Davidson Kempner Sees a $770 Billion Stressed Debt Opportunity

00:00:18 Speaker 1: Hello, Welcome to the Credit Edge, a weekly Monkeys podcasts. My name is James Crumbie. I'm a senior editor at Bloomberg, and. 00:00:24 Speaker 2: I'm David Haven's, a senior analyst at Bloomberg Intelligence. This week, we're delighted to welcome Susie Gibbons, partner and head of research at Davidson Kempner. Susie, how are you. 00:00:32 Speaker 3: I'm great, Thank you, thanks very much for having me. 00:00:34 Speaker 2: Well, that's excellent. It's great having you here. Davidson Kempner has been around for about forty years and has managed assets of about forty billion dollars, so some nice symmetry there. There are always a few things going on in the markets, but geez, Susie, it's feeling like we're getting to that drinking from a fire hose stage again. Tons of questions about private credit, resilient spreads in other areas of credit, Iran and America clashing over who gets to close off the straits of horn Moves and twenty percent of the global oil spigot. And I know you've got some interesting thoughts on equity versus credit allocations, where to go in the private markets. You've had some terrific white papers that you've published on your website. 00:01:12 Speaker 3: Thank you. 00:01:12 Speaker 2: We have a ton to talk about and I know that James is champing at the bit to get started. 00:01:16 Speaker 1: Thanks Daviy Dan. Great to have you on the show, Susie, we do have a lot of questions despite all of what you've laid out, David. Credit markets are sailing quite calmly through the shot waves from the Iran war, although private debt is keeping everyone on edge as the gates slammed down on retail funds suffering a wave of redemptions. But there's just a ton of liquidity out there. Every dip seems to get bought, and investors on this show are sounding pretty bullish about the fundamentals and the technicals for corporate credit. They assume that the cycle just keeps chugging along. But Susie, you're seeing a lot more worrying stuff out there, and I'm interested in, you know what, why, you know why we're missing that and what's the real story under the surface there. 00:01:53 Speaker 3: Sure absolutely happy to share that that was actually one of the motivations for the recent white paper that we published, Optimizing the Efficient Frontier Opportunistic Credit amid a capital structure reset. What we have been seeing is for the past few years a delayed problem in leverage credit markets which has been building, and so we really wanted to dive into the data and describe that. On top of that, we've more recently had the issues in software come to the surface. That was actually something that we flagged back in a twenty twenty four white paper called Tides of Credit. At that time, we did not know what AI disruption would look like, but we saw a high level of concentration in software lending. In the direct lending market at the time, it looked like the low twenties percent, and in leverage loans it was in the mid teens. And we didn't again know what these models would look like, you know, fast forward a year later, but with our lending cap on, we thought that anytime you have a lot of disruption in a sector, as a par lender, that's pretty uncomfortable. And so fast forward from the time of that paper to this past October of twenty twenty five, I think this came to a head in public markets where you had very high quality software companies reprice in terms of enterprise value multiples and that and we can talk about that more and what that means for losses. But that really has directed a lot of attention on the leverage credit markets. But again, what we found in our research is that the problems in leverage credit are broader than software, and as I said, they've been building. I think we'll talk about the default cycle and how this one is very different from past default cycles that we've seen, where what we would call moving from a period of soft defaults to hard defaults. But the data that we dug into suggested that the leverage in the market is actually a lot higher than people appreciate, and I think that's been masking the problem. 00:03:51 Speaker 2: Yeah, there's it's an interesting topic because I'm the BDC guy here and I read about BDC credit, So I look at the private bd privately traded BDC is the public BDCs, And the data that I look at is by definition, historical data. So I'm looking back, you know, over the past couple of quarters. But I'm not seeing the I shouldn't say. I'm not saying the BDCs are not reporting an increase in non accruals. They're not reporting, you know, any substantial change in payment in kind income trends. Now, there might be something going on below the surface on both of those measures. So if I look at BDCs and look at BDCs as a public window into sort of the private world of direct lending, what are we missing? 00:04:36 Speaker 3: I think a few things. For one, the issues in software are the acute focus, but they're not where the defaults are today. If you look at the Fitch Direct lending universe, the default rate for software, as an example, is one of the lowest default rates. I believe it's well under two percent. 00:04:52 Speaker 2: I think healthcare may be the highest. 00:04:54 Speaker 3: Yeah, that's right. Whereas if you just look at fundamental credit data. Fortunately, the Krol Stepstone Universe provides pre full coverage of all of the direct lending universe in the US, and we were able to analyze that data looking at leverage above seven times on reported EBITDA and let's get to that the difference between reported and adjusted EBITDA, because that's a root of the problem here. 00:05:18 Speaker 2: And also we. 00:05:18 Speaker 3: Looked at interest coverage ratios below one and a half times, and we found that slicing the market based on those parameters suggested that in direct lending and actually also in leverage loans, about a third of the market is stressed based on just fundamental credit data and in terms of defaults, which is obviously something that people pay attention to. You know, they've been above five percent in the Fitsch universe, but primarily soft defaults, similar to in the leverage loan universe the data that Moody's tracks, where we're on year three of having defaults above five percent. The reason I think that people haven't focused so much on this is that it hasn't manifested yet into losses because it's been the defaults have largely in direct lending, been picking based on non contractual pick so that the issuer has problems after the debt is raised, and so that's often a sign of in future issues because they can't afford to meet their contractual obligations. And in leverage loans, it's been a lot of liability management exercises which is not being able to address, often a refinancing because there's too much debt. Big picture, this all goes back to the broader problem, which was a lot of capital structures were formed during the low rate period I've call it twenty sixteen to twenty twenty two, and with higher rates they just don't make sense anymore. Not all capital structures, but there's a big enough portion of the market that is fundamentally stressed. 