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Excess Returns
The Private Credit Apocalypse That Isn’t Coming | Larry Swedroe Dispels the Myths
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Podcast Host 1
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Larry Swedroe
New friends, Gary the Snake and your last name, the Snake Dream Team. Get new habitats. Zootopia has a secret reptile population.
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Larry Swedroe
This is far better situation, much less risky for the economy than when the banks are lending because the banking system provides the, you know, the liquidity for the whole economy alone. That was still paying well, right, because you originated it and the spread was 550 and now it's 700. But maybe you can sell it at 95 or 96, not the 30 cents on the dollar or 70 cents on the dollar that the press reports. We get a serious recession. Clearly, credit losses go up. And if private credit losses go up to the extent like in 08, my crystal ball is always cloudy. But I'm willing to give you whatever odds almost you want. That Cliff Waters fund will lose money maybe that year, but it will far outperform public equity, far outperform junk bonds. They want to create a panic so that people tune in and read their articles.
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Podcast Host 2
Larry, welcome back to Excess Returns. It's always good to see you.
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Larry Swedroe
Yeah, it's great to be back.
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Podcast Host 2
In today's conversation. We're going to try to focus on three key areas, but maybe we'll just focus on one, which is the first one we're going to discuss here. And that's, you know, some of the biggest misconceptions around private credit from your perspective. I think we want to work through, you know, to educate our audience as to what private credit is, where you think the real risks are, and then also talk about what investors and maybe the media and the, you know, overall financial profession is getting wrong about the broader narrative with private credit. You've been writing a lot about this and this is obviously front and center in the media on most financial news stations. And so that's going to be, I think, the, the key topic of today's discussion. But if we have time, we'll also talk about diversification and what is, you know, a highly concentrated market these days. And then lastly, I think this is very interesting. Hopefully we at least get to touch on it, this recent academic paper on thinking about earnings versus cash flows when valuing a business and sort of what the implications for investors might be. So a lot to cover and always a lot to cover with you because you're such a prolific writer writing about a whole host of things. And so for people that want to follow along with you to read your research and your work, I mean, you can finally, in a lot of different places. But his substack is great. That's Larry swedro.substack.com and you've written, I don't know, 18 or 19 books. Is it at this point?
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Larry Swedroe
So depends on how you count 18 and three sequels or second editions with updated data.
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Podcast Host 2
Yeah.
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Larry Swedroe
So 21.
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Podcast Host 2
A lot of nice. A lot of. A lot of content to say the least. So anyways, okay, so let's start with the private credit thing. So you've been pushing back and offering an alternative view and voice as to what you see. Some of these misconceptions are around private credit. But before we get into that, let's just level set here with our listeners on what private credit actually is. We've talked about on the podcast with you in the past. But I think it's important to discuss that, like discuss the scale of it and sort of where it fits in in the importance of financing in our overall economy.
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Larry Swedroe
Well, private credit was a really small niche business up until the great financial crisis of 2008. The banking sector provided the liquidity needed the debt financing for medium and small businesses and even some, you know, obviously larger business as well. What happened in 2008? Obviously, the banking system was devastated in terms of its capital by bad credit decisions and how to be bailed out, as we all know. And part of that process resulted in much tighter credit standards, much tighter regulation. The banks, in order to meet those new capital standards, had to scale back their lending to businesses dramatically. And businesses needed a place to get that credit and they turned to the private markets and that market exploded. Another advantage of private credit that has helped fuel it is unlike going to a bank, which you have to go through Committee after committee. It may take months or even longer than that to get approvals. Private credit doesn't have that bureaucracy and has a little bit more flexibility, maybe in its terms, can adapt them more to the specific needs, and so they can get much quicker responses. And in return for that flexibility and speed, companies are often willing to pay a little bit more because they know that private credit can be illiquid and they're going to have to pay up for that illiquidity. So it's gone from a few hundred billion to almost 2 trillion maybe today.
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Podcast Host 2
Where's the money coming from? Who's, who's backing this? Right, the backers.
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Larry Swedroe
Originally it was mostly from big institutional investors who will clearly have the ability to accept the illiquidity risk. You know, the Harvard Yales of the world maybe spend 5, 6, 7%, maybe, you know, of their assets in any one year so they can devote a significant portion of their portfolios, the illiquid assets, and earn a significant illiquidity premium. Because investors hate illiquidity and therefore they demand a big premium for it. About five years ago now, no, it's a little bit more now. It's almost seven now. Clifforder was one of the first to come up with an interval fund structure which made it more liquid. Prior to that, you had tender offer structures, and before that you had drawdown funds as well, and the business started to explode. So you had BDCs, tender offer funds, and now interval funds entering the space with the biggest player, which is why I think they've attracted the most attention being Cliffwater, which has got almost 40 billion in this space today.
