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On Apple, Spotify, YouTube or wherever you get your podcasts. Hello, welcome to Credit Edge, a weekly markets podcast. My name is James Crumby. I'm a senior editor at Bluebeg. I'm Matt Gortner. I'm a credit analyst here with Bluebeg intelligence. At this week, we're very pleased to welcome Matt Harvey, global head of middle market direct lending with PGM, which oversees more than $200 billion in private credit. How are you, Matt? I'm great. Terrific to meet you both this morning. For the listeners, Matt's been with PGM's 2003, originally doing private placements before moving to PGM capital partners where he focused on middle market mesoneme before moving into the direct lending role in 2018. So I think it's safe to say we've got a pros pro today on the pod. So I'm ready to jump in James. Do you want to talk about it? Yeah, great to have you on the show, Matt. Private credit is obviously getting all the attention these days and direct lending is a huge part of that. Not that long ago, the middle market corporate loans department was one of the most boring parts of the shop. No one wanted to talk to you. But then we had the gold-nature private credit when everyone wanted to be your friend. Now it seems to be the most feared part of global finance has growing concern that something we just can't see in private markets will blow up the entire financial system. Matt, you've been doing this for a while and you're based in Chicago, the home of the so-called middle market lending. How worried should we be really about all this? What's a great place to start? We said, I think setting the context for the asset class in the industry is really important here. And in many ways, this type of lending has been happening for decades. You alluded to the fact that private credit already is a much broader asset class than direct lending alone. Direct lending tends to be leverage loans, privately negotiated, more leverage borrowers. The private credit generally goes well beyond that. Investment grade credit, fixed rate credit, asset-based finance, etc. And that brings me back to the question about why Chicago and why have I been doing this for 23 years? Well, if you look at the middle market lending landscape in the US, Chicago really was the capital of middle market lending because it financed the industrial heartland of America, medium-sized companies. Before they were so large that they could access the capital markets of Wall Street. And when you look at the original players doing that, many of those banks were of course in Chicago. But other original players included life insurance companies, like potential and PGM's asset management arm. And so over time, what's really changed is the fact that we've structured these assets into investor portfolios in a different way. But what hasn't changed is fundamental lending to companies, making loans for productive use of capital and returning that capital to the underlying investor. Yeah, so I think you alluded to the definition has definitely broadened out over the last couple years. I feel like it used to be the bread and butter. It was direct lending. But now we're starting to talk about stress debt, specialty finance, real estate, infrastructure lending, the whole gamut, and mezzanine, which I'm not your, you're acutely involved in. So I guess what's the scale of the businesses that you guys are prospecting, selecting and ultimately lending to and more importantly, why are they turning to you guys instead of the public markets? What's the value proposition do you guys have for these guys? Let's focus on the strategy that I lead, which is direct lending. And as generic as that name implies, what it really is is leverage loans, privately negotiated for companies undertaking events, acquisitions, recapitalizations, major growth financing, etc. And when we think about the scope of that market, it's estimated to be somewhere between two to three trillion AUM of outstanding capital, which would in many ways rival the size of the leverage loan, the syndicated loan market or the high yield credit market. So in and of itself, direct lending has become a very large market. Of course, the broader private credit asset class would would would greatly dwarf that number when you extended further. In terms of where we focus within that, I think the greatest utility is finding these companies that are not so large, they can efficiently access capital markets and creating a solution for them. Traditionally, that solution comes down to private equity sponsored finance or private equity companies are undertaking leverage buyouts, they're acquiring businesses, private credit, especially James, you alluded to the the so-called golden age post financial crisis, private credit stepped in as a suitable finance provider that delivered a value, the banks typically were not well suited to do, higher quantum of loan, better execution, certainty, more flexibility, etc. But as the market has evolved and grown over time and scale to your point, the solution is much broader than that. And what do I mean by that? I mean, it's accessing now family owned companies, corporates, businesses of all shapes and sizes that are doing far more than just leverage buyout financing. And that way what you see in these portfolios starts to look like a traditional loan portfolio that in prior days might have set on the bank's balance sheet. But today is structured and assembled in a way that meets longer term investors needs. The assumption now that is that because they're going to private markets, they are in some ways riskier, weaker, more likely to default or have to pay in kind in terms of their sales. Is that actually true? It can be true, but generally it is not. And