00:06:49 Speaker 2: Yeah, that that causing capital gets to be an issue. As you step away from the ZERP zero interest rate, you know, sort of phase of the markets beneath, you know, sort of are you seeing like these soft defaults. It seems like in order for them to transition from soft to hard we need a spark. It seems like there's no lack of sparks in the in the world these days. But we haven't seen that filter through yet. Do you think it's going to go slow and then all of a sudden pick up and peak. That seems to be the traditional way. 00:07:23 Speaker 3: So we we do think that it's starting to pick up in terms of now that especially with the Iran war, they're in sticky inflation. I think there's a greater level of recognition that we're not private equity owners aren't going to get saved by lower rates, and so in this past three years, understandably they've done what makes sense spot time with these capital structures, but I think there's growing recognition that there in many instances, there just is not a path to equity value, and so it makes sense at that point for the owners to hand the keys back over to the car editors. And so we are starting to see that increasingly, and I think it's likely that in addition to that dynamic, we still have this delayed problem in terms of just thinking about the repricing of enterprise value multiples. Just going back to the software example, it doesn't show up today in the stress. Some of these companies are still performing, but it's more of a question of the future refinancing being very difficult. And just to break that down in terms of just simple math, if you think about what happened in public markets or when a lot of LBO activity was happening in twenty twenty one, let's say public software companies were training at twenty five times, they were training around let's say twenty times in twenty twenty five. Fast forward to today, we're looking at high quality companies in the low double digits. And so the implication for a software LBO is if you purchase a company let's say at thirteen times EBITDA, and you financed it with forty five percent, you know LTV first lean and a second lean at going through fifty five percent, but you've had you know enterprise value multiple rerating let's say from thirteen times to eight times, and in many instances, based on the data we have seen, EVADAH has not improved. It. It's generally flat to maybe a little bit up, but there are fat tails. But even in that just average example you're looking and. 00:09:24 Speaker 2: That ebitdah maybe a little fugazy. 00:09:26 Speaker 3: Which was that's absolutely. 00:09:29 Speaker 2: With depreciation and interest added back completely. 00:09:32 Speaker 3: But just in that simplistic example, what started out as a first lean LTV of forty five percent is suddenly seventy three percent, and that second lean that was at fifty five percent is now close to ninety percent, and the equity value is down eighty five percent. So that's the looming issue. That is not what's coming to a head today, and we'll see where it manifest in terms of marks. But that I think is something that is creating a lot of worry for people. 00:10:01 Speaker 1: But to back up for a second, you're talking about third of the market being stressed. I'm wondering how you're measuring that and what market we're talking about. Is it public leverage loans and high yield bonds that we can see or is it broader Sweden and how. 00:10:12 Speaker 3: Much debt absolutely, So what we focused on was the public syndicated leverage loan market, which is about one point five trillion in the US, and the direct lending market in the US, which is slightly smaller. And we did not look at the high yield bond market because we actually don't think that that's where most of the problems are. A lot of times people look to high yield spreads as a proxy for leverage credit, and increasingly that's really not a helpful place to look. If you just look at the quality of high yield, it's increased dramatically over the last decade. If you look on a readings basis, the high yield bond market is currently close to sixty percent double B rated. That's up from about fifty percent a decade ago. In contrast, if you look at the leverage loan market, it's only twenty five percent double B rated. It's primarily B rated. And similarly, if you look at the direct lending market based on Fitch's ratings, there's no double B exposure and it's even more single B rated than the leverage loan market. And so that's where we focused on the leverage loan market and the direct lending market, and again I said, we got the data from Krol, Stepstone's Universe and Octas and what we did was we looked at reported EBITDA, which is important because we do think that in this period where you've had a flood of capital go into private equity and in turn leverage credit, you've had loosening of underwriting standards and one of the ways that that has manifested is in the way that EBITDA gets calculated. And so we had been hearing for a while about these low LTVs and direct lending and we were scratch our heads because we anecdotally we weren't really seeing that. But it was very helpful to get the data on new issues in both leverage loans and direct lending, what the leverage was on a reported and an adjusted EBITDA basis, And what jumped out at us is really interesting is the ad backs over the last ten years have basically doubled, such that, as I mentioned earlier, there's been a masking of leverages. People increasingly use adjusted EBITDA as the proxy for leverage in those markets. The EBITDA add backs and direct lending amount to close to two turns and a little over one vere. Well, it's not so much that it's tricks, it's that if you're the equity owner, this is your plan to optimize EBITDAH. So you have a plan for cost savings for synergies from acquisitions and you outline that and that is part of your adjusted EBITDA. And I think as there was more capital going into the credit market just think about direct lending. It grew ninefold over a decade since twenty fifteen, so that's a lot of growth. People were very anxious, you know, to get put that money to work, especially in BBC's and so I think there was more of a tolerance for these adjustments because there were so much competition to do the deals. And some companies do ultimately meet those objectives with the cost cuttings or realize synergies. The problem is not all companies do. It often depends on management teams and execution plans. And actually SMP Global came out with a report in February based on eight years of data and they found that in the vast majority of cases, management teams actually don't come up with meeting those adjustments in terms of realized YBIT. And it's basically over leverage is overstated based on their study, and a lot of the problems reside in the single B part of the market, which again is where most of credits are in leverage loans and direct lending. 