INSIGHTS

It’s an environment made for active managers. From high yield to credit risk sharing to private credit, we see a strong opportunity set for those with the flexibility and research capabilities to take advantage.

Hosted by Sriram Reddy, Managing Director for Credit at Man GLG, a panel consisting of Matthew Moniot, Co-Head of Credit Risk Sharing at Man GPM, Mike Scott, Global Head of High Yield and Credit Opportunities and Man GLG, and Zeshan Ashfaque, Senior Managing Director at Man Varagon, discuss topics including:

• The impact of the secular shift in how companies access funding;
• Why the catch-all term ‘private credit’ is misleading and ill-understood;
• Divergence in the outlook for the US and Europe; and
• Why credit is an increasingly relevant asset class

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Sriram Reddy

Let’s maybe set the scene, talk about the implications of higher interest rates, where we are in the cycle and this tug of war that we’ve been seeing between the attractive yields that we’ve seen in credit markets, but also what are relatively tight spreads, particularly in public credit markets.

Mike Scott

So over the past 1220 months, we’ve seen a very aggressive interest rate, high key cycle from all the major central boats globally. And certainly this has started to feed through into significant pressure in certain sectors. Certainly by any stretch it hasn’t been uniform, but certainly those interest rate sensitive sectors, it’s been quite material, not least in areas like commercial real estate, for instance, and early cyclicals like Capital Boost for instance. We do expect these pressures to broaden, and with that, I do think that the dispersion in public credit markets is only going to increase from where we are currently. That’s a very good thing for stock pickers and certainly is an environment in which stock picking should be rewarded as opposed to just taking market exposure.

Sriram Reddy

Great, thanks Mike and Matt, let turn it over to you and bring you into the conversation. I can’t kind of go a day without seeing a headline on SRTs rank cap transactions or CRS. So maybe I can start with that. Why are there so many different names for these types of transactions and what is the benefit? What is this providing towards banks? What is this providing towards investors? Maybe we can just level set for the audience.

Matthew Moniot

Yeah, sure. Creditor sharing transactions, also known as SRTs or CRTs. I’ve been around for a number of years. They’re beginning to, if you will, come into their own in particular because of some clarification out of the US Federal Reserve in particular. And we are beginning to see US banks increasingly interested in the product. SRTs are a form of regulatory capital, perhaps somewhat akin to an A T one, which in Europe and a US context context would be preferred equity or a contingent convertible instrument in Europe. But Credit Suisse in particular has shown some of the fragilities of that market. And SRTs perhaps a bit more powerful given the fact that a T one is relatively tightly limited in terms of how much the total regulatory capital it can supply. So demand from the banking system in particular the us, but an expansion beyond the largest European banks as well. And we’re starting to see relatively mid-sized European institutions come to market. We’re also starting to see some new geographies in southern and eastern Europe. And so just quite an opportune time for the CRS RT Market.

Sriram Reddy

Great, thanks Matt. Zeshan, let me bring you in here. You recently wrote a paper about the growth in private credit over the past three decades. You talked about the secular shift that we’ve seen to particularly post the global financial crisis where banks are stepping back from providing lending directly to companies. Maybe you can walk us through those developments and in particular if you can focus on the potential for growth of the asset class and how you would benchmark that relative to maybe other asset classes.

Zeshan Ashfaque

Yeah, absolutely. So the financial crisis was obviously a pivotal moment in the evolution of really direct lending private credit, but just the broader lending universe. You had regulators focusing on reducing systemic risk, which negatively impacted the bank’s ability to compete. And you’ve seen the withdrawal from their side that has been filled by private credit and has really coincided with the growth of the asset class that you see starting off with small middle market businesses and has now moved up over time to directly compete with the banks in the broadly syndicated market as well. Historically, banks used to dominate the syndicated loan markets 10 years ago they had a market share of an estimated 62%, and today that’s now somewhere in the 10 to 15% range and direct lending deal volumes, private credit, deal volumes, account for about five times bank led deals. It’s no surprise based on everything that’s been happening from a future outlook and growth perspective, we still think that there’s tremendous room for direct lenders and private credit to continue to grow. While the growth rates may not be what we’ve seen over the last five to 10 years, I think the actual amount of growth still remains significant. To put it in perspective, private credit is highly correlated with private equity being one of the key providers of leverage for LBOs. When you look at fundraising and private equity, it has outpaced direct lending by a factor of 10 to one historically. While I don’t think that’ll necessarily become a one-to-one ratio over time, there’s still significant room for convergence and that’s coming from private debt growth.

Sriram Reddy

That’s perfect. And Mike, have you seen that the impact on your markets leveraged finance market on the syndicated side, is that shrinking and is private credit a solution to maybe some of the maturity walls that we’re seeing or how are you assessing risks and opportunities with that?

