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- [00:00]
John Bowman
Well, welcome listeners, to the off season countdown of the top five episodes of the inaugural season of Capital Decanted. And we have reached the number one episode of season one. In a late surge to take the number one spot by a hair was Private Credit with Katie Koch, the CEO of TCW, and Kip DeVere, who is a partner and head of credit at Aries Management. And in this episode, we tackle not so much the virtue of private credit as an enduring asset class, but rather whether it's come a little bit too far, too fast and needs a bit of a breather. We even suggest perhaps a spring cleaning, a rationalization, a fascinating discussion history with Katie and with Kip. So tune in to this great number one episode of season one of Capital Decanted. Welcome to Capital Decanted. In this show, we say goodbye to tired market takes and superficial sound bites 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 one, episode 11 of Capital Private Credit. I'm John Bowman. And I'm Christy Hamilton and we are your hosts. As always, a huge thank you to our season one title sponsor, Franklin Templeton Alternatives. With over 40 years of alt investing 260 billion in assets under management, they've assembled and offer specialist investment managers across six different asset classes. Private debt, hedge funds, real estate, digital assets, private equity and venture capital. And of course, all of them operate with the client first mentality that has always defined Franklin Templeton to prioritize investment outcomes. Now, as you know, listeners, we've been working our way through these Franklin Templeton alts groups and we'll be talking with one of those sub managers today, Franklin Venture Partners, at halftime. So be sure to tune in for that. So thanks again, Franklin Templeton Alternatives. Well, Kristy, this is a unique episode. We gotta be careful at face value. This is our first episode that if you just skim the surface, look at the headline appears that it's focused on an asset class private credit. But here's the dirty little secret we're going to unveil this early today is really not about the asset class per se. When we envision this show, it was never to take a tour of the markets and assess the merits of different strategies or asset classes and opine and whether they were good or bad. As Kristi is fond of saying, nothing is inherently a good or bad investment. It all depends on the client and the portfolio fit. And further, quite frankly, there's plenty of noise and I would say nonsense on cable TV investing sites and other pods that offer an abundance of hot takes on any investing subject you want. But here at Capital Decanted, we're not trying to provide investment advice per se. And now, obviously, Christy, I should say we are human and our biases and inclinations and our own views come through from time to time, and today will be no exception to that. But our goal mainly, primarily is to help you, the listeners, think more critically and thoughtfully and balanced about investing topics, to make your own decision to get out of our echo chambers and examine issues more deeply. So as such, today's episode is much less of a tour of what private credit short and long term prospects are. And by the way, I should say it's here to stay. There is much to like and we'll talk a little bit about that. But on the contrary, what we're trying to accomplish today is much more about stepping back, asking some fundamental questions about its current role in the economy and maybe whether we've come too far too fast. This episode, interestingly, was born out of two sound bites that both inspired us in their realism and honesty, and therefore what you'll notice is that they form the skeletal structure of this episode itself. And these two quotes are really questions were part rhetorical but at the same time deeply cerebral. And today we're going to ignore the rhetorical nature as we always do, and we're going to attack the cerebral. That is how we roll, Always staying curious. So here are the two sound bites. Let me give them to you. So number one, last May 2023 at the Milken Global Conference in Los Angeles, I was attending a panel on the future of asset management and it naturally meandered its way to private credit, as all panels seem to these days. As an aside, by the way, I'm going to break my rule of giving investment advice, Christie, right away early contradict myself completely. But you want a leading indicator of when to begin taking money off the table in an investment watch the proportion of conference content devoted to that topic. And let me tell you, there is nothing that was more nauseatingly frothy for a few years on stages than private credit. Actually, let me back up, maybe pickleball, but I Haven't figured out how to short that yet. There are Dutch tulips and then there's pickleball. That is probably my biggest pet peeve. But there you go. Be careful from the stage at conferences. Anyway, I digress. Back to this Beverly Hilton last May. Katie Koch, freshly minted new CEO of TCW. After having spent the last 20 plus years at Goldman, the ink was barely dry on this new gig at TCW. Basically two months. So she's sitting on this panel with other CEOs and as I said it was mostly self congratulatory, a lot of bullish sentiment and Katie in a refreshingly candid manner. And I've gotten to know her a little bit, which is why I love Katie. She explained that quote, the price of credit or interest rates has been repriced in a very short period of time. And when that happens, stuff breaks. Bad accidents happen. As she said, the central banks in fact are trying to break things. That's their whole purpose. And by the way, she went on to say 96% of private credit managers started were stood up post the gfc. There really aren't many managers that have invested outside of a free money, zero interest rate environment in private credit. That doesn't mean the individuals don't have experience pre gfc, but the gps that they sit within and work for are almost exclusively brand new in the last 12 years. So in other words, this is just not tested throughout a cycle. Danger ahead as the wizard of Oz sign as they approach the Wicked Witch of the West's castle. I'd turn back if I were you. That's what is echoing to me. So that's number one. Katie Koch number number two. Last July, a few months later, Kip de Vere, partner at Aries Management, one of the largest private credit shops in the world, was on our good friend Ted Seides Capital Allocators podcast And he said, quote, you can't run the economy on 12% cost debt. Eventually this will drive you into a depression. End quote. So despite LPs salivating over the return expectations, these high RRRs of private credit strategies in recent years, this is simply not sustainable. Kip was saying the real economy, small and medium sized enterprises, really the engine of the US can absorb obviously debt service at rates that high for that long. So what were these two saying or @ least cautioning? How would we like to echo these yellow flags in this episode? I think it's the following and it's that while private credit has done an outstanding job being the primary source of capital to small and medium sized businesses in the last 10 years and we're going to talk at length about that. First from Katie, is a necessary residual of this acceleration from 0 to 60 in a very short period of time. Is there a reason that we need to see some washout of this significant excess that the markets are maybe not pricing in? Okay, so that's number one. And then second from Kipp, is there actually a moral burden or at least a calibration here in the profession as a double digit cost of capital, frankly is going to be a self fulfilling prophecy towards economic hardship that hurts all of us, not just the particular borrowers that are in Aries funds. So in sum, there is enormous value creation happening here. No doubt no argument from either of us, but should we expect some short term patchy waters is really what we're trying to deliberate on today. So here is where we're going. Listeners, I do feel obliged to set the stage a bit for this discussion and debate with our normal background playbook to give you some context and working guardrails to assess where you come out on some of these cerebral questions. So I'm going to do two things in my segment. Number one, I want to give you a sense of the history of private credit instruments and the optimal or almost storybook conditions, particularly in the last decade or so that created this monster that is accelerating at a rapid pace. You can't properly evaluate how you think the next five years will go for the asset class if you don't fully grasp how and how quickly we got here. So that's number one. And then number two, I want to give you a very brief current size and segmentation of the Marketplace today in 2024. And then of course Christie is going to provide some commentary in her typical both energizing and skeptical disposition. I hope that's a fair characterization. That's why we love Christie. That's what makes you a great investor and podcast host. And then finally, we really scratched our heads to get to the drum roll here on our guests, who are the best guests to help us grapple with the current state of private credit and these two sobering questions from Katie and Kip. But then we thought why not just let them speak for themselves. So with us today are those two pragtagonists themselves, Katie Koch, CEO of TCW, a multi strategy asset management firm with over 210 billion of AUM, including over 20 billion in private credit strategies and growing quite aggressively. And Kip de Vere, partner at ares Management, the 420 billion private capital firm, which of course makes them one of the largest alternative managers in the world. And almost 300 billion of that, by the way, is in credit, which is the division that KIP runs. So, Christy, as you think back, I want to think about this rapid rise and arrival and constant new identity that private credit has been going through in the last five to eight years. When did private credit enter the vernacular in your circles as a separate asset class? And how did allocators initially respond to this newfound area of credit?
- [10:41]
Christy Hamilton
This one's funny because I got back to the beginning of my career back in 0607 08, and it wasn't as common. So Katie's comment resonated with me because I was like, was it always there? And I just missed it. But when I look back and really look back, I mean, it was there. People invested in it. There were commitments that were made. It was typically a small part of a portfolio that was a little bit more tactical or nuanced. But really, I think that this came into my orbit, if you will, probably 2015, 2016, 2017 in there when just rates were really low for a long time and people were needing to park money somewhere. And there was this element of reaching for yield in a way. And a lot of private funds, particularly direct lending and those types were actually offering some level of yield and people were just accepting it. So I think it's funny because I remember back in the day just people whispering at conferences and stuff that they're tired of direct lending funds just because there were so many of them raising capital at that point, and for very specific and in many cases good reasons. But it got to the point where everything in private credit was just direct lending at that point. So that was where it hit my radar. And to your point, though, I've seen so many different derivations of private credit at this point, everything from specialty finance. Some people park royalties under that heading. So there's all sorts of nuanced ways or paths that you can take within private credit specifically, which is fun. What about you?
