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- [00:00]
A
Well, hello capital decanters. As we take a short break and a needed rest between season two and three, we're doing something a little bit different this year to highlight our key episodes. So given the sequence and the timing of when these episodes are released, as we thought more about it, because they drop across a period of 10 months almost, it's a bit unfair to simply take the quantitative number of downloads as that of course is going to arbitrarily advantage the first few episodes that have been available, of course, the longest. So this year we're going to combine a little bit of art and a little bit of science to highlight what we're calling the decanted half dozen. These are the six episodes that were the most influential and popular. And that's based of course on the pure stats, but also on what we're hearing around the industry about what topics are most timely and transformative. So here they are, season two's most influential and popular episodes. Coming in at number six of the decanted half dozen for season two was episode ten, Asset Based Lending. We often like to talk about the Kaya stage quotient on this show of the unique perspective that we have in our travels and stage time to monitor what's trendy, what's out of favor and what's full of froth. You might say ABL is a formative and rapidly expanding portion of private credit that we just felt the need to address much more holistically. Welcome to Capital Decanted. In this show we say goodbye to tired market takes and superficial soundbites because here, instead of skimming the surface, we dive into the heart of capital allocation, striking the perfect balance and exposing the subtleties that reveal the topic's true essence. Prepare to have your perspectives challenged as we open up the issues that resonate with the hearts and minds of those shaping capital allocation. We've enlisted the wisdom of visionary leaders in the industry and just like a meticulously crafted wine, will allow their insights to breathe, unfurling their hidden depths and transforming our understanding. This is season 2, episode 10 of Capital Asset Based Lending. I'm John Bowman. And I'm Aaron Filbeck and we are your hosts. A huge thank you as always to our returning title sponsor, Alternatives by Franklin Templeton. We are of course grateful to have them back to partner with us. They've been here from the beginning. Franklin Templeton has over 40 years of alt investing experience, over 260 billion of assets under management. Their specialist investment managers have expertise across six different asset classes. Real estate, private equity, Private credit, hedge strategies, venture capital and digital assets. And of course, all of them operate with the client first mentality that has always defined Franklin Templeton to help prioritize investment outcomes. So thanks again. Alternatives by Franklin Templeton all right, Aaron, Asset Based Lending. We've done several episodes on what I would call coming of age stories that it often navigates to those types of topics. This show across the two years that we've been doing this, where strategies or techniques or financing mechanisms, they might start in the dark corners of Wall street or high sophisticated finance and then they institutionalize a bit, they go mainstream. And so I'm thinking, for example, GP stakes, that was season one, episode 10, or secondaries, which was episode 14. Those were great examples of this evolution. And even in some sense the larger category we're going to be speaking of today, our episode on private credit last year, which was episode 11. These capabilities often blossomed from distress, desperation, from lenders or capital providers of last resort to widely accepted portfolio tools. And just as the story goes, today ABL serves now as a crucial and flexible source of capital for business expansion, inventory financing, growth and acquisition, and cash management. And we'll talk a lot about that. They've gone from fringe to widely accepted. So ABL shares this coming of age story with many topics. But Aaron, I don't know about you, but that's really where the similarities as my research unfolded ended. Because I would argue, and I know this is hyperbole and perhaps a bit of exaggeration, but it seems to me that this is the most idiosyncratic and complicated asset class we've covered. In fact, I'd suggest it's hard to even make the claim that this is a single asset class or exposure or economic factor that you can kind of put your thumb on and say, I need some more of that beta, or I need some more of that risk premia. And that's even after hours of study, reading and conversation, because each of these loans are snowflakes. They're each unicorns to borrow from our family, office, friends. If you've seen one ABL loan, well, you've seen one ABL loan. ABL puts the specialty in specialty finance. I like that one. So yet that's what makes this space so fascinating and intellectually stimulating, at least to me. But I will say nonetheless, I do not envy the CIO in having to think about the right way to allocate to this space, if that's even how you should think about it. By the way, we should ask Greg about this. How do you allocate, should you allocate actually to the space explicitly and even more so I don't envy even more conducting the multifaceted due diligence and eventually underwriting and sizing of these gps. So you're in for, I think, a really nice journey here. That is however, why Capital Decanted exists. That's all the more reason ABL was the perfect topic for this show. It it combined a couple of characteristics that really define who we are here at Capital Decanted. One is this multi layered, complicated, misunderstood nature of this category of credit. As I've just been talking through. You need a few breaths, maybe a couple glasses of wine to navigate your way through this Sound bites and social media fluff just ain't going to cut it Aaron on this stuff. But second, this stuff is hot. We often talk about the Kaya stage indicator, as you might say, to identify the trendy. In other words, given all the industry events that we host and speak around the world, we have this unique perch in which to gauge how often panels and speakers are mentioned and what topics or investment opportunities are advocated for most often. And Aaron, I was thinking about this, by the way, in my prep. I think we probably could have monetized this leading indicator to make some serious money. I think back to crypto cycles and middle market lending over the last few years. I think we should back test this so if you could get to work on that.
- [06:35]
B
The great collateral. John speaking of asset based lending.
- [06:38]
A
Wow, you've been waiting for that one. So we'll check back in on this backtest on whether we can productize this going forward. I wouldn't say, to be fair, that ABL has reached the fever pitch that we've seen with some of the others, but we are certainly hearing a lot about it right now, particularly in light of how crowded the direct lending, the traditional, if you can call direct lending traditional, but the traditional direct lending space has gotten. So today we're marrying, as I said, complicated with a lot of momentum. That's a perfect candidate for us here on Capital Canton. So asset based lending, it's exactly what it says on the box. For those of you, which I assume is very few who are new to this, but asset based lending, rather than a traditional loan that is secured or based upon the credit quality, the operational health, the cash generation of a business, an ABL is secured by the underlying value of a specific company asset or assets identified as the collateral, hence the name. And of course under the terms of these loans, the lender has the right to Seize that collateral if the borrower defaults on their loan. The collateral could be tangible like real estate, machinery and equipment or inventory in house. These are things you can feel and touch or intangible such as intellectual property, royalties, R and D discovery and patents or accounts receivable, which is very popular as we'll talk about. So just to make this very simple, the mortgages on our homes are effectively asset based loans, most likely a bank, not most likely, almost certainly a bank conducted or commissioned an appraisal on the value of of your house and they determined through that appraisal an appropriate loan to value LTV against said appraisal and they therefore loaned you that amount of money for you to buy your home. And just like with all ABLs, as I mentioned, that bank actually has rights to claim and sell your property if you default on that loan because it serves in this case, in this example, as the underlying collateral to secure that credit, that mortgage. So the great contradiction here, Aaron, getting back to my point on the most idiosyncratic, the most complicated, is that it's fairly straightforward concept at the micro level. At its essence, as I just explained in an individual mortgage, the issue is that it's expanded to a myriad of very complex industries and collateral types. And so grouping this and generalizing and stereotyping is where you get into trouble and where you find yourself working through just a wide variety of different credit types, collateral types and GP expertise. And it's that that we're inviting you today listeners to discover with us today. And I think we're going to have some fun. So speaking of that journey, I'm going to do a few things. First, I'm going to give you, as I typically do, a brief history of abl. And unlike some of those other coming of age stories, this is neither linear nor smooth. Its evolution is better represented by starting at a single point and beginning to draw bigger and bigger circles outward. From there it's this meandering maturity story, like the start of the yellow brick road for you wizard of Oz fans. Aaron, when you know, you know. So history. Second, Aaron's going to go into a little bit more detail on types of collateral, especially how it's expanded away from the banks here. But I want to outline a few archetypes of businesses where ADLs are particularly fit for purpose, as I think, at least it was for me. This will practically reinforce the real economy need for this type of credit. So getting away from the philosophy to how does this actually help the world in which we walk in and operate in and transact in as consumers and finally as a segue and some important identity hooks. As I hand off to Aaron, I want to give you very quickly some market sizing, some profile data for the ABL industry today, which is a whole lot more challenging than you might expect. Aaron's going to then unpack in his segment in more detail the different types of ABL today, which by the way, seem to broaden by the day. Every article I read is reshaping types of ABLs, who plays in which of those segments with a particular eye towards where the banks are still dominant or at least a major factor. And finally outlines some of the common misconceptions, areas of confusion, things to look for when analyzing these strategies. So he's going to be putting on his old due diligence hat there. And then we will be joined this episode in studio by two exciting guests that are really experts in this field of abl. Cedric Henley, partner and chief risk officer of specialty finance at SLR Capital Partners, which is a 13 billion of investable capital private origination platform. And then Greg Turk, deputy CIO and head of private markets at the 13 billion Illinois Police Officers Pension and Investment fund. So we'll be looking forward to speaking with Set and Greg as we navigate through this exciting topic. Sound good, Aaron?
- [11:24]
B
Sounds great.
- [11:25]
A
Well, let's go. I want to open with a question to you. You shared with me, I forget in an email as our prep was wrapping up that you found a cool or weird anecdote, I think were your words about ABL that you came across in this space. And listeners, by the way, decanters. I've not heard this either. So we're hearing this for the first time. And if you get to know Aaron, you need to buckle up when you ask him for weird anecdotes. So Aaron, off to you live.
- [11:50]
B
Yes, absolutely. So this is a bit of a preview of what's to come in my segment. But I talked to a couple people and trying to prepare for this because as John mentioned, this is a very complicated and growing esoteric area of the private credit complex. And one of the examples that was given to me in terms of a deal or a loan that one of the GPS presented to an LP that I was talking to was a loan that backed bitcoin mining companies and the collateral was the computers that were actually doing the mining for bitcoin, which sounds great in theory until Bitcoin falls 50%. So we'll get into some of this a little bit in terms of collateral, but that was one of the weirdest things that I've heard in terms of just the collateral backing some of these loans. You can get really specific and esoteric with some of this collateral. The last thing I'll say, John, because I have to get a joke in here, is I will be listening to your segment and the duration of your segment with great interest too.
