Transcript: The Future of Private Credit

Air Date: December 9, 2024 | 12:00 PM, EST

Caroline Cakebread: Good afternoon, everyone, and thanks for joining us. I'd like to welcome you to this week's Monday Minute Live Chat, hosted by the Canadian Leadership Congress. The topic today is the future of private credit, and here to talk about it is John Sherman, Portfolio Manager with Polen Capital. Moderating this discussion with John, we have Sriram Vedula, Director, Private Debt with BCI. Welcome to both of you, and I'd like to hand things over to you, Sriram, to get us started.

Sriram Vedula: Thank you, Caroline. John, it is my pleasure to have this conversation with you today. I've been very much looking forward to this. There are a few topics I'd like to get to today with you, and they include market themes, M&A activity heading into next year, public versus private markets, and the state of the private markets today, which is of primary concern for all of us, and ADF. There's this new relatively new area for private credit, asset-backed finance. If there's anything else you'd like to cover here, I would love to touch upon these as well. Is there anything else you want to add here, John?

John Sherman: No, I'm looking forward to the discussion. Thank you for agreeing to moderate.

Sriram: Excellent. Excellent. Look, you're a man who covers both the private side of the markets and public side of the markets and you have a bit of a unique perspective when it comes to private credit and how we interact with the public markets. Our market themes, it's been quite an interesting year, and it's definitely been an interesting month so far, but where we sit today, I think we can safely say, perhaps, that we are at the end of a rate hiking cycle.

There's a new administration in place and we just see it largely as pro-growth. There is a broader deregulation theme that's percolating in the market, and another tailwind has also been a stronger-than-expected customer, growth in the market, growth in the broader economy, and a stronger-than-expected customer, regardless of how we all feel about inflation and where that leads us. These headwinds are counteracting a little bit by some tailwinds, too. The tariffs, trade tariffs, no one's quite sure how they're going to work, the extent of that, and what the impact might be.

Then there's the whole issue of immigration, what's the direction, how is that going to impact certain sectors, especially tech and some of the other sectors that rely a lot more on immigration than perhaps some of the other sectors? Finally, some possible rate volatility. That's a lot of themes to balance, and I would love for you to unpack some of these and share your perspectives on how these might all impact our return.

John: I think the biggest theme that I see in private credit right now is just the amount of money that's been raised and is sitting on the sidelines, both on the private credit side but also on the public side as well. I think one of the themes that people haven't been talking about as much is just the war chest of money that is chasing not that many deals. As you talked about, this has been an extremely strong year in both the public and private debt markets. It's really been an environment that's been characterized as refinancing, so really not that much net new debt to go around. There's been a lot of money chasing a lot of refinancings, but not a whole lot of new debt creation, either M&A or dividend-type deals.

The biggest theme that I've seen is really both the public and private markets chasing very little opportunity, and the two markets really converging from a pricing as well as a documentation perspective, and just a lot of competition between the two. What I'm really looking forward to over the next 12 months, now that the election uncertainty has been removed in the US, is whether the M&A engine turns back on, whether that new debt creation starts coming back on, to really start taking some of that supply out of the market because if we continue with the current pace, the spreads are going to be even lower than they are today and we're at historically low levels.

Sriram: Let's unpack a little bit of that, John, because that's a very pertinent topic. If I'm an investor, as an LP, I'm concerned that private credit feels more like a beta investment. I'm investing in the beta of the market. The opportunity for alpha returns seem harder to combine, especially with some of the larger gargantuan credit managers who have these massive funds and they're deploying into, and this is a game of scale.

The point you mentioned earlier about strong issuance, but not necessarily new issuance, I think I saw a number somewhere that said $140 billion in September alone between the public and the high-yield markets was 70% higher than the comparable period last year. We know there's been some green shoots of M&A, but not a whole lot. This was largely repricing and refinancing.

As we turn the corner into the New Year, help us understand some of the structural factors that are driving this M&A volume. We talked about some of these things. You mentioned earlier about the volatility of the election behind us, something along the lines of more stability in rates. Unpack that a little bit more for us, please.

John: In my mind, a lot of the uncertainty is gone. You have a new administration that's coming into power that has a pro-growth agenda. I think there's not as much concerns around tax cuts, which may have slowed down the economy a little bit.

Inflation, I wouldn't say it's quite in check yet, but it's lower than it's been. You really have a pretty good environment to do deals. I think one of the observations that I've made is that holding periods for private equity limited partners are at some of the longest periods in history. That's because number one, there was a lot of deals done in a zero interest rate environment. Now that interest rates are higher, that's, compressed valuations. There's not as much easy money to be made in terms of multiple expansion for these companies so private equity firms have held businesses longer than they typically have.

