Ladies and gentlemen, welcome to the business Brew.
I am your host Bill Brewster. This episode features Larry
Hosenthaler of first Eagle discussion on private credit
here. And I found it to be quite good
and candid and I was unsure of how it would go coming into it.
I have sort of a natural aversion to things that have
like private in the in front of them.
However, I found Larry to be measured, honest, and I'm quite
happy to be featuring him. So this episode was recorded on
February 3rd. We'll try to get it out quickly.
Got some compliance stuff to work through, but hope you enjoy
the episode. And none of this is investing
advice. All of the information in this
program is for informational and entertainment purposes only.
Please consult your financial advisor before making investment
decisions and do your own research.
All right, ladies and gentlemen, excited to be joined by Larry
Hosenthaler today. Larry, you want to introduce
yourself and tell the people what you do.
Yeah. So I am a portfolio manager for
what we refer to as FEAC First Eagle Alternative Credit, quite
a mouthful, but we are basically a corporate lending team that
sits within First Eagle, which is kind of our parent company.
And 1st Eagle flies a little below the radar, pun intended.
But we have about 100 and 150 billion of assets under
management. And actually the organization,
if you go back to the roots of First Eagle has existed since
the 1860s. But really from AUS soil
perspective, we started to build out a mutual fund business in
the late 1960s, early 1970s. So a bit of a pioneer within the
world, actually a value investing, which I know is
something you talk a lot about on your show.
And so we specifically had this kind of niche that we kind of
focus on, which is corporate credit basically below
investment grade. Corporate lending is what we do.
So my team runs about 20 billion of assets.
We have about 55 people on our investment team.
So we kind of live and breathe the world of private credit
every day. What was the transition from
sort of, I guess, traditional equity value investing to
credit? So it's interesting as a firm,
First Eagle has obviously felt that the change is coming from
the world of passive ETFs. In fact, First Eagle recently is
kind of reacting to that by launching their own kind of ETF
products for their equity team and really just trying to bring
some of the principles of value investment to different asset
classes. So like as an example, what we
do, we're kind of like the mortgage on the House, we're the
first lien senior secured loan within the capital structure.
So there's a lot of emphasis on downside protection, being
conservative, staying out of trouble.
So you know, those are all themes that obviously from kind
of a value equity tilt are kind of common, common factors.
And so the thinking was let's kind of take the brand of first
Eagle, which is a conservative kind of organization and and try
to get into newer areas that obviously are higher growth than
managing large cap value equities at least the last few
years. So in the last several years or
so, First Eagle has acquired a few businesses that have this
kind of specialization. So my team was came over to 1st
Eagle about five years ago. We were formerly part of THL
Thomas H Lee, the private equity firm.
We were kind of their credit arm and and joined First Eagle about
five years ago. Napier Park, which focuses on
more like CL, OS and, and, and, and different types of credit
strategies about a year after. And then most recently actually
first Eagle acquired a team that I've actually worked with in my
prior organization, John Miller, who runs a high yield municipal
debt team. So just trying to come up with
the different, different ways we can add value within some of
these not necessarily niche year, but kind of smaller asset
classes and obviously the equity world.
Yeah, I have. I have noticed a, a general
increase in the amount of pitches for the merit of of
private credit specifically in people's portfolios.
And I can't help but like I've I've got that value investor in
me too. So I, I feel like whenever a
product gets pushed through a distribution channel, I get a
little bit wary of it. It is my spider sense correct?
Or am I sort of? Do I have a bias there that I
should maybe think about differently?
So there's definitely a lot of marketing involved in in kind of
the optics of the asset class. So if you take a step back,
lending to companies is it is really not very new.
But on the flip side, it hasn't been going on for 50 years.
If you think about it, the, the genesis of kind of what we do
today, I would say started to take formation in, in the kind
of mid to late 1980s when you had Drexel Burnham, Michael
Milken. Junk bonds became kind of an
asset class that people would kind of willingly allocate to,
you know, before that, these were the, the bonds that went
bad, but you wouldn't voluntarily invest your money
in, in junk bonds. In fact, even today, we refer to
it as below investment grade, meaning it's like it's not
worthy of investment, but obviously credit and below
investment grade credit is, is an asset Class A lot of people
allocate money to willingly today.
And so I think about the, the loan market, which more
specifically a lot of the facilities people are using in
private credit tend to be loans versus bonds.
There's less registration process needed, lower barriers
to entry. You don't need to get them
rated. There's no Q sips.
So they kind of lend themselves to smaller companies.
And I would say in the kind of kind of early 90s to mid 90's,
the loan market was kind of maybe 5 to 10 years behind the
high yield bond market. So if you look at the loan
index, it's now the UBS index, used to be the Credit Suisse
index. It only goes back to 1992.
The high yield bond indices go back to 1986 for the most part.
So it's 686 to 8 years behind high yield.
And initially the loan market was kind of focused on smaller
issuers. Bigger issuers would go to the
high yield bond market. But over time the loan market
grew and so companies started to use both loans and high yield
bonds to a lot of this stuff gets created to, to finance
leveraged buyout activity. So you look at like the RJR
Nabisco deals and some of the, the big deals that started to
get done out of the LBO market, They would started to finance
both with bonds and loans. And as the market grew, you
started to see a secondary trading market develop just like
high yield. I could call Citibank or JP
Morgan or Goldman Sachs and I could trade these loans in the
secondary market. And when that happened, it
really opened up a lot of a lot of doors.
Now you could have loan mutual funds, ETFs came along and the
primary buyer are CL OS, which are these structured products
that think of it as like a a big pool of assets that go to back a
bunch of tranches of bonds and that pool of assets is a is a
big pool of loans. So then you started to see the
development of the CLO market in kind of O four O 5.
And then all the sudden, the loan market became really liquid
and it moved up and down a lot. And initially that was a good
thing. Now I have some liquidity, some
transparency. You have banks trading this
stuff. The market's grown a lot.
But then I would say what happened is in in the global
financial crisis, the loan market saw a ton of volatility.
You had all this for selling in, in this kind of illiquid market.
So Long story short, loans sold off like 30% during the global
financial crisis. Then they snap back very quickly
because all this stuff is senior secured.
Yeah, I was going to say, what were the recovery rates on I, I
would imagine fairly good. Yeah, I mean recovery rates even
they've trended lower still probably $0.50 on the dollar and
that's for a defaulted loan. Global financial crisis, the
average price of loans was 60. So I mean, literally, if every
loan in the market defaulted, the market was still arguably
cheap, just the kind of backing out the implied default rate.
And, and so then I would say what really happened, what, what
really catalyzed this recent push was, was COVID.
So during COVID, your average syndicated loan fund was down
about 20% in a really short period of time.
We're talking the last two weeks of February, 1st few weeks of
March, and you started to have these new private credit funds
that were out there, whether they were BDCS or interval
funds. And those funds, the one
difference between these private loans that these funds are
making and the syndicated loan is there's no secondary trading
market. So you make a loan to a company.
