Evergreen Funds, Redemption Waves & Private Credit Conditions with Philip Hasbrouck

Hello and welcome to the Upside Capture Podcast. My name is David Stubbs, Chief Investment Strategist of Alpha Core World Advisory, a wealth management firm based in San Diego. Today I'm joined by Phil Hadsbrook. Phil is co-head of Cliff Horser's asset management business, joining them after roles with TCW and JP Morgan. I'll be discussing with Phil how best to use private markets in portfolios, the current moment we're experiencing in private credit, and where Cliff Horser is planning to deploy capital today. Now remember folks, nothing in this podcast is investment tax or legal advice, Phil or myself may have positions in the securities and assets discussed and always, always, always do your own research. Now without further ado, Phil, welcome to Upside Capture. Hey, thanks so much for having me, David, and for everybody at Alpha Core who I've enjoyed working with since I joined Cliff Horser eight years ago now. Well, the background of Cliff Horser firms 20 years old, and our business is advising institutions and building funds for investors to capture premiums that we believe exist in private markets above public markets. We're also active in hatch funds where we believe you can generate diversified returns that complement portfolios. So I think of us as a diversified alternative asset firm that's been in business a couple of decades, and today we have 225 employees across the country and five offices. I think people look to Cliff water for private markets, but you also do a lot of work inside the institution around the capital market assumptions. What people can expect across different asset classes, public and private? Can you share with us a few of the key takeaways from the latest version of that and the overall conclusions around multi asset investing right now? A forward basis. Now we look ahead 10 years, which I know requires some investor patience. Some people put out 20 or 40 baths, so you know, got us a little slack, but right now I'd say some of the headlines would be public stocks in the US over the next decade. We think our return between 7 and 8%. We think there's a similar return available on real estate over 10 years, maybe higher in the short term if the market comes out of a correction zone. Bonds, we believe are going to be about a 4% return over the next decade. And traditional bank loans that you fight in a mutual fund, somewhere around 5%. So I kind of think about the liquid markets with US stocks at the highest end and just think about stocks seven and a half up to 8%. And then as you move down and you take credit risk, maybe you give up a couple hundred basis points, then you get down to actually I just want bonds, then you're at 4%. And if you really throw in the towel, you can just buy cash or treasury bills and make 3% or so, at least if a risk-free rate projections are good. On the private market side, it's simpler than I think the press wants folks to believe it is. We think you pick up, you know, about 3 points over stocks and investing in private equity. Now we're assuming the execution or the manager selection is nothing special. When we describe that 3%, one would presume a group like Alphacore who has expertise and access to the market. Maybe they can take that 3% premium over stocks and turn it into 4% or 5%. We've seen that, you know, frequently over the last 20 years that higher quality manager selection is possible. So again, think about a private equity premium about 3 points, going up to 5 points above stocks. Private credit, we similarly look for about a 4% premium over a public credit over the next 10 years. Manager selection does matter in private debt, not as much as in private equity. For private debt, yes, you want that as managers that diversifying is equally as important. So we would say that there's a lot of value ad that an advisor like Alphacore can deliver just executing safely in private markets and budgeting liquidity. That's going to help you pick up that baseline 3% to 4% and then with great manager selection, maybe there's numbers can go up to 5% or higher over the standard public markets. So think of private markets in general as low double digit and public markets and credit around 5 and stocks at 7 or 8. I think you hit on a whole range of things that we emphasize to clients. Firstly, it doesn't matter if you got a clear 40, you got a JP Morgan, you got to any of the big banks, the expected forward return on some of the liquid markets is lower than we've been expecting. We've been getting middle double digits out of US large cap for years now, those institutions would say if you go to the website, it's most likely that you would get something in the mid to high single digits. That's a different environment. Then of course, I think you did well at pointing out the different premiums, the private markets in theory can provide and historically maybe have provided over your private markets, but the absolutely essential part of manager selection. That is, as you said, one of the things that Alphacore really focuses on, we do all of the due diligence in house, we want to work with the best of private market managers and then also utilize asset allocation, both within private markets and public to try to also improve risk-adjustive return. The manager selection piece is absolutely essential there. I think that what Cliffwater is most known for is the tremendous success the firm has had in the private credit space. We're obviously