Summary by: Todd Eklund, CFA, CAIA
On Thursday March 28th CFA Society New York hosted the annual Private Credit Outlook. An event that featured a full slate of distinguished panelists offering informative perspectives to navigate opportunities and risks in this burgeoning asset category.
Many thanks to our organizers that spearheaded this event:
- Stephan Connelly, CFA
- Ceyda Savasli
- Mark Sullivan, CFA,
Our three panels included:
- LP / Allocators in Private Credit
- Direct Lending GP Panel
- Specialty Finance in Private Credit
LP / Allocators in Private Credit
- Tod Trabocco, CFA, Managing Director, Cambridge Associates
- Robert Kiernan III, CEO, Advanced Portfolio Management
- Antonio Rodriguez, CFA, Director of Investment Strategy, NYC Board of Education Retirement System
- Robert Thompson, CFA, CAIA, Senior Portfolio Manager, Credit UPS
- Jae Yoon, CFA, Chief Investment Officer, New York Life Investment Management
The symposium kicked off with a panel featuring LP asset allocators deploying capital into private credit. Moderator Tod Trabocco, CFA, opened the discussion by highlighting Cambridge Associates research into the attractive historical risk-adjusted returns offered by private credit in comparison to other broad asset categories in private markets.
Define the Landscape
“Private Credit” is a broad playing field of lending and financing opportunities that can include many subcategories: Direct lending, mezzanine debt, special situations, distressed credit, distressed real estate debt, and infrastructure financing – some investors in this space even evaluate opportunities into aircraft lease portfolio securitizations and railcar asset-backed structured financing.
As such, it is important to define and distinguish among different segments as a framework for a target level of return, risk, and illiquidity premium. The panel acknowledged that performance is difficult to benchmark, but generally agreed that private credit and middle-market loans should offer an illiquidity premium of 200 – 300 bps over a broadly syndicated loan.
Robert Kiernan of Advanced Portfolio Management emphasized that “Credit” is a continuum of various segments, asserting that views and allocations in the space should not stay static. Other panelists echoed this sentiment, indicating the episodic and cyclical nature of where and how they have deployed capital. Numerous factors influence the evolution of prospective risk / return dynamics across private credit: Business and credit cycle, regulatory regime, relative competition, and marketplace participants.
The relative attractiveness and risks within the credit opportunity set shift over the course of time. Investors should have a keenly trained eye for both entry allocation, as well as when to pack up and leave various lending segments.
Vigilance: For both due diligence & managers
Panelists were asked to share viewpoints on the evolution of private lending markets over the past 5 and 10 years, as well as a diagnosis looking forward.
While acknowledging that certain unique pockets of attractive opportunity do exist today in private credit, several panelists expressed apprehension regarding the “margin of safety” and undisciplined practices that are permeating in private lending deals. This includes “covenant-lite” loan terms that have trickled into lending across middle-market loans, and even down into the smallest company deals.
A concern more often overlooked is the use of “pro forma” or “adjusted” EBITDA metrics. Panelists noted the inflated assumptions used in some lending deals. In recent years, it is not uncommon to see aggressive 30%-40% add backs on adjusted EBITDA. To the untrained eye these assumptions create the appearance that a borrowing company is significantly more profitable, and capable of debt service and coverage.
Panelists also remarked on the changes to the marketplace both for private lending issuance, as well as the investor base and asset managers buying into private credit. On the origination side, private equity and LBO sponsors occupy a much larger footprint in the issuance marketplace today. The number of PE firms has swelled in conjunction with the large commitments of investor capital pouring into private equity over the past 5 years.
On the other side of the table, flocks of new asset managers have entered private credit. Many lack the length of experience and depth of skillsets to successfully navigate the management of a loan portfolio over the course of a full cycle. Jae Yoon, CFA, Chief Investment Officer, New York Life Investment Management remarked that many new entrants have spent their careers in the business of sell side loan origination. Often this “transactional” professional background can lead to a lack of discipline, as well as a void in the know-how for loan restructuring, recovery, and exit when the credit cycle takes a downward turn.
When evaluating and selecting private credit managers, LPs and asset allocators should seek to dig into some degree of track record to understand the managers losses and recovery rates on loans. Tod Trabocco of Cambridge Associates emphasized that private credit requires an intensive level of due diligence, even when evaluating experienced managers with a lengthy history. There are unique challenges to scrutinizing managers alongside the underlying loan portfolio history. Blemishes from bad loans are opaque, and potentially masked by material modifications and re-papering. Top-notch operational due diligence and expertise is a must. Investors must dig into highly nuanced elements of valuation policy, and have a clear picture of the assumptions that produce various reporting and position values.
Panelists acknowledged that in spite of the aforementioned risks, private credit offers an attractive return opportunity for investors with the right knowledge, sophistication, and time horizon.
In the institutional marketplace, many insurers have come to view private credit as a relatively “safe” asset because quarter-to-quarter price swings are not required to mark-to-market. Private wealth allocators have also flocked into private lending in recent years, drawn in by similar sentiments: Lofty yields, floating rate structures, and a value that does not fluctuate in lockstep with wobbles in the equity markets.
Panelists warned not to be naive about the characteristics and nature of private credit. The risk and volatility are there, but you will only see it when things start to get painful.