the reason why it is not is because again, the same type of company that's raising this capital is the same type of company that previously or in a competitive dynamic still today is also entertaining capital from the banks and from other lending sources. And so what really is the difference? The difference is the form of capital that's being provided. It often is longer term in nature. It can be delivered with higher execution certainty. And it can finance events that go beyond what banks typically would finance. What do I mean by that? A cross-border acquisition as an example. A cross-border acquisition is riskier than a domestic acquisition. So that was my point about it can be riskier. But the idea as a sophisticated investor is that we identify those risks. We underwrite and we structure the loan package to address those risks. And frankly, we price those risks in a return that is greater than typically bank loans would earn. And therefore it's more attractive to long term-minded investors. And then the flip side of that for the borrower is that floating rate rates are probably going to stay higher for longer. They're paying the biggest spread on that than they would in the publicly broadly syndicated market. And that potentially makes it harder for them to serve that debt. Is it going to be more expensive over time? Is that going to put them in a tougher spot? And are they going to be more defaults as a result of that higher debt service? It's a great question, but I think the context of that implies the borrower is unaware of that dynamic. And in our case, these are sophisticated mature companies that are professionally managed. And they undertake a quite serious level of financial planning when they raise capital for these event driven transactions. So the first thing I would say is it's self-selecting. The companies understand the debt service capability they have, therefore their own leverage tolerance. And we provide a form of capital that suits that tolerance. Our job as the investor then is to, of course, underwrite the risks and the things that could take that off track, let's say, those risks to your point can be rising base rates. Those risks could be economic cycle. And again, that's where it comes back to the package of the loan and the structure to ensure we're well protected for those risks, i.e. covenants in terms, collaterals and leans, and so forth, whereas the company also gets the capital they deserve. The one point I want to make that is really, really important when speaking to private equity-owned issuers, but especially, frankly, non-sponsored-owned issuers. We're quite transparent. We don't compete on price with the banks. We don't have deposits. We don't provide short-term capital. We provide longer-term capital to fund events. What does that mean for the issuer? It means it should be in a very accretive trade for the equity. So they are consciously paying a higher margin on the debt to do something they otherwise would not be able to do. And over time, they make that capital constructive and they deliver a higher equity return. And that is the fundamental premise of our argument, and that's why it's a solution, not just a short-term loan. And when you talk about, so the track of the term is from the investment.
just standpoint, if I'm looking right now in the terminal, the high yield index looks like 7.5% yield to worst, PA3, B1, credit quality, and I'm sure these are just under five years. If I look at the leverage loan index, it looks like 8.5%. And it looks like credit quality is B1, B2. Can you kind of frame like what's attractive for PGM is what relative to these benchmarks? Then what's the sort of tenor you guys are looking at? And obviously I'm not going to do 30 years, I don't think. Right. So what not in this risk category. Yeah, right. Well, I think you hit the nail in the head. One for us, we start with this idea that we can over time, deliver a relative value premium or access return to our investors versus comparable liquid credit. And you just named high yield and syndicate loans syndicate loans is the closest cause into direct lending. Because think of it quite simply, it's the same loan and structure. It's just not rated by the agencies from a credit rating perspective. It's not syndicated by the investment banks. It doesn't have liquidity. It's all bilaterally privately negotiated on a more discrete basis. So where does that access return form? It forms from two primary components. Number one is the ill liquidity premium. That is the entry spread and price of the loan that we would demand to have an asset that we can't readily trade out of. We have to deal bilaterally with the issuer. That over time has given some level of demonstra premium to liquid credit. And you can debate what that is. A lot of agencies and research houses would say plus or minus 100 basis points above a comparably rated liquid loan. On top of that, and especially as you then go deeper and deeper into the middle market, where naturally more inefficiency exists and the ability to therefore provide a solution that's valuable to the borrower becomes more more profound. We think as a manager, we can deliver other forms of premium. What are those things? Selection premium. Covenants in terms of reprice risk. So again, we don't buy the asset and then have to live with that duration risk as credit quality changes. We have a covenant that protects ourselves from underperformance. And we can do something about it. We can reprice the loan. We can ask for additional collateral. We can restructure the security package, et cetera, et cetera. And then finally, you also get the idea of as a good credit investor at the end of the day, what we have to do is avoid losses. Losses are asymmetric. We don't