- [12:46]
A
Good. That actually rhymes with a couple examples I'm going to talk about later. Maybe not quite the volatility of crypto, but there's some systemic circular elements to this when you get into high tech, abl. So put that up on the wall, park that for a few minutes and we'll get back to it. All right, so before I unleash my inner historian, we first need to throw out a huge definitional disclaimer. This was something Aaron and I talked about at length. This was an enigma, honestly, that haunted the entire prep and perhaps has you scrambling too as you start to read about this. And if you read articles in the media, there is massive conflation of what I'm about to talk about. So we are going to make a big distinction between asset based loans, abl, as we're calling it again, these are individual credits secured by specific underlying corporate assets with the entire world of asset based finance or asset based securities, ABF or abs, you might have heard that called. Now that might simply sound like semantics or acronym gymnastics, but these are literally trillions of dollars apart. So it's really critical we draw some lines here. When I say asset backed finance or abf, I'm talking about the enormous world, mostly originating in banks pooling a bunch of asset based loans and then tranching and syndicating them. KKR for example, has this space, ABF at nearly 5 trillion and moving to 10 trillion in 2030. So as we'll talk about shortly, true ABL is a fraction of that. Asset based finance has occupied our conscience and frankly, Hollywood theaters in the form of collateralized loan obligations, collateralized debt obligations for all kinds of underlying credit, perhaps notably, as you all remember, or at least most of you should probably remember, the subprime mortgage crisis that brought the global financial system to its knees in the gfc. But these collateralized securities also have other flavors of mortgages, consumer credit card debt, auto loans and project loans in areas like commercial real estate, aircraft, just to name a few. So to be clear, again, I cannot put a finer point on this. Today we are disciplining ourselves to focus on true private capital origination platforms that are sourcing, underwriting and servicing these loans and credit risks from their own balance sheets or funds. So another way to say this is that this is true. Asset based AUM versus syndicated financing. Really important preface here. Okay, so definitions established off to the history. As you might imagine, ABL in one sense are probably the oldest form of credit in human history. Aaron, you're going to like this. And that's because the relative security, the known downside, again, you've got assets, and particularly in the earlier days, all physical assets that you are valuing these loans against. So there are actually records in ancient Mesopotamia, this modern Iraq and Iran as early as 3000 BC. This is during the Acadian and Sumer empires. This was the time of Gilgamesh, if you remember your high school epic, Sargon the Great. So this is a few moments ago now, I'm not sure Gilgamesh did any syndication of these abls. We'll have to look back at the record. But nonetheless, traveling merchants would borrow against their goods, their livestock or their land from these money lenders or farmers would borrow against their future prospective crop harvests. Again, this is 5,000 years ago, so really mind blowing if you think about it, during the middle Ages, Fast forwarding just 4,000 years, Mercantile Finance extended this practice to things like spices, gold, textiles, Famously Henry vii after the shame of the family food fight of the English throne, this is the infamous War of the Roses resorted to ABL to fund his invasion of France later in his reign. Very interesting. So the military has levered their assets for purposes of invasion and war. So in more modern history, this practice began to proliferate during the industrial Revolution early in the 20th century. Now you can imagine that heavy manufacturing and back then, early in the industrial explosion, it was overwhelmingly textile, garment, steel factories. They would struggle to secure traditional financing because they were asset rich and cash starved, these business models. And particularly as they were beginning to establish themselves, these businesses had very big balance sheets, but very thin and often upside down PNLs. So they were forced to turn to alternative forms of revolving credit that levered their prized assets, typically their factory equipment or their physical inventory. And this reliance on ABL for heavy manufacturing companies was of course exacerbated during the Great Depression when the credit market seized up for years and they needed a reliable cash facility to survive this economic turmoil. But it was not until the 80s when you begun to see two parallel identities of ABL emerge, which really starts to paint the picture of our coming of age story. So on the one hand, the use of ABL begun to be used as a working capital tool, intangible assets like accounts receivable begun to be levered to ensure the company could cover payroll, rent and general expenses while their supply chain worked itself through their cash cycle. It also allowed companies to fund expansion, new equipment purchases and growth endeavors. So that's one side of this dual path. But this is also when the distress, stigma and narrative really emerged for ABL as it begun to be associated ABL, I.e. with the very last option and source of capital for businesses with limited cash flow. Or even worse, companies in process of restructuring, dancing on the bankruptcy line or facing LBO recapitalization. Because this is the time the chapter of the corporate raider of the hostile takeover phase that really picked up steam in the late 70s and into the 80s. Now most recently, ABL really took off during COVID when global supply chains literally froze for several months and arguably you could say even though they picked up again, at least they started moving again after several months. They really didn't completely thaw for a couple years. So ABL was an unprecedented lifeline for many to survive that cash desert and that economic volatility. So as you can see, there's been these chapters of IT serving urgent needs and chapters of IT allowing for balance sheet optimization. Hence my point on IT meandering this history. It wasn't a straight line. So I think that winding and serpentine shaped history leads us to our archetypes, which I think is really interesting. It's here that we see the diversity, the ultra bespoke nature of this credit category. It also brings, as I alluded to, some full Technicolor illustrations to the concept that really helped me at least crystallize the role of these loans, as I said, in the real economy. So by the way, I certainly don't pretend that these are anywhere near exhaustive, but what I've done through the course of my reading is chosen and grouped five business profiles that really dominated my research and extend this practice way past its desperation label. So I'm not going to cover the distressed narrative here at all. These are beyond that and I realize it's still working to shake that narrative. But nonetheless, these are five archetypes that take advantage often of ABLs. So number one, I'm going to call this long payment cycle or extended supply chain. So these businesses usually have multiple specialized raw materials, significant lead time between purchase of those inputs and ultimately harvesting the cash from their finished product sale. Think of garment and apparel companies or healthcare providers. And by the way, when your main payer healthcare providers is the government, you don't have high Expectations for quick turnaround of bills. So import, export businesses and international trade would also fit, I think into this category as days sales outstanding, you might say for payment could be literally several months. So you might call these extended supply chains cash delayed businesses. They need access to working capital, so that's number one. Number two, lumpy or seasonal businesses. Aaron, by the way, do you know my very first job, 14 years old.
- [20:48]
B
I don't, I don't think you've told me.
- [20:50]
A
Well, it was Chick Fil A, which by the way is neither seasonal nor cash rich. But my second job importantly was KB Toys, which probably did that exist in your childhood?
- [21:01]
B
It did. I shopped there quite a bit actually.
- [21:03]
A
Well, I worked there. I ran the Fashion Square mall in Charlottesville, Virginia. KB Toys, that's an exaggeration. But I worked there. I stocked shelves basically is what I did. This is largely defunct, which is hopefully no correlation with my lack of skill in stocking the shelves or merchandising in the 90s. But the toy business itself is massively hit driven and seasonal obviously. So when a new Star wars or Avenger film comes out, you see a spike in sales. When a new video game system is released, you see a spike. And of course we all know that the large majority of toy sales come around the holidays post the so called Black Friday when these businesses move from the red to the black in annual profitability. Have you ever seen a Halloween store?
- [21:45]
B
I have, yeah.
- [21:46]
A
That's the oddest business model that's ever been created. So I don't know why these exist, but I imagine for example, their cash balances struggle for about 350 days a year. They get about two weeks of cash movement. But beyond toys, jokes aside, there is seasonal apparel and equipment. You can imagine agricultural operations, obviously that's massively seasonal tourism related activities. So you get the idea. These are great examples of businesses that need to smooth their working capital against these jagged and concentrated cash behaviors of their consumers. Third, industrial product. So to some extent this is an extension of the delayed supply chain. But the reality here, the unique additional factor here is that the working capital, the shipping and the production costs are really substantial in these types of business models. So think of drilling and mining, aircraft engines, auto parts, freight and trucking, medical equipment, technology infrastructure. These are big, big product, expensive, long production cycle, assembly line product, very expensive, physically large, take a long time to monetize. So the idea here is to unlock trapped capital that just gets clogged up in the system. Given the timing. That's 3rd, 4th, R&D our guest today, SLR is actually one of the private capital firms that have really built this practice in life sciences or pharma or biotech. This is lending against those future discoveries, royalties, patent exploitation. So these companies need access to ongoing capital to keep funding the chemistry, the research, the design, the trials and the marketing associated with their innovation so largely in the healthcare space. And finally, number five, growth financing. Now the most obvious here is early stage companies that don't have the history of cash flow similar to the early history of abl. They can't justify traditional direct lending because they don't have that three or four paychecks we're used to giving to the bank when they're looking at our credit capability, but they can lever their assets. So similar to back in that industrial revolution, but very much these are new economy models I'm really pushing on. And this category is also robust for established companies that want to enter new product lines, new geographic areas, make acquisitions. So I mentioned to put a pin in Aaron's story on the tech side a few moments ago. So one of the recent examples here I found fascinating that has received a lot of press coverage has been the AI cloud companies that provide support to companies that are building LLMs, large language models and generative AI. So these are companies like Crusoe, Lambda Labs, Core Weave. These are businesses that have secured massive ABL facilities against their inventory of. Drumroll please. Nvidia GPUs. So a single AI GPU from Nvidia could cost 30 to 50 grand and a full rack might cost as much as 2 million USD. So you can imagine the levering power of this equipment in these data centers basically. And guess what these NEO cloud companies are doing with all this new access to capital? Well, yes, they're buying more Nvidia GPUs. So I alluded to this systemic risk. So question for another day is whether Nvidia is creating some circular systemic risk in the credit system. Because they are basically syndicating and syndicating these loans and credit against the same collateral to buy more of that collateral than leveraging it and on and