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Podcast Host 2
Yeah, we'll talk about Cliffwater in a few minutes, but I wanted to state that, you know, one of the core arguments that you've been making is that private credit is not a monolithic asset class and that, you know, by just dumping all these different tranches, if you will, of private credit together, you know, it leads to kind of a bad analysis, if you will, of the risks and the levels of, you know, opportunities and risk in, in these, in these buckets. So you. Can you just kind of explain that a little bit more?
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Larry Swedroe
Yeah, sure. There are three big risks that investors need to be aware of and do their due diligence thoroughly before investing. We spent many months discussing with Cliff Warder their structure and their credit culture and what their objectives were, how they ran the fund, their underwriting capabilities before we would even consider them. As for investment, when I was part of the investment team at Buckingham, which became Focus Wealth Partners today is one of the largest raas in the country. And we had a whole team of people analyzing, doing that work. So the three risks are of course, one, you have credit risk. Okay. And something that's very important for investors to know is that credit investing is very different than equity investing. And the reason is with equity investing you have both the potential of huge losses, you could get wiped out 100%, but you also have the potential of massive gains. If you invested in Nvidia in the last few years looking pretty, you know, pretty good thousand percent type returns with. So you have this wide dispersion of outcomes. You have a very different dispersion of outcomes with credit because the best you could get is the yield minus the expenses of the fund and the worst you can get is minus 100%. So I'm the big believer you don't want to stretch for yield, you want to focus on the return and have high quality credits. And private credit offers you an advantage over public credits. In this sense is if you are able to accept illiquidity risk or limited liquidity, then for you it's not a free lunch, but it's close to a free lunch as you're ever getting investment. Good example is I don't spend more than 2% of my net worth every year. I don't live a high lifestyle. And therefore with a interval fund structure, you are guaranteed to get basically 20% a year. And if I'm only spending 2% of it, I can build a diversified portfolio of private funds, reinsurance, private credit, private equity infrastructure or private real estate, each of which are giving them some level of liquidity and I can get more than enough liquidity. And I think one of the big mistakes individual investors make is they for at least higher net worth individual, vastly overstate their need for liquidity. By that I mean this. I worked at a very large firm with when I retired that had 70 billion of assets. We had thousands of clients. I asked our advisors once, how many of your clients are taking more than their RMD or acquired minimum distribution? And the answer was virtually none. Non zero, but very close. And do you know Jack, what the R and D is at age 90?
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Podcast Host 1
I don't actually.
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Larry Swedroe
It's about 10%. Okay, so if you can get out in a private credit vehicle with a guaranteed liquidity of 5% a quarter in two quarters, you get it all guaranteed and you don't need the rest of it. Right. And I'm not suggesting at all that anyone should have 100% of their money. There but every investor who has higher net worth, you know, and has a sufficient amount of liquid assets, I mean they could easily invest 10, 15, 20, I think even 30% in less liquid assets in my case are now over 50% in these less liquid assets. Because for me that's as close to a free lunch as possible. And the illiquidity premium can be quite large. It's typically a minimum, I would say of one and a half percent. And it could be much higher, 3, 4, 5%. Especially in bad times when people really hate illiquidity and those spreads widen. And that's when I want to be a buyer. So that's important. That's risk. One is the liquidity risk. Number two, of course is credit risk. So what I don't want is to be taking the big risks. I want to be in the space that is the least credit risky within private credit. And Cliffwater produces two indices. One is called the cdli, the Clifford of Direct Lending Index. And it looks at all loans in the industry, all the BDCs, etc. Reported. They get filings that they have to make and they report their credit losses and all kinds of data. That industry used to be more or less non secured. Often higher risk that the banks maybe wouldn't touch. That all changed when 08 hit and losses. So it's become mostly senior secured. Okay. But they also run a second index called the cdlis which is senior and secured. Not just senior, but also secured. Not just secured, but also senior. And Cliffwater itself differentiates itself further by saying we only want to invest the vast majority in the loans in the pool. Something like 97% are not only senior and secured, but also sponsored by private equity. So what that means is you have some extra layer of possible protection because let's say you're a private equity fund and CLIFFOrder on average LTV is about 40%. So the equity's got to drop 60%. Right. You know, before you even have to worry about the private equity being hit for losses. And say you get that type of environment and the private credit lender says well we're going to seize the assets. And the private equity firm might say hey, before you do that, let's negotiate an extension. We're willing to put in some more equity in return for the extension and restructure the note and those things. So it does help. A good indicator is now have a little bit of a problem. The data doesn't match up exactly alike. The CDL is CDLI goes back to 2004. So it encompasses the 2008 Great Recession. And it is tainted a bit by the period 0408 when it was more not secured, not senior. That changed in 08 09. But the historical data back to 04 is a 1% loss per annum. The CDLIS goes back only to 2010, but now you have a much tighter underwriting. It's more secure. Did go through 2020, but we didn't have any severe recession. So it's not quite as tested. But clearly it's going to be