Inside Private Credit: What the Market Is Missing

Kristian Kerr (00:00):

Welcome to this Week's Market Signals. I'm your host Kristian Kerr, and I'm excited to have Andrew Deck on as this week's guest. Andrew is the head of alternative investments at LPL on the product side. And just given his bird's eye seat in alternatives I think he'll have a lot of unique perspectives to share with us today. Andrew, welcome to Market Signals. Thank you. To kick things off, can you tell us a little about your role here at LPL and maybe quickly walk the audience through your background? Sure.

Andrew Deck (00:28):

So Andrew Deck, I lead alternative investments, as you said. So that is the evergreen space and the finite life, the drawdown side of things. I used to describe it as semi-liquid and illiquid, but we're moving away from those terms given what's going on in private credit right now. So been at LPL for a little over two years, about two and a half years in this role for about two years. It's my first venture on the retail side of things. I've been entirely on the institutional side up to now about 25 years. On the street I was a former PM and a couple hedge funds headed risk and trading at some hedge funds, and I spent the GFC at Blackstone in their fund to funds.

Kristian Kerr (01:06):

Okay. Diverse background across kind of all areas and alternative investments. I think that's going to be a really interesting conversation today. Let's not beat around the bush. Let's get into what is driving the narrative right now. And that is private credit. And given your time at Blackstone, I think you can give us some good perspectives there. So what's your take on what's going on in private credit, is it bumping the road, GFC part two?

Andrew Deck (01:38):

Definitely not GFC part two. I've heard some advisors liken this to this generation CDO, which is just kind of absurd to think about. You're talking private credit right off the top where you're talking leverage anywhere from like a quarter turn to a turn. To liken that to a CDO where you had 10 to 20 times leverage, it's just not the same thing. And with GFC, the comparison to GFC, even if you do the basic math, and let's say that you take the worst case scenarios across the board from a default rate to recovery rate to a distribution rate on the underlying funds, you're not actually talking about nav losses here. You're really just talking about kind of this bump in the road to use your phrase of maybe you have a few years of muted returns, maybe you're making no money, maybe you're making a point. But it's definitely just a bump in the road. And frankly, I think it's very much overblown.

Kristian Kerr (02:42):

Okay. And I gotta imagine what you're saying, there's going to be a lot of dispersion among managers going forward. So say this is a bit of a normal credit cycle, everyone kind of does well with the tailwind of the expansion phase, and now we're kind of past that, so now we see who's really a good manager or a mediocre one. Right?

Andrew Deck (03:06):

Oh, completely agree. And it's also, even when you look at, even if you took what's in the media at face value and you look at what's being said, there are managers and products that have very little exposure to the software space, and that's really what the driver is here, right? It's like there's a lot of talk around COVID-era loans and you saw that with Medallia and advanced care, I think is the latest one. That just defaulted. Those are COVID-era loans, 2021 that were done. And you're talking about software and the impact of AI. We went through this with the cloud, we went through this with blockchain. We're going through this now with AI and there's going to be winners and losers to sit there and say, oh, you've got 40% software exposure. Not all of those are going to be losers. Some of those are going to be AI winners. So, to use your phrase, there's a wide dispersion.

Kristian Kerr (04:11):

And a big cushion, right? Saying, oh, there's a massive cushion. But to push back a little, I think roughly a little less than a quarter of private credit is in software. So how do you work through that level of concentration? Does that just lead to the dispersion we're talking about?

Andrew Deck (04:29):

I think it does. Yes, it leads to the dispersion. Yes, it's going to lead to some losses in the sense that you're going to see some down months on your nav and things like that. But let's take that math for example. Let's say a quarter of it is software, and let's just say over the next four years, all of them go bankrupt, all of 'em. So you're going to lose 25% in default. Okay. Worst case scenario we're seeing was a recovery rate 20%. That was kind of the worst case in reality. Look, recovery rates are going to be much higher than that. But let's do a worst case recovery rate of 20%. Okay. So you're going to recover 5% out of the 25%. So you're going to have 20% of nav losses. Okay. You're going to spread that over three, four years. It's not going to all happen at once. So you're talking 5% losses on nav per year over the next four years. Okay. On an asset class that has distribution rates currently in the eight to 10% range, let's take those down to six. So you get a 6% distribution rate on an asset class, and you're still not losing money.

