The Investment Conversation: Exploring the Private Credit Landscape

Andy D’Souza: Welcome to The Investment Conversation, a Lord Abbett podcast series where we explore important themes in the investment management business. I'm Andy D'Souza, partner and chief marketing officer and guest host for today's podcast.

For today's conversation, it's important to note our long history in the credit markets. At Lord Abbett, we've been managing high-quality fixed income since 1930s and leveraged credit since 1971. Over the past six years, we've heavily invested in our alternatives platform across four key pillars: opportunistic credit, a CLO [collateralized loan obligation] platform, strategic partnerships, and finally and most relevant to today's conversation, private credit.

Joining me today is a very special guest, a fellow partner of the firm and our head of the Private Credit business and a friend, Steve Kuppenheimer. Steve, thanks for being here today.

Steve Kuppenheimer: Thanks for having me, Andy. It's great to be here.

D’Souza:  Of course. For today's podcast, I want to take this in three parts, maybe go a little bit through your background first and foremost. Then maybe take the audience through a little bit of a Private Credit 101, talk about the players in the marketplace and sort of how it all works. And then get a little deeper into some of the current trends and themes in the marketplace and get your opinion on what's happening and what your outlook is going forward if that's okay with you Steve.

Kuppenheimer: That sounds great.

D’Souza:  All right. Let's do it. So, looking at your background, Steve, you've held a variety of roles, partner and portfolio manager at Blackstone. You founded your own private credit asset manager, FSI Capital, and you were the head of CLOs and structured finance at Merrill Lynch. Now, as a young Steve Kuppenheimer in Evanstown, Illinois, did you think from day one, "When I grow up, I want to be a head of a private credit business?"

Kuppenheimer: Of course not. I think, like so many of us in the industry, I think you kind of fall into what winds up being a very specific career. And usually, there's a lot of random circumstances that lead to that. For me, when I graduated from law school, I knew I wanted to get into the business side but started at a law firm.

And this was in the late '90s when a lot of these products did not exist or were just being thought of initially. And by pure chance, I was put into a very small structured private credit legal team at a law firm. And because it was such a new concept, even as a junior attorney, I got a lot of access to client meetings and thinking.

Our firm did a huge amount of the business for Merrill Lynch, who at the time was a leader in the space on the cutting edge. So, I got this just very fortunate access to the beginning of a lot of these products.

But I had no idea what structured credit or private lending was at that stage in my career. I just knew that I was attracted to the markets, and this was a new space with a lot of innovation going on.

D’Souza:  Gotcha. And then, again, within your bio and your background, it was FSI Capital, the firm you founded, that really caught my attention because I noticed in there from what I understand and getting to know you over the years here, FSI played a major role and was eventually part of the TARP, the Troubled Asset Relief Program, right in the midst of the teeth of the global financial crisis (GFC). Can you walk us through sort of how that happened? How did you become involved in the TARP program?

Kuppenheimer: So, another series of very fortunate events, maybe unfortunate given it was in the wake of the financial crisis. But FSI Capital was really an expansion of an existing platform called Financial Stocks Inc. run by Steve and John Stein out of Cincinnati.

I was fortunate enough to have them as clients for years when I was at Merrill Lynch. You mentioned my time at Merrill Lynch running structured products there. So I left Merrill to really expand their fixed-income business, which was something we called FSI Capital.

We were very focused on the financial services industry and lending into the financial services industry, specifically banks. And we started that in 2006 or I should say expanded in 2006. And then in 2008 and 2009, I think everyone remembers the specific part of TARP, which was the Capital Purchase Program which was kind of the investment bank bailout part of TARP.

[Former U.S. Treasury Secretary] Hank Paulson put out the capital really at an incredible pace. After the capital was put out, Treasury put out an RFP [request for proposals] for asset managers, and we applied largely because we knew banks very, very well as a firm, but we were a small, relatively new player so we weren't really expecting a lot to come from our application, to be honest.

But we did wind up winning. They hired three original asset managers. Hundreds applied. You could rerun that process 20 times and we don't even make it to the second round. So, very fortunate that we got that contract. And maybe what I'd highlight there is I think everyone remembers TARP as kind of the top 15 to 20 banks that were part of it, but Treasury invested in over 700 different banks. And so that was really where we had incredible overlap was outside of the top 20 banks. We knew those too, but we had a lot of experience in kind of the middle and lower part of that market. But that was an incredible experience for me.

