Transcription