Kristian Kerr (05:50):

No, good point. So, you mentioned the vintages. Coming out of the low rate era post-pandemic. Just given that, there's always this maturity wall of boogeyman that's around the corner. And you and I have been around markets long enough to where, sometimes it is and more times it isn't. How are you viewing that potential kind of upcoming hurdle?

Andrew Deck (06:17):

Well, there definitely is maturity walls that are coming up probably late 27, 28, 29 are really where those walls tend to come in. Looking at 2020 and 2021, when those are going to come due. In the grand scheme of things, private credit right now is about $2 trillion. Even if you take a lot of the retail money out of the private credit space, banks are going to come in and re-underwrite those loans. Jamie Dimon was very vocal that they'd missed private credit due to regulation, and banks have been looking for an entry point to get into this, to get back into this type of lending. So they're going to step back in, and again, there's going to be winners and losers because some are going to get rewritten at much higher rates. Some won't get rewritten at all, but in general, that capacity is going to get taken up.

Kristian Kerr (07:15):

And if it's a 27, 28 story rates could do anything between now and then. Which tends to be how the maturity wall dissipates. A lot of times the markets are either wrong or too ambitious on where they think rates are going. I guess another question, a lot of the headlines we're seeing, a lot of the narrative is being driven by the retail side, right? So I'd love for you to speak a little bit about how, the gating aspect, it's a feature, not a bug. And maybe talk a little bit about that as I think that's really important here.

Andrew Deck (07:53):

It's very important. I've been talking a lot to our sponsors around, we as an industry need to do a better job educating and putting the right narrative out there around what these products are and what they aren't. And that's why I said, I used to describe my job as overseeing semi-liquid and illiquid, and part of that is we need to stop calling them semi-liquid because of that gating feature. And a lot of times, that gating feature is typically 5% a quarter, and a lot of times, if you're a normal retail investor in a normal fund, you can pull out all of your money in any one quarter. But then you get into situations like this where it is gated.

Andrew Deck (08:35):

But what you have to understand is that you're in a product that has private loans underneath it, right? These loans are illiquid, they're typically underwritten to seven years. They're illiquid. That's what you're buying into. But you're getting paid for that. If you want daily liquidity, you need to go into your public fixed income and you're going to earn three or 4%. And you just have to accept that if you want the increased distribution, the increased yield from private credit, you have to understand that that's the illiquidity premium that you and I often talk about. So I think in general, what this is really exposing is that as an industry, both on the distribution side as well as the product sponsor side, we just need to do a better job of educating, putting the right narrative out there so that advisors and investors know what they're getting.

Kristian Kerr (09:35):

Know what you're buying, know what you're getting yourself into. Exactly. I think Howard Marks said, "should" is one of the most dangerous words in English language, but you should know that. But the reality is, I think both sides need to have a better understanding. That's great. I guess, where do you think the industry goes from here given this hiccup? Another great kind of Howard Marks' analogy in his recent letter was he was talking about, this reminds him a lot of what we saw in high yield in the late seventies and eighties, to where, you can have kind of momentary hiccups, but then when it happened to high yield, it became a bigger and bigger product. Right. Over the ensuing decades. Do you see something like that happen here?

Andrew Deck (10:21):

Oh, absolutely. There's no stopping private markets. The percentage of the investible universe that's private is only growing. This is a little bit of a blip overall. Alts adoption has slowed because it's gone beyond just private credit story. And the reason for that is not because of any correlation between private credit and another asset class, but it's because how the media is telling the story. The media's telling the story around this broken liquidity mechanism, which isn't really broken at all, but because we haven't done a great job educating people, the media can tell that story kind of unencumbered. They can just tell that story and make it seem that way.

Kristian Kerr (11:10):

There's very little talk about the size of the retail market versus institutional market. Right. Which is another lost aspect in the narrative.