D’Souza:  That's awesome. There are a lot of things that were sort of behind the scenes or under the radar. Some of the headlines were very eye-catching at the time, and it became very political in many ways. I know along the way, I'll never forget watching the TV at the time. And there was the vote on the floor of the House, the vote count. And when it failed and then came back again--

Kuppenheimer: Yes, it was incredible.

D’Souza:  It was a pretty intense moment, in my mind, looking back at the GFC. But if you think back on the whole experience you had, it is kind of unique and once in a lifetime, hopefully. In terms of lessons learned or things that you kind of figured out from going through that crazy process overall, what would you say to the audience here about lessons learned from that experience?

Kuppenheimer: I would say the most impactful lesson I took away from my experience with the TARP program was: crises bring out the best of us. And I saw that in terms of maybe primarily the people that worked at Treasury at the time. They had an incredible group of people that had been at Treasury for a long time in addition to people that left much more high-profile jobs really to provide their service and expertise to Treasury at a time of need.

And some of these people are some of my closest relationships to this day. But you just saw a lot of selfless, highly focused, highly competent people looking to do what was best in a time of great uncertainty. And you saw it on our team as well, people working around the clock in very uncertain times, trying to get to the right answer.

Maybe the second lesson learned, I would say, is the value of private markets. What you saw in the case of the Capital Purchase Program was a lot of private capital in the form of big capital base coming from U.S. Treasury. But being able to be long when liquid markets were massively dislocated has a lot of advantages, plays a pivotal role in the capital markets generally. And that was also another lesson learned about the value of patient capital and what private capital can do in a market.

D’Souza:  And speaking of, I guess, the private markets in general, if we could zoom out for a second--headlines you read about the size of the private markets out there today, $1.7 trillion's a number that's being tossed around here and there. But it seems like private credit can mean different things to different people. So, when you think about private credit and that $1.7 trillion number, what does private credit mean to you?

Kuppenheimer: I think in today's world, you really got to define private credit in two ways. I think there's the historic definition, and then there's the definition that gets used more broadly today. So, when you mentioned the $1.7 trillion, that's a little bit of a broader definition than what's historically been private credit.

So that $1.7 trillion wouldn't just include U.S. corporate direct lending, which is more the historic definition. That would also include I think a lot of kind of private asset-based financings and other types of financings that have been in the broader definition today.

Interestingly, what it doesn't include is one of the big areas of growth in private credit going forward, which I think is an investment-grade private credit. So, and that's trillions on top of that $1.7 trillion in terms of potential market. But the historic definition is really lending money to private companies in the United States.

And I think of that $1.7 trillion, it's a little under $1 trillion of that number. So, it's a material part of the market. It's probably 25% of the leveraged finance markets and growing, but that's a historic definition. Again, that broader definition is how you hear it used in the press a lot today.

D’Souza:  Let's continue that sort of zoom-out approach a little bit with private credit and more specifically with U.S. corporate direct lending that you just mentioned as a subset of private credit. And maybe you should walk through first, who are the players at top of the ecosystem of private credit and direct lending here? Who are the major players in this sort of act, right, and then we can kind of follow a dollar from there. But first and foremost, obviously you've got borrowers, lenders--anybody else that we should be talking about?

Kuppenheimer: Absolutely. I think that when we've mentioned borrowers, what we're really talking about are again, these companies that are looking to borrow money for strategic purposes.

I would add an important third member, which is the owner of those companies. And sometimes that's a family. Sometimes that's another company. But often, it is private equity firms. And so, another term that gets used around private credit is “sponsor finance.” Sponsor refers to private equity, and I would say the majority of U.S. direct lending volume is driven by private equity firms making strategic decisions for the portfolio companies in terms of their financing.

D’Souza:  And so, the borrowers, to paint the picture, what's the size and scope of the borrowers in this private credit direct lending marketplace in the U.S.?

