Is Private Lending the Future of Investments? with Phil Hasbrouck (Ep. 35)

Welcome to the Millionaire Nextdoor Podcast with Robert Curtis, CFP, accredited investment fiduciary from Signature Estate and Investment Advisors. In this podcast we help successful wealth accumulators like you looking to transition to a work optional lifestyle by helping you build strategies for growing and maintaining your wealth. Robert draws from years of experience and fiduciary responsibility and interviews guest experts to help you build reliable strategies to grow and maintain your wealth. Now on to the show. Good day everyone. Welcome thanks for tuning into the Millionaire Nextdoor Podcast. I'm Robert Curtis, I'm a financial advisor, certified financial planner with Signature Estate and Investment Advisors. Today we have a terrific guest Phil Hasbrook from Cliffwater. They manage private assets. We've had a lot of success with this. We're utilizing them. It's been really good for a lot of clients are using it. Just thought we'd go a little bit deeper into that unpack what's going on there. Because to the typical investor they don't see this they don't understand this. So I thought we'd share a bit on that. So Phil please want you to introduce yourself and tell us a little bit about what you do, private lending. Go for it. Sure thanks Robert. Again my name is Phil Hasbrook. I go ahead the asset management business at Cliffwater. Cliffwater was founded in 2004 as an alternative investment advisor. Offering advice to very large institutional investors whether it be in private equity or hedge funds or private debt etc. A big state pension plan or sovereign wealth fund means help investing in these asset classes. Over time we made a shift as a business one to really focus on private debt or private credit which we'll be talking about more today and also to get into the management business versus just offering advice. Today we manage Cliffwater corporate lending funds which is the world's I think second largest private debt fund which offers kind of a broad market exposure that nobody else does and a smaller enhanced lending fund which still has a couple billion assets which is kind of higher conviction ideas. But in general Robert I think the way that we got connected with your firm we became well known for the research we did in private debt. We're not just fund managers we're probably the party that is research this asset class more than anyone in the world. We created the index which everybody uses to track the asset class etc. So to wrap it up it's kind of a firm that's been around almost 20 years with the research and advice backbone that we think we've found a way to help investors find a better way and that's been a specific asset class. That's terrific I mean we we have a research department that does a ton of due diligence and we don't have that many on our platform. We go deep sometimes take a couple years to look into these on every angle and do the diligence before we ever permit our clients to go in there and you're talking billions but you know the title of podcast a millionaire next door. So this is pretty new to them they're not used to investing like like an institution or a sovereign wealth fund. We can bring that to some folks and explain that. Talk some more about private private lending what you guys do and you guys really have this deep expertise in the space. So I talk about that and then just sort of maybe some opportunities. What's going on in the current environment? How does that fit in? You know who's this even suitable for and I'll let you yeah that's why we have you here. Thanks. Yeah so we we really became very so private okay you're going to hear about your kind of major we come food groups with an alternative. It's investing I don't need to explain then around since the beginning of time people can wrap their head around at private equity just investing in non-public companies. You know some of these things are fairly similar private equity's really been around in a big way 20 plus years now. Private debt is the fastest growing and also probably the newest major alternative asset class category and I'll get into why that isn't what it is because what is it? Most of this lending activity is one company wants to buy another company for a private equity for months to buy a company and they want to finance the purchase. So typically they're going to put down 50 or 60 percent of the purchase price and equity and then they want to borrow 40 or 50 percent of what they need to make that acquisition. This is not different than you know investors who think about investing in commercial real estate might get a loan to go get a building or even to buy their own home. You know on your own home you can get typically go 20 percent down. Here's the equity in the deal needs to go like 50 percent down. So the debt pieces aren't as big as you'd see in the mortgage world but they're very important. So for this kind of private equity ecosystem to exist for companies to buy other companies they need this kind of financing or lending available for them to close transactions. This space was dominated by banks 15, 20 years ago. Over time that scrutiny under which