on. So you get layers and layers of Nvidia GPU collateral. So there you go, extended supply chain, seasonal businesses, industrial product R and D and growth. Again, probably not exhaustive, but I think it really brings to life the power of some of this ABL credit capital access. Okay, let me finish off my segment very quickly by painting a picture for you of the current sizing and the state of the ABL ecosystem. So remember what I said at the start of the show we are differentiating for purposes of today's episode from asset based finance only focusing on true originators and operators of abl. These are GPS and banks where you could explicitly capture AUM or what you might call investable capital. But it's a whole lot easier said than done is there is a ton of double counting conflation overlap in the data we've looked at. Loan pooling and syndication creates this messy octopus of interconnectedness that we had to unravel a bit before we could draw any types of lines and pencil in some sizing here. So as I mentioned earlier, the ABF again that's pooled, collateralized and syndicated is about 5 trillion. I looked at a ton of sources to try to size just true ABL as a part of that and those estimates ranged Aaron, for 2025 anywhere from 700 to 900 billion. So just taking the midpoint there, I think we can say with some level of confidence that ABL is roughly 800 billion of the 2 1/2 trillion of private credit and arguably the fastest growing. So as we alluded to earlier, cash flow direct lending has become very crowded. It's pushed GPs and LPs to look for other sources of yield and fixed returns. So there's significant demand pull from capital allocators down the value chain for these types of offering for other exposures to credit. Further, of course the continued retrenchment of banks from the space, especially after the collapse of Silicon Valley bank, has further emboldened the private capital firms to be aggressive here. However, as we've tried to explain, this is a very specialized form of finance that requires deep technical subject matter expertise, much more so than most forms of credit that's crossed a very narrow and unique forms of collateral as we tried to explain and we're going to talk to Greg and to SED about how they think about the specialization of this. But to do this well, abl, you can't just build a group of credit generalists and release them into the wild, even if those credit generalists have significant experience in origination and underwriting. And this is really important these next couple sentences because the key here is business model intimacy, valuation competency in the specific type of collateral the borrowers are levering. Your team of underwriting and valuation experts as you might imagine, are very different looking professional profiles when you're underwriting, Say Life Sciences vs Manufacturing Equipment vs Nvidia, GPUs vs Bitcoin Mining Equipment, very different types of individuals with very different competency sets. And furthermore, lenders are facing expensive and increasing pressure to invest in data analytics, cybersecurity, advanced fintech tools that are enhancing the decision making, improving risk assessment and real time monitoring of the assets that are the collateral to really streamline the loan origination process. So I mention all of this in a bit of an aside as there are unique pressures that add I would say an inherent governor to the growth of abl, a scarcity element that limits the velocity of the segment, at least the velocity of quality capabilities and GPS on the segment and that keeps the supply demand dynamic very favorable for I think experienced investors. Now despite all of that, most forecasts have that growing to sound terribly contradictory at very healthy cagr. So perhaps unrealistic clips in my opinion for the reasons I've just highlighted. So for example, Research and Markets puts a nearly 11% growth rate 10.7 growth rate on it resulting in a $1.3 trillion market by 2033. Business Research Co. Is even more bullish using a 13% CAGR resulting in 1. 4 trillion as early as 2029. And Global Market Insights also uses 11% resulting in it reaching 1.5 trillion in 2032. And by the way, if you're trying to do this math at home, just stop. Don't try this at home. These are not apples and apples cause I mentioned earlier the start are all different. But I think you can see we're at least in adjacent zip codes across these research houses. Whether you think they're a bit too aggressive, which I do, they seem to be concentrating around a certain low single digit type of cagr. So as I finish off, how about segmentation from a collateral standpoint? Accounts receivable ABL is now the largest type at approximately 45% of total inventory financing. The original would be next at 35%, equipment at 15 and there's this long tail of others for the last few percent. Unlike the earlier industrial ages, small and medium sized businesses versus large are now dominant in ABL almost 2/3 of the total and growing. So again this is growth capital now, much more so than it was desperation capital. From an industry standpoint, manufacturing, no surprise, is the biggest user at almost a third of the total. Healthcare Perhaps surprisingly is second and over 20%, retail and wholesale is nearly 20%. High teens and tech is 15%. And then you see again this long tail of construction, auto logistics, agriculture and so on. Origination still is owned by the banks at about 40%, but private capital firms have exploded here and are quickly gaining share at over 30% now, so Apollo, Blackstone, Aries, 6th Street, Oaktree, Carlisle, KKR, HPS, these are all household credit brands. They've all made acquisitions and or launch dedicated platforms and funds really in the last few years. This is really new in many ways. Finally on the geography side, while the US still holds nearly half of the global market, Asia interestingly has been a region of very high ABL growth expected to close the gap from its current 35% due to these rapidly growing economies, particularly in Southeast Asia and quickly developing infrastructure and manufacturing supply chains that has been I think, supercharged. Post Covid as you near shore and diversify your supply chain dependency across countries. China itself now represents over 100 billion in ABL. The last couple other fun facts here as you digest that segmentation is that unlike direct lending, which is nearly all floating rate loans, ABL is 2/3 fixed rate lending. ABL is also typically represented and I mentioned this earlier, if you picked it up in much shorter term facilities or revolving lines of credit. So they're rarely direct term loans that dominate the cash flow space. This is usually a line of credit, for lack of a better way to phrase it. And that gives them an average life of one to two years on average versus perhaps triple that indirect lending and of course five or six times that in private equity. So in summary, let's call this an $800 billion segment that's led by the primary profile of accounts receivable collateral loans at SMEs in manufacturing in the US with fixed shorter term revolving lines of credit. That's your typical profile here. So there you have it. You've got your primer on the history and the current status of abl. So Aaron, I want to turn to you to tease out these segments and collateral types a bit more with a different lens, a lens of how this affects your investing thesis and your approach to partnering with these gps. So Aaron, off to you.
- [32:38]
B
John, just a couple reactions just listening to you talk and I think most listeners know this. We don't give each other what we're about to say. So I'm learning this in real time as John goes through some of the history. I'm shocked that the US is so small relative to direct lending, that Asia presence being much larger. When you look at like direct lending now, I think it's somewhere around 80% is US origination and then it's slowly moved overseas. But were you surprised by that half and half?
- [33:05]
A
On the one hand, yes, for the reasons you've decided because private credit is overwhelmingly western based currently. If you look at just a stat on what percentage of banks still are relied on for credit facilities. And as you know in the west something like 70, 80%. Now non banks are lending. Asia is the exact opposite. So they're early. So if you look at the private credit origination platforms just generally in Asia, they would still be mezzanine, desperation restructuring, non performing loan type capabilities. And the only thing to get to your question that I'm thinking is that given that the early stages of ABL typically mirror those restructuring or bankruptcy or trouble type of companies, that my guess is is that's why ABL is perhaps exploding in Asia early. So I think just a few things are coming together. The stars are aligning for ABL to do quite well in the current Asia space.
- [34:03]
B
Other thing, maybe more of an aside. I have this mental image of you going back in a time machine and trying to explain tranching to Gilgamesh and Henry vii. So that was fun as you were talking.
- [34:12]
A
I'm sure that they'd be interested in your micro credential on private credit.
- [34:16]
B
There you go. Well, great. That was really helpful John. And I think previews some of the things I'm going to talk about from your perspective, maybe a little bit different perspective from me relative to what you were sharing. But nevertheless this is a challenging place to define and get your arms around just given some of the different definitions and where some of the assets are lies. So what I'm going to do is I'm going to walk through the universe of ABL and try to codify and put some definitions around some of the different collateral players that are out there. I'm also going to talk through banks versus private lenders. John walked through some of the different types of companies, but I think some of the characteristics is also important to differentiate between where the private players play and where the banks play. I'm also going to walk through a little bit on structure and mechanics of abl. And John, your intro talking about mortgages, that's a great preview for what I'm going to do there as well. And then I will wrap up with a little bit on some of the opportunities and risk considerations for investors moving forward. So on the universe of ABL and the different players that are out there, there's a couple of categories and again this is not all encompassing and you may see some of this in the direct origination space and you may see it in the bank in the syndicated space as well. But I want to focus mostly on collateral and then we can get into structure. So from my perspective there's really three main groupings of ABL that's out there. There's hard assets, there's balance sheet assets, and then there's specialty finance. And you can maybe trade between each of these in terms of which one fits within each one. But when you look at hard assets, you're looking at, as the name suggests, physical properties, assets that are available to the company. So that's things like real estate, infrastructure, farmland, timberland, and then commodities and energy getting into oil and some of the raw materials that go into the business and how the business operates. On the balance sheet asset side, this is where we get into some of the receivables, the inventory, the equipment assets that are held on the balance sheets of some of these organizations that may be more specific to different parts of their operating model and their business model.
- [36:19]
A
I found it odd in my prep that often inventory was grouped in the intangible space. And I guess I'm probably thinking about a certain type of inventory. You walk the factory floor and there's widgets laying around, which is very tangible and kind of the old school abl. But can you help me and the listeners understand what the variations of inventory that would label it intangible would be?
- [36:44]
B
When I was thinking about grouping this. When you look at card assets, so like you look at real estate or an infrastructure project, these are typically very specific pieces of collateral. It's a specific property, it's a specific project that's being done. When you look at the balance sheet assets, like an inventory or equipment, it's usually based on a collection. So I think it's less about physical versus financial, and it's more about a grouping of some of the assets that are backing that particular loan. That may not be the right way to think about it, but that's how I group this within a balance sheet context instead of a physical hard asset context.
- [37:17]
A
Okay, that's helpful. Thanks.