participate in upside. If we can avoid losses at a more durable pace than our competitors or comparable liquid credit markets after recoveries, that's a form of excess returning of itself. So that's really the dynamic we're looking at to go back to the original point you mentioned B2 is the average quality and leverage loans. We self credit quality rate every transaction we do because we're very intently focused on determining true relative value. And that can only start then with comparable quality. Is it a B2 equivalent? Is it a B1 to B3, et cetera, et cetera? Most of the direct lending loan world does live in that B1 to B3 range though. So that B2 context that you set, you could say that's proxies for the direct lending universe. And what are we talking about in terms of size? Because we went from you know, middle market. I was always thinking of around a hundred million dollars. And then during the golden age, a private credit, it shot up to someone on this show said it could be a billion dollars in size for a middle market. But what is your expectation for size of transaction? Well, I think I think you alluded to it correctly. The market segmentation in size has greatly expanded over time. And so we would view middle market as the classical definition. And our view that's 25 to 75 million of EBITDA operating profit at the company level. Some would say up to 50 million, but it's in that range. If you start getting above that, what happens fundamentally is you have companies that are of a size and sort of issuance tolerance, back to your question, James about leverage and issuance quantum that they can start to access syndicated loan markets and other forms of capital. And that's the market we referred to as either upper mid market or large cap depending on who you ask. It starts to get to a billion dollar or more financing sizes. Again, it's an ad Jason Cedar core middle market direct lending because it is quite similar and that the fundamental value proposition is your delivery and execution, certainly in a private format. Those are dealing with companies that typically have other access to capital markets. And therefore, it can be a more competitive issue with respect to syndicated loans or high yield from that perspective. But for us, middle market up to 75 million of EBITDA very deep, whether you look at the US, Europe or even other developed markets like Australia these days. And the general trend is adoption curve companies sponsored and non sponsored alike, so family owned businesses, understanding that access in this form of capital has a lot of utility. And for event driven transactions in particular, it can be very valuable. And you directly land us in it's a bilateral loan and you just hold it on your balance sheet to limit yours is that the bilateral lending at primary issue. Yes, we tend to not at least the the mandate and the portfolios tends to not be to buy so called secondary positions or trade loans. That's not the idea. Our value is in creating the bilateral lending relationship. And frankly, controlling the quality of that relationship, ie, we want to be the sole or lead or co lead, we want to be a significant lender in the company's capital structure because we want to have influence and voice. As you look at where the assets go, well, these days, like many of our competitors, we've put those in to investment portfolios that are suited to the long term owner of the asset. We have comingle funds with your usual mix of institutional investors, insurance companies, pension funds, sovereign wealth, et cetera, et cetera. We have product that ends up being a little bit more structured where investors through an SMA account can have a more customized or bespoke mandate, ie, I'd like to be overweight us loans versus Europe or the opposite or I'd like to buy a certain part of the loan structure, not all the loan structure. And then of course, these days, you also have the private wealth and retail market, which tends to for the most part come through this format called the perpetual non-traded BDC. So multiple outlets for that loan collateral that ultimately is driven by the idea of a long term owner of the asset, understanding there's an ill-equity premium that can be generated over time. And in a way that then is the product is structured to suit the investor's tolerance. How do you mount the loans over time? We mark, first of all, with a combination of fundamentals and technicals. So fundamentals are your traditional loan coverage metrics that a bank underwriting department might look like, look at no differently. Now loan to value, interest coverage ratio is the company compliant with that service and therefore on a cruel and so forth. And then we also overlay the technicals. Well, loan spreads change, market prices change in the syndicate loan market. So we have to have a mechanism to convey that under the price of the private asset, even if the private asset is not trading. How we do that, best practice we believe is using independent third parties. We hire evaluation firms and investment banks and they surveil our entire portfolio at every valuation mark that you can trade upon and affect and produce an independent price. The concern in the private credit market right now is that those marks aren't accurate and the independent valuation providers are kind of paid to give you a decision and that deals that should have been marked down, haven't been marked down. Is that a concern that you share or are you confident in where these things are being marked? I think it's a legitimate question that starts with the understanding of the manager's valuation practices. It is not generally a concern that I share because I see the rigor at which we approach valuing the portfolio. And as I