banks go and the regulation and which they need to operate has changed the landscape of what they can do and the big shifts over time after the great financial crisis in 2008 you know we as a kind of country that decided hey we don't want our banks taking as much risk as they are because we know they're critically important and it's unfair that we need to bail them out all the time. So we're really going to tighten up what kind of risk they're allowed to take and for banks that didn't just mean stopping risky activity but stopping a lot of core activity like making loans to businesses who want to acquire one another and the private market is stepped in and said hey we'll be the provider. We'll be the solution provider here and you know the big players range from black stone to black rock to KKR to Apollo pick your major brand basically the private equity world is now financed by the private debt world that financing used to come from banks and over time banks have become more and more restricted and so the private sectors come in with a better solution. You know as we think about the current environment obviously regional banks are under a ton of pressure. On the surface regional banks into a lot of this lending anyways but what it does is whatever capital you know the big banks do have the lens that's being strengthened much more because the regionals aren't able to decide capital for the US economy and so as a result of that you probably read a lot today about private credit and the opportunity I would think about it is the more kind of restricted US banking is the more opportunity there is in private lending and so that's how this has become a multi trillion dollar market versus that may be a 50 billion dollar market 20 years ago on the private side. Robert if you want I can get into kind of the risk and return characteristics or you can leave the conversation from here. That would be great I just want you know with the banking sector the way and what happened in March I can only imagine that trends continuing and accelerating and so you're probably seeing more and more opportunities in that space but go ahead where you're going but also on the due diligence side I just want to make sure since you know there's less folks offering it that you how do you guys go deeper to make sure these are actually really suitable but maybe that dovetails right into your risk reward discussion. No that's perfect for offer they're all related. I'd say you know just thinking about the current environment and we like you think a long-term asset allocation and day-to-day months amount of year to year you never know if you're going to catch the best wave but over the long term you will catch a good one so we try not to get too caught up with what's opportunistic today now with that in mind the regional banking challenge is really do matter and you heard Jamie Dime in the CEO of JP Morgan come out a few weeks ago you know I like him quite a bit but aside from that he was complaining basically saying all my banks about to come under all this new regulation because these smaller banks are failing and he said I think his term was the private lenders are parting in the streets he's basically saying why you know so there does seem to be a big shift going on and another transaction rob that was interesting recently. Pac-West Bank which I believe is headquartered in Los Angeles from the West Coast at these I think they were acquired by Bank of Cal recently they sold billions of dollars of assets to areas another Los Angeles space private debt manager maybe largest in the world recently that took place a couple months ago people are interested in making Google this but these regional banks Robert are under enough pressure it's not just that they're saying hey I guess one's right now it's they're saying I've got good loans I need to sell them to get some cash and you've got private lenders saying all take them off your hands at a price and then they're really good phones. So there is an opportunistic story here today. Right. The big picture, and we'll talk about diligence, where we got excited about this asset class as a firm. It's always easy to get excited about yield as investors. And the question is always the right question we think is not what's the yield, but what's my yield after my credit loss is an after my fees. Things aren't going to go perfectly and you're not getting execution for free. So has my yield tempted us as much as anyone and around 2015 really, we were looking and saying, geez, interest rates are so darn low, we're looking at these returns in private debt, nine, ten, eleven percent. You know, this is pretty tempting and we said before we make a big move into this space, we've got to understand the risk. Because if you meet with most managers, they don't talk about risk a lot. They just respectfully to them. All they talk about is they're so good at managing risk. It doesn't matter. And that doesn't work for us. We need to understand the DNA of any asset flats we're investing in. So we collected SEC filings. All these lenders need to report to the SEC on a quarterly basis. We collected every SEC filing made by a debt manager going back to 2004 and we built