Kuppenheimer: I would again maybe go to the historic and then the current. So, I would say, historic it runs down to the smallest companies in the U.S. up to probably $100 million, $150 million of EBITDA. There's probably about 200,000 different companies in the U.S. that fit that description, which is an incredible pool of potential borrowers.

The U.S. middle market, which is roughly what I'm defining right now is the third largest economy in the world behind the U.S. as a whole and China. So very diverse, deep market in terms of number of issuers. Now in more recent times, I would say since 2020, larger companies have been using private credit as a financing tool more and more.

They always had looked at it episodically and on the margin. But now it's becoming a core financing tool for them as they look to diversify their sources of capital and use more customized forms of capital as well. So now I would say, Andy, size of the company's almost unlimited. So EBITDA going to the hundreds of millions [is] not uncommon to see using private credit as a tool.

D’Souza:  And so let's just stick with sort of the mid-market traditional space for a minute here. And the three players in this we're talking about, the borrowers, the lenders, and the sponsors, you just painted the picture of who the borrowers are. We can talk about the lenders. Who are the lenders now?

Kuppenheimer: So, lenders historically–I think a lot of commercial banks if we go back decades. So again, lending money to middle-market companies is far from a new concept. It's been around for decades, largely in the commercial banking sector, in regional banking sector.

I would say alternative lenders are often the focus of today and how I'd answer your question currently. So there's a lot of alternative lenders in the space. I would say, the great financial crisis is really a watershed moment for when this space got more institutionalized and more kind of this era of the business, where before the great financial crisis, the estimates were that only about 50% of the capital needed in the middle market was even available on the lending side. And about half of that, or 25%, of the overall need was provided by the banking sector and the other 25% by alternative lenders.

So, think alternative lenders like large alternative investment houses like some of the largest private equity firms that have grown massive private credit businesses. There are also insurance companies that have gotten very big into this space, and some banks remain in it.

But net of the great financial crisis, the banks had to pull back due to the regulations that came as a result of the GFC. And a lot of estimates now have banks providing less than 10% of the needed capital. And really it's become a market more driven by alternative capital.

So after the great financial crisis, as banks pulled back even more from an already underserved market, you really had a capital vacuum. And that is what alternative investors look for. They look for markets that are underserved by capital, where you can get outsized risk-adjusted returns by being a provider of liquidity. And that's really when you saw a lot of the major alternative investment houses, like my former firm, move in in size and kind of scale since then.

D’Souza:  So again, it's like the borrowers are changed over time and evolved as always--

Kuppenheimer: Yes.

D’Souza:  But traditionally speaking, it's about 200,000 middle market businesses in the U.S. The lenders have changed from more of the regional and commercial banks into a little bit more of these alternative lenders, meaning maybe asset managers and others. And then the final player in this is, you mentioned the sponsors, the private equity firms. Give us a little more color on private equity firms.

Kuppenheimer: Sure. So, there's about 4,500 private equity firms in the U.S. It's a lot more than people realize. I would say less than half of those are relevant to leverage finance, meaning regularly use the leverage finance markets for their strategic needs.

But you're still talking about 1,500 to 2,000 different private equity firms that are active in the space. There's a pretty big barbell dynamic here where I mentioned that larger part of the direct lending markets earlier in the conversation where you have companies looking to borrow a billion dollars plus.

I would say, there's less than 100 private equity firms, probably less than 70 that have the ability or own companies large enough to look for that size of loan. So one of the things that you've seen develop is kind of two ecosystems where a smaller number of sponsors driving a lot of the business at the upper end of the market, and then a very large number of sponsors or private equity firms driving the bulk of the deal count really in the core middle market, which is the historic business of private credit.

D’Souza:  I want to follow the dollar through the system in a sense kind of just to find out how it actually flows through the system overall. What are these companies looking to do with these proceeds?

Kuppenheimer: So, it runs a wide range of “use of funds,” which is usually what we call this, of strategic initiatives or goals of the firm or its owner. And those can be M&A [mergers and acquisitions] activity. So, you might have one company buying another company, and they want to do that with borrowed money.

You might have the sale of the company from one private equity firm to another and the new private equity firm wants to redo the financing. You might have the sale of a company that's not owned by a private equity firm like a family-owned business that is then sold to a private equity firm.

