It's no secret that the market for private credit has boomed in recent years. The surprising thing is that it has continued to do so even as interest rates have surged, defying many people's expectation that this relatively new market would suffer once an era of "loose" money comes to an end. Instead, the market for private credit in the US now rivals the size of the market for publicly-traded, junk-rated corporate bonds. But what exactly is private credit? How does it differ from broadly-syndicated stuff like leverage loans and corporate debt? How susceptible is it to higher rates? What is driving continued interest in this asset class? And what could cause it to wobble? On this episode we speak with Laura Holson of New Mountain Capital — where she manages about $9 billion across various private credit investments — about how the industry works. This transcript has been lightly edited for clarity.
Key insights from the pod:
What is private credit? — 4:08
What does New Mountain Capital do? — 5:05
How old is private credit? — 5:55
Private credit’s performance in 2020 — 7:24
What does a typical private credit deal look like? — 8:52
Treatment for creditors in private credit — 12:28
Why should investors buy private credit? — 14:26
Relative value compared with broadly-syndicated deals — 16:13
How do private credit funds identify potential deals? — 17:40
How reliable is funding for private equity? — 19:26
Building up industry expertise — 21:12
Increase in defaults in private credit — 23:45
How frothy is the private credit market? — 29:40
How much dry powder in private credit? — 32:50
Can private credit get even bigger? — 34:22
Bank response to competition from private credit — 36:16
Illiquidity in private credit — 38:01
Regulators and private credit — 39:59
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Tracy (00:10):
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal (00:14):
And I'm Joe Weisenthal.
Tracy (00:16):
Joe, what do you know about private credit?
Joe (00:19):
I know it's grown a lot.
Tracy (00:23):
That's pretty good. I mean, that's the important thing.
Joe (00:25):
I know it's private and there's credit involved. I think that's about it, and I know it's grown, and I think that's about the extent of it.
Tracy (00:33):
Okay.
Joe (00:33):
No actually, wait, can I just add a little more?
Tracy (00:36):
Eh, maybe.
Joe (00:37):
No, I get the… My sense is that for whatever reason, and this I don't know, people perceive there to be opportunities in private, like, you know, there's private equity buying stakes, there's VC, etc., but people see an opportunity in pools of capital that are then lent out, another, you know, lending that's not through banks.
Tracy (00:55):
That’s it. That's the episode, we're done. No, I mean, you hit upon the most striking thing at the moment, which is that this is a market that has grown remarkably over the years. And I've seen various estimates, I think people calculate what counts as private credit somewhat differently. But I've seen estimates of about $1.3 trillion to $1.6 trillion outstanding. If you think about the publicly traded bond market or the publicly issued bond market, so if you look at junk-rated corporate bonds, I think it's like $1.3 or $1.4 trillion outstanding, which means that the private credit market is now as big as the more broadly-syndicated junk bond market, which is pretty stunning.
And you also hit upon something really interesting that's happening right now, which is that the conventional line of thinking was that as interest rates go up, this was going to be bad for private credit. You are going to see more financial stress, maybe funding for private credit was going to be more difficult to come by, and instead the market has boomed and appetite for these deals remains pretty strong.
Joe (02:03):
Yeah, it's sort of a subset, I guess, of the surprising resilience of credit in general. But absolutely you would think here's this rapidly growing asset class that is booming in the Zirp era in 2020 and 2021. You think, okay, well this comes to an end now, right? And other parts of private markets have gotten a lot of trouble, you know, I think about VC and how much slowdown there has been there.
And yet, as far as I know, as far as we can tell, and everything that we've heard in sort of snippets from other conversations, that has not been the case in the private credit space. I got to say, I'm surprised when you were about to say how big the junk bond market was, I thought you were going to say something much bigger than private credit still. So the fact that it's caught up is pretty striking.
Tracy (02:45):
It really is. So we've been meaning to do this for a while but I think we need to dive into this market. I expect we're going to do more over time but to begin with, we need to figure out how these deals are structured, how they're different to broadly-syndicated debt — stuff like corporate bonds or leveraged loans — what higher interest rates actually mean for this asset class and maybe even what private credit’s impact could be on the broader economy.
I'm very pleased to say we do have the perfect guest. We're going to be speaking with Laura Holson. She is a managing director at New Mountain Capital. She's also COO of New Mountain's credit platform, which manages nearly $9 billion across private credit. So everything from private funds to publicly-traded business development companies, or BDCs, you might remember them from our interview with Dan Zwirn way back in the day. I think that was like seven or eight years ago.
