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- [00:01]
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Welcome to Thoughts on the Market. I'm Vishy Tirupator, Morgan Stanley's chief fixed income strategist.
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And I'm David Miller, global head of private credit and equity within Morgan Stanley Investment Management.
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Today, the evolving risks and opportunities in private Credit. It's Tuesday, March 31st at 10am in New York. Until recently, private credit was among the fast growing parts of the financial system. In just over a decade, it went from a niche strategy to a market that's well worth over trillion dollars. After years of outsized inflows and unusually smooth returns, private credit is now in focus and investors are asking tough questions about liquidity, transparency and valuation. David, you manage private credit and equity portfolios within Mogustani Investment Management. Do you think the industry is facing its first real stress test and how do you think the industry is faring?
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So I think private credit has been tested before. You could go back to the GFC and I know that was a long time ago and the industry was quite a bit smaller, but you could certainly look to the pandemic and the rate shocks of 2223 as a stress test. And I think private credit performed quite well through that despite the initial volatility. We saw some of that recently, last year with Liberation Day and the current environment from a fundamental perspective doesn't feel as bad as those time. And the industry does not feel under that stress. I think the current situation is more of a test of the non traded BDC structure where roughly 20% of direct lending assets sit. And the liquidity provisions in those vehicles are designed to provide some liquidity but not total liquidity. And so while I think the vehicles are working as intended, obviously there's been a lot of noise.
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So I totally agree with you, David. The liquidity provisions that are in these structures or are there for a reason are designed to be that it's part of the feature and not a bug precisely to prevent fire sale of assets and that really would hurt the overall system. So we think there is a greater understanding of this is very much required.
- [02:09]
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I think that's right. The limitations on liquidity are there so that the vehicles can operate properly over the long run. When you have illiquid assets, you maintain some liquidity, but clearly those protections are in place so that the vehicle continue to run in ordinary fashion. I think there is a bit of a disconnect, you know, in the media between the sentiment and the fundamentals that are underlying private credit. And yeah, there are concerns about software and macro and unseen future risk. But right now private credit portfolios are performing pretty well. And actually if you look at 20, 25 versus 24, the metrics were actually improving.
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Absolutely. We look at across various metrics in leverage and coverage metrics, we see overall trends are actually improving Software very much in focus. Fitch reported year to date there have been no software defaults. Another point I would make is there are about 5% defaults generally speaking in the private credit space and the default rate within the software sector is a little bit less than half of that. So that's an important distinction to make.
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Yeah, I think software is a very interesting and long topic but generally our view is we think that AI is going to be a net tailwind overall for software over time. You know, even factoring in some of the erosion to the SaaS business models, I think well positioned incumbents will get their share of the upside and so there will be some losers. We think that'll be pretty narrow. But overall we feel very good about our software book. We've been looking at AI risk for at least three years when we made loans and we think that lot of the embedded enterprise software platforms are going to be net beneficiaries of AI.
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I have a slightly different take on the software exposure and all the discussion points on this. The way I think about it is the market assumption is that AI disruption is necessarily going to disrupt all of software companies and that disruption is imminent. I would push back on both of those points. You could easily imagine that AI will lead to some disruption at some point in the future. But a necessary thing for that to happen is a significant amount of capex related infrastructure to enable AI from innovation to adoption that needs to take place. That will take some time. So this potential disruption is not imminent. It's potentially coming in the future. But all in disruption is also not going to be negative. We'll have some companies whose business models don't have the moats and may not be able to benefit. But. But on the other hand, as you point out, there will be a number of business models which will actually flourish because of AI adoption and see their margins expand. So I think I would push back on this notion that's prevalent in the media narrative here that all AI disruption is imminent and is all bad.
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I think that's a very good point. And we do believe that there will be dispersion in outcome in private credit portfolios because of some of those facts. And it's really important for managers to have deep experience not just in software, but any industries that they participate participate in and really do very strong credit Selection.
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So another thing that's happening in the private credit space is really the advent of the retail investor into the private credit. What do you think the advent of retail investors had done to the portfolio selection, portfolio construction and credit selection in your portfolios?
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So for us, we haven't changed our portfolio construction or credit selection process for retail portfolios. They're virtually the same as our institutional portfolios. And that's, you know, based on a lot of diversification, limiting borrower concentration, avoiding cyclicals, et cetera. The one difference that's important for our non traded BDC is we do have about 10% of the portfolio in broadly syndicated loans to add a little bit more liquidity to the portfolio, but otherwise they're pretty much the same. I think the biggest impact that we've witnessed over the past few years where there's been a large inflow of retail capital has been to push spreads tighter and weaken some of the terms than they would have otherwise been. There was a lot of capital that needs to be deployed quickly. So we saw that and we're quite cautious. You're seeing that trend reverse now as flows have moderated and we expect that those trends will result in better pricing and better terms going forward. So Vishy, how are you thinking about risk in the system now? Are you seeing signs of systemic risk or is the pressure more isolated?
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I think the pressure is really more isolated, more focused on the software sector. As we just discussed. It will take time to figure out the winners and losers coming out of this. But that process we think will result in some pickup in default rates. But we think it will be very concentrated within the software sector. So when I look back at the systemic risks, the echoes of the financial crisis of 2008 come back. We both have gone through that in different roles. I used to be tall and good looking before the financial crisis. So the scars of financial CR clearly upon me now. But I compare these two time periods and I say in any metric the risks in the system today are nowhere comparable to the kind of systemic risk that existed back then. You look at the risks, the leverage at the company level, you look at the leverage, the vehicles where credit risk is sitting, look at the risks and the leverage within the banking system and the links of the non banks to banks, all of them put together make us think that the, the systemic risks are very, very contained. And any allusion to that we are back in 2008, I would very strongly push back against that illusion. So David, let me ask you one final question here. If we had to highlight one risk or one opportunity in private credit for investors over the next year, what would it be?
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I think the headlines have covered most of the risk, so I'll go with an opportunity so we believe spreads on private credit loans have widened quite a bit for direct lending, both for non software and software names. So for investors looking to deploy new capital or investors who are underweight their target allocations, we think it's an interesting time. But we believe there's also a really nice opportunity in opportunistic or hybrid private credit, and that's coming from borrowers who need more flexible solutions. And that can come from M and A activity, non dilutive growth capital or balance sheet rationalizations where one can inject junior capital to good businesses that have over levered balance sheets and you can get paid well for the flexibility and the optionality that's providing equity holders. There's been far less capital raised for these types of opportunities over the last few years and they're pretty favorable dynamics going forward as demand increases.
- [08:57]
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That's very insightful, David. Thanks for taking the time to talk.
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Great speaking with you Vishy, and thanks for listening.
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