00:14:02 Speaker 1: Again to the point of size, I mean, if we talking about a trillion dollars here of stressed debt. 00:14:08 Speaker 3: Oh yes, so basically we when we did this analysis of a third of the market. I should have made that point earlier. That equates to seven hundred and seventy billion, which is a huge number in percentage terms, it's actually double what it was back at the end of twenty nineteen, and in dollar terms, it's three times the amount because of that growth of the market that I mentioned, which jumped out at us when we looked at this again, that number is just in the US seven hundred and seventy billion. That if you compare that to the global opportunistic capital that exists based on PREQUIN data of six hundred and forty billion, that's a big amount of problems potentially coming. Again, not all of this is coming to the surface today, but it's you know, it's likely owned by or the debt I should say it is owned by lendersuit don't ultimately want to own these companies on the back end or deal with their restructuring or roll their sleeves up and kind of fix the underlying problems. And so we do think increasingly there will be opportunities for opportunistic credit investors who have those resources and who are focused on, you know, that type of investment to increasingly purchase debt at a discount effectively from the direct lending universe, which we really haven't seen in material volume to date. 00:15:26 Speaker 1: But to make that cool that it is actually stressed. What are you looking at? Is is it a loan price of let's say, eighty cents on the dollar? Is it again with direct lending? How you even seeing what it should be actually you know, worth in terms of you. 00:15:38 Speaker 3: Know the proxim Yeah, so know what, we just use the fundamental credit metrics of leverage over seven times and interest coverage ratios below one and a half times, and using the ladder is what showed us. It's a third of the market in both cases. It actually can be higher if you if you just use the leverage over seven times for some of the markets it looks like forty percent. But overall, we thought the third it was was a very reasonable proxy based on just again fundamental credit underwriting. 00:16:08 Speaker 1: Because the market sorry, clearly isn't showing that right. I mean, is that just a matter of technicals on the public side there's too much demand for enough net new supply and on the private side that people aren't actually marking this stuff properly, or I mean, what's why is there such a disconnect between what we can see from market levels and what you're seeing in terms of you know, fundamental. 00:16:27 Speaker 3: Metrics you just mentioned, Well, I think in direct lending it's an opaque market, so it's you don't know necessarily what all the marks are, although increasingly people are looking to the BDCs to see how how how those marks are showing up. 00:16:38 Speaker 2: Yeah, good luck with that. 00:16:39 Speaker 3: In terms of leverage loans, you know that that market definitely does price and risk. Software is the latest example. I mean, you've had significant moves and loans from par downward over over the last couple months. And I think the question is beyond software, you know, is there more of a tolerance in the lever's lane market for other sectors that have high leverage? It varies across sector. There's a lot of dispersion in the market. But if again, if you just look at the reported EBITDAH leverage over seven times, it's a huge portion of the market. 00:17:18 Speaker 2: So just sticking with software because we've mentioned it a couple of times now and there seem to be maybe not a wide range of opinions, but there's there're different opinions about it, and they're different opinions about the how concerned people should be. So when we talk about software in the private capital system, debt and equity, are we talking about problems where we're going to see the equity side of the private market feel all of the pain? Is it going to you know, cut through to the debt side, do you think? And I realized that these these software tech firms, not all of them are vulnera AI, but AI is obviously an existential threat for some and it seems to me that the fundamentals are part of the story. The bigger part of the story is really the enterprise valuations. 00:18:10 Speaker 3: Absolutely, and I do think performance will be uneven. There will be some companies that are strong, that are software companies, and there will be winners and losers. But I do think that where there are problems that emerge, people will be probably surprised by the losses being higher than anticipated. And I think that's because people often look to prior cycles to inform current cycles, and this cycle is fundamentally different. That's because the starting leverage is higher than prior credit cycles. Again, that trend that we've seen of leverage ticking up over time, valuations in private equity have gone up over time with the flood of capital. So I think it's a more fragile starting place. And as a said, it's been a already we're on your three of this soft default cycle in the leverage loan market, and that's been delaying problems but not solving problems often. There's actually an interesting Harvard Law School study that came out this earlier this year called Liability Management's Limited Runway, and it shows how studying eighty nine non pro rata lemis over the last decade, ninety three percent of the time the companies end up as a repeat defaulter, and it's about a little over seventy percent of the time that's in the form of a bankruptcy. So again, this problem of hasn't really been addressed yet fundamentally in terms of fixing the underlying companies. And often the fix really is the capital structure, too much debt. Back to the point of the capital structures were created during the low rate period. When I say that, I think the losses will be higher. Again, that's the starting leverage, and we're seeing it where there are hard to fault. We have seen a steady trend in the leverage loan market of lower recoveries. If you look back ten years ago, the average recovery and the leverage loan market would have been closer to sixty cents. In twenty twenty five, it was thirty six cents, and that's just been a steady move down. We have no reason to think in the direct lending market that the recoveries will be any better. If anything, the leverage is higher in that market, the data suggests. And also it skews smaller in terms of companies. And we think in this environment, with this macro environment, where you have a lot of technological disruption, risk, high rates, uncertainty coming in all directions, their benefits to scale and smaller companies really are I think more challenged in the current. 