Andrew Deck (11:18):

Well, and there's the other piece, and that's the fact that the institutional market is still going into this stuff. They're allocating, they're in there gobbling up a lot of this stuff as a result of it, but that really has to do with how the institutional market looks at liquidity versus the retail market looks at liquidity. And the retail market almost looks at it in the sense that they'll see the headline and be like, wait, I don't have liquidity. I want it now. The institutional market is just like, these are holding maturity loans, these are money good loans, we're just going to put 'em there, hold 'em, clip the coupon, and we're going to be good with that.

Kristian Kerr (12:00):

Well, along those lines, where do you see personally kind of the biggest mispricing within this space right now?

Andrew Deck (12:11):

Well, I think in general, the biggest mispricing is kind of an underpricing in the secondaries market, and it's come with any fire sale, right? There are institutional shops out there that operate in the distress space. They see a fire sale sometimes you could argue that maybe they've helped create the fire sale. They've certainly fanned the flames of that fire sale and they're out there taking advantage of it. So you've got loans out there that should not be trading at 60 cents on the dollar or 70 cents on the dollar that are trading at 60 or 70 cents on the dollar. So that's where I see really the biggest dislocations right now are just because you've got this fire sale that's going on into the secondaries market because these funds have to create liquidity. And they only have two ways to do that.

Kristian Kerr (13:00):

The next evolution of the cycle will be special opportunities funds to take advantage of that. A lot of what you said has been pretty optimistic, so just to push you a little bit. What would have to go wrong in private credit to meaningfully kind of disappoint investors over the next five years?

Andrew Deck (13:22):

Well, I've been very hesitant to say this quiet part out loud, but you can't have private credit go bad, so to speak, without private equity going bad. Right. So, depending on how you want to break down private credit.

Kristian Kerr (13:36):

Oh, and let me explain why that is.

Andrew Deck (13:38):

So depending on how you break that down, let's just say ease of math, 90% of private credit is sponsor backed, meaning it's lending to private equity companies. Private equity backed companies. So if these companies are going into default, that's the hit on the private equity company. So when you talk about Medallia for example the journal had an article out where they expect Thoma Bravo, who was the big PE backer to take maybe a $5.1 billion hit on Medallia. So that's kind of what that means. There was, I think, a $2 trillion private credit hit, but the private equity hit is five. So that's kind of where some of the skeletons might be.

Kristian Kerr (14:26):

Okay. So it has to metastasize into something bigger and you have to see business valuations come down a whole lot, right?

Andrew Deck (14:36):

And frankly it's a little bit less than business valuations. It's more about the health of the business, right? Jeff Bezos said it back in the early two thousands when he was talking about Amazon stock, right? He said, the stock's going down to six, but when I look at all of our internal metrics, they were all going up. So when you look at private credit, maybe the valuations are coming down, but if they're still doing well from an earnings perspective, if they still have strong cash flow, they can still repay the loans. Private credit could care less. What the valuation is, it's not tied to valuation.

Kristian Kerr (15:14):

From their perspective, it's the old Buffett 'Mr. Market' concept. Alright. Last question on private credit in your view, kind of what separates a good private or a great private credit manager and the average one

Andrew Deck (15:30):

Discipline. Okay. I'd say when you look at private credit and let's just stay within the sponsor back space to keep it consistent, you've got the lower middle market, you've got the core, you've got the upper middle market. When you look at that, it's really about discipline. So if you're lending into the lower middle market, you know it very well, and you just stay in that market, you're going to know those companies. You're going to know that space. You're going to be able to have that discipline approach to stay in it. Where we see things start to kind of go sideways a little bit is when you have a manager that says, okay, I'm in the lower middle markets, but then they get hit by First Brands. Or maybe they get hit by Medallia and you're like, wait a second, you were never supposed to be in that space in the first place.

Kristian Kerr (16:23):

Drift. Yeah.

Andrew Deck (16:24):

A little bit. So that's, to me, discipline is the biggest differentiator there.

Kristian Kerr (16:30):

Okay. I wrote a piece recently kind of talking about the same thing where it leans back into your whole idea of discipline, but firms that actually look through the full credit cycle. And not just the expansion phase, because everyone loves it when you've got the tailwind, but it's how do you manage across, the zigs and the zags of the 10, 15 year period, whatever it is, right?