Joe (03:41):
The real Odd Lots heads remember the Dan Zwirn interview?
Tracy (03:45):
Well, this was when we still referred to private credit as shadow banking, which I don't see as much anymore. It's sort of this more accepted part of the market. On that note, Laura, thank you so much for joining Odd Lots.
Laura Holson (03:58):
Thanks for having me.
Tracy (04:00):
So maybe I could begin with a very simple question, which Joe kind of alluded to in the intro, but what exactly counts as private credit nowadays?
Laura (04:08):
So the way I think about private credit is that it's debt that is privately originated and Joe, as you said, meaning not intermediated by a bank, but that's also not traded on any kind of public market. And the term ‘private credit’ is pretty all encompassing. There's everything from direct lending, which is probably the largest element of private credit, but there's also opportunistic debt, there's distressed, there's real estate financing. There's a pretty wide range of things, I think, that counts as private credit and it can be up and down the capital structure. So you could be senior in the capital structure, you could be junior, subordinated. It's pretty all encompassing.
Tracy (04:45):
It also tends to be unrated as well, right? It seems to me like this is the big difference. So you'll get a corporate bond that is rated by Moody's or a Standard and Poor’s, but a direct loan or something like that would be unrated.
Laura (04:57):
Correct. Yeah, it's typically not rated.
Joe (04:59):
Before I ask another detail about what private credit is, why don't you tell us what New Mountain Capital is and what you do there?
Laura (05:05):
So New Mountain Capital, we're an alternative asset management firm. We have kind of three pillars to our strategy. We have private equity, we have credit and we have a net lease strategy. And the way to think about New Mountain is that we're focused on what we call defensive growth sectors.
So those are sectors of the economy that we think are going to perform well, regardless of what kind of macroeconomic environment we're in. So whether we're in inflation, deflation, boom or bust, we want to invest in very resilient, acyclical sectors and we apply that strategy across all of our products. And importantly, we use the knowledge that we've built up over in our nearly 25-year history as a firm and apply that same mentality and the same underwriting knowledge and intellectual capabilities that we have to credit to net lease and obviously to our core private equity strategy.
Tracy (05:55):
Okay. So here's my other question, we were talking about how big this asset class has actually gotten. How old is it actually? Because I hear different things. I hear people express concern for private debt because they'll say ‘Well, we don't actually have that much historical data about defaults’ and things like that. But I also imagine there were private debt deals being, you know, done decades ago. Maybe not in the same format and certainly not to the same extent, but we must have some historical basis for comparison.
Laura (06:29):
Yeah, no, it's a fair question. I mean, the reality is the asset class has grown tremendously over the last 10 to 15 years. But New Mountain's credit business, for example, we've been around since 2008 and we got our start by buying debt on the secondary market. Debt that was trading at distressed levels, not because those companies were fundamentally impaired, but just because of the technical reasons in the marketplace that drove...
Tracy (06:53):
Because it was 2008.
Laura (06:55):
Exactly, because it was 2008. And so as a result, we've seen our own track record so we feel like we have been cycle-tested, right? We've gone through Covid, we've gone through the Silicon Valley Bank, we've gone through definitely a pretty crazy period from an inflation standpoint. So there's been a lot of elements that we feel like we've kind of cycle-tested our portfolio. But you're right, I think it's a little bit of a different form today than maybe private credit was, you know, 15, 20 years ago.
Tracy (07:24):
What happened to private debt during the big Covid market rout? And you can look at proxies, so you can look at publicly-listed BDCs and I think New Mountain has one of those. You can certainly see the share price went down quite a lot, but what happened in more opaque corners of the market?
Laura (07:42):
So I think during Covid private credit, I would argue, held up better than the broadly-syndicated market. You saw the debt and the broadly-syndicated market from a trading level perspective trade down pretty meaningfully. But from a default loss perspective, actually private credit turned out to be more resilient during Covid.
And I think it's a function of how these deals are set up because they are meant to be a little bit more bespoke, more relationship-oriented. And so private equity sponsors were able to have direct dialogue with the lenders and talk through like here's what we're seeing in these underlying companies, here's what we're doing about it. Let's talk, it's not a group of 50 or so syndicated investors that they have no relationship with. And as a result, I think we saw better outcomes in terms of just actual default losses during that period.
Joe (08:37):
Okay. To help understand this market, what would be the modal or typical borrowing entity for whom private credit is a more attractive lending option than, say, going to the bond market and/or going to a bank?
