C (3:41)

Said another way, a secondary solves a problem which solves liquidity for the investor. And they have entire portfolio. You could have a venture secondary, you could have a private equity secondary. Why can't you have a credit secondary? And your answer is yes, we can do that. And that's what you created.

A (3:57)

Absolutely.

C (3:58)

And it's a bit different in that credit secondaries and private equity secondaries, you're buying out some kind of discount and then it might be undervalued or overvalued depending on the intrinsic value of the equity. In credit secondaries, it's whether or not the credit instruments pays off, it's whether your loan is repaid.

A (4:21)

There's a lot of different value drivers in credit secondaries. You've alluded to this correctly, which is we're trying to figure out what the asset is worth and what kind of risk adjusted return are we getting on that asset. So the way we think about credit secondaries is you're providing a liquidity solution. There's a cost related to that. That cost in the form of a discount and potentially portfolio selection helps cushion you against some level of expected loss that will manifest itself in those portfolios over time. And then as a, as a buyer, we can do other things. We can get the dynamics of a pull to par in a portfolio. As an example, a portfolio might be marked at 95 and it could repay back at 99 or a hundred. We'll get some call protection, maybe some equity upside in some of these portfolios. So there's a lot of different drivers of value in a credit secondaries book of loans versus just Simply buying as an example in the private equity market, an asset at a headline discount. So the dynamics are much more complex, much more nuanced and that's what makes it, I think a pretty interesting place to spend time in.

C (5:37)

And the underlying loans. What's the quantum within your fund and how do you think about diversification and exposure to different market cycles?

A (5:48)

So we, we've been in this market a long time, so we have exposure to over 5,000 loans on a look through basis. We have relationships with over a hundred GPs globally. We are spread primarily between North America, primarily the US and Western Europe. And we span a whole range of different underlying credit strategies. They could be on the senior side, middle market, direct lending. We do participate in lower middle market and upper middle market parts of the direct lending market. Within other credit strategies we have exposure to mezzanine and subordinated debt. We've done some things in real estate credit, structured credit, capital solutions, special situations. We've even done some things in royalties and film finance, music royalties and film finance. What we're trying to build are depending on the various components of assets, diversification across many different matrices. Diversification can come through individual company obviously where we really limit the look through exposure. It can come through vintage year sector exposure, those sub strategies as well as, as well as duration and credit quality. So what we're really trying to do for clients is deliver an access point for them that they might otherwise not able to get themselves in a significant way and they're able to get it at a discount or attractive pricing with much shorter duration and potentially even better credit quality than they might get on a new origination basis. That's the real beauty of this strategy. In a nutshell, one of the hardest.

B (7:27)

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C (8:51)

Invest is the product supposed to encapsulate an end investor's entire credit portfolio? Is it, is it intended to do that or should it be part of a broader credit portfolio? And talk to me about that.

A (9:05)

Great, great question. I think the use cases vary depending on who you are as, as an investor. We found that a number of institutional investors are looking at credit secondaries as a very attractive complement to what they already do in private credit. So they in many cases are looking for alpha. They're looking for a differentiated way to get access to many of the assets that they're familiar with, particularly in direct lending. So that could be a use case for many investors. They want to get access to alpha, a premium return, a better risk adjusted return by investing in fully funded diversified portfolios. We have some clients who are insurance companies and, and their real attraction to this space is that they can invest in a very capital efficient way because many of these portfolios have a diversification and cash flow profile that allow them to be rated attractively on an IG basis. And so for them that's, that's incredibly attractive. What, what a lot of investors have also realized is that the benefits of credit secondaries are such that you can reduce the dispersion of returns that exist in private credit if you were otherwise investing on a blind pool basis in a new portfolio. And again that's where the benefits again of investing in fully funded portfolios at attractive pricing come into play for a lot of high net worth investors who otherwise can't access closed end funds because of minimums or they want some sort of periodic liquidity. Again, we created access points for private wealth both in the US as well as internationally to get access to credit secondaries. Again solving some of those same needs around getting alpha, getting interestingly access to strategies and assets and other types of portfolios they might not otherwise get access.

B (10:55)

To the fund invests through LPs and.