00:20:51 Speaker 2: Macro Yeah, I mean, in this case, it seems to be not really a matter. I mean, financial engineering obviously plays a role in all of this as you lay out, but to software tech space, it seems to be there's there's a real disruptor, you know, sort of coming from the from the outside. And I think that what people are trying to figure out is, you know, which of these firms or what proportion of these firms have real cash flows, have real contracts, you know, have real sources to repay debt, and which ones might just end up being donuts because they're going to be you know, made obsolete. I guess we're all trying figure out. 00:21:27 Speaker 3: Yeah, right, I mean, and the public equity markets are trying to figure it out as well. So we've seen extremely high levels of single stock volatility in the public markets and high levels of sector dispersion, all due to this uncertainty of how this is going to play out. 00:21:43 Speaker 1: What do you expect the default rates to be there in software? 00:21:46 Speaker 3: Oh, I'm not going to weigh in specifically on software, but we think that software within direct lending, let's say, is roughly thirty percent of the market if you use the broader industry classifications. Sometimes a software company that let's say, provide software to an industrial segment gets tagged as industrial, but the broader industry definitions suggest over thirty percent. So we think, you know, for some instances, these companies that just have single products and therefore a lot of there's a lot of risk because they're not diversified. It's all going to depend on the nature of your product and how critical it is and how how much of a moat you truly have. You know, that's really for our software analysts to figure out. They've been sifting through, and you know, we do think there could be opportunities for sure, but big picture, I think where there are issues there recoveries could be as you said, you know, very very low. Because these companies don't have hard assets. It's really always been about the stickiness of the customers. And to the extent that that's called into question, that's going to be a big problem at David's encomenteror I can say one reason that we did avoid and flag the software issue is just because at the end of the day, we are value oriented investors, very focused on downside protection. So by definition, we tend to focus more on hard asset lending, and when you have multiple sources of recovery from the hard assets and also the cash flow from your business that tends to bode better in a restructuring. 00:23:20 Speaker 1: How common will a zero be do you think in self for a zero recovery. 00:23:25 Speaker 3: I don't want to make a prediction on that. I hope for everybody that's not the case. But I do think that if a business is disrupted, you could easily have scenarios where more businesses go. 00:23:35 Speaker 2: To basset companies for sure. Yeah. Yeah, sort of moving back out from sort of a single industry. In one of the reports that you wrote, I think the most recent one about optimization, you wrote something interesting, we remain in the early innings of a capital restructure event talking about private equity portfolios. Maybe can expand on this a little bit more. 00:24:02 Speaker 3: Yeah, So there's been all this attention on private quit which inning, yes, I think we're in the very, very early innings. So much of the focus has been about the lending side, and we really focused in our paper also on the private equity side, where the owners of these deals. Because we think we're in the early innings of this what we call private equity dislocation, we wanted to better understand the issues there in private equity, and so we actually looked at fund performance globally and in the US basically since the end of twenty fifteen, so from twenty sixteen onward, and we found that twenty one percent of the global private equity universe is below their hurdle rate of eight percent, and in the US it's actually twenty seven percent. So it really is more of a US problem, this underperformance, and so we really dug in that made sense based on the other metrics we were seeing. 00:25:02 Speaker 2: But that sounds somewhat surprising. Is that a supply issue? 00:25:07 Speaker 3: Well, so if you think about private equity in the US, absolutely in GDP terms, it equates to seventeen percent in the US versus let's say Europe, which is the second biggest market, it's just six percent, so dramatically bigger market here. In terms of leveraged credit, in the US, the investor owned a leverage credit market is twelve percent of GDP, whereas in Europe it's just five percent. That's because a lot more of the corporate debt in Europe's is provided by banks, and so that's a different discussion we can have on how this cycle is somewhat unique to the US. But there are other interesting aspects of Europe related to the bank market that keep us busy. But in terms of the private equity problem, it's been showing up really in the in the lack of distributions. We focused in our report on the quantum of net asset value that's aged over seven years and found that it doubled over the last five years in the US to just over a trillion. What's interesting about that is most of that growth is actually a function of the growth of the private equity industry itself. It's only twenty percent of that growth is coming from the delayed distributions. That problem really started with the twenty sixteen vintage. That's the first one that when we look back at the distribution curve in private equity, that was the first one to get off course, and it's only gotten worse since then. If we fast forward to twenty thirty, we see this number, the seven year nav in private equity doubling again to over two trillion, and at that point half of the growth is due to the distributions falling behind. So that's kind of related to this issue that we talked about with the soft defaults and the buying time, the delayed recognition of the problem I mean, understandably the owners have wanted to see if the capital structures could work, but it's been hard to sell assets, it's been hard to refinance assets. And the most obvious way that's been showing up is in the distributions coming down and the NAV, the aged NAV over seven years growing. 