Laura (08:52):
Yes. So the way I think about it, and again, from where I sit at New Mountain, we focus primarily on what I call sponsor-backed direct lending. So direct lending to private companies that are owned by private equity firms and the private equity firms need to make a decision, as you said, do they want to go to the syndicated market or do they want to tap the direct lending market for their financing?
And there's a bunch of things to consider, but the way I think about the benefits of direct lending are, number one, you have more certain execution because when you're doing a syndicated deal, that's a deal that you're getting intermediated by a bank, they're underwriting it at a certain pricing level. But then they have the ability to flex that pricing level wider or tighter depending on market conditions at the time. And you're in market for, I don't know, maybe four weeks. And so you're taking a lot of market risk, particularly during times like we're in today where there's a lot of market volatility.
So that's one thing, is just the certainty of execution because a direct lending deal you commit from a pricing perspective and then you stick to that price throughout the rest of the negotiation. So you know what terms you're getting from the sponsor perspective.
The second thing is, it also can be a little bit of an easier execution because in a syndicated market, if a sponsor wants to get a first lien and second lien financing done, that's two different credit agreements. A first lien credit agreement, a second lien credit agreement and an intercreditor agreement as to how those two tranches interact with each other.
Again, you contrast that to a direct lending solution where you have a unitranche structure with just one credit agreement. So it's also easier, you also don't need to go through the rating agency process, which also just saves time. And as I said, it's more relationship-oriented. It could be more flexible and more bespoke to what the sponsors are looking for.
Joe (10:51):
Real quickly for the listeners and also me, what does the first and second lien mean?
Laura (10:57):
Yeah, no, it's a good question. So it depends where you are in the capital structure. So the first lien means you have the first claim or the first priority on the assets and the second lien would be junior to them.
Tracy (11:23):
I think we're kind of getting to the heart of why this asset class has been booming. because I hear this a lot from market participants, this idea that like, well, maybe the deals are structured in a way that makes them more appealing to investors versus the broadly-syndicated stuff. So you mentioned that sponsors can get more definitive terms, maybe the issuer doesn't have to go through the hassle of getting a rating, and that sort of thing.
And then you mentioned the first lien and second lien issue. I've seen this come up in various ways, the idea of a preferential treatment in the payment waterfall. Is that the right way to think about it? So if you're in a private debt deal, can you structure it such that maybe you're closer to the issuer than anyone else? Maybe you get more insight into potential credit challenges before others, and maybe also you can enforce remedy payments that make you come out on top in the event of a default? So preferential treatment versus other creditors.
Laura (12:28):
Yeah, I mean, I think that is a fair way to think about it. When I think about, again, the purpose of a direct lending solution, right? It's a lot simpler of a capital structure, right? So you don't get into a situation where maybe you're fighting between the first lien and the second lien creditors.
Tracy (12:45):
Which we've seen recently.
Laura (12:46):
Yeah, absolutely and to your point about just being closer to the borrower and closer to the company, the way most direct lending deals work is it's a club of direct lenders. So you don't typically have one direct lender that's underwriting and holding the whole tranche, but you have a club, meaning you might have, I don't know, anywhere from three to 10 direct lenders in a deal.
And there's real benefits to having that diversification from the sponsor perspective because you have more dry powder, meaning you have the ability to go back to that same group and upsize and do incrementals or follow-on deals for that same company. But you're also not beholden to any one lender because one thing you could say is ‘Oh, well, in a direct lending deal, if you have fewer lenders in the group, maybe those lenders have more power over the company or the private equity firm.’
And again, I think that really speaks to the benefit of having a small club. But you contrast that to a bank syndicate, which might have 30, 50, a hundred lenders in it and inevitably, when you have a club of three, that those three lenders are all going to have more access, they're going to have more conversations with the sponsor, they're going to be able to call and have more of a direct dialogue with the management team as compared to if you're one of a hundred.
Joe (14:08):
So I think I understand to some extent the appeal of direct lending. What is the pitch? Let's say I'm an ultra high net worth individual or family and my advisor says you should allocate some to private credit. What is the pitch to limited partners or investors for why this is an appealing asset class?
Laura (14:26):
Yeah, so the way I think about it is private credit and direct lending specifically offers very attractive and consistent yield. And it's, I think, a very good thing to allocate as part of your fixed income portfolio. I think number one, it's floating rate typically. So we move up and down with interest rates. In this period where we've had a significant runup, that has helped increase the yield of direct lending funds because the way the coupon is structured is you are tied to a base rate plus a spread.