C (10:59)

Through GP led portfolios. Tell me about that rationale and what, what are the pros and cons of that strategy versus going out and buying direct loans yourself.

A (11:09)

So our market sources opportunities through those two channels. So we simply look at the market as one where we are trying to buy seasoned, performing credit with top tier managers by providing solutions around liquidity to the holders of those assets. The holders of those assets can sometimes be in the form of an LP interest, where you're simply transacting on those particular portfolios. The benefits for us are that you know you're investing in a set portfolio, you can't really change the composition of that portfolio or the structure or the terms of it. So very simply you're providing a point of view on price and execution to deliver that liquidity. What's really growing in our part of the market is what we call kind of these GP liquidity solutions, which I would carry, which are often in the form of what we call continuation vehicles. And what we're really doing there is we're buying a select portfolio that we curate based on our views of credit quality, the attractiveness of pricing and how it fits in our overall portfolios. And those assets may be held by one vehicle, one investor, or across many different vehicles. And we're often partnering with the gps. The benefit for us is we can often get very detailed diligence on each of the underlying assets in a greater way than we otherwise would on the LP side, even though we do underwrite line by line and bottoms up on the LP side as well. But what we can also do in terms of picking the portfolio is we can also dictate the structure in terms of what the ultimate fees, expenses, recycling, if any, might be on that portfolio, what kind of leverage structure might be on it. And then finally, we can also dictate what the alignment might be on that portfolio, which is really important. Obviously as an investor you want to make sure your GP is aligned on that portfolio and shoulder to shoulder with you with their, with their capital as well. So the benefits can often be much more downside protective in a GP liquidity solution because you can eliminate potentially problem assets, you can lower the overall risk profile, but very simply they are just two different channels to get access to the same types of assets. The way in which you can do it can be a little bit different. The timeline in prosecuting them can be very different. We are seeing almost a very significant sea change on the GP side. We've, we've executed over 45 of these types of transactions in our history. We did over 20 of them by 2022. So what's often viewed as kind of a new development in our Market is certainly something that we've been very familiar with for the last six or seven years, and we see the growth of that continuing for the foreseeable future.

C (14:01)

Secondaries always sound great. You're getting in private equity secondaries, you're getting 10, 15, 20% discount ventures. Sometimes you could get 30, 40%. The number one thing to always look out for is why is this person selling, also known as adverse selection, potentially? How do you know that your portfolios are not adversely selected? And how do you do the diligence to make sure that that's not the case?

A (14:22)

Great question. Well, our. Our view is that adverse selection can come in any market, right? Whether, and it really depends, the way to mitigate adverse selection is having a really wide origination funnel. So as I mentioned at the beginning, we've spent a lot of time cultivating relationships directly with GPs, directly with LPs, with intermediaries. We created a funnel that was broad geographically and by strategy. So we've sourced somewhere on an annualized basis, somewhere between 50 to 55 billion dollars of deals this year. That compares to something close to around 36 billion last year and almost six or seven years ago, around $5 billion a year. So that gives you a sense of the growth. So the way to mitigate that adverse selection is having a wide funnel, but it's also having access to tremendous amounts of information. So having all of those incumbent relationships in private credit, as well as a very large portfolio and a $2 billion primary program in private credit just gives us unique insight, incredible vantage point, both on a micro level and macro level, around what's happening in private credit and with specific companies. So that allows us to identify things that are problem assets. Obviously they might be marked already in the 70s or 80 cents on the dollar. That's obviously a red flag. But even more importantly, is the red flag around an asset that's marked at 98 or 99 and is potentially underperforming? Right. So we are in the midst today, at the end of October, of a lot of talk in our market around idiosyncratic risks that have happened, generating losses in, in, in the credit universe. Not necessarily private credit, but companies like First Brands and others that looked seemingly performing from a valuation perspective, but were clearly underperforming from an operating perspective. So having that information, having those relationships, and just having a team of credit experts that have been doing this for a long time, with decades of experience analyzing direct credit and all of these different end markets, you know, we have specialists who've done both sponsored and non sponsored direct lending, asset based lending, European lending, special sets. So when you put that all together, that's a good recipe for being, I think, very confident in terms of being able to vet credit and make sure you're not stepping into someone else's problems. Fundamentally for us, for me, when you talked about first principles around investment philosophy, you really want to be focused on performing credit and performing assets. Buying someone else's problems is really much more of an equity risk. And that's not what our investors are looking for. They're generally looking for consistency, predictability and stability. That those are really important attributes around credit investing. Protect your capital at all costs. First and foremost principles of investing in our asset class.