Andrew Deck (16:52):

And that ties to discipline as well. Because if you look at some of these COVID-era loans that we're talking about now that was a lack of discipline. They got the money in and they were so frantic to put it to work that they would do these covenant light deals, or they would style drift into areas of the market. Because they just felt they had to deploy this capital. Whereas the discipline approach would either you'd hold onto the capital for the right opportunities, or you'd say, we can't take more money in right now because we can't put it all to work in the right way. That's the difference between a great manager and a mediocre or poor manager is that discipline and how they do those things.

Kristian Kerr (17:34):

Makes sense. Alright, let's shift gears a little bit here. Within the alternatives universe, in your view, what's being under allocated today? Under allocated to.

Andrew Deck (17:46):

Under allocated to today? Yeah. actually, you know, surprisingly for me to say this out loud.

Andrew Deck (17:55):

I do agree with that. Is that what you're saying? Yes, I do believe that hedge funds are undervalued. That's not what I was actually going to say. I do see some green shoots in real estate as interest rates are coming down, activity is picking up, you're seeing more and more kind of return to work. Even if it's not a five day mandate, you're seeing more and more people back in the office, just not the class B or 20-year-old medical plaza type real estate. But the newer amenity-rich stuff is coming back, and multifamily in certain areas is coming back. So I do see green shoots in real estate. I feel that cycle has played out.

Andrew Deck (18:45):

Hedge funds can be a very effective tool. In markets like this where you see stocks just climbing that wall of worry. You and I joked previously when we bombed Iran the first time, and rates went up and oil went down and we're just like, this isn't supposed to happen. We're kind of climbing the face of the Iran War now. And in my opinion, not really pricing in all the risks associated with that. It's a great time for active professional management in the portfolio. Yeah.

Kristian Kerr (19:29):

No, I very much agree. And I'll say just a side note on what you're talking about with respect to real estate, I think that what happened in real estate a few years ago is precisely why gating works. Right? And that's what stymied the panic and allowed the asset class to reset. So gating is a feature, not a bug. Looking out a decade, how do you think alternatives will be used in portfolios?

Andrew Deck (20:11):

Much more extensively? I think when we look back 10 years from now, this will be viewed as what we see, which is the infancy of this product innovation is going to continue to be an ever present thing. I think access is going to continue to expand and as a result of that, you're going to see a lot more adoption of private markets and alternative investments. So, 10 years from now, I think it's going to be a core holding. Even if you still have a 60/40 portfolio, some of your 60 can be private equity. It's not about throwing that out the window, it's just about injecting private markets into those spaces, whether it's your fixed income side or your equity side. That's the way I think we're going to start to see it.

Kristian Kerr (21:17):

Listen, in a world where the index composition is very different than it was 25 years ago, and it's because of private capital, right. It's going to have a bigger and bigger role whether you like it or not. Great stuff. Let's end on, what advice would you give an investor building an alts allocation for the first time?

Andrew Deck (21:44):

I would say know what you're getting. Right, so when we talked about liquidity along the way, what you should be doing is understanding your liquidity requirements, understanding that you're getting this illiquidity premium as a result of that. Not to mention these things can really help you from yourself, right. People get emotional, people get reactive. They start opening their statements or they turn on CNBC and the market's going down and they're just like, get me out. Get me out. Create that illiquid portion of your portfolio, leave it there, put it into alternative investments, put it into a diversified portfolio. Do some private credit, do some real estate. I think infra is great. Infrastructure's great for any portfolio. It's a great core, non-correlated core holding. And just leave it alone. Just put 'em in there and leave 'em alone and realize that the illiquidity's there for a reason.

Kristian Kerr (22:43):

It's not necessarily all bad, right? How many times we have conversations where you talk to people and they say, oh, I owned Amazon right at a hundred bucks and then sold it at one 50. Right. And to where if it wasn't that type of, structure, format, whatever, it would keep you from yourself wanting to ring the register a little bit too early. Alright. Great stuff. Well, I think we can wrap up there. Okay. Andrew, thank you for joining Market Signals today and sharing your insights and look forward to having you on again.

Andrew Deck (23:12):

Great, thanks for having me.