better data, right? Or you know, for that index, you'd expect lower credit losses. That index has only lost 25 basis points a year. So it's telling you that if you do a good job, okay, then the risks are not that great. They're still there. You shouldn't assume they're zero. And there may be a lot worse in the future than 25 basis points a year. The third risk is one that you really have to be careful of and monitor. And private credit is concentration risk. And it's one reason I would not recommend investing no matter how good the credit culture is in any of the proprietary vehicles like BDC is run by really well run firms like Ares and Blue Owl and others. Because the typical BDC proprietary one be more narrow, concentrated by industry because they specialize and have experts in that industry. It's going to be more concentrated by credit, by borrower. In my writings I've shown the charts. For example, the typical average BDC, the top 25 loans make up almost 2/3 of the portfolio. 61% okay at Cliffwater, because it's an open architecture. It partners with dozens of the leading firms who have long credit histories of focusing that way. So instead of hundreds of loans, you got 4,000 in Clifford's portfolio, many more unique credits. And their top 25 has a concentration of 12%. Okay, so one fifth of the concentration. Diversification, as you know, is the only free lunch in investing. Because you get the same expected return with much less risk. You narrow the dispersion of outcomes. And since you can't have a great right tail anyway, you want the narrow dispersion of outcomes. So those are the three risks. You have to be aware of them, you have to underwrite for them, you have to monitor them. Because things can change, management can change. A good example was BlackRock. They bought a firm and then a bunch of the people left and maybe didn't have the talent and then they got hit with some big loss.
- [19:03]
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- [19:35]
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- [20:04]
Podcast Host 1
What do we know about the risks right now in terms of what's going on? Like, you hear about things like First Brands and Tricolor. Like if you listen to the media, you'd probably think we're seeing like significantly above average defaults and losses in private credit. Is that what we're actually seeing?
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Larry Swedroe
Yeah, you probably are saying some because and I would say a lot of this has to do with and here's an interesting risk we should talk about. When interest rates went to zero and stayed there for a while, right? For more than a couple of years, we were at zero. Okay. So you're underwriting at a zero interest rate and maybe a 7% or 6% spread and maybe on the right for 1 or 2% rise in interest rates and stuff like that. And maybe because of that, your credit standards got a little looser and stuff and didn't think about, well, if rates go way up. So a lot of these losses now are coming from companies who when rates went up five and a half percent now, maybe had a tougher time meeting their debt obligations. So one of the things you want to look at is what is the maturity of the book of business? When was it originated? Okay. And so it's one of the things you look at in the case of a Cliffwater, for example, less roughly 5% of the portfolio is pre2022, which means at that point rates are up. People then tighten underwriting standards, of course, and you're seeing, you know, better production, better default risk, I think, out of those periods as well. So you need to look at that book of business as well there I think you're, you're seeing some more losses because of course rates went way up, tariffs could be creating some problems, slowing of the economy. This k shaped recovery and there is of course a clear threat and we should talk a bit about this about AI disrupting businesses, but that is conflating. The way the media is portrayed is like every business and software is going to go out of business which is not going to happen despite what the media are saying. I just wrote a piece on that which was published by Financial Advisor. So anyone can see it either by following my substack column or going to Financial Advisor. I go into great detail to analyze what's really the risks in the software space. So yes, let me hear one other thing and this gets to the media mis portraying things. Clifford I think is as I mentioned getting its attention because it's by far the biggest player. And one article talked about the 60 million and you know, in losses they took from two credits. This was some analysts writing about it. Well, I pointed out that 60 million on 33 billion and 4000 loans. The credit write offs was 18 basis points given the exposure on these two loans. Now Cliffwater expects based on history and budgets. So they're actually reducing the earnings number by a budget every, you know, every month they expect a 2% default rate and 70% recovery. Okay, so it means you're going to have 30% losses. So that's 60 basis points a year or 5 basis points a month. So in the first two months they took 60 million losses which was 18 instead of 10. So that was part of the reason the fund slightly underperformed what it had been earning of 80 basis points each month and it earned 68 basis points or so. And spreads widened a bit and the fund took what it's called a beta adjustment. It actually prices daily marking to an adjustment what's happening in the public markets belying another media myth that they don't mark daily and don't price and these things are badly lagged, etc. There is some truth to it, but it's not as bad as the media is portraying. So we are seeing some losses but the losses will be much bigger with some bdcs who have much more concentrated risks. I think obviously blackrock got in trouble and there are probably some others and that's why you want a highly diversified portfolio. We get a serious recession. Clearly credit losses go up and if private credit losses go up to the extent like in 08 one thing my crystal ball is always cloudy. But I'm willing to give you whatever odds almost you want that Clifford is fund will lose money maybe that year but it will far outperform public equity, far outperform junk bonds have much lower losses. So that kind of environment is going to be bad for everybody. And I'd much rather be in private credit senior secured, highly diversified than other risk assets.