00:27:19 Speaker 2: I mean, it kind of seems like each of the past three or four years, a lot of the some of the news stories at the beginning of the year or some of the outlooks, you are kind of like, well, this is the year that M and A is really going to take off, and you know, it's been busy, but not it's. 00:27:33 Speaker 3: Actually been very busy. So we have a merger arbitrage business and it's focused on public deals and it's been very busy. Actually, like Q one volumes picking up. It's just not the private equity activity. It's been busy, but in terms of the larger M and A deals that has picked up, and it really started last year. 00:27:53 Speaker 1: Where is the trouble living private equity by sect to my country my vintage. Is there any patent or particular focus for the stress. 00:28:02 Speaker 3: Well, Interestingly, most of the activity the last few years has been in software based on the deal Loogic data about thirty to forty percent of the activity. So that's the future problem, and that differs by fund. There are some funds of very little software exposure, there are some with a lot, so that's going to be uneven. But as I said, the problems in what we look at leverage credit they transcend sectors because again it goes back to this issue of higher rates. A lot of companies were bought when you had a zero interest rate environment. You could put debt on. That made sense at the time, and it doesn't make sense today. So it's not often also that these are bad companies. A lot of times they can be fundamentally good companies. They just don't have the right capital structure, and that for us is the opportunity, especially if you couple it with the fact that the owners maybe the last few years haven't really been that focused on those companies that maybe don't have equity value because they have too much debt. And so there's a lot of low hanging fruit on the other side of a restructuring, where in some instances it's not even that difficult. It just takes the focus to make some changes to optimize these businesses, but understandably, you know, some of them we think have been neglected. 00:29:20 Speaker 1: At the same time, earnings of weakening are they Are you seeing signs of that as well as the interest costs going up? 00:29:27 Speaker 3: Well, it's very mixed again across sectors, and I think that that we're seeing that in the equity markets as well. It's very within a sector. You can have winners and losers. A lot depends on management and business plans, so I wouldn't generalize. I would say there are certain sectors, for sure where more of the problems have been accumulating. But the issue of the higher rates affects all companies. 00:29:49 Speaker 1: Right, So it talk to us about the play here because a lot of people it just sounds terrible and you know it's going to be a disaster, everything falling apart. But you're talking about companies that are actually sound. They just got a bad structure. You have ability to do what and how do you do it? 00:30:04 Speaker 2: And maybe on that point, we're talking about opportunistic credit now, right, yes, yeah, so maybe maybe not everybody listening is completely in tune with exactly what that is. So we could level set sort of give your description of what it is and as James says, the opportunity set. 00:30:19 Speaker 3: There absolutely, so opportunistic credit really spans everything from stressed credit, stressed performing credit, to restructurings, liquidations, litigations. So it's broad and actually that sometimes is what makes it difficult for allocators to allocate to it because it doesn't fit neatly in a box. You can start out, let's say, is the debt in a capital structure, but you take it through restructuring and you end up with a combination of debt and equity, so it is by definition flexible capital. We think this environment in the US certainly seems like it will be more interesting for opportunistic credit. You know what's interesting for US is we're very global. Actually about half of our capital is outside the US, and so we don't need this cycle to come for there to be plenty to do. We do think being global is helpful because there are different cycles at different times across the world. But we can't ignore what's coming because, as I said, it's been building and it hasn't really fundamentally been addressed yet. So we did want to dig into the data. But as I said, that this can involve purchasing debt in the leverage land market at a discount. Sometimes it's performing debt and it re rates to par and that's your return is your coupon plus the points of accretion. Sometimes it's through restructuring. Where you're underwriting suggests that this business has a lot of upside. It's maybe that some of the issues are cyclical versus secular. So we look for that in deep fundamental underwriting. And I think what's interesting, as I mentioned, is in this cycle, we think in increasingly that direct lending market will start to open up because a lot of those lenders aren't going to want to shepherd companies through restructurings. They don't have the operational teams in house. We have that, We have people who have a lot of experience in restructurings, operational execution. We have external teams we work with, and so this is something we've been doing for now over forty years, and we could do it at different regions, but we just think in the US it's increasingly likely that this opportunity will increase. 00:32:31 Speaker 1: But I'm wondering what kind of opportunities When you talk about discount, how discounted is this debt in the market right now? 00:32:37 Speaker 3: It can completely arrange. There are situations where maybe the company is over levered, but it might not be an enormous discount, right. It can really depend on the capital structure, so I wouldn't put one number on it. Even in the leverage loan market, we're seeing a very broad distribution of training prices, so it really is company specific for us. It's all about that where your careering the business on an enterprise value basis, through the purchase of the debt and where you think EBITDA is going. And that's where I think the adjusted EBITDAH point becomes interesting. It makes sense that if you're the owner of a business, you're thinking about what you can do with EBITDA, how it could be optimized. As the creditor, you always want to think, what can I hang my hat on? Is like really solid ebitdah, Right, So it's a different Through restructuring with the equity, you get the benefit of that unlimited equity upside. So it's a different risk return profile. Is a litter being captive. 