And so as that base rate has gone up, the overall interest rate that the investors end up earning has gone up pretty meaningfully. And it also provides some interest rate protection because valuation, for example, for a fixed rate bond has come down very meaningfully as rates have risen. So I think that's one thing to highlight.
The second thing would just be that the higher spread compared to a broadly-syndicated loan, and part of that isn't an illiquidity premium because it's not traded, you can't necessarily get out as easily, but you need to get paid for that so you do get some extra spread from that. And then I think there's been good data showing lower loss ratios also of direct lending, again, compared to a broadly-syndicated fund or a high yield fund.
And so I think generally speaking, it's kind of that all of those things combined end up with a higher, more stable, more consistent yield, which I think is very attractive for an ultra high net worth. And the other thing I would just say is it does provide some diversification because it's not quite as correlated with all the other public markets as maybe high-yield or broadly-syndicated loans are.
Tracy (16:13):
Just on the yield and spread point, I mean, it is true that we have seen both yields and spreads start to pick up in the broadly-syndicated market recently. And I've seen some people making the argument that like, well maybe now — maybe not right now, maybe a week ago — was the time to sort of pick up some exposure in the corporate bond market and things like that.
But do you see, you know, when yields and spreads start to move around in the broadly-syndicated market, do you typically see investors start to make that relative value judgment? Like, will they sit there and think ‘Well, I could either have this private debt deal or I could buy this in the publicly-traded market?’
Laura (16:56):
Yes, I think people definitely look at the relative value versus the public benchmarks. But again, I think direct lending as an asset class has historically over many years outperformed the public credit benchmarks. So you've seen that relative value, I think, always kind of shifts in the favor of the direct lending funds. And again, it comes back to the spread premium compared to just a broadly-syndicated loan.
Joe (17:24):
Can we talk about, you know, you mentioned the clubs and the idea that you're not just going to have one direct lender, you might have three, 10, whatever it is. How does deal flow typically work? How does something land on your desk in the first place, in the sort of standard mode?
Laura (17:40):
Yeah, so I think most credit firms, the way they attack the market, most direct lending firms, they have sponsor coverage — people who go out and call on a set group of private equity firms and they call them and they say ‘Hey, what deals are you working on on the private equity side? Can we help you finance them?’ So that's the typical model as to how most standalone private credit firms get deal flow.
I would say New Mountain, we approach things a little bit differently. Because we also have a private equity business, we are seeing the deal flow earlier because we're seeing it on the equity side and what we're able to do is then triage those deals and not all of them we're going to buy for private equity, of course, but a lot of them are really high quality, good businesses that maybe are going to trade at a valuation that we think is too high.
So rather than buy the company on the private equity side, we can say, well now we know that deal is in market. Let's see if we can go finance it for another private equity firm. So we take a pretty different, and I think more proactive, approach to deal sourcing because we know those deals are out there and then we just need to go find them.
And again, the conversation that enables us to have with our private equity clients is that we know this deal is in the market. Our private equity firm is not looking at it, but we like the business, we have a view on leverage, we've already underwritten the space. Again, back to the point that I made in the beginning is that New Mountain focuses on the same industries across the board, and we have some really unique diligence angles that we could bring to bear. So that kind of conversation with our private equity clients, I think gives us an edge and allows us to source very effectively.
Tracy (19:26):
Just on this note, how sticky or reliable is this type of financing for the company itself? Because again, this is a place where you hear different arguments in the market. So on the one hand, a lot of private equity funds have lockup periods, and so people can't suddenly withdraw their money. But on the other hand, there is a concern that maybe this kind of financing is less sticky than, for instance, a bank loan where maybe some of that is funded by deposits and things like that. So how reliable is this type of financing?
Laura (20:01):
Yeah, it is very reliable. When you think about the types of structures that underlie private credit funds, a lot of them are permanent capital vehicles. You mentioned business development companies, or BDCs, the publicly-traded ones are a form of permanent capital. So that's about as stable or as sticky as you can get.
And you also have other kinds of funds that are structured as drawdown funds, which again, have kind of a locked--up life for a period of time. There's of course, other types of funds that are maybe a little bit more open-ended, and the ability to come in and out and so that can be where maybe you have a little bit less sticky, but I would argue that you have those dynamics kind of in all areas of credit investing not just the direct lending market. So overall, I think it is really sticky and very reliable from the sponsor standpoint. And that's ultimately what they care about.
Joe (20:53):
How do you build expertise when you're walking through a whole range of industries? Because private equity could be literally anything. Do you have to build that expertise in-house to be able to judge the credit quality of each type of deal that comes across your desk? How do you internally get to know whether a company has a good credit or not?