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Podcast Host 1
Do we know how significant is this to the economy? Some of the doomer people on Twitter will say this could bring down the whole economy if it collapses. How important is this if we think about this in the context of the overall economy?
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Larry Swedroe
Well the first thing I would say this is far better situation, much less risky for the economy than when the banks are lending because the banking system provides the liquidity for the whole economy. There are much bigger, I don't know if it's 50 times bigger than the private sector things. 110 billion of credit overall and private credit is 2 of it or you know, some number like that. So you know, I think there is far less risk. Is it non risky? No. Banks lend to Clifford for example they have you know, something like I think the number is 6 billion of credit lines outstanding or more. That's guaranteed, you know, but that's you know their look, their leverage is only 21% at the moment. So the banks likely losing money on that I think is non zero. But I don't think it creates a crisis. The banks would worry much more about their direct loans to companies than the loans to the private credit. So individual investors will lose, but it doesn't mean the banking system gets in trouble which is what really causes financial crisis. Banks have limited exposure directly to the private credit industry. Non zero, but limited.
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Podcast Host 1
As someone who invests in this, how much you think about like digging into the actual portfolio? Like I think there was an interaction between you and someone on Twitter who was trying to like pick apart I believe was Clifford's portfolio and look at like all the individual loans and say there's problems here and there. Like how much do you get into that and how much value isn't there in that?
- [27:41]
Larry Swedroe
Yeah. So let me say it this way. First of all, much of what I have read by analysts is from what I could tell, okay, is reading and ask Clifford, did these people, you know, talk to you about it? Because when I ask the facts I get totally different answers. And, and any analysts wouldn't have written what they wrote. So I'm guessing what they do is they go through the SEC filings and then make assumptions and never call an ass cliff order because the answer is wrong. I know for a fact that almost everything that analysts wrote was incorrect. So that's a problem. So the problem for the individual investor is they're not going to have access to. When I was at buckingham we had 70 billion of assets. We were probably the biggest retail type investor, you know, in Clifford and we had a quarterly call going through, you know, everything you could think of about their portfolio, concentration risk, default risk, what's the level of pick, you know, payment in kind or deferred interest, everything you could think of and talking about, you know, what their credit issues are, etc. Now so what an individual investor has to do because you can't access them directly is you have to have an advisory firm that has the talent and the depth of skill knowledge to ask the right questions. I was the senior credit person at the largest mortgage company in the country, so I have a fair amount of credit experience. I know there are questions that, you know, types of questions to ask. Not every RA is going to have those kinds of skill sets. Of course there are other RAs that do have that talent, but most don't. And that's why one of the reasons I'm now a consultant to a bunch of RAs because they look for someone like me to help them do that due diligence and choose the right type of vehicles. And so again, one of the reasons I will only work with an open architecture firm is I want that much broader diversification. I don't have a single manager risk where they could decide to make bets on sectors I want as concentrated a portfolio. In other words, I'm trying to earn the beta of the asset class. I'm not trying to be an outperformer and find the single best manager who's going to generate a little more alpha. But boy then I'm taking much more idiosyncratic risk.
- [30:29]
Podcast Host 1
Speaking about the beta, do you think this is an asset class? I mean would there be any reason to index this asset class? Or you think this is an asset class that probably is not indexed?
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Larry Swedroe
Well, there is an index. Now there's two of them, the CDLI and the CDLIs, but they're non levered, they don't have any expenses, but it is at least a benchmark that you could use. You could also look at the public equivalents funds like BKLN and srln. Those two own these vehicles but they're unlevered, they have much lower expenses. So if you're going to, as I did in one article, compare and look to see what the risk adjusted Returns are, you have to take into account the leverage in say CCLFX versus an unlevered fund like srl. And once you do that, I estimated the liquidity premium was close to 3% a year based on, you know, since inception returns, taking the count, the leverage, etc. 3% a year. And actually Cliffwater is a little safer from a credit perspective because it's almost all senior secured and sponsored by private equity. Not much difference, but some. So let's call it a 3% liquidity premium. That's a lot every year compounded, you know, even if you use the CDLI, it's 1% a year in credit losses and I'm getting a 3% premium.