- [37:19]
B
So the one other thing that we didn't talk about is nav lending. So a lot of what we focused on here on the balance sheet side are companies that are operating and trying to get loans based on their collateral. Well, we're actually seeing fund managers and gps that are using this facility to raise funds to help them through the cycle of making commitments and exits and potentially reinvesting in some of those different portfolio companies. And that's a unique, maybe more esoteric asset that's being backed by loans, but sits on the balance sheet of the gp, if you will. On the specialty finance side, you've got more esoteric assets so this is things like consumer finance, which includes credit card loans, SoFi, personal loans, if you will, and then this whole revolution of buy now, pay later, which I'll get into as well. A lot of ABF tends to play in this space, but you're seeing more and more direct platforms as well. You also have royalties, healthcare, R and D. Some of the things that you mentioned, John, before and then finally is these insurance contracts and policies, so life settlements and reinsurance, catastrophe bonds and so on. So there is an asset backing it up. It just happens to be a insurance contract instead of something physical. So if it's not obvious, this is clearly not the same as what we see in the cash flow based lending space. Cash flow based lending tends to look at the entire company and their ability to repay the loan, whereas the asset based lenders are looking all at the collateral and the collateral that's backing that specific loan. And you can see that it gets very, very esoteric very quickly. So as John mentioned, some of these categories originated at the bank. So I think it's essential to differentiate who plays where today. Where are the banks making these loans versus where are some of these private lenders making these loans? And this is a really tough delineation to make. It's not as clean as saying the banks are here and the private lenders are here. So we can't really divide the world up in that way. But you can do it based on some characteristics. And I think there are some clear differentiations that you see between preferences between these two different types of lenders. So banks tend to lend to more investment grade and asset heavy companies, whereas private lenders are willing to go down below investment grade, maybe take on more complex situations and may lend to companies that don't have as much physical assets backing some of these different loans. So this lends itself to the different types of collateral types. So banks tend to be focused much more on hard assets and more standard balance sheet assets like receivables and inventory, where you can bring it all together and make a loan based on a collection of assets. Whereas private lenders, they may operate in the space as well, but they might take on some of those more specific, complex, esoteric assets like receivables that are more specific to a particular area, royalties, which are much more challenging, intellectual property, certain types of equipment, and then again those NAV loans that I mentioned as well. Now, in terms of structure, banks tend to follow this originate to distribute model, which means that they tend to go into securitized products, which means that they're much larger and much more standardized in nature. So banks are working within a box, if you will. They've got to check a bunch of things within the box so that it can then distribute it to an spv, which then can be securitized. So this is where the asset based finance or asset backed finance tends to show up. Private lenders, as we've talked about, are much more bespoke and are willing to go much smaller in terms of size and scale. So as you can imagine, greater complexity, higher yields and greater flexibility tends to exist in the private lender space. And the opposite is typically true in terms of what you see in the banking space. The other thing that I'll say here is there's a lot more intensive monitoring that takes place from the private lenders relative to the banks, which I'll get into with an example. A related thought here and the evolution, John, that you were walking through is that the banks and the private lenders are actually increasingly working together. So this is not a clear again, delineation between those two lenders. So in some cases you may have a bank and a private lender split an opportunity and they'll play where they are most appropriate, where the bank is much more risk conscious and the private lender is able to take on some of those different esoteric characteristics or maybe a particular asset for the private lender, whereas a more generalized asset might support the bank lender. So let's talk a little bit about the structure and the mechanics of asset based lending. So in asset based private credit, it's impossible to talk about any of this without talking about the collateral. We've talked about it quite a bit, but the collateral drives so much of the decision making for those private lenders. So lenders in this space are laser focused on assessing the collateral value of the assets for the loan. And that tends to be based on a percentage. So getting that ltv, the loan to value ratio right is so important. But more important is the V the denominator. How do I actually assess the value of the asset that I'm lending against? And typically there's a whole process that goes into this, but even more so to give themselves cover and a safety net, typically the loan is not 100% of that asset's value. It's much lower than that and depending on the riskiness of the asset can be even lower than certain other types of assets. So typically the owner or the company has to make up financing elsewhere that could be their own equity, it could be through bank financing, and it could be through direct lending. Again, these are multiple parts of a capital structure. So the asset based lender is not the only lender for the overall organization. Typically these assets are also cash flow generating themselves. And that could be directly like receivables where you're waiting on money to come in and you're just waiting on that cash flow to reenter the company so you can distribute it back to the loan or they're somehow tied to a revenue generating activity. So at least having a form of liquidation value in the event payments can't be met is important because if you're not getting that cash flow, then the asset is somewhat worthless. And again, I'll get into an example here in a second. So an extreme way to put this, John, is that the lender doesn't actually really care about the borrower's prospects as an overall company in many ways, maybe with the exception of how it actually impacts the assets themselves, they just care about the collateral. What is the collateral actually delivering at the end of the day?
- [43:24]
A
I think that's where Aaron, my mortgage example breaks down. Because any of you out there that have gone through it doesn't sit in one camp or the other. I mean, they go through your income generative capabilities with a fine tooth comb just as explicitly and carefully as they send the appraiser out to look at the underlying collateral. So I use that just as an introduction. But you're right, true, ABL is much more extreme in their laser focus. To your point.
- [43:51]
B
No, absolutely. And actually that's a really good segue in terms of how to structure the loan. And I will use the mortgage analogy. I had a breakdown of how this might actually work with the full caveat that you just made that it's somewhere in the middle. In some ways, asset based lending, again is very laser focused on collateral. Maybe not so much focused on the overall cash flow generating capabilities, but I do think that the analogy is helpful in understanding some of those characteristics. So I also think it's helpful because John and I have both recently purchased new homes, so this might bring up some bad memories. I don't know. This is not investment advice and certainly not advice in terms of what rate to get, because I think I top tick that perfectly. So don't listen to me in terms of when to buy a house by any means. So when you buy a new house, and let's use this mortgage analogy and we'll beat it to death. But I do think it is very helpful to think through this. There are some critical things that the lender and you as the borrower have to talk about in exchange for structuring a mortgage. So I mentioned the LTV and the asset. There's a whole discussion around the value of the home and how much you're going to put up versus how much the lender is going to provide you. The lender does not, or the bank in this instance does not give you 100% of the home value. You've got to put up some level of equity and of course show that there's cash flow that's going to go towards repaying that loan.
- [45:10]
A
Unless we're in 2009 in which case the lender gives you 120% loan to value. But we'll park that.
- [45:18]
B
We won't talk about that. Yeah, that's bad vibes. But yeah, you're exactly right. And this is where you can get into trouble. How much are you giving relative to the actual value? And I don't know about you John, but when I go to a bank and I'm asking how much can I afford? They're giving me two times what I actually want to pay. So maybe there's a bit of moral hazard there that exists as well. But you do have to put equity and skin in the game in a normal environment outside of 2008. The other thing here is that your house is the collateral and there's a constant monitoring that takes place. So it's not like you just buy the house and then you never hear from anyone ever again. There's annual appraisals, there's monitoring that takes place to make sure that the home itself actually holds its value. So banks might do this less frequently. For me as the borrower on the house, typically it's annual or maybe every couple of years where they're assessing the value of the home. Lenders in the private space, when you've got a specific asset, are doing this constantly. Sometimes that's property and equipment and then other times it's looking at the aging of receivables and the likelihood of that repayment. It's a much more frequent appraisal that's taking place, but there is that ongoing. Let's look at the underlying asset and are we actually going to get repaid at the end of the day? There's also the amortizing and self liquidating nature of a loan and a qualified mortgage. It's an amortizing loan, so you are repaying principal and interest at the same time, which is pretty typical for a lot of asset based loans. So unlike direct lending or cash Flow based lending, where you're paying interest over a time period and then a large bullet payment at the end of that term, the asset based loan is being paid down as you go. We very much like what we see in mortgages. And then of course, if you're in the unfortunate situation of default or foreclosure, if I don't make my payment, the bank has my house as collateral and they can come in and seize it, repossess it and make themselves whole. And similarly, private lenders have that capability, although we'll get into a couple of examples where that's really important to pay attention to in terms of how they can actually acquire that particular asset. So it's a very large and general oversimplification. And again, there's a lot of caveats that come into the mix. But if you think of ABL as a mortgage and some of those characteristics, think of ABL as like a mortgage, but it's on a constantly changing pool of properties, if you will. That revolver that John mentioned, you're constantly re upping those particular loans. But again, like a mortgage, if the value of those assets does drop or there's impairments, the lender does ultimately step in.
- [47:44]
A
Aaron, I'm curious, maybe you're going to cover this, but I talked about the very varied and diverse needs for different competencies based upon which collateral. So where are these private capital firms and the banks finding collateral experts on these eclectic forms of collateral? Obviously they've got a long history and there's an entire cottage industry they actually commissioned to an appraisal and there's some sense in which there's a conflict of interest. The banks actually can't have these people employed. So I'm curious, are these employees, these valuation experts, are they third party, Big five accountants, are they specialist healthcare, life sciences valuation experts? Where do these people come from?
