← FireSide: A Podcast Series from Future Standard
FireSide: A Podcast Series from Future Standard
The Takeaway with Troy Gayeski: How Andrew Beckman approaches credit
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- [00:03]
Harrison Beck
This is the Takeaway with Troy Gajeski, a podcast from FS Investments. We sit down with chief market strategist Troy Gaejeski to get the latest on what's happening in the economy and what investors may want to do about it. I'm Harrison Beck, FS Investment's content strategist. I'll take Troy through today's top questions so that you can get the takeaway. For this special edition of the Takeaway and our first podcast episode recorded here in our New York office, we're reporting from the place where fund construction meets investor needs. We're joined today by Andrew Beckman, head of our global credit business here at the firm. Andrew, you have decades of experience sourcing opportunities and credit for some of the industry's biggest names. For our conversation today, you're going to be bringing us the latest movements in credit markets from the perspective of a portfolio manager. And Troy, you'll be speaking to how allocators are responding to those movements and adjusting investor portfolios. So, Troy, Andrew, welcome.
- [01:06]
Troy Gajeski
Thank you very much. It's great to be here with Andrew.
- [01:10]
Harrison Beck
Well, first, let's start with some background. Andrew, for listeners just getting to know you and your team, if you were to create a highlight reel for your over 20 year career in credit, what would be the greatest hits?
- [01:23]
Andrew Beckman
Sure. So graduating from Wharton, undergraduate, went into investment banking at Solomon Smith Barney. After the typical investment banking program, I spent six years in private equity, which was a great place to really kind of get deep into kind of fundamental investing. Had a lot of experience with credit investors when I was in private equity, syndicating debt, dealing with kind of distressed companies and distressed debt, and ultimately kind of got the itch to kind of move into a more active credit investing role. And I had known some people at Goldman Sachs and the Special Situations Group through some of my distressed experience in private equity and ultimately went to work with them at Goldman. So I spent, you know, probably the longest part of my career at Goldman in their Special Situations Group, which was a really interesting place. It was proprietary capital, Goldman capital. And I think the core part of our thesis was to be very dynamic and tactical investors within credit, like really just go where the opportunities were, try to have an unconstrained mandate. And what I found was it really led to like differentiated alpha, the ability to just go where like the green lights were and avoid areas of the credit markets where there were more red light. So that was certainly like a pivotal part of my career. I transitioned from Goldman to Magnetar, which was another interesting step in My career because at Magnatar I was running a credit business and Magnatar Capital was fund capital. We had outside investors and I was responsible for, for one of their funds. So that really kind of gave me the experience of managing outside capital, dealing with investors. But you know, really importantly, Magnatar was very, very astute with kind of like risk management, dissecting investments. So every single investment, whether it was a private or public investment, really looking at like, how much market risk are you taking, where is the alpha really coming from, and how much downside do you have in this investment related to the market? So I think I took some really good portfolio management, risk management skills. And you know, if you fast forward to kind of where I am today, it's really kind of the confluence of that, like deep hardcore private equity underwriting, Goldman very tactical strategy, and Magnatar Risk.
- [03:48]
Harrison Beck
Management sounds like some really formative experiences, shaping your own ideas in terms of what you wanted to do. So then what attracted you to join this firm? Was there a strategy you wanted to bring to a broader investor universe or something about the culture here that you wanted to build on?
- [04:05]
Andrew Beckman
It was a little bit of all of those things. I left Magnatar with a vision of recreating a business very similar to the Goldman Sachs special situations Group with a couple of tweaks. The biggest tweak was to have a core middle market focus. So I saw an opportunity brewing in the core middle market as the large firms were getting bigger and bigger to really do that differentiated investing in that part of the market. So that was my goal, was recreating that. And I thought FS was the perfect place to do it. I was really drawn in just by the people and the talent, the entrepreneurial drive of senior management. And, and when you took that and coupled it with the resources of the firm and the firm's access to permanent capital, it really just I think, created an opportunity to build a really nice business.
