Michael Zeuner: 00:08
Hi everyone. This is Michael Zeuner, one of the managing partners at WE Family Offices. Thanks for listening to The Wealth Enterprise Briefing. Today, we’re going to have a conversation with Matt Farrell, our deputy CIO, and we’re going to do a little bit of a deep dive into the private credit markets. A lot has been written in the press lately, and several prominent financial executives have commented about the state of the private credit market. And what I’d like to talk with Matt about is, as you as our regular listeners know we’ve done deep dives into the private credit market in the past, why private credit might make sense for certain investors. But today, we’re going to take a look at what’s been happening in the private credit space, some of the big headlines that we’ve been hearing about, and hopefully give a little bit of insight into for investors for whom private credit makes sense in their portfolio, how they might think about navigating the kinds of commitments they make to the private credit markets going forward, given what we’re seeing in the space, I guess, Matt, let’s, let’s kick it off by just, you know, refreshing for our listeners, what I think started this whole conversation in the press about the private credit markets was a couple of very high profile bankruptcies in the last few weeks. And maybe just give us some context and color for what’s been happening out there, and then we’ll talk about what the implications are.
Matt Farrell: 01:41
Hey, thanks for having me. So you’re right. In the news, there’s been several different bankruptcies, and I think the common thread amongst them is fraud in a lot of these, right? And so what we’re banking on for our underlying managers in which we invest with is for them to conduct diligence and flesh that out, so that can come in many shapes and sizes. But whenever you’re lending to a company, there’s collateral that could be a general corporate claim against the company, or it could be specified collateral, such as receivables or an individual asset, for example, and that’s really what your recourse is against. And so a key component of collateral, of due diligence, is confirming collateral and making sure they’re sufficient in terms of recourse. So you know, one of the main things that we’ve observed is maybe there was a shortcoming in the diligence of the underlying collateral in these specific examples.
Michael Zeuner: 02:41
So Matt, what I what I infer from that, but let’s just make it explicit, is that you don’t necessarily see a systemic problem in the private credit markets, but you do see instances of managers in the private credit space, perhaps not doing as robust a job as you would like to see when they do their underwriting and are putting capital to work.
Matt Farrell: 03:08
I think that’s fair. You know, we believe we talked about a prior episode, just the amount of capital that’s flooded the space. And anytime that happens, it gives us pause and makes us reassess, as we always do, but what we concluded is there’s still plenty of capacity in terms of demand for financing. I believe we said private credit represents roughly 7% of all US, US debt. So it seems like there’s still capacity, but then when the flood of capital happens, that can give rise to kind of loose underwriting. So you know, what we do is, as part of the investment research, is spend a lot of our day meeting with managers, and so it gives us great context just across the landscape, and we really hear kind of common talking points. And you know, whenever we ask, what’s your differentiation as a manager. Why would a borrower pick you as a lender? A lot of what we hear is the ability to close quickly and certainty of closing and for a borrower, that makes sense. You don’t want to go to this broad, effectively, an auction process and take a lot of time to pick a lender because you have a financing need, and so you want to get through it as quick as possible. And so if you’re able to pick a lender that can go through the process very quickly, that’s appealing to you as a borrower, but you know, the skeptical side of me would suggest like, okay, great, that you can do this quickly, but does that mean you’re forgoing due diligence for the sake of winning the deal, or at least doing a high level diligence, not necessarily, fact, but it just raises the question.
Michael Zeuner: 04:49
Okay, so, so when you, when you think about those lenders, right? I mean, if you think about the families we’re advising, right? Or investors in general, they are giving capital to those lenders to be deployed into the private credit markets. So the key you know that to be thinking about is, when you’re giving your capital to a private lender to be deployed into the private credit markets, you want to be sure that that lender that you’re giving your capital to is thinking about, sure, how do I make myself attractive to companies looking for capital? But I think equally, if not more importantly, how do I protect the interests of the people who are giving me the capital to lend to those companies? And you know, when you talk about sort of the fact that the answer you get is, well, we’re quick to close, right? That’s really appealing to the company, as opposed to necessarily protecting, you know, their investors’ interests. What kinds of things do you look for when you are underwriting a private credit manager that would signal to you that they’re thinking as much about their capital providers as they are about the companies to whom they’re lending money?