Laura (21:12):
So the due diligence process is incredibly important. And as you said, it takes a lot of time in many years to build. So at New Mountain, we proactively have come up with sectors of the economy that we think are going to be, again, those defensive growth sectors.
Joe (21:30):
What are they?
Laura (21:31)
So sectors like enterprise software. You have mission critical software that's deeply embedded, very sticky, very hard to rip out, high retention rates, good recurring revenue. So we really like that sector, for example.
We also really like tech-enabled healthcare, right? Where you have different types of tools and both services and technology that power different healthcare providers and payers to ultimately take costs out of the system. So we get very into specific niches because it's not good enough in our mind to say ‘Oh yes, healthcare is a good sector, let's go invest in healthcare.’ We want to really narrow that down and find the sub-sectors within healthcare and within enterprise software, within business services that we think will be really resilient for the long term.
And then what we do is then we staff a very full team. We have over 150 investment professionals at New Mountain that spend every single day in some of these sectors and then we become experts in these sectors. We look at companies that are in these sectors, we map them out in a lot of detail, we hire bankers and consultants to help us map these sectors out and figure out what's good and what's bad about these sectors.
We also own companies in these sectors, right? So we own 45 companies on our private equity side and so we're seeing the real-time trends within these sectors and we can apply all of that knowledge, all of that intellectual capital, we can apply it to the next credit deal. So we're never trying to figure out something from scratch. We're not waiting for that deal to come across our desk and then say, like, let's go try to figure this out. No, if that's the case, we're not going to look at that and say ‘That's not within our scope.’ But what we do is we say ‘We want to be starting from the sixth, seventh, or eighth inning from a diligence perspective’ and really just be doing bring down work and not trying to figure something out from scratch.
Tracy (23:45):
So I take the point about due diligence and expertise, but it has to be true that the macro environment where we have seen this very dramatic increase in interest rates, is deteriorating in some way. And I think if you look at leveraged loans, broadly-syndicated leveraged loans, which would be private credit's nearest competitor I think, the default rate there has increased. It's not enormous, but I think it's gone up from like 1.4% last year to 4% now, and you've also seen some ratings downgrades there, although you've seen a lot of upgrades in the junk bond market.
But anyway, when you observe what's going on with defaults in the broadly-syndicated market, what are you thinking about how that will feed through into the private credit market? And also, you mentioned illiquidity previously. Is a lot of private credit’s resilience just down to that illiquidity? Because I always think of liquidity as both a pro and a con, right? You pay a liquidity premium so that you can get rid of things if you need to. But on the other hand, if there is financial distress and some things are illiquid, maybe you don't have to take your marks on it as soon, maybe you have more time to work something out with the issuer.
Laura (25:04):
So a lot is embedded in that question for sure, but you're right. With rates rising, call it over 500 basis points in 18 months, of course that is going to pressure these companies, right? A lot of these companies were financed and the capital structures were put in place when rates were close to zero.
So I think it really comes down to what does your portfolio look like from an underlying industry perspective, from a quality perspective. Are these companies equipped to deal with that? And I think some are more than others. When I look again at our portfolio because of the sectors that we focus on, these sectors tend to be higher EBITDA margin businesses. So you're starting from a good place, from a cash flow perspective and again, it comes back to cash flow. And so these sectors tend to be lower CapEx, lower working capital from a cash outflow perspective because they're asset light, they're more, they're tech, they're service-oriented.
And so they are generating a lot of cash flow, which helps them cope better with the higher-rate environment. All that being said, I think the other thing that we take a lot of comfort in is something that we talk about a lot, which is loan-to-value. And so when we look at a capital structure today, or one that was put in place even a couple years ago, the vast majority of the capital structures that are sponsor-backed, again, are financed with equity not debt.
So if you just rewind and think about the history, right? In 2007, the capital structure set-up of a typical LBO was mostly debt and the equity was a small portion of it, so it was really more of an equity option. Whereas today, equity comprises the vast majority of the capital structure, meaning that the private equity firms have a lot more at stake.
When you think about what that means, 1%, 2%, 5% change in interest rates, that dollar cost of supporting that company is pretty small relative to the equity dollars. Just to give an example, because I think it brings it to life a little bit, if you think about a billion dollar capital structure that's financed with $300 million of debt and $700 million of equity, and that's a typical capital structure that we're seeing today.
If you have interest rates go up by 1%, that's an extra $3 million of interest expense or maybe it went up 5%, so that's $15 million of extra annual interest expense. But that's still such a small amount compared to that $700 million of equity that a private equity firm has at stake. So again, unless the business is fundamentally broken or really just a disaster, they're very inclined to feed it and support it to preserve the equity value that they have.