Mike Scott

Yeah, I mean I think that’s absolutely right. These trends we going on for quite a considerable period, particularly as I say, so I’ve spoken about since the GFC, there’s been a real step change in that disintermediation. I mean certainly when I look at the higher bond market in the leveraged loan market, there’s been significant growth in the leveraged loan market at the expense of the bond market and the types of deals that are now getting financed within the leveraged loan market is very different to maybe where leverage loan market was just 10 years ago. Much more asset like businesses, slightly looser covenants I would say, and has been more favoured I would say, by private equity in the syndicator space versus bonds. I do think that this maturity rule is both a risk and an opportunity. I think when we look at the way the market is approaching some of these situations where there may be problems with respect to refinancing those debts, there can be very, very elevated yields and there is certainly scope for more bespoke financing that can come in to provide a runway into liquidity runway at the expense of clearly better governance, higher capital structure, high coupons and the like.

And so whilst it’s often spoken about as a risk as maturity wall, I’ll actually characterise it as both a risk and an opportunity. Certainly from our perspective in more asset heavy companies, this is certainly a sweet spot for us in the way that we can look to really take advantage of some of these financing opportunities that we see.

Sriram Reddy

Great. Thanks Mike. And we switch a little bit to opportunity. So Matt, maybe I can bring you in here as well. You talk a little bit about the increase in supply and it would make sense and that spreads do look quite attractive in the CRS market now, but is that being met by increased demand and how do you think that balance will be being handled? Then? I wonder if you can talk a little bit more about that regional diversification that you’re starting to see within this market as well.

Matthew Moniot

Yeah, sure. There’s a clear bifurcation in the market between some of the more public transactions in particular, those that preference large corporates, it might be transparent, meaning you can see and underwrite every one of the line items in a given portfolio. And unsurprisingly, those will tend to attract liquid market players, hedge funds. We have seen ’em come into and leave the market on multiple occasions over the last 20 years or so, and they’re definitely starting to come in and look right now. We don’t think that competition will push all that much beyond the level of those sorts of transactions. In particular, we don’t particularly see hedge funds as a competitive force in more bespoke transactions, more bilateral transactions, transactions that might reference more complex collateral pools and might need more structure and more handholding. Some of those deals can take six to 12 months to negotiate and structure.

There’s are a fair legal lift upfront and again, just not the DNA of most investment managers. You asked about the issuance side. We’re certainly seeing a lot, at least discussion, but in fact even transactions out of the United States, a market increase partly due to, as Mike referred to the increase in interest rates earlier, this has obviously impacted the banking system not only through the CRE channel, but most perhaps particularly through the CRE channel now and clearly the Silicon Valley First Republic, et cetera, debacle of last year with realising the fact that so much of regulatory capital in fact was phantom because health maturity portfolios were being market to market that clearly injecting a level of regulatory conservatism into the dialogue in the us all of which would tend to drive issuance. And we’re seeing a similar thing play out in Europe. I’d say in Europe it’s more about optimising. Europeans are a bit further along, if you will. It’s less perhaps and a bit ironic given the fact that the conversation has been largely completely the opposite for the last 12 years. But Europe is largely not about increasing capital ratios and more about optimising and making sure that you’re not building up too much capital and you’re using as much external capital as possible, which is at the end of the day what the CRS transaction is.

Sriram Reddy

That’s super helpful. And Zeshan talk about opportunities with you in your paper that I referred to earlier, and you talked about a lot of direct lenders have been chasing the opportunities that they’ve been vacated by banks, so the broadly syndicated markets, but you highlight a couple of facts I thought were pretty incredible, whether it’s over 200,000 middle market companies in the US and if you combine those revenues together, that would be the third largest economy in the world. It’s a pretty staggering amount, but I’m guessing that creates a pretty fertile hunting ground for opportunities for you in terms of investments. And is that still a focus for you? Yes, absolutely. And you’re right, it’s a significant market where analysts estimate in the US that there

Zeshan Ashfaque

Are 200,000 to 300,000 companies that make up the middle market with aggregate revenues of around $13 trillion, which to put in perspective is around half of US GDP. So we think there’s a significant opportunity to find good companies that are growing and make great candidates for direct lending. So that remains a focus of ours. And as we think about market segmentation, we think the middle market has a great risk reward profile where in the middle market you can get tighter structures compared to upper market deals as well as spreads that remain attractive and are arguably less volatile than what is experienced in the upper markets. Especially when you think about the broadly syndicated loan market. You have competition from private credit providers and obviously the traditional banks who will come and go, and with that comes some volatility and spreads, whereas the middle market has historically been more resilient and a grid balance of risk versus reward. So with all those factors, we think it’s remains an interesting market and one that we expect to continue to grow and focus on.