And we could talk a lot about some of the important benefits
of direct lending from an investment perspective.
But from a marketing perspective, one of the
phenomenon was that these things just didn't move.
COVID only lasted six weeks. So your average syndicated loan
fund was down 20%. The average direct lending fund
was down about four, yeah, and then ended the year higher.
So people, the marketing guys looked at that and they went,
oh, this is great, yeah. And the.
And the people at pensions that allocate looked at it and they
said, hey, my volatility is lower too.
Yeah, and there's. Nice incentive dance.
There's a lot of good reasons that you don't want to have
these loans just exposed to the whim of the market and the big
mutual funds are selling it. So now I need to mark so a lot
of pensions understand the optics of what's going on
between the mark to market or lack thereof and the actual
risk. But quite frankly, I think in
the retail market, you mentioned distribution are are fear and
suspicion. What's happening is people look
at a NAV, it looks a lot like a money market fund with an 8 to
10% yield and they go, oh, this is great.
Why would I ever buy the syndicated loan fund that does
this if I can buy the fund that does this?
But underneath, they're just three to four to five times
leverage corporate loans that look a lot more similar than
different from an investment perspective, from an
underwriting perspective. But the optics of one asset that
marks the market every day and one that doesn't is enticing.
So I think that's a lot of the reason you're seeing a lot of
focus on private credit is the optics of that stability, which
again, if there's good reasons for it, but there's also some
risk that if you don't manage expectations, people don't quite
exactly know what they're buying.
They're just looking at the NAV and going, oh, this is great.
It has less valve than the AG quite frankly.
Yeah. What are some of the good
reasons that you're citing? So if you looked at
fundamentally what, what started to to drive some, some focus
towards what we call middle market lending.
Everyone has their own definition in middle market, but
these are like sub billion dollar enterprise value type
businesses, which is it's a it's a wide range.
And so the first thing I would say that kind of drew focus to
the middle market was there just more issuers out there.
But if there's almost so many like for us the average EBITDA
of the companies that we tend to write direct lending loans to is
around 25,000,000. So think about we're doing 5075
million, $1,000,000 loans. And so there's obviously more
businesses doing 25,000,000 of EBITDA than doing 400 million of
EBITDA to the point where you could probably make the argument
it it might even be 100 acts. There's about 1500 issuers in
the syndicated loan market. You look at the index.
So it's a pretty finite group of issuers versus there might be
150,000 issuers in the US that fit that definition.
You're doing less than 50 million of EBITDA, but you're
big enough that a private equity firm might take you out.
And so you just have more more issuers to engage in
transactions with? I was going to ask what
percentage is sponsor owned? So for us, everything we do is
sponsor back. We could talk a little bit about
kind of everything we do goes back to mid trying to control
risk and for us everything we do is spot.
The only exception is if, if there's a public company in the
syndicated market, you might find companies that actually are
New York Stock Exchange listed. There's very few of them today.
But at different points in time, there's been 25% of the loan
market have in particular, I'd say telecom names, guys that
have a lot of hard assets might have some loans.
The airlines, all the big airlines have had loans at
different points in time. And so, but the vast majority
is, is private equity owned. And then in the, in the direct
lending market, you could, you could do a transaction with,
let's say, a business that's been family run for generations.
And the problem you have is I don't know exactly what the
value of the business is. I'm I'm kind of beholden to the
family to try to help me frame out what that value is.
And I just don't know exactly what my subordination is.
I don't know how much equity is in the business to absorb
losses. And the really nice thing about
a sponsor transaction is the PE sponsor comes in, they say we're
we're buying the company for $75 million.
And typically what happens is they look to finance half in
with guys like us and half in equity.
So the loan was, we would say the loan to value day one is
around 50%. So the private equity firm can
be wrong. They can overpay, but at least I
know I had a professional investor come in, spend months
underwriting the company, they paid for the company and they
absorb all the losses before we have a it's just like the
mortgage on house. The equity goes to 0 before the
lenders are are impaired typically.
So, you know, we try to stick to sponsor back everything within
the direct lending market and even in the the syndicated
market, pretty much everything we do there, there's APE sponsor
sitting beneath you. So we've seen some horror
stories in the past few months even of a big manager like us
that lent money to a family business.
And then you find out they use money to buy a yacht or invest
in the Prosecco vineyard. And those things are can always
happen, but they're less likely to happen when you have a
private equity sponsor with significant equity sitting
beneath you in the capital structure.
That's interesting. How do you think about the risk
of like the, I guess the incentives of private equity are
to keep doing deals, right? So as valuations continue to go
up, it's like how do you think about just sort of managing the
cycle and where we are in the cycle and where you're lending?
Yeah, I think spreads have clearly tightened in as you've
had a lot of capital chasing a, a finite, a finite number of of
transactions. I, I think within our market,
the, the kind of what I'll call the lower middle market, but
smaller, smaller deals that if I could generalize tend to not
just be pure GDP plays, but tend to have something kind of
thematically that the private equity sponsor is looking to
exploit. Could be something as simple as
like taking a fragmented business and trying to scale it
up. Could be we've done deals for
like think about landscaping businesses, a commercial
landscapers or registered investment advisors, financial
advisors, HVAC servicing, orthodontic clinics, things of
that nature that you're, you're trying to create some scale
basically versus just kind of a more wide Moat GDP play you tend
to find within the bigger, the bigger cap structures.
So it's all about trying to find private equity sponsors who have
sourced the right deals. And even even with that, I would
say that deal making has been constrained just because
borrowing costs have obviously been elevated and the fact that
they're coming down even marginally makes the math work a
lot better if you can find the right transaction.
But having said that, we again, one of the reasons we tend to
like the lower middle market is it gives us a lot more looks and
more transactions. So I mean, we probably, and we
end up passing on nine of the 10 deals that we bring to
investment committee. And even within that, most deals
that we get phone calls over don't make it to investment
committee. So if you think about kind of
the filter or the funnel, you, you end up having to pass on a
lot of deals. And it might not be that you
don't like the private equity sponsor.
In fact, you want to encourage these guys that, look, I'm
sorry, we passed on 9 deals in a row.
We like you guys and we like generally your view on things.
Please come, come back to us because what you don't want to
have happen is you don't want to have to sacrifice protections.
We're talking about a lot of the things that brought money to
private credit to begin with is that typically we're the only
lender to the company or there might be one other junior lender
with us. So it's not us and 30 other
people. So what that does is it allows
you to really effectively write the credit agreement to, to
customize the deal documentation based on where you see risk and
making sure that you get made whole.
So one of the ways people bend if they don't see the right
deals is they'll bend on making deal documentation more borrower
friendly and less lender friendly.
So it's kind of a multi variable equation.