And I think that speaks to the second part of your question, which is around default rates and thinking about, yes, clearly default rates have picked up in the syndicated market. You haven't seen it pick up materially in the direct lending market. And I think a bit of that is what you said, which is illiquidity and therefore it's not as much out there and the data probably isn't as strong.
But I think a big piece of it, and probably the bigger piece of it, is the fact that kind of [goes] back to the dynamics that I talked about before, is that the relationship between the lenders and the sponsor, that more flexible capital structure allows people to work through things a little bit more effectively and therefore don't end up as frequently in kind of a default scenario.
Tracy (28:37):
That's my impression as well. Just looking at the wider market, what is your impression of how much froth is out there in private debt? Because I wouldn't expect you to say that ‘New Mountain has underwritten a bunch of frothy deals’ or something like that.
Joe (28:52):
Just trash your competitor.
Tracy (28:54):
No, but seriously, I remember in the leveraged loan market like, I guess this must have been circa 2013 or something, I remember going to the office of a certain Swiss bank that doesn't exist anymore ,and that's one reason why I feel comfortable now telling this story. I think I've told it in public before, but I went to the office of this leveraged loan guy and he had a shirt that was framed in his office with a little plaque that said ‘I stole this shirt off my client's back,’ which is pretty amazing. But this was the time when the leverage loan market was booming. There was a lot of concern about deterioration in quality, more risk embedded in these deals. Have we seen a similar dynamic in the private debt market?
Laura (29:40):
I don't necessarily think so. I mean, if you go back just a couple years, certainly 2021 probably felt a little bit more like that environment where rates were low, leverage was high, it was a competitive environment for the direct lenders and spreads were a lot lower. And so you kind of had a little bit of a dynamic where everything was kind of peak peak.
But I do think we've kind of come off from that quite a bit. I think just the volatility in the markets, the fact that the syndicated market had been closed for big chunks of time and just overall deal flow had come down so much given the rise in rates. And I attribute a lot of that to just the valuation gap where people are just trying to level set as to where valuation should be in an environment where base rates are 5.5% and you have a dynamic where buyers don't want to pay those high prices anymore and sellers don't want to sell at prices below those peak levels. So you've definitely had a little bit more of a pause in the market.
Tracy (30:41):
It's like the housing market, Joe.
Joe (30:43):
Absolutely. Speaking of 2020, 2021, in other credit conversations there is a lot of talk about firms taking out a bunch of debt, refi-ing their own debt, terming out the debt, and we talk about this maturity wall that's coming. But I guess in private credit, if it's all floating, that's not really the same phenomenon, [that] doesn't really exist in there. There's not going to be some day when companies that you interact with suddenly resets?
Laura (31:08):
Well, I would say that these still have a finite life on them, these underlying loans, right? So they're typically six, seven year loans, but you're right, the maturity wall that exists on the syndicated market, there's I think almost a trillion dollars of debt coming due by the end of 2026. That's going to create, in my mind, that's going to create a lot of opportunity for the private credit market.
Because as I talked about it, the direct lending market has taken share and so as those deals come up for refinancing, a lot of those are going to need to be taken out with a direct lending solution. And we've seen some of that happen already, right? There are large syndicated loans that have been taken out with very large direct lending loans. There was a $5 billion one earlier this year, which is huge in the realm of private credit. And so I think that if anything, it'll create more of an opportunity set.
Tracy (32:02):
So you mentioned the maturity wall, and we are obliged to say the looming maturity wall, I feel like we cannot have a credit market discussion without mentioning the maturity wall, but also we cannot have a private debt discussion without mentioning the term ‘dry powder,’ which you already have. So I guess my question is A) how much dry powder is actually out there? And then B) on the topic of sponsors and their behavior and their goals and targets and how those might change, would there ever be a time where you do get this pressure where the entire industry sort of needs to get out, maybe they're mandated to exit, maybe there's a wider macro thing happening, and you're not as able to roll all this stuff over?
Laura (32:50):
So you're right. We do spend a lot of time talking about dry powder. I do think it is a tailwind for our industry. So the way I think about the numbers, these are maybe a little bit dated, but for private equity, I think there's about $580 billion of dry powder, so funds that they've raised that they need to deploy. And again, we're coming out of a period of time that's been relatively low from a deal volume perspective.