an index. The cliff water direct lending index. You can go to cliff water direct lending index.com and see all the data. And we kind of uncovered, hey, how did these kind of loans perform in 2008? When do when does private lending do well? When does it do poorly? How bad can it get? How good can it get? So on and so forth. And our key takeaway was that over time, if you're if you have decent managers and get into how you find decent managers and you do a decent job negotiating fees, you have been able to generate returns about six percent over the risk-free rate. So today the risk-free rate in America, you can buy treasury bills yielding a little more than five percent. We believe if you have good management doing direct lending or private debt, five plus six is 11 percent. And that's kind of the expected return and private debt today. Now if interest rates go back to zero, you're going to be looking at a six maybe a seven percent return all in, but again about six points over the risk-free rate. So the name of the game here is we would say the yield is there. That's the good news. So what are the next two components? One is finding managers that can help limit credit losses. Now we don't go out and originate loans at Cliffwater. We're kind of center square of the direct lending marketplace, and we allocate to who we think the best lenders are in the country. We're one of the top 10 largest private debt investors in the world. So we have about 300 lenders calling on us per year. We've chosen in our funds, for instance, to partner with about 50. We do think there's another good 15 behind them. What we're really looking for is managers with i10 really 15, 20-year track records proving their ability to the limit or eliminate credit losses through more conservative underwriting. Now everybody's going to say I'm a conservative underwriter, so let me just frame that a little bit differently. If you're willing to lag the market a little bit when things are really hot and everything's working in the economy and you're more conservative, then when things get bad you can avoid a lot of credit losses in a recession or a downturn. So our kind of style of investing, Robert, is finding these managers who are generically conservative who look very boring when the economy is very hot. They're not the top performer, but they're always a pretty good performer because they're not taking too much risk in the kind of companies they lend to. Basically, we find ourselves favoring a lot of good firms, whether it's KKR or Bullack Rock or Aries that are firms out of 15, 20-year track records showing that they can identify good businesses that they don't get too greedy reaching for yield and that they kind of are thinking all the time, "Hey, what if there's a recession tomorrow?" If you have that attitude in that discipline as an unwriter, you can typically lend to businesses that are going to make it through the tough times. The other key risk statistic, I think, for investors to think about is loan-to-value. So the average, think of loan-to-value the same as when you go by a house. As I mentioned today, you might not want the big old mortgage where rates are, but typically we'd all go 20 percent down and then we'd have 80 percent debt. In these deals, there's a much bigger equity cushion. So the average loan-to-value we want, instead of being at 80, like on a home purchase, is the lender, we want to be about 40 or 50. And what that means is even if we lend to a business that loses 10, 20, 30, 40 percent of its value, we're still insulated from losses. The equity component is still large enough where it can cover the debt. So ultimately, Robert, to wrap it up, if you're willing to be a little conservative, because there are private liners out there who come to you and say, "Hey, it's in nine points over the risk-free rate." And our experience, it's too much, it's too risky, but if you want a traffic in the six, seven percent area, you can do it pretty consistently through cycles without a lot of credit losses. Yeah, I think that's really good advice to get that extra three percent. The amount of incremental risk you're taking on probably really ramps up. And most of our folks are looking at growing. They still need to grow to beat inflation, but they need some risk. We have a lot of retirees, a lot of folks who've accumulated a lot of assets. But by the way, you mentioned these double-digit 11 percent, returns 6 percent over the risk-free rate. We do treasuries all the time. Five and a half percent is what I'm seeing as of yesterday. So this is mid-August, by the way, 2023. So you're going to accumulate wealth at a pretty good rate at that level. That's fantastic. That is so interesting. Yeah, I think that's a real good risk reward trade-off. I love that you guys are the index. You're actually the index. So you're not co-dabbling and you're a major global player in this. So that helps a ton. And just those opportunities, do you have comparative numbers just to give people kind of a big picture sense? I've seen some stuff like the S&P 500 relative risk versus this versus maybe higher bonds or a T-build. Just to help people have that maybe comparative scope in general sense. If