Direct Lending GP Panel
- Richard Farley, Kramer Levin
- Fred Buffone, Partner, Freedom 3 Capital, LLC
- Rich Zander, Partner, Maranon Capital
- Brett Hickey, Founder and CEO, Star Mountain Capital
- Michael Leitner, Managing Director, Blackrock (formerly of Tennenbaum Capital Partners)
- David Rous, Managing Director, CVC Credit
What You Know & Who You Know
The second panel featured individuals sharing expertise and insights from the lens of General Partners (GPs) engaged in direct lending. Panelists emphasized that key success factors for direct lender GPs include not only depth and breadth of experience, but also a well-developed network of relationships for sourcing deals.
Opportunities within direct lending arise from two broad segments. “Sponsor” led deals are made available through an intermediary such as an investment bank. Whereas “Non-sponsor” transactions become available through a more direct relationship to the end borrowing entity. Panelists referenced examples of the types of relationships that typically create non-sponsor opportunities. These opportunities are generally inbound inquiries from networks of private equity organizations, CEOs, and company boards.
Sponsored opportunities are put out for auction, and get shopped broadly up and down the street. This can drive the pricing of the debt down or weaken the protective terms within the loans to levels that might not adequately reflect the risk in a deal.
On the other hand, non-sponsor deals tend to be more bespoke oriented direct engagements with the borrowing party. Non-sponsor transactions, while requiring more proactive efforts to source and conduct due diligence, present a less competitive deal space and more attractive risk-based pricing levels from the perspective of the lender. David Rous of CVC Credit spoke to the benefits derived not only by direct deal flow from senior management, but also transactions from “repeat customers” in which a deal has been conducted with a C-suite or senior management individual in the past.
Plumbing and Patience
Looking beyond networks and relationships for attractive sourcing activity, direct lending GPs must have the right blend of resources, organizational infrastructure, and patience to properly conduct due diligence on loan deals.
Brett Hickey of Star Mountain Capital underscored the scope of administrative, data, and document review that must be collected and analyzed. This can be all the more challenging when evaluating deals to smaller family owned businesses that may be seeking external capital funding for the first time. The extra work that arises with non-sponsor deals is part of the reason firms like Star Mountain Capital can command higher yields from their loans.
As the marketplace has become more competitive with a growing flood of new entrants and investor capital, borrowers have come to expect a shorter start to finish shopping timeframe for due diligence. In some cases, more competitive sponsor deals expect as little as 2 weeks as a diligence review time period.
Several panelists spoke to the importance of an adequate timeframe (several months) that is necessary to conduct thorough due diligence. A process which often includes time spent onsite at the borrowing company, speaking with key customers and vendors, and bringing in accounting specialists to leave no stone unturned in reviewing financial statements.
Beyond loan level due diligence, several panelists emphasized the importance of patience in capital deployment. LP fund investors at times are anxious to see their fund commitments put to work. Michael Leitner of Blackrock (previously Tennenbaum Capital Partners) noted that in many instances there is a 3-year deployment period for credit and lending funds managed by his group. “Investors need to be patient with slow deployments, it does no good to rush versus taking the time and pacing to find the right opportunities”.
David Rous of CVC Credit expressed his view that the root cause of weakening loan terms (e.g. “Covenant-lite”) is the result of new entrants in the private credit space that need to deploy money, either quickly or in large volume. Several panelists expressed caution regarding oversized mega funds that have been raised in recent years, warning that these larger funds will have more pressure to deploy capital in an undisciplined fashion.
Private Credit Specialty Finance Panel
- Daniel Zwirn, CIO, Arena Investors
- Bill Cisneros, President, Primary Wave Investment Management
- Barry Lau, Managing Partner & Chief Investment Officer, Adamas Asset Management
- Keith Lee, Co-Founder, Feenix Venture Partners
- Ben Radinsky, Managing Director of Research, Lloyd Crescendo Asset Management
The final panel focused on unique specialty finance opportunities that exist in highly non-traditional assets. Often these opportunities are available exclusively to a narrow subset of GPs possessing a specialized mix of experience, relationships, and patient long-term investor capital.
Ben Radinsky of Lloyd Crescendo Asset Management provided examples of financing student loans to Non-US citizens admitted into top tier graduate school programs at Ivy League universities. Facilitating lending opportunities of this type requires hands-on efforts in sourcing, credit analysis, and investigative verification – but the effort can be rewarded by capturing a much higher return versus “identical” risk student loans via traditional channels made to domestic citizens.
Other intangible opportunities in the form of Intellectual Property (IP) can present extraordinarily compelling return opportunities. Bill Cisneros of Primary Wave Investment Management specializes in music IP, and provided examples of acquiring IP rights and interests in music catalogues from renowned artists of past decades.
Mr. Cisneros alluded to the unique relationships that must be cultivated for sourcing and negotiating deals. IP assets usually do not go up for auction, and in many cases have been negotiated or extracted from the estate of a deceased musician or entertainment industry executive.
When it comes to investing into music IP assets, patient long-term investor capital and the right fund structure are critical. Music IP assets in many cases provide a high current distribution yield. Yet in addition to the cash flow produced, IP assets can provide a significant multiple on exit value – but only if investors can commit to an arduous long horizon with lock-up and extension options.
20 years or longer are often required to fully realize the potential value and properly secure exit value for music IP assets. Thus, investors must be in it for the long haul awaiting full return of invested money.
We hope that you can join us for upcoming events on the horizon in the Alternatives series: