Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com/audio. That's vanguard.com/audio. All investing in subject to risk vanguard marketing corporation distributor. [Music] Hello and welcome to the Credit Edge, a weekly markets podcast. My name is James Crumby. I'm a senior editor at Bloomberg. And I'm Arnold Kekuda, senior analyst covering banks at Bloomberg Intelligence. So this week we're very pleased to welcome Michael Gross, co-founder of SLR Capropartors. How are you, Michael? I'm great today. Thank you for having me. Great. So a little bit of a Michael. So he comes from the vaunted credit lineage that includes working at the junk bond king, Michael Milkins, Jeksel, Burnham Lambert, in the late 80s. And then he helped co-found what is now the credit juggernaut Apollo with his colleagues from Jeksel. And then in 2006, he co-founded his current shop, SLR Capital Partners, which is a private credit investment manager with a multi-strategy approach that has I think last I checked is 13 billion of investment capital. And it's public BDC. SLR Investment Corp, ticker SLRC, has two billion of investments, which currently have, I checked, zero nonacruals, zero. So we'll definitely have to ask him about that later in the show. But before we do that, I'll turn it back to James. Thanks, Arnold. Great to have you on the show, Michael. Some of you are prospective of your history. But I do want to start with the BDCs. You have one, as Arnold says. They become the ground zero for growing concerns about credit markets. The latest three-letter acronym that people think will blow up the financial system. We are talking about business development companies. That's the type of investment firm that lends to small and mid-sized private companies. Sounds pretty boring. But while the drama, Michael, have they made a lot of bad loans? Have they taken on a ton of leverage? How worried should we really be about BDCs? Thank you. And again, thank you for having me on your show today. Just to put in perspective, we have had a public BDC since 2010. So that's well before most BDCs have been in existence. So we're going under 16th anniversary. Having invested through multiple credit cycles, one of my philosophies, which ultimately becomes true, is that things are never as good as they seem, nor as bad as they seem or appear. And when things were going great in private credit, when things were on the way up, you could argue about what the opportunity was as good as everyone marketed out to be. But today, I do not think things are as bad as they've been played up. The media has had a field day with Pyleon, and it comes from really several different circumstances, began with the few blowups of first brands and tri-color, and then MFS. We can talk about those. Those were each fraud situation, so not systemic to private credit in general. And then the latest fear, two fears, was software. And the impact on people's portfolios, because some 20 to 25% of public BDCs, as well as private BDCs and private credit funds exposure, is to software. And then that fueled a big degree of fear by retail investors, which fed into redemptions on the non-listed BDCs in many cases, ended up being more than the required 5%. That said, if you look through people's portfolios, that they reported on in Q4, there were very few defaults in commercial defaults. And so, no, I do not think things are as bad as they've seen. Nor do I think it's creating potential systemic risk, because by statute, BDCs cannot be levered more than two to one. And generally, they're levered one to one and a quarter to one. So there's not much financial risk in the system, even though the commercial banks have provided that leverage, they're not really at risk from my perspective. Got it. So I think a lot of the concerns you've mentioned, and I think you've talked about some of this liquidity premium, right, that private credit does provide. But is that suitable, you think, for the retail clients, who are really worried about all this gated redemptions going on right now? Well, I'd answer a couple of ways. One is, you know, private credit was built on the expectation that you would get a reasonable, illiquity premium for giving up liquidity. And that illiquity premium used to come in the form of two to three new basis points above the on with the public markets offered in leverage credit. With the explosion of our asset class and some $200 billion now in the non-listed BDCs, which has created intense competition for loans by the lenders, that illiquity premium has shrunk, probably argued with two 100 basis points. And that causes some concern. Investors in these non-listed BDCs have known from the very beginning, or should have, because it's very prolific. It's in the documentation upfront that you are limited to 5% liquidity per quarter. So that should not be a surprise. And, you know, arguably, you know, the FAs who put their clients into this should not put their clients into it. If there was a real desire for real liquidity, because these never were meant to offer that. Do you think there was a misscelling then? You know, it comes down to incentives as do most things. You know, FAs generally get paid, based on how much capital is put into these vehicles. And their clients may not necessarily be well aware of what they're putting into them. Okay. And on the illiquity premium, we've had a lot of discussion around that. And you're saying 100 basis points. What's that for? Is that for a kind of standard leveraged loan in private versus BSL, brought these engage loans? Is that the sort of. Yeah, so I'm glad you brought that up, because we're kind of talking private credit in one big general category. And, you know, the vast majority, some 90% of the capital has been raised in these non-listed BDCs, if not more, are for really one strategy, which is lending money to private equity backed LBOs. And that's what's competing with the leveraged loan market. If you move to other more esoteric areas of private credit, like asset-based lending, you're still getting significant illiquity premium. And I would argue that it's more than illiquity premium, it's complexity premium. Strategies that carry complexity, that therefore encourage less competition, and have allowed investors like ourselves to get excess returns, even in this compressed environment that we're seeing. Seeing. So, and I think that's, you know, when you talked about on the call, that's, right? You've seen all this crowding within this private equity backed cash flow lending. And, you know, I think you guys have pulled away for that moving towards this ABL lending, which still has us, I think you call it the complexity premium. But what are some of the positive and negatives, I guess, of maybe not having a private equity affiliate? Great question. One of the positives is you're dealing with counter parties that don't have the luxury of having a capital markets person that can go out to the marketplace and say, "Fill into blanks this term sheet, you five or ten different private credit providers and fill in the lowest rate, the least amount of covenants, and that's who we're going to take." That doesn't happen in asset-based lending. The asset-based loans are so complex and one-off that you have to directly originate it, directly negotiate it, and you have to monitor it. And so we're lending in these situations against hard assets like receibles inventory. We become their working capital facility. And so it's a very much a relationship driven loan, but it's one where the the borrower doesn't have 15 or 20 different opportunities to go reprice your every quarter if they wanted to. The negative one would argue is you don't have the backing of a depocketed private equity firm that will bail you out if and when there's trouble. That sometimes happens, doesn't always happen. But the flip side is when you're lending against inventory and receibles on a borrowing base, and you have very tight documentation, you can protect yourself without relying on other people's capital to do so. And you can protect yourself by exercising your rights as a lender. And if worse comes to worse, you can liquidate the collateral and pay yourself back. Does it be clear is that what your fund overall does or is that what the BDC does in terms of this asset-based lender? That's what our funds overall do today about if they look at our public BDC, about 75% of our assets are in our specialty finance asset-based lending strategies. It's less high of a percentage of our private funds, but it's still our dominant strategy. Okay, and there is a complexity to it, as you say, and that is already worrying some people that all these comparisons to the previous financial crisis that there was this complexity. There were structures that people didn't really understand and they were levied up and they were kind of blowing up and we didn't know what was in these stretches. Why is this different? An asset-based lending? Yeah. I talk about being complex, but it's also simple. We're lending against hard assets on a unilateral, bilateral agreement.
directly against the bar or we're not buying portfolios, they're not levered portfolios, we're able to go in and say, this is the inventory, this is the receibles, we're gonna verify its existence and then we're gonna apply a bar and base against it. We then once the loan is made and this is back to complexity, but we have, he mentioned earlier, you mentioned earlier we have 13 billion of capital management, we have 330 people, 260 of those people are focused on asset-based lending and most of those are focused on monitoring our collateral on an ongoing basis, which allows us to be very close to it. So there isn't this opaque environment where we don't know where lending against, so there's leverage upon leverage, these are direct loans that we know at Zachoverl lending against. - And what's the collateral? - Inventory and receibles for the most part. We focus on collateral that we think we can turn into cash in 30-90 days. So we don't lend against oil rigs or airplanes or ships, we won't lend against commodities, whose value could fall off the cliff or go way up like oil today. - What kinds of companies we're talking about in terms of receibles? - So generally these are smaller companies, but what's very interesting is if you peel the onion in these companies, most of the receibles are investment grade receibles. So the receibles from people like Amazon or Google or Microsoft and so we get to lend to companies that would otherwise be rated maybe B-minus, we even triple C, but the collateral we're lending against is investment grade collateral, but we're still getting 11 to 13% returns. - And it's business services, it sounds like. I mean, it's not a retail business, it's not a, I don't know, what kind of sectors are we talking about? - It could be almost anything. It's really, our focus really is what the counter-private receibles are. So it could be someone who sells goods through Amazon. It could be someone who is providing services to a Google or Microsoft. - And why is then the longstanding relationship bank that's not doing this? Why does it take a non-bank lender like yourself to step in? - So one of the benefits for us of the regional banking crisis that took place a couple of years ago is that banks were forced to kind of exit some of those businesses 'cause of the regulatory complexity and because of the capital charge, associated with these smaller companies. These companies would otherwise be criticized as by the Fed 'cause they're too small, they don't have great financials, they may be operated at a loss. That's where we can step in. We're not regulated. So we're not burdened by those requirements that the Fed puts on the banks. And so we can step in and provide these facilities where historically our competition was a commercial banks, but they're not as much a competition anymore. - Got it. And then obviously it's been a few years, I guess over three years now since SCV has failed. So regionals are back. And then with the Trump appointed Fed, we're moving more towards regulatory easing. Bank capital requirements are coming down. We're gonna have some big news tomorrow. And I think the goal is to try to promote more long growth coming from banks. So do you see that as a potential, I guess re-encursion, I guess, of banks back into some of the stuff that you're doing or has kind of the horse already left the barn? And it's already kind of too late. - So I think for many of these regional banks, the horses left the barn because they stopped doing it or they got rid of their teams or they sold the business off. I think the biggest benefit here, the Fed easing, is the big money center banks. This will allow them to be more aggressive in leverage lending, which will benefit ultimately the private equity community. It will provide more direct competition to your traditional private credit. - Got it. And then you talked about the receivables and collateral financing. And some of the fraud cases that you mentioned actually, I think were based on kind of the receivables and IE the double pledging of collateral. So how do you avoid that kind of situation? I mean, I think we've seen this double pledging of collateral come up in multiple cases with like, you know, first friends and even more recent MFS. So what are some of the checks and balances? And it seems like most of this, right, is within the banking space, right? And that's a lot of-- - Yeah, at the end of the day, from our perspective, it was all avoidable. I'd start off by saying that when we think about our asset-based lending, when we lend against receivables inventory, we are typically the sole lender to these companies. So we have all their collateral. And we cannot allow that double, it can't happen because we're the only lender to it. The other thing I would add is, the biggest risk in asset-based lending, we're hitting the nail in the head is fraud. And you know, how do you avoid fraud? You avoid fraud by doing tremendous amount of de-diligence going into the transaction. The interesting thing is, when we look at a new perspective lender from ours, we typically get a deposit for de-diligence from the counterparty. The first dollar we spend of that deposit is a deep, deep, deep background check of the owners, the management, the founders. And in each of those situations, try calling first brands, you would have found a history that would lead you to conclude you shouldn't lend to these people. And for us, it's black and white. It doesn't matter that something happened 20 years ago that someone did some kind of financial shenanigans. We're a credit investor, so our upside is getting our coupon back. Our downside is we can lose a lot of money. We say no if anything appears gray. So both those situations were completely avoidable. How often have you said no recently, such that we could shine light on the potential for more of these things to. To come out. We have said no recently, probably. It probably happens to us three times a year. It's not just fraud. It's other illicit things that someone made on the past. But in these good times that we've had for many years up till maybe a few months ago, surely someone ended up lending to them. Yeah, look, I think one of the negatives of the explosion we've had in credit is that underwriting standards were compromised. People were sloppy. There was a real need to put capital work quickly. And things were ignored because they thought, "It's not going to happen to us. It's not going to happen again." And the other thing I would add also is a lot of these situations were underwritten and syndicated loans where the underwriter wasn't going to hold the loans at the end of their own balance sheet. And so their incentive was to package it and sell it off as quickly as possible. And the level of diligence that takes place on those type of situations versus by someone who's actually a principal investor is dramatically different. How bad was it though in terms of history because you've been in these markets for quite a long time? Is it just as bad as it was pre-financial crisis or is it way different to that? In terms of finding fraud or in terms of the lack of underwriting that was going on? I think it's-- look, again, I don't want to say it's lack of underwriting, but in terms of willingness to accept higher leverage, lesser covenants and lower yield, it's definitely increased. And you can point to the explosion of the analysis of BDCs having grown to $20 billion in the last five years. Those structures demand that you put the capital work in the month that's taken in. And so the investment decision that used to be by a private credit manager would be, do I want to draw down capital because it's a great opportunity versus I just received capital and maybe it's a decent opportunity has changed the dynamic. So I guess before some of these issues had popped up a couple of months ago, there was talk about putting private equity into 401Ks, and stuff like that. So do you think that still progresses? Or have we kind of approached an area of like, OK, now, we're more of any net redemptions versus money coming into the space? I think it still progresses. It may slow down. And I actually still think retail, whether it's 401Ks or high net worth investing in private credit, private equity is still a good idea if it's done the right way and with the right manager. The interesting thing is up until the last six months, we had been in a benign credit environment since the GFC. And we went through a period of 11, 12 years with virtually no defaults. And literally everybody within private credit did well. A rising tide lifted all boats. That's all changed. And for the first time in a long time, we're in an environment where two additional things are incredibly relevant. One is manager selection. And the other is asset selection by the manager. And that's really changed the underwriting that people need to do when they decide whether they want to be in private credit and who they want to be in it with. And I think this is a good segue to you were in a Bloomberg article saying, hey, your public VDC only has about I think 2% exposure to software. So that could potentially be more of a safe haven within the space if people are concerned. So is that really the big thing to worry about right now and VDC private credit? The software exposure or is it something else that people should be worried about? Look, I think when talking about private credit within cash flow lending or lending to private community about companies, I think there's two things to be concerned about. Software is definitely concerned. With 20% plus exposure, there's definitely to be some downside and some pain. I can't tell you how much it's going to be. But we all know that AI will have an impact on many of these companies. I think what people aren't talking about as much, because it's not as retail-oriented yet, is if that's the case for private credit, then what's the case for private equity? Whether the largest percentage of deals done in 2021, 22 were software deals.
And if people are concerned about, you know, private credit taken hits, then the impact to private equity is exponential from that. The other thing I think people should be concerned about within traditional private credit is just the sheer amount of volume that took place over the last few years and the potential relaxed underwriting standards took to do that and the acceptance of, you know, lower yields and lesser structures and less covenants. And you know, with general people's portfolios are healthy. So I don't see, you know, a whole swath of, you know, defaults coming down the pike. But what I do believe is that the loss given defaults will be higher than we've historically seen. And what I mean by that is if you look back at data from Moody's, for example, they typically publish that when there's first lean bank loan defaults, the average recovery is 70%. Well, the issue with that is most of that data was from loans made when there were covenants, which allowed a lender to get the table before it's too late. Given that the vast majority of loans being done today within private credit to private equity firms has virtually no covenants, my concern is that the loss given default will be much higher and the recovery instead of being 50% could be 40 to 50%. Got it. And then, you know, I have to ask you about the zero non-accruals. And I think your fund has, the BDC has, typically lower right now, the coals. How can that be when you have hundreds, I think maybe close to a thousand positions? So is it a definitional thing or is it better investment picking or could you kind of delve into that a little bit, please? Sure. I think it's for a number of reasons. First is, you know, philosophically, we still view private credit as an investment business and not an asset accumulation business. So what that translates into is myself and all my partners and literally everyone in my firm are investors in all of our funds and we take a significant everyone's comp every year and roll it back to the funds. So everyone views himself as principles. That creates a different discipline. People have to ask themselves, do I like this loan so much that I want to own it myself? And if the answer is no, we just don't do it. And so by not being focused on growth for growth to sake and still being focused on investing for investment stake, it brings a different discipline. But that's also what's led us to kind of pull back from cash for lending and treat that as an opportunistic business and focus more on asset based lending, which can be more of a day-to-day business from an opportunity perspective where our downside is much more protected. And so when we look at our cash for lending portfolio, to your point, we have, you know, we have a total of 2% across the entire firm and software. We're concentrating things like healthcare that we're very good at, but we're staying away from, you know, all those other volatile industries. And importantly, we don't have to get our diversification by being a lender to every sector within cash for lending. We get a diversification from everything else so that we can be really focused on what we're willing to lend to. And that's created a different discipline. And in general, we're good at what we do. We're very good at what we do. But in general, asset based lending, if done the right way, and again, financing current assets has a very low historical default rate and a very high recovery rate. How exposed are you, though, to the US consumers under pressure from inflation now and other parts of the economy kind of cracking? I mean, consumer discretionary, particularly that is a big part of the leverage loan index. I'm assuming there's a similar proportion in private credit. So again, you know, if we look at our cash for lending portfolio, we have literally very little exposure to consumer discretion. We don't do any consumer discretion. We don't do cyclicals. We don't do commodities, energy, retail restaurants. We'll lend to those types of companies like retail restaurants. If it's an asset based lending, then we can grab that collateral. But because of your exact point where consumer spending can create volatility, we stay away from the industries in cash for lending. How much leverage do you have at the moment? Against our portfolio? Yeah, about 1.2 times. Okay. So in terms of the loans underlying it, we are seeing a lot of concern about mark downs and, you know, marks in general and transparency. But how often are you having to mark down these loans every quarter? So we have to mark our loans every quarter by statute. But as you can see kind of from our performance and the fact that we have known non-accruals, we've had very little mark downs over the last few years. What about redemptions? Our public BDC doesn't have the ability to redeem this public and we don't have a non-listed BDC today. Okay. So do you see that as an issue generally? I mean, back to Arnold's point, you know, that there are lots of concerns on the retail side. Maybe they should have read the paperwork more thoroughly. Maybe their financial advisor should have sat them down and explained what they were actually getting into for that extra pickup in yield. But, you know, there is kind of an outflow story feeding on itself, maybe not your BDC or other BDCs. What impact is that having? So right now, Crea, it's creating concerns, it's creating volatility. Do you not see, you know, large sell-off of loans by these managers, they have the liquidity whether holding liquid loans or tapping the revolvers to pay out the redemptions? I think I, I personally look at as an opportunity. I think the fact that there's redemptions and the fact that inflows are slow, I mean that the amount of capital that's available to go invest in private credit, is it a common pressure? And the way we approach capital lending is we tend to be aggressive when there's dislocation and when there's just capital flowing in, we stay away because it's too competitive. So I personally think that with kind of this, with what's going on today, you're going to see the leverage loan market pull back a little bit and you're going to see private credit spreads increasing, which is going to create an opportunity for those of capital available to put it more attractive returns. We, for example, in 2023, when the leverage loan market closed down, everyone talked about that being the golden age of private credit. And for about six months, it was pretty golden. You can invest in well structured LBOs that already been private for two to three years. You could get returns 11 to 13%. You could get covenants and leverage was probably close to five times. And everyone was very aggressive during that period time, including us. But we viewed it as a trade because we knew that the minute the leverage loan market came back, every private equity response would be pounding on our door, saying, you have two choices, SLR, you can either reprice me and hold the loan at a lower yield, or we're going to go refinance you either to another private credit fund or the liquid loan market. Our response was simple. As a lender, we love getting repaid. Please pay me back. We'll take that capital, reallocate it to our special sheet finance strategy, which we're still getting 11 to 13%. Most of our peers, given that they were in one strategy, which was casual lending, accepted the repricing. And so you could see going back to the end of 2023 yields within the public BDCs have come down about 25 points a quarter. Whereas our yield have not come down because we're able to redeploy into those higher yielding strategies. As of now, is this the time to buy those assets you've seen good enough prices? Because the sense I get is that there is a lot of cash out there, but prices have to go down quite a bit more before everyone gets excited. And we've looked at what Sabah did. Boaz did, you know, he's offering basically 65 cents for some of those blue-al Portfolios. So that's a big drop from where we are now. I'd be surprised if investors take that up. That's a silly discount. That said, public BDCs are trading at anywhere from 0.5 or lower of NAV to 0.85 or 0.9. I personally think that people have thrown the baby out of the bathwater. I think selectively within those BDCs, there are opportunities. I personally, in the last three days, have bought a significant amount of shares of our BDC. I'm a believer. But I think from an investment perspective for us as a manager, I think we need to spread a little more before we get more excited about putting more money into cash lending. So you guys had a nice call out from grand investors, I guess, back back in October. And I think some of the story might still be similar, given low software exposure, low accruals. But what concerns you? I think we've seen JP Morgan kind of pulling some potential, lowering the credit lines to some private credit firms based on their software exposure and stuff like that. So is that kind of this reversal of some of this funding, not only from the investor side, but then from the bank side as well, is that a concern that that may eventually creep up? What are some things that you're looking at? It's definitely a concern. If you think about the private credit universe, whether it's the public BDCs, the private BDCs or the private credit funds, we're dependent upon two sources of capital. Equity from our LPs or public investors and leverage from our counter parties. And we all borrow money, those of us who are large up, we borrow from the investment grade market, which is driven by the insurance companies. And we borrow significant amounts of money from the commercial banks who've been very aggressive lending the space because it gets very favorable regulatory treatment. But as we know, when people get nervous, the pendulum swings. And so you start to see banks get nervous and start to pull back whether it's JP Morgan reduced their advance rates or people started to be more select about who they borrow to by either not lending to people or by raising rates. So the net effect is it's going to increase people's cost to capital, which will make it hard for people to invest efficiently. But I do think that if you think about the impact of that as well as kind of the response of people pulling capital out and people