living through now an interesting moment in private credit. Tons of press about the asset class, last year it was all about is private credit a bubble. This year it's all about is private credit exposed to the AI disruption. I think when let's start at the beginning, there's also types of private credit, but the main one that the wealth industry has been engaging and I think is direct lending. Can you could you define what direct lending is and then we'll get on to a discussion about what is the future for that particular type of asset class? Sure, direct lending is the most prominent part of the private credit market. It's probably the simplest to understand. These are loans generally to private companies that 20 years ago might have been made by a bank, but large asset managers of Blacks like Black Sound KKR, Al Rock, you know, whoever built their own underwriting teams that can move faster and offer better loan terms and better alignment of incentives to corporate borrowers and banks have largely been displaced in this area. So I wouldn't think about it as much more than lending to a company, typically a private company, at loan to value ratios of 30 to 50 percent. I'll stop there. Average home buyers at 80 percent loan to value. These loans are at 30 to 50 percent. So we call them low-lovered loans or highly collateralized loans. And the companies themselves are not so small. When I really got into this space seven years ago, people tell, "I don't want to lend to those companies, they're too small." You know, it's not a lemonade stand. The average company in our portfolio is a market cap of over a billion dollars and makes over a hundred million dollars to your profits. So a lot of companies are deciding not to go public these days. They need financing from projects, acquisitions, etc. And this is the market being served by the direct accounting space. I think you hit on some really important points of how this is a structural change, a lot of regulation in the 2010s after the financial crisis that wanted these loans to move out of the banking system. The growth there, the size of the companies is essentially a large and stable companies. I think as private credit has grown in the last year, five to 10 years, we've been in a fairly low-default environment in general. We've been, we've had a lot of rapid growth in the economy, profits across the economy, profit growth has been, has been pretty strong. Today we do have your people questioning the asset class somewhat. And there has been a big increase in redemptions out of these funds. Now, your funds like you, the ones that cliffwater, your run, do offer liquidity periodically, usually up to a cap on, you know, on the nav, you know, we've seen large redemptions, you know, recently across the industry. Tell us a little bit about how the team internally is thinking about this redemption cycle and all the tools you have available to meet those redemptions going forward. Sure, and there's many themes that are kind of causing concern in the direct accounting space. One is, well, defaults are so low they could only go up from here. Some of these like intellectually, you're like, wow, that's true, but does that mean I should redeem? But it gets a camp for people thinking they should redeem. There's concerns about artificial intelligence, displacing technology companies in the economy, and too much finding being done to technology companies. And there's concerns about underwriting potentially becoming more [BLANK_AUDIO] lose over the last 10 years as the market has grown. I will save you the trouble. There's about seven different themes, all of which warrant some conversation. But they've all just kind of been put in a blender today in a smoothies bid made that doesn't taste very good. And so a lot of folks are saying, hey, I've had a great run in direct blending. Not really sure it's going on over there. It sounds like mad chaos to me with all the news. I'm just gonna, you know, sit out for a little while. What am I really missing? And I'm, you know, ultimately should it remain in direct blending or should they get out is probably a personal decision and one that should be guided by their advisor at Alpha Core. We don't have any kind of sense that it's our money we're managing, we're managing client money. To that end, I don't view and we've not viewed, we'll call these redemption cycles or media cycles. We don't view these as surprising. Rather, they're probably imminent. If you're going to invest in any asset class, it's some point we'll fall out of vogue for some period of time. Whether it falls out of vogue for valid or invalid reasons, that's a separate conversation. But whether it's when you're waking up and CMBC has the, what's their favorite term markets in turmoil when stocks are down and all of a sudden everyone on stage is trying to convince you to sell when it's probably not a good time to sell. At some point every asset class goes through this. So the decision really in accessing private markets is what kind of a vehicle, and this is where Alpha Core can add a lot of value, kind of vehicle's best for a given asset class for what funds structure. And our funds structure basically says each quarter, the fund is going to buy back at least 5% of shares. And in our own discretion, we can go up to 7%. So the way this looks last quarter, we have 14% of the funds say they wanted to redeem. At our own election, we said we're going to buy back 7%. That's the regulatory maximum. So the answer, one piece of confusion, David, they