00:33:33 Speaker 1: As you mentioned returns though, I mean you also do need to make a return in a quite tricky you know, macro environment. That is, you know better than comparables out there, and I'm wondering what your what your expectations are for returns, you know, in this kind of business, in this environment that only looks like it's going to get more difficult. 00:33:53 Speaker 3: Well, that might be a good segue to our optimization exercise, actually, if that's okay, because we looked at the asset class portunistic credit more broadly as part of this paper. Again, returns are going to span across companies, but we looked for that exercise. We basically we saw this growing opportunity and we wanted to explain to allocators really what opportunistic credit both is and what it can do in a portfolio. We looked at Cambridge private asset market data going back to nineteen ninety for opportunistic credit for private equity, for real estate, for infrastructure, and we saw, I mean, the historical returns for opportunistic credit are roughly nine percent over the risk free short term risk free so over cash meta fees versus in private equity you're at about twelve percent historically. To run this optimization analysis, what we had to do is what's called d smoothing the volatility, and that goes to the points about marks a lot of times, you know, you get the published returns in private equity, which don't around much because the marks are marked to model versus mark to market. So to compare private market asset classes and the role they can play in an optimization portfolio. When taking the public sleeve into account, which in our analysis we said the public sleeve was seventy percent sixty percent public equities, forty percent fixed income, we needed to see what the volatilities are on an equal playing field. And what we found through this desmoothing exercise was that actually published private equity volatility of ten percent really is more like twenty percent. And that makes sense when you think about the strategy. It's levered equities. How do you d smooth Oh that's a long explanation. We have a whole appendix on it. But the method that we chose was actually using a public market proxy. So we filtered public equities also going back to nineteen ninety that fit the parameters of what are typical private equity investments based on industry type, cash flow, margins, size, et cetera. And we found a whole universe, and then we compared the movement of that universe over time to the marks of private equity, and that's where we compared and saw that a proxy in the public markets would have had volatility closer to twenty percent. When we did the same analysis for opportunistic credit, comparing the volatility from the published returns to the public proxy, the difference wasn't nearly as material. It was a few percentage points different, so low teens volatility. So we found that the combination of the returns being very similar, and actually we think the go forward returns for opportunistic credit should be very promising given the supply of opportunity that we alluded to, plus the fact that historically in a higher rate environment, opportunistic credit performs well, whereas private equity historically performs less well in a higher rate environment. And you couple that with the fact that, as we talked about, we've had a flood of capital to private equity that we think vodes less well for forward return So we actually reduced returns two hundred basis points in our analysis for the go forward for private equity. And even with that pretty modest assumption, but with the higher vall the optimizer preferred opportunistic credit. One interesting sort of side note there is. We did a quick LBO analysis just to sanity check how private equity looks today in the higher rate environment. And what's interesting is you've had multiples go up over time just as interest rates have also gone up, so therefore deals are more expensive. And it suggested to us that even if you use the same multiple in the ZERP period and today for a deal, let's say ten times ebitdah for an LBO, the excess return over cash today for private equity is four hundred and fifty basis points lower than it would have been during SERP, and that's all a function of the higher financing costs. So that seems like a real headwind for the industry just due to the interest rate issue. 00:38:04 Speaker 1: Nine percent was the opportunistic credit return. That's nine percent over what over cash? 00:38:10 Speaker 3: So over the three month treasury. 00:38:12 Speaker 1: Okay, so I'm just on top of my head, I'm thinking thirteen percent roughly. All in. 00:38:16 Speaker 3: This is again, this is the Cambridge. This is the Cambridge. 00:38:19 Speaker 1: Historical and data, and that holds you think going forward. 00:38:23 Speaker 3: What we're saying is that based on what we're seeing in terms of opportunity and supply, it looks like a promising asset class. Again, it's a global strategy, so this is not just us. 00:38:37 Speaker 1: And is it basically picking a bunch of scraps from tiny capital structures or is it you know, I'm wondering how scalable it is by you know, a single name. 00:38:46 Speaker 3: Well, that's a very good point, and we make the point in our paper that there's no way in which all allocators could could put all of their private sleeve into opportunistic credit because the asset class just isn't big enough. But our exercise suggests that I'm the margin. It's a creative. Basically, what we found is when you a portfolio that has opportunistic credit versus one that doesn't, based on our inputs, can generate forty basis points a year of greater return at the same risk profile. So basically it pushes out what's called the efficient frontier forty basis points. And that's due to the lower correlation with the public sleeve and the lower volatility and yet the still attractive returns. 00:39:26 Speaker 1: David Din's jump in, but I have on that. I mean, who is it for? Because we've got this issue right now with retail realizing that private credit is not liquid and trying to get out because they're panicking a bit. But who is this strategy for? 00:39:39 Speaker 3: Yeah, so I mean for us. The genesis of writing the paper was really geared more towards our institutional clients, for whom, as I said, sometimes opportunistic credit. It doesn't fit neatly in a box. Nobody had done this analysis before on the optimization exercise. People had done it with private equity, but never looping in opportunity is to credit, And so I think it was it was just helpful for us both to check the ASSEAD class. This isn't just this isn't Davidson Keepner's data. This is all the data out there in terms of private assets. So we thought it was pretty interesting to see, you know, what looks attractive just based on a quantitative analysis. I will say shout out to our quant research team for the great work here. They You know, it was a lot of different analyses to get to this conclusion. 