performance, it's going to create for the first time, you know, dispersion people's performance in our space, which we haven't seen for a long time, which I think will eventually create some kind of shake out in our industry. Got it. And then I think you talked about some of the, you know, the yields in the AVL space being still pretty high and not so rate dependent. So, you know, what if we do, I guess now we're kind of in this model, you know, rate rate area given given all the inflation concerns, but if is it an advantage for you if rates go down or go up or stay the same or does that really not matter? It certainly matters, but it doesn't matter much to us as it does to people who are just in casual lending. So, what's interesting, you know, our average yield in our special lending strategies is somewhere between, depending on the strategy, between 11 and 15%. When rates spiked up, we really couldn't move our rates much higher because it would probably have hurt many of our counter parties. So, our rates didn't go up nearly as much as people in just pure cash flow. By the same token, when rates come down, our yields don't go down as much either because our lenders are more consistently accustomed to paying kind of a total return as opposed to a spread. And so, we're obviously cognizant we watch it. It will impact us, but not as much as others. I'd like to go back to one of the point you made though back to your comment about banks lending to our vehicles and our competitors vehicles. One thing I would say is I think there is, I don't want to say hysteria, but there's kind of overblown concern about this in terms of systemic risk. You know, most people are levered one to one, one and a half to one, as opposed to, you know, banks being levered 10 to one or, you know, looking back at the GFC when all that stuff happens, levered 20 or 31. There's, for my benefit, I have no concern that banks will lose money lending to a private credit fund. In fact, if you look historically, no bank has ever lost money lending money to a private credit fund or a BDC. You'd be hard pressed to find someone who's that bad of an investor that's going to lose half of their market value or of their loans, making senior secured loans. So I, you know, throw some caution against people being overly concerned about the impact on commercial banks. But we have seen some big write downs. I mean, Blackrock had a loan that went from 125 to zero, you know, so yeah, but that hit the equity of the fund, not the not the not the lender to the fund. Okay, so you don't think there's going to be a big set of defaults, but you did use the word shake out in private credit. What does that mean? Is it some companies going versus it consolidation? What's the shake out? I think the shake out is going to be that you're going to see a disparity in performance. So you can see people who still can put up nine to 11 percent net returns. And then you're going to see people who have much more defaults and others and have returns that are low single digit. And once that happens, those people who perform that we're going to have a very hard time raising capital to continue to be in the business. And you don't think this most recent shake out is going to stop completely the retail participation. I don't think I think it'll it'll slow it down and put a positive, but I don't think it's going to stop it. And what needs to then happen to sustain it? Is it really just expanding to the retail customer? What this actually does and how it works? I think it's that. And then showing people that as we work through this cycle or period of time of uncertainty that most people are going to come out just fine. Right now everyone right now everyone's assuming if you look at where the public BDCs are trading, everyone's assuming that we're all going to have a wave of defaults. That's just not true. It's not going to happen. There will be those who have that. But once we get through kind of a six ninth period and see, you know, more, you know, points in the scoreboard or more results in the fact that it's not true. And you see, hopefully BDCs trading back to where they should be. You're going to see dispersion. Those who are trading well because of performing and then those who are trading poorly because they're not. So Michael, we've had some pundits, you know, talk about, oh, this feels like a pre-financial crisis, you know, people are doing dumb things and stuff like that. So what do you have to say to that? I look at having lived through that crisis and others. I don't think this is anything like that. We don't have systemic risk. We do have, you know, a situation where the asset class is exploded. And so people will put out a lot of money at lower yields with worse structures. And that's going to have an impact. But I don't think it's going to be anywhere near where we experience back then. I think you're going to have, you know, a few funds or BDCs do really poorly. And you've got most of them do just fine. And you're not going to see, you know, capital structures within these credit funds blow up and creating issues for the banks or any other lenders to these entities. How high does the default rate go? You know, it could go, you know, five to seven percent. Okay. That's just a Michael Gros gas. Okay. And I think it'll vary. I think you'll have all those who will be at one or two percent. And you'll have, you'll have those at 10 to 15 percent. We've seen forecast for as high as 15 percent particularly in software. Getting that's I think I think software could be that high. Right. It's definitely possible. Right. Look, I think, you know, we have, we have, I believe we have of our two percent software, we have three loans. And, you know, interestingly, one of them approached us and said, you know, would you like to, you know, amend and extend for a few years. And they were going to offer additional pricing. And this company is doing just fine. It's doing fine. It has cash flows, ebit.com, it's media, it's requirements. And my co fund, Bruce and I spoke to the investment team. We said, we hear you it's doing great. But frankly, you couldn't pass enough to stay in. Why? Because the upside is it does fine. And we get a coupon back and we get called out early because it's doing better. The downside is, AI hurts it. And we're going to lose a lot of money. And so, because we're credit investors and we don't really get paid to take risk, our response was very easy, which is no. The asset-based financial you're talking about, that is something that a lot of people have been looking at, including your