And they may have never borrowed money before. So sometimes or a lot of times it's an M&A activity. It can also be used for growth initiatives. So, you might have a company whose business is to roll up dental or doctor practices or veterinary practices across the country, and they need to borrow money to roll those businesses up. And they'll borrow money for that reason.

Sometimes you have dividend recaps, which is really private equity firm buys a company when its EBITDA is let's say $50 million. Now the EBITDA's grown to $100 million, and they can borrow more money against that company because it's grown in size, it's doubled in profitability. And that allows them to take some of their initial investment off the table. So it runs the gamut of strategic initiatives from the company and from their owners.

D’Souza:  And so if we were looking to match up sort of these borrowers and lenders together in the marketplace and walk through and follow the dollar, I guess the first step is sort of finding the loans? For us in a sense that would be origination. And the second step might be the underwriting or analyzing those loans. And the third step being portfolio management, ongoing management of those loans. So go back to the first one then in terms of origination or finding those loans. How do you match up the lenders and the borrowers here?

Kuppenheimer: Well, the first thing I'd say is all three topics that you mentioned there, kind of the lifecycle of risk in the system, origination, underwriting, and portfolio management, they're all critical. And they are the ways different platforms differentiate themselves in the market.

There's a lot of focus on origination, and we'll go deep there. But I would also say, underwriting and portfolio management probably get talked about less but can have an equal impact in terms of different platforms having different outcomes in their portfolio.

So, yes, origination, really this is true of any private asset class, whether it's private equity, private real estate, or private credit, where you're getting your risk not from a trading desk. You have to pull it from the market, and so that requires direct coverage of borrowers and the firms that own them.

So, what’s required to be successful at origination? You need to have a great reputation, great relationships in the market. These are illiquid loans as I think is well-known, and usually that focus is on the investors, that these are illiquid investments. However, they're illiquid loans for the borrowers as well, meaning they know that the initial lenders when they close a loan are likely never going to sell. There's not going to be very many of them in number, and they're going to need to deal with these lenders over the life of the loan.

Hopefully, they're going to be growing and want to borrow more money, but they might have strategic updates that they need votes on. They might encounter some stress and they're going to need to talk to the lenders about how to amend the loan. But regardless, they really care who you are.

So, knowing the platform, knowing the team, having a reputation of scale, patience, reasonableness, are really critical to having successful origination. There's a number of reasons why private equity firms are an outstanding source of this risk, to continue on the origination point.

One is, they're their own source of investment performance. So good private equity firms, they underwrite companies. They professionalize them. They optimize their structure and their operating performance, and that's a good alignment of interests for borrowers.

So, we look for sponsors that have a really good history of making good investments, of operating the companies responsibly and efficiently, and also being a source of financial strength if things run into volatility. So, they're not required to put more money in in those circumstances.

But different private equity firms, the ones that have a good approach to this business, will often put money in to defend their capital and the borrower's capital in times of stress. And then, the final advantage I'll say about private equity firms is, it's a more efficient origination model.

You can be talking to one private equity firm and see 10 deals a year versus trying to find those ten deals organically not from sponsors. And that's harder to do.

D’Souza:  And so then, now you see these deals as you mentioned, and they come across your desk, so to speak. You've now moved from sort of I guess the first stage of origination, finding looks at these deals to now underwriting or assessing the deals. What's unique and different or what's similar about looking at a deal in the private markets versus the public markets?

Kuppenheimer: I think that despite the convergence that I know we're going to talk about that's been in the market, there's a pretty big difference here. So, when you're looking at a deal in the liquid markets, you're often limited in time in your ability to react to making an investment decision.

And what you're going to rely on is two things. One is your historic familiarity with that issuer, and that's going to come from your research department or a portfolio management team just being active in the market. And then, secondly, you're going to rely on your ability to sell out of that loan easily, if you have concerns going forward.

In the private markets, you don't have the luxury of that second point, so you have to look at every loan as a buy-and-hold-to-maturity position. And that takes time to underwrite the risks and get comfortable or not with a given company's proposition.

So, on the private side, what we describe that we do is we do private equity-like diligence. What does that mean? So that means you're having conversations with management, with ownership. You're going through their historic financials. You're looking at their customer database, what their history is with customer retention and customer growth.