can fall out there is, oh my goodness. So you only bought the shares back from half the people. No, it's 14% wanted to redeem. We bought 7% shares. So everyone for one quarter got 50% of what they asked for. And unfortunately, the headline that that makes, whether it's asked for everyone else in the news day is, fund is gated, they didn't have enough liquidity. No one knew what they were getting into, and they're stuck. When in reality, this was always the fund structure. This is how you hold these private assets. Groups like Alpha Core have been educating their clients the whole time on how this works. But the Wall Street Journal, they're selling clicks. And it's a much more compelling story, in my opinion, for them to say, no one knew what they got into or now they're stuck. So your choice on how you want to access vehicles, like this is, you can buy evergreen funds like we have, but offer periodic liquidity. Meaning each quarter we commit to buying back a certain amount of shares from investors. And if you ask for your money when everything's going great and you have the reputation of gas at last is good, you're going to get all your money. And if you come for your money when everyone else does, you might get half that quarter. And you might need to come back for more of the next quarter. But what it's doing is it's protecting the people who are staying in the fund, who are the vast majority of investors and who aren't panicked and who understand private markets. There are other ways to access private markets like long-term locked up funds, which have seven or eight year lives in private credit and offers zero liquidity for investors until the end of the fund life. So while it's always ideal for investors to be able to access all of their liquidity to all the time, the reality of these structures so that we can invest in private assets is that there will be moments when you might get some or most of your money in any given quarter. And I think that's great if you're a long-term investor. And even if you're an investor looking to invest in private assets that may be not quite as patient at this moment, you're certainly getting a lot more liquidity than you would be from a private fund. So this is kind of a fun structure that we've prepared for the last seven years. We went through this in 2020. We quickly came out in 2021 and folks got all their liquidity. So I think over time it's important that investors, anytime I complain to my doctor about working out, he says, "You really need to get comfortable "being uncomfortable." And to some extent, if you want these private market outcomes, if you wanna earn that three, four percent premium, one, you can just give alpha core the keys and not get involved too much, that can be hard to do through times like this, but the other option is to just get comfortable, being uncomfortable and knowing, yeah, I can get some of my liquidity right now, not all of my liquidity, but that's okay. So it's a big conversation, there's different views on it, but we think long-term, this is gonna be a good thing, it's a maturation of the market. - Yeah, I agree that your education is absolutely crucial here. If advisors have engaged, if thoroughly and comprehensively with clients about the liquidity nature of the fund, and as you said, right now, the liquidity outflows are being prorated, right? People are getting some of their money and proportion to the requests versus what the fund can pay out. That is how these types of funds do work. We have been through it before, as you mentioned in private credit, of course, the private real estate folks went through it in the early part of this decade. You know, I think most funds emerged okay, these my understanding, some did struggle because liquidity management is important, but this is the type of fund where that liquidity is conditional on the actions of other investors, and as you say, those provisions are there to protect long-term investors, and people should not really be in these funds, unless they understand those liquidity your needs, and they're a vice of the plan for the liquidity needs of the client, you know, factoring in this possibility, and I do believe this type of fund structure, not just talking about Clifford particularly, but that type of fund structure in general is going to be a big part of finance going forward, but people do need to understand these types of issues. Now, when you look at the meeting these redemptions, you've got some things helping you out here, right? You know, a lot of these loans, obviously, are just a few years and length. They run off, and there's a repayment that provides some liquidity there. I believe that leverage levels are fairly low, going in. When you look ahead now, if we do your state at this elevated redemption level, you know, what type of liquidity tools do you need to use, and do you see a possibility of actually having to sell loans in a secondary market? - There's different levers here as David describes. The first one that investors should be aware of is, so we have an obligation, no questions asked, to buy back five percent of shares of Porter. Now, we decided to go up to seven percent, because we had actually liquidity at the time in the prior quarter, and we're trying to get people out of the fund who don't want to be in it, right? Presently, the quicker we can get folks out that don't want to be in it, without hurting other investors, the better. To put things into context in Q4 of last year, we had 14% of our loans pay back in our portfolio. 