Shiloh: Hi, I’m Shiloh Bates and welcome to the CLO Investor Podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news in the CLO industry, and I interview key market players. Today I’m speaking with Ted Goldthorpe, the Head of BC Partners Credit Business. We discuss some of his lessons learned in what you’ll hear is a very impressive financial career. While most asset managers grow their business by launching new funds, Ted is also active in acquiring other asset managers. We talk about why that makes sense for his platform, and we also discuss the evolving landscape of private credit and business development companies. If you’re enjoying the podcast, please remember to share, like, and follow. And now my conversation with Ted Goldthorpe. Ted, thanks for coming on the podcast.
Ted: Thanks for having me, Shiloh
Shiloh: Why don’t you walk us through a little bit of your background and we will take it from there.
Ted: So my background, I started my career in investment banking, and then during the Asian crisis I was in the FIG group. And then during the Asian crisis there became a lot of opportunities to invest in Asia, but particularly around financial institutions. So I got moved into private equity and then ultimately into distressed. So most of my background early on was on a distressed investing business. And then moved over to a group called the Special Situations Group where I ran a lot of their illiquid businesses, so things like a structured equity business, a turnaround business. I ran a Canadian business, a regional business as well. And then at the end of all that, I took over, ultimately the Global Bank Loan and distressed business on the investment side for Goldman Sachs. And then a lot of my career macro has an impact. So Dodd-Frank and Volker came out. It was much harder to do what we’re doing at Goldman
Disclaimer: Note. Dodd-Frank and the Volker Rule were regulations put in place after the financial crisis of 2008. The goal was to strengthen the US banking system.
Ted: So a number of us moved to the alternative asset management space. So I landed at Apollo where I ran their opportunistic businesses and then was there, ran their public company, did direct lending, ran their hedge fund, and then ultimately moved to start BC Partners Credit business. So BC Partners been around since 1986. It’s a very, very, very blue chip, white shoe firm that’s been around for a long time, but it had only really done private equity, so we diversified their business to credit. So today we manage about $10 billion. It’s split between sponsor finance, non-sponsored finance, and specialty finance. And we invested across a number of different, either long-term, locked up capital vehicles, or permanent capital vehicles.
Shiloh: So one of the things I’ve noticed is a lot of the leaders from other alternative asset managers got their roots in the Goldman Sachs special situations desk or bank loan trading. What was in the DNA there that got so many people their head-start in the business?
Ted: I think it was a couple different things. Number one is a really deep commitment to fundamental underwriting on both sides of the business. And then the thing that’s interesting about it is when you look at the people who grew up in the special situations group, a lot of those people have moved on to more locked up capital structures. So Fortress Sixth Street, one of the guys now has taken a very senior role at Blackstone. So that’s the path that those guys went on. Off the trading desk, originally it was David Tepper, but then post him it was Jonathan Kolatch and Ed Mule who started Silverpoint, and Anchorage, and all these amazing firms. That all came out. So it was more of like a hedge fund beginnings that’s now transitioned to institutional capital. But Goldman was very, very good about providing us capital and providing us capital at times where there was good times to invest. So the key I thought to us and our success was mandate flexibility. If we had a big investment in alternative energy in 2005, 2006, it became much less interesting. So we monetized a lot of assets and transitioned to other areas, and to this day, all of us continue to adapt to whatever the environment is. So a lot of things that I did 10 years ago, we just don’t do today. So you always got to evolve as a platform, but also as an investor you have to evolve as well.
Shiloh: So from your time at Apollo, is there a handful of lessons that you took away from that experience?
Ted: I think Goldman Sachs really taught me a lot about investing. So what makes a good investment, what makes a bad investment? And really the concept of risk-reward, and not selling tail risk.
Disclaimer: Note selling tail risk means earning a profit in calm market conditions, but exposing yourself to massive losses in downside scenarios.
Ted: And I worked with some phenomenally amazing investors there. Obviously Apollo is a best-in-class investment firm as well. The one thing I learned at Apollo is the asset management business. So Apollo is so strategic around a lot of these broad themes that you’re hearing about in the market, and they’re way ahead of people. So insurance, the rise of retail, all the big areas, origination, permanent capital, all these things that today seem obvious, weren’t obvious 10 years ago and 15 years ago. And Apollo is very, very early into a lot of these places. So I give a lot of credit to the management team over there who really sees things way down the road. And when you look at how our BC business is set up, we’re like a mini-Apollo. We have an insurance company, we have a retail business, we have a bunch of permanent capital, and we have institutional funds. I learned a lot from them around the importance of focusing not only on the asset side but also the liability side and your funding.
Shiloh: So why was BC Partners a good platform to build out your credit business?