Depending on the type of company it is, you're looking at SKU [stock-keeping-unit]-level data, meaning product by product, what is the volatility in sales, what's it contribution to margin? You're usually getting quality of earnings reports. It's a much heavier lift, and you're doing it with a mindset of never selling the loan.

So, what does that mean for us? What that means is we project economic stress in the loan, assuming that there's an economic cycle that's worse for that company. So, to be more specific, these are six- to seven-year loans. We assume that you'll have something like the great financial crisis that occurs during that hold period.

And then, what we're looking for is that net of that stress, the company is still able to pay us interest and principal when it is due. And that can be--not a large number of companies that'll pass that. So now marrying origination and underwriting is an interesting dynamic.

Because it’s not uncommon that we're turning down 90% of the opportunities that we see. And that selectivity I think is critical to performance, especially in illiquid asset classes, but you've got to be able to turn down that much deal flow and still see the next deal.

And in some ways I think the art and science here is maintaining that selective discipline but also maintaining the relationship so that you see the next deal. And that takes very strong relationships. It takes great communication. It takes very reasoned underwriting, so people understand what deals you like, what deals you don't. And they're comfortable keeping you in the loop going forward.

There's two other points I want to make on underwriting, Andy. So one is, as I mentioned before, the primary objective is to avoid defaults. And that I think is the most common understanding of it. But there's a second, equally important, dynamic that we see, which is finding unusual risk-adjusted returns.

So, we view our underwriting as a competitive advantage in its patience and depth. And we have found that there's deals that others may pass on very quickly, maybe because they're looking to move at a faster investment pace. But if you take the time to really understand what could be a complex credit story, you can find some really good risk-adjusted returns because others may not go that deep.

The other point I'd make is the value of having a broader credit franchise that's linked into your underwriting business. So, at Lord Abbett, as you know, as you mentioned, we've been a leveraged finance investor for over 50 years, which is really incredible. It's really since the beginning of leveraged finance as a concept. And you fast forward to today, we're managing $50 billion across a leveraged finance universe, and we have a 30-person leveraged finance research team that is covering over 2,000 credits.

That is an incredible resource for our team to plug into as we perform our underwriting. So, most private credit investors are not industry specialists. We're really good at originating, structuring, negotiating private loans. And so to be able to go to an industry-focused research team and get the context of what's going on in that space. What are the trends in the industry? How do the financial metrics of a private company we're looking at compare to other companies in that sector? How do our margins look? How does our growth rate look? Are there any pending regulatory dynamics that we may not be aware of that could be disruptive to the market? Are there any geographic dynamics that we need to be aware of? It allows us to get a lot deeper a lot faster and is a real competitive advantage for us.

D’Souza: All right, Steve, so the first step was origination. Find the loans. The second step was analyze those loans or underwriting. Now let's move to the third and final step, managing the loans. What's your philosophy on portfolio management when it comes to private credit?

Kuppenheimer: Portfolio management I think has two different aspects to it in this context. So, the first is your ongoing monitoring and management of the positions that you've taken. And what that's going to look like is, depending on the company, we're getting monthly or quarterly financials.

We are reviewing those, updating our investment committee on performance, and keeping an open dialogue with the other lenders and the owner in the private equity firms and the company themselves about not just their historic financials, because you get financials in March that's based on fourth quarter of the previous year, but we also want to be getting their current just verbal updates on the health of their business.

And these are illiquid loans, so we don't do that with a view towards selling the loan. We do that with a view towards making sure we understand the current state of play for a company and how it's performing. Is it outperforming its projections? Is it underperforming? So, it may be a case that a company's financials are showing that they're growing at a 10% rate.

But that could still be a red flag to us if they projected that they were going to be growing at a 30% rate. So, we're going to want to understand why they're missing their projection. And it could be a good reason like it's seasonal timing of revenues, or it could be a bad reason like they lost a major company or something of that nature.

The second concept of portfolio management in a private credit context is management of the fund. So not just looking at the individual investments but how you pull them together and how you're optimizing returns for your investors. So that's going to include the liquidity of the fund, how the fund is levered.