14% against in the same quarter, we have five percent liquidity. So some people were surprised, geez, why is Cliffwater giving out extra money in Q1? We had three times the loans pay off that we needed to do in the first quarter, and if you look long-term, I guess the largest quarter I'm looking at here, 17% of loans pay off, but on average, it's about six and a half percent. So given we've been in mostly friendly times in lending and things are paying off, it is worth noting that loans organically paying off provide liquidity for investors. After that, you've moved to either lovers. First one for us is what I call a rainy day fund, and what most managers call revolvers. So we interface and do business with banks. We issue different borrowings with them, and one thing we're always asking for in exchange is revolvers, which is just kind of like a bank extending you a line of credit that cannot be withdrawn. And you generally want to have about 20% of your fund. 20% of your fund size, you want to have available and revolvers. So today we rent approximately a $30 billion fund. We have about $60 billion of revolvers available. We can use it any time. So if we assume there's zero loans paying off for a year instead of my six and a half number, that kind of debit card provides a full year of liquidity without a selling asset. As far as selling assets goes, we've done billions of dollars of sale over the last couple of years. Sometimes a lender wants one of your positions more than you do. So I think we're seeing right now, there were different views of it. Blue Owl had a secondary transaction that they were in price with, where they sold loans it, their state of value in a large size. I think that's an option for us if we get there, but I would say that's probably the third liquidity lever, and probably when we look to, again, only one if we're going to make money for the funds doing it, or two, we'd be doing it after we exercise other liquidity options, years ahead if it's a really bad recession. But in general, we look and say, hey, look at global financial crisis. It took about two and a half years for things to calm down. Markets have become somewhat orderly. That's kind of the budget we lay out for ourselves. If we, you know, kind of think about what our liquidity playbook is. Yeah, no, I think, well, well laid out there, there are multiple, you know, levers to pull here and managing those levers, having the banking relationships of the revolvers, you are spacing out the loans so you get a good amount that are, you know, that are coming due every quarter. That's part of high quality portfolio management. Of course, the other side of things and is the quality of the loans themselves. Everything gets easier if the assets and the fund are high quality. It's that when the real estate funds were in pro-ration, those that had high quality portfolio, you know, going into it were able to deal with the redemption wave easier than those who are potentially overpaid. So a three-part question here. What are the current metrics for, you know, Cliff Orton's loan book in terms of the things that people consider default rates, payments in kind, liquidity management exercises, for example. Secondly, you know, what about the impact of AI on loans, so much chatter about whether AI is undermining software companies and that could be a threat. And then thirdly, and finally, are we seeing somewhat of a lagged impact from the Fed hiking cycle coming out of the inflation period after COVID 2021, 2022 strikes me that some firms were able to borrow very low interest rates. Those maybe now coming due at a higher rate and not putting the companies under stress. So a three-part question for you, that Phil. So we run the most diversified private credit fund in the market. Now, the positive about that is when things go wrong, they're small things. The negative about that is there's always something going wrong. And that's kind of the nature of our style. So I think our default rate right now is about 70 basis points or 0.7% of the fund. You know, when we launched the fund, it was zero. It's hard to maintain a perfect round of anything. The market right now has a, I think, 1.3% default rate. And the 20-year average or 10-year average is about 1.5%. Put all these little numbers together. My takeaways are all low. Are we better than everyone because we're at 70 basis points, not 1.3? These are really marginal things. We're really playing the diversification strategy. But the managers we partner with have done a great job. Pick rates, payment in kind, were borrowers basically raised their hand and say, "Hey, I can't pay cash anymore, but I'll get you on the back ends." And I'll pay even more. It's almost like a perfectly investment. This one up quite a bit with the Fed rate hike. And it was one way that borrowers were able to deal with their borrowing rate going up four to five percent. Our pick rate, I don't have off hand, but I believe it's about 25% lower than market. Or I'm sorry, 75% lower than market. We've generally, again, partnered with high quality lenders who don't take a lot of risk. There's always more yield available in market. But if you want the extra yield, it's going to convert to pick more quickly. So we're not trying to outperform the market. We're kind of trying to offer a second portal return very consistently. So we've been able to avoid quite a bit of the pick rise, as you've seen in the market, that pick rise can also be around kind of venture lending and at their more