- [04:58]
Harrison Beck
Well, fast forward eight years and the credit team now manages over $7 billion across five strategies spanning liquid public credit, public private and, and 100% private. So give us a flavor of your investment platform today.
- [05:15]
Andrew Beckman
So Today we are 23 investment professionals. Over half of them are managing directors. Six people on the team share the Goldman heritage. So we have very similar kind of values predating fs. And essentially, if you look at our mandate as a whole, our core mandate is private credit with an opportunistic tilt. The other part of the mandate is to look at the public markets opportunistically and make sure that you're Going where the opportunities are. So at times the public markets can be more attractive than the private markets. And we want to maintain that optionality to pivot and make sure we're putting capital in the best place. So that's sort of like the very high level. If you dig into that and say, well, what does that mean core mandate being private credit with an opportunistic tilt? I'd say the business has a wide range of things that we do in private credit. And it probably starts at what I would call blue chip sponsor lending plus 50 basis points, plus 75 basis points. So we're not trying to compete with the big on the run private credit lending to kind of blue chip sponsors. We're starting at a level sort of at a premium to that. And what that could mean is it is generally smaller businesses, smaller sponsors, emerging sponsors, and that's where it begins. And then it bleeds into lending to non sponsors, family owned businesses, you know, businesses owned, owned by entrepreneurs and goes on up. So you're at that like 50 ish basis point premium on the low end. And at the high end you get into high teens, highly structured private investments.
- [06:58]
Harrison Beck
Well, and that's the perfect place to pivot to credit markets today. So, Andrew, credit markets are gaining increasing attention both from investors and newsrooms. What are you seeing in credit today that investors might not have seen in the past?
- [07:14]
Andrew Beckman
So credit markets have adapted a lot since I started investing. You know, if you fast forward to where we are today, we obviously have a very vibrant private credit market. I think the private credit market has become a bit more bifurcated. So the large part of the private credit market is really becoming much more of a beta market and that market competes with the syndicated market. So if you look at what large cap sponsors are doing these days is they're weighing their alternatives to do a broadly syndicated, usually levered loan issuance through a bank or going down kind of the private credit route. And those options are starting to look more and more similar from a covenant perspective, from a pricing perspective and whatnot. The core middle market though is starting to look different than traditional private credit because traditional private credit is starting to look more like public credit. So the core middle market is kind of that old version of private credit. And I think that's the biggest trend is the bifurcation there.
- [08:24]
Harrison Beck
Well, Troy, let's get you into the mix. Is there something that investors are seeing today that they might not have seen 10 or 15 years ago?
- [08:32]
Troy Gajeski
Yeah, well, just to close out Andrew's point before, I mean, that's why it's so important for investors these days, even within private credit, to make sure they're picking the right manager. And also they're bifurcating themselves looking for those that are providing alpha, not just beta. So, you know, know, dovetailing directly to your question, you know, if you think about the evolution of private credit, the growth in private credit, you know, you have some managers that are gobbling up, you know, billions of dollars. They're pushing up to upper past upper middle market covenants have gotten weaker. You know, payment in kind is a term that not many people have heard of, but much more. I've heard more of it from investors the last six months than I did probably my entire 23, 24 year career prior to that. And then you know, in the sweet spot where you're at upper middle market, you're sponsored, lower middle market sponsored, or some of the special stuff that Andrew does, lower middle market, non sponsored. That's where you're still getting opportunities to add meaningful alpha. And some of that can be an asset based finance, some it can be in non sponsored areas, but in general a vibrant market that's grown much more bifurcation between alpha and beta players. And then more broadly in credit markets, I think, you know, when you think of public securities, high yields, exceptionally tight these days. We would say it's tight for a reason though, right? You have good fundamentals, the US Economy, we'll see what shakes out with the tariffs. But the US economy is in very good shape. Defaults have been relatively low, so the fundamentals have been good. But also technically there just hasn't been a lot of supply and there's still a substantial demand for yield. So that combination of fundamentals and technicals are what's keeping liquid high yield and levered loans tight. That being said, you can get a 2 to 300 basis points excess return in private credit relative to securities, which is why we find it so attractive today.