- [12:01]
John Bowman
I think the corollary that we talked a little bit about in the prep was perhaps hedge funds. And one of the big mistakes that I think a lot of commentators, I'll just use that word broadly make is categorizing hedge funds as an asset class, which is completely wrong. It's a set of strategies that serve very different purposes, as anybody that's allocated capital will know. Well, private credit is similar. You don't invest in a distressed or mezz fund for anywhere near the same reasons as you distress in a secured direct lending fund. Those are completely different exposures, drivers, factors, however you want to categorize it. And yet we throw it all together and now there's music royalties in there and what do you do with that? Probably, like we said on the last episode, somewhere in tactical or diversified bucket of some sort. So I think as we discover this, we'll also, I think come across the reality that this is a potpourri of all different types of stuff that we need to be careful with and referring to it in a uniform manner. It's just not the case. So let's get started on this history. Now, as I said, this is not explicitly an episode scoping the full history, risk return characteristics and portfolio fit for private credit. That's not really our goal here today. We are going to dance near that line from time to time, but we'll leave that to others. In fact, I would say shameless Plug Kaya's Unifi platform has what I think is the authoritative micro credential on private credit. In fact, it was a great source for this episode in particular, I'd encourage you to check it out. We'll link to that in the show notes if you want a broader investment overview of private credit. But instead our hope in this episode is that we provide a rubric, as we said earlier, for you to think more carefully about this asset class given its short, at least short in the modern form history and how that youth interplays with or will behave given where we are in the economic cycle. That's really our goal today. Now the history buffs on the other side of the iPhone and your podcast players are probably wincing that we are not going to talk about or begin in the 13th century Renaissance Florence, where the Medici family's private bank issued bills of exchange and letters of credit to finance the explosion of global trade across the Mediterranean, as well as artists, scientists, da Vinci in particular, the construction of churches and other public architecture. This is perhaps the first appearance of direct lending, at least from what I understand. But that is not our hunt today. Nor are we going to begin, as you might expect in the Gilded Age, as we often say in the States, at the end of the 19th century, at the sunrise of the Industrial Revolution, when the great robber barons and merchant bankers think Rockefeller, J.P. morgan, Carnegie, Vanderbilt largely financed the development of the railroad, the steel, the electric and the oil industries. That is also out of scope and for another day. Great stories though, you should check them out. But it really wasn't until the 1970s that innovation began occurring on Wall street that started to create the climate for the post GFC explosion in private credit that we are going to zoom in on a little bit later. And that's where we're going to begin. And let me just say, by the way, a shout out here, a brilliant source was a post that we actually both found independently, Christie, a post on the Wall street fintech blog called the Definitive History of Private Credit. We're going to put that in the show notes, but if the author Van Spina is listening, thank you so much. That was a service to us and I'm sure many others. So we'll be following your blog from now on. Most of you will know listeners the story of the once relatively obscure investment bank named Drexel Burnham and a young banker named Michael Milken had capitalized on a couple Trends in the 70s. First, the late 20th century M& A wave had begun and regional and subscale banks were beginning to join forces or get gobbled up by bigger players. And this transaction spree continues all the way until the present day. Just between 1999, much later, much more recently to 2024, for example, the FDIC tallied a total of more than 8,000 combinations between commercial and industrial banks, savings and loan institutions, thrifts and credit unions in 1999. Again, just to drive this point further, traditional banks provided over half of the capital for what you might call levered loans into the corporate market. Today that is down to the mid teens. So where has all that gap of financing gone? That's what we're going to talk about today. And Michael Milken caught this wave very early. Now all of this transaction activity left a vacuum or at least a growing gap in providing credit to small and medium sized companies. And Drexel had coined the junk bond market that is synonymous with Milken. They didn't invent it, but they certainly made it a wholesale segment in the marketplace and part of the lore of financial history that certainly pop culture and Hollywood have come to enjoy. And this idea of offsetting corporate risk with higher yielding paper would become commonplace three decades later across the full spectrum of borrower sizes. So that's the first one was this M and A spree. Now Second, the other trend that Michael capitalized on was as the LBO market, the leverage buyout market and corporate raider mentality descended on Wall street In the late 70s and the 80s, all of these Gordon Gekko look alikes needed capital to fund their acquisitions. So while the private equity asset class, I'm not even sure that Vernacular existed yet was in its infancy. This idea of credit providers drafting off of these deal making sponsors was born, as was a new mentality of highly levered finance and capital structures. Now to be clear, as you probably know, Milken and Drexel Burnham were issuing and trading publicly traded high yield bonds. But nonetheless, the seeds of the future in private credit began peeking out of the soil, you might say through this period, even though they would appear to go dormant for some time until the gfc. So you have had the dawn of M and A in the bank sector and the financialization of the middle market. But Milken's greatest contribution, even more so than these themes mentioned, was this epic harvest of credit professionals that would run the markets that worked for him, that were developed by him, and would largely dominate the C suites of almost every major credit shop today. This was Milken's coaching tree, you might say. And while this is far from exhaustive, this diaspora includes Apollo, Blackstone Credit, Blue Owl, Churchill, Bane, Cerberus and guess what, the founders of both ARES and tcw. Who are our guests today? It is just spellbinding, literally how influential Michael has been in weaving and crafting the modern private credit industry and its leaders across the world. But back to our story here. The subsequent collapse of the junk bond market and the savings and loan crisis in the 80s and 90s, coupled of course with the globalization of the economy at that point in time, really got the attention of regulators. And those in Washington and Europe began to fret over the systemic risk of the global financial system if the increasing interwoven system was overexposed to excessive leverage. And they looked therefore to begin exercising more oversight of the health of the bank's balance sheet. So beginning in the late 80s and extending all the way to the post GFC period, a parade of congressional acts and new regulations, most notably the Basel trio and Dodd Frank, significantly raised capital adequacy and liquidity ratio requirements in the banks. And they made lending to small and medium sized enterprises as a result, both cost and risk prohibitive. So this combination of rapid consolidation and increased scrutiny of banks balance sheets from the regulators literally shut off the spigot almost entirely of private equity finance deals from the traditional banking sector post the gfc. And that's when non bank institutions were left to fill the void and continue to chase Milken's initial vision of financing Middle America again, the engine of GDP growth. So we've devoted a lot of time to the subject of companies staying private longer, but this played a role here too, so it bears repeating by the way, in episode two Democratization of Alts, we outlined the key reasons being the administrative burden of regulation such as Sarbanes Oxley. That just has been a headwind to the excitement and the idea of going public. Second, the fact the private markets have matured enough to provide pretty much all the growth capital you need into a company's mature stages. And then thirdly, maybe most importantly, the ability for ownership and management to stay aligned around long term enterprise transformation rather than the whims and emotions of day to day gyrations and quarterly earnings drama that goes with the public markets. So more private companies, more need for growth capital, more demand for private credit. This was all coming together as we approached GFC and post gfc. These various winds of change seem to combine with the decade long accommodative monetary policy into what you might call a violent torrent of private capital fundraising. Private equity firms and a spree of dedicated private credit gps for the first time rushed the doors and Christie the weird vivid image, honestly, that I had when I was prepping for this history as I was writing this portion. The scene that came to mind, if you've seen it, was in World War Z with Brad Pitt where the zombies breached the wall of Jerusalem and this mass hysteria are climbing on top of each other. They're forming human ladders, they're eventually jumping over the wall, over the gates of Jerusalem. Welcome to Private Capital. Post gfc it was a rushing the doors. So the pace of private Capital fundraising in 12 or so years since that point since the GFC has been staggering. Literally trillions of capital from LPs looking to be exposed to two important areas, admittedly. One, the new economy, which was expressed largely in startup and mid market private companies. Suddenly, for all the reasons we've talked about, and two, and we're going to talk a bit more about this, the increasingly scarce yield in the portfolios in private fixed income instruments. This hunt for yield that you mentioned earlier. You might remember Chris, it was only a few years ago, during that decade long zero interest rate period that now feels like forever ago, that the biggest concern for asset owners looking to meet actuarial or spending rates in the high single digits was where quote was the new 40. This is 6040 language, the 40 being your ballast, your fixed income, steady credible expected coupon payment every month. And remember what I said about conference content, by the way, being a negative leading indicator. If I had a dollar for every session in which I was either sitting as a panelist or a moderator where there was a question on where is the new 40? Just imagine. Just imagine. But in other words, allocators were rummaging around for any asset class that could stand in for what public fixed income used to do for them. Provide stable, reliable coupons, cash flows, and frankly in private credit, 10 to 20% gross IRRs depending on the sub strategy sounded pretty darn good in that environment by comparison. Particularly when the ten year here in the US was yielding less than two and a half percent for many, many years through the late teens and into the early 20s. Chrissy, I don't know if you remember the new 40 or how much buzz there was in the circles of allocators that weren't on the stages, but what other asset classes came to mind in this period, whether you agreed with them or not, by the way, I just think this is fun. That met the quote, new 40 conditions.
- [23:30]
Christy Hamilton
Oh gosh, in my view, none of them. But on the private side there's definitely direct lending. There was specialty finance. Somebody brought up warehousing clos, which I was like, that's wild. And I don't know about that. There were a range of just weird one off things which I will say I throw all of that out there to say that I was incredibly sympathetic to pensions during that time because you go from decades of basically being able to meet your required rate of return with just fixed income and then all of a sudden you're in a world where you're having to not just reach for yield, but go into private credit and private equity and really lengthen the duration of your fund in order to just meet this basic thing that used to be met by really safe fixed income. So even as we laugh about it, I am incredibly empathetic to any pension CIO during that time period because it was brutal. Because obviously the discount rate really impacts how much money has to go in. And if you have to keep going to the legislature saying we need more money, it's a difficult position to be in. So I totally get why it exploded is what I'm trying to say. What were some of your favorites? Do you have any?
- [24:29]
John Bowman
Yeah, again I'm gonna just stress that this question was not that I agree with it, but the craziest one I heard was crypto staking. Crypto lending. You've gotta be kidding me. The yield on lending out your crypto. So there you go. But to each her own, to say the least.
- [24:46]
Christy Hamilton
Indeed. I'd never thought that people were seriously considering it, but you're absolutely right, those things did come up.