aggressive portions of the market. The AI situation is really interesting. Our big picture view is that AI is going to impact a lot more than software. It was what maybe 10 weeks ago now, it was like the whole world woke up to the idea that AI might display software. And by the time we got a white paper out on it, the real estate stocks were down 25%. Then it was the insurance companies. And it became really quick, quickly, you could see this AI was like a bouncing ball of fear just going through different towns. Now that's not to say software isn't the first line, it is. But investors should be prepared that you're not just going to say, oh, I don't invest in software and solve your problems. It's worth noting software has been the leading part of our GDP really over the past several years. And if you look at the market today, it isn't saying AI is going to display every software company. About 25% of the loans are marked. Now, like, hey, this is a software vulnerable company. And 75% are priced in a way where the view is, they're actually going to be a beneficiary or well insulated for a long period of time. And they're just going to know better how to implement AI than a software company. And how many companies out there are really aggressive enough that they're going to build all of their AI tools versus when Salesforce walks in the door and says, here are new AI capabilities. They'll say, hey, thanks for doing that. Now I don't need to do that. We're not in that business. So some software companies are going to have problems. The market sang about the refores of them are very well insulated. And I think that that's healthy that the market gives us a signal there. We shouldn't ignore the theme. But when folks say, oh, you're 20% software, all that's dead. That's also probably not the way to think about it. There is, you know, right now, as we look at it, some we would guess that default rates are going up from here, simply because they're so low. It doesn't mean they're going up to 3%. We just think market to fault rates of 1.2% for a decade are going to be difficult to sustain. And our expected returns across all asset classes are a little bit more conservative in the 10 years ahead. If you have a great 10 year run, that means at the beginning of this 10 years, at least in the case of the United States, all the assets were cheaper. And we had better earnings growth than we were expecting. So it's kind of like high fives all the way around. But that doesn't leave us with an environment today, where we can say, yeah, let's just play it back. So we would say, if you look at private credit, you're probably going to have marginally lower returns in the last decade because rates will come down a little bit, maybe default rates go up a little bit. But the premium you're getting over public markets might be every bit as good because your public market returns will be lower too. And we would guess the same for stocks that if you're buying companies that are more expensive right now, you're going to get lower returns. But that premium from private equity will be as valuable as ever. So I might have gone lost a little bit there, David. But maybe I answered most of the question and happy to move to what I missed. No, no, I think I think you hit the nail and head there. That spread is really the focus of investors because asset allocation is a relative game. You've got the money and you're picking between, you know, between the options. And none of us can go back in time and to appear where maybe assets were a little cheaper than they are today. I was thinking on the AI theme, but let's turn it around and talk about the opportunity. It's clear for today actively seeking out opportunities across data centers, power, fiber, et cetera, to play the AI boomer. Are you doing that both in private credit and your private equity, your franchises? We are. We think these are real trends that could continue to drive massive growth for the economy. We're launching a real assets fund where this will be a focus and pushing to get that going in the next few months. And then we have a private equity fund as well where we had a webinar three hours ago, focusing on, you know, the biggest opportunities we see in AI and AI infrastructure. I am far from an expert on the stuff, David, so this might be a segment you ask, but what it can say is these are priorities in house. And we have people with real expertise, you know, focus on them. Let's pivot to something to another question. You then again, maybe a turning to being more positive about what's going on in private credit. It does seem to me that there's going to be some type of shake out, right? And Cliff water is a long established major player in the space, but there were a lot of new entrants, you know, into private credit, a lot of new funds opening up. As that shake out, you know, is starting to, you know, to make itself known. Are you starting to see better pricing? You started to see more opportunity than when the market was more crowded, say a year to two years ago. And do we actually be on the cusp of an attractive vintage because there's a little less competition for the high quality loads? Yeah, there's two things that are going to drive marginally high returns. One, if you look at your Q1 statements as a client, you might say, hey, we're at my, you know, two, two and a half percent return to go. I made, you know, one percent. And you had spread widening during the first quarter, just meaning that new loans coming to market were pricing