said, if you take the view that you have an entirely independent governance model and valuation, in other words, the PM cannot influence the mark, which is the case with our valuation policy. Then what you have to do is you have to operate from the context of I have a new liquid asset that I can't trade and make a market price on every day on the one hand. But I know the components of valuation and the components of valuation are the fundamental performance of the asset and it comes down to is alone covered or impaired. And you can determine that based on a long set of fundamental metrics. And then irrespective of the fundamentals is the price to issue capital in today's market wider tighter. And that's where the technical overlay comes into play where you have to adjust the price and you have to recognize that based on broader market prices. At the end of the day, though, I think most investors, they clearly want to ensure your valuation practices have integrity. And depending on the structure, that may be more or less important in the sense that you can either enter or exit at that price versus a traditional co-mingled fund, which is drawdown and everybody buys at cost and they're on the same basis. But also to understand the liquidity premium I mentioned before, the ability for the manager to generate excess return through the various management techniques we have that develops over time. And the whole idea is you're not trading the asset. And the liquidity premium, you mentioned it was plus or minus 100. That's 100 base point. I'm assuming it's over.
of its ill-equidity. That's over the equivalent BSL spread over sofa. That has changed considerably since we first started talking about it on this show. It seems for a leverage deal. It was more than 200 basis points last year, I would say. According to some of our guests, do you expect it to be compressed further as competition increases or market conditions change? Well, the interesting perspective on that for me is that I'm not sure it has changed. I think it's how people frame the ill-equidity premium, so to speak. And that's my point about there being multiple components. We talked about spread. Issue spreads the most notable comparative where you can say a B2 that's liquid and just got syndicated by major investment banks of credit rating issued at let's say 325. That's a prevailing price today. And I could issue that or buy that comparable private B2 at 425. What else do forms the excess return? And sometimes I think it gets conflated with an ill-equidity premium. It's the original issued discount price. It's the ability to have call premium or friction cost to refinance at their forced ed duration of the asset. It's the ability to have covenants in terms that allow you to reprice risk i.e. increase the coupon or the spread based on risk profile. Have an amendment fee if the company is looking to do something different than what was originally underwritten. There are many different forms of economic enhancements that I think over a long period of time go well beyond that binary easily identifiable issue spread ill-equidity premium. I think when we're talking about credit quality and spreads obviously there's a ton of different sectors that you can play in and all of those sectors have different spreads. Where are you guys overweighted in terms of your book? If you're more heavily exposed to smaller construction guys or you guys have a big portfolio in consumer staples which would seemingly have less eclicality. Where where where you guys at? All the above. I think we the the principle and credit especially mid market credit and again ill-equid assets we've got to go manufacture and originate the deal flow. So we can't go to the screen and select the asset and construct the optimal portfolio top down. We have to do that over time with deep origination and all different segments of the economy. So what that avails our self to is broad sector diversification and the principle again that we create the value with the liquidity premium and manager technique and where I'm going with that is our in our view and it's not always the view of others but in our view you're not very well rewarded for taking a significant overweight or underrate model to sector allocation. We don't participate in price upside. The best case is par. We participate fully in price downside. And so if you're wrong in that concentration the risk reward frankly is I think punitive. What that means in the middle market is we finance companies very broadly across the modern economy. You name some of the sectors but these are typically businesses that are not hypercyclical not capital intensive. So construction would generally generally not be a sector we'd allocate to because that's obviously very cyclical can have low barriers to entry. It has all sorts of challenges from a credit standpoint. Consumer staples on the other hand food and beverage. Industrial services high value products that tend to be resilient through cycles even if still moderately cyclical distribution logistics. These are the modern backbone of the economy. So these are free cash load businesses that have reasonable demand visibility. And if they have some economic cycle risk we can either address that with structure leverage and entry ratios and so forth and or price. But in a broadly diversified portfolio that we think is is is a valuable place to be. Take the example of software. And in the idea of overweighting certain sectors the leverage loan market has over weighted software and an issuance perspective over several years in part because it was a favored leverage buyout opportunity for private equity. And many of those companies are very good company very valuable businesses. Again for us we were underweight software