00:40:27 Speaker 2: So basically, what. 00:40:28 Speaker 1: Was saying is that there's seven hundred and seventy billion dollars of stressed in the US direct loans and leverage loans. You know, stressed sounds bad. They could blow up, they could default something, back could happen unless someone comes in and you know, lends the money to tie them over and they get you know, fished out of stress. But I'm wondering what the knock on effect is because that's what most people, I think, looking at financial markets are worried about. You know, does this spill over onto banks, does it spill over onto insurance comeanies. Does it have a much bigger riff of effects on the on the economy. And I'm wondering, you know, what you were seeing there and whether you think that there is a bigger problem here. 00:41:09 Speaker 3: I think we think that it will actually be naturally resolved, but it will be slow. It's not going to be some big systemic crisis like we had during the GFC with subprime mortgages. Rather, I think the implication of this, as the losses start to manifest is that the allocations likely to private equity and direct lending over time go down. I think that's the natural consequence. That's partly why we showed the optimization model. I think as people re underwrite the asset classes based on what are the go forward returns, you your you're that the issue will correct itself. 00:41:51 Speaker 2: I mean, I think the resolution process has changed over the years too, Like bank regulators were all over banks to you know, sort of fess up to problems early and deal with them and move them off off their balance sheets. And then you know, as you had some disintermiation out of the banking system into more static clos and conduits and secured lending vehicles, those vehicles don't have flexibility to sort of work with borrowers to the extent that direct blending does. So it seems like it's just going to extend itself the way that these resolutions occur. 00:42:30 Speaker 3: I think that's right. It won't be an acute crisis where everyone I don't think will be needing to sell at the same time. But I do think where there is the recognition from the private equity owner that there's no more equity value, they will move on. Hopefully in their portfolio. They'll have other investments you know, that work out. But probably bigger picture, the returns for private equity won't be as good as they had been historically before the asset class became crowded. And then yeah, for the direct lenders, I think in some instances they'll be happy in there's more troubled credits to sell the loan and take the proceeds and do something else with it, right, make another par loan, meet redemption requests, or there are all sorts of uses for that capital. It probably is more efficient for them to free up that capital rather than continue to own some of the troubled assets. But I do think it will be less chaotic as a result of all the changes from regulations post GFC, where we don't have a lot of leverage in the system the way we did, you know, where banks were levered, you know, I think Lehman was up to fifteen times and you had synthetic. 00:43:35 Speaker 2: CDOs there more like fifty zero. 00:43:38 Speaker 3: So that this does feel more contained, And I do think it's just it's more about the future implications for asset allocations. 00:43:44 Speaker 2: Yeah, and I think, you know, sort of explaining the dimensions of the market, you know, we're talking to sort of using a round number. Direct lending is a two trillion dollar market. That's a big number, but the context of the overall financial system in the US credit market, it's not that big. Yet. 00:44:03 Speaker 1: Does all of this drama those slow the growth or averse the growth of private credit? 00:44:08 Speaker 3: Yes, I definitely think the direct lending growth. I mean again ninefold growth over the last ten years, so that we're not going to see that maybe even at best a flat trajectory. Probably it's going to start to dip, I would imagine. But there is in the meantime a lot of dry powder. So that is the one that's why it's going to take a while for this to adjust, because you have a lot of dry powder sitting in private equity and direct lending that they still are going to want to put to work, but hopefully at lower valuations or you with better underwriting. 00:44:39 Speaker 2: Well, I think I think you also have to think about direct lending in two ways. There's the retail side of the marketplace where you've got you know, privately traded business development companies, where there is you know where you do have a stampede for the exits, but the gates have come down, which by the way, is a very responsible thing for those those funds to do. But then on the institution side, I think that black Rock had their earnings called today and they were talking about you know, continued significant demand for private credit for direct lending, you know, opportunities from the institutional side of things. 00:45:15 Speaker 3: Yeah, it'll definitely be interesting to see how it plays out and how that diverges. 00:45:19 Speaker 1: But if this seven hundred and seventy billion just in the US alone gets marked down significantly, someone takes a hit, and you know, I'm wondering who that's is and how concentrated those losses are, and then what's the impact of that. 00:45:31 Speaker 3: I think, you know, if you look at some of the different BDC structures, it could have implications for some of the in addition to not having liquidity, you know, effectively having dead money for a period of time because the losses will offset the income. And you know, leverage worked well on the way up, but it doesn't work well on the way down, and so I think that's more the implication is that people are stuck in the asset class with turns that they're not happy with. Even if even if you just look back to twenty fifteen, before this asset class became so big, the direct lending vintage from that year, based on an academic study that came out a few months ago, still has thirty percent of its return stuck in the funds. So there still are issues for old vintages where people have gotten reported returns but they haven't gotten realized returns, and so the question will be also, you know some of that where is it marked? Has it just? I mean, that's a long time for a private or a direct lending fund to still have a big chunk of unrealized years. Yeah, so I think that was an early indicator of some of the issues. But yeah, I think it's going to show up more in returns that people aren't happy with. 00:46:50 Speaker 1: Going back to David's original question earlier in this conversation, that we've been hearing for years now, maybe a decade, that this is the end of the credit cycle and it's all going to blow up from here, and you know we're facing a big wave of distress. It never happens. So I'm wondering what gives you conviction right now that this call you know that we are actually at a tipping point for distress. 