Ted: Good question. So in a publicly traded context, incentive fees don’t really get a multiple. So management fees trade a big multiple. The reason why BC is interesting is the private company. So I think the partners here are indifferent to how we make the money. It’s just a matter of making the money. So it fits our investment style a lot better. I mean, typically my DNA is invested in higher returning type asset classes, and those asset classes oftentimes are much more incentive fee-based versus management fee-based. So because we’re private and because we’re a partnership, a lot less pressure on us to grow. And at the end of the day, even though Apollo’s all about making as much money as they can, again, incentive fees just don’t trade a great multiple, and in a partnership, that issue is not as relevant. I think Apollo is still in that business, but a lot of other big asset managers have exited that opportunistic business and that’s created a huge opportunity for us for this exact reason we just talked about. Opportunistic is hard. You need a lot of people, it’s risky, it’s headline risk. And at the end of the day, if you’re not going to get value for it in your stock price, why are you burning the calories to do it?
Shiloh: I think people in the market look at it as the management fee is a perpetuity, and they’ll put, like you said, a very high multiple on it, and then for incentive fees, you could have earned nice incentive fees for 10 years or more, and a buyer will look at that and assume you’ll never make an incentive fee again. So that discrepancy is really quite stark in the market
Ted: In Apollo, I always called it recurring non-recurring revenues. Apollo would always get incentive fees, and we couldn’t tell you exactly where they’re going to come from, but it’s not like we got zero incentive fees some year. We always got ’em from somewhere. But as a shareholder, it’s hard to underwrite that. It’s hard to model out incentive fees across a lot of different businesses over time. So people just give you zero credit for it. So there’s a little bit of a public-private arbitrage.
Shiloh: So recently I listened to a podcast where you were on, CreditFlux, and they asked you a question about is private credit a bubble? Is it overheated? And just would love to hear your answer, your take, on that question.
Ted: I got to remember what I said, but listen, I mean, to me, it’s every day for the last 15 years I’ve read on the front page of the paper, “Bubble in Private Credit?” and I think people look at the amount of money that’s been raised, and view it as a lot of money. If you track it versus private equity, it’s actually lagged. Most of private credit, it’s only 40% of our business, but a lot of private credit money is used to back private equity deals. So private equity has grown faster than private credit. That’s number one. Number two is when we started the business, we used to focus on companies with 10 to 50 EBITDA. And I remember a huge milestone in our space is when Blackstone did the first billion dollar unitranche. And that today happens every day. So that was only 10 years ago. And instead of doing these, it used to be called middle market lending. Now private credit is doing much bigger hold sizes and competing not only with each other but also with the banks and the syndicated markets. So the high yield market has shrunk, as has the loan market the last couple of years. And a lot of it is the private credit markets taking share. And again, 10 years ago, we did not compete against liquid markets. Secondly, we’re pushing into a whole bunch of new areas that we didn’t play in before, that used to be dominated by the regional banks. So GP, NAV financing, lender to lender finance, all these other areas, consumer finance, again, 10 years ago, 15 years ago, that was GE Capital. And I remember when I worked at Apollo, people were talking about the bubble in BDCs and all this stuff. GE capital’s middle market lending business was larger than the entire BDC sector combined. So if you took every BDC and add ’em all up, and you added up all the middle market credit managers, they were smaller than GE Capital. So GE Capital isn’t here. As much as people talk about new entrants, people don’t talk about the big people who’ve exited and the size of those numbers. So I think Silicon Valley Bank is 20% of venture lending, and they’re not making new loans right now. That’s a huge impact on supply-demand. Wells Fargo used to be our biggest competitor. We haven’t lost a deal to Wells Fargo in 15 years. As much money that has been raised, there’s also money that’s shifted out of the banking system, and being redeployed in other places. So it’s not apples to apples. It’s a very long-winded answer of saying, I find it very ironic when banks call our sector the shadow banking system. I always find it very interesting because everything I do is published and every investment I make is in my 10-K. And you go look at a bank, we have no idea what they own. You can’t itemize out every single loan they’ve made. So I find it ironic that they call us the shadow banking system when that system’s much more opaque than us.
Shiloh: Well, sure. And there’s a lot more exposure to commercial real estate for banks as well. And then when we were maybe prepping for this call a while back, one of the things you teased me with is you mentioned that you occasionally teach at Harvard and Columbia. Would love to hear some of the advice you give to MBAs who are thinking about maybe entering our business.