not because we didn't like software frankly or we are so precious three four five years ago to say aha AI is going to disrupt this entire sector which I think can be a bit exaggerated to begin with. But it was actually just the principles of diversification and the principles of a mid market we need to show the relative value premium. So software in other words gets overbought and the relative value premium to your original point James shrinks because the markets more competitive not as attractive as allocating to the boring food and beverage deal because the illiquidity premium in a diversified portfolio is ultimately what we're after. So I'm talking about structure you guys heavily just right down the middle first lean seniors secure or do you guys go all the way down to guys have any pick pick toggles in your portfolio. Well it's it's funny investor I was with last week referred to our portfolio as boring in a good way and I think that's good for credit to your point where we're sort of chucking about it here. But look what this is a 100% first lean senior secured loan model in our portfolio. And there are many different flavors and variations more broadly in the asset class but our strategy is to not take structure risk or collateral risk and therefore take the risk at the credit level with the company level and again a broadly diversified portfolio. What does that extend to for us that extends to we buy cash pay loans only. There's an idea today that's becoming more and more prevalent of you have good pick and you have bad pick many issuers especially as you go a market they can get deals done with with pick toggles right and that's very valuable for the issuer there's no debate about it and certain companies of a certain quality can dictate those terms on the marketplace. We generally avoid that because again we think the downside is greater than the upside and our model is to produce stable cash income above a liquid credit alternative to our investors. And the more you introduce things like pick toggles or second leans or go down balance sheet on on risk even though at a portfolio construction level you could say well that generates some excess return from our perspective that introduces exogenous outcomes to the portfolio that our investors did not mandate us to take. So with the with the big rate rise that we saw from the Fed over the last few years I'm assuming you guys haven't been exposed to the same level of of sickle quality and and the issues even though we've seen the cost capital rip for a lot of these these small guys right. We've certainly been exposed there's there's really no manager or portfolio in this asset class that isn't subject to the dynamics of the Federal Reserve money supply all the technical factors that impact credit and we're no different that way. These are floating rate loans typically and so you do have the idea of when central banks are tightening and inflation is high that cost is passed on in the bar which actually conversely can be an investor benefit in some ways right you're not long duration you're getting natural inflation protected returns and then conversely when central banks ease and liquidity is rich the the issuers get the benefit of that as rates come down. So for us we've lived through that cycle over the last four years you know clearly coming out of COVID stimulus was high very quickly reversed into a tightening cycle and the opposite has ensued over the last 18 months you look at the Ford curve any day with the news cycle ran it can change but generally the market has has sort of found a sort of plateau and landing level on that we've been doing this leverage lending that is for almost 30 years over 25 years and that means we've lived through rate cycles we've lived through serious economic cycles like the financial crisis and we've seen firsthand the cost of excess leverage in the system we focus on firstly senior secured portfolios that are underwritten on the basis of cash flow and the companies again going back to that earlier part of the conversation have the tolerance to service that debt through cycles and we underwrite that we underwrite for economic cycle we underwrite for rate rise cycles and if we can assure ourselves that all else equal the loan can continue to be serviced then we think we have a healthy portfolio and that's been the case for the most part with our portfolio over the last four years now arguably at least in recent period benefiting from from lower rates where we see defaults it's then not generally because of those macro cycles around things like interest rate movements that's certainly the the modeled objective in the portfolio we want to take those risks out of the portfolio for the most part at least insulate from those risks it tends to still be those idiosyncratic measures company xyz lost a major customer unexpectedly regulation or tariffs in that particular business model changed the risk profile and that's where we really measure the resiliency of companies what are the default rates then in the portfolio I mean is it rising are you seeing higher than than average levels of nonpayment or or companies you know not able to cover the just trip basic engine.