- [10:25]
Harrison Beck
Well, and it sounds like it highlights the importance of having a really good manager. And with that in mind, let's talk about assessing relative value and risk versus reward. Andrew, given your seat investing across private and public credit, how do you assess relative value and risk versus reward? And is it an either or decision or is it more about turning the dials up and down?
- [10:47]
Andrew Beckman
It's a combination. So it's about turning the dials, but kind of looking at the risks and the reward and weighing the two things together when assessing relative value. So if you look at the public markets today and you look at like the Average new LBO there is probably about $0.50 of the cap stack done in a newly issued levered loan. That levered loan is probably coming to market at around SOFR 350. If that issuer wants to go down the road of kind of issuing in the private credit market, which so we're generally talking about large sponsors, large private credit issuances, that same deal would probably come at 125 basis point or so premium. The covenants in those two transactions are going to be very similar. The large part of the private credit market and the broadly syndicated market. As you start, you know, going down market essentially and you look at other private transactions, private loans, you're generally not competing with the broadly syndicated market, you start to get more yield and you start to get better covenants and better downside protection. So what we look at is the downside protections that you're getting in a particular loan and as well as the spread and total like return potential and weigh the two together. Often our investments, you know, we're trying to kind of perform on both elements, get a little bit more spread, but also get something where we think the recoveries and downside protection are better. And I think as we fast forward the better managers are really going to differentiate themselves from an alpha perspective on that downside.
- [12:32]
Harrison Beck
Moving on with thinking about managers, Troy, let me turn this on to you. How do you assess relative value? Where are investors on the mark in terms of assessing relative value and risk versus reward? Or where might sentiment maybe be getting the best of them?
- [12:48]
Troy Gajeski
It's like the conversation we were having before. If you're starting a portfolio today, 100% new capital, you're going to do some combination of private credit, whether it's upper middle market sponsored, lower middle market sponsored or lower middle market non sponsored, which again is really your sweet spot. And the reason for that is, you know, high yield spreads like we talked about before are just so gosh darn tight, you're really not making any money. It's not that the world's going to end, but it's really hard to hit your return objectives that way. And then, you know, levered loans, not much higher yields, but empirically much higher defaults. It was, you know, we just got a data update today and it's really interesting to see that levered loan defaults are more than doubled that of non sponsored private credit. So you're getting more return for less risk. So you would start there. And I think anyone that's objective could come to that conclusion. But because of some of the headlines around some big firms that have moved up in market. As you were talking before, there's this perception perhaps that private credit's oversaturated. And I guess our message is, yeah, certain areas of the market where there's too much money being raised, that may be the case. But private credit is now a multi trillion dollar asset class. So you really got to focus on the alpha areas. You know, I think another area that folks don't appreciate enough is how deal flow driven these strategies are. And what I mean by that is we see a lot of competitors not knocking them that don't have the pipeline capacity to put the capital to work they're raising. And so what they inevitably end up with is more syndicated bank debt in their portfolio, even though they're supposed to be running private credit portfolios. So wait a second, you're investing in something with less yields, with more downside, with more beta. That's not good. But very few people are even aware that's taking place. So having a pipeline in place where you can source private credit and that matches up or exceeds the amount of capital you need to put to work, very, very important. And I think that's often lost on investors when they're looking at the headline yield, their distribution, how a fund particularly performed in 22 versus a benchmark. Very, very important stat to focus on how much syndicated bank debt is in your private credit portfolio.
- [15:04]
Harrison Beck
Well, bringing things back to risk. Let's talk a little bit about restructuring. Andrew. How do you think about your capabilities in restructuring in the event that things go wrong in the economy or even within a sector?