former friends at Apollo. And everyone's talking about it as a percent to your 40 trillion dollar opportunity. But you're competing against the pretty big guys. I'm wondering how you how you come up against them, whether being small is is advantage to you or, you know, do you need to scale up to do best? It's a great question. And so, we've been doing the database analysis in 2009. People have been talking about getting it asked by somebody for the last two or three years. And it's primarily coming from the large guys like Apollo and Black Stone and KKR. Why? Because the parts of ABL that they're focused on are incredibly scalable. They're not doing what we're doing. What they're doing is they're buying ABS, asset-based securities. They're buying portfolios of consumer-based loans primarily, whether it's credit card receobles, student loan receobles, card loans or mortgages. These are loans that are not originated by them. The originated by third parties and repackaged and sold to them, which can be a great business. But it's not what we do. We don't see any of those guys in our business. So this is a situation actually where being smaller and nimble is actually highly valuable. These businesses that we're in are incredibly difficult to scale. They take a lot of people. But for us at 13 to 14 billion, they're very meaningful to us. But for an Apollo to go after a factoring business where we have a billion dollar portfolio, if I'm going to go to portfolio, it's not worth it to them. So we don't see them as competition. They're not putting pressures on our yields. And we don't really see them in all of our businesses. And they're not like to come for you. When we talk about what it takes to be successful in this business, they always say, well, scale number one. You just still think you're protected because what you're doing is too much of a need. Yeah, I think, you know, I touched it earlier in our conversation about complexity. These are businesses that carry complexity premium. And it's not something you can wake up and say, I want to be in business today. You have to have the infrastructure and teams that can actually go evaluate that collateral and protect it. And so no, I don't I'm not concerned about that. I actually think that we actually were in a day and age where there's actually some disacconnories of scale. Scale is definitely important. You need to be able to track the right investment professionals, the right cost to capital, leverage from your borrowers. But scale can also be a detriment. And that detriment is if you become too big, you become the market. And you have to chase opportunities that may not be the best investment opportunities. And when you use the receivables, a lot of people do think of trade. Trade has been very difficult because of policy, particularly in this country. How are you navigating that? How does it affect your business? So 95% of receivables are domestic receivables. Okay. So these are again, companies that have either produced something domestically or provided a service domestically. And the people they're selling to are domestic companies. So you talked about, you know, the current zero non-acruals. But I guess as a credit guy, I didn't think I mentioned this today, but like, are you being too conservative? Like, what's the right target? Like, are you missing some, right? Are you taking too many balls? And then you're not taking enough swings. Are you that type of question? So again, we're definitely not perfect. We have had non-acruals in the past. We will have them again as painful as they are. But you know, I'm glad you asked that question because I actually thinking credit especially.
ship you're not focused on growth for growth sake, there's no such thing as being too conservative. One of the things I learned when I transitioned from private equity to Apollo to private credit Apollo, but creating their BDC, AI and via Apollo investment court, was that when you're private equity investor, you can be right three quarters of time because your 40 percent return deals at offset your losses. And credit, what I quickly learned when I made the transition is you have to be right 9.9 percent of the time because you don't have any upside of equity to offset your losses. And so from our perspective, and this has been the culture of SLR from day one, as I mentioned earlier, we act as principles, we only eat vessel loans that we'll own ourselves, and we've realized that our return profiles are symmetrical. And what I mean by that is because we have very little call protection, the good loans get taken out within two or three years because either they get reprised, the company gets sold, and the bad loans you wish you never made. And so in the business where the only thing you get is your coupon and maybe a little some fees, we're not paid to take risk. And so our culture is that when we see hair on anything, we say now now have we missed out on opportunities, especially in this benign credit environment, could be a grown much faster than we have. Absolutely. Would we have been able to sleep at night? Probably not. And talk about these asymmetric returns. I think this AI boom and the funding of that, I think we've heard like Kyle Marx talk about that. Maybe that's more of an equity play versus all the debt financing needed for that. So are you guys involved with some of the AI catbacks build out or is that an asymmetric return that you talk about? Look, we're not involved in that. I think if you want to play kind of AI, I think you kind of want to play on the equity side. Got it. Imagine your long history and private credit going back all the way to Apollo in 2006. It's really taken off over the last few years. People are talking about it a lot more. When I talked to private credit, people who have been doing this a long time there was kind of laughing about how we used to be the boring guys that normal to talk to in the back room. And now everyone wants to put us on the stage. I'm wondering from your