Then you've had this uncertainty that's been persisting over the last 12 months or so. I think the combination of those two factors number one, the holding periods being longer, and number two, that uncertainty going away. I think it's going to drive a lot of M&A activity next year, but specifically in the first half of next year. I think that M&A activity should help soak up, again, some of this large dry powder that's out there that's looking to put money to work in the markets.

Sriram: I'm going to have to agree with you on that, John, because some of the things we've seen, private equity, to be fair to them, have done a really good job over the last few years, recognizing that they're holding onto assets for longer. They've done a great job of rationalizing costs. Then, by virtue of a host of factors, having the ability to pass on increase in input costs down to the consumers, I think you could argue that perhaps they might have reached a little bit of a limit in terms of how much cost they could pass on down to the consumers. They've been good sponsors, they've been good partners to work with for the private credit industry, and that they continue to support the businesses.

Because the high rates have persisted for a long time, I think whenever liquidity issues started to manifest themselves, they've done a good job, generally speaking across the board of approaching the lender group and asking for solutions to mitigate that, either through extensions or conversion to PIC and paying a little fee for that, but in general, it feels like there's been a good partnership at work so far to mitigate some of these issues that might have otherwise led to more, perhaps defaults or contentious relationships between the lenders and sponsors. Is that something you're generally seeing in your day-to-day [crosstalk]--

John: Yes, absolutely. I think private credit is-- I shouldn't say solved, the case is not completely closed on this. I do think, in general, private credit, the solution that they can provide by having a tighter lender group, whether it be one sole lender that funds the entire issue size or a handful of lenders, funding a larger, size to two companies, I think they're able to work collaboratively, with the owners of the business and the company to come up with solutions when things go wrong. I think the contrasting view is that in the public markets, you're seeing these transactions that are called liability management exercises, LMEs. Some people nickname them the lender-on- lender violence, et cetera. When you have these huge syndicates of lenders, there's this motivation to stack lender against lender to provide a solution for the company, but at the expense of another lender. The great thing about private credit so far, again, a couple of isolated incidents where this has happened in the private credit world, but by and large, the structure of private credit is allowing for these transactions to occur that are fair I think to both parties, ultimately come to a solution that's a win-win for the company and for lenders.

I think that's unfortunately used to be the case in the public world but it is not the case right now, so I think that's a big advantage of private credit in this environment. For LPs is not seeing those transactions happen.

Sriram: I would have to agree with you on that. That is certainly one of the advantages of the private credit worth although the cycle is still the critical factor here. John, you've seen the cycles. You've been through some credit cycles here.

You have a better perspective on the market. Then certainly a large number of managers out there who perhaps haven't seen the downside of the cycle. Where do you think we are?

Are we still in the golden age of private credit as you tend to see every other day on Bloomberg or Wall Street Journal or do a little bit more stress in front of us or do we are a happy medium where there's been stress but we've been able to work our way through it and there's sort of in a balanced period. What's your perspective here?

John: Maybe a little bit about controversy you'll take but I think we're in the golden age of asset management in private credit but not the golden age of returns for investors in private credit. What do I mean there? I'll unpack that a little bit. I think the returns that private credit has generated, especially in a zero interest rate environment where you can lever up the portfolio, one-to-one or even higher, you can really amplify good returns, again, low default rate, so you're not getting much loss in your portfolio.

You can amp up those returns and you've generated really good relative returns versus any other debt asset class because the economy's been good, you haven't had much defaults, and again, the leverage on the individual portfolios have amplified those returns. Now, the private credit industry as a whole has taken advantage of that to raise a ton of money. It's north of a trillion-dollar asset class at this point in time.

You're right, you can't pick up a newspaper without reading a story on how great private credit is and how it's uncorrelated returns, and it's a great place to include it in terms of a model. I think it still is. That being said, go back to one of your initial comments is, is it more of a beta, type play in private credit or is it an alpha opportunity? I think it's more beta. I think it's matured very quickly as private credit managers have gone up market and they're competing for the same deals that the syndicated market would have done 12 to 36 months ago.

I do think if people are looking to put money to work in private credit, especially upper middle market, large cap private credit, I just want to set expectations that I don't see the type of return differentiation that was there over the last 10 years in this environment because of where spreads are. I would just be very cautionary towards new investors that, again, haven't had that great run up, that are just getting in the asset class that maybe want to slowly get into this trade because I do think it's a great place long term to have money, but I wouldn't want to put my entire allocation on today, just given spreads are really low.

Again, spreads being the amount of additional yield you get or coupon you get for taking company-specific risk, they're at some of the lowest levels in history right now.

I wouldn't want to put on all that money in this environment. I'd want to slow down. I don't know if you have any thoughts as to--

Sriram: No, I agree with that. I think the two further directions of thought I want to lead you down are what happens, once a lot of M&A soak up some of the dry powder, are we going to get back to a more balanced supply-demand where credit managers, can actually do real price discovery, set real pricing, and get some covenants and other covenants with peak coming back, and you have a meaningful protection in your documentation?

That's the first thing. The second, related but not exactly the same, is the 800-pound gorilla in the room, our friends, the banks, especially with the theme of deregulation, but more importantly, Basel endgame in 2025 and what the banks can or cannot do. Their presence has a great impact on what we do, so how should we think about these two different vectors, if you will, for the market?

John: I think from the spread perspective, from the rationalization of the market perspective, I don't think it's a huge M&A soaking up the supply in the market. I don't think that's the catalyst. I think it's the question that I didn't do a good job answering that you asked as previously. I think it's that recession and specifically a medium to large recession that really causes the rationalization to occur in the marketplace. I do think it is worth several years of mediocre returns that cause people to maybe step back in terms of their private credit allocation, but there is more than enough money I think out there to soak up whatever increase in M&A occurs.

I think it's really going to take some pretty big losses to get through the private credit universe, which I think are out there, that's just unlikely, just based on historical patterns that an asset class could continue to do as well as it's done for the history of the world. There's pretty good precedent over 30 plus years in the leverage finance market for cycles and defaults and lower recoveries. It's unlikely to me that you're going to get a perfect track record and private credit of just picking the good deals and then all the bad deals go to the public markets. I think that's pretty unlikely.

I do think this rationalization will occur. Spreads will widen out. Again, when we see spreads this tight, they generally stay there for 6 to 18 months, but is it likely that spreads are going to be at this level 3 years from now, 4 years from now? I think it's incredibly unlikely. Now, what caused it to change? I don't think anyone knows. A lot of people, including myself, did not see the housing crisis unfolding and the great financial crisis, oil going negative. There's been a lot of catalysts that have taken the market by surprise. I think it's one of those events that will because the rationalization of the market.

Again, I would encourage people just where spreads are, especially on the upper middle market and larger side that I wouldn't be going all in on the asset class right now. Now, I do think that there's a lot of opportunities in the smaller company and lower middle market side because of what you said in terms of the exit of regional banks from financing that market. I think there's still quite a bit of opportunity there. A lot of those companies are too small to get banked by the biggest private credit players, so there's less competition in that area and there still is opportunity to get some nice yield associated with these smaller companies.

Now, there's obviously some risk as well associated with smaller companies, but I do think there's opportunity there. Then I'd say the last point just in terms of the banks, I don't know that I see the banks getting back into underwriting and holding credit like they used to 10 plus years ago. I do think that these partnerships, these very public partnerships that these banks have made with private credit managers, I do think that that's more of the model for the future in terms of offloading that risk to vehicles that are meant to hold, riskier assets. I think that's a good thing for the entire system.

If anything, I see the banks trying to syndicate more deals, but I don't see a wholesale change where you have banks coming in and underwriting 10 to 100 billion worth of syndicated deals, committed financings that they, again, try to shop down the road. I think enough people have gotten burned by that in recent memory that that's not going to change. I don't think that's going to change any time soon.

Sriram: Understood. That's luck. That's a great perspective to have and to share because it never felt like up until 2022 maybe that the banks would ever truly and genuinely walk away. They always saw this as an avenue to fees. Having worked in a bank, it was never about the one product. You basically look at a customer and say, "I have these seven different things I can offer you, tragedy functions, I can offer you M&A advice, and then I can do an underwritten deal. It's a one-stop shop."

Clearly, with the regulations in place, especially around regulatory capital, you could make the argument that they're more and more focused on just being fee-generating centers rather than having these massive balance sheets and all these other matches because there's not a natural match between the assets and liabilities. You could argue that these loans, by virtue of closed-end funds having this longer- duration asset base, they're the ones that should be holding this and not the banks. Structurally speaking, it feels like, while there might be some growing pains, hard to see how the banks come back in full force at any given point in time in the near future.

John: Yes, and I don't think they will, and I, frankly, don't think they should. I think banks have realized that they can earn very good "risk-free fees" by arranging deals, and again, by partnering with asset managers, private credit asset managers, they can offload that balance sheet risk to that asset manager who is going to be doing an independent review on that situation. They can still arrange deals and do syndicated deals and do best-efforts deals, but they're protecting their shareholders from the volatility that's associated with these riskier deals. I think that it's a net positive for the stability of the financial system.