- [15:17]
Andrew Beckman
That's a great question. So if I went back to kind of my career, right. And you think about private credit. Right. So two things. Private credit is a newer industry. So people that are in private credit have come from different backgrounds. Right. Some have come in, you know, from like syndication desks on, you know, levered loan, you know, levered loan syndication desks, you know, at banks. You know, some have come in from kind of the public market, some have come in from different areas. I've really come in from like the distressed industry. So the business I was in at Goldman when I joined was a distressed investing business that retooled itself to become a private credit investor. And really the view there was let's use our distressed skills to structure investments in a creative way to kind of protect downside. The benefit there is, I have a lot of distressed experience. The people I have hired are people that have done similar things. So if you look at our Business. I'd say a good half of our business are old school, kind of distressed investors that have transitioned over the years. It makes us very comfortable in handling kind of restructurings. Almost all of our investments were pre wiring in a creative way such that there is a restructuring like we're getting the downside we need, but then we have the skills to kind of restructure it. We've got the resources, the connections, the relationships, and we don't have to outsource those activities, you know, to, to another firm or just one point person in the business.
- [16:48]
Harrison Beck
That sounds like a real potential edge in terms of creating these investments. Let's focus in on the middle market. Andrew, you say you have a middle market focus. What does that mean for you and your team?
- [17:00]
Andrew Beckman
Everyone defines middle market a little differently. At one point, private credit was synonymous with middle market because it just meant it wasn't the syndicated markets. If you look at, you know, where we are today, and you know, Troy was mentioning this, I think private credit has really become bifurcated. There's a part of the private credit market that really focuses on the exact same companies that are coming through the syndicated market. And that's the large part of the private credit market. For us, the word middle market means not those businesses. We are still very much trying to focus on underbanked businesses. So if you ask me what is middle market for, you mean like I could give you an EBITDA size or an enterprise value size, but really the common thread is businesses that are underbanked, businesses that aren't looking to go through the syndicated route, that don't have access to kind of those types of options and that the big private credit funds aren't looking at. And the goal there is, by focusing on an underbanked opportunity set, we can drive better terms for our investors, better downside protection, higher spread.
- [18:10]
Troy Gajeski
And if I could jump in one second, I think Andrew, as usual, is too modest with his team's history. If you think of how it plays out in any credit market, your job is to extract income, add some alpha, keep defaults as low as possible, and in the event of a default, make sure your recovery rate is as high as possible. So to put this into perspective, people, the benchmark indices for private credit typically lose about 100, 110 basis points per annum. Over time, sometimes it's higher, like a global financial crisis, the oil bust briefly in the pandemic, sometimes it's lower. But the way you get there is 2% per year defaults and 50% recovery rates. When you have the structuring expertise that Andrew and his team have and you can raise those recovery rates much closer to par or even par plus. Well, even in the event of a default, you're not losing money. And so the way that empirically plays out for folks is if you're earning a 10% income stream, but you're giving back 100 basis points per year in default defaults, your total return is 9%. If you're earning a 10% income stream and you're giving 0% back, keep up the good work, you know, keep up the good work, then you're actually making a 10% total return. I mean, that is a tremendous advantage. And again, I think it's one of the areas that people don't focus on enough. Again, private credit has had lower defaults than syndicated bank debt, lower losses than syndicated bank debt at least recently. But if you can keep those losses as low as possible, your short, medium and long term total return is going to be vastly better.
- [19:39]
Harrison Beck
And is the middle market an important ingredient in that conversation, especially from an investor's perspective?