- [24:51]
John Bowman
They did. So listeners that Short history was really the path towards today, which is really the entire capital stack of the sub fortune 500 is effectively going private. Public companies have halved banks, lending practices have retrenched, and private capital demand has soared. And that all has created these conditions as we move progressively closer to our couple cerebral questions with our guests, to creating the environment that we're in today. And that leads us to today's segmentation, which was the second assignment I had. What is the current state and size of private capital here in 2024? Now again, like hedge funds, unlike maybe public equity or even private equity, where you can get your hands around this and there are clear separations around what is and what isn't, these definitions are squishy. So huge amount of disclaimers on what I'm about to say. But this is using a number of sources and trying to find a respectable middle as to how to size this thing and segment it. There is lots of room for argument to say the least. But let me just start with prequent. It has the drawdown AUM on private credit, right at about 2.2 trillion at this point. Now the large majority of that, about 1.7 trillion, is still direct, what you might call cash flow based corporate lending. So this consists of things like secured first lien loans to companies, in addition to mezzanine distressed and special situation credit. So you're loaning to corporations. The other 400 billion, that remaining piece is asset backed private credit. Again, this is drawdown. Remember, asset backed credit is much, much bigger than this in the broadest sense. But as far as drawdown funds, 400 billion in both real estate and infrastructure, that's about 270 in real estate and about 160 in infrastructure. But as I've said, drawdown funds are probably massively underestimating the long tail of private credit instruments at banks, at hedge funds, traditional asset managers, asset owners themselves, not to mention the rising tide of semi liquid private credit funds, BDCs and shall I say it, you already did CLOs. So my guess though is that this could be approaching 5 trillion. I saw in some sources, depending on how you count all of it. And if that's the case, we're talking about a solid 25 to 30% of all of private capital that's been largely committed, as I keep hinting, in just the last five to eight years. That's what we're effectively trying to unpack today. And I think it's this reality that I want to conclude my segment with by circling back to where we started when we posed the purpose, the skeletal structure and the reasons we wanted to do this episode. It's the tension that really catalyzed our discussion today. Should this rapid rise think that zombie scene again, breaching the wall concern us? From what I can tell, this was as little as 200 billion rising out of the ashes of GFC. It was a rounding error. That means this is a 10 bagger at least in a little over 10 years. And neither prequin, nor we nor anyone else, allocators included, broke this out as a separate asset class until probably the late teens is a fairly new phenomenon. To have a dedicated bucket per se of private credit. Not that there weren't, as Kristi said, allocations, but we didn't think about it as its own thing, as its own slice of the piece until literally within the last five or so years. Now, I want to be clear. On the one hand, we need proper perspective. I'm in no way suggesting we have another savings and loan or subprime mortgage crisis on our hands. The comparable size and the risk management skills of these new financiers are in a different league. And further, the professionals at private capital firms are much more sophisticated than those that were pulling the strings at the mortgage companies and local banks that led to these prior excesses. Just think about their sourcing, their underwriting, their portfolio structuring capabilities. These are light years ahead of that group. And these non bank institutions, I should also say, are not facing the stereotypical borrow short, lend long risk that has haunted so many bank balance sheets. There is a long history of those that lend long and they borrow short. Think Silicon Valley bank most recently, as we noted, the majority of these loans are collected in the 10 to 12 year drawdown funds. Without risk of flight to capital, you don't have a run on the bank with a drawdown fund. And institutional investors ironically have even more longer time horizons, at least technically, philosophically, than the gp. So you've got the exact opposite problem of a typical bank depositor where there's a mismatch the other way that creates this risk of flight of capital. So to be honest, I'm structurally and philosophically bullish on this space. Long term, there is much to like. This is an asset class that is here to stay, has a lot of wind behind its sails. It's serving, you could even argue, a very virtuous purpose in society. As I said, filling a gap that those that we know are really driving the future of the economy. Small and medium sized businesses creating jobs, creating new products that all of us are Using this is a good thing. And I want to be clear, I want to be abundantly clear about my position there. However, Kristi having raised six teenagers, if you can believe it, so four are no longer teenagers. I've got two left, but I've raised six. The current state of private credit reminds me of that early high school student. Highly promising, but horribly awkward. The raw materials, the intentions, the potential are huge. But the path is going to be far from a straight line and a bit volatile at times. As Katie said, and we'll ask her more about this, when things are built this fast, accidents happen. And despite all that sophistication I mentioned a few moments ago of private credit leaders and professionals, euphoria has a seductive way of compromising all of us. It's just human nature. Think about it. Covenants get lighter, due diligence gets faster, competition gets fiercer, underwriting standards get looser, barriers to entry get lower. This is an age old story and we're just asking the question of whether this untested phenomenon, this space needs refining and some streamlining. Especially when over 95% of private credit managers have been formed since the GFC, as Katie reminded us of as well. So I'm not talking an existential reset by any means, just a what you might call a heavy spring cleaning, the first adversity for our gangly youth going back the teenager metaphor now, for example. I just can't believe, as I still often hear, I just heard last week on a stage, a private capital conference, that default rates in these private books are still less than 2%. I just can't believe that we're that good at this yet, or more importantly, no matter how good we are, this higher interest rate regime and debt service that has lingered for longer than I think all of us expected, at least longer than we all hoped for, that these young companies aren't starting to see that catch up with them. As Kip said, at some point the music has to stop. Either borrowing rates need to reset in the near future, these PNLs are heavily burdened with debt service, or these balance sheets are going to have to pay the piper. They just can't stay at levels this high and continue to grow and reinvest in their business. So I'm going to stop there. That is the tension we are examining today. I hope that the history and the current sizing is helpful context for the questions and the dialogue and the banter that we'll have with Katie and Kip. And I am now going to pass it on to our resident CIO Ms. Christy Hamilton for her thoughts.
- [32:10]
Christy Hamilton
Thank you for that. I was really excited about this one in particular because this is a topic, particularly private credit, very specifically, that I still continue to struggle with at times because there are so many unique opportunities that provide amazing solutions, particularly for investors that need to match either certain exposures or that need to meet certain return thresholds. And private credit helps with those things. However, I think it gets mixed up a bit sometimes in how we actually think about a portfolio and then it gets maybe parked in places that it shouldn't. And so I say all of this with the background that as many of you may remember, amazing listeners, I started on the institutional side of investing in probably, I would say late September, early October of 2008. So I remember sitting in training class as the world started melting down and seeing it on Bloomberg and just wondering if we were all going to have a job. And I had a couple of years of experience in investing at that point, but having to join a high octane team that was then helping new LPs that were coming to the consulting firm I worked for who were having trouble and having to navigate the fallout from the gfc. I was there front and center for all of that and watching it with and honestly being a part of those teams. It was baptism by fire in some instances. But in many ways it was also one of the most impactful learning experiences of my life. And I share that because I learned so many valuable lessons and I think that one of the big ones that I don't know if I've necessarily shared this as directly in any of our previous episodes, so I want to call this out separately, is that there's this huge idea that the endowment model is just investing in privates. And the thing that I learned is that if you're going to follow some derivative of modern portfolio management that ends up at the endowment model, it is absolutely imperative that you remember the whys of each component of your portfolio and why you are allocating the way that you are. Because I think sometimes we say, oh, if it looks like a duck and quacks like a duck, it's a duck. But at the same time, if, for example, you're going through your IPS and you end up in a traditional endowment like portfolio equity is technically for growth, fixed income is to hedge deflation and hard assets are to mitigate inflation. And then sometimes you can throw in maybe diversifiers in a tactical bucket in small pieces. But it's not just everything that looks like and sounds like fixed income gets parked in that fixed income bucket, because the majority of that is to actually hedge deflation. So I think that sometimes private credit is one of those ones where people just say, oh, we'll park it here and then it becomes part of that allocation of fixed income. But the reality is if there's a huge market downturn, you're not going to see the same bump you would with say, long term Treasuries or some of these others. So it's the realization that you only follow the endowment model if you need very specific outcomes. And that is maintaining a growth and asset base while maintaining a payout. And each of those components are supposed to work together to make sure that you can continue to meet those things. And I say all of that to say we are also human as we invest. And we are. I include myself in this. I think that we are very terrible at projecting forward. So I remember back in 15, 16, 17 where we talked about before where private credit got very big. I remember people saying, new rate environment, never going to change, we'll never see inflation ever again. Or people would be like, oh, at some point we're going to have super hyperinflation. We had never been in a world like that before. And so I think a lot of people projected the reality indefinitely, which isn't completely irrational because we don't know we don't have a magic ball. But I think that I really saw private credit, or the excitement and full lean into private credit happen during that low rate environment when people were saying we're never going to have yield again, we're never going to be able to meet these payouts. Private credit is going to be the thing that helps us get there, and particularly for pensions. Again, I understand it. However, again, if your fixed income is supposed to be a pure deflation hedge, then I think you have to be really careful about how you slot it. And so it's my personal opinion, when you think about it in that way, to look at it as more of a tactical play, I think that there is absolutely a place for private credit in a portfolio. I think that there's a place long term, particularly on a tactical side. I remember funding distress managers or committing capital even though there was no distress because the promise was that they weren't going to call down and they weren't going to charge us fees. And so knowing that at some point distress happens and when it does, we have to be able to move quickly, it absolutely makes sense to partner with managers in that way. On the direct lending side, however, it is interesting that you talked about the low default rates, John, because I think that monetary policy has been so, I don't want to say lax, but it has been so easy that we haven't really had to deal with massive defaults. And I think that there has been enough lending out there to help companies bridge gaps. But with that said, that only goes so far. And I do wonder sometimes if maybe both on the private equity side and on the private credit side, just this push into funding managers is possibly pushing capital to companies that don't really need it or shouldn't need it, or shouldn't even exist. And I say that again empathetically because there's a lot of opportunities out there and the importance is really finding someone who can uncover those and whose capital isn't commoditized and who actually offers opportunities to partner. Because I think otherwise what could be happening behind the scenes? There's some academics that have been looking at it basically wondering if default rates actually are higher. It's just they're not technical defaults. And so on the private credit side, it's not necessarily registered as a group in default. It's we have a 50% exposure to these groups of funds or this other GP on the private side and we're not going to push them into default because that doesn't benefit us. So I think that there's some question around that. I don't think that that's necessarily dishonest. That's just the way that terms shake out sometimes. But I think that there's the technical default and then there's the spirit of what we're trying to play here. So I say all of that to say I personally have invested tens of millions of dollars in private credit. Actually, if you go all the way back, it's probably in the billions at this point. And so I'm not saying it's not a good investment. I'm not saying you should only be in long term Treasuries and your fixed income portfolio. But I will say that I think that a lot of times these funds hide equity risk. I don't want to say hide it because I think that the people going into it recognize that. But I think that they can hide a lot of equity risk. One of the things that I found on a portfolio that I was on was we had GPS on our lending book, actually making loans to GPs and our private equity book. And that's a massive double whammy right there if anybody goes under. And luckily again, defaults have been low. So it wasn't that big of a problem. But when you did an actual look through, these were risks that you would have never expected with the tens of thousands of private credit and equity funds out there. So I think it's really important to know who you're partnering with to remember why you're doing it and to really recognize the drivers of those returns. Are they coming from some sort of belief of where we are, the economic cycle? Are they coming from some opportunistic bent? Because if you're expecting your private credit to all of a sudden have this massive payout when markets are in downturn, I don't think that that's realistic at all. So I think it's just a slight consideration and something to think through when you're pricing out your portfolio. And don't just look at it as like, oh, it looks like a duck, so it must be a fixed income duck, if you will.
- [38:57]
John Bowman
Yeah, I think your point on technical defaults is a really good one because these private credit professionals and experts and the fund structure allow for a lot more maneuverability than a traditional bank or obviously a Treasury. Most fixed income instruments are pretty technically in default or not. It's fairly binary. And when they're collected and grouped within funds with direct relationships between the lender, meaning the underwriter, and the borrower in this company management and there's a lot more alignment around the outcomes in the future, I think naturally you're going to see a little bit more flexibility and creativity and approaches to extending or shifting terms a little bit in times of stress. So I think that's understandable and probably a good thing that there's a little bit more maneuverability for. Again if you small medium sized enterprises, we need this. We are all aligned around them succeeding in a general way. So that is a good thing. But you bring up a good point. The definition I think is a little bit more squishy in this part of the credit world than in maybe our traditional public side. So very good point. Well listeners, we are going to move with all of that said as you digest that to our halftime break. I've mentioned it and hinted already but we have the benefit of having Bobby Stevenson from Franklin Venture Partners as we continue our tour through Franklin Templeton Alternatives with us. So stay tuned for this and then we'll be back with Katie and Kip. Welcome back to Capital Decanted. And I'm just delighted to be joined here at halftime with Bobby Stevenson, the co head of private investing at the Franklin Equity Group. Bobby, welcome to Capital Decanted.