more attractive. And therefore, we and other lenders have an obligation to mark down our existing loans, such that that they're at a fair value. That doesn't mean they're going to default. And in fact, if they don't default, you can earn back those losses as they approach maturity. So there's two things going on. One, you're getting a little discount in the price of loans and two of loans you already own and two, the loans coming to market are pricing right now, about 75 basis points wider than they were three months ago. Now we're not so convinced. Spreads are going to, I say, blow out completely because this market is still largely driven by institutions, and there's a lot of dry powder institutions are trying to get into this market and trying to get invested while retail investors are pulling out of it. So we don't know that spreads are going to go too wide, but the way I kind of think of it simply is the asset class, if we went back two years ago, some people called it direct lending or vana, the golden age of direct lending. Everyone was making, you know, if you could throw a dart, you could make 12%. That's a positive thing. And if spreads continue to widen expected returns will go up. So things are starting to price a little bit more attractive. We just don't know how far they're going to slide. But, you know, in addition to saving capital up for repurchases, we are active investors in the market to pulling, you know, a few hundred million dollars this month and a few hundred the next month. So we'll continue to be active taking advantage of an opportunity. As we get close to the end of our conversation here, you look back on your career and you focus now on where private markets are. I wonder if you've got a contrarian view to share with us, you know, what is a widely accepted belief about private markets that potentially is is off the mark. The one that when I began my career, I had that I got educated out of pretty quickly. The idea that at large, you can be really opportunistic or to try to be in private markets is a difficult one. Now that doesn't mean you shouldn't take advantage of spread widening. It doesn't mean there aren't moments when thematic funds come out that can do things in a liquid structure better. But the best way to generate kind of corridor backlining returns is to just sit there and click that daily coupon of two basis points. It's really difficult to jump in and out of integers in and out of cycles and jump from fund to fund. And I think a lot of the market because it sells in the media and some advisors who are trying to create inertia at all times for their clients might be inclined to make things more complicated than they need to be. So I think setting a good long term asset allocation and, you know, focusing not on did private equity outperform the S&P 500 this year or over two years or whatever, I think that that is a dangerous game that's kind of encouraged by the press. I guess if it is contrary and view at least to what's on the TV would be that stories really are told over five to ten years. And if you try to go back and forth between public and private et cetera. You're not likely to actually end up with the better results. You've been when it seems obvious you should then that's what that's well said. You're closing up now with a little bit of a rapid far around what's the biggest allocates a mistake of the last decade. I mean, this one's embarrassing. So we launched the fund and the first investment black rock allocated to us was the e cigarette company jewel. And we have a good relationship with black rock, but pretty quickly we were like, hey, what what's this company do like what's the view on how this is OK. They're like, well, if you look at the statistics, it's getting this many people to quit smoking and it's this much safer than tobacco. And that is huge case. And we were like, well, it's the first one they allocated to us. If we turn it down, you know, what's that do for relationship, they have all this great data. And like two weeks later, there were explosive investigative journalist stories about these cigarettes right ultimately being sold totally inappropriately to younger people, et cetera. The mistake there was really don't be afraid to tell your investment partner. This isn't for me. And just because they presented with a lot of good data, follow your intuition. Fortunately, the loan paid off quickly, but that's the only happy part of that. Otherwise, it's most embarrassing credit we've ever been in. If there's a positive to it, we became a very, very boring lender over the seven years that followed. So yeah, I don't know if they got a lot worse than that. Yeah, yeah, I think it goes to the nature of credit investing while you're always looking for what could go wrong. And it's essential to understand what the things can happen out of left field to totally change the public's view or the regulators view of the company you've lent to. A couple of other quick questions defaults 12 months from now. I think you already answered this, but you see them higher or lower. I think returns higher and defaults higher. Interesting. And then direct lending spreads 12 months from now, higher or lower higher. That's how we're going to bail out those losses that I was just talking about. Right. Well, we'll leave it there Phil. Thank you so much for sharing your thoughts on the asset allocation side where we have direct lending and a few other lessons learned along the way. 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