- [19:45]
Troy Gajeski
So there's a lot of different stats to discuss here when describing the middle market. To Andrew's point, in some of the ideas you've flushed out today, depending on how much money you're putting to work, depends upon how you define middle market. Some define middle market now is a billion to 5 billion in EBITDA. We always sort of think about it as somewhere between lower end 20 to upper end 500 sweet spots, maybe 100 to 300. But I think the big picture here in the US economy is we've had this mega trend of more and more companies staying private, more and more public companies being taken private. So you've had this huge surge in private enterprises, roughly 40, 44% more than we did back in the 90s. And the number of listed companies has dropped from over 8,000 to barely above 4,000 now. So you know, when you think of the middle market broadly, you know, typically those are US based entities that are focused on US revenue. Last I checked, the US economy is the greatest economy in the world. You know, we've, we've had 5, 6, 7% nominal GDP for quite some time. So when investors are thinking globally and then locally, where can you get the best revenue growth? Where can you get the best EBITDA style growth, which in turn allows you to service your cash flows and then where within there can you as an active manager, add alpha? You know, the broad middle market is clearly the place to be in private markets. And you Know, unfortunately for public security investors, it's been a narrow, narrow opportunity both on equity and in credit. On the private side, the opportunity sets just expanded dramatically to again, add alpha or detract alpha if you're no good at it. But luckily Andrew's pretty good at it. Yeah, well, yeah, so far, so good. Come on, eight years, that's a long track.
- [21:33]
Andrew Beckman
I agree.
- [21:34]
Harrison Beck
Well, and let's dive into this process a little bit more. So, Andrew, you mentioned that you invest across the credit spectrum from public to private. How do you determine what makes it into the portfolio?
- [21:46]
Andrew Beckman
So our core focus is private credit. And the way we look at Publix is opportunistically, how do publics compare to private credit? Right. And there's times, as I mentioned earlier, where there's like red light, green lights and yellow lights in the different asset classes. So I'd say every day we're sort of coming in and investing in private credit, but we are looking at public credit opportunities. We're underwriting public credit opportunities. We're seeing how they compare and when they compare favorably, they make it into the portfolio. When they don't, they don't. So it's really a very bottoms up approach of comparing actionable investment opportunities. The risk reward, the total return, and then seeing where the best opportunity is. And the portfolios can naturally migrate. So there's times when the portfolios migrate one way and there's times when the portfolios migrate other ways. And those times are very obvious to us. But for mandates that are much more constrained, they stay boxed into the less attractive area. I think that flexibility has really created differentiated returns for our vehicles over time.
- [22:58]
Troy Gajeski
And you know, one example that would be what we're going through now. Right. The economy's been strong, just got some pretty ugly tariffs enacted. Not going to be so good for the auto industry, auto parts industry, we'll see how long they play out. But in the event that this does precipitate a recession, we don't think it will. But in the event it does and credit Spreads wide Now, 4, 5, 600 basis points in high yield, that gives Andrew and his team a tremendous opportunity to go after public securities when they're wide, enjoy the price appreciation as they tighten, and then flush it and go back after private credit. So having that flexibility between sponsored, non sponsored, private, public, where do you want to be in the capital structure? Obviously the North Star is senior, you know, safety. But every now and again you get an opportunity in more positively convex securities and more positively convex public markets.
- [23:50]
Harrison Beck
Well, and that's a perfect transition to talking about deal flow. So Andrew, how do you source deals and does your team maybe think differently about sourcing than your mega fund or large fund peers might?