- That's hang, but asking for, can I get a covenant? - Yeah. - Wave over here. - Ask for forgiveness, not permission. - Exactly. - No, generally looking, I can't comment on specifics in anyone fine, but what I can tell you is, again, having done this over 25 years now at PGM, we see an environment that I would characterize as a normal from a default rate perspective today. And I emphasize the word normal because I think most of us appreciate in the last decade, we've had a non-normal abnormally low default rate cycle that every credit investor in the industry said, it's gonna change. I'm bearish, I just don't know when. So we have to prepare for this, and structure for this. I think what's happened is, in part because of the rate cycle, in part because of persistent inflation, in part because of some of the more geopolitical issues that every company in the world seems to be dealing with these days, the default rates have returned to normal. I would characterize it as, but in the context of a portfolio that still shows reasonably strong fundamentals. In other words, you're seeing revenue and earnings growth by and large, you're seeing that in the backdrop of a U.S. economy that continues to generate deliberate albeit moderate GDP growth and consumer spending. And we have all sorts of concerns, we're credit investors, but overall, I would say, we're in a normal default environment for a single B quality style portfolio. As long as the war goes on, there seems to be more risk of much higher oil prices that's gonna feed through across the board to fuel increases, we're seeing $4 of the gallon gas, which is higher than it's been for a while, but then you've got potential supply chain issues, you've got the consumer coming under stress. I know your consumer staples is where you focus, but it must have some potential to riffle across the portfolio if it goes on. - Sure, that's absolutely right. I think that the biggest thing we worry about is credit investors, the so-called stackflation scenario that hasn't been in scope for a long time other than briefly maybe two years ago, you could argue it isn't scope again today. And so we need underwrite portfolios to manage through that type of a cycle. There's no question rising oil prices, supply chain disruptions that cause inflation impact the consumer and the consumers, what greater than 70% of US GDP. So there will be an indirect effect on all portfolios. I would argue then is the strategy resilient enough to withstand that cycle in the context of an arcade so direct lending, firstly in senior secured loan that's meant to return coupon interest as the primary source of income. I start with the first area that type of stress hits, it hits the equity of course. And on average our loan enterprise value ratios and these portfolios are 30 to 40% at loan level. So pretty significant equity question. And in next hits cash flow and the ability to service debt and therefore enter the question of defaults. And I think again, if you've started with the idea that you're firstly in top of the balance sheet, you have integrity and control over the lending structure. IE the company's ability to issue capital or to do things that could create more risk or devalue your loan. And you've started with the basic, basic premise in lending that it all comes back to cash flow. So college professor once told me cash is king, it's never been more true than today in lending, right? And if you have the cash flow that can withstand some reasonable economics cycle for some period of time, hopefully the lending structures will not be, will not be challenged in a serious way from a default standpoint. Buy and large. You'll have the idiosyncratic issues that eventually combine with that macro pressure of that increase the default rate. But buy and large you have portfolios that are well covered. The concern also is that not just the default rates going up but also the recovery rates going down. So I'm wondering, you know, from your perspective in the middle market, do you see the potential to recover a lot less in a stress, distress scenario? That potential exists for sure. When you have a default that impacts in a stressed macro scenario, which clearly there's a lot of correlation to that. If you have a structure or an unnatural need to generate liquidity or to seek the exit, seek the recovery at the point of heightened stress, you take that risk. Our view is much of that stress is cyclical and therefore it is temporary. The question is how long is temporary measured but it can be temporary and that's our experience over time. And if we've done our jobs correctly in the front and it's stuck to our discipline of underwriting, credits we know, we've bilaterally originated. We understand the business models and have what I call information advantage or at least information parity because we've gotten to know these businesses and how they will cycle and we've modeled that into the lending. - So it sounds like the message you're getting from the middle market, which according to the middle market, the association is 200,000 companies in the US, they create over $10 trillion in revenue, they employ 48 million people, it sounds like the message you're getting right now from that segment of the economy is very positive. - Generally, and structurally yes. And I'm glad you started with those statistics, those are often the same statistics we look at. As a cohort, the US middle market is the third largest economy in the world. And with over 200,000 issuers, if you then break that down into the issuer segment, it's estimated less than 10% of that segment is actually owned by private equity. So the other 90% plus is a, what we call non-sponsored, but it's family owned companies. And those family owned companies by and large are looking for capital solutions the same way private equity owned companies do. Because one out of 10, you take a general role of thumb, every year those companies is gonna go through some form of demographic or structural change and need a form of financing that's longer term. And if we can access those businesses in the overlay that US economy long term is a productive place to invest capital, which of course we think it is. Probably I'll hear all here in New York because it is. That is a constructive environment to originate into. And