Ted: My advice would be: This is an awesome job. I have the coolest job in the world, and I think when I was in college, I didn’t really understand. I went to investment banking and I thought I knew what it was, but I didn’t really know what it was. And same with private equity. I went into Goldman Sachs’s private equity area and I thought I knew what it was and it wasn’t. So all I’d say is we have the coolest job. I wake up every morning, I get to learn about businesses, I get to meet CEOs of companies. I probably meet 20 management teams a week, and what we do is super interesting. And just think about this versus anything else I could have and would’ve done. We have an unbelievably interesting job. So I’d say that’s number one. And then number two is, I always say the same thing, which is you can’t really have a long-term plan. So it’s good to have a five-year plan and a 10 year plan, but when I was investment banking, I didn’t even know what distressed debt was. And then here I am a couple years later on a distressed debt business doing stuff that I didn’t even know what it was three years ago. So the advice I always give young people is, a lot of your career, you have to make micro decisions. People always say stuff like work for good people. And to me that’s like, of course. That’s like saying marry somebody you like. Of course you want to work with good people, but you have to take a step back sometimes and look at the macro. During the 2006 time period, it wasn’t like people thought housing was cheap. Everybody knew the subprime thing was crazy, but obviously people didn’t forecast severity. They didn’t think that it was going to unwind and Lehman would fail. So I think you have to take a bit of a macro approach, too, when you’re picking a career, in the sense of it’s probably not a good idea to go into the cigarette business today. But when you look at other businesses with tailwinds, if the industry is doing well, oftentimes there’s a lot of opportunity for young people to do well as well. I’ll say one more thing, and this is what I always say to people: People always say “take a risk in your career”. And I can’t disagree with that more. What I always say is take calculated risk. To go to some startup out of college and try to become the next Mark Zuckerberg and be the 10th guy there… For every one of him, there’s thousands of people who are not him, and then you don’t have a brand on your resume. So it’s always good, if you can, to start at Apple, or Amazon, or Goldman Sachs, or McKinsey, or somebody like that. And if you are going to go to startup, make sure it’s calculated risk versus just risk.
Shiloh: Do you think the distressed debt business is a good one for investors today?
Ted: I got to be careful on this one. I just don’t think distressed debt is a good asset class. If you back-test returns for a very long period of time, distressed returns are not that great. And what I would tell you is I think distressed is a really interesting asset class, every four years, but it’s not always interesting. So going back to my comment about mandate flexibility, having the ability to do distressed is really important, but if you’re only doing that, it’s a really tough business. So today, distressed debt’s not interesting. And it really hasn’t been interesting for a while. Even in 2020, just because it was a broad selloff, you could buy Charter bank debt, cable company, who knows what’s going to happen in the pandemic, who knows what was going to happen in the next couple of years? No one knew a vaccine was coming out. The one thing you do know is people are going to pay their cable bill and they’re going to do that every month, or more importantly, their high-speed data bill. So that bank did trade at like 78. Meantime, cruise line debt was trading at 70. So yes, cruise line debt was cheaper, but who knew that? Yes, we all thought people would get back on cruise ships, but we didn’t know when and how long and how much cash they’d burn through in the meantime. So just buy the easier thing. Even 2008, you could buy anything at 60 cents. I don’t view that as a great distress cycle. You can go buy great companies bank debt at 60, 70 cents. You didn’t have to go buy some piece of — company that has a terrible balance sheet. So I think the last real good distress cycle or good relative returns was in the early 2000s, post Enron, WorldCom, Adelphia, all these things all happened at the same time. It was an unbelievable time because the market hadn’t reached a level of sophistication that it’s today. Today, there’s such sophisticated people in our market, and when I say that I’m not just talking about Oak Tree, I’m talking about Eaton Vance and Fidelity. They’re very sophisticated in this area now. And unless you have a ton of capital, you don’t want to go into distressed because you get run over in these LME trades and creditor-on-creditor violence. If you’re a little guy, you’re going to get absolutely destroyed. And I just don’t think it’s a good idea to do that.
Shiloh: Do you think part of the last attractive opportunity set is just a function of how much capital has been raised in these distressed funds?
Ted: One thing that’s always talked about in newspapers has been a great thing is the rise of passivity. ETFs, no fees, outperforming active management. In 2020, we had six of our seven worst trading days of all time, in a row. And you and I could debate this, but it wasn’t worse than 2008. So why is it that we had our six worst trading days in 2020 and not in 2008? And the answer is, everybody we were buying debt from in March of 2020 was an ETF. So when an ETF gets inflows, they buy stuff, and when they get outflows, they sell stuff. So when we went to business school, we learned about the efficient market hypothesis. And obviously when so much of the market now is in passive hands, it becomes much more flow and technical driven than fundamental driven. And that’s, by definition, not efficient. So the key, I feel, is to buy assets during periods of dislocation, and then sit on the sidelines for the rest of the time.