- [24:02]
Andrew Beckman
Well, so sourcing is super important. As Troy mentioned, it's one of the ways you really differentiate yourself. You want to see things that other people in the market don't. You want to have quality deal flow so you can have a large number of deals and pick the best. So our big focus here in building out the business was building out like a differentiated sourcing network. And again we're a core middle market business. So when I say a differentiated sourcing network, I mean a differentiated sourcing network versus our true middle market peers. Our sourcing is a combination of different like pillars. So one pillar is sponsor based sourcing. Again, we're not trying to cover mega sponsors. We're trying to focus on smaller emerging sponsors or creative solutions for those sponsors. And we have relationships with over 300 sponsors that we as a firm directly cover. A lot of that comes from our private equity business that has relationship through kind of their, their, their primaries business and their secondaries business with sponsors. So we will get a first look at deals, you know, coming out of a large part of those sponsors and are a trusted partner of theirs. We also have a non sponsor or intermediary channel that we, that we focus on. We've got a CRM where we reverse cover essentially 300 plus intermediaries. And that's a mix of restructuring firms, financial advisors, non bank intermediaries, law firms, industry consultants, kind of business brokers where we're constantly out trying to kind of mine deal flow. And it could be sponsored deals coming through that channel when there's if they're being represented by someone in that channel or, or non sponsor type transactions. So that's the second component. The third component is we have a proprietary relationship with JP Morgan that we structured last year. We're one of a handful of partners with them in their private credit initiative. They're trying to capture more of the wallet share of their customers, their investment banking customers, both sponsor but also kind of non sponsor type customers like just you know, companies that their industry bankers like cover. So we created a JV with them or essentially they're trying to source private credit opportunities through those banking relationships and then we are investing with them side by side. We're actually structuring and underwriting the opportunity side by side. So that's the third pillar. And the fourth pillar is really just a deal. A firm wide sourcing network so we have a lot of different businesses at fs. We have a lot of different touch points. Investment professionals are constantly looking out for other businesses and just sucking in deal flow. And then the deals go to the business where it makes the most sense. The thing I think that's most interesting is I mentioned all these different pillars, but we're generally competing in the middle market with middle market firms that don't have any of those pillars. It could literally be, you know, 20 investment professionals that make up the entire firm. So we're able to kind of leverage our scale to have differentiated flow vis a vis our competition.
- [27:21]
Harrison Beck
That sounds like a tremendous differentiator.
- [27:24]
Andrew Beckman
Yeah, absolutely.
- [27:25]
Harrison Beck
Well, a key component of deal flow, of course, is screening opportunities. You have a really wide sourcing engine that you just mentioned, so you must see a lot of options. How do you screen and diligence those opportunities?
- [27:38]
Andrew Beckman
Well, you know, one of the things kind of I learned throughout my career is you have to be an expert in what you're looking at and what you're screening to really differentiate yourself on the alpha side and pick the good opportunities. So the way we're structured is there's individuals in the business that are focused on sourcing and the front end, and there's also individuals in the business that are focused on screening and underwriting. And what we do is we align ourselves like from an industry perspective. So we usually have industry captains that are like MDs, you know, or MD. Kind of like people that have been covering their industries for 10 plus years. So they're industry experts. They live and breathe their industry. They follow all the trends and like, if there's no deals, they're still reading about their industry, following their industry, talking to their industry contacts. So what happens is when deals come in, they make, they make their way to those industry categories. Captains who then start screening them and ranking them and trying to kind of figure out like which ones are worth focusing on. And then when we screen and rank them and decide which ones we want to focus on, those captains are the ones that start out with like the diligence process of really trying to, you know, understand them and underwrite them. It sounds basic, but again, I'm coming back to we're a middle market business. We're competing with middle market firms. A lot of the middle market firms that we compete with don't have that industry experience. They have a handful of generalists that will underwrite something in health care and then, you know, something kind of in telecom. Two very complicated industries.
- [29:08]
Troy Gajeski
Yeah. And just to touch upon that A little bit more. Remember, the sourcing network makes sure you have good deal flow. The diligence and research make sure they're high quality investable ideas. And the key to this all is you always want to make sure you have four far more high quality investable ideas than capital you're being forced to put to work because your marketing and salespeople may be running a little bit fast.
- [29:31]
Andrew Beckman
Yeah, I mean, our goal is to really have enough deal flow that we could say no a lot, which means we can have a really high bar and just invest in things that really stand out.
- [29:41]
Harrison Beck
Well then how do you think about downside protection and recovery?
- [29:45]
Andrew Beckman
It's super important. Right? I think that's what's going to differentiate managers going forward because you know, there are spread premiums, but you know, there's only so much spread premium. But difference between 100% recovery and a 40 cent recovery can make a big difference across, across the portfolio. So for us, like downside is our biggest focus. Like we're always looking at every individual investment saying if things go really wrong, will we get all of our money back? The way you achieve that is through kind of picking good investments. You know, from a fundamental perspective, like companies that are like well positioned, well capitalized in industries with favorable trends, but also from a structural perspective. And structure is super, super important. Structure has kind of been removed from the broadly syndicated loan market. Like there's no covenants, there's very few protections. We're very focused on getting structure. Cause what that does is it keeps everything in the box, like all the pieces of the company that you went to together and it gets you to the table early. So if there's a problem, the problem arises when you're over collateralized and in a good position to do things to ensure a par recovery.