perspective, I mean, where are we in the evolution of private credit and where do we go from here? Look, I still think we're, you know, to use a baseball analogy in the fifth inning. We have a long way to go and this could be an extra inning game. The asset class, to your point, you know, five years ago, no one really talked about it. Wasn't something people wanted to do. Now everyone at three wants to do it once investing it. We still see tremendous interest from the institutional community in the asset class and and desire to put more capital work and hit their allocations. But what we are seeing from them is a more discerning way to do it. Five years ago, when we talked to institutional investors whether it's pension funds or downmints and we talked about our multi-strategy approach and asset-based lending and life science lending and factoring and receibles, their eyes would glaze over. Why? Because they weren't quite ready to focus on more asset-toric parts of private credit. They were going with the the plain vanilla cash lending that was available and it was a good time to do it. Now we talked investors, it's a much different scenario. They say we have plenty of exposure to traditional private credit. We actually have a tremendous amount of overlap amongst our different people we invest with because they own the same loans and we need to get smarter about other parts of private credit whether we can grow into it. So I think we're going to see a lot of growth into those areas. In terms of hard asset. Yeah, well credit. And there's not a sort of contagion across from direct lending right now when you go and talk to potential investors about, oh no these headlines, all this stuff I'm seeing. And see you took a swipe at the media earlier but that's fine. But the jellyfish, the cockroaches, all this stuff that is freaking everybody out. So they're not just saying, well, forget about, I just want to say in a four and a half percent tea bill which is, you know. They don't say that but they're also a lot more careful. The amount of scrutiny that we've seen because of things like first brands and try color. The amount is put down we have to spend with existing investors and business for a long time kind of reeducating them that this is not what we do and therefore you don't need to worry about it with us is a lot. But that's time well invested on our behalf because we need to show people that we are different and that there's a different way to play private credit than people have historically. Which is kind of a good thing, right? I mean it's a you know sign that this market is growing up. Yeah, it is. I mean you've come through a period of astronomical growth and as an Indian industry, you know, it becomes growing pains from potentially growing too fast and then there's typically as a shakeout that takes place where, you know, certain people who were too aggressive and did to your earlier comment dumb things during that period of time will pay the price. Michael, what else is on your radar to worry about? I mean there is there is a lot going on but you seem pretty chilled out. So what's the outlook for you? Look, I think you know, as credit investors, we always worry. You know, while we don't have many things that are watchlist, we watch our portfolio extremely carefully. You know, I share your concerns about, you know, the banks. I think we are going to see them pull back not just from a pricing perspective, but in terms of access to capital for, you know, people like ourselves. That's how the pendulum swings. And so I think unfortunately, you know, we're going to see the impact of other people's, you know, bad performance on those who actually perform well. And that will, you know, cause some slowdown in being able to deploy capital. The other thing just to echo on your comments earlier too is I think, you know, this was also supposed to be a big year for PE exits. You know, if the if the leverage low market and the private credit market, you know, around pause and spreads wide and that's going to slow down. And there's been, you know, real concerns amongst the PE investors because there's been a real lack of liquidity for them for several years now. And that will also have an impact on private credit because those some same people who are investing in private equity are investing in private credit. So that's it's all, it's all related. And we could see more frauds potentially when you talked about trickle law and first grounds. You know, look, I don't think that's necessarily a pattern. I think those are all isolated incidents. And they're going to, you're going to see one or two a year here and there. Yeah. Okay. To close it up, then it's, it's looking like you're going to ride through this latest storm and we're going to see the light on the other side. Yeah, look, I think we're fortunate. We have a lot of liquidity in our ballot across all our balance sheets. We have a lot of capital to invest. We're not dependent upon raising third party capital or barring much more additional money. So we kind of look at this as long as our portfolio is healthy, which it is to what's its investment opportunity. This this volatility creates more opportunity for ourselves. And we'll deploy our capital on a very efficient and conservative basis as we see opportunity. And I think as we said, the sort of pitch yourself as a software light BDC, how's that pitch going? Are you getting a lot of calls? Yeah, we're getting a fair amount of calls. I think people kind of appreciate that we were discerning going into this. But you know, everyone's concerned about it. Great stuff. Michael Gross co-founder of SLR Capital Partners. It's been a real pleasure having you on the credit edge. Many thanks. Appreciate it. And to Arnold Kakuda with Bloomberg Intelligence. Thank you so much for joining us today. Always happy to join. For even more analysis, read all of Arnold's great work on the Bloomberg terminal. 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