Shiloh: And then in terms of the, maybe tracking back to the MBA classes where you’re guest lecturing, besides what they should be doing as career advice, is part of what you’re lecturing there, just what are some differences you should expect from what you’re learning in the classroom versus what you’re going to experience in real life in the job? Is that a big part of what you’re teaching?
Ted: Yep. There’s 10 key tenets to my business school education, most of which has been wrong. For example, you learn that classic formula: inflation plus currency equals… Currency should always adapt to the inflation rate over time. So if the markets were efficient, why is there a Japanese carry trade that’s persisted for 25 years? So like the markets had a massive spasm in July around the unwind of the carry trade. And again, if the markets were efficient, and that formula held, that carry trade existed for a long, long time. That’s just one example. Or I use the efficient markets hypothesis, which you know what that is. And then again, the world’s changed. The number of banks has declined by a lot. The number of public companies is down a lot, 75%. And more and more capital is flowed into alternatives. The world is a very different place today than it was 25 years ago. The idea of Apollo and me being super excited about insurance is we had that conversation 25 years ago, be like, what? How is that exciting? But now it’s exciting.
Shiloh: I think some of the differences I’ve noticed would be in school you learn valuation is DCF, and if you start in my firm of yours and that’s your first inclination is to do that, that’s probably not going to get you very far because there’s just so many assumptions. It’s correct theoretically, but you have to put so many assumptions into a DCF that, at the end of the day, probably not super useful, but things trade at a multiple, they trade at a multiple of earnings, or they trade at a multiple of EBITDA a and that’s really how people think about it. And then the capital asset pricing model, beta times the return, less the risk free, or people using that. Maybe you’d find that if you hire a valuation expert, and they put together a 40 page valuation on something, maybe that would be in there somewhere. I think it’s good to know the theory, but it’s not what practitioners are doing. We think about risk, really, as it’s something that you have intuitively in your head after a ton of reps, as you’ve said in a previous podcast, but there’s no way to necessarily quantify… When you invest in a middle market business, there’s some chance it’s going to go bankrupt. That’s the risk you’re taking. But how you would really put a number on that to quantify it, I think that’d be really challenging. And the risk is low. It’s a low number.
Ted: I agree with that a hundred percent. It’s good to learn this stuff because it’s the theoretical underpinnings of, again, six times EBITDA, and that’s cheap, ties into a DCF. You can actually tie it all back to theory, which I think makes sense. But your point about beta is a good one. Why is it that Bitcoin gold stocks are all trading at all time highs? Spreads are all time tights and Treasuries are rallying. That doesn’t make any sense. Every correlation’s gone to one and we think about portfolio diversification and allocation of capital. Again, these things are supposed to move in different ways. And when correlation goes to one, it comes back to we’re supposed to rethink some of these asset allocation models.
Shiloh: So one of the things I think you’re doing at BC that it’s very interesting is that most of your competitors, I think they’re just growing by launching new funds. And at BC Partners, it looks like acquisitions is part of the strategy. So I’d love to hear how you think about that and what you’ve accomplished thus far.
Ted: Credit’s very different than equities. You and I could start a hedge fund in equities with $30 million and make money, and you and I, 20 years ago, could have started a credit business with you, myself and A CFO. The barriers to entry are so high and the costs are so high, fees have gone down, compliance has gone up, legal has gone up. So you need a big business. When people talk about all these people entering private credit, it’s just not true. It’s the same people, they just have a different business card, but it’s not that easy to get into our business. So I think the reason there’s opportunities to buy is scale is becoming very important, and both to service our clients. So as their deals get bigger, we have to hold more and more debt from them. And on the GP side, for us, the economics of our business, we need to invest in distribution. So we need to hire IR people and build out our retail distribution, everything else, which is expensive. So you need scale to be able to do that and it becomes like a flywheel. So I’m not saying AUM is, we’re big into controlled growth, but for example, there’s a space called the business development company space, or BDCs, and there’s a number of sub-scale BDCs that just didn’t trade well, that couldn’t grow. The management team was stuck. We took five of them and rolled them all together and now we have a bigger BDC, and it trades better, and shareholders are really happy, and we’re more relevant to clients. Scale has just become more important, and sometimes buying is better than building. I think people look at it and say, well, why you spend all this money? For me, I’ll give you an example. We bought a retail business and it came with a team and a five-year track record and AUM. If I started that business from scratch, it would’ve taken us five years and I would’ve spent more money than what we did on the acquisition. So you obviously grinded it and did it organically, which is one way to do it.
Shiloh: Yeah, for us it was just organic.