- [32:09]
Podcast Host 1
I was asking about indexing because there's, there's more and more effort to push this down to your average investor. And I'm wondering what you think about that. I mean, obviously I think you're probably going to tell me like putting this in an ETF is not a very good idea but like in terms of bringing it down to the average investor, like is this an asset class your average investor should have exposure to or is this something where you have to be more sophisticated to understand what's going on?
- [32:26]
Larry Swedroe
One, it can never be in an ETF by definition I think because ETFs are limited to 15% illiquid assets. So you could hold some of them in there but no more than 15% in a portfolio. So you might put it in a vehicle that's a diversified alternative funds and owns a lot of other things that are daily liquid so you could have some. I don't believe that this should be allowed in 401ks or things like that because you're not going to have the advisor holding the individual investor's hand, taking the time to explain the illiquidity, making sure they understand that. When I was at Buckingham, I recommended they get a letter from every client before they would move forward saying, I've listened, I've heard that this can have gated liquidity and I am willing and able to accept the risk and sign that before I would allow them to invest. I would advise every advisor because individual investors have short memories. You didn't tell me, I've heard that, which I know wasn't true because we were in the room, you know, those kinds of things. And I will tell you that some advisors, I think my experience don't do a good enough job. They, their firm maybe has a model portfolio and has 10% private credit or 5% in that and they just Put people in those models, never walk them through all of the risk. Not saying all do it, but I do know that a significant number just plop people in and don't thoroughly explain it. At least that's my personal experience.
- [34:13]
Podcast Host 1
How about a mass redemption scenario? Even with the gates in place, you could argue if It's a terrible 2008 type scenario. If people go all the way up to the gate amount, you know they're going to have trouble selling enough. I mean, some of that's managed by cash. I know, but they're going to have trouble selling in a terrible time. And this, this could be a problem for investors. Like, how do you think about that?
- [34:30]
Larry Swedroe
This is really the most important issue in underwriting or doing your due diligence on a private credit firm. So let's talk about that. What the media fails to talk about is, is that there are several sources of liquidity. Okay? So the first line of defense, of course, is cash. And second could be public assets. So what some of the firms do is they'll go out and own public assets like BKLN and SRLN, but you're getting, let's call it 3% a year less for that on a risk adjusted basis. On an un risk adjusted basis, it's higher than that because of the leverage in these vehicles. So you're giving up significant yield to keep that liquid. But if you own 15% of that and you got 5% cash, you got enough to meet a whole year's liquidity. So some firms do that. Okay. Second thing that you have to understand is you can have bank lines of credit now, banks or private credit firms, some of them, and one of them was in the press, I don't recall the name, got in trouble because it didn't pay for a guaranteed line of liquidity. Well, we've got an agreement with the bank, but the bank could pull it. Cliffwater pays for. It's another reason why I use it for guaranteed lines that go out multi years, tranched over a number of years. So they got rolling and they keep rolling it forward. Okay? And they've got, I think 21% of the portfolio has got guaranteed lines of credit. So that's enough for a whole year in and of itself. But that reduces returns. But I think it's a much cheaper way and a better way than owning public assets with much lower returns. You don't have to give away 3% a year to get a guaranteed line of credit. Second thing most people don't understand, and I haven't seen any article write about it, private credit loans are typically made five to seven years, but the average outstanding is about three and a half. Because some of them prepay early. Because a new private equity firm takes over, they could take it public as an acquisition. Lots of different reasons. Their credit quality improves so they can renegotiate. Now, better terms, lower spreads, that gets redone. And the average maturity or average outstanding is about three, three and a half years. Now, if you have a normal environment like that, that means about 1/7 of your portfolio, or 14%, 15% is paying off every year. That's 3/4 of a full year, maximum payout. Now that's a risk because in an 08 or even in a mild recession, that's going to slow down, right? So maybe it gets cut in half. Okay, so maybe it drops from 14%, you know, down to or 15% down to 8 or something like that. But then you also have dividend or distribution reinvestments. Typical. I know the case of Cliff Water and others. It's in my experience it's over 50%. So if you're paying out right now, let's round it to 10, you're getting distributions of 2.5% a quarter. That means you're getting one and a quarter every quarter, right? Or call it 5% or so a year. That's on top of your right. So that's. And then you can have new cash flows. One of the things that really bothered me in the press is the article Bloomberg just wrote about Cliffwater. They Talked about the 7% redemption and 14% request.