we go back to 2004, which is as long as state as we can get on the asset class, the long-term return has been 9 percent. It's actually nearly the identical return to the S&P 500 over the same period. The difference is the standard deviation or volatility of private debt is about 3.5 percent where the stock market's about 15. So what it's been is, at least on a long-term historical basis, you kind of get a stock market level return with 70 to 80 percent less volatility. And instead of all of your return coming in appreciation, it's coming in current cash flow every quarter. So what I would say and what you help your clients with Robert, very attractive risk characteristics. Not going to be tax-efficient like your stocks, but if you want current cash flow and you want to eliminate volatility, it's a really attractive asset class. There's also decent liquidity, which we can talk about if you want where if investors need money quarterly. Most of the time you're going to be able to access all your capital if things get really bad, maybe you get the most of your capital out on a given quarter. But one thing we think about, you know, stocks are daily liquid, but they're very volatile. And if you thought the wrong time, there can be huge tax consequences. So it's catch-22. What's kind of interesting about this fund, you wouldn't want to use it as a core liquidity item, but if life events do happen where you need to get money out of line the way, you know that the fluctuations won't be that big. You do have an opportunity once a quarter to trim or eliminate your position if you need to. Yeah, absolutely. So I'm using this quite a bit. We use it a lot in Iro accounts, things like that. It's completely tax-efficient. You're getting this nice yield. It's the funds are probably going to stay there other than RMDs and we can work around that. So it's not, I mean, for life. I've got someone right now who's 102 years old still taking RMDs. So you know, in a. Well, then you really enjoy the power of compounding exactly. You better believe it. Yeah, it's actually says RMD is still growing to sprite that distribution rate. But the in a taxable or like a trust type account, I explain it's not super tax-efficient to which some people, you know, there's other alternatives or they just take it and pay it if they need it. And we, you know, liquidity-wise, it's quarterly liquidity. We've never had an issue. I'm usually not allocating it where we think we'll need it. And the client or investor says, you know, I think, this can stay in there. Occasionally something comes up, like I have a guy who's buying a piece of real estate, but he gave me, you know, six months notice. So we had plenty of time to get it out, but it hasn't been a problem. So that's been really good. It is quarterly liquidity windows and you guys send out a mailing. So I tend to get a lot of calls too. By the way, what is this thing? Do I need to do it? I'm like, no, I would listen to those mailings off, but the SCP wants to make sure the clients are aware of their options. Sorry about the paper trail. Every time I have this point, they cover. Go ahead. You and I were talking about the other day, Robert is fees. So after you go out and you decide, and I know, you know, Cliffwater, you invest with us, you're kind of buying a full stable of private debt managers. And our pitch to you is, hey, this is six times more diversified than going to a single manager diversification, by the way, take it. It is a free lunch year. And even the best lenders get unlucky sometimes. When you're hyper diversified like we are, you can afford to get unlucky. And it's not going to change your financial status. You know, diversification in addition to manager selection is really important. So again, manager selection, think long-term track records, firms that can prove they're doing the same kind of loans today that they were when they built their track record. That's the big track door. If someone says, look at this exceptional track record I built. But then you start going through the loans, and you're like, the loans you do today are nothing like the ones you built the track record on. So we have a team of about 30 people making sure that, you know, for lack of a better term, the manufacturing and the components are the same as they were on the product they've been selling you over the years. The last thing is fees. And this doesn't exist for every asset class. Some asset classes investors get into. You just need to pay the fees because there's only so much room in these funds. But private debt, if you have scale, you can really reduce your fees. What we've done at Pipwater, number one, is use our scaled and negotiated fees with managers. We can get 50, 60 percent discounts versus if a client were to go directly to the manager. The second thing we do to keep fees down is we don't work with like Morgan Stanley, Maryland, Wells Fargo, etc. A lot of the products on those platforms, the fees get really beefed up because so many different parties need to get paid. We work with fee-only RAs like SCIA, there's no interest in us paying them anything. And so our fees are about 50 percent skinnier on an all-in-basis than the comparable