You have to look not just at the transaction itself, but what's
the pricing, IE the spread. And then what does the credit
agreement look like? Because we're definitely seeing
as you've had this much money chasing deals in private credit,
not surprisingly, a lot of this stuff starts to get watered down
a bit. The really fat pitch pricing
looks all of a sudden not so fat.
And the really strong covenants you had two years ago, all of a
sudden maybe you don't have in, in parts of the market more
leverage. So we feel like we're we
operating like I'll call the old school kind of traditional
direct lending market, the lower middle market, everything still
has covenants spreads on a relative basis.
So we think we can be a little bit choosier.
But having said that, I don't think any manager out there is
super happy with the amount of deal flow and the terms.
I think you just you have to be much more selected now, just
given kind of where the pendulum has swung.
Why has the growth in private credit, why are banks not taking
up some of this slack? I mean, I like I worked at BMO
and they've got a sponsor group, right?
I don't know that they're covering Blackstone, but I would
imagine that that banks are getting looks at similar type
deals. Why is there an opportunity for
private credit to take this kind of share?
I think there's two things going on.
I think that part of the tagline for private credit in terms of
why does this fat pitch exists, a lot of that has been that it's
a function of the banks aren't lending anymore, which which is
partly, partly true, I would say.
So on the one hand, I would say for what we do, it hasn't hurt
the fact that the banks are just not playing in this market,
whether it's even providing like delayed draw facilities or
revolving credit facilities are kind of like safer aspects of
corporate lending versus a term loan where everything's funded
day one and it's likely used to fund a leveraged buyout.
The banks are not typically lending money for leveraged
buyouts to software companies like like we might be doing.
So it's not necessarily the entirely that the banks aren't
lending any more. And so now this business is
ending up in our hands. Now the private credit umbrella
is a big and growing umbrella and includes a lot of different
things. And I would say that the private
credit managers. Are starting to take business
that usually historically had been done by the banks.
Like one of the examples I use is a lot of the the funds that
you know, that we manage or if you look at like the interval
fund peer group or business development companies, the banks
used to provide leverage for as an example, like mutual funds or
closed end funds. And it was pretty good business
in the sense that let's say you have a billion dollar mutual
fund that has a billion dollars of assets in it, a billion
dollars of loans or a billion dollars of bonds and they're
looking to get a $200 million leverage facility.
So if you look at that from a lending perspective, you say
this is a $200 million leverage facility backed by a billion
dollars of assets. So like at the end of the day,
even though they're below investment grade, to your point
about the recovery values, what are the odds I don't get my
money back? It's it's low.
So it's it's kind of investment grade rated type business and
the banks have largely shunned that business.
So you used to get that loan from Bank of America and now
increasingly you might be getting that loan from one of
our competitors who it's not 300 basis points spread, but it's
100 plus and it's pretty good. It's pretty good, kind of at
credit risk. Why is that?
Is it? Is it just a function of
regulations and how much capital they have to hold?
Yeah, a lot of it is regulation. It's just too onerous now and
there's there's more profitable businesses that they can use
their balance sheet for. So underwriting and other
things. It's just there's much more
spread involved. You think about the fees
attached to doing a leverage facility on a boring mutual fund
or closed end fund it it's not great.
It's nowhere near the types of spread you're going to get on
underwriting a new below investment grade loan or high
yield bond or a new IPO transaction.
So the banks just need to be choosier with what they're
doing. And so we're seeing that also in
like consumer loans now guys are starting to in the private
credit world do things like RV's and auto loans and other types
of kind of ABS transactions that again I I would say is in
fairness kind of a function of the banks just kind of turning
that business away. So a pretty good private credit
manager can come in, do a modicum of underwriting and go,
this is a pretty good. Loan like a warehouse facility
or like direct to private borrowers?
No direct to private borrowers. In a lot of cases these loans
are. I'll tell you, we're sharing
some personal stories before I, I bought my house 4 years ago
and when I look to it was a non conventional mortgage I was
looking at. And when I initially went to my
mortgage broker who I ended up with is a fund who we compete
with everyday interest. They're a very well known
distressed manager out of Los Angeles.
I won't give them free publicity, but you know, and
honestly, I went to Wells Fargo and they didn't want my
business. And I've been banking with Wells
Fargo since I got out of college.
And so I was literally working directly with their mortgage
underwriting team that was part of this very well known credit
manager out of Los Angeles. So again, when I looked at, I'm
probably a little bit biased, but when I looked at the spread
and the risk of my mortgage, I went, I've never missed a bill
in my life and I'm not getting a really big loan versus what my
house is worth. So when I looked at my mortgage,
I thought this is a pretty good, pretty good asset for obviously
rates went up a lot. But from a from a spread
perspective, that day I was surprised that the folks at
Wells Fargo didn't want my business, but some quasi
institutional manager was happy to make me a loan.
Yeah, maybe Wells Fargo's going too far into not wanting too
many ancillary products in every relationship.
You would think a mortgage would be right down the right down
their alley. Yeah, it's really interesting.
So if you go then into the corporate world, which it's a,
it's a much broader spectrum of issuers, in a lot of cases, they
just don't have the underwriting wherewithal to get involved,
especially as you have, as I mentioned, software, technology,
just more complex businesses. The, the banks are going to, are
going to look, look away from that business and maybe try to
get a finder's fee by lining those people up with someone
like us. They're, they're not going to
underwrite that loan. So yeah, it does create a little
bit of extra deal flow to look at that is, you know, not ending
up in the bank's hands. I mean, I, I guess it, I guess
the reason would be like the probability to fault given an
LBO they probably think is higher and then the LGD is
probably higher too. So then they just have to have
so much capital. It's just weird to me like who
does the cash management on these facilities and stuff?
Obviously not like not you guys, right?
I I don't, I don't think. So that's where you know, the,
the systems that are involved in managing loan portfolios are,
are, are fairly high barriers to entry.
Anyone can come in and buy a bond with AQ sip in your
personal account. And it's, it's relatively
doable, But you know, loans are very non standardized.
They have amortization payments, free cash flow sweeps, a lot of
different things that need to be accounted for.
And so the the kind of cash management you obviously I
mentioned have revolving credit facilities, delayed draw term
loans. All of these loans are also
going to have especially within our world leverage based step up
and step down in the coupon. So let's say my leverage is
three times, my coupon might be so for plus 450.
But if the leverage goes above 3 times, it might be so for so
that you. Need you got like a pricing
grid? Yeah, You need a lot of systems
to account for what those interest payments need to look
like, cash management system. So we have a big back office
team that supports our investment team to to kind of
reconcile buys and sells with obviously we trade these loans
too to add another layer of complexity to it.
So. The servicing side, for lack of
a better term, right? Yeah, exactly.
So there there's a, there's a lot of the loan market is still
somewhat arcane. And so there's a lot of, a lot
of that that needs to be kind of managed underneath the hood
within these facilities. But like at the portfolio
company, right, they have deposit accounts and they've got
corporate credit cards and whatnot.