So there is some pressure to deploy that capital, right? They raised it and they need to deploy it and generate attractive risk adjusted returns. But I think also importantly, and this is something that I think gets talked about less, is the need for private equity firms to return capital to LPs. And so whether they're deploying or whether they're returning capital by selling companies, both of those events create opportunities for us as lenders to finance deals.
When I think about credit and private credit, dry powder, again, there's not great data around this, but one number that I saw was there's about a hundred billion of private credit dry powder. When I think about sponsor-backed direct lending, we're still a very small percentage of the dry powder of our clients and they've been raising money at a faster pace even than the private credit market has grown. And so I think it ultimately creates a good backdrop at a good opportunity set for us to deploy capital into this environment.
Joe (34:15):
Is there a lot of room for private credit to expand as a share of credit markets?
Laura (34:19):
Absolutely.
Joe (34:20):
Where would that be?
Laura (34:22):
Yeah, so during Covid and during these peak volatile moments when the syndicated markets have been closed, direct lending and private credit has gained a lot of market share. I don't expect that we'll have, as an industry, have a hundred percent market share forever by any stretch.
But one interesting way to think about it is if you look at our private equity business, because we issue a lot of debt, we’re, you know, prolific issuers of financing as part of our private equity business, we used to be a hundred percent syndicated in terms of the types of deals that we would do for our private equity deals. Then maybe five or so years ago it was probably about 50-50. And now we're doing pretty much exclusively only direct lending deals. So we've seen that market share capture even in our own experience.
And so I do think that is something that will continue, and it'll ebb and flow with just the overall market dynamics and how open the syndicated market is, how attractive deals are getting priced there. But right now, I would say the syndicated market is open, but it's a pretty tight box as to what can get done from a syndicated perspective. You need a certain rating in order to do it. You need a certain credit story and loan-to-value to kind of access that market, and you need a certain size because liquidity is important in that market. So for all of those reasons, I think, and for the reasons that I talked about before as to the benefits of direct lending, I think that market share shift will continue to occur.
Tracy (35:54):
Do you see banks responding to competition from the private debt market? Because if we think of leveraged loans and corporate bond issuance, these are extremely lucrative businesses for an investment bank. I can't imagine that they're going to sit idly by, as they watch more and more issuers issue in the private market.
Laura (36:16):
Yeah, no, it's a great point. We've seen some of the banks, not all, but a good portion of them set up their own little direct lending businesses that are on their balance sheets, basically, I think to your point, to offset some of the revenue that they've lost from syndicating loans or syndicating bonds.
And so we'll see how that evolves because then to some extent they're competing with some of their clients, right? But I do think they've had to address it by kind of setting up their own capabilities so that when a private equity firm approaches them and says they want to finance this, they can offer two solutions. They can offer what the syndicated path looks like and what does the direct lending path look like? And they can have confidence as to how to really show those two paths and how to price it knowing what their own direct lending business would do.
Joe (37:07):
I want to come back to something you said, I think it was about what is the appeal from the perspective of the investor of private credit? You mentioned in some cases lack of correlation to other markets and this is of course, Tracy sort of hit on this, but also people get very cynical about this point when it comes to private markets, whether it's VC or PE, and they say it's uncorrelated because they don't have to change the prices and there's no market.
And of course, the fundamental economics do go up and down, but there's no forcing mechanism. And some people think, well, maybe that's a feature that you don't have to look at a line on a chart that went down, which is never a pleasant thing. Is that real? Do people really like private assets in general because they don't, on a day when their stock portfolio may fall 2%, their private assets were flat on that day. Is that a real phenomenon?
Laura (38:01):
It’s a fair point. I mean, I think some of it you can just say, you know, for private assets, you're just kind of ignoring the other data points. So I hear you but I do think that still the inherent nature of it is that the direct lending market or some of these other private markets, like they don't react in as volatile of a way or as quickly, right?
So like I think about the price for a typical unitranche loan, I'll just use this as an example. Like over the past 10 years, the range of price of spreads for a unitranche loan has probably been anywhere from SOFR plus 525 to 700. So it's a wide range, but not so dramatic, right?
And so depending on where we are in those kinds of ebbs and flows of the equity markets, of the public credit markets, you're seeing a little bit of movement, but you're not seeing the same spikes or the same valleys. And so I do think it offers a little bit of inherent protection. And again, I think also in terms of the lenders, we continue to show up and to be there, whereas again, the banks can kind of pull in and out of the market a little bit more aggressively.