Again, it's going to continue to create opportunities for investors to get access to these great assets that used to just sit on the balance sheet and earn shareholders the outside interest rates spread. Then, individual investors can team up with asset managers like ourselves and others to get those attractive interests to themselves.

Sriram: Calling back to an item we both touched upon a few minutes ago, does the resiliency of the US consumer surprise you a little bit? The fact that small to medium businesses, and some of the larger corporations too have been so successful for as long as they've been, in being able to pass the additional costs down to the consumer, and the consumer continued to stay resilient, and the margins continued to stay strong. I'll admit, I don't think I anticipated that if I was looking ahead to the future in Q1, Q2 2022.

I thought there'd be more pain in front of us, but surprisingly, pleasantly, there's been a lot of strength in both the consumer and in the ability of the companies to manage the situation. Was that surprising to you? When you look back, can you point to structural factors that say, "Look, that shouldn't have been a surprise?"

John: No, I was candidly surprised as well. I do think the unfortunate issue is that it's really bifurcated in terms of the consumer. I think the lower end consumers are absolutely in a spending recession right now, but the larger consumers have so much more purchasing power than the lower consumers that net. We haven't seen that big impact, but I think by all accounts, there's a recession going on in a large part of America.

The numbers have softened, but they have been more resilient than I would have thought. The only thing I can think of that has been continuing to be very supportive and one of the biggest factors that we look at, we're not huge macroeconomic people, but one factor that we do look at is employment, and that's been persistently strong. I think as long as employment stays strong, the economy does continue to do well.

I do think that there's a large part of the country that's struggling right now with inflation that's hurting purchasing. I do think a lot of the reason for the change that we've seen over the last few weeks has been people wanting more of a progress agenda for the entire country. I am interested to see how the economic policies roll out because I do think that there's still a lot of uncertainty as to what policies will hit versus what the rhetoric is.

Sriram: Maybe we wrap this up by asking you for a couple of perspectives. What gives you optimism as we look forward to the next four to five quarters? What gives you causes for optimism, both the public and the private credit markets? What makes you cautious over the next, again, similar four to five quarters with respect to the public markets and the private bonds?

John: I'm really excited. We focus mostly on domestic companies, domestic being United States. We do a little bit in North America. I do think over the next four to five quarters that there should be an acceleration in the economy, which should help continue to drive a lot of deal-making activity. For us, that creates the excitement of getting to look at a lot of new companies to finance that either there's going to be new owners, there's going to be additional M&A opportunities, whether it's bolt-on acquisitions or wholesale buyouts of companies that we haven't seen before.

I'm excited about a lot of new companies coming into our markets that we can analyze and hopefully add to our portfolios to generate great returns for our clients. I'd say that's what I'm most excited about is the increase in activity that comes with a stronger economy and just the less uncertainty out there. What gives me pause is really just the continued low-spread environment that we're in.

The debate that we have is are we getting compensated enough for taking the company-specific risk in each of these individual deals? I think we're tasked with a really difficult choice of having to say no to some great companies that we really like but we just can't justify the very skinny spread that you get over buying government bonds. We have had to pass on some very interesting opportunities just because the spreads are so tight, again, relative to government debt.

I'd love to see a more rational market, but, right now, I'm still a little bit cautious on where spreads are, and again, just making sure that we're staying disciplined and not taking too much excess risk in an environment where you're not getting paid a lot to take that company-specific risk.

Sriram: John, that's a great place to end. I agree. We are cautiously optimistic for the next little while as well. We see a large opportunity set in front of us finally coming together, and you still have to be very careful, you still have to-- I think the key is to make sure you're holding on to your underwriting standards and then this avalanche of deals finally lands on your plate. It's good to be in private credit. I still feel very optimistic that we are in a really nice niche of the market to be in. On that happy note, thank you for having this conversation.

John: Thank you, Sriram. I really appreciate the time, and I would echo the cautious optimism. I do think it's a great asset class and it's one that we're going to be excited to play in for a long time to come.

Caroline: Thanks so much to both of you, John, and Sriram. I think that was a really insightful discussion. I thank you for taking the time to have that for our viewers. That wraps this week's Monday Minute. We've got a lot of exciting content and great interviews lined up for our future Monday Minutes that you won't want to miss. Be sure to go to our website, leadershipcongress.ca to sign up for our very informative and timely CLC newsletter. In the meantime, thank you all for joining us, and see you next time.