00:47:15 Speaker 3: It goes back to that we're in year three of what's already the longest default cycle in twenty years. The only other longer one was in the early two thousands. But most of the defaults have not resolved the underlying issue. They haven't been restructurings where the capital structure was fixed. They've been about extending maturities deferring interest. And so that's why we think that the cycle will extend. But this second phase of it will be comprised increasingly of hard defaults, where the losses will be fault And so it's not that we're going to have a spike necessarily an overall default rates. Maybe a bit in certain sectors for sure, But it's that the nature of the defaults is going to change, is going to feel different for people. People didn't really pay attention in the last few years because, particularly in direct lending, it didn't show up in marks. It was just deferrals. And I think that's where the next few years are going to feel different. 00:48:12 Speaker 1: And with that, where is the I mean, you talked about a global portfolio, and it talks about very briefly about how the other opportunities exist elsewhereund the world. But where is the best relative value for you right now? 00:48:22 Speaker 3: Oh? A good question. We find value across different markets. It's just the nature of what we see that differs. If you're talking about credit. Yeah, increasingly we're seeing interesting opportunities in the US because of this dynamic, We're seeing more engagement from the direct lending universe. That's pretty new versus where we were a year ago. So that's definitely a big focus. 00:48:47 Speaker 1: Engagement, by which you mean they are coming to you and saying, can you take these loans off our hands because we're not refinancing. 00:48:52 Speaker 3: Is that there's more of that. We had had some activity in the past, but it seems to be picking up in terms of the level of due diligence that the team is doing. So that's that's an interesting indicator. 00:49:06 Speaker 1: It will continue at this pace to grow into I think it's. 00:49:09 Speaker 3: Going to I think it's going to keep growing in the US and then in Europe, where we have a lot of activity. It's really been more about the bank dynamic there. As I mentioned that, you know, the banks basically provide twice as much of the credit as in the US, and what we've seen is, whereas in the US we've had actually regulations at loosening up earlier this year, in Europe that hasn't been the case. And I think you add on the Ukraine War and now the energy shock from the Iran War, I think there will be more opportunities for opportunistic credit investors to provide capital to companies where banks might be more cautious and so again quality companies. But we're flexible capital that can kind of see through cyclical versus secular issues can be very helpful and generate you know, positive outcomes. 00:50:00 Speaker 1: Is there anything that kind of worries you in terms of you know, potentially positive bull shock, you know, the government suddenly bails everyone else, or you know, the midterms. You know that someone weighs a magic wand and we turn into this GOLDI Loot's economy when none of this distress happens. 00:50:15 Speaker 3: Again, we don't need distress to be busy. The cycles are different. What we see in Europe is not related to this private equity dislocation issue. It's related to actually fragmentation even we didn't get to but parts of southern Europe in particular are really underbanked and are growing rapidly. So that's a different dynamic. In countries like India, we actually provide structured credit to businesses that are you know, very I would say asset heavy, so the opposite of the AI disruption theme or the Halo theme. But these are low LTV loans that are structured. Again, our activities differ across the world. But you know, if you're saying if there's going to be some sort of a bailout in terms of fiscal stimulus. We're already seeing a lot of that in the in the U US in terms of the impact of the one big beautiful bill and tax refunds coming. We have, you know, headwinds and tailwinds in the US in terms of the you know, all the AI capex spending, but also on the other side of the AI disruption. Right there's there's a lot of cross currents in the market, which makes it fascinating. And I think the big question longer term will be, you know, where rates stay, what's the new normal given structural deficits, sticky inflation. You know, that's all I think the longer term question. But for for a credit investor, a higher rate environment is actually favorable because, uh, not only you know, you have more coupon, but we think there tends to be more dispersion and therefore, you know more, uh, your sort of credit underwriting matters more in a higher rate, higher dispersion environment than in the Zert period where there was just everybody got bailed out by low rates. 00:51:56 Speaker 1: Great stuff, Sousi Givens with Davidson Kempna. It's been a great pleasure having on the Credit Many thanks, thanks so much, and of course to David Havens with Bloomberg Intelligence, thank you very much for being on the show. 00:52:05 Speaker 2: It's been great being with you both and all of you out there. 00:52:07 Speaker 1: Bloomberg Intelligence is part of our research department, with five hundred analysts and strategists working across all markets. Coverage includes over two thousand equities and credits, as well as outlooks on more more than ninety industries and one hundred market indices, currencies and commodities. Please do subscribe wherever you get your podcasts. We're on Apple, Spotify, and all other good podcast providers, including the Bloomberg Terminal at b pod Goo. Give us a review, tell your friends, or email me directly at Jcromby eight at Bloomberg dot net. I'm James Crombie. It's been a pleasure having you join us again next week on the Credit Edge.