- [40:40]
Bobby Stevenson
Thanks John. Great to be with You.
- [40:42]
John Bowman
Well, as you know we've been cycling through the alternative managers at Franklin and you are one of the two of the six that I think it's fair to say have been organically incubated and built Franklin Venture Partners. So first of all tell us a little bit about how FVP came to be and how you look today as far as the scope and set of strategies.
- [41:03]
Bobby Stevenson
So the Franklin Equity Group is the original mutual fund group here at Franklin Templeton. Go get in the wayback machine since before we bought and merged with Templeton and Sir John Templeton. So we manage about 100 billion in mutual fund assets. Traditional long only product that people would think of. Very growth oriented, the north star of the group forever. I've been in the group for 20 years and certainly the mantra when I got here was find the best growth companies in the world and invest in them. And as you fast forward and get to the post GFC time period where more and more capital was sitting in the private markets. If you think back, those were the days when Uber and wework were some of the big large market cap hottest private companies. We just started looking around and saying the world's changing with more capital here we think we need to be aware of and potentially investing in private companies in the Franklin Equity Group in order to fulfill our mission of investing in the best private companies in the world. So we were fortunately or unfortunately depending how you look at it, we were a little late on the Uber and we work stuff. But right around that time we said all right, we are going to lay out a mandate for the 30 industry analysts in the group to to cover both the private and public parts of their sectors and be aware of the best private companies in any sector that you cover and then ultimately recommend those companies to the mutual funds for potential investment just like you would any other company. So we started making those investments in 2014 with the belief that we could both add alpha in the mutual funds and also use the insights we gained from covering the private part of our sectors in order to better understand disruption that might be coming for the existing public portfolio holdings after a few years. First investment there 2014 in the mutual funds. In 2017 we raised our first private fund and we started making investments in the dedicated private funds to give LPs a way to access the deal flow that was generated by using the Franklin Templeton platform to partner with these private companies pre IPO. And where we sit today is we are about 1.4 billion in assets in those private funds and we're Actually about the same size, 1.3 billion in terms of the investments in the mutual funds in private companies.
- [43:22]
John Bowman
Bobby, I love the way you described the charge to your sector analysts back 10 years ago. Because I think so often in this space, and we're all guilty of this, we get so laser focused on things like illiquidity premium that we miss the bigger structural shift, which is just value transformation is happening in the private markets. And you need to be there. You just need to be there to get access to where the global economy is going. So thanks for that. Maybe as just a follow up, as you talk with clients about these funds that now reside in Franklin Venture Partners, how do you counsel them to structure them within a total portfolio context as far as risk and return characteristics?
- [43:59]
Bobby Stevenson
Here's what I would say. What we tell people to think about is look, and we think a lot about where are we as Franklin not just capital. Because we believe when you're not just capital, that creates opportunities in an inefficient market, which certainly whatever level of efficient market theory you subscribe to in the public markets, the private markets are less efficient. So whatever level you think about there, what we think about is where are we not just capital? And what that means is we're not running around investing in seed or a stage companies doing what real venture capitalists would consider venture. We're looking for companies that are category winners on a glide path to ipo. We think they are going to be enduring public companies. So we're not underwriting to acquisition. We're not doing any of that type of stuff. What we're doing is we're going to entrepreneurs. And what we're saying to them is, look, let's partner one to three years before your IPO so that we really get to know you and you really get to know us. And if there's a good fit, what that ultimately is going to lead to is us being a great public shareholder for you when you get to the public markets. So what that means when we take a step back and we talk to potential LPs about where we think we should fit into their portfolio, what we tell them is the right way to think about us is we are leveraging the Franklin platform to build these relationships with these entrepreneurs and we are extending the opportunity to get access to the deal flow that comes from that to our LPs. So what that means for them is you should really be thinking about this stuff as these are companies that I will want to own in the public markets for the long term. So ultimately if we are successful, the place that these companies will actually eventually sit in your portfolio is on the public side of your portfolio. You just hopefully will have invested at half the price of the ipo. And also you will have gotten the allocation that you want. That's impossible to get in a hot IPO as a family office or not. Obviously a, quote, retail investor in terms of the LPs we're working with, but retail in the sense that you're not one of the largest hedge funds or mutual funds in the world as you're fighting for IPO allocation.
- [46:23]
John Bowman
Well, Bobby, that's a really helpful and fascinating summary. I really thank you for the quick engagement with us. I'm sure the listeners benefited from learning a bit more about FVP and listeners, Stay tuned for the next segment where our guests will join us. Well, welcome back to Capital Decanted. I am now thrilled, as promised, to be here in studio with Katie Koch, CEO of the TCW Group and Kip de Vere, partner and head of credit at Aries Management. Welcome to Capital Decanted.
- [46:54]
Kip de Vere
Yeah, thanks. Nice to be here.
- [46:55]
Katie Koch
Thanks for having us.
- [46:57]
John Bowman
Well, Kip and Katie, as you know, Katie just admitted she listened to her first episode, which I was very flattered with. But Capital Decanted is all about intellectual honesty and realism. And as you also both know, this episode was inspired by two intellectually honest and real quotes, one from each of you. That's how we've structured the flow of this particular topic and episode. And in the opening segment, just so you know, we summarize what I call this torrent of fundraising and demand and regulation and product proliferation post GFC that has created this perfect staging ground for where we are today in private credit. So we're really thankful to both of you to come on board and help us further explore whether there are some short term yellow flags, caution flags that we should be aware of before we continue this secular march upwards with this new and evolving asset class. So that is our task today and again we're glad to have you help us expand upon our knowledge. So I want to start a little bit with that history. We spent a little bit of time retracing the Milken era, 70s and 80s up until today. Kip, and you are one of Ares, that is this very small percentage of private credit leaders and firms that pre existed gfc. So walk us a little bit through the evolution and maybe inflection points, trail markers over those last 20 years or so. In your personal experience and in the industry, how did it get to a $2 trillion asset class in 2024.
- [48:24]
Kip de Vere
Thanks for that. And I'll see if I can try to be reasonably succinct, but that's a long period of time and a pretty significant evolution. But just by way of background, I'm actually celebrating my 20th anniversary now at Aries and joined with two, and then eventually three other partners here back in 2004. And our experience was we spent the early parts of our careers in US banks, most of us in either leveraged finance banking material. And what we noticed in those US banks over time I worked at JP Morgan was just increased focus on larger and larger issuers. These businesses, the banks all continued to consolidate right through the 90s and into the early 2000s. And with that consolidation, what we found was just an increased focus on large companies and things that could be global in nature and in leveraged finance, focus on companies that obviously did other things than simply drive leveraged finance revenue. So equities, revenue, M and A revenue, et cetera. And for the most part the middle market companies that are served by private credit were not even 20 years ago particularly good banking clients for these banks. So if you fast forward and I'll say pre gfc, each of us then got together and started working in some foreign banks that still had not gotten large enough to not focus on the middle market, which then again changed over time. We were in French banks that consolidated up into Calion, we ended up at RBC who were trying to make a push into leveraged finance and all of that which they've accomplished since then. But we figured out pretty early to try to get to the point that doing middle market private credit as we did it back then and frankly still do it today was just not something that was going to be very well done in a bank. And that was true. Everybody thinks the GFC drove that. But this has been going on long before the GFC and it's driven largely by bank consolidation. And what are their objectives as a business and who do they view as strategic clients. Now when you get to the gfc, obviously a significant distinction comes along because you really see regulatory come to drive it. The bank consolidation continues through that period. And then with the bank's challenge for capital, I'd argue that their risk appetite diminished leverage levels came down. The way the regulators thought about their capital obviously was different. So even if they'd wanted to hang around in the middle market business, they really couldn't post the gfc. So it's been a pretty long evolution, but everybody always thinks it's just the regulators, and it's really not. It's the bank's behavior and the desire to accomplish certain business rather than others as they've all gotten larger.
- [51:00]
Christy Hamilton
Thank you for that. And Katie, we're going to touch on some of the newer areas you've launched in a few minutes, but can you just take a minute or two to give us a history of TCW as an entity?
- [51:09]
Katie Koch
Sure. And I want to actually start by expressing my admiration for Aries. As was articulated in that great answer from Kip, Aries was early entrance to private credit. They built a very large scale business, they've maintained continuity in the senior roles and they've obviously generated really attractive returns over a long period of time for their investors. So they're really true professionals and run a successful business. And it was really fun to hear that story from a TCW perspective. Tcw, or the Trust Company of the west, was founded in 1971 by Robert Addison Day. And interestingly, it was, I think, about 50 years after his grandfather William Myron Keck founded the Superior Oil Company and grew Superior to become the largest independent oil and gas company in the world until it was sold to Mobil in 1984. I actually had the privilege to meet Robert during my first week leading tcw and we're really proud to still have a member of his family on our senior investment staff. I've also had the privilege of spending some time with notable TCW alumni, some of which many people would have heard of, which include Howard Marks, the co founder of Oaktree, Mark Atanazio of Crescent Capital, and Bob Beyer, who co founded Crescent and actually served as the CEO of tcw. So we have a rich history of a lot of great alumni. And while TCW has evolved a lot over the past 50 years into a $200 billion globally oriented, largely private and public credit platform, what's remained really consistent is that we're an investment led organization, remarkable track record of disciplined credit selection, and we maintain to today high levels of employee ownership. So I'm really in awe of the investment talent that we have on the platform. And it is the great honor of my professional life to work with this talented team of investors to chart the next 50 years for TCW along with our shareholders, which includes our employees, as I mentioned, but also Carlyle Group and Nippon Life, Japan's largest life insurance company.
- [53:09]
Christy Hamilton
So building on that, just as a relatively new entrant, how has private credit evolved and been positioned at TCW as an asset class or strategy and how has that developed so for private Credit.