- [48:28]
B
Yeah, it's a really good question and it gets to some of the due diligence considerations as well, I would say, John, It's a bit of a mix and again, it depends on the collateral. If you're talking about healthcare, intellectual property and royalties, or R and D, you clearly need someone that's got a healthcare background or a science background that's going to be able to help you think through some of that. They may or may not be a collateral expert by any means, but having that subject matter expertise is important. But a lot of these organizations will also rely on third parties. So whether that's big four accountant firms or specialists that are in this area, it's a Bit of a mix. But the bottom line is that typically, I guess the ones that do it right have many more people, whether that's employees directly or it's a network of people that can help them through that assessment. It's a lot more than what you might typically see in a traditional private direct lending underwriting. So it's really, really important. If you get into consumer finance, for example, you need someone who understands behavior, FICO scores. It gets really specific really fast. Might be a little bit easier when you get into things like real estate or infrastructure, because that might be more of a general area of expertise, subject matter expertise for a lot of investors. But the bottom line is the headcount, whether direct or indirect, is much higher than what you see in more traditional direct lending. So John, that's a good segue into due diligence. So we talked about expertise and background. I think that's an important consideration. Again, we see a lot of money in direct lending and there's a lot of people moving into direct lending. But that doesn't mean that the skill sets in direct lending translate completely over to what you see in the asset based lending space. So we talked about getting that expertise on board and employed or as part of the process as a third party. So that's one second is sourcing capabilities. And this is not unique necessarily to abl. And you see it in direct lending as well, traditional public credit as well. But where are the actual assets and deals coming from? From and what we have started to see, that 800 billion that you mentioned is not large. But as people start to move more and more into this space, you see people who have been at it, or firms that have been at it for a very long time that have built up their ability to source opportunities and build a network of deals. And then you've got newcomers that might rely more so on the banks. So some of these banks are distributing directly to private lenders. So where is the sourcing coming from and where does that expertise come into play? As I mentioned, it's much more hands on in the private space than what you might see in the banking space. So if you're getting deals that have checked a couple boxes, that's a question that you should be asking. The other thing here is again the collateral value and sensitivity. So to your question on valuation, how do you actually value this stuff going through that process of internal versus external? That's very critical. The other thing I mentioned, the Bitcoin example, which is a good one, but what is the actual sensitivity to the economy to esoteric events that are happening. You mentioned the Nvidia example. Are you actually going to run into what we call wrong way risk? So despite the fact that your loans are performing well, if the parent company is not, that's where you start to get into trouble. So we've seen examples of this mentioned Bitcoin, but energy as well. If you've got loans that are tied to the price of oil, that can be very challenging even if the particular asset is doing well. If the company can't pay you and make you whole, that's a challenge as well. And then there's fraud and collectibility. So this is really important. Again, collateral is so key when making these decisions. So when issuing a loan you have to make sure that the collateral is actually there at the end of the day, which requires a bit more hands on due diligence and might actually require physical trips to insure and as an lp, ensuring that the capabilities are there from your gp. So there are two examples that I want to mention here. One of the biggest asset based lending frauds in recent history was with a company called Arena Television which worked on the Glastonbury Music Festival, the Six Nations Rugby and the Euro 2020 Football Championship. So media company had a lot of equipment and they needed money, they needed cash flow. And so they went and borrowed almost 300 million British pounds from 20 different lenders. And it was all supposedly backed up by the company's equipment. But when it came to verification and getting their money back, turned out that none of the equipment existed in the first place. So that's a challenge that's not good for those particular lenders. So that's an extreme example on a corporate sign. A more recent example is again this rise of buy now, pay later in consumer finance. So while physical assets may back some of these financing options, others aren't or have assets that are hard to seize in the event of default. John, I don't know about you, but if you go to Chipotle, you can do buy now, pay later. It's not like they can seize your burrito if you don't make that payment. So there's a lot of risk in terms of some of the collateral. And Garp actually released an article that showed the delinquency rates of buy now, pay later versus regular lending practices like credit cards and so on. And they found that it was about three to five times higher than what you see in traditional lending sources. So you have to be very careful about partnering with some of these platforms because you may not get your money back and you may not have collateral to seize at the end of the day. So when you zoom in, and this will be a final thought before turning back to you, John, but when you zoom in, there's a lot of differentiation in why LPs and investors are interested in this space. You mentioned a lot of the crowding that we see in direct lending that's taking place. I think that's a very real challenge for a lot of investors. Hear anecdotes about the same direct lenders competing for the same deals and that brings in spreads. It causes covenants to lighten up, to be competitive. And so I think investors are trying to find other ways to continue to expose themselves to private credit but do so in a more thoughtful manner. So that's important to mention collateral. Again, you've got exposures to different parts of the real economy. There could be inflation sensitivities in there that could differentiate your return, sourcing, liquidity and duration. Some of these, as you mentioned, are revolvers. They're shorter in duration, they're amortizing. You're getting your money back sooner and more frequently than you might in a bullet loan risk management. Again, because there's a collateral element attached to a lot of these loans. They tend to be much more structured, have many more covenants and safeguards that are put in place. But I think more importantly this is a diversifier within your private credit allocation to your very beginning. Early Comments John I don't know that I would call this an asset class, but there's certainly credit characteristics that exist. But still you can diversify around your traditional public credit and your direct lending allocation. So lot to think about. Lots of ways to define this, but hopefully that scratches the surface before we meet with our guests.
- [55:05]
A
I'd also double down on your point about the crowdedness that I mentioned earlier too of direct lending and just the interesting curiosity and diversifying your credit. Book out a bit into these ABL type strategies. You've also got the return with ZIRP going away, zero interest rate environment going away. You've also got the return of traditional public fixed income. So there's a lot of headwinds for direct lending. Direct lending exploded out of this need for where am I going to put. Do you remember when we used to say what's the other 40? Where's your 40 going? You remember those conversations when there's no yield in your portfolio and pensions have to deliver a 7% actuarial rate? Where are you getting at least the more stable form or portion of that return. And that's why there was this voracious sprint towards other forms like direct lending. And now you're starting to see those options and choices open back up. One thing we didn't talk about is rates relatively given the both perceived and real nature of the risk profile of a abl. I don't even want to say the average ABL because there is no average JBL as this whole episode has suggested. But on average these tend to be slightly lower rates given that the profile of the credit as determined by the lender is slightly better and lighter than a direct lending, a cash flow loan. Am I right about that?
- [56:25]
B
Yeah, it's really hard to pinpoint. I thought about trying to generalize that, but I've seen some performance measures of you can kind of expect maybe 200, maybe 300 basis points above public high yield ish credit. But I think that changes when you get more complex. I mean clearly if you're looking at real estate, it's going to be very different than healthcare, R and D if you will. But it's a wide margin. But yes, I think lower than direct lending, which I don't think is such a bad thing in some ways. I mean I know on its face low double digit yields is attractive, but you see some of the cracks with PIK interest picking up and amend and extend taking place. So you might be giving up a little bit on the yield of face value, but yeah, somewhere between your traditional public credit and direct lending.
- [57:11]
A
Yeah, well this is the catch 22 that younger or cash starved or cash delayed businesses, to use some of the language you used face, is that you can't run an economy on 12, 13% cost of capital. And so the whole point, as we said of a lot of the newer ABL is to spread and challenge and protect their working capital. And if you end up just stretching your P and L even further with debt expense, then you've shot yourself in the foot. So they do seem to have found a nice middle ground for rates based again upon the downside, the known downside given that you've got collateral associated with these loans versus cash flow, so.
- [57:50]
B
Exactly.
- [57:51]
A
Well Aaron, that was fantastic. I do think we're going to need to leave it there and just returning to where we started. So hopefully that was a good overview, a good flyover of where we are with ABL and some of the specifics and, and implications for how to think about it as an investor. And we are now going to move to a quick halftime episode and after that we'll be back with Ced and with Greg. So stay tuned. Well, welcome back to our halftime segment and I am just delighted to be joined now in studio by Matt Brancato, who is the head of alternative sales at Franklin Templeton. Matt, welcome to Capital Decanted.
- [58:30]
B
John, thank you.
- [58:32]
C
Pleasure to be with you today.
- [58:33]
A
Well, as you know Matt and listeners, as you know, we've been spending some time with different segments of the Franklin Temple Tim machinery and I'm actually really looking forward to this one, Matt, because it's going to be a bit of a postcards from the pavement. What are you actually hearing? So, Matt, maybe I'll start with the proverbial intimidation topic. What is it that you hear most that clients, prospective clients or those that are already allocating to alts are challenged with, are intimidated with these issues that they can't seem to get through?
- [59:04]
C
I've been blessed to work with financial advisors for over 20 years with the goal of helping them build better portfolios through the use of alternative investments. And when I think about the main challenges and roadblocks that many advisors have when it comes to allocating to alternatives, they all center around some form of educational or expectation gap gap. And these gaps are what I like to call my three lessons learned about these challenges that have been constant throughout my career in alternatives. So lesson one, in order to have a productive conversation about alternatives, whether it's sponsor to advisor or advisor to client, you need to be speaking the same language. And I think that's a roadblock. A simple high level conversation on the role and benefits of alternatives in a portfolio can lead to confusion if you're not defining exactly what you're talking about. And at Franklin Templeton we define alternatives of private markets, hedge strategies and digital assets. So you need to have a shared language, I think. Lesson 2 Alternatives are just tools. Like all investments in a portfolio, alternatives are designed to achieve a desired outcome in an asset allocation. So no different than stocks or bonds. Sure, the pathway to the results, John, are a little different with concepts and constraints like illiquidity or the structures may be different like a limited partnership drawdown or a perpetually offered strategy. But hesitancy and intimidation quickly fall away when advisors shift their perspective on alternatives from different asset classes or funds to viewing them as a means to achieve a desired goal. And then lastly, and this isn't necessarily unique to alternative investments, but really the human condition, lesson three is people typically allocate to what they wish they would have allocated to 12, 18, 24 months ago. And this is really where the power of Alternative investment education plays such an important role in private wealth. In addition, it also stresses the value of partnering with the right asset managers, the right partners, so they can help in identifying early cycle opportunities. So those are really the biggest roadblocks, the three lessons learned.
- [61:13]
A
Yeah, those are fantastic. Matt, you certainly are preaching to the choir here. On a couple things, we've been very vocal about leading with purpose and portfolio fit instead of product wrapper or product design. I think many will miss the point. And that conversation typically goes south. When you're talking about the product specs as if they're on a used car lot and you're trying to explain this air conditioning versus this upgrade versus this package and instead what are you trying to accomplish by actually potentially including this in your portfolio? So obviously education is our bread and butter. So love that you're leading with that and I know we've been a part of that as well. Matt, maybe the other side of this you talked about 12 to 18 months out, they're starting to get a little bit of backward looking desire to have chosen a little bit earlier. So in your conversations now, what are they jazzed about? That in 18 months those that don't choose are going to be coming back to you and saying, man, I wish I would have allocated back then.
- [62:12]
C
This is really where my passion and my team's passion comes to the forefront. We want to help advisors with early cycle opportunities and I think that the tenor in the industry is changing because advisors are rallying around this concept of early cycle opportunities. So at Franklin Templeton we're seeing excitement around asset classes like private equity and how to simplify that access for private wealth investors. So things like private equity secondaries, we're starting to see the environment shift to private real estate debt lending into real estate assets, things like private equity co investments and digital assets. And while at first glance those are all very different asset classes, I think, John, the common thread is they all have long term structural shifts in these particular areas of private markets and they're paired with something that I've seen over time. There's an immediate supply demand imbalance of the opportunity set and the capital that's available to take advantage of it. I think that's what we're most excited about and I think it's being well received by advisors. They're getting excited about it.
- [63:21]
A
Well, good to hear. Certainly the product proliferation is happening at a frantic pace and it's good to hear that the dialogues are much more focused on fit and bespoke need and purpose. As we talked about earlier. So Matt, so thankful for your brief time with us and keep it up. We loved the angle and the approach and the anchor to making sure the client's interests are put first. Thanks for joining Capital Decanted. And listeners, stay tuned for our guest segment. Well, welcome back to Capital Decanted. And as promised, now in studio we have Cedric Henley, partner and chief risk officer of Specialty finance at SLR Capital Partners. It's a private credit asset manager with over 13 billion of investable capital. And SED is joined by Greg Turk, deputy CIO head of private markets. Of the 13 billion, also conveniently same number, Illinois police officers pension investment fund, ced and Greg, welcome to Capital Decanted.
- [64:22]
D
Thank you for having me.
- [64:23]
E
Thank you. It's great to be here.