- [31:02]
Harrison Beck
Well, Troy, let's turn things to you and talk a bit about building resilience. So in terms of risk, what are the general challenges investors might encounter in credit markets today? And conversely, where do you think markets might be overblowing potential risks?
- [31:18]
Troy Gajeski
Yeah, so I think one of the biggest challenges more broadly for investors across asset allocation is just getting comfortable that we're in a higher for longer interest rate environment. You know, as I've talked about since last June, it was inevitable for yields to go higher, which is really, you know, painful for duration. But the flip side of that is when you're higher for longer on the front end, where the fed funds rate is, that means debt service coverage ratios are going to be lower than they would be otherwise. That means that if we get in an environment where a rising tide through strong nominal GDP doesn't lift all boats, you know, there could be more defaults. So, you know, that is one of the biggest changes that I think people are still grasping not only in private credit, but also in real estate markets that you're in a higher for longer environment, which is complemented by stronger for longer as it goes to private credit in particular. You know, I'll go back to that term pick or payment in kind. You know, we pride ourselves as you know, on keeping de minimis exposure there. It's not that all payment in kind are bad per se, but if you're using that to mask the underlying company's lack of an ability to coverage or cover their interest payments, that can lead to problems. So that, that's come up a lot more recently. I think some firms, when I Look at, they have 7, 8, 9% payment in kinds in their underlying structures, which is starting to, you know, set off alarm bells for investors, particularly within perpetual BDCs where you, you have to pay out 90% of your income and if 8 or 9% of it's coming from picks, you really can't pay that out. So very, very important point. And the other thing, just to touch back on what Andrew was talking about before, and this gets back to this. Rising tide lifts all boats. So as we went from 20 to 21 to 22, the 2021 vintage for private credit was arguably the worst ever originated. Part of that was because you had a lot of perpetual BDCs that were raising a lot of money. You had banks that were lending at a rate that was 2 to 3x the nominal GDP, which is very unusual. You've already had a 4% default rate on that vintage, despite a very strong economy. But what happened then is, and I would have done the same thing from a messaging standpoint, was everyone focused? Oh no. EBITDA is growing. EBITDA is growing. And don't worry about my debt service coverage ratio because EBITDA is growing again. Rising tide lifts all boats. You know, we were actually discussing this today at our investor meeting, our investment team meeting. You know, we're now entering an environment where nominal GDP is dropping from 7, 6, 5 to we now have a 4 handle. So on loans originating from this point forward, you can't count on tremendous nominal GDP growth driving tremendous revenue growth, which in turn drives above forecast EBITDA growth. So I think that's another factor that folks are going to have to grapple with higher for longer environment More funding stresses coupled with revenue and EBITDA that are growing at slower paces. Which segues back to what Andrew does focus on how do you generate return and mitigate risk. Right. Which is back to you got to pick your manager carefully. You got to pick an alpha provider, not a beta provider.
- [34:37]
Harrison Beck
Well, and Andrew, what is the potential downside you might worry about and how do you shape your investment process to help increase resiliency?
- [34:45]
Andrew Beckman
Yeah, I mean, I think Troy's said it pretty well. I mean, we've been in a favorable economic backdrop for a while, so there's been this rising tide that's kind of mass problems. I worry that things will change when, broadly for the credit markets, when and if the economy slows down, down and companies just won't be bailed out by that, like nominal gdp. And you could see increased kind of defaults, like, you know, spikes in leverage and increased defaults. So my big focus on all of our investments is, okay, we understand what the base case might be or management's base case or like some strategist base case. But what happens in more troubling economic times to these underlying credits? And are the credits resilient enough to go through recessions and avoid defaults? Or if they're not and they're going to default, what is your collateral? What is your loan to value in a downside scenario, and are you covered? So our biggest focus is really figuring out what the downside looks like, modeling it, understanding how we're protected from a fundamental perspective, and then making sure the structural protections are there. So if those downsides manifest themselves, we'll still walk away with our credit like returns and par recoveries.