- [53:20]
Katie Koch
Specifically, I want to start by emphasizing that as Kip mentioned and like Aries, we are also very early entrants to this asset class class. So there's no private credit tourists on this podcast, which is actually a statistically Improbable event because 96% of private credit managers launched post global financial crisis. We acquired our private credit platform about a decade ago and it continues to be led by my colleague, the extraordinarily talented Rick Miller. However, our direct lending business, which is the type of private credit we're going to, I think talk about a lot on this call. And Rick Miller, go back even further, more than a few decades. So before private credit was cool, before it was an asset class. And if you've been doing this as long as Aries and TCW, that means that you've navigated the.com error, the post 911 economy, the global financial crisis Covid and rising rate environment. And if you're still doing it like Aries and tcw, then you've been built to last. So I think you're asking an important question, Kristi, which is what is the history and what sustained our success? Our private credit business started at Regiment Capital, a money manager that had its origins in Harvard Management Company. So we were managing the school's endowment and that relationship played a really active role in the design of what the market is now calling direct lending. So to state the obvious here in the direct lending market, we're just trying to get our money back and banks have gotten pretty good at that concept over the last several millennia, lending money to people and getting it back. So our strategy focused on what we thought were the compelling characteristics of bank debt. And that's what we continue to emphasize in our direct lending business today. So think senior secured, top of the cap structure, limiting loss, potential floating rate, so avoiding taking interest rate risk and emphasis on the loan agreement, including the financial covenants. And I really want to emphasize here, the loan agreement was really important and it was viewed as a hedgehog relative to any asset class because it allows the lender to do a do over if the borrower deviates materially from the underwritten performance. And I want to come back to this because covenants, while they were table stakes, when Aries and TCW started doing this, they're actually for better or worse now, a differentiator. So in conclusion, our investors also wanted a premium over traditional bank debt. So we did a couple of other things. We cast the net well beyond private equity borrower community. So while 80 to 85% of direct lending is focused on the private equity sponsor borrower. We're actually owner agnostic. Half of our origination comes from outside sponsors and we loan to a wider range of end markets. So well beyond the trodden areas of health care and tech. We don't share the consensus view that somehow those industries are cycle resistant. And then I would also say important for us, we assemble the team that can actually leverage those covenants I referred to to fix mistakes and surprises, including monitoring the borrowers, people with actual restructuring experience and workout experience. So in summary, we avoid risk by taking the best aspects of conservative bank lending. So senior floating and strong covenants. We originate interesting ideas by looking beyond private equity and we've got very long tenured talent that can action these covenants when stuff goes sideways. And as a result we've built portfolios that have unique credits. So we're viewed as a diversifier by asset owners in their credit allocation while delivering on the objective of not losing money. We've had about six losses out of 300 investments over a couple of decades and that's allowed us to outperform the Cliff Water index, the high Yield Index, the LEV loan market and the conventional middle market over a long period of time.
- [57:05]
John Bowman
So Kip, I want to just continue our march through history a bit here. We talked a little bit about at least the modern history post gfc. I know you guys are one of the exception in that 3 to 4% number that Katie quoted, the reciprocal of that, which means you've been around for a few cycles. But I've often said publicly when I describe private credit that they've jumped out of the petri dish and become this fully fledged asset class in a matter of 10 to 12 years. At least from an LP perspective, despite the longer history you have been involved with. So I'd love to talk to you a little bit about. Katie just mentioned sponsor agnostic. This started largely as a financing appendage, part of the capital stack of mostly private equity deals, LBOs. And now it's, as we've talked about it is a legit standalone asset class that is not completely dependent any longer on private equity deals. So how is the sourcing process, the relationship process? How do these deal opportunities to underwrite come across your desk?
- [58:05]
Kip de Vere
It's definitely changed a lot. In the old days it was a little bit more of just a clubby deal business, a lot of it driven by. I'm friends with so and so at private equity firm XYZ. Look, I mean over the last 20 years or so, here as the business institutionalized, it's actually required that you put real institutional things in place. So we've built. I'll just be specific to corporate direct lending, but there are a lot of other appendages too, to use your word. We've put a couple hundred people in the field in a variety of different geographies. So New York, Atlanta, D.C. chicago, Louisiana, the Bay Area, Texas and then over to Europe. We have a very significant sourcing network there. You know, London, Paris, Stockholm, Frankfurt, Amsterdam, et cetera. So first and foremost it is about body count and boots on the ground in local markets. I mean that's really how you have to think about building sourcing and how you think about building your salesforce. There's so much focus though on origination that I like the point that Katie made too, which is sourcing the deal is not getting your money back. Right. So we've also I think built a best in class team of folks that actually know how to manage risk, that are cycle tested, that have lived through things like Covid and the GFC and understand these assets and how more frequently than you may like, you have to have people that can really roll up their sleeves and deal with workouts and own companies and actually minimize losses. And in our case, we've actually generated gains on the portfolio on a net basis over 20 years. So it's gone from being cottagey and informal to actually being something that is, I think, very well developed and very institutional in nature. You made the point. And I'll just finish off a little bit about Aries. We did grow up as a sponsor finance business. I would say that we've changed that substantially, particularly post the gfc. So to give you some examples, and we've talked about this in public earnings calls, we now have a sponsor coverage team, but we also have a non sponsored team. For a long time we didn't think it made sense to separate those functions because a geography should be able to do both. Over time we've actually realized that if you have somebody in a local market, they're probably by the way, like the banks did, they're probably going to gravitate towards doing the 500 million or billion dollar sponsored deal instead of the $50 million non sponsored deal because they think that's what's good for their career and how they make more money and all of that. So we actually pulled those functions apart. And importantly in the non sponsored business, we started hiring very specific folks for distinct industry verticals. We're actually having the industry expertise allowed us to go into industries and into companies in a very intentional way. So we've done that in software and tech. We've done it specifically in life sciences and healthcare power, which would include renewables as well infrastructure, sports media and entertainment. I'll leave a few out, but you get the gist. And what we found is if you're calling directly on a company and not going through private equity, being an expert in that industry and being able to sit across the table from a CEO and compel them to do something with you instead of somebody else really brings a tremendous amount of value not only to the sourcing, but obviously the ability to underwrite, to do due diligence and to manage risk and the relationship. Post closing it's changed a lot. It's not only a lot bigger, but as we grow, the impetus is on us to continue to be delivering something that we feel is differentiated to our investors.
- [61:38]
Christy Hamilton
So Katie, a major part of the private credit thesis has been this story of call it progressive retrenchment of traditional banks from sub Fortune 500 lending and credit solutions due to Dodd Frank and other regulations worldwide, particularly in the wake of global financial crisis. Do you see that reversing, slowing, continuing in the West? What are your thoughts there?
- [61:58]
Katie Koch
So the headlines. No we don't. We actually see this expanding. But I'm going to break it down to the macro and regulation, some of the partnerships that are arising in this space which I think are interesting to explore and then also hit on the risks here as we go through this transition. So on the macro, let's just start really big picture and let's agree that you need credit for growth. And I think we can further agree that there's two main providers of credit which should we've both talked about extensively here, which is the banks and then also the investment community. And in response to the global financial crisis, regulators decided to put capital rules in place that restrict the lending capabilities of banks. Kip did a very good job of articulating that this asset class for both of us started well before regulation. But I think we both agree that the regulation has expanded the asset class because the banks are providing less credit. I'd also say, aside of someone who manages a large liquid fixed income business, that the same regulations mean that the banks are providing a lot less liquidity, which a related but separate problem that will rear its ugly head at some point. But the capital rules were designed to make corporate lending less profitable, less interesting to commercial banks, and to basically shift the risk away from government bailouts at its extreme. And it's worked. So I'm relatively certain it wasn't the regulatory intention to turbocharge the private credit asset class. But that's basically what's happened here. Debankification and private credit are really two sides of the same coin. And exactly no one, in my view, should be surprised that private credit markets now rival both the high yield market and the levered loan market, because that's how this works. The world needs credit, banks were forced to supply less of it. And Wall Street's pretty good at finding supply to meet demand. And so to answer your question, we don't see it reversing. And in fact, we see private credit expanding its reach in the capital markets, not standing still or retrenching. I'll hit on partnerships and then, like I said, close out on risk. So these dynamics have given rise to partnerships. A lot of them have been announced recently between these private credit companies and also the banks. So what are the partnerships? The way to think about this, I think at its simplest, banks are long origination and short lending capital because of the regulations we just talked about, while private credit players are long lending capital and short origination. So sure, some originate better than others, and we can both make arguments that we're great at originating. But no one can originate like a full service bank, just in terms of volume. So this allows banks to provide cash to generate loans and structures away from the regulatory limitations that we've talked about. And then what's motivating the banks to do these partnerships? The commercial banks are reacting to the growth in private credit. So in other words, they're reacting to actual and potential lost market share. And I also think they're doing it to remain relevant to their vast customer base, which is very important for them. And whether this is viewed as defensive or offensive, I don't think it really matters. It's just going to be a very relevant dynamic going forward. One thing I want to emphasize is that it appears that most of these partnerships or the ones announced so far, are primarily focused on the larger cap, what we would call the BSL like portion of the market. Another relatively recent and popular trend in direct lending that has seen private credit expand is its reach to larger borrowers competing in the BSL space, which Kip alluded to. So while we see the large market opportunity as an interesting development, we really think there's a terrific opportunity in the core middle market that may not be as crowded. And if we did an origination partnership, it'd probably be focused there because we think it's underpenetrated and then if I can, I'll just end with some risks, because when you move things around this much, it can create risks. I think Mark Rowan, who the CEO of Apollo, has made very public and persuasive case that the movement of some credit from banks to private credit and then obviously the insurers providing the capital is net de risking. He did a good podcast on this. The podcast, I think, is conversations with Tyler. It's obviously not as good as this podcast, but he does make a good argument in there and people should just listen to that because I'm not going to be amazing at summarizing it. But the upshot is that private credit better matches duration because obviously life insurance, which is long duration, whereas banks borrow short and lend long, and we end up with less leverage in the system. So I agree with all that. I just want to take a second to scrutinize the other side of this coin a bit, which is that, okay, so can private credit managers do this without blowing everything up? I think that's probably yes, for the reasons articulated. Although let's maintain some humility that most of this asset class hasn't been through a cycle. But I'm really spending time with the team on this second derivative question as it applies to our whole platform and all of the money that we manage for clients, which is. Is the world in an inherently riskier place when banks have artificial lending constraints that regulators have been working on for 10 years now, being implemented to address a crisis that happened 15 years ago. And thinking about JP Morgan, who CEO has been really vocal on this topic. And if you're a financial market participant, and surely if you're a regulator, you should read the J.P. morgan annual report carefully and listen to J.P. morgan, America's largest balance sheet after the U.S. government. And I do think 20 years into the gig, he's speaking to America, not just his shareholders. But as an example, they have about a 12% CET1 ratio, so tier one common equity ratio with minimum requirement of 52 billion in excess capital. That excess goes down to I think, about 10 billion if Basel III endgame gets enacted the way it's proposed now. And we all know that they're taking a look at that, but that's what that would be. And that means major balance sheet optimization, which is obviously code for pulling leverage from clients and the private credit market. In our view, it can provide part of the solution, but it can't and won't step fully into that void. And this would have a negative impact on the economy. And also very negative impact for financial markets, especially as QT starts to bite. So in our view these things, bank lending and private credit do need to coexist.