Sriram Reddy

Great. So we’ve talked about opportunities and maybe we can finish up with risks. So Mike, maybe start with you, what’s keeping you up at night? Is it leverage in your space, other fundamentals? And I guess when, I guess you don’t have a crystal ball, but when do you expect some of these factors to be placed into the spreads?

Mike Scott

Yeah, I think actually fundamentals are relatively good. They’re coming from a fairly high degree of strength, not at least given how strong the cycle has been or the recovery has been post covid. We’ve actually seen a lot of companies improve their credit profiles over the past three or so years. That said, I think if we’re looking forward, we certainly do expect global growth to slow. We’re certainly seeing a lot of pressure within the CRE market or commercial real estate market. We’re expecting further pain to come, particularly in the US this year, somewhat counterbalanced by Europe and particularly Eastern Europe, where we see much strongly trends, I would say relative to the us the 2024. But nonetheless, it is a sector in which we think that there is both significant risk but also counterbalanced by opportunities. And I think further out clearly the regional banking spaces is something that we are watching very closely. My personal view is that however much fed liquidity is pumped into the market, I can certainly deal with flighty liabilities at these banks, but doesn’t necessarily fit the assets side of the balance sheet. And I think this is going to be with us for a number of quarters, if not years as they work through those

Sriram Reddy

Exposures. Right. Zhan, maybe for you, I guess, are those similar trends that you’re seeing in the middle market space or are there other indicators that you typically look for potential stress into the future or risk that you think we should be aware of? Now?

Zeshan Ashfaque

I agree with Mike. Fundamentals have historically been strong. I think thinking about risks to private credit is rising interest rate environment higher for longer puts pressure on borrowers, but being a floating rate asset class, you get rewarded for the yields, the absolute yields with the base rates being elevated. So again, there’s a balancing of that equation. I think fundamentally the way we think about the business being illiquid hold to maturity directly originated deals, it’s focusing really upfront on credit selection structuring and active portfolio management. All of these are important. It’s easiest to get out of trouble if you never get into it in the first place, but you have to be ready for even the best deals to potentially underperform. And within private credit and direct lending, we like having tighter structures, real covenants, both financial covenants as well as affirmative covenants that could require more frequent financial reporting, which allows you to be closer to the asset direct conversations with management, the owners of the business, whether it’s private equity or others. And that allows you to be more nimble, move quickly, and take action swiftly before it’s too late. So we think the structural fundamentals of the business and asset class really provides significant downside protection.

Sriram Reddy

That’s great. And maybe Matt, if I can finish up with you just to talk about banks. We’ve maybe talked about some risks with CREs, but what maybe are some of the risks specifically to investors that need to think about for CRS and a bank failure or other risks that you’re thinking about right now?

Matthew Moniot

I’d say we learned quite a bit in the securitization markets from about late 2007 to mid 2009, just about every securitization structure was put to the test. Many of them failed. One of the really strongest aspects about the SRT structure is nowhere in the capital structure of securitization are there opportunities for diverting cash flows. These are synthetic securitizations, typically only a single issue tranche. And so our transactions are not built to protect aaa. The vast preponderance of cash securitizations are built to do just that. And in terms of our financial collateral, there are a few different versions of how this is handled. The two most common would be proceeds from note issuance are set aside as financial collateral and invested in short-term securities. Those would typically be short-term GOs or they sit on balance sheet as the functional equivalent of a senior preferred or derivative collateral, which is a non-preferred, excuse me, a non bailing category of banks capital structure.

There have been a number of issuers that have been resolved by regulators, by resolution authorities, and in none of those cases have SRT node holders realised a loss as a result of that. So the structure is pretty well considered, pretty well thought out with most smaller institutions. Collateral is actually held unsurprisingly in financial collateral form at a third party bank in a European context that would typically be with a JP Morgan or a US Bank Corp or somebody akin to that in a trust account in Dublin, Ireland. But again, a variety of different ways to manage that. So quite a strong structure, which allows us to really spend the vast bulk of our time thinking about the underlying assets and the performance of underlying assets. In terms of what we worry about, obviously CRE is a major issue. Interest rates and what that’s doing to asset prices, a major issue indeed higher for longer, something we’re keeping an eye on for the time being. Okay. And there are otherwise very limited pockets of obvious imbalance in particular outside of em in Europe and the United States. Europe has seen very, very substantial de-leveraging over the last 10 years. It’s really quite extraordinary, in fact. And the US markets, with the diversification, the rise in permanent capital vehicles, like private credit funds, it’s a much, much stronger credit market today than it was in 2008 per se. And so all in all, we feel quite good.

Sriram Reddy

Great. Well, I think on that cheery note we will call this to an end, but we’re definitely here to continue these conversations, myself or these panellists. We do see a lot of opportunities across credit markets. We do think it’s an attractive place, but we do expect more dispersion as we move through this portion of the credit cycle. But we appreciate your attention and feel free to reach out to your sales reps if you want to continue these discussions.