Like when I was at BMO Harris for a while and that was a not
the corporate credit cards, but the cash management was a big
part of, I mean, that's pretty good business from a return on
capital perspective. So y'all aren't that interested
in that, right? I mean, you're more of like the
loan economics. Yeah, although that's where the
sponsor relationship comes into play.
You'd be sometimes surprised that some of these fairly large
family run businesses, if you look under the hood at their
their cash reconciliation process, it's not up to snuff.
And so typically the private equity firms are going to target
businesses that obviously have their ducks in a row or, or work
with them to try to make sure that they're doing things to
mitigate those type of losses that can, that can kind of to
your point, the devil's in the details.
You can have a fantastic business, but if your, if your
record keeping and cash management is sloppy and you're
running two to three times leverage, all of a sudden the
private equity sponsor can be in a precarious situation.
So you want to make sure that the stupid mistakes are are
mitigated as much as possible. Yeah.
I guess what I'm asking just from the banking side, like do
you have a, do you have a relationship with like JP Morgan
that they are doing the cash management and then sending you
the the reconciliation because the cash management, the actual
treasury management stuff doesn't go through first Eagle,
right? Yeah.
So we typically have fund administrators who who deal with
all of that for us. So JP Morgan is actually fairly
heavily involved in in the fund administration business.
So they're typically the ones especially like with our public
funds that they're going to custody all the assets, they're
going to price those assets daily.
They're going to go through basically like an appraisal
process to make sure that the assets are marked at a fair
price. If there's been any new news
that we're using that information to to kind of
reprice those loans. So all that happens typically
within the administrator of the fund.
Yeah. It's not something you think
about every day, but there's a lot of administrative work and
obviously our funds have have inflows and outflows if they're
getting in some cases daily or quarterly inflows.
And then there's also a redemption process.
So the the fund administrator typically deals with NAV
calculations and things of that nature.
I mean, is it a conversation with the Trump administration's,
I would say advertised stance on regulation?
Do you anticipate more banks entering the market as banking
regulation may decline or is that not really on their radar
of like what they're actually thinking about from a
deregulation standpoint or TBD? Yeah, I think it's very much
TBD. I, I think even if you're a
banking analyst, which I, I certainly have not, I think
there's still a lot of of variables.
And I think for us specifically the types of deals that we work
on, I, I don't necessarily see that, that changing very much
within these higher quality investment grade type type parts
of their business. I, I suppose, you know, at the
margin, certainly a little bit less regulation obviously what's
happened with interest rates on the margin.
I would imagine that some of that businesses, some of that
business does come back to the banks, but it, I would say it's
a fraction of the overall market in terms of what guys are
focused on today. I think longer term the big
opportunity for private credit is investment grade, higher
quality. It's just a much larger
opportunity set. But the reality is the spread
attached to a lot of those assets.
I, I'm not quite sure how scalable that's going to be.
That's a private credit manager who wants to earn their fees can
deliver a, a 4% return to to investors.
I'm not sure that that's necessarily going to be
something that is going to attract the type of capital
that's certainly the eight 910% yields have the last few years
or so. Yeah.
Well, what the If the average fee rate is 2%, you're making
four. You're giving a lot to fees,
right? Yeah, no, absolutely.
And the types of transactions that these guys are working on
too, we always say underwriting $100 million enterprise value
business and a billion dollar business is not necessarily 10
times the amount of work. And yet I'm charging fees based
on the size of the loans I underwrite.
And so we've seen loans just in the last couple weeks that are
$5 billion loans. So you do the math.
If I'm getting one, one and a half, 2% on a $5 billion loan
for three or five years, there's, there's a reason some
of these guys are buying NHL hockey teams, right?
It's a very lucrative business. And so to the early point, I
think there's always going to be concern around are people more
focused on the end result for clients or are they, are they
really trying to put this money to work?
And and so no doubt the the amount of fees attached to
private credit looks like hedge fund light type fees versus the
fees you would typically find attached to a syndicated loan
fund or a CLO. So what fees are those?
Pardon the ignorance. So there's different frameworks,
I would say. So if you're talking about the
institutional world, what people typically refer to as like a
closed end fund or like a drawdown fund, those funds
typically charge anywhere from, I'd call it 1% on equity, so
kind of invested capital. And then they'll typically use
leverage. So they might use anywhere from
one or two turns of leverage. So instead of having, so for
every dollar of invested capital, I might have $3 of
investments post, post leverage. Now they don't charge on the
leverage, they just charge on the equity.
But then they charge a performance fee, which you know,
I would say average is probably 1212 1/2 percent above a hurdle
rate, which the hurdle rate is usually around 5 or 6%.
So in a, if I assume kind of a eight to 10% type IRR, the the
fees can be pretty attractive. And then the other construct
that you tend to find are interval funds are another
popular vehicle for for private credit.
Now what interval funds tend to do is they tend to charge fees
on what we call managed assets, which is it basically includes
the leverage, but they use a lot less leverage.
So, you know, let's say I have $100 million fund, it uses $20
million of leverage next to it. I'll get paid on the 20 million.
So I get paid on what's in the administrator's account, which
is 120 million. It's the equity plus the now,
but I don't get performance fees.
So what both of those are kind of designed to do is to
basically incentivize the manager to produce returns.
One does it be an incentive fee and one does it.
In other words, one does it by trying not to disincentivize the
manager to use leverage. The manager obviously has to do
more work to put leverage on. So what you're trying to do is
you're obviously trying to incentivize the manager to to
not be shy to use leverage because they get paid on on
those leveraged assets, if that makes sense.
Yeah, it does. So for every invested dollar,
you're probably looking at fees anywhere from 1 1/2 to 2% I
would say, depending on the private kind of BDC structure as
well tends to be a little bit higher fee than you find
typically within the interval funds.
In an interesting way, like as the like SOFR goes higher, your
percentage of fees should go down, right?
Because a lot of this is is floating rate.
Yeah. So that's been one of the fair
criticisms around the, the hurdle rates typically don't
change. So everyone comes out, they have
a 5% hurdle rate and that's in the document.
It's kind of onerous and fairness to change that number
around. And you some of the pushback I
get is if the risk free rate is 525 and you guys are getting
paid on everything over 5, that's am I making things a
little bit too easy on you? But then on the flip side, as so
far as trended back below 5, now all of a sudden it's a little
bit harder to hit those hurdles. And I think over time, we're
lucky we don't, we don't have to forecast interest rates, but our
view would be that the economy is doing pretty well.
We have a hard time getting to a thesis that the Fed is going to
have to lower by three or four more times this year just based
on kind of what we see today. So our kind of view has been
that rates are obviously have come down a little bit, but
they're they're not likely to go back to 2%, which obviously
would make that 5% hurdle rate a little bit trickier to hit, even
if I assume a 4% spread. Yeah.