- [67:55]
John Bowman
So first of all, thanks for the shout out Katie on the podcast. I think we'll just use that sound bite to headline. Kip, Let me just pause there before we move on because I think Katie cited and articulated some really great things there, some balanced things there as we aim to in this show. Would you agree with what she said there, both on the continued retrenchment of the banks and the balanced view of the risk levels of the private credit books?
- [68:20]
Kip de Vere
Yeah, I think there are a couple of things she referenced in play, all of which I agree with. That is very well put, Kate. But I mean look, post the GFC it became very clear that the regulators wanted to take certain risk taking operations out of the banks and not expose them to deposits. It just became very obvious in terms of how capital charges got restructured on certain businesses. I also agree with Mark Rowan's point about insurers and other capital sources perhaps being better places for these risk taking activities to live based on the duration of the capital and the way that we all think about taking money on. But the only other point I would make because we're getting a lot of inbounds on this from the press and others, is last year the banks were so wounded that they didn't care about leveraged finance and private credit. Now they're back and they must be killing the direct lenders, et cetera. And we don't really think about it that way. We're also like the folks at TCW in the public credit markets, managed loans, Clos high yield bonds along with a very large private credit franchise. So the banks inherently are very important counterparties for us and great partners. But as it relates specifically to direct lending too, I think that they've just changed the way that they've wanted to access these assets. Our largest lenders in all of our funds are the US banks and some of the foreign banks, but they've simply changed the way that they can create those assets. By being a lender into these pools they get an investment grade rating. They can inherently then use more leverage against their exposure. It can be very large and they can do that with a pretty small team if they manage their relationships appropriately. So they're still very much getting access for their shareholders to these types of assets. They're just doing it in a different way. Now where do we go forward? As Katie was talking about origination partnerships and all of that I think that there have been some announcements, but we haven't seen anything that's been frankly relevant or tipped the scales as it relates to our business yet. And Katie's point I think was the right one, which is the banks want to and should have some private credit alternative for their clients. To the extent they hit a series of rocky markets where you can't syndicate a loan transaction or you can't bring a high yield bond issue to the market, they need to be able to go to their clients as bankers and say we have other alternatives for you. But at the end of the day, that alternative is really just making an introduction probably to us or to Katie or one of the other folks that are significant players in the market.
- [70:46]
John Bowman
And I think I'll just reiterate what we both said in the opening segment and what both of you have just articulated in different forms. The time horizon alignment of the investor and the GP sponsor is critical here because you don't have a George Bailey it's a Wonderful Life bank run scenario that you'd have at a traditional bank. And so I just think that's an important critical piece of the difference between these loans sitting in a traditional bank and them sitting in a private credit sponsors. So let's get to the spicy stuff as we promised as we structured this episode around these two questions that each of you catalyze at different stages over the last year. Kip, I want to start with you and at our mutual friend Ted Seides. You were on maybe last July, I think, and you had a great quote which maybe was throwaway in the larger context, but I just really keyed in on it and appreciated it where you suggested that you can't run the US economy on 12% cost of capital. I think your words were you'll eventually drive it into depression. We're taping this about a week after CPI was released here in April. And let's just say I doubt we're going to see any Fed moves anytime soon, perhaps longer than we all thought and hope so. I'm thinking about where you stand on the moral tension, if I can put it that way. That sounds hyperbolic, but this is the financing source to the engine of America's economy. Now, as we've laid out, how do you think at Aries about this risk of the Depression if these IRRs and interest rates continue at these levels?
- [72:13]
Kip de Vere
See, I gotta stay out of the press or stay out of these casual conversations in Connecticut with another podcast host that I play a lot of tennis with. But so the good News is we're not financing at 12% anymore. It's more like 10 and a half because spreads have come in as folks show more confidence in the economy. But the point remains the same, which is the cost of capital for leveraged companies these days is very high relative to what it had been the prior 10 to 15 years. And obviously when the cost of capital is high and there's less cash flow at companies, it's difficult to pay down debt. It's difficult to make growth investments, it's difficult to hire people, it's difficult to build new factories, plants, et cetera. It's harder to buy your competitor across town because your cost of financing. So all I was trying to get at in that quote with Ted was a little bit in response to the chatter of last summer, which was, oh, it's the golden age of private credit. Why would you do anything else? Guess what? It's not going to last. The returns available to core direct lending at 11 or 12% don't last because what happens is what's happened over the last 12 months. The economy proves that it's actually a little bit more resilient than people might have expected. Guess what? Credit spreads, narrow credit spreads actually tend not to actually widen again until you see an increase in defaults. And I know you wanted to talk about that later, so I'll leave that for later. But typically what happens then is you see weaker performance, defaults go up, credit spreads widen, and then what happens? Policy comes in to lower the base rate, base rate goes from five to pick whatever you think your terminal number is, and all of a sudden you're back where cost of financing things maybe is a little bit better, not quite as bad. But you're in a weaker economy and then you grow off the base from there. Defaults tend to heal themselves. Rates can then go back up. So for now we are in a nice period. And I don't want to discount the golden age of credit. We're in a nice period as direct lending firms where we think we're achieving extraordinarily strong risk adjusted returns simply for making first lien loans, which is great. Will it be this easy on the New deal front forever? Probably not, based on my 20 something years in the business.
- [74:18]
John Bowman
So just for the record, Kip, who wins when you play Ted in tennis?
- [74:23]
Kip de Vere
He's a lefty. We play a lot of doubles, luckily, so I don't think I'd like to take him on in singles.
- [74:28]
John Bowman
Okay. That crafty southpaw spin, I'll have to.
- [74:31]
Kip de Vere
Remember that I'm just saying that because I'm sure he'll listen to the podcast so that'll make him feel better.
- [74:36]
John Bowman
Katie just to continue and put you on the spot, I think this is where we first met was at Milken a year ago, which is by the way, coming up again. And you were fresh in the job two months in, so you hit the stage with a bang. And I've teased you about this, but I loved your realism. Otherwise on a stage that was full of self congratulations, I might say, and I won't mention who else was on there and I respect them all, but there was a lot of aren't we awesome? And you effectively said, look, we're a little bit more cautious here that the quick repricing of credit was, quote, inevitably going to break some things. It was going to cause some accidents, I think were your words that it was going to put a governor on growth. And I was just in Chicago last week and I mentioned this in the opening segment and still private credit managers largely are saying the default rates to Kip's point, are 0 to 2%. And I just want your sense of can that really be true? How can we have operated even if we're down to 10 and a half from 12, how can we have hovered at this rate and still see these books, really realizing no pain so far? Doesn't some rationalization need to happen? Katie sure.
- [75:37]
Katie Koch
I'm going to give you my thought on the defaults and I'll have Kip jump back in. I will say from Milken, that was a first couple of months in, I gave a very nuanced answer to the Future of Private Credit, which the podcast format will allow me to unpack here. But you can imagine how excited Rick Miller was when the headline was Major Accidents Ahead for Private Credit. There's actually some of that, but it's more nuanced. So on defaults, let me take that from our perspective. Give Kip a chance to jump in and then I'll talk about where I think this is all headed. So we agree, declining default rates or low default rates seems odd to us given the rate backdrop. But like most strange things, there's an explanation for us when we look at it. We assess 2023. There was an inordinate amount of amendments happening, maybe three to four times the normal amount as lenders and borrowers were considered getting out in front of these looming defaults, smaller loan syndicates, fewer participants, sole lending facilities, et cetera. They make amending loan agreements easier in private markets compared to public markets and this is probably the period we've already talked about, the history of the asset class where we just saw the biggest pickup in that activity around amendments. So I'm not saying whether this is good or bad, but I do want to posit that we may have removed the data point of defaults as a reasonable or certainly as the only gauge of the market health going forward in the private market. And we focus more on recovery rates, which we think should be a primary focus for investors because of those dynamics and not so much on defaults. I think if you go back and kip, you might know better than me. But if we take 2010 leading up to Covid, which were obviously very good years to be a lender, the recovery was in the 60 to 65 roughly sense range and we would expect it to be lower in the future. And that's what we're really monitoring.
- [77:21]
Kip de Vere
Yeah, I think the simple answer for now on the comment that you think default rates are artificially low or surprisingly low maybe is how you put it for me too. So we are seeing default rates in that 1.5% in the direct lending portfolio today. If you'd asked me 18 months ago if I thought we'd be there, I probably would have said my guess is it's going to be worse. But actually I think the economy is better than I might have expected. I think the comment that Katie made in private credit, the ability for lenders or small groups of lenders to materially just re underwrite and amend and extend credit to the extent they need to does keep default rates lower. But I guess the only other thing I'd add is we think default rates are going up. People have been asking my partners and I here, what do you expect for 24? Do you think default rates are going to go up? It's like, yeah, duh. The question really is by how much does it exceed the historical averages. But defaults are inherently lagging indicators. To Katie's point. You get a default if the company has found no other way to avoid that default either by dealing with its lenders, dealing with its owners to infuse capital and the amendment activity and the portfolio management activity that's going on inside these private credit portfolios, I can tell you is very active and over time with higher rates and presumably slower growth has to lead to increased defaults. My own view though is it doesn't get materially probably gets to the historical averages, but with the strength of the economy, I don't really see any reason why it would materially exceed those historical.