Ted: And it was great. And you guys have had massive success, but for every one of you, there’s a lot of notyous. So you guys have done the best amongst a lot of people. We just made the decision to de-risk. Let’s buy it. It’s going to cost us the same to build it, and if we build it, it’s not without risk. You guys have had great performance, great AUM growth. That’s not a guarantee when you start a business.
Shiloh: Do you find it’s a competitive space, acquiring other asset managers that are subscale, or maybe haven’t had the same performance you’ve had?
Ted: I think there’s a big valuation arb between big platforms and not big platforms. Because Oak Tree is not going to pick up the phone for a hundred million dollar BDC. It’s a waste of their time. They raise more money in a day than the four month process for them to buy it. So when you look at the big BDCs that have sold, they’ve traded a big multiple premium to the small ones just because who’s going to waste their time on a small BDC? So this is my own view. I don’t think it’s that competitive. And the reason for that is because most of my peers are pure investors, so they’re really, really good at investing. To buy companies there’s a whole separate skillset. It’s M and A, it’s social, it’s pitching boards. It’s convincing shareholders that you’re doing the right thing, getting shareholder votes. There’s a whole other set of things you need to do. So I think everybody fantasizes about it and wants to do it, but they don’t really know how to do it. And it’s not rocket science. Anybody could do it. It just takes time and you have to go for a lot of beers and you have to grind out on these processes. Obviously it’s competitive, but I think we’ve shown that we’re pretty good at it. And then once you do your first one, it becomes much easier to win because people now see, okay, you got this done. They talked to the employees who came over who were super psyched to work here, and it becomes a little bit of a self-fulfilling prophecy.
Shiloh: Are you surprised that there’s not more M and A activity in the BDC space? Because it seems like there’s a lot of BDCs trading pretty substantial discounts and not really a lot of shareholder activity pushing for change. How do you think about that?
Ted: I think a lot of the BDCs that needed to get merged have merged. I don’t think you’re going to see a wholesale wave of BDC mergers. I think there’s some niche areas within BDC space that probably need to be consolidated, but by and large, I think a lot of that consolidation has been done. I think the one thing that people aren’t talking about is there’s lots and lots of money that have been raised to do BDCs, interval funds, et cetera, that are subscale in the non-traded space and there’s a lot of stranded assets and funds in that space. So it probably makes sense for some of those guys to come together or merge with a public company. So I think if I had my crystal ball and rolled forward three years, I think a lot of the M and A will be private companies either merging with public, or private companies merging together. And things like closed-end funds. There’s lots and lots of closed-end funds that don’t know what to do. They’re perfect candidates to merge with. So I think you’re going to see what I would call non-traditional M and A.
Shiloh: One of the things we’ve seen over the last few years is that there’s a real trend towards just the private BDC, which stays private perpetually, rather than going public. Is that something that your LP investors are more interested in that structure than the traditional publicly traded BDC? Is that what you’re seeing?
Ted: I think there’s different markets for both. So my shareholders in my BDC are pretty different than my LPs and my private BDC. And again, a lot of my LPs in my BDC want the steady distribution of cash. They don’t want the daily mark to market and the stock, and they want to be tied to NAV, not market. So I think it’s two different buyers. And if we could take our BDC public at two times book, I think our LPs would be pretty open-minded to it. But I think LPs have a bit of a fear that these things go public and trade at a discount. So you get dinged on your net asset value, or at least market trading price.
Shiloh: Would you say BDC is an asset class that overall has performed well for investors and that people should have a decent allocation to in their portfolios?
Ted: I think so. Take a huge step back. Everybody always stares at stock prices in BDCs, but they don’t look at stock price plus dividend yield. So my stock pays the 13% dividend yield. That’s a lot. So you can withstand a lot of mark to market because we’re paying out so much cash to our investors. BDCs over time, I think, have delivered for shareholders, and you get what you pay for. If you back a high quality manager, they’ve done very well. So something like an Ares has done incredibly well, fundamentally and stock price-wise and also been able to grow. So I think if you were a good credit underwriter, and you’re balanced about growth, I think they’re great investments. And again, it’s changed a lot. When I started in the space and took over, I was running, I think, the second biggest BDC at the time. It might’ve been the biggest. At that time, most BDC managers were entrepreneurs, and if you roll forward today, it’s institutionalized. So KKR, Carlisle, Blackstone, best in class firms, all have BDCs, and the entrepreneurs are largely gone. So if you roll back 15 years and look at a comp sheet, basically they weren’t attached to a large asset manager, and now the space is institutionalized. So what does that mean? I can’t say that they’re better investors or not better investors, but KKR is not going to miss-mark their portfolio. So some of the noise around some of these books that Einhorn wrote and everything else,
Disclaimer: Note: “Fooling Some of the People All of the Time” by David Einhorn is an excellent book about investing in business development companies.