Well, in thoughts bound to be wrong.
I have this this recurring thought that with savings rates
where they are as as interest rates are higher, I actually
think it's kind of stimulative. At the same time, I think it
decreases the amount of investment.
So I think it's kind of inflationary.
And then if the Fed hikes and I'm close to right, it's almost
like a self fulfilling prophecy that rates go higher and higher.
I, I actually think lower rates are, are better for inflation,
But we will see if that's crazy talk or not.
Time will tell. It's certainly not conventional
through how they look at things. No, no, I would say overall, you
know, I'm a credit guy. We are credit guys.
And so we tend to be kind of glass half empty kind of cynical
by nature. Because if you think about it in
our world, it's all about staying out of trouble.
It's not about finding the next Elon Musk.
It's really about avoiding losers.
It's kind of how you outperforming in credit.
So I think anyone certainly on our team, if you had asked us a
few years ago, hey, the Fed's going to raise rates to 5 1/2
percent, what's going to happen to the economy?
We would have been dead wrong and said, oh, boy, that's really
going to. That's really certainly within
the companies that we are involved in who were by nature
floating rate issuers. Yeah, the economy's held up
really well. Operating results whether I'm
talking margins, top line are certainly a lot better than I
think we all would have assumed just given how how quickly the
Fed jacked up rates. Yeah, Yeah.
I think the last four years have kept everybody humble at least
should have. Who knows.
So you had mentioned interval funds.
For those that don't know, do you mind talking about the
difference between an interval fund and sort of a standard
product, for lack of a better term?
Yeah. So the way I would describe an
interval fund is if it's almost like a mutual fund, it has a
daily NAV, it'll have a ticker symbol with share classes that
kind of look and feel very similar to a mutual fund.
But the redemption process basically consists of you
typically get quarterly redemption windows that are
about a month. And so that the sponsor like us
will go out to investors and just say, hey, here's a
reminder, your redemption window starts April 15th and, and ends
May 15th. And so you, you basically call
your financial advisor and, and they put in a redemption notice.
And the interval fund is designed to redeem up to 5% of
the NAV of the fund every quarter.
And without getting into too much weeds, I think it's
important to mention that most interval funds have the ability
with a very quick approval from the board to go an extra 2%
higher, meaning you can, you can redeem up to 7% of the net asset
value. So what that does on the one
hand is it allows the fund to control the flow of assets, you
know, much better than a mutual fund.
You know, in theory you could pull as much money as you want
out on a nightly basis. So they can be very painful for
even like liquid, quote UN quote liquid loan funds, syndicated
loan funds, they can get hammered without flows and
there's no imminent buyer. And it could be very tough for
short periods of time, especially like a COVID or a
2022. So at the interval fund is
designed to protect that and then it also obviously gives the
fund the ability to own illiquid assets.
So you can own assets that you're not going to have to sell
because you can control them by having kind of packaging them
next to liquid assets. So what a lot of managers do is
they have, you know, and you typically you can look on the
fun fact sheet and kind of see, OK, these are the private
assets, these are kind of the illiquid assets.
And then they have other things sitting beside those liquid
assets typically is part of the investment strategy, but often
times it's to provide liquidity. If we have outflows, these are
things we can sell to JP Morgan to fund those those redemptions.
Now what I will say is if you think about it, you're maxed at
the five and seven. So in theory, if if everyone
tries to sell at the same time, the fund is going to get more
than 5 or 7% redemption requests.
So then everyone gets kind of prorated.
So if you get 10% request, everyone gets kind of half of
what they asked for. And so it's really interesting
if you go back a few years ago, interval funds, financial
advisors did not like interval funds.
They just like the idea of getting their money out on a
daily basis. But over the last few years, the
ability to package less liquid assets that again, we could talk
about the fundamentals, the kind of advantages of some of those
illiquid assets. But I think the reason you have
a lot of retail advisors allocating to those funds that
have illiquid sleeves is. It smooths out the Nava lot,
which yeah, it's a good thing, but it's also you need to manage
expectations and the other structure that people typically
use for private credit, which is arguably just as popular as a as
a business development company or a BDC.
So BDC's there are several different kind of forms of a
BDC. The most I would say the fun
that's been around the longest or exchange traded BDC's.
So there's, there are BDC's that are literally New York Stock
Exchange listed. So it's almost like a closed end
fund. You can buy the share price and
then it has this, this, this portfolio.
More recently, the real growth in BDC's has come from unlisted
BDC's. So it's a 40 act fund, It's
structured just like ABDC, but it's not listed on an exchange.
So the redemption process for BDC and unlisted BDC is a lot
like the interval fund. You do it basically with the BDC
sponsor and it's similar in the sense that it's typically 5% per
quarter. But the, the BDC is a little bit
different in the sense that if the, if the board of directors
believes that it's not in the bench best interest of
shareholders, they can suspend the redemption on ABDC.
So you have like a 2022 or a COVID and some of the REITs,
REITs are kind of a similar structure to ABDC.
A REIT can kind of shut off the redemption process if they think
that there's been a dislocation in the market.
Yeah, Blackstone, right? Yeah, whatever, Barry sternly
wrote. I'm.
Pretty sure he gated it. What I always say is like, did
you read the document? Because if you read the
document, you would know like this can happen in an interval
fund. There's really no like we're not
going to do it this quarter. The interval fund kind of has to
redeem up to 5% per quarter even if it's not the right time.
So there's, it's a bit of a nuance, but I think it's
important for people to understand that with these BDCS,
you do have a little bit less liquidity than you might with an
interval fund. So you really have to take kind
of like AI don't know what the right number is, but a little
bit of a long term view. I don't know if it's two years,
three years, but you definitely don't want to use those
structures if it's money that you think you might need.
It's really longer term capital that you say, do I really need
that money daily? That is starting to kind of
gravitate towards some of those some of those semi liquid
structures. Yeah, the interval fund is
almost it's like a way to get a liquid E liquid exposure without
the lock up of like a 10 year fund or something basically and
you can put your money to work right away, right?
Yeah, it. Waiting on called capital.
No, it takes daily, daily inflows, which again is part of
the reason that you want to have some liquid assets in there is I
don't want to have to originate a loan to put that money to work
every week or two. So you, you could say, look,
let's just go buy a little bit of XYZ big public liquid loan
only for a few months. And then when we see the right
transactions in the direct lending origination pipeline, we
can sell those loans and, and, and kind of allocate.
So it helps you manage your flows a little bit better by
having some liquid assets. The BDC does it much more on a,
a monthly, quarterly basis. So they're not taking in money
every night. So they tend to have more of a
focus on just those private assets versus the interval
funds. If done correctly, you should
always have some liquid assets that you're using there to
manage your inflows and obviously your outflows.
Yeah, that makes sense. You'd mentioned as as a credit
person you're you're naturally averse to losses, which makes
sense. So like if I were to look
through your portfolio, are there themes or what are you
thinking about to avoid the loss in in what you're lending to?
