a direct impact to us, but the bulk of the concerns around software are in the private credit market. We've not yet seen that contagion come to the public markets, but if we see a material change in the valuation within private credit, we do think there's a chance that it could start to feel it in the public markets.

Gregg Greenberg: Can you explain a little bit further on your thoughts about private credit? Because there's a lot of nervous people out there.

John Sheehan: Absolutely. So we roll back the clock a little bit and look at private credit. One of the big tailwinds for that product was its lack of transparency. So they were 10, 12% coupons, marked at par every month or every quarter. And that was a real big draw for investors to put money into that product.

Now, people have woken up to the fact that you have public BDCs that are trading at large discounts to their NAV, 25%, some even greater than that. So people are waking up and saying, "These are similar loans that are held within private credit funds. One's marked at a 25% discount, one's marked at par. So what should the value of private credit really be?" And then you overlay that with what's happened to public software stocks. Much of this private credit were loans to private software deals on the private equity side. So how are these loans going to be repaid if there's a rerating of software stocks?

Gregg Greenberg: So that's a problem out there. So how is it affecting your portfolio? So talk your book for a while, if you don't mind.

John Sheehan: Yeah.

Gregg Greenberg: What Do you like? What are you holding that's good?

John Sheehan: Yeah, we've held up well. The portfolio rate now is positioned as conservatively as we've been. There's only been maybe two or three times in the 20-plus year history of our fund where we've been positioned as conservatively. The last time we were this conservative was in 2019. We benefited from the disruption around Covid. We didn't know there was going to be a global pandemic, but we feel like we may be around the corner to another opportunity for us to take some of that conservative positioning and go on the offensive. So we have very little exposure to software, and we're going to be patient and wait for better opportunities.

Gregg Greenberg: And then finally, so where is more of your exposure? Because one would think also that, if you're conservative, maybe you have some energy stocks, which have been doing very well this year, which have been helped by the war in the Middle East.

John Sheehan: Yes. Historically and right now, we've, tend to avoid energy. We don't like the correlation to oil. We're not oil experts and the credits, particularly in the high yield market, are very highly correlated to the price of oil.

Another sector that we've historically avoided has been private equity sponsor-backed companies. So when you filter that out, those are two pretty large sections of the market. So we end up owning good companies. They're essential to the economy, tend to be smaller, fly below the radar screen a little bit, and that's where we're going to continue our focus.

Gregg Greenberg: All right. Well, thanks a lot for coming on and talking about it.

John Sheehan: Thank you, Gregg.