Ted: The reality is these firms are too big and too important to screw around with shareholders. So the worries around bad behavior and stuff have just gone away.
Shiloh: One of the things I saw during the COVID downturn though was a lot of the BDC share prices got cut in half. So if you got an exposure to a portfolio of secured loans, mostly first lien, some second, and then some other funky stuff, and down half is what you get in a downside case, I mean that really pretty unfavorably skews your risk return. That was my takeaway from COVID.
Ted: Fair, but I view it the other way around. Which is, just take 10% defaults. So in 2008, defaults in the broadly syndicated market didn’t hit 10%. And the broadly syndicated market typically has higher default rates than the middle market. So just use the number of 10%. And in the middle market, recovery’s been 80. So a really bad year for a BDC would be to lose 200 basis points of NAV, unlevered, and then they’re levered, so call it 4%. So if a BDC stock trade is down by 50% and they own first lien debt, you should buy the stock. I view it as a buying opportunity, and if you own it, buy more. And that’s always worked. Anytime you buy BDC at a big discount to book, these things always normalize and they revert to the mean. So anytime you can buy one of the best in class guys at 90% of book, they almost always go back to book. And when they go to 110 of book, they oftentimes will trade back down to 90. So in my experience, there’s been a big reversion of the mean trade and there’s some really smart BDC investors who’ve made a lot of money by doing that.
Shiloh: Do you think that in general the fees in BDCs are too high and that’s what has some investors shying away from the asset class?
Ted: Again, I think everything you have to look on a net return basis. So those platforms who’ve cut their fees are, generally speaking, not best in class. So if you correlate fundamental performance to fees, there’s no correlation. Meaning those who’ve cut their fees, typically, are guys who have not performed well, and those who have the high fee structures that perform well. So I tend to come at it, like, you get what you pay for. I know certain hedge fund allocators, they will only give money to managers at really low fees and they don’t understand why their performance is poor, and they have to understand you’re getting adversely selected. I just think you get what you pay for. So the thing I think that is a bigger issue is the differential in fees between what public shareholders pay, and in certain cases, what private investors pay. And maybe we have a debate about the differences, but the differences in some cases are too high, and that’ll normalize over time as well.
Shiloh: And then transitioning to CLOs, I know you guys have a few that you’re managing, should we expect to see more issuance from your platform over the coming years or how are you viewing the CLO product as being useful to you?
Ted: Well, I’d say a couple of different things. One is a CLO business to us is strategic because you have a library of every credit out there. So when there is a downturn, you can be aggressive and opportunistic in the whole business, and you’re more relevant to the street, and everything else. So that’s number one. Number two is one thing that you do, which I think is an awesome business that quite frankly, listen, you’re best in class and I’m not sure that we would be, but CLO is a great asset class. You just have to hold it in the right place. So if you look at 2008, no CLO has defaulted. In the height of structured products, carnage, CLO equity performed and CLO liabilities performed. So I always think CLO liabilities provide really off-market risk return, always, in any environment and in periods of stress, crazy risk/reward.
So it comes back to size. It’s very hard to source that stuff in big size during downturns. It is a weird conversation because I feel like you’re the professor, I’m the student, and I’m lecturing you on it. But the reality is it’s very hard for me to say that CLOs and CLO liabilities and having that capability isn’t great risk reward in many different environments. So I think the problem, it gets tainted a by broad structured products and the subprime mortgage crisis has nothing to do with subprime mortgages. They’re totally different and the abuse that happened over there just doesn’t happen in CLO land.
Shiloh: I think the difference though, by contrast, our CLO equity or double B investing versus just owning middle market loans directly, in like a GPLP fund or a BDC, it’s just that all the CLO securities, they’ve got a CUSIP, they’re trading around in the market, they’re modeled in Intex so anybody can see what’s going on. And if we’re trading, or somebody else is trading with a bank or a hedge fund, a lot of those trades are reported. So you’re going to see volatility in CLOs, CLO securities, that’s going to be quite different from just holding a middle market loan directly. In middle market loans, we see, a lot of times they’re underwritten at a price of 98 cents on the dollar, and if everything goes according to plan, the mark will be around that price for the five-year life of the loan, call it. And even if the loan underperforms, I think different managers would mark it differently. Some take a more optimistic look at it and say, “oh, well this has underperformed, but I still think I’m getting my money back and it’s near par”. I think other people would take an approach that would have the loan marked at a discount, but the end result is that the middle market loans do have a lower standard deviation than the CLO securities, less volatility, and some GPLPs just want that. But if you’re holding it for a long period of time, and you can bear a drawdown on your NAV, then my DNA is the CLO. That’s what I like.