Are you optimizing the marriage of the liabilities and the assets? And this is really a critical point. When you look at the history of corporate lending, it's not really defaults that cause the ultimate bad outcomes. Of course, that is our primary job in underwriting is avoiding deals that are not going to pay us back. But when you look at the history of stress and crises in the lending markets, they're usually crises of liquidity. Meaning you've got long-term investments and short-term liabilities. I would point to Silicon Valley Bank as maybe a recent kind of great example of this where they really hurt themselves on Treasuries just because they short-term liabilities in the form of customer deposits and long-term Treasuries.

And they didn't hedge the interest rate exposure, so as interest rates went up, they had a mark- to-market loss. But no one really thought that if they held those Treasuries to maturity they were gonna lose money. But there was a crisis of confidence in the bank, so the deposits get taken out.

And now they've run out of liquidity, and they have to sell positions at a loss. So, you're looking to avoid that. You're looking to have a great marriage of your assets and your liabilities and to have structured it in an optimal may so that you're maximizing returns.

D’Souza:  So that's been very helpful again and sort of a “101” on private credit, following the dollar through the system from the borrowers to the lenders and again with the sponsors involved, taking us through origination, finding loans, analyzing those loans through underwriting.

Let's shift topics a little bit now and go into a little more of the current events out there and some themes and trends happening in private credit and get your insights on what we're reading in the news. You mentioned earlier in underwriting the importance of underwriting a credit through a full cycle.

And it seems like recently, maybe in the last maybe two years even, we've seen a pretty big shift in the cycle overall for investments, meaning base rates jumping from zero [percent] to over five [percent], a lot of other things happening in the marketplace.

But what do you see as sort of happening or different now in private credit with that regime shift? A lotta people say, and have been saying for a little while now, it's the golden age of private credit. Has that regime shift changed that at all?

00:34:53;01

Kuppenheimer: Well, I think the last few years have been the most dynamic few years ever in the history of private credit, in my opinion, which I know is a little bit of a dramatic statement. So let me try to back it up some. I'll start where you did, Andy, which is the spike in rates and what impact that has had.

And that's had two very notable impacts. So one I'd say is for legacy portfolios where loans were underwritten at, let's say, 25 basis points in terms of base rates, for those loans to then be going through base rates going all the way up to 525 basis points, that's put some stress on those historic loans.

I still think you see strong performance by and large through the sector, but there's no doubt that's put some stress on some of the historic loans and not just in private credit, I think in the liquid markets as well. The second thing it's done, which is maybe a little bit more nuanced, is it's muted deal activity, not because companies need less financing but because the owners of those companies want to wait for a lower-rate environment for two reasons.

Number one, when base rates go up the discount rate goes up and that means enterprise values drop. So, if you own a company and it's worth 18 times, you believe, EBITDA in 2021 after rates go up to 525 basis points, maybe that's worth 14 times.

And so, an owner of that company may just want to wait for rates to come down to a more advantageous time before they sell it. And then secondly, the cost of capital goes up when rates go up, obviously, especially for floating rate product. And that's also resulted in some delays in financing activity.

So, what that's done in the private credit markets is I think it has really moderated the gap between the best credits and maybe just the good credits. So, what you've seen over the last couple years with little bit slower deal volume but still a lot of capital formation in private credit is the pricing differential between a good credit and a great credit is lower than it used to be.

What you're seeing now is a little bit of a shift, although it's the early stages. So, rates have now come down tangibly some, and maybe more importantly you're seeing agreement in the markets on where rates are going.

So not just the reduction but the agreement on the future allows buyers and sellers to agree more easily, and you're starting to see new LBO [leveraged buyout] activity pick up. And again, this isn't unique to private markets but certainly impacts private markets.

So, we're now seeing a material increase in new LBO activity. We see that in our pipeline. We see that in the deals we're being shown. I personally believe that 2025 and 2026 are shaping up to be very active years. And I say that for a couple of reasons.

First, when you have muted deal activity for the last 18 to 24 months, that puts pressure on the owners of those companies going forward. So, if you have private equity funds, yes, they're long-dated funds and their investors are signing up for an illiquid experience; they still like to see realizations over, let's say, a five to seven-year period.