So I mentioned earlier that everything we do is sponsor
back. That's that's one of the things
that's pretty objective kind of black and white.
The other thing I would say that's pretty objective is the
vast majority of all the loans we do are first lien senior
secured term loans, which is kind of the the old facility
that's been used since the dawn of time in the loan market.
More recently, we're seeing a lot of these direct lenders
using what are called Unitronch loans where it's the same credit
agreement, but kind of built into that that loan.
I have some people that are first lien, others that might be
what we call. It's kind of AI always laugh
when I say this. First lien last out.
Which means you're not first lien, you're technically first
lien. Closer to mez, right?
Yeah, but someone gets their money back first, and so that's
meaningful in terms of the risk you're taking when someone gets
their money out first. What is that that matters for
like for, for the security, right?
If your first lien last out, then somebody can't come and
prime you or something. Exactly, Yeah, Yeah.
So again, you're up there in the in the priority of payments, but
you're not first. And then the other thing I would
say, getting into kind of more subjective things, we tend to
really like businesses that have a lot of recurring revenue.
So that could be everything from, like I mentioned, Ras.
If you're a registered investment advisor, you have a
bunch of clients, you charge a fee on assets.
If you don't, if you do a good job by them, I can kind of model
out what your revenue is going to be year over year.
Other things I mentioned also like HVAC servicing, orthodontic
clinics, tax and audit firms that regardless of what happens,
your clients need to get tax and audit work done, just the higher
percentage of recurring revenue. Every business has some
cyclicality, but if I can try to remove that as much as possible,
let's try to do that less leverage.
We're we're seeing a lot of direct lending managers now
refinancing these broadly syndicated loans.
These loans are kind of existing mutual funds today and they're
kind of taking them private. And a lot of these, these, these
loans are getting refinanced into the private markets, these
larger deals because they have a lot of leverage and they can't
get done in the syndicated market.
So these might have 467 times leverage and leverage is
typically how much debt do you have versus how much, how much
EBITDA do you throw off to, to service that debt.
So I would say our direct lending business tends to focus
on deals that are more like 2 to three times leverage.
So they're smaller companies. So I'm taking risks.
On a debt to EBITDA basis, yes, And your EBITDA, the cash
conversion is probably quite good given the businesses that
you're talking about. Yeah.
So in exchange for dealing with these smaller businesses,
you're, you're typically buying day one at a level of cash flow
that it is, is very significant relative to the overall amount
of debt outstanding. Yeah.
And then the other thing I would say too is as the market has
grown, you're seeing a lot more what I'll call creativity, which
again, it's a good thing and a bad thing.
Creativity is great. But I always say like, I always
like to go back to the mortgage on the House analogy.
And like if you tried to use that same framework with the
bank when you try to get a mortgage, what would the banker
on the on the other side of the desk say to you?
So one of the structures or features we're seeing in the
direct lending market today, it's become a lot more prevalent
is what's called a pick or a paid in kind.
So a paid in kind means I'm not paying my interest in cash, I'm
paying my interest in more debt. So, so this again, the people
are going to tell you the good reason that this is happening is
there's a lot of lending right now to very high growth
technology businesses and software businesses, AI.
And so the thinking is if, if the business is really growing
rapidly, you don't want to consume.
Cash and interest expense. Yeah.
And so I want to let the business grow into the cap
structure, the old school kind of loan guy in me would be
saying. Used to say, let's lend to the
cap structure as today in the growth can go to equity.
Yeah. And so, you know, imagine if you
went to the bank and you said, look, I want to put 50% down on
my house. I'm buying in a great community
in Florida that's growing and everybody likes it.
But the only thing is I can't pay my first four mortgage
payments. But then beyond that we're good.
I mean the bank, which is they're not going to make you
the loan. There's there's nothing you can
do to tweak the other variables that the bankers going to make
that loan. So we don't that and then that's
what we call pick as plan A. So a pick can happen if all of a
sudden the business runs into problems.
Typically a pick is built in to say, OK, if you can't pay your
interest, you know, we will allow you to pay it in kind.
But going into a deal day, one that you know the first year is
going to be paid in kind, I don't know, I'm sure some of
these transactions are going to work out well.
If I'm getting paid to take the risk, it might be a good trade
off be kind of guardrails and everything we do has covenants
within the direct lending market.
So things that we try to do just to control risk day one that
other lenders might have a little bit of a different
framework than we do. Yeah, that makes sense.
Yeah, I would. I would think a pick is
traditionally like more mez right than senior secured first
lien type stuff. Yeah, there's definitely a home
for it like distressed lending. Some of the smartest guys in our
world are distressed debt managers and they take a lot of
risks. There's nothing wrong with that.
The question is what am I getting paid to take the risk?
And so as long as the risk return trade off is fair, then
it can be a great investment. But if I'm all of a sudden being
risk into the document and I'm and the spread isn't, isn't
moving commensurately with that, but it's a multi variable
equation that the manager needs to figure out.
And are there things that I just always say no to that even for
another 200 basis points of spread?
I, I just don't do that. You got to find somebody down
the road that does so yeah, within mezzanine and certain
other kind of approaches guys are doing this.
But for us, we've tended to to kind of error on the side of
caution a bit. Again, I think it goes back to
kind of the first Eagle brand too.
I mean, that's part of the reason we ended up here is our
team has been doing this a really long time.
It had guys who I report into and over time they just decided
like these are the things that we, you know, kind of bend on
the things that we don't. How does deal flow work?
And like why do you win deals? You're competing I assume
against Aries and and the other 6th St. or whatever.
Like who is it that a sponsor wants to spread sort of the, the
debt around so that they can rely on the market to come to
them? Or I always get worried that the
answer is we're loosest on covenants and and structure,
right? Which is not exactly the answer
you want out of a debt shop. So curious to hear your.
Answers, yeah. So one thing I will, I will
mention is we don't compete with those types of folks.
I would say most of the household name private credit
managers who people are familiar with the one you just mentioned,
I would say going to generally focus on companies that are
doing 250 million of EBITDA or generally a lot more.
You know these are, so these are, these are much larger
transactions quite frankly. And again, these are the larger
managers who tend to have the big distribution teams who might
have BDC's and interval funds and they're on the platform at
the big wirehouse firms by nature just going to be bigger.
They're going to focus on bigger, bigger deals because
like I mentioned, our team runs about 20 billion and there's
guys who deploy $20 billion in in a couple months.
So, so we're a lot smaller than them.
And so I would say that for US, one of the things that's a
little bit unique is the sense that because you're right, a lot
of private equity firms if we're involved with other lenders in a
deal, the, the likelihood is the private equity sponsor wanted
that. So they're planning on growing
their business over time because that's that's typically the MO
in our world, especially in the lower middle market is we're
coming to you today, we're looking to acquire an HVAC
servicing business. Once we absorb the business and
we are able to kind of prove that we know how to operate the
company, we're going to come to you in six or nine months with
another HVAC servicing business that we're looking to acquire.