Ted: I think that’s very well said and that’s why I made the comment earlier about just make sure you own it in a place that has locked up capital or you can withstand mark to market.
Shiloh: So is there anything that’s interesting to you that we haven’t talked about, or anything that’s going to keep you busy this fall?
Ted: The thing that I’m spending my time on is, so if you think about the business of a GP, we can either scale assets very quickly, but they’re low margin and there’s other things we can do that are high margin but hard to scale. So the question is what scalable platforms are there that are high margin? So a place that we’re really active in is, and I mentioned it briefly before, is we’ve spent the last 15 years replacing banks in corporate lending. And now if you look at for the next 10 years, I think we’ll replace the regional banks for a lot of things that they do. So lender to lender finance, factory and equipment finance. It’s a strange world right now. Blackstone is able to provide us with financing. So five years ago we would’ve gone to Credit Suisse, now we go to Blackstone. We can go to other people too. Or if you think about, Apollo bought Atlas, which is Credit Suisse’s securitization business. If we had a security, something that was complicated and whatever, that’s an amazing business. So now if I have to securitize something, I’d go to Apollo. It’s interesting to see the evolution of all this stuff. When we had a problem, we used to go to the banks and the banks would help us solve it, and now oftentimes the banks come to us and they want us to solve their problems in terms of risk transfer, or reg cap relief, or leveraged finance businesses feel like they’re getting their clocks cleaned by private credit. So how do we monetize our origination efforts with your balance sheet? So there’s some really interesting dialogue and partnerships going on right now with large banks where we think about what a bank is, they have an amazing front end and amazing origination. What are we trying to build? We’re trying to build that and we have a balance sheet that is able to take on these assets. And to your point, we’re not dealing with ratings and risk charges and the Fed and we don’t have to deal with that stuff. We’re heavily regulated and we obviously have things that we’re regulated by, but it’s a very good marriage in a lot of different situations. So this whole private credit thing, I still think we’re in early days. We’ve replaced middle market lending. Now they we’re replacing large lending, now we’re going to replace the regional banks. Athene now is bigger than Swiss RE, I think. So our world is now taking over insurance and I’m actually really, really excited for the next 10 to 15 years, and I just think there’s so much growth ahead of us.
Shiloh: Does the asset based lending and the securitization that banks are doing that’s maybe being moved to alternative lenders, does that really offer returns that are interesting to your investors? I thought of those asset classes as being quasi-investment grade or at least highly internally rated at the banks.
Ted: So after Silicon Valley Bank, the average bank has a 25% mark to market hit to their equity. A lot of it’s driven by rates. Everyone thought there’d be a lot of M and A. Well, if there’s M and A, then you’re merging with somebody else. You still have a big hole in your balance sheet. What banks used to do in the US is they used to issue equity, but Silicon Valley Bank tried that and there was a run on the bank. So the only real solution is to ramp back on lending, and that gap over time is just going to close as things mature and duration shortens. So that’s what’s going on. Again, all this will normalize, but spreads are wide and do work for our investors at current pricing. And there’s other things we can do like back-lever it and do some other things that get to the returns that we need to get to if we want to do that. But you’re making a good point. We don’t really have a whole bunch of L350 or L400 products. We just can’t compete because if I raise money in that space, I can charge 30 bps, 40 bps, and I need an army of people to do that business. We just can’t make money doing it. What we can make money doing is if we can get a little bit higher yields, then you can charge a hundred basis points and then just do the math. We can actually afford to hire a team and build out a business. So the only counter to all that is if you can get stuff rated. So a lot of what we do is we originate illiquid stuff at wide spreads, we get it rated, and now they comp incredibly well to liquid credit and we sell that to insurance companies. That’s becoming a very large part of our business.
Shiloh: So the SRTs, that’s the significant risk transfer, so that’s banks selling exposure to investment on their balance sheet and they’re doing that rather than issuing new equity to the market. Have you guys been involved in that?