- [64:25]
A
All right. Well, as most of you know, this show often consists of coming of age stories, the kind of evolution of topics, of asset, classes of strategies, and this one was no different. It echoed, as I can remember, at least from my perspective, some of the work we've done on things like secondaries were GP stakes that started off with a very different motivation in mind and grew into a necessary tool in the tool set for modern finance and modern capital allocation. And I think as you'll see over the course of this discussion, this will be much more of the same. So I want to start with a little bit of retrospective to try to help fill in the history that Aaron and I attempted to tell in our intro section. So set, I'm going to start with you if you don't mind. We did a private credit strategy more generally last season and as with all flavors of private credit, they really originated in the banking sector quite a long time ago and particularly in this case regional banks. And often those loans are secured by hard assets, as we know, real estate, equipment, et cetera. But in recent years we've seen a lot of this regional bank activity and dominance shift to private market origination platforms like yourself. Can you tell us a little bit about the reasons and the catalyst for that evolution? Sure.
- [65:38]
D
It's a very astute observation and really one of the drivers that you've seen this transition. And if you look at cash flow loans, it's somewhat similar. But ABL is a nuance unto itself and really one of the main drivers relative to this transition to private capital has come about from the regulatory framework that regional banks and even money center banks operate in. And when you have borrowers who either have a short term issue relative to their income statement, maybe they're undergoing a transition. There's a reason why they need further liquidity. The banks in their regulatory environment really struggle with that type of a borrower. And so really you've seen private credit step in and fill the void relative to that.
- [66:23]
A
I guess the other makeover or evolution has been in the spirit of the popular shows where either homes or individuals or reputations are made over. There's been many ways in which this has taken on a new form. It's been resurrected abl that is for a very different purpose. I think it started and you correct me if I've misread this history as a bit of a lender of last resort. If direct lending, traditional cash flow lending was unavailable for whatever reason, whether too early in life cycle stage or cash flows weren't particularly dependent enough based upon the lender you relied on, you were desperate and moved to basically levering your asset base. Now this seems like it has entered traditional flexible risk controlled financing toolset as I've alluded to at the beginning. Tell us about that parallel perception evolution as well.
- [67:15]
D
It is correct. It used to be 10, 15, 20 years ago you went the ABL route because you didn't really have the availability of the cash flow route or other liquidity triggers. Really where it's sort of morphed itself into is there's still obviously that that aspect of it. There is an aspect of ABL that hasn't gone completely away, but really where it's begun to morph more and more to is for not only privately owned or public companies, but also sponsor backed companies that want to generate incremental liquidity away from their cash flow structures. This is a great way to do that. If you have accounts receivable and inventory. It is a simpler way to put that in place because you're really driving your liquidity based on your working capital as opposed to waiting for cash flow metrics. So it's really become a solution provider as opposed to this last resort. Companies are almost on their desk doorstep here. Capital solution. It really has moved that way and we see a tremendous amount of flow coming not only from strategic corporate owned companies, but also private equity entities that are looking for liquidity. They're looking to do something strategic. It can be a great solution for those and that's really a change.
- [68:30]
B
So set. I want to pick up a little bit on some of the evolution that you walk through. So we've talked a little bit about the lender of last resort evolution. We've talked about the growth of asset based lending in general. I think one of the other dimensions of this is the collateral itself. And when you look historically, 10, 15 years ago, maybe it was real estate that was dominating and equipment and so on. But as you look more recently, it seems like that menu of different collateral options has expanded quite considerably onto balance sheets, royalties, healthcare, all sorts of different options that are backing these loans. So maybe we can matrix this a little bit. But could you talk through the evolution of the collateral that's now available backing the loans, and then in particular, where private markets and private lending comes into the equation versus maybe the more traditional banks that have been there historically? Yeah.
- [69:20]
D
And you mentioned a couple of interesting areas where ABL has really started to rise, and that's from the different assets that are available. There's always the traditional working capital, accounts receivable and inventory. There's the equipment finance and real estate that you mentioned. But there's also drug royalty, which is a big portion of the healthcare market, et cetera. That's in essence an ABL loan where you're banking on the future cash flow streams. And looking at the cash flow streams, that is something that's relatively new. And if you look at it as well, you could think about a lot of recurring revenue software company deals. That really is an ABL deal that's being structured like a cash flow loan as well, where you're counting on recurring revenues and basing your loan off of what that recurring revenue stream is going to be. So again, that's another new entrant into what I would think of as the ABL market. And I think one of the things that you've seen in private credit is most of the private credit guys that are doing abl, such as slr, you are also seeing them have the ability to do equipment finance because the two go hand in hand. And you want to have that arrow in your quiver that when somebody comes to you, maybe you're not so crazy about the assets on an abl, but you know what you really like the equipment that they own or the real estate that they own. So you really have to have in private credit all these various methodologies in place to really offer a complete solution. So it really has matured and I think again, it goes back to the banks have challenges with a lot of these different asset classes. It's really hard for them to lend money. And the other thing relative to ABL that's really interesting and why private credit makes a great partner for banks is that we're asset gatherers. We are really focused on assets and asset growth. We want assets. On the other hand, banks historically they have been ones of syndicating risk, whether it's a cash flow loan, an ABL loan, you pick it. They're in the business of syndicating risk, but what they do like is deposits. Well, abl, in partnering with banks like we do, there are structures that you can come up with where, hey, they'll keep the cash deposits because we obviously don't want cash deposits. We're not a bank, but we'll take the assets. And so we're constantly having these dialogues with banks and quite frankly seeing opportunities where ABL can potentially really inure to us in terms of the assets. The bank can keep the deposits because at the end of the day they really want deposits. They want that capital base to support themselves.
- [71:44]
A
One thing that's really interesting to me, we talked a little bit about it in the intro, but this idea of differentiating between ultimately syndication flows out from the bank, meaning moving it off of their balance sheet, tranching it, syndicating it. Do private market origination platforms do much or any of that? Does SLR do any of that?
- [72:03]
D
Great question, John. We do not. So we're not good buyers off of bank desks. There's really nowhere on the SLR platform that we look at that. And one of the main reasons, and this is really across all of our strategies, is we have a pretty long track record of we do our own diligence, we do things in conjunction with the owners of the business, whether that's a private equity sponsor or a company. And we do things hand in hand, putting an intermediary right in between that. It just never really worked well for us. And I think a lot of ABL folks that are on the private credit side, I'd venture that that's probably similar. And honestly, the private markets, and you've seen this in the cash flow side as well, we're much better at clubbing with our frenemies than we are doing something with a bank.
- [72:46]
E
And we like it when the frenemies are us big investors through co invest and generous economics. So yeah, there's a way for, let's call it a smaller, larger contingent to benefit from Cedric's work.
- [73:02]
D
And Greg brings up a great point that is growing dramatically. Five years ago that wasn't the case. Now it is the case. So that when we have investors and LP relationships like Greg, one of the conversations now is co invest, and that's a big part of the conversation.
- [73:17]
B
So sed in addition to maybe the frenemy line. So obviously working with banks on some of these things are There places where you're actually competing with banks and making some of those direct loans. Are there places where they're playing that you're also playing or is it a pretty clear delineation between the two?
- [73:31]
D
I wish it was clear Earn. It's not really clear. But if a bank wants to come in and offer SOFR + 150, no private credit shop is going to meet that. When you start to get a little bit more gray is when you get into the SOFR 400 ish area 375400 then it starts to get a little bit gray. Obviously above that, that's private credit world. So you do have this little bit of a gray in the middle area. And a lot of times in these ABL deals the natural takeout is a bank. The company will get through whatever issue, the liquidity will clear up, things will improve. And the natural takeout be a bank not dissimilar from a cash flow loan where maybe they started at five and a half times and they paid it down to four times and the company's grown dramatically and they're going to go do a bsl. It's the same thing.
- [74:16]
B
So going back to the evolution of collateral, so you've now got this wider opportunity set that's out there and each of these different pieces of collateral and assets are all different in different ways. It's structured differently. So I would imagine obviously the underwriting process is challenging, but I would think that the, the default process is even more so relative to a cash flow based loan where companies might be able to get a little bit more creative in terms of how they make you whole or partially whole relative to your original commitment. So could you just talk through the process that you guys see across those different collateral pieces and what that process is like to actually collect and make yourselves whole during a challenging period.
- [74:54]
D
Honestly, we do do both at SLR Cash flow and abl. So we have a good vantage point to speak to what the differences are. And a lot of ABL quite frankly, the real work begins once you've booked the loan. Because you're getting a borrowing base on your assets. Quite frequently you have to review those borrowing bases. You need to ensure that the company has sufficient liquidity. You need to constantly monitor borrowing basis. On the cash flow side. You generally after you close the loan, your interactions you get, maybe you get a monthly statement, but generally you're getting quarterly financial statements. If you have a covenant, you're getting a covenant compliance record. So the monitoring of an ongoing cash flow loan is Much different than abl. It's very intensive and you're constantly in ABL world. That's one of the reasons why you have so many people. For us, with 13 billion, we have over 300 people. Predominantly on the asset based lending side is the majority because of all the nuances and checking that goes into abl. So it really begins after and it comes from years and years of experience. Again, we have cash flow and I did cash flow for the first 20 years of my career. Now I've been doing ABL for the last 15. But for the cash flow side, the diligence process, we all know what the diligence process is. On the ABL side, you're really looking at working with not only the company. There's two really big points. You're looking at what the liquidation value of the assets that you're working on. You need to determine either from in house appraiser or out outsourced appraiser what that liquidation value is going to be at closing and then you're updating that constantly. The other thing you're also looking at in terms of ABL is you're really looking at the company's ability to report that information to you on a very timely, accurate manner. Because it is the old cliche of garbage in, garbage out. If they can't report to you or they can't get you the information timely, it's really hard to do an abl. So really those two things go hand in hand and you're constantly monitoring those after you've closed the loan and after you're working with a company and really in ABL land, your covenant package and your structuring is tighter than you're going to see on a cash flow side. So you are going to get a lot of footfalls. And that's by nature you want to make sure when you're in ABL world because you're really depending on those values. You really want to make sure that you're not going to get the phone call on a Thursday night saying, hey, I can't make payroll, I need to over advance. Which is really, that's the Achilles heel when you start doing that over advance. That's the problem with abl.