C (17:27)

So said another way, if it's performing.

B (17:30)

That'S a good thing.

C (17:30)

If it's not performing, it's very difficult to tell to the extent that it's.

A (17:34)

Not going to perform, you're going to discount it, right? So if something's a problem asset and you have to take it, then you know you're going to mark it down. So, you know, a good example of this more recently was we, we bought a portfolio, an LP interest with a very high quality manager that had a line item in it that recently hit the news. We knew it was a problem asset and during the course of our diligence we, we realized and, and noticed that it got marked to zero in the portfolio. So even it was a problem asset in the portfolio, we didn't have to worry about it because we weren't paying anything for it. The GP proactively decided that the, that asset was going to be worth zero. So for us to take it as part of the portfolio didn't impact how we thought about overall pricing or return. But it's important to identify those things as part of your diligence process so you know that, you know you're not stepping into other situations that might have similar characteristics to them.

C (18:29)

I want to have you take off the hat of private credit investor and put on the hat of private credit and finance entrepreneur.

B (18:38)

You've built this $12 billion franchise within pantheon. How does one go about building such a franchise? What is the first step, what is the second step and what are some principles that you use to build out such a franchise?

A (18:49)

We are in the human capital business, so I think first and foremost you have to look around and look at the kindling that you have. And I think the first thing that we gathered was putting together a great team. So we put together a team where we had expertise in direct credit, we had Expertise in secondary solutions, fund finance, M and A. These are all important skill sets to have to bring together in one place and then finding people who are really interested in building a business and growing an asset class. So I think early on we discovered a common thread among people we were talking to who also felt uncomfortable about kind of the risks and challenges that were existing in the primary market of private credit and were looking to exercise their investment muscles effectively in a place where they could be creative, solve complex problems and be part of something that could have a real future and change our industry, particularly in credit and in secondaries more broadly. So it really started with a culture of those types of attributes and team expertise and then leveraging our strengths as a firm. Right. We've really been innovative in other parts of the secondaries market over our four decade history and then obviously leveraging a lot of our personal connectivity and relationships as individuals. I think one of the things I really like about our business is that we are real partners to GPs. We're not competitive to them and we help them with references, we help them think about the market, we help them with investor introductions, we help them think through fund structures. So we're trying to be not just capital. I realized early on when I was involved in building other credit businesses, you know, your capital is a commodity, but who you are as an individual and your relationship and where you can be constructive to somebody, whether it's someone that you're interacting with on a transaction, you're trying to buy something from them, you should try to be constructive and value added. Or whether we're partnering with a GP who's going to be stewarding a lot of our assets on a go forward basis. That's important to be value added to them too. So those are all the, I think the most important elements of, of how you build something from the ground up.

B (21:12)

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C (22:36)

What do you think GPS look from you from a perspective of value add and how have you been able to add the most value?

A (22:43)

So I think GPS recognize that we are GPS ourselves. We're not just LPs. So I think first and foremost there's that level of commonality of experience and being in the trenches and investing in different things. Similarly, over the course of our careers, I think GPs are really looking to us as a trusted sounding board. They're looking at us for candid advice that they probably can't get from other allocators in the market or other investors that just don't bring some of those shared experiences and battle scars. Having worked through different investment cycles, different investment environments and different types of strategies, so GPS are ultimately looking to us as a solutions provider. Obviously, if we're looking at a particular transaction, but when we're not working on a particular deal, they're really looking for us, for knowledge, for expertise. Can people on our team help them think through how to be better in fund management? How can they better serve other LPs that we also have as part of our own ecosystem?

C (23:50)

Private credit today is somewhere around $1.7 trillion asset class 1 with a T. What are some of the misunderstood risks on the asset class and what are maybe some of the headwinds?