then again, it comes down to as a manager in private's, can you expand the funnel of origination? IE just simply see more deals and opportunities to select the best and to be consistent with your strategy. So we are constructive. Doesn't mean it won't cycle. It will medium size companies by and large, have a risk profile. It's different than a large cap company. We all know that. But again, the principle is a lending and how you structure the loans and price the loans to deliver the right return to your investors. That is available and that becomes I think even more profound when you get into the middle market economy. And that private equity segment you mentioned, they are quite dependent on the business development companies which are going through a lot of stress at the moment. They're seeing outflows from retail holders. Their stock prices are tanking. Their cost of funds is going right up. To what extent is that creating noise that's affecting what you're doing or is it an opportunity because there will be more demand for capital? Thank you have to acknowledge it to both. There certainly is a lot more noise every day that comes out of those headlines. And I think there you have to distinguish between fundamental credit risk and sentiment. And BDCs are ultimately structured to allow retail and private wealth investors to invest on a semi-liquid basis. And we all know sentiment can change very quickly in that market for any number of reasons. Fundamental reasons, personal reasons, price targeting reasons, et cetera, et cetera. So what that has done, I think, is creating an environment where from a credit entry perspective, perhaps as a lender, you're a little bit more conservative. You're a little bit more rational in terms of your view on how to structure the asset, how to price it, how to deliver that acceptable ill-equity premium to your investors. And so notwithstanding private equity does rely, I think quite heavily on the direct lending market, which increasingly is amplified by BDC flows. That market will be there. And like other credit markets, it's a question of what is the price to issue? And is there a higher price today than there was-- or a higher cost rather to the issuer, than there was two, three, four months ago, because of that market sentiment? On the other hand, we've seen over time-- and again, having run these portfolios for over 25 years-- generally, and it's probably no surprise, if you can sustain ill-equity tolerance, ventages that were entered during periods of capital markets disruption or sentiment disruption tend to have shown the more compelling returns. Because the market rationalizes a bit, only the best assets get financed, the price of the asset comes back to a level that is a little bit more interesting as the lender. So I think you're going to see a little bit of both, frankly. And I think there's a price discovery process undertaking the market right now that I think will be actually constructive for making new loans to these types of companies. So this beauty blow up. It's kind of creating a reprising of risk that maybe got a bit over its keys and so on, that some of these loans were maybe not priced according to the risk. I think it will have a bit of a chilling [BLANK_AUDIO]
effect on the need to deploy capital quickly is the way I would frame it. Because again, even in private credit, especially in private credit, you could argue that you need to originate and find the next deal, right? Depends on M&A supply, depends on our ability to go identify these companies and convince them this capital is suitable. It's a long-term model. And if you have a sentiment-driven market that raises a lot of capital very quickly and supply is tight, well, we know supply and demand and what that means on prices. Prices go up, they become Richard and we've seen that across credit. IG credit spreads at 25-year tights, right? So direct loan is no different that way. If that pace of demand for capital slows down or finds equilibrium again, then I would argue all else equal, that's a good entry point. Because if you're as a manager sticking your knitting on the types of loans you make, the price has probably found equilibrium in a way that may be a little more attractive. What about outside the US? There seems to be a lot more interest in Europe up until the war when it's cooled a bit. But European direct lending is popular. It's apparently better spreads and less risk according to the guys that are doing it. What's your view? We do have a European mid-market direct lending practice as well. Although PGM is known as an American firm, we have over 50 investment professionals and five offices across Europe. We've been on the ground there for decades. And our view is the following. One, technically speaking, you can always find periods where Europe or US is in or out of favor in comparison to the other. Right? E spreads are a little wider, risks a little lower, etc., etc. Generally though, the market principles are the same. You have a large and growing middle-market economy that is seeking capital solutions away from banks. It's even more the case across the continent that those companies are still private than either not owned by private equity, have likely not ever considered a direct lending or private credit option away from the banks, but that's changing. And so the penetration curve is increasing. Therefore, it's the market's less mature. It's slightly less competitive, although I would say it's still very competitive. And right now, the European sentiment is you can get moderately wider spreads for the same risk profile, the same point of leverage, same types of terms, etc., etc. Now the trick in Europe, of course, it's very heterogeneous as you know, and you have to have localized