- [77:25]
E
A lot of questions there. It's to the heart of what we do every day. The hardest thing with being an allocator and I've been an allocator 20 plus years now, every day you have more, you have more options. 30 years ago when I got out of school, felt like there were maybe five or Six options. Now you have five or six options just within abl. So the long and short of it is nobody is arguing or nobody's really having a conversation whether private debt or private credit broadly is worth having an allocation to. In 2009, all of a sudden the asset class really opened up when public debt rates went down, all of a sudden you needed to find a premium and private debt supplied that. So the industry overall, the private debt sector, from an allocator's perspective, is still only about 15 years old. And the first mover was probably the easy move. And I think Said mentioned this with cash flow lending, it's very understandable metrics. A lot of it has to do also with understanding a lot of its private equity back. So you understand the sponsors that are largely personified in a portfolio, and that was an easy first move. And a lot of allocators moved a lot of capital that way and they waited on ABL because exactly what you said, understanding the liquidation value metric, not only did we have to understand what Cedric meant by liquidation value for receivables, but we had to understand the third parties that they were working with to truly get a feel for what that collateral was worth. So it's one of those step functions that it's a little, I think, harder to understand. And then there's a scalability issue. In 2009, I was working with a $65 billion plan and cash flow lending through $2 billion fund was easier to get an allocation size, whereas the ABL profiles then were a little bit smaller, a little bit more niche. You didn't have all the size that you have now. So I think the understanding is there now from the LP community in terms of what ABL due diligence really means. And there's plenty of my peers that are probably growing their portfolios a lot faster than we are here at the Police at this stage. But I think the metrics are just better known. And the other thing is, to Cedric's point, on domain expertise, the checklist for understanding the analysis on the collateral, but then also setting up the infrastructure, that's 10 years. We really only want to invest with institutions that have really been doing this for 10 years, have a great database, have the relationships already built, have the network, and that takes time. So I think all of that has come together in the last two or three years to really make ABL look extremely attractive. But I think it is a little bit of a harder diligence that has kept people away. And honestly, the returns in cash flow lending had been so good that I think people were just repeating that until about three years ago when all of a sudden it really felt like middle market cash flow lending was getting very crowded.
- [80:45]
A
So Greg, I want to double click on the diligence topic just a slightly more. But before I do that, I want to maybe ask you a little bit more because I'm curious. When you think about the underlying collateral of some of these loans, they could be duplicative with other parts of your larger portfolio. So let's take the obvious one, real estate. So you've got inflation hedge built in there. Perhaps you have geographic plays or angles or even risk control that you've got through your real estate book. There's other themes that you're playing through your real estate book. Those could be duplicated, replicated in your ABL credit book as well. So how do you think about avoiding that unintended duplication?
- [81:26]
E
As an allocator you can take one of two positions. You can really try to understand all the underlying loans and industries and metrics within your portfolio and keep them apart or you can just understand that there's a lot of different methods. Middle market companies need financing and we like when they have a lot of options and then we like looking at what we think is the best option, not just from a cost of capital standpoint, but from a long 715 year horizon. So to answer your question, there's going to be some overlap. And real estate, the real estate end markets can often be the poster child for that. I think what we like about ABL and what we find with the platforms within ABL that we really like, like it's a tighter relationship with that end collateral and that end company. And I think Cedric went into this a little bit more, but ABL is a little bit more structured and we like that structured part because it takes that credit risk that we know we're underwriting to and it maybe it doesn't get rid of it, but your all in return profile now comes a little bit more from the structuring. And Cedric uses the technical term footfalls. When companies, their whatever levels reach a certain amount, they have to call Cedric up. Maybe he gets some money, maybe he has to renegotiate stuff. Those are tighter than cash flow loans. Cash flow loans, there's usually a wide margin of error. So you're getting paid and then all of a sudden boom, your enterprise value may condense. Whereas with ABL you're tighter along the way and I think you're getting paid back a little bit better from the structuring part of it. With that said, there's lots of ways cash flow and like I said, we like platforms like SLR because they're both a cash flow and an asset based lender. So they can work with the entities that they want to where those entities may want that exposure. So we do measure it. But the overlap, we're not overly concerned about that overlap as long as we feel like we're getting pretty good risk return characteristics for our underwriting.
- [83:34]
D
John, you bring up a really good point that in the past few years it's a little bit of a tangent, but one of the things that I've noticed when we're speaking with folks such as Greg and others is that when we talk about cash flow, one of the things that we now do is we track basically a correlation of exposures to us and the other big private credit managers because they're very interested to know, hey, if I go and put out names, if I go and I'm an investor in Aries or Gallup or pick whomever private credit manager and I invest in slr, am I just buying the same loan three times because I'm in all three of yours? So we've had to track that because I think it goes to your point, John, hey, where are we relative to that? Because they don't want to be overexposed into one loan. And the other nuance relative to that is one of the things that we found over the past couple of years is that when you talk about ablaze to folks such as Greg, they really enjoy it because you don't really have that much correlation that you do find in cash flow.
- [84:38]
A
That's fascinating and it actually rhymes with a lot of work that we've been doing on the blurring of asset classes, which is kind of the thrust of my question is that these things don't fit in one bucket or another cleanly anymore. And that's why I'm teasing this out. Greg, last question for you as I really beat this horse to death a bit. But you talked about the layers of ablaze due diligence, the tighter relationship I think, were your words. Is there anything you would point out that makes this due diligence with SLR or an equivalent, a contemporary, unique against either cash flow lending or other types of GPS that you work with. You've got the gp, you've got the underlying portfolio company, the organization taking the debt on and then you've got their underlying collateral. You pull back this onion and there's lots of ways you could approach this.
- [85:25]
E
Due diligence There's a lot to talk about here and I am definitely not. I keep joking around with Cedric. I'm an equity guy that's still learning the way bond guys talk. But by far the biggest difference that you have to switch off from cash flow lending and then switch on for ABL is you immediately need to get to how do you assess the value of that collateral. Whereas with cash flow it's more. All right, let's model that cash flow. Let's look at where your covenants lie on that. That let's see what your work looks like compared to the company's work. What you got to switch on immediately with an ABL is how do you come up with your liquidation value and then how do you lend off of that? Because there's a lot of, I think, differences with how Cedric's platform might differ from others in terms of how you lend off that liquidation value. But we tend to side obviously with the ones that I think do the most and get a lot of outside third party validation on that liquidation value and then keep their covenants very tight. So whenever I get asked that question, that's the key one. And honestly, what we like as investors in this asset class in general is there are a lot of subsectors and I'll talk about slr, but with slr, nobody can really do healthcare. A lot of the healthcare underlying industry and life sciences the way they can. So once you start peeling the onion, you really understand where that specialization is. And then once you get into each of those collateral types or each of those industries, as you would expect, there's industry specific terms, language and all that. So healthcare is not everything that SLR does, but it's a good component of it and we think it's a huge competitive advantage. So that's the lens we put on when we're underwriting these platforms.
- [87:20]
A
That really is fascinating. As I said, I'm just curious, just before we turn back to Greg, is what Greg described echo most of your perspective and existing LP relationships. You were in cash flow lending, you mentioned, for a large portion of your career. I imagine you have to go into abl, given these layers we've just talked about with a little bit more patience and expectation that LPs are going to have to kick a few more tires, go a little bit deeper, walk around the house many more times before they're willing to commit. Is that fair?
- [87:51]
D
More than fair? It is because I think it goes back to the root of the expertise of the liquidation value and how you execute on that how you structure things, how you monitor things, how you move day to day is not a simple one times conversation. Or they just look at your loss ratio or your default ratio. It's not nearly as simplistic as that. It is a very in depth long process. And honestly, it's a lot of education too. Greg, for his claiming to be an equity guy, he really knows he has great questions. But a lot of LPs really do dig in and go through a lot of these questions and understand who do you use? And the answer is we're talking a lot about liquidation values. You use different appraisers and liquidation firms for different situations. Some are really good at retail, some are really good at consumer products, some are really good at real estate, some are really good at equipment. So you have to know which one you're using. And then you also have to. I'll give you guys a great example of the human touch element relative to ABL is a few years ago everybody knew that Toys R Us was struggling. That wasn't a secret. Everybody knew that here comes a default. They may not pay their bonds. This looks like it's going to go into bk. Well, if you're the ABL lender to a company supplying to Toys R Us, you have to be able to go to the company that you're lending to and say, you know what? But I'm not accepting any more accounts receivable in your borrowing base. I'm stopping that because I know that you're going to be an unsecured creditor and you're not going to get recovery. The debt ahead of you is going to get recovery. So you have to monitor things like that. And I can give you a lot of other examples of companies where you just immediately put them on watch. You got to go to your borrower and say, you know what, I can't accept any more ar. I need you to collect out and move on. So that type of diligence that you have to do and then relay that to Greg's of the world. It is a very cumbersome process.
- [89:41]
E
And just to put a final point, cash flow lending, again, the metrics from one firm to another to another, very similar. And all of us on the LP side have a template now. But think about transportation. We did a lot of transportation ABL in the mid teens. Airplanes and supertankers. Compared to healthcare, it's night and day. And by the way, those go together well also from a portfolio construction standpoint. So there's a lot of degrees like that that just make It I think.
- [90:13]
B
Challenging maybe as we close here. And Cedric, I love your views as well. But Greg, on the flip side of the question I asked Cedric earlier in this conversation of the evolution of all the different types of ABL strategies that are coming to market, it seems like we've moved from everyone was a middle market cash flow based direct lending strategy to more and more ABL strategies coming available on the market. So I'm assuming you're getting more and more GPS that are trying to partner with you and fit into your portfolio. How do you think about the breadth of all of those different options that are available and any things that you are interested in investing in, things you might be avoiding just from a pure collateral perspective. And then Cedric, I'd love your thoughts on this as well just from observations of competitors that are out there.