A (24:04)

Yeah, I thought a lot about this. I think there's, there's a number of things that I think are misunderstood. One is, you know, maybe more at a micro level. You know, valuations are always things that investors scratch their heads about. Right? To our, to our earlier discussion around if an asset is in trouble, why is it marked so highly? And I think, you know, the valuation anomalies that exist in our business are a function of just private markets, time lapses between how valuations are put together and when information is, is got or received. And that's just the difference between, you know, being a private market, private markets investor and a public market investor. I think other things that are misunderstood include kind of correlation risks in our business. So when I see a lot of investors getting into asset based lending as an example, and again, it's kind of been more in the news lately because there have been several instances of fraud or collateral that's been mispledged or not diligenced. Well. And I think a lot of investors tend to overestimate the non correlation of certain types of assets when they invest. And then finally the, the other thing I think is misunderstood is just alignment. Right? Our, our industry has changed a lot. We have a lot of large asset managers in our business and we have a lot of boutiques. And I think how gps are incented around their portfolios to deliver performance to clients is, is changing a lot. There's a lot of consolidation going on in the market as well. And who is aligned against your capital I think is an important consideration always. But I think it's an even bigger risk today than it's ever been over the last 10 years.

B (25:47)

Conversely, what do you think the skeptics.

C (25:49)

Get wrong about private credit? And maybe they should be a little bit less skeptical on.

A (25:54)

There's a lot of angst about private credit, but they don't realize and there's a lot of worry around competition. But I think for a lot of things to negatively impact private credit, a lot of other things have to go wrong in other asset classes. So we as credit investors always talk about the fact that if you're worried about credit impairments, you have to think about equity impairments first. So being first dollar at risk in many businesses fundamentally means that you are not in a first loss position, someone else is. So if you really are going to think through challenges in credit, you really have to think through challenges in other parts of your book as well. So we often see investors that are very heavily in the private equity business or heavily in equity, and they're really wringing their hands around private credit, but not understanding completely some of the, the connectivity in that relationship. The other thing that I think is also maybe misunderstood is just this concept of risk adjusted return in private credit. I think it's unique to the asset class because there are many different ways to get a 9% return, a 10% return or a 15% return in private credit. Most equity investors, as an example, think about multiple of capital. They think about the specific industry exposures or style of deals that they're involved in. In private credit because of the use of structure and leverage and different forms of duration and cash flow profiles. I think the risk adjust, the nature of how you invest is really important. Right. If you can get a levered 15% return lots of different ways, but the risks involved in getting that 15% could be markedly different. So I think those two facts I think are probably kind of key things to think about in private credit. For the skeptics anyway, you built one.

C (27:40)

Of the first evergreen private credit funds aimed at private wealth. What has surprised you the most about building an institutional grade product for the private wealth channel?

A (27:51)

It probably wasn't a complete surprise, but what surprised me is the appetite, the level of demand for clients. I think we've always viewed it being strong, but I think it's really touched a nerve with investors with respect to getting access in a diversified low risk way. I think has really resonated with folks, particularly around credit secondaries. So we've I think been very careful around making sure we build it in the right way, that we're finding the right types of investors and explaining from an education and suitability standpoint the trade offs between investing in private wealth or retail evergreens and the trade offs between, you know, with me using leverage or having access to liquidity and the pacing of those types of investments. So we think that has a long leg ahead of it. We, we as Pantheon have been involved in private wealth evergreens for, for over close to maybe 15 years. We have 12 billion, 12, 13 billion in that area across all asset classes. So we think we know what we're talking about and have a long history of performance there. I think the other thing that surprised me maybe is that it's a complex business. It's very difficult to manage a daily marked fund with quarterly liquidity, which we do on, on the US side of our business and, and exercising those skills to make sure we're optimizing for performance and deployment in the right way. I think is a unique skill set and we've been having, we've had the benefit of being able to do that for a number of years now. But a lot of people who are new to it just don't have that level of expertise. So they're effectively learning on the job which is, you know, has its own challenges and risks.

C (29:40)

Last time we chatted I was a bit critical of the tax schema for private credit. A lot of people are paying a lot of taxes on. Then you hinted that you guys might be working around a solution. What do you see on the horizon in terms of tax efficiency and private credit.