- [39:00]
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- [39:30]
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- [39:59]
Larry Swedroe
The 7% redemptions was not the net cash flow in the fund. That's what they chose to redeem. The fund was still receiving positive net inflows of some significant amount during the month and the interviewers knew it. I'm sure. I can't imagine that wasn't discussed and yet they don't report on it because it doesn't fit their narrative. They want to create a panic so that people tune in and read their articles. It's not an unbiased job of the media, is not to inform. It's to create noise and get people to pay attention. That's.
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Podcast Host 1
They weren't looking at. They weren't looking at net redemptions, they were only looking at outflows.
- [40:45]
Larry Swedroe
Yeah, yeah, they only looked at the outflows and didn't report the net number. So, you know, you have those figures. So Clifforder did not experience a 7% outflow during the quarter. I don't know what the exact number is. They don't necessarily tell me or make it public. But I guess that there'll be this quarter some that paid off and there'll be. I know there were some cash inflows because I reinvested my own distributions during the quarter as well. So Clifforder has told me they do a stress test and they think they've got even in an 082 years of liquidity. Now here's the other thing that I would point out. In a recession like 08, what's the unemployment rate go to? Let's say 10. Does every credit card borrower default? How about the 90% of the people whose jobs are still working and they're paying? Maybe some of them are under stress and stuff, but the vast majority are still paying off. Right. Well, the same thing happens in a recession like, oh wait, defaults go up, but they go up to 10%, 12% and they don't stay elevated forever because in those environments, governments come in, get fiscal stimulus, monetary policy loosens and you eventually, you know, the economy starts to recover. Right. So in a bad environment, let's just pick a number, say really conservative, 70% of the loans are paying off well. And you know, and so those loans can easily be sold, packaged and sold at or near par. But I will say this, what the risk in the short term is and in a forced environment, right. Forced redemptions that you have to sell well, what's going to happen is, and we're seeing that already is spreads will widen a bit. So maybe you can't sell it at par. Right. A loan that was still paying well. Right, because you originated it and the spread was 550 and now it's 700 but maybe you can sell it at 95 or 96, not the 30 cents on the dollar or 70 cents on the dollar that the press reports. Right. And therefore. But in that environment, you tell me what you think has happened to high yield bonds. Were they down 40, 50, 60%, emerging market equities, the stock market would be down 50, 60%. So there is risk, but where would you rather be in that environment? You know you're not going to put all your money in T bills. You have to decide where you think the risk that you're willing to take. And if you're getting an expected return today of 9%, how much better do you think equities are likely to do? At least a broad diversified portfolio of equities. So that's the other side. They focus on what the losses could be. And I agree you might end up with a double digit loss. I would think worst case would be low to mid double digits. But in that environment you're going to see very high double digit losses in the other risky assets.
- [44:23]
Podcast Host 1
Just one more before I hand it back to Justin for some other topics, I want to ask you again about software. You brought that up at the beginning and like software is very interesting because for this type for lending to a business, you would argue that's a great business to lend to where it was before AI because there's a lot of recurring revenue going on with software. Although an equity investor like me might not have liked the valuations like in this space, you would argue is a great business to lend to. And you've talked about how with Cliffwater this is not a significant issue, concentration in software. But I'm wondering is it an issue for private credit overall because these were such great businesses that were so great to lend to, you have this AI disruption. Do you see it like beyond Cliffwater as a potential major issue for private credit?
- [45:00]
Larry Swedroe
It certainly is an issue it should be talked about. But the press is sadly is again one sided and talking only about the bad and the worst case scenarios. This sas, SAS apocalypse, or I call it SAS catastrophe, whatever you have to differentiate between products that are easily replicated by AI. A single thing that's doing some calculation or something like that, and an embedded software that's an enterprise wide product. Some of the products that you may lend to could be disrupted easily by AI and others are embedded software that integrates many different products would take months if not years for you to replace, retrain your people. And the AI tools that you're talking about disrupting you can use and you have time to implement, to improve your system, so they work better. Those embedded software tools, I think are probably at very minimal risks and they may even benefit from that. Okay. And therefore you want to look at one. How much concentration do you have in software in general? Okay. In Clifford, his case, I believe it's like 21% or something, which is typical of the industry. All right. But Cliff Water, I would say this in my discussions with them. They've been underwriting for disruption risk in AI for years. This has been talked about and they made the decision to avoid businesses or minimize risk to businesses they thought could be at a higher risk of disruption and focus on more of this, what you might call embedded software. Now, they can make mistakes and be wrong, but again, they'll be highly diversified. They take a few hits, it's not going to blow up the fund and cause massive losses. And from what my conversations with them, they've done webinars to explain to the advisor community. They just did one the other day. They believe their risks are relatively low. That's where they've concentrated. And so you want to underwrite each individual firm to see how much of their portfolio is concentrated and within that, how much is really at risk to technological disruption or how much might even benefit. Now, let me add this. All these other industries that they lend to, the history of innovation is, in the end, it's not the innovators themselves, it's the users who often are the biggest beneficiaries. So all these other companies, let's say a trucking company that they lend to, well, now they've got better systems that enable them to be much more efficient in the use of the trucks and drivers and manufacturing. And you know, you got supply systems and you know you're manufacturing like a Walmart. Right. How much they store and stock of each good. And supply chains can be better managed. The profit margins of those companies could go way up, greatly reducing their risk. The media never talks about any of that stuff. I don't know why. Right. There's two sides to this AI disruption thing. Yes, there are clearly risks. It's part of the story. It's a risk you take in any industry. But it's not limited to private credit. It's there for public equities and it's there for public credit. Who lends to these companies as well?