- [78:52]
Katie Koch
Averages, so I'll just pick back up there. We also would agree that from here we should see rising defaults. And linking it back to the comment that I was making at Milken last year, I guess what I would say is that what we really want to focus on is we do think there are going to be some accidents. As I mentioned, we are optimistic about the future of this asset class. So we share Kip's view that it can continue to be a very good returning asset class. But we do want to highlight that we think manager selection really will matter a lot more going forward. So the way that we would articulate it is that the beta trade is over in direct lending. So I was at a dinner a few weeks ago with John Zito, who's the Deputy CIO of Credit at Apollo, and he shared a really great stat on this that if you look at this asset class direct lending over the last 15 years, the difference between the top and bottom quartile manager is only 15 basis points. That feels directionally right if you look at people's numbers, because everybody gets to be geniuses when money's free. And now we are going to have some advantages where we're going to experience problems because we saw record issuance. It's not to say that this is what areas in TCW does. I'm just talking about the asset class. We saw record issuance in 2019 and again in 2021 in line with private equity activity. And obviously a lot of money flooded into the asset class and a lot of those transactions were made at record high enterprise value multiples which required record high debt to EBITDA ratios. And these capital structures were established somewhat by some folks under the assumption that interest rates would remain low forever. And they haven't. So math has taken over as it tends to do, and record debt levels combined with a 500 plus rate increase in a record amount of time, I think we can say that has created liquidity challenges for more than a few of those borrowers. And now people are focused on interest coverage ratios. And by the way, the amount of companies with 1 times interest coverage has doubled since 1Q22 pointing to why we will eventually see more defaults. So many legacy private credit portfolios have these loans and portfolio decisions are going to need to be made about which credits to support, which credits to move on from maturity extensions, picking interests and additional capital infusions. And there will be accidents. That's what I was trying to say. So I just want to end, if I can, by saying that despite all that at tcw and I want to hear Kip's view. But we feel awesome about this environment for our clients for three reasons. I would say two are related to regular way direct lending. And when we look back at those vintages, we're a conservative lender, we're in the business of saying no. We're diligent heavy, we're covenant heavy, we're aggressively prepared to work out on our client's behalf if needed. And we're going to demonstrate strong alpha versus the peer groups relative to those vintages. And then when you look forward as we deploy capital now in new loans, we feel positioned to win regardless of the environment because already the rise in rates is allowing for double digit returns while positioned in the senior most portion of the capital structure. And that makes this asset class attractive on a relative and an absolute basis. If the Fed can navigate a soft landing and rates remain higher for longer, it's an attractive asset class. Earning a high current income with a healthy economic landscape sounds great. If on the other hand the economy weakens and the Fed does have to pivot, rates will decline. And where else would you want to be than the safe harbor at the top of the capital structure in a senior secured loan managed by an experienced lender with an actionable loan document. And then the last reason I'd say we're excited is we believe and we're working with our clients a lot on capital solutions here. And we think it's going to be a very interesting environment for rescue because this asset class is going through for the most part its first stressed distress cycle in its relatively short history. And we're going to get there, I think we think just through higher rates, regardless of a recession. But if we throw a recession on, then obviously the opportunity set will widen. So what does rescue lending mean in private markets? To us at tcw, it is about lending to decent companies with challenging liquidity through controlled positions, top of the capital structure, term loans, high coupons, pick components, strong call protection and warrants driving very high teens, low 20s IRR. So think equity like returns that are contractual. And we believe that this is going to continue to be a very target rich environment for that type of lending. And you can always find good companies with bad liquidity. But we do think that opportunity set will continue to widen.
- [83:18]
Kip de Vere
I think it's very well said. I can't add a lot, but I will say to maybe reinforce Katie's point, you're thinking about the market opportunity today and unfortunately deal flows lighter. It's either really high Quality company probably getting a first lien or Unitranche solution at 500 something basis points over the curve. I agree with Katie, that's just great and frankly pretty easy risk reward if you're talking about quality healthy companies that are growing. The other piece of it is do you have the team to go do some of this opportunistic credit and special situations you work which we obviously have a pretty significant practice. And I'd agree with Katie as well that these are often pretty good companies to your point Katie, but even in this environment, better than that because we're seeing a lot of quite good companies today that are simply over leveraged and don't have the right amount of free cash flow relative to their underwriting plan simply because rates are higher. And then you have owners of those companies who paid very high prices for the assets and don't want to sell but need some sort of structured capital that's flexible, that can have pick components to the coupon and all of that to pay down lenders and actually extend the duration for the equity holders who need more time to create returns for their investors. So those are really the two areas where we too are probably most focused in terms of just new originations.
- [84:34]
Katie Koch
Yeah, I like that point around actually. Probably the companies are fundamentally higher quality businesses than you would expect to be involved with in rescue, but they have a math problem.
- [84:45]
Christy Hamilton
And now switching gears slightly, Kip, your firm has quite a few boots on the ground in both Europe and Asia. So data seems to suggest that in Asia the markets there are largely still reliant on bank financing. Approximately 70% versus say 30% in the United States. And the majority of private credit largely resides in Mez and Peel distressed opportunities. Europe seems to be somewhere in the middle of the US and Asia. What are you seeing in private markets.
- [85:11]
Kip de Vere
Outside of the U.S. our business in Europe was basically created almost as a carbon copy of what we've done here in the States and continues to build out in very similar fashion. We hired the initial team, not surprisingly in London back in 2008. I got that right. And built out across continental Europe throughout 12 and it's a large business. It's 60 plus billion dollars of AUM. It's probably even a little bigger than that these days. But look, we're seeing a lot of similarity between the US and Europe. Just great risk reward, a lot of senior secured and unitranche investing in that business, continued ceding of territory from the banks and it's highly reliant on our origination in these regions. I would say it's less focused today on NPL distressed than maybe our Asia business which is newer for us. We acquired in Asia. We bought a manager just prior to Covid called SSG that's now called Ares Asia that did actually have a distressed and NPL background with a team that early days was at Lehman Brothers on the prop desk together for a long time. But they've done a nice job building back to core as I always say. So today we have a couple of products there. We have a stressed and distressed product but we also have a much more just regular way Asian direct lending platform. We've expanded pretty substantially into Australia as part of that. So the only nuance I'd say is there's a lot of caution around China. We've deemphasized our investing in China through our Asia business. And the good news is we have folks on the ground in Singapore and in India and all over Southeast Asia that can invest capably outside of non Japan Asia and limit investment for the time being in China because I think we're cautious as are others.
- [86:52]
John Bowman
So Katie, as we move towards the end here, we've spent most of the time and I think it's pretty proportional to the size of the segmentation of the market. Now talking about direct lending, corporate lending, cash flow lending, but you've really recently expanded into asset backed finance. I think Christie alluded to this a little bit earlier. You've broadened your cielo business as well. So tell us a little bit what excites you about those areas and maybe without maybe breaking news, of course, TCW news. Are there other segments or areas that we should expect to see more activity from TCW in the credit spectrum in the coming years?
- [87:24]
Katie Koch
So at TCW we've doubled the size of our alternative credit platform over the last couple years on clos. Specifically, TCW has been in the dedicated bank loan business for over a decade generating top quartile returns since the inception. So my involvement was really at the margins working with the investing team to expand our equity partnership so we could scale the business. This led us to commit to a CLO equity partnership with Lakemore and it's been a really productive partnership. We're working on additional partnerships to support our growth ambitions. So why are we focused on levered loans? Why CLOs? What's the right to win here? First of all, we want to be the most relevant and powerful lending partner to companies to sit across from our CFOs and B solutions partners, public private across the capital structure in meaningful size with the Ability to act with alacrity and clos are part of that. We also have a proven edge in disciplined credit selection extending back many decades and we have 30PMs and analysts supporting this business. And finally, because of our value oriented philosophy and this robust underwriting capabilities and our flexibility of capital, we're also able to step up and lean in and provide solutions quickly when other people can't. So all of this of course strengthens our value add proposition to our main stakeholders, our clients. And then on Asset Backed Finance, people throw around that term like it's a new asset class. But to be clear, TCW has been in the asset backed finance business for 25 years. It's called securitized investing. There's really no one in the market doing securitized for as long and as deep as tcw. Asset backed finance. Basically think of it as including really two subsets. The first is traded asset backed securities. So think individual loans bundled together by a securities dealer that's distributed to investors and trades in the secondary market. Unlike a corporate bond whose return is linked to the actual issuer, ABS return depends on cash flows of underlying assets. The second subset is private asset backed finance or private securitized. It rhymes with what we just talked about, but it's bespoke, privately originated and negotiated and structured by an investment manager. We manage $90 billion of asset backed finance at TCW and the majority is in traded asset backed securities. But we've also invested in private asset backed finance deals and illiquid securitized products across all collateral types for the last quarter century. We do observe a growing opportunity in the ABF business, so we are adding dedicated talent in that space to collaborate with our existing securitized team. And we announced publicly the launch of a dedicated ABF business anchored by a billion dollars from TCW and affiliate capital. From the supply side, we see the opportunity set widening a lot for private sector non bank lenders because banks are going to face the regulatory pressures that we've been talking about on this podcast. And from a demand perspective, there are clients who are willing to sacrifice some liquidity for the premium returns of private ABF while diversifying away from corporate debt. And again back to what's the right to win here on behalf of our clients. We think that first of all, we're one of the few asset managers coming at this opportunity set with a massively scaled securitized business. So we have already 500 origination relationships across multiple collateral types and we know that many of these will do and will continue to value, some private funding. Second, we have proprietary analytics and a scaled and growing database of credit performance across these same asset classes in the liquid space that will benefit the underwriting of these ABF investments. And then finally we have the infrastructure to serve the clients, to build portfolios, to manage risk. That's all already built. So we'll incorporate private asset backed finance in existing mandates where appropriate. And as mentioned, we're going to offer these dedicated vehicles anchored by our affiliates and we'll offer it both in investment grade as well as in some higher yielding approaches. And we think the total addressable market here is in fact multiples over direct lending.
- [91:29]
John Bowman
Before we shift back to Kip, a few things you said about the calculus of launching expanding new businesses struck me because it tied back to a point you made earlier about the importance of manager selection, which by the way is the case across all private capital asset classes. But with this proliferation explosion that we've been talking about at length in private credit, I have to imagine for the average investor that a lot of this stuff starts to look the same. Has commoditized a bit when you think about launching new lines or adjacencies is what you like to say of credit. How can you be assured you're going to differentiate yourself when everyone seems to be doing this?