- [90:57]
E
Stop me if I'm rambling on too long on this question but anyone in my seat with unlimited time horizon, a healthy risk perspective. We're in the business of taking risk. We're in the business to be able to pay off long term benefits. So we start all of our analysis with a very high level. Is an asset category growing or not? Do we like the metrics? Do we like how many players are in there? So broadly private credit is still an asset class of growth. So I think most allocators including us are continuing to find ways to allocate even with base rates moving back up and bank loans and high yield being a little bit more attractive. Some of the public side. With that said, I think for the last two years 2021, 22 was a bit of a pause with a lot of markets or a lot of markets altered direction somewhat. But we think the growth of ABL will outpace the growth of middle market cash flow. And I think there's plenty of studies out there. The one that I was just looking at last week, ABL was maybe and Cedric probably knows this data better than I do but it was maybe 4, 4 and a half trillion of the loan market and by 2030 it's supposed to be 10. So within a decade that's a big number. And direct lending cash flow not as good, still growing. So anyways that's how we start our analysis on anything. Those projections are great but then you have to do the work and do your capital market assessments and we really do think to try to get to a conclusion to your question. What we really think is available with ABL to direct lending now is twofold. One, I think too much money is chasing cash flow lending to the Point where I think if you returned an 11 to 12% with your platform in the last 10 years, maybe it's going to be more like a 9 to 10. With some of the underwriting that we're seeing right now and expectations, it's still healthy number still reason to be in there. But I think some of these ABL platforms and the looks that they're getting and the higher barriers to entry in areas like healthcare platforms like that are going to allow the seasoned providers and to generate probably a low teens. I like seeing when private equity is going after, when there's some consolidation, when there's some M and A. I was just talking to a European platform earlier this week where they got a big private equity infusion and basically doubled the number of disparate lines, underwriting lines that they had. So that's a little bit of a show of the growth. And if you peel the onion back on Cedric's shop, they have, for the size of institution that they have, they have a lot of regional offices, they have a lot of teams that are just going after one specific collateral type, one specific loan type. So we think people that have already put that together and have a very seasoned platform within ABL I think are going to be very well off over the next 10 years.
- [94:04]
A
I think what's clear is that this is not a space for a credit generalist. I think that's what several answers to our questions you've reinforced, which is these are all micro specialties and they deserve and require and demand their own teams that do a very unique due diligence process, have to get very close to the business, the underlying collateral. And if you don't have that, it's going to be really challenging to create Alpha. I imagine said just in closing that while as I mentioned earlier, ABL hasn't quite reached the red flag on our stage but. But as far as the trendiest thing we're hearing, but there's no doubt it's getting more interest. Are you seeing underwriting cycles, sourcing approaches start to shorten, quicken, become a bit more urgent?
- [94:51]
D
I'm not really seeing them become a bit more urgent or quicken. And I think one of the things that we really like about ABL honestly is that if you picked up a cash flow document from 2018 or 2015 and you compared it to 2025 cash flow document, they would look really different. If you picked an ABL document in that same time horizon, you probably couldn't tell which one was from 2015 and one was from 2025. So the process that we have to go through in ABL that we've been talking about, really, you can't force feed and do inventory counts or accounts receivable, or get values on equipment or real estate, whatever you're lending on, you can't do that overnight. There is a process that you have to go through. So I think you're getting heightened interest from all the players, whether that's private equity or corporate side, et cetera, in this space. But one of the things for ABL is the process. You can't go faster. Everybody can go faster. But there's a lot of times. And honestly, you're bringing up an interesting point in ABL land. And this is just my experience, when you get the phone call that somebody needs to close in three weeks, an abl, that's generally a really bad phone call because they've either fallen down. There's two scenarios that I think about. And again, you're getting to my why I'm a risk guy. You're either talking to somebody who's like, oh my gosh, my company's going to explode, or it's fraud. The latter is a big problem in abl. Fraud. When people want to defraud you in abl, they work really, really hard and they can be very creative. It usually goes hand in hand with, I gotta close in three weeks. And so that raises such red flags for us that normally we just put our pencils down and move on because.
- [96:29]
A
You can get burned still hearing plenty of supply to go around, but you have to be careful nonetheless. So listen, guys, that was a masterclass. That really was a view from the trenches of much of the summary that we opened with. I know the listeners will have massively benefited from many of those illustrations, those real life examples. So Greg and Seb, thank you so much for joining. Capital decanted. And listeners, stay tuned for the Last sip. All right, welcome back to the Last Step. Aaron. I really appreciated the interchange between Greg and Ced that I think is the second time in our 24 episodes that we've had an LP and a GP that actually work together. And I don't know that that's necessary every time, but in this case I think it was really helpful given the newness and the somewhat foreign nature, at least to most of the listeners, I would guess, of abl because I think their play off of each other and how they think about this, what they demand from each other, what they're seeing said was really, really helpful. And this is Greg's style at Illinois but here's what we see, here's why it's very common the way Greg approaches it, here's why it's a little bit rare, and here's what we see from some of our other LP partners. So I just found that conversation really enlightening on bringing to life some of our philosophical stuff that we talked about in the intro. But anything that was revolutionary or a big takeaway that came across in that conversation for you?
- [97:53]
B
Well, first of all, I loved Greg talking about being an equity guy and making this transition. I think that might be indicative of a lot of people. This is new for a lot of investors. So that was just interesting to hear him talk through his thought process as he learns more about this and begins to allocate more to it. I think there were two takeaways, one from Greg and then one from ced. So you asked the question on allocation. So how do you think about this in a portfolio context? And. And if I remember correctly, I think Greg was like, it doesn't really matter. It's more about just getting exposure. And I think that's the right way to think about this. I'm biased and you mentioned this. TPA is what we're focused on quite a bit. So that was just the blurring of asset classes. And it almost doesn't matter where you put it in a bucket. It's more about the exposure at the end of the day and then from set. This is more of a reinforcement, I think, based on our prelude before they came on. But the idea that this is not for generalists. This is for investors who can build out a team that can have the expertise to be able to analyze collateral, but also go through the workout process when things get really tough. So those are two for me. But how about yourself?
- [98:59]
A
I agree Greg didn't seem overly concerned about real estate collateral in his ABL book versus his actual real estate portfolio or allocation. And I thought that was interesting again, and I think it's. It goes back to where I started at the intro, way back, which is, is this even an asset class and allocation? Is it right to think about it that's in the same way? Or is it extensions of lots of asset classes or almost a diversifying bucket of credit that just doesn't fit anywhere else? So that's interesting. I think the biggest takeaway for me, and I can't remember if this was in the green room or in the conversation, but I had talked about and introduced this entire topic as one of the most complex, one of the most idiosyncratic And I think it really crystallized for me when Set and Greg were talking about the fact that what you're doing on the due diligence side is there's due diligence on the gp, there's due diligence on the loan, the credit structure, and then there's due diligence on the underlying collateral, as you talked about at length. So you've got three, I think they called it, layers, and you're just peeling this stuff back and every one of those due diligence elements. I suppose most LPs are used to the first two, but they're certainly not used to the third or even having a third. And so these layers and mechanisms by which you need to ensure that you are clearly understanding what that partner is delivering to you, that they have expertise, that the valuation, the LTV is appropriate, the monitoring system is current, I think is fascinating. And so is this iceberg metaphor where at outside the water you see just this little bit of this beautiful credit against a piece of machinery, but underneath the water is just a whole lot of process complexity, expertise and workflow needed to make sure that you do that. And perhaps more than any other asset class we've looked at, at least my impression is so again, this is why I think there is this Governor, as I mentioned in the intro earlier, at least to do it well now, you might have a bunch of copycats jumping in, but I think to do this well, you really need to step back and make sure you've got the right approaches and build the muscle before this is allocated to explicitly.
- [101:11]
B
So, John, how does this all make you think about monetizing our insights on capital to cancel it? You started with that at the very beginning. So are we moving to an originate to distribute model? Are we getting an asset based loan? What's going on in your mind?
- [101:24]
A
I don't know. I think I'm more confused on that front than I was when I opened in the intro. It sounded clean and fun then, but I would like to do some back tests on that because I think we could perhaps sell a Kaya leading indicator that could be quite interesting. All right, listeners, so our personal question that we agreed on I think is a fun one and that is Aaron. And you're a different generation than me, so probably thinking about this differently because you're more native than I was at an earlier age to the phone and the behavior of the use of your mobile. But the question was, if you had to delete every app except three from your phone, which three would you leave first?
- [102:05]
B
And foremost, I would leave Apple Music because I'm a huge music nerd.
- [102:10]
A
First and foremost. Wow.
- [102:13]
B
First and foremost. That's the most important one. I could stop there and I'd be totally happy.
- [102:18]
A
So it's an ipod.
- [102:19]
B
It's an ipod, which is fine. That's fine with me. But yeah, Apple Music would be one. I guess I have to keep messenger so I can actually talk to people. So my imessage. And then I would probably have to keep Instagram just because one, you gotta see people. And two, the reels, they're good. So those three. How about yourself?
- [102:38]
A
So on the music side, I get made fun of by my adult kids all the time because I use Pandora.
- [102:43]
B
Oh, God.
- [102:46]
A
A little old school. The eye rolling when I turn that on on Friday night.
- [102:51]
B
Are they still in business?
- [102:52]
A
They are. That was AI before AI was cool. Let me just say their algorithms are wicked awesome. I would not choose that though. I would not. As much as I like music, that would not be one of the three. I went much more utilitarian than you because thinking about how my life would change if I didn't have certain things. So first of all, I chose messenger because I think that's just an absolute life necessity, at least the way we run our lives now. I chose United and Uber because I literally can't imagine my travel schedule without my ability to call an Uber and the constant navigation delays, rebookings on United. If I didn't have access to that, it would be the old school calling the 1, 800 number, which I do not want to do. So there you go. United, Uber and Messenger.
- [103:37]
B
Uber was my fourth. Just because I'm out in the middle of South Jersey and if I need to escape, that's tough. But yeah, I didn't make the cut. That's good.
- [103:45]
A
Well, that was a fun one. I mean, every one of these, I learned a ton. This might be one. Although this follows China, so it's hard to argue that the educational depth will ever match what at least I learned in China. Speaking for myself. But when I think about investment asset classes, this was really enjoyable because it was outside my depth. I think I've mentioned to you, similar to Greg, I was an equity guy, so credit generally, fixed income generally is always a stretch for me. And when you throw a whole lot of weird collateral and structures and covenants against this, that just adds a whole lot of complexity that is outside of my comfort zone. So I found it really helpful. So, listeners, I hope you enjoyed that pathway, that journey as much as we did and we hope to see you Next time on Capital Decantan.