And so we're going to try to scale these businesses up over
time or an orthodontics firm or a registered investment advisor.
And so they want to have access to, to, to different lenders.
But the other thing that that tends to happen is the initial
transaction might be quite small, but if the private equity
sponsor is successful, they're going to they're going to grow,
they're going to grow the business.
And so I think one of the things that we've been able to do to
potentially put ourselves on a short list of lenders to get
involved in is we don't mind doing smaller transactions
upfront if we then can grow into this larger business with the PE
sponsor because it's it's really beneficial for for both of us.
And it's beneficial for us because there's nothing we love
more than an add on where we worked with the PE firm before.
We know how they behave. We might know how they behave
when things don't go according to plan and what happens when
surprises to the negative kind of happened, how do they react?
And there's nothing better than an add on because we've worked
on a deal with you, you're basically coming back and trying
to replicate a similar transaction with a similar firm
that's in a similar industry. So there's a lot less
incremental work we have to do. And now I can put another 30,
forty, $50 million to work. So add-ons are really great for
us. But again, if you're, you know,
especially some of the the names you mentioned, you know, when
you call them up and you say, hey, we need a $20 million loan,
they're not going to call you back for them to do six weeks
worth of work to deploy $20 million.
Yeah, they're going to go to the smaller, the smaller lenders
like us. But on the flip side, we are big
enough that we can hopefully scale.
So we're not just doing $510,000,000 loans.
We can kind of grow with the business.
And we have a lot of people on our team.
We have 50 about 5055 people on our investment team.
So that gives us a bit of an edge in that we have kind of
industry specialists across these different sectors who can
hopefully add value in terms of structuring the loan.
They understand the business really well.
So I know it's a little bit cliche to say it's a
partnership, but it's a little bit of a partnership.
Like we like how these guys behave.
They they're good to work with. So I think you tend to find a
little bit more of a tighter knit relationship between guys
like us, the PE sponsors and the issuers.
Then you might find with even these multi billion dollar deals
that have become a little bit more commoditized because I
might not shop the deal to you, but I can also call JP Morgan
and I can get them to syndicate that risk.
So there's a little bit more of an arm's length relationship
within those bigger multi billion dollar transactions.
And we've seen this is not prevalent, but we've seen a few
deals recently in the direct lending market where the private
equity sponsor tried to effectively extract assets from
the lenders and put it into kind of like subsidiaries where the
lenders now low no longer have liens.
So these are like aggressive tactics.
You tend to see more in the syndicated market that we're
starting to see a little bit now more in the larger direct
lending transactions that we really don't see in our market.
We have private equity sponsors we've worked with 456 deals on
with. So anyone can do things that are
unscrupulous. I've worked on Wall Street long
enough to know that this isn't an industry of angels
necessarily, but certainly knowing your partner's better
helps mitigate you from some of that, some of that risk that
might be more more prevalent within some of these, some of
these bigger deals. Yeah.
Well got to know your restricted assets and what not right?
Yeah, it's definitely an asset class that you really need to
read the fine print. There's a lot of language now
founding credit agreements that have come from some of those
aggressive tactics. So we call them blockers.
So it's the the aggressive transaction, ABC transaction,
it's now an ABC blocker that mitigates that risk.
So the other market's evolving a little bit.
But definitely the deal documentation within these loans
can vary a lot. And knowing the details in terms
of what you own when things don't go according to plan is
again, ultimately how you kind of protect capital within within
these loans, whether it's syndicated or a direct lending
deal. That has been a consistent,
what's the word that I'm looking for?
When I talk to people about why there should be outperformance
in credit versus the index. This is a common thing that
comes up right, is that the index can get swallowed sort of
by some of these poor credit agreements where if you're a
prudent manager, you can avoid some of those.
And in a game where it's all about avoiding losses, that
should matter over the long term.
Yeah, It's interesting. I mentioned earlier that I was,
when I started to get into investing in college, I'm like,
where do you go? You go to like Warren Buffett
and then you kind of branch out from the Buffett books.
And so I think a lot of people kind of start there.
So you start to think a lot about active management.
And obviously with passive management, it's a conversation
everyone has in our business. And I remember I took a class at
Columbia Business School with Michael Mobison, who who at the
time had worked at leg, was working at Leg Mason, you know,
back in the Bill Miller days. And so this is like, this is
like where you go to talk about active management, right?
And we're talking to Professor Mobison about his investments
and he was talking about how he has a lot of money and passive,
passive mutual funds effectively in in ETFs and in the equity
world, obviously sitting at First Eagle and our Global value
Fund. It's a debate we have every day,
but if you think about the what we do in the loan market, it's
it's really very different because all these indexes #1 are
cap weighted. So you start with the largest
issuers in the market. So if you look at a cap weighted
high yield bond index or a cap weighted loan index or, and, and
a mutual fund that tracks that cap weighted index, they're
naturally going to own the companies that have more debt
than everybody else. That's just kind of how you get
to be the biggest name in the index.
Now, that doesn't mean that you're going to have more
leverage, but it can. There was a company years ago
called Texas Competitive Electric Holdings TXU, which was
one of the, I think it was technically the largest default
in, in history if I take both the loans and the high yield
bonds. And when it defaulted, it was
not surprisingly the largest name in the high yield index and
the largest name in the loan index.
So just starting day one and saying, let me just not start
with the index. Let me start with the companies
I like, Punk, the companies I don't like and and just kind of
start there. What you tend to find is like
syndicated loan funds versus the index.
They beat the index pretty handily.
They have a huge advantage and the ETFs in our market are
somewhat systematic so that they sell to rebalance to an index
versus a mutual fund manager who gets outflows is presumably in a
better position to say, let me sit down with my trader and
figure out it's 2022 where it's COVID, what do I sell and what
do I want to sell? And again, that person, it's not
an ideal world, but I'd much rather a, a, a smart PM and a
trader sitting there going, OK, what do we do here?
Can we call JP Morgan? Can we call Citi?
Can we figure this out versus an index and a computer just going
boom, just going through and just rotating out?
So that active versus passive debate I think in the credit
market is still one that if you really understand the mechanics
of of our market where you have a lot of money in open and
mutual funds and ETFs, that could be for sellers, for
buyers. A trader working at Goldman
Sachs who has five screens in front of him or her who can see
flows. It's a professionals business.
And so an ETF operating in that market is we think we're biased.
And if I look at results, they tend to bear it out.
A good active manager should be able to beat an index pretty
regularly. Yeah, that makes sense.
That makes sense. Let's see.
Oh, I, I think y'all can borrow to fund distributions.
Have you ever done that or is that just kind of like what's
what's the purpose of that sort of language?
So we have never done that. You can.