Ted: So we’ve been acting in that space for a long time. Deutsche Bank has a program called Craft. They have a new one called Loft, but now we’re actually seeing it at a much smaller level. We saw one from a HUD based lender, smaller bank that, again, would never have done one of these 10 years ago. So it’s becoming much more relevant for not just the big, big banks, but for a lot of banks. And it’s a win-win. If I’m taking a revolver from Bank of America as a company, you don’t want to see a distressed lender showing up at your door owning your revolver. You just don’t want that. So this is a way for them to maintain their client relationships, maintain a front end with these clients, but from a risk capital perspective, get off their balance sheets. It is a win-win, and these things price at a place where it’s very hard to lose money. You may not make lots of money, but in terms of risk return, it’s hard to lose money. All that being said, the caveat to everything I just said is the thing that SRT that always keeps me up at night is you’re selling first-loss risk. And it feels a little bit, and I dunno if you agree with this Shiloh, but it feels a little bit like we might be going into a more elevated default cycle. So if you’re doing first loss risk and defaults go up, those things aren’t good combos. So with the economy slowing down, and again, I’m not a macro economist, but it just feels like it’s slowing down, and that usually leads to defaults, and that usually leads to bad things for SRTs. So that’s the two sides of it obviously.
Shiloh: Is one of the issues, and I haven’t looked at SRTs that much, but they’re obviously quite close to CLOs in structure. But in the SRT, it’s a pool where they may be a hundred designated assets at first and then the portfolio changes over time. Not sure how you’re in the first loss there. I guess you’re underwriting the bank’s underwriting, and getting comfortable that the loans that they continue to underwrite and put into this vehicle are ones that fit into your credit box.
Ted: So I would say the way these are typically structured is one of two ways. So either do it against a static pool, which you can underwrite. More often than not, it’s a identified pool of loans and the bank has the opportunity to recycle some of that capital in what I call a credit box. So they obviously can’t start putting in derivatives and a bunch of random stuff in there. They have to fit a certain box, whether it’s regional, leverage levels, rating, so you can put restrictions on what the can and cannot do, and make it so it’s not purely a blind pool. And that puts limitation around the business. And then if you look at that static pool of loans with a three year reinvestment period, really you’re only taking exposure to 20% of the assets rolling off or something. So you can actually get comfortable with it from a bunch of different ways.
Shiloh: Are you finding the SRTs that you’re interested in, or do they have assets that look similar to your private credit portfolios, or are they pretty heterogeneous in what’s in there?
Ted: So the classic SRT that we see is the relationship lending book of big banks. So every time they do a leveraged finance deal, Deutsche Bank takes a piece of the revolver, and it sits on their balance sheet, and then they do a SRT to get that off their books. That’s the classic trade. So when we see these things, you would know all the obligors, it’s all liquid loans. We are beginning to get into more esoteric loan books, but those require a lot more work. So if you’re going to get into private credit assets, and you don’t know who these obligors are, that’s obviously a lot more work. So a lot of times the banks, when you look at who they own, they own GM, they own Pfizer, they own companies that you know. Verizon. Companies that are rated well and you know and can box credit risk. More and more and more the new ones we’re seeing, for the smaller banks, we typically don’t know any of the names, so we have to do a really deep credit underwrite. So those take a lot more time.
Shiloh: Interesting. Well, Ted, thanks for coming on the podcast. Really appreciate it.
Ted: Thank you so much.
Disclaimer: The content here is for informational purposes only and should not be taken as legal, business, tax, or investment advice, or be used to evaluate any investment or security. This podcast is not directed at any investment or potential investors in any Flat Rock Global Fund.
Definition Section
AUM refers to assets under management
LMT or liability management transactions are an out of court modification of a company’s debt
Layering refers to placing additional debt with a priority above the first lien term loan.
The secured overnight financing rate, SOFR, is a broad measure of the cost of borrowing cash overnight, collateralized by treasury securities.
The global financial crisis, GFC, was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009.
Credit ratings are opinions about credit risk for long-term issues or instruments. The ratings lie on a spectrum ranging from the highest credit quality on one end to default or junk on the other. A AAA is the highest credit quality. A C or D, depending on the agency issuing the rating, is the lowest or junk quality.
Leveraged loans are corporate loans to companies that are not rated investment grade
Broadly syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations, and often traded by market participants.
Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity
Spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds or another benchmark bond measure
A reset is a refinancing and extension of a CLO investment period
EBITDA is earnings before interest, taxes, depreciation, and amortization
An add back would attempt to adjust EBITDA for non-recurring items. ETFs exchange traded funds
CMBS are commercial mortgage-backed securities. A BDC is a business development company
Basel III is a regulatory framework for banks
Efficient Market Hypothesis posits that it’s hard to consistently beat the market
GP NAV lending refers to lending against the equity value of a private equity firm’s investments
General Disclaimer Section
References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to, securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Flat Rock Global disclaims any responsibility to update such views.
This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation, offer, or solicitation to buy or sell any securities, or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from, any investment-related course of action as neither Flat Rock Global nor its affiliates are undertaking to provide impartial investment advice, act as an impartial advisor, or give advice in a fiduciary capacity. Additional information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.