Tracy (39:15):
So just on that topic, I realize we've had this entire conversation without actually talking about regulation. And I mean, to some extent the boom in private credit has been by design of the regulators. So post-2008, they wanted to squeeze out a lot of the riskier stuff from the banks and into the so-called shadow banking market, which includes things like BDCs, private credit funds. Do you worry at all that they'll maybe start to take a closer look at the private debt market? And I think there have been some rumblings around this, but how are you thinking about the sort of, I guess, regulatory arbitrage question between the banks and private credit?
Laura (39:59):
Yeah, so I mean, you're right that I think a lot of the growth of the industry has somewhat stemmed from just the change in regulation and the fact that the banks kind of were somewhat prohibited from maybe doing some of the things that they used to be doing. But at the same time, I think there's a lot of other reasons for the growth of the private credit asset class.
When I think about the inherent riskiness of the asset class, I think it's a very different story than the banks or some of these other higher levered structures, right? Because as a BDC for example, we're limited as to how much leverage we can incur. So we can be max two times debt for every one part equity. So that's not very levered in the scheme of things and most BDCs, including ourselves, run way below that so you compare that to other financial instruments where you're 10 times levered or 40 times levered, that's just a lot less risk in the system.
And as a result, sure there might be more regulation or there might be more focus around it just as the asset class becomes a little bit more institutionalized. But it's hard to attack the underlying fundamentals necessarily because we're lower levered, we're pretty matched from an asset and liability standpoint from a term point of view, we're also largely matched from a floating rate perspective, a lot of our liabilities are floating rate. So there's a lot of inherent safety, I think, in a lot of the structures of the private credit market. So it is a little bit different but that's not to say we won't see more regulations. I can definitely imagine that we will.
Tracy (41:34):
I'm getting flashbacks to covering BDCs for the FT and I think there was a discussion about raising the leverage limits and maybe they did it.
Laura (41:45):
They did, right. But raising it from one times debt-to-equity to two times, so it's just still not very highly-levered.
Tracy (41:51):
Alright, well Laura, that was an incredible conversation, a really good entry point to the private credit market. As I said before, I suspect we're going to be doing more on this, but appreciate you coming on Odd Lots and explaining the market to us.
Laura (42:05):
Of course.
Joe (42:06):
That was great. That was exactly what we needed. That was exactly the conversation we needed. Thank you so much.
Laura (42:11):
Thank you guys.
Tracy (42:24):
Joe, I feel like we should go out to the private debt market and raise some capital. How much was the dry powder? Like $580 billion.
Joe (42:30):
Let's do it.
Tracy (42:32):
It seems like there's a lot of money out there, but I thought that was a really interesting conversation. A good introduction to the market. There were a couple things that stood out to me. So one thing I've been thinking about a lot recently, I think everyone's been thinking about this, but to what degree the economic landscape has changed in recent years.
And I think maybe the evolution of the debt market, which includes this boom in private credit, is an underappreciated one. And if you think that suddenly you have this market that's the same size as the junk-rated bond market, but is more able to be flexible with issuers, has more of a tendency towards workouts and things like that, then maybe it explains some of the reason why we haven't seen such a huge impact from interest rate hikes just yet. Like, maybe that resiliency is coming from, not just the workouts, but also maybe some of the illiquidity that Laura mentioned. This idea that you're not under as much pressure as maybe a public vehicle.
Joe (43:33):
My mind went to the same place with the workout. I guess we also talked about this in housing, although there's been no housing distress in a long time. But of course there's that infrastructure that got built up after the great financial crisis to work out mortgages. So it made me wonder if just the credit industry in general after the credit crisis, after the crisis in 2008, 2009, just has deeper in its DNA the ability to avoid foreclosures or avoid defaults for a number of reasons.
Tracy (44:01):
Well, I guess we'll find out, right?
Joe (44:03):
Well, when though, I don't know.
Tracy (44:04):
Yeah, that's the question. One other thing I would say, just on the illiquidity point, is, I think it was Perry Mehrling’s quote, but this idea that liquidity can be your friend until it kills you and then it kills you pretty quick. So I guess that's the sort of doom scenario for private credit. Although again, $580 billion of dry powder sounds like a pretty big cushion to prevent that from happening. So I guess we'll see.
Joe (44:30):
We'll see. No, that was great and now when I follow it, or now when I read about it, I feel I can at least attempt to track the trajectory of this space.
Tracy (44:38):
Excellent. Don't go chasing payment waterfalls, Joe.
Joe (44:42):
Oh, that's a good one. Did you just make that up?
Tracy (44:43):
I did, yeah. I don’t know why. Shall we leave it there?
Joe (44:46):
Let's leave it there.