- [92:07]
Katie Koch
So I have a really strong view on this and I'm excited to hear what Kip's perspective is. But we would really encourage LPs to focus on three things. Does this manager know their client and remember what business they're in? And I'll unpack that briefly. Are they bringing in experience in an asset class that has a lot of new entrants and are they maintaining discipline? I want to just lean into this point on knowing the client and what business you're in because the client is the asset owner or the investor, not the borrower. But I think that we do have some managers that forget that too many managers that are trying to differentiate themselves by providing more money, which we could say is greater risk and lower economics which reduces returns and looser loan documents which weakens protections. And these are bad ways to differentiate yourself. Kip said this earlier as the way that Aries approaches it and I so agree with this, try and understand the underlying business, try to be more of a thought partner versus a commoditized capital provider and create customized solutions for these borrowers. In our experience this leads to fewer surprises, makes for faster and more informed decision making and even when challenging situations come up, which they do, it will allow us to come up with better solutions to address whatever the issue is. So as a lender, focusing on the downside and prioritizing capital preservation is how you stay in a market for over 23 years. And I think Aries and TCW probably share that in common. Second is experience. Longer track records are better than short ones in general, and you'll be able to weed a lot of people out just by having a shorter track record that doesn't go through cycles. In this asset class, you want to hire people that have been. You want to hire people that have been around long enough to make some mistakes, push them on what mistakes they've made and what they've learned from it. You generally have to go through cycles to have done that in a meaningful way. And I'll just end on the discipline point. Does the market determine the level of discipline in the manager's investing process or does the manager stay true to the process and approach that you can rely on and underwrite, regardless of what the environment brings? Those are the areas I would focus on in picking a manager in this space.
- [94:08]
Kip de Vere
Pretty hard to disagree with. I do think the point about differentiation of results here from your dinner with John is right. So many folks say I want to increase exposure to direct lending and they really don't, to Katie's point, understand how to access the asset class. And as a result, unfortunately, some of them start choosing by who charges the lowest fees. That tends to be a very, very bad way to higher quality active managers in a space like this, which requires a tremendous amount of hands on work and heavy lifting around portfolios. Again, this dispersion we think is very likely in this market because the business has gotten harder, it's more competitive, there are more people doing it back to where we started. It's not the clubby little cottage industry it used to be, which means we need to continue to attract and retain the best people that we think can drive better outcomes on a platform like Ares or a tcw, I'm sure feels the same way than it can at a smaller firm with less resources and less information and less advantages to actually be good at doing this. And I just caution people, manager selection is going to be the key because everybody says they do the same thing. And I can promise you, just knowing what we do here and how we do it, I think we do it very differently than a lot of other places that haven't been around as long and aren't as large as we are.
- [95:30]
Christy Hamilton
So last question, and this is to Kip. So your firm bought one of the largest players in secondaries with the acquisition of Landmark about three years ago. So secondaries used to basically be viewed, I would say as this forced selling as a last resort for some liquidity problem that an LP was having. But more recently it's more LPs and frankly now GPs looking for liquidity and flexibility throughout the cycle. How has that gone and what is the role of secondaries in the marketplace today?
- [95:57]
Kip de Vere
We've added on credit secondaries to what we acquired with Landmark. We felt secondaries was a missing piece perhaps of our offering to limited partners and other investors, having obviously brought them credit and real estate and private equity. In a lot of geographies, we thought secondaries was a nice add on. So today it's pe, it's credit, it's real estate and it's infrastructure. To put it simply. I think you're right. In the old days it was just buying LP stakes at a discount and trying to capitalize on that convexity. Today it's much more partnering with gps. We don't have as large a stakes business as some other folks do, but there's obviously a lot more of that out there with Blue Owl and many others. But look, to simply answer your question, Christie, LPs whether they're locked up in credit funds, private equity funds, infrastructure funds, real estate funds, et cetera, are being impacted negatively by less returns of capital than they expected and underwrote over the last five to seven years. So the pacing of their new commitments has substantially exceeded what they've gotten back. And we think it could be a little bit of a golden moment here for secondaries to be a significant part of the solution for LPs that are not finding themselves where they hope to find themselves today in terms of just return of capital.
- [97:16]
John Bowman
That's certainly been the buzz on the circuit from what I've heard too. Kip, I think we've got a new golden age. It's shifted from private credit to secondaries now. So on we march to the next.
- [97:26]
Katie Koch
No, it's both. Kip agrees, it's both.
- [97:29]
Kip de Vere
Yeah, look, I think the diversified alternatives firms are very well positioned relative to how they're growing and the segments of the industry that they're in relative to some of the other asset managers out there. And we've been hard at work over the last 20, 25 years here trying to build something that's differentiated for our clients. We always remind people, unlike tcw, we don't manage public equities, we don't manage high grade bonds, but we think we're pretty good at managing alternatives.
- [97:55]
Katie Koch
You're excellent at managing alternatives. And we're really privileged on this platform to do the alternatives as well as public fixed income and equity markets. I do want to just say end with a comment that yes, there's going to be some replacement. I agree with that of some of these fixed income assets. Just as someone who was in public equity markets for a long time, we are in the early stages of watching some of the public CUSIP market be displaced by private and I think that's going to continue. And it's a real trend 100%. I have reasonable pattern recognition. I just also want to make the point that it's not going to eliminate the need for public fixed income. These things actually have to exist alongside each other because it turns out a lot of these asset owners really do need liquidity. They have pension obligations to meet. They're in drawdown in retirement. And not everything can be locked up for three to seven years. So I do think these things can coexist and I do think there's still alpha available in public markets. It is also true that clients increasingly are going to have to be across the public private divide, whether they're individuals or institutions, to fully capture the opportunity set.
- [98:59]
John Bowman
I think that's a good final wise word. And Kip and Katie, we're going to have to leave it there, I think. First of all, thank you so much for joining us. You've really helped Kristi and I, I know and I know speak for the listeners to suss out the reality that while I think many of us agree, certainly those on this podcast about the long term opportunities and benefits of private credit, nothing is a straight line and there's always objectivity to layer on and unpack. And you've helped us do that with a lot of clarity and perspective. So thank you so much for that. And listeners, stay tuned for the Last Sip. Mel, welcome back to the Last Sip. And what a last sip this will be. Kristi, that was everything I hoped it would be. Those two quotes that I heard again over the last 12 months have really stuck with me. I've used them to frame questions at conferences, to moderate panels. I've written about them. And then to have Katie and Kip on the pod and I think just honest with themselves and the listeners, they didn't back away. They nuanced and they had subtleties. But hey, look, I think they realize that just like I said at the end of the session, that this is not going to be clean and perfect and without some growing pains, some teething pains. And I just thought that was an awesome fresh discussion.
- [100:15]
Christy Hamilton
Agreed. I actually, I really love, I don't want to lump everyone under bond people, but just the credit side of the business is just, it's so different and the things that they look at and the way that they look at risk and put together portfolios as so different. I'm actually infamous for one time telling my former boss Ryan Bailey to put me on anything but credit, anything but private credit, anything fixed income related. I thought it was so boring. And so he naturally looked up and said great, you're going to be not solely, but you're going to have partial responsibility over the fixed income portfolio. And I was like, ah. But just five years of really getting my hands dirty there has given me so much respect in admiration. I would even say for the bond side of the business. It seems like a thankless job when it's done well. So I appreciated their context.
- [100:58]
John Bowman
Well, the obvious stereotype is the fixed income folks or the cranky pessimists. That's the old joke, but I just found both of them to be very, very balanced and not drawn or biased in any direction. I love what both Katie and Kip said about defaults. I think they shared our yellow. I don't want to say red flag, but certainly some caution and expectation of what's to come ahead. I think both of them realize that they have a team and a talent and a history and probably underwriting discipline that is going to see them through on a relative basis better than others. But nonetheless they also, I think are eyes wide open. That credit cycle is the credit cycle and it ain't pretty when it's moving against you no matter how good or how experienced you are. I think I'd also come back to this differentiation point that Katie was, I think so articulate with. Manager selection and dispersion is one thing, but I think just partnership and solutions along the capital stack and understanding the borrower I think is such a good point. Private equity I think would say that's what they've made their business off of is you become a partner along for the ride and you are in it with the wins and you're in it for the losses and the hardships. And I think the mature and winning private credit firms, now that we've come out of the at least the hottest part of the golden age, maybe I'll say it that way. People are going to start to be more discerning. They will require to be more discerning. And that I think will be good for not only the winners, which are probably Ares and tcw, just to name a few, but I think also for investors and the larger industry, when this cleans up, grows up, matures, improves, that's always good as industries develop and evolve and learn from their mistakes and so forth. So I actually came away from that conversation maybe slightly more comforted and confident that we're going to get through this and investors will be seen through this in a positive way.
- [102:47]
Christy Hamilton
Oh, and one more quick point on the default rate. I do think it's funny that sometimes we historically have question numbers, but more recently as just inundated with data, I think it's very hard to question all of the data points or to unpack what is embedded in those numbers. So just a reminder to read your footnotes and to ask questions around that, because if something seems too good to be true, there's probably a reason. And again, not nefarious, but it's a really great explanation. It's like, yeah, there's no defaults because they just renegotiate them. Makes sense. But that doesn't necessarily mean that things are healthy because it's low. It just means the willingness to renegotiate is there. So all in all, I totally agree though. Completely. Great conversation.
- [103:24]
Katie Koch
All right.
- [103:24]
John Bowman
Well, listeners, the funnest part, of course, at least for us, at least for Christie and I, I hope you guys agree is our fun question to get to know each other and for you guys to get to know us a little bit better. The one we agreed on for this one, Christy, and apparently you and Luke were talking about this recently, but I'm so excited to hear. What is your walkout song? If there was a reason for you to have a walkout song, which you might. I don't. But what would that song be?
- [103:50]
Christy Hamilton
So I think it depends. I will say that my husband would probably joke that mine would be Waiting on a Woman by Brad Paisley just because he heard it once and he's like, oh, I thought of you. And I didn't know how to accept that, but it makes me laugh now. From an investment perspective though, absolutely 100% Wu Tang clans, cream Cash rules everything around me what about you?
- [104:09]
John Bowman
Wow. And the bright lights are flashing the spotlight I can now visualize this. Wow. Don't stop believing I am Old School Journey, my very favorite band. I might say the greatest band of all time. The vocalist capability of Stevie combined with walking out with that on stage, I can't imagine why anybody would ever want to see me that way. But if that were to be the case, that would be, I think, what I would choose. There you go. Don't stop believing. Well, we're going to leave it there. We're going to wrap up a fantastic journey. Fantastic discussion. I loved that one. I really liked that one. Asking some tough questions of each other. And that's what we're here to do, is to honestly assess the more difficult and nuanced topics, the ones that are not given enough air time or oxygen to really breathe, as we've often said. So hope you enjoyed that as much as Christy and I did. And we can't wait to see you. Next time on Capital Decant.