A (29:53)

I think this is also just a huge area of potential focus in the future. I would say we haven't cracked the code yet on it, but you're seeing lots of other parts of the investing world trying to figure out ways to deliver tax efficient solutions to their private wealth clients. And I think it's going to be one of these areas that's going to have just a huge amount of growth potential ahead of it. I mean part of the whole push for retail in private credit around 401ks and the like is to obviously have some sort of tax sheltered solution. But I think there's a lot of innovation, I think coming around our structures where there can be marrying of different investment products to generate tax shields against private assets as a, as a very high level example. So I think smart people are working on this and I think more and more clients should expect the delivery of these types of solutions on a go forward basis. I think it's pretty exciting and I think could be a real game changer in terms of how, how investors get access to, to these types of funds and these types of products.

C (31:01)

Most family offices ask this exact question. They say typically the answer is we have it in 401k roth ira. We have it within a ppli instrument or other tax tax aspect. But drilling deep into this topic ahead of the interview, I realized that some of your gains are actually capital gains because of the secondary component. Not all of it is, is income.

A (31:23)

That's right. So I think look it by itself it's, it's, it's a very, can be a very tax efficient alternative in private credit compared to other forms of private credit exposure where the vast, vast majority of the return profile is just focused on ordinary income. But the beauty, the next innovation is really figuring out how to wrap a tax efficient blanket over that whole thing to shelter even more what's going on on the ordinary income side. So I think that could be pretty exciting.

C (31:56)

Historically what percentage has been in capital appreciation versus credit roughly for credit secondaries?

A (32:02)

It really depends on the end market. So if you're, if you're investing in something that's more senior secured floating rate in nature, I defin end has a medium term duration on it. By definition more of the total return is going to be oriented around ordinary income. So probably 2/3 ordinary income versus you know, 1/3 capital gains oriented. And again those are, those are maybe averages with a high degree of variability. You know, deal to deal and situation to situation. If you're investing in more opportunistic credit, where the discounts and the risk profile is a little bit higher because you're investing perhaps deeper in the capital structure. Those discounts can be 50% or more of the total return profile. So that can be a different level of mix depending on the risk reward.

C (32:53)

Looking ahead in five years, where do you see the credit platform and what do you see as the future of Pantheon's private credit platform?

A (33:01)

We're only at the very beginning of market education and adoption of credit secondaries. When we first started the business, I think the goal was to have a $3 billion business in five years. From an AUM standpoint, we've quadrupled that expectation over that timeframe. We continuously, I think, are surprised to the upside in terms of the deal flow, the size of transactions that we, that we see. You know, we are now regularly looking at LP and GP transactions that are 500 million a billion, $3 billion in size in terms of asset value. And we're just at the very beginnings of, of where that goes. So, you know, we're incredibly optimistic about where, where the, where the environment is going. We, broadly speaking, depending on the estimates, there's around maybe $20 billion of transaction volume done in credit secondaries on an annualized basis. You know, we could very easily see that, you know, triple over the next four to five years.

C (34:06)

You've had an amazingly storied career. We didn't even get into your time at Morgan Stanley, Goldman Sachs, Citigroup. A topic for another day. What one piece of advice would you give yourselves coming into Morgan Stanley 1994? That's timeless. That would have either helped you accelerate your career or helped you avoid costly mistakes.

A (34:26)

I think, I think the biggest thing is to, you know, think about relationships and picking your partners carefully. When you're a young person, especially back then, it was all about technically being as proficient as possible, being able to grind through complex situations, handle multiple projects at the same time. And sometimes there wasn't that ability to really develop a lot of that mentoring or personal connectivity when you're early in your career. But I think over time, as you kind of graduate out from the bullpen and the, you know, 80 to 100 hours a week to type of lifestyle and start exercising those skill sets. I think certainly developing relationships is so important, picking smart people that you can learn from recognizing that when mistakes happen, you really understand why those happened and learn from those in a, in a really appropriate way. So those are probably, those are probably the things I tell my, myself from, from 30 years ago to, to Think about more broadly, but I think we all, we all kind of work on those things at different points in our career. And I think hopefully over time I've been able to develop those types of relationships that have made, made us and our platform and our team so successful today.

C (35:44)

Being in the right rooms and also reflecting on mistakes when you make them.