- [36:06]
Troy Gajeski
And not to belabor the point, but when you think about how strong our economy's been, the fact that over 7% of leveraged loans have defaulted in this environment just tells you how poor the underwriting was. Clearly, in the levered loan market, things have not gone wrong and you already have over 7% default, default. So just a cautionary tale again for folks to make sure that whoever you're investing in is doing that high quality.
- [36:30]
Andrew Beckman
Underwriting and the recoveries have gone down, I mean, pretty significantly. I don't know exactly where the stats are today, but in the old days of levered loan investing, when the structure was good, people used to think about recoveries in the 70 cent range, 75 cents range. For syndicated debt, we see a lot of scenarios where those recoveries or in the 40s. Right. And I wouldn't be surprised if that's where in a weaker economy. That's where recoveries ultimately shake out. And again, it's because of those weak covenants. There's asset leakage. There's a lot of things that happen before the default that's very negative to those vulnerable credits. So again, our focus is like, let's get our recoveries at or as close to 100 as possible in those scenarios. And that's where you're going to have, I think, big, big Alpha.
- [37:21]
Harrison Beck
That makes perfect sense. Finally, as we wrap up the episode, it's the name of the show and a great way to summarize our conversation today. Troy, I'll start with you. What is the takeaway you want listeners to have about credit markets?
- [37:34]
Troy Gajeski
Well, I think the one takeaway again is as private credit markets have grown in size and scope, there's far more opportunity to add alpha, but also to detract alpha. You know, we talk about that 200,000 companies between 10 million and a billion of EBITDA, or should I say sales instead? And you can add value or detract value. And one of the things that's impressed me the most with what Andrew and his team have done is their insatiable focus on extracting that income, but then adding alpha on top of that from a total return standpoint and then making sure that you, in the event that something goes wrong, whether it's the economy, sector, industry, or just idiosyncratic, there's as little downside as possible. So pick your manager carefully. There's much more differentiation in private credit today than there was, say, 10 years ago.
- [38:24]
Harrison Beck
Makes sense. Andrew, I'll turn the same question to you. What's your takeaway from our conversation today?
- [38:29]
Andrew Beckman
I think it's a very similar theme. If you looked five years ago, seven years ago, maybe even three years ago, you know, private credit, if you were investing in an alternative asset manager's private credit product, it more or less meant the same thing. Like private credit was private credit, it was senior secured sponsored lending. If you fast forward to today, the private credit market has grown tremendously. There's lots of different areas, niche areas of private credit. So it doesn't mean the same thing. Like one private credit product from one manager could be very different than a private credit product from another manager. And they could lead to completely different types of returns in different market scenarios. So I think you got to look carefully at the type of product you're investing in and ask yourself, is it a beta product? Is it an alpha product? And how will this product perform in different types of markets than we've seen in the past few years makes sense.
- [39:32]
Harrison Beck
Well, for more from Head of Global Credit Andrew Beckman or Chief Strategist Chief Market Strategist Troy Gajewski, our listeners can visit us on our website@fsinvestments.com thank you Troy Andrew for a great conversation.
- [39:45]
Troy Gajeski
Thanks. Have a great day.
- [39:46]
Harrison Beck
Thanks for having us read Troy's full strategy note and get up to the minute investment strategy research and more@fsinvestments.com it was hosted by Harrison Beck and edited and engineered by Aaron Sherman. Video edited by Melissa Vendetti. Special thanks to Ellie Zhang and Laura Coleman. Make sure to follow and subscribe to the Fireside Podcast wherever you stream. Thanks for listening.