- [49:10]
Podcast Host 2
This may or may not be a good connection, but I'm just wondering your thoughts. So, you know, one of the arguments that some are making private equity is that, you know, the valuations of these Private companies have, you know, over the last 15 to 20 years they become much more expensive. And so you have a lot of money in private equity and now private credit to some extent, you know, coming into the market and I'm wondering, do you think, would it make any sense to think maybe the risks in private credit are a little bit elevated because you have so much money coming into private equity that's trying to invest in this asset class, it's propping up returns and maybe making some of these companies maybe not as healthy as they would have been historically. Is there any merit in that or is that not really right way to think about it?
- [50:03]
Larry Swedroe
I think that's always a good question to ask. And I would say in 2021 and into early 22, that was a more relevant question. I think standards got looser. Standards have tightened quite a bit since then. And by the way, and private equity valuations are below and always have been below the public equivalents. I wrote a piece about that showing it that there is always an illiquidity premium. So it is a risk across the board. And that's why it's so critical to do a due diligence at the firm level to see if the fund you're investing with has that very strong credit culture that doesn't get caught up in manias and sticks to its discipline. Making sure they're not chasing the latest fads, not chasing to grow assets, they're focusing on minimizing the left tail risk and not focus on trying to grow the assets as quickly, making sure they're staying, like I said, with Senior Secured, backed by private equity, in addition to which is hyper diversified across sectors of the economy, geography and even outside the US where private credit is becoming a growing industry, I would expect to see more private credit going into those foreign markets as well. Europe is ripe for that.
- [51:52]
Podcast Host 2
That's interesting. So if you were to try to sum up like the top pillars, if you will, that investors should be paying attention to and thinking about when investing in private credit, it would be number one, make sure you're in an open sort of diversified system like Cliffwater to, you know, understanding that there is some risk here but that, you know, normally the risk is not maybe what the media is making it out to be. You know, just walk through, I guess what, you know, to sum up your views of private private credit. Like, what would you say are the top three to five things that investors should be paying attention to?
- [52:29]
Larry Swedroe
Yeah, one is open architecture. Clifford is not the only good name out there. There's Stepstone and Hamilton Lane, Kalamos, Axia. There are others that you could probably name. I also want scale. I want big because big gives me that diversification. I can own thousands of loans. Can't do that if I'm $100 million or even a $500 million firm or a billion dollar firm scale. Unlike in public equities where scale hurts because the bigger you get, the bigger your market impact cost. Right? So that's a problem here. Scale helps because it allows you to diversify there and you get access to the best managers because they want access to your money. You get access to the best deals because you can commit to them quickly because you can hire deep teens. Clifforder has 50 roughly analysts underwriting every single loan they look at. Well by the way Bloomberg article implied that they were and others have implied that Clifforder, because they invest through some other funds is delegating its underwriting. There's no more nonsense than that. They actually underwrite every single loan and reject loans that they see from from that. So you want to have that deep team and that deep culture that focuses on that. As important if not more than that, if it was possible, is to make sure they've got a deep focus on liquidity management. Are they paying and willing to pay for guaranteed lines of credit? Clifforder actually has a team of six people that interacts with the asset management side to make sure they've got as good a cash match of duration risks. They know what's coming in, they know what's going to be going out and they monitor their cash situation daily. They've got a wide dispersion of banks, I think something like 30 financial institutions providing credit. So if not relying on one or two banks that could decide to pull the plug, get out of that business, whatever and they contract out for very long term agreements. Cliffwater is unique in that they're the only one that I'm aware of at least today that has an A minus rating from S and P which not only allows them to borrow cheaper, so that helps with when they're using leverage and helps the funds returns. But it's telling you the banks are more willing to lend to them and make long term commitments than the BDCs which are typically triple B or triple B minus grading. So that's another thing you could look at what's the rating there and then concentration risk of course. What's the largest loan? Typically it's for BDC 5, 6% or more. At cliff order it's 70 basis points. I'd look at the top 5, 10, 15, 20, 25 credits. I told you, for the average BDC, the top 25 is 60%. It's a little higher than that. A cliff order, it's 12. I'd ask that your fund, what's their number? And if it's high, I wouldn't want to own it. So those are the things culture is really critical. Also, I would look at leverage. Remember, leverage is good when you have a low volatile asset and you can earn a spread. Right? But if you add leverage to a high risk asset, you can blow up quickly. Right? Well, private credit is a risky asset and it happens at the worst time. The risks show up. Okay. And you can have a mismatch to some degree, so you could be forced to sell. Right? So I don't want to see a lot of leverage. I don't mind a little bit because the volatility of the asset class is low. The standard deviation is low because of two things. One is strong credit if you're teamly secured and backed by sponsored equity. And two is there's no duration risk. So it's relatively clifford and uses just enough leverage to cover their expenses, basically. So they even look through leverage is under 70%. The typical BDC is 1% or more and can be 150% or even 200. So I don't want those because now I'm trying to drive that leverage up to get me higher returns. Or BDCs typically have expense ratios that are two or three times cliff order. So they need the high leverage to cover the expenses and hide it. So I want to avoid the high leverage. I want to see something no more than one, including look through leverage and preferably less.