A (35:48)

Absolutely. You know, you got to be introspective, you got to be always learning, you know, even, even on our, even at my age and my vintage, you know, you're always learning from folks. And that's, that's the other thing I love about this business is we get to touch, you know, some of the, the biggest successes and brightest minds in investing in private credit at all of these great firms and even at smaller boutique firms. They're just people that just had a myriad of different experiences, have invested through so many different cycles, have had successes and failures, and being able to talk to all those people all the time, I think just makes us better investors and better partners. That's probably one of the biggest benefits of being in credit secondaries and being in secondaries generally. All of the smart gps that we get to work with, as well as just the interactions we have with LPs as well. There's a lot of talent on that side of the street. And those folks oversee not just things in private credit, but they see across multiple asset classes and also have, I think, very unique vantage points in terms of how they see the market, how they think about risk, and therefore how they think about investing. So it's a, it's a fun spot to be in.

C (37:00)

Perhaps a dumb question, but where do private credit secondaries fit into a portfolio? Are they secondaries? Are they credit? Do they compete with bonds? Are they in the alternatives bucket? How do most people think about it and also how do you think they should think about it?

A (37:15)

For a lot of investors institutionally that have already been in private credit, they are, they are looking at their direct lending book saying, well, we don't need 10 direct lenders anymore. Maybe we only need five. And we want a compliment to that strategy. So I think in some cases they're taking those dollars from traditional fixed income or they're taking it from existing allocations where they might already be overexposed to that sub asset class. I think a lot of investors also who want to pursue opportunistic strategies look at the world of those other opportunistic credit categories and say to themselves, it's pretty daunting out there. There's 1100 credit managers out there globally 360 plus direct lenders just in North America. How do I efficiently get access to really smart people in a scaled way? I might be writing a $20 million check, I might be writing a $200 million check. It's difficult to do that. Access is also an important consideration. And for the high net worth crowd, for, for private wealth, we've seen all sorts of use cases. We've seen people use credit secondaries as a transitionary asset class to hold cash from selling a large position in the equity markets. Let's say a founder of a large technology company wants to gravitate into other private markets that use credit secondaries efficiently. And then other people I think are generally just looking for strategies that have a really nice supply demand imbalance. Right. If you look at lots of different parts of the private markets they are under, they are oversupplied with capital. There's a lot of competition, there's a lot of spread compression. I think in secondaries generally, whether it's private equity infrastructure and certainly private credit being the least mature of those asset classes, there is an abundance of market opportunity and it's under capitalized from, from both money as well as skill and resources. And as an investor, you always want to be investing with that kind of tailwind behind you because it means your capital is going to be priced appropriately in that type of market.

C (39:19)

I don't know if you would like people, investors to look at you this way, but one of the most interesting strategies I've seen is when people are building out their book. This was originally told to me by Frank McLell from North Dakota Land Trust. They look for just exposure to a certain asset class through evergreen funds. So let's say they have their private equity evergreen, they have their private credit. And as they find managers, as they find alpha, assuming that these evergreen funds are beta, they reallocate into those asset classes so that they can make sure that they're not keeping money in cash while they're choosing the managers. And also having capital in these evergreen funds also allows them to have a high bar where the manager has to be better than the aggregation of many managers. So it's useful I think both, but functional, but also as, as a way to discipline your investing.

A (40:09)

Yeah, absolutely. That's a smart way of thinking tactically around using different access points and vehicles to achieve your objectives. You know, as a CIO of a very large plan like that at North Dakota as an example. So we are seeing LPs that are sophisticated like that start thinking about using not only different asset classes, but those structures to their advantage. So I think that's, that's pretty clever way of being able to, you know, manage your book and allocate risk appropriately.

C (40:40)

All Rick, this has been absolute masterclass in private credit and private credit secondaries blew my mind. Thanks. Thanks for jumping on. Look forward to continuing this conversation live.

A (40:48)

Absolutely. See you in the in the next in in the next iteration of this. We'll be looking forward to talking about the report card and update on credit secondaries at that time. Thanks so much for the time and great to speak with you today.

C (41:00)

Thank you, Rick.

B (41:01)

That's it for today's episode of How Invest. If you're a GP with over 1 billion in AUM and thinking about long term strategic partners to support your growth, we'd love to connect. Please email me@davidisburgcapital.com.