products being sold by the big brokriges. Again, part of this is us using our scale. Part of this is like there is real power in hiring a fee-only RIA. And that goes straight to the bottom line and you want to know how we see it. But our success has largely been driven by the fact that we focus on a market that wants to deliver the lowest cost solutions to their clients. So again, our fees are about 50 percent lower than our competitors. I think it's going to force fees down across the board. But working with RAs is kind of what makes it possible for us. That's great. That's really adds a lot of insight because as I mentioned, there are a number of private funds out there, but our research does a lot of due diligence. And I've talked with Sam Miller on the podcast, all the things they go into. But those, there's lots of processes, the investment, but the fees are that you guys have this scale that you guys are now, you know, one of the largest players in the market, like seconds. So you can kind of cherry pick these opportunities. With the banks pulling back, you can see more, but with the fees coming down, but the diligence, that's a very powerful formula all taken together. And we're full fiduciaries. You guys are too, I assume. So when you stack all those layers just looking out for the client and someone like myself have done this 25 years, working with second and third generation clients, you get a strong sense of what where the appropriate fit is for the client. So this has been amazing. And you know, again, you're just an extension of what I call my value at at support team. These are other folks, other professionals that we're really baking into our process to bring value to clients and let them know where this is appropriate. We're not. We're not telling people put 100% or 50% in, you know, what you guys are doing. There's practical limits and guidelines. I just consider myself, I don't have to do what I do. I feel very blessed I get to do what I do. And it's looking out for the clients, but interacting with professionals like you and Cliffwater and sharing this to deliver that kind of risk reduction and those kind of yields. That's really satisfying to where they're going. So thank you so much. Any other thoughts or discussion points. This has been amazingly great in just terms of getting a little deeper, getting the context around it. It can be a complex topic, but you've spelled it out really nicely. Would love to hear any other thoughts you have. I don't have any other big thoughts except what I tell my own kind of parents and people, my family, circle or whatever. Which should be there, there is a lot of there's a very real movement and opportunity for private clients to start investing in alternatives on a more meaningful basis. And it will, if you look at the long-term data, big institutional investors who are savvy and done this right are generating, you know, many higher returns with useful alternatives, but there's a million products out there and a million brokers who want to sell these things. Your team is excellent. You're lucky that you have huge resources at SCIA. Just stick with an advisor, preferably one, and try to let them put this all together for you. Because, well, it's all very exciting that you might be able to generate these more outstanding risk returns. You can really, for like a better term, screw this out, trying to do much of it, do it yourself. So, that's all I've got. But thank you for the time today, Robert. No, 100%. It's so helpful. And, you know, I tell people with, I mean, you know, we lived through the last 15 years. There wasn't much yield out there, right? So, you know, now in a simple treasury, you know, a million bucks, it was getting 500 bucks. A short time ago, now it's 55K. You know, on what you're talking about, there's 110K. Maybe blend those two. It's just incredibly low risk. But people can finally earn some income. Not to say inflation isn't there. And we know that's a reality. And despite it being sort of covered up or denied for a while. But, you know, it's really nice and somewhat refreshing. And this is one solution. It's been really good. So, anybody listening who has any questions, feel free to, to let me know. And I'd love to go into it a little bit more. And this has been absolutely terrific. Really appreciate your, you're coming on, your professionalism, our collaboration. And we'll share this with you as soon as it comes out. Thank you so much, Phil. I really appreciate it. Thank you for listening to the Millionaire Next Door Podcast. Click the subscribe button below to be notified when new episodes become available. The information covered and posted represents the views and opinions of the guest. And does not necessarily represent the views or opinions of signature estate and investment advisors or Royal Alliance Associates Incorporated. Member FINRA SIPC. The content has been made available for informational and educational purposes only. The content is not intended to be a substitute for professional investing advice. Always seek the advice of your financial advisor or other qualified financial service provider with any questions you may have regarding your investment planning.