So all of these funds have leverage facilities built into
them and we have the ability to kind of dial up, dial down
leverage depending on our view of the market, funding costs,
opportunity, how we could deploy it etcetera.
And I would say again, going back to kind of our team, kind
of our desk overall, we tend to try to keep leverage levels low.
And one of the reasons we do that is certainly in a really
bad scenario, it's another lever that we can pull to try to get
our investors redeemed out of the funds without just fire
sailing assets. So it's obviously it's limited
the amount you can do that. But if I'm running maximum
leverage and all of a sudden the market gets really hairy and I'm
getting outflows, the only way I can fund those redemptions
dollar per dollar is obviously with selling assets into the
secondary market. So if I'm running my leverage
below target, it just gives me a little bit more flexibility to
use that. It's not something we do
regularly. We've been pretty lucky.
The funds have grown certainly since we've launched them and
it's been a fairly benign market for us.
A lot of our funds really didn't live through the, at least here
at first Eagle through the initial COVID time frame.
So it's been a reasonably benign market X 2022.
But we always want to be prepared for that worst case
scenario where everybody wants their money out.
There's some big macro shock. And so having the ability to
draw down on some leverage a bit to to help fund those outflows
just gives us something another kind of leverage that we can
pull. Yeah, makes sense.
It's, I don't know, it kind of triggered me to be like, OK,
well does that create some risk in the portfolio?
But I understand why you're from your perspective, you would
definitely want that get get you through a little bit of a
downturn, right? Yeah, one of the, again, the
nuances of loans is loans are technically not securities so
that the settlement process of loans is bond settle, T plus
one, T + 3. Loans settle on average
somewhere between T + 5, T +7. And there's really no mechanism
to force settlement necessarily for loans unless you call the
agent and kind of for settlement.
So again, it, it, it's not even necessarily that I can't sell
the loans. It's I've sold the loans, but I
may not get the cash for seven to 10 days and I'm getting
outflows. So obviously with the interval
fund that is that's mitigated significantly.
But if I'm talking about like as an example, an open end fund,
they might use their leverage facility temporarily to try to
kind of bridge that gap between the the settlement time and when
the the loan was traded, if that makes sense.
Yeah, that does make sense. That makes sense.
All right. In closing, my final question
is, I mean just generally, we probably touched on it
throughout the conversation. But if you were to give me an
elevator pitch on why private credit, given that it looks like
spreads are are as tight as they've been in a long time and
it looks like valuations are as high as they've been in a long
time. Like why is now the time to take
or to be OK allocating this some risk here?
So it's interesting, private credit, credit in general tends
to get kind of lumped up into the fixed income bucket, which I
understand why that happens. All these loans have maturity
dates, income is going to drive the vast majority of your
return. So it's kind of a debt
obligation. So I I get that.
But when I think about the risk that we take everyday by by
lending to these companies, it's very similar to the risk you
take as an equity investor. We're in essence betting on the
operating results of these companies that they can continue
to pay their bills to service their debt.
So in a lot of ways we do it from the, the other part of the
of the capital structure. But I'm, I'm kind of making a
bet that the company performs well, which is in some ways a
lot obviously what I'm hoping if I buy the equity of a company.
And so I think relative value becomes really important.
And there's been obviously a lot of conversation around
valuations in the equity market and I know our equity team
wouldn't disagree with this. If I look at the S&P 500 or even
the equal weighted over the last few years, it's it's up 50 to
75% depending on what time frame you look at.
And I look at the earnings yield on the S&P right now or any
other equity index, it's probably an environment where if
I assign A6, seven, 8% return to equities long term and they've
just outstripped that by a huge margin over the last few years.
I probably want to start to think about a mean reversion
that maybe equities if I buy an index only return 5 or 6% or 6
or 7%. And so if I look at credit, one
of the things I really like about credit is I can kind of
model out my potential outcomes a little bit easier.
And what I mean by that is I generate income.
So I go, OK, the income that this fund generates is going to
drive my return. So what's the income?
Maybe it's 8%, nine percent, maybe 10% on some of these
structures. And then I need to figure out
the manager is going to make mistakes.
Even First Eagle. I think we're really good at
what we do. We have a huge team of really
smart people. We make mistakes.
Default losses happen regardless of how good you are.
And So what I need to figure out is what type of default losses
should I expect? And we talked a little bit about
this, but you know, an average default rate for the index is
around 3%, maybe 4%. And then a recovery rate is
maybe $0.50 on the dollar. So I go, OK, the manager.
I'm guessing if I hire a bunch of these different credit
managers, my default losses should be somewhere around 2% a
year, a really bad year, maybe a little more, a good year, a
little bit less. But my return is going to be
something in that 8-9 percent minus my 2 or 3% for default
losses. So if I'm thinking about the
total return of that investment over time, I'm getting equity
like returns with a lot less risk.
And what I'll say is not necessarily Mark to market like
the S&P was down. Obviously today looks like a
rough day for the stock market. Again, the S&P is down 1% today
and that fund is flat. I'm talking about long term risk
over time and what types of credit losses am I going to see.
And that's where I think for investors who still think the
economy is doing pretty well, maybe they're a little bit older
and they don't have the stomach for big volatility drawdown and
maybe they need income. Credit could help be a proxy for
equity risk, but certainly helps to augment income from a fixed
income portfolio. But comparing what we do to AAA
rated bonds is kind of an apple to an orange.
If we're going to recession, you're going to wish you on
those AAA bonds. That's just that's just the way
that the world works. So I look at things like
equities and I say, I think that credit offers a really
interesting relative value, an interesting mix of income, less
volatility. But ultimately I'm taking the
same risk. I'm taking the risk that these
companies continue to do well, but I'm doing it from kind of
the top of the food food chain. So that's the way I look at
credit. By the way, I'm, I'm in my mid
40s and I have a lot of my own personal money invested in
credit. Historically, I should be in
equities, but I look at compounding my money and credit,
different tax consequences. Obviously it's a very
interesting part of an asset allocation, particularly if you
think base rates are going to be high and higher inflation has
the potential to cause volatility in equities.
So that's kind of that's my maybe not elevator pitch.
It's a long elevator. But I like that one.
That's my pitch. Well, that was a good one.
It was better than I was expecting and I think it was a
very well said argument, so thank you very much.
Excellent. All right, cool.
Well, I appreciate you stopping by.
Did we miss anything in the conversation?
I don't think so. We certainly covered a lot and I
appreciate you having me on this was this was fun.
Definitely not my my typical Monday morning I'll have.
To, well, good. I'll have to wear my Tommy
Bahamas shirt next time. Well, you know, sometimes you
got to lighten up the mood with the shirt, so that's what I was
working on. I like it.
We'll see each other hopefully in in similar shirts.
Next time, I promise you, you see me, I won't have my hair
slicked back and won't be wearing a tie.
That works all right, man. Well, thanks again.
Absolutely. Thanks, Bill.