Matt Farrell: 06:18
Right, so in our job is to essentially diligence the lender, which so you’re effectively, you’re diligencing the diligence there, right? Because they’re conducting diligence on the borrower. So we want to make sure that they’re conducting effective due diligence, and so we’ll walk through their investment committee memos and maybe a case study to understand how they conducted due diligence, so everything from reference calls to confirming collateral that we discussed at the onset, so making sure they’re running a robust diligence process is obviously first there. And then second, we’ve talked about cove light before. So what that means is essentially no covenants for that protects the lender. And what we’ve seen with the influx of capital and private credit is that in the most competitive parts of the market, you know you’re competing to win the deal, so therefore you’re essentially having no covenants. That’s just too much risk, in our view, and we want to have a lender who actually has covenants. Now there’s, it’s not black and white, there’s shades of gray. So you can have no covenants, or you can have seven covenants. Some will say, oh, we’re not cove light. But then they only have one covenant, which, of course, is better than nothing, but still it’s one covenant. So we’re biased towards managers who are able to attain more covenants. How do they do that? Well, a couple ways. Maybe they have some kind of proprietary deal flow, you know, specialized origination, or maybe they’re just accessing the less efficient part of the market, which we’ve talked about in prior episodes. So maybe that’s, you know, smaller businesses which have a certain risk profile, but it’s more fragmented. So there’s, there’s spaces in which you can operate and command more covenants. So those are two things that we look at, and then, you know, I’ll just say overall diligent seeing private credit is quite tricky, because there’s, there’s games that one could play. Maybe games is the wrong word, but, but just ways to market themselves in a way to suggest that they have an unblemished record. So for example, they could say we have no defaults since inception. Well, that may be true, but the reality is they don’t have any defaults because they restructured the loans, the terms of the loan such that the borrower doesn’t default because you restructured the loan, and therefore you can continue marketing that you do not have any defaults. So it’s very important to do a deep dive into the track record to assess how many of the loans have been restructured in order to prevent default. And you know, it happens, there are going to be, you know, mistakes that are made, or just borrowers that have some kind of headwind, and so it’s just, it’s not a deal breaker, but you also want to make sure that’s not happening too much, and that they’re they have a robust due diligence process to prevent that as much as possible.
Michael Zeuner: 09:12
So like many things, and we’ve been using this expression on episodes a lot lately, you have to really look under the hood, right and and in the context of the private credit space right now, the headlines right are, are can be, can be scary, right? But that doesn’t mean you necessarily have to throw the baby out with the bathwater and not invest in the private credit markets. If private credit makes sense right for you as an investor, right? And it clearly does not make sense for all investors and all portfolios. But if it does make sense, maybe we should end Matt and remind our listeners as to the thesis behind private credit, right? More broadly, why we think for some investors. Who have the tolerance and capacity for illiquidity, why private credit makes sense in their portfolios?
Matt Farrell: 10:07
Sure. Well, maybe just starting out with what private credit is, and it’s a debt instrument in which, if you’re familiar with capital structures, you know it’s at the senior part of the capital structure, which means the equity, which is the subordinated part of the capital structure, absorbs kind of any first losses there, right? So structurally, it’s senior to equity, so therefore there’s kind of an embedded layer of protection there. But aside from that, it’s the mechanics are generally such that it produces a Cash Coupon, and many families like that. Because, you know, as rates come down in the public markets, and we’ve talked about implications there, you know, a lot of these private credit loans, most are floating rate as well. So you know, the total return could come down for private credit as well. That being said, you’re generally able to get a premium of coupon in the private market compared to public so that’s another reason we like it. And and, you know, the way we think about it is any kind of cash yield de risk your investment, in a sense, because it’s less capital at risk. So all the reasons we like it also it offers a bit of a diversification benefit, and many others. Maybe I’ll add one more thing, you know, one of the headlines, I think this is even yesterday, talking about private credit becoming private equity. And what’s that? What’s that is saying is that you starting out as a private credit manager, and then when things go wrong and you have to restructure these loans, you often become the equity holder because of the borrower’s inability to pay. And so what that means is you then essentially own the company, and therefore you have a company to manage, to prevent losing all of your capital, because there’s a concept called loss given default. So if they, the borrower defaults on their loan, you want to try to prevent as much loss as possible. So sometimes that means taking the keys to the company. So another consideration, you know, especially if we were to enter some kind of dislocation or recession and defaults increase, you want a manager who’s equipped to to manage that situation. Do they have the experience with workouts, or have they ever taken over a company before? So that was just a recent headline. I thought it was interesting as well.
Michael Zeuner: 12:30
Yeah, and another factor that that we would want to be throwing into our diligence efforts on on the private credit manager. So okay, Matt, well, thank you. Always good to talk to you and look forward to continuing conversations in the future.
Matt Farrell: 12:47
Thanks.
Disclosure: 12:51
The Wealth Enterprise Briefing is for informational and educational purposes only and does not consider the specific investment objectives, financial situation or particular needs of any listener. The information in the briefing is not a recommendation of any security and should not be relied upon as investment legal or tax advice.