And so, you take 18 to 24 months off and now investors in private equity funds are expecting to see some actual realization. So, I think they're feeling some pressure from that standpoint, and that's coinciding with this notable reduction in rates that I think lines up and should lead to increased deal activity going forward.

The other dynamic I'd touch on is the increase in dry powder in the private equity space. So private credit dry powder has increased. It's gone up to $200 billion or $300 billion, which is a notable number. But private equity dry powder has increased at really an exponential rate.

Some people estimate it to be as much as $1.7 trillion today. And very roughly, private equity likes to borrow a dollar for every dollar it invests. So those numbers roughly equate. So not all that money's getting spent in the next year or two, but it's one of the medium and long-term tailwinds that we like in terms of the use case for private credit going forward.

D’Souza:  So the dry powder, in a sense, is sort of pent-up demand.

Kuppenheimer: Absolutely. Pent-up need for private lending and liquid lending.

D’Souza:  Gotcha. And speaking of that liquid and private lending, another major part of the evolution of private credit over the years (and more recently especially), is this idea of convergence, right?

Kuppenheimer: Absolutely.

D’Souza:  And so, I want to talk more about that in terms of how you see it going forward. I think earlier this year we saw in some sense some companies that were normally going to the private markets going to the public markets and then going back to the private markets.

It's kind of going back and forth a bit now it seems. That wasn't always an option though. Could you take us through some of the evolution of how we got here today, where now a CFO has an option to issue in private or in public [markets] and could toggle back and forth? How'd we get here?

Kuppenheimer: So it's a great question and been a fascinating dynamic. I would say this was a fairly slow-moving trend up until about 2020 when you had the confluence of two things really. You had my former firm and just a couple of other ones get big enough to write over a billion-dollar check to a single borrower.

So, by definition that's now a borrower that has access to the liquid markets, as you mentioned. So that's a company that now has a choice. They can look at the liquid markets, they can look at the private markets, and decide which is the better outcome for them.

And they both have their advantages. I would say the liquid markets clearly are cheaper. That's their primary advantage and a deeper investor base. And often price will be what drives the decision. Although the private markets are more expensive, they are good at some important situations.

So, think about a take-private transaction where the participants may really value only a few lenders being aware of the transaction, versus the financing being marketed to hundreds of different liquid lenders. Or you might have a case where (and I think I mentioned this earlier), the company's business relies on not just today's financing but having more financing available in the next year or two for mergers and acquisitions that they know are coming.

That's called a delayed-draw term loan, and that's a financing tool that the private markets provide regularly and the liquid markets cannot provide. And then finally you might just have very complex credit stories, where the capital structure is complex. We have the business models complex. And private lenders can go deep, provide a more customized financing solution, versus the liquid markets which is going to be more of a one-size-fits-all tool. So those are all the reasons that you can see private credit winning even when it's a more expensive option.

But like I said, that was moving fairly slowly up until 2020, where not just a few firms got big enough to write these large checks. But then of course you had COVID, and COVID dislocated the capital markets. This now made private credit a much more attractive option because the capital markets weren't really available.

There were some loans that were attempted on the liquid side that weren't able to get done because people were more risk-off [i.e., risk-averse] and you had private lenders really provide capital in a needed time during that year or so when the markets were dislocated.

So, what you see now is those larger issuers really evaluating their options more and wanting to have access to both markets because it's good discipline. You might encounter another market where the liquid markets dislocate, and you want to be known in the private markets.

So, one of the dynamics here, Andy, is when you're competing with the liquid markets (and now they're open and they're not dislocated and you're going to be more expensive because you're private), what you do see is there's been maybe a difference in documentation.

So, for the larger loans those documents need to look more like the liquid documents. So they're probably going to have a little bit more leverage in them, less covenants.

D’Souza:  Another hot topic in the press we read about is this idea of LME, or liability management exercises, or maybe call it “lender-on-lender violence” if you want to be more dramatic about it. How has is LME and other things like this, how do they manifest themselves in public versus private credit market? Is it different again? What's similar about it and how do you think about that overall?