origination teams that know how to develop these relationships, track companies, structure loans across any individual country in the Eurozone. It's suitable to what we're trying to achieve at the portfolio level. Big picture opportunities similar. It's less mature though, and so we see the pace of growth actually be at higher. And right now, I would agree it happens to be slightly wider spread environment at entry. And even given the bigger macro exposure that we're going to get from the around war, you think that this interest in European private credit will remain as strong? It's going to be tested for sure. It's that much closer to some of those issues. And the biggest query area, of course, was Ukraine. And in 2022, that's where I mentioned, tactically, you'll see sometimes the opposite occur. US was generally more in favor than Europe. Having said all that, I think the implications of ongoing conflict in Iran, as you alluded to earlier for the broader economy, its oil prices and inflation. Europe obviously will be impacted by that, but so will US companies. And so I come back to the idea that you have a deep set of attractive, resilient, healthy middle market businesses. Many in Europe being a little bit more export-oriented, right? And the adoption curve of those companies is earlier days in the US, and that means the opportunity to lend constructively in theory, big picture is we think really attractive. The cycle question, you probably have to evaluate that deal by deal in country by country across Europe, and there could be a quicker impact. Is there a country you'd take the light now in Europe? We like the entire Western European economy, really. I would say generally you'll see leverage lending in particular being the so-called beer drinking countries, northern Europe, which 10, not always 10, to have more prescribed, slightly stronger, creditor-ized than the wine-drinking countries. But we think that's a bit of a dated reference, and we look at our opportunity set, some of our most productive origination teams are in Milan and Madrid because those economies are growing. Take Spain, for example, fastest growing economy in Europe the last couple of years. On the other hand, take Germany, what we like about Germany is you have this idea of the Middelschland company, which correlates to the same point you made about the US, massive middle-market economy, not that many companies have access private credit yet. Well-run stable businesses, and as the largest economy in Europe, it's actually the fourth-largest issue of direct lending paper. Why is that? Well, that to me is structural based on bank competition and cultural norms, and that's changing. That's changing in a really interesting way for direct lenders. And you're doing all industries there? Is it mostly staples as you're doing in the US? Same approach from a sector standpoint as the US. The one notable difference might be health care. In the US again, we, as I said before, our model, there are different models to be clear. Our model is to not take exogenous risk in the portfolio. What I mean by that is to underwrite identifiable and controllable risk as much as possible. Health care in the US is, of course, highly regulated and legislative driven. We call it stroke of pen risk. You have the insurance company private pay model, which is critical to the profitability of many health care operators in the US. In Europe, of course, you have socialized health care in a way that provides a little more stability and visibility into how the system at least works and makes money. So we may, for example, we have tactical differences. We may take a little more health care risk in Europe than the US for that reason, but overall it's the same approach in the same principles. When you look across the globe, all the stuff you're doing that, what's the single best credit market opportunity you think for the next, let's say, 12 months? We see the value through cycles. And so we're never one to say time entry here or there. I would say though, by and large, simply because it's the supplied demand dynamics, which is the one thing that's sort of irrefutable. Europe is less mature. Australia is even less mature. If you have origination teams on the ground that can access, underwrite, manage the credit through cycles, I think just like we saw in the US over the last 10 years, that's a pretty constructive place to invest in private credit if you're willing to take depending on where the investor sets the currency risk or the offshore risk, et cetera. So best relative value in Europe and Australia in terms of a global direct lending platform. That's right. But again, 70% of the markets in the US is a thriving and a powerful economy that you want to be invested in. So it depends on the investor tolerance and maturation curve of each of those markets. Great stuff. Matt Harvey, headed to direct lending at PGM Private Capital. Thank you so much for joining us on the credit edge. Sure. Thank you. And of course, very grateful to Matt Goyne from Bloomberg Intelligence. Thank you for joining us today. So I'm going to be back. For more credit market analysis and insight, we'd all have Matt's great work on the Bloomberg terminal. Bloomberg Intelligence is part of our research department with 500 analysts and strategists working across all markets. Coverage includes over 2000 equities and credits and outlooks on more than 90 industries and 100 market indices, currencies and commodities. Please do subscribe to the credit edge, wherever you get your podcasts. We're on Apple, Spotify and all other good podcast providers, including the Bloomberg terminal at BPod Go. Give us a review. Tell your friends or email me directly at
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