- [58:09]
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Podcast Host 1
How did I not know Rack has Adidas?
- [59:07]
Larry Swedroe
Cause there's always something new.
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Podcast Host 2
We had two other topics that we wanted to talk to you about. But we're probably not going to have time to get to these today. But let me ask you this. I probably don't know anyone. And Jack, feel free to chime in here. That is like has their finger on the pulse of what is coming out of the academic world in terms of like empirical finance and new research. And so what I'm wondering from you is, is there any thing you're seeing, I'm going to use like trend following here, but is there any up and coming trends you're seeing in the academic research and literature that is jumping out to you that has you excited? I'm thinking like anything along AI that you're seeing. I mean because you would have, I bet if there was a Larry Swebro like database of like academic research, maybe you have one. It'd be very interesting to see how that kind of has changed over time and different trends that may have, you've had insight into that have kind of worked themselves into the investing world over time. So I know this is kind of a sort of far out question, but I'm wondering are you seeing anything that kind of really excites you or anything different?
- [60:36]
Larry Swedroe
Yeah, well, I would say the biggest thing which has both positive negatives, I'll try to touch on them both briefly is you hit on it AI. So AI, unlike the limited tools we have before using regression analysis, types of things which can look at linear relationships and has really changed the world because you can look at much more complex relationships. So AI I think is already changing and finding, uncovering new relationships. Firms like Clifforder have been using AI tools now for many years to improve their ability to uncover, call it, you know, nuances in the market that they can exploit. Okay. The problem with AI is making sure that you actually have a hypothesis before you come up with the answer. Because there's, you know, there's the old story about the guy who found the strongest correlation best predictor The S&P 500 was butter production in Bangladesh.
- [61:57]
Podcast Host 2
Right.
- [61:57]
Larry Swedroe
And clearly you wouldn't put your money on that. So I, you know, you tell it to find a relationship, it would and they'll find relationships, but the odds of it being real. So Andy Burkin, in our book, your Complete Guide to Factor Investing, we said there has to be not only a premium evidence, but it has to be robust to various definitions. It has to be pervasive across sectors, asset classes, regions, country persistence across economic regimes has to be survivable of implementation costs. And there has to be reasons, either risk based or behavioral, for you to believe that the premium will persist. AI can produce lots of stuff that won't meet all of those criteria. So whenever I read a paper that's got AI tools and every paper coming out now is using AI virtually right to look at and examine things, I'm looking in there one did they make sure they're doing in and out of samples? So no look ahead bias? Are they giving you robustness tests? Are they doing in and out of sample tests? Are they providing the logical risk based explanations? Are they including transactions costs in there? And some cases you'll find they do. You'll see more papers using that checks, but some papers don't and I point it out when I read it. The other topics I guess we'll have to leave for another time. I'm more than happy to come back and and discuss those with you, Justin.
- [63:46]
Podcast Host 2
You're always welcome to come back. Larry. Thank you very much. And I don't even think they eat butter in Bangladesh, so that might be the first. The first red flag. So anyways, thank you very much Larry, very much. Appreciate it.
- [63:58]
Larry Swedroe
My pleasure. Great to see you Jack and Justin,
- [64:00]
Podcast Host 2
thank you for tuning into this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the pages podcast in the Excess Returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@excess returnspodmail.com no information on
- [64:20]
Larry Swedroe
this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts.
- [64:27]
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- [64:42]
Larry Swedroe
or their clients.