Kuppenheimer: Well, first, let's talk about what this is exactly. So what you're talking about in LME exercises or the lender-on-lender violence is a company hasn't performed as everyone has hoped and they're looking to raise additional debt financing to get through a period of stress.

And you will have one set of lenders either seek out or wind up with a more preferential outcome than another set of lenders, which is not what they expected when they came in. So, they all come into the loan, let's say, as first-lien lenders aligned and then there's new capital brought in that takes some of the collateral and splits it off into a new subsidiary of the company that only some of the lenders go to.

That's a common way it's used. And historically, I would say, this was seen as a rather kind of surprising and dramatic events. To your point, Andy, it has gotten more common. It's talked about a lot in the liquid credit markets where the documents are more permissive.

But it has bled into the private markets for the reason I just mentioned, which is if you're lending money to the company that is looking at a liquid loan as an alternative, they often will ask for the same documentation in terms of flexibility.

So, it has led to tension in the market to some degree. When you're in a space that's not competing with the capital markets you get far more protections on liability management exercises, basically covenants requiring that the lenders be treated the same or materially the same through periods of stress.

D’Souza:  So, Steve, as we think about private credit through the lens of the investor, what are the potential roles that this could play in their portfolio and what are some potential benefits they could realize by investing in this space?

Kuppenheimer: So what you see in private credit is a historic, very stable asset class with almost zero duration, given its floating-rate nature and high current dividend yields.

Maybe we'll take it this way, Andy. If you look at on the global investor base, who has access to this type of risk-return and who's been under-allocated to it? I think historically things like private equity and private real estate and private credit have really been dominated by institutional investors who have had the scale and access and depth of understanding to go into these spaces.

The original funds focused on these types of asset classes required very patient capital. You'd have capital locked up for anywhere from five to ten years. In more recent years there's really been evolution on more retail-friendly products that provide a lot of transparency in terms of reporting, independent governance with independent board of directors, and liquidity in terms of either interval structures or BDC [business development company] structures that tender for shares or even list their shares.

And so that's made it a far more accessible asset class. And you I have talked before about the shift, the focus on global wealth management to gain more access to alternatives. I think a lotta estimates show that only about 3% of global wealth is exposed to alternative investments of any kind.

And over the next decade or so that may need to go as high as 20% for investors to meet diversity-in-return goals. That's really an incredible amount of capital that we're talking about. And private credit, of all the alternative asset classes (I know I'm biased), but I think is just really well positioned in that space.

And the reasons are, again, it pays a high current dividend. It's floating rate so you don't have to worry about changes in interest rates having an impact on the value of your holding. And it's a very stable asset class. These are first lien, generally top-of-the-capital-structure loans to growing companies that are often in growing industries. And it can be a very stable high-return experience.

So, I think historically investors have compared it to their high-yield allocation. They've compared it to their cash allocation. And I think in recent times you mentioned some market participants referring to this as the golden age of private credit, which is a bit of a grandiose statement, but I think what is trying to be highlighted there is that in this rate environment you can get to targeted returns in this space that are competitive with historically more risky products, like private equity or private real estate. For the first time in a long time private credit is actually creating comparable returns, which is really an amazing statement given that it's at the top of the capital structure.

D’Souza:  Yeah, that's great points on the democratization of alts [alternative investments], as they say in the business. As, again, the private wealth marketplace globally increases their allocations to the space, we can hear from you today all the reasons why they would do that, and it's exciting times ahead for the asset class it feels like for sure.

Steve, thank you for the time today. We've been through a lot.

Kuppenheimer: Thank you, Andy. It's a pleasure.

D’Souza: First and foremost, it was great to hear about your background and your history and experience all the way back to the teeth of the GFC and the TARP program.

The one-on-one on private credit, follow the dollar through, thank you for entertaining me with those questions as well. And then, finally, talking about some of the themes here now, we just hit on one of them, which was the democratization of alts.

We talked about convergence. We talked about LME and lender-on-lender violence and all kinds of exciting topics like that. But again, Steve, thank you very much. Looking forward to having you on again soon. And for our listeners, thank you for joining us. Again, I'm Andy D'Souza.

For those of you who'd like to learn more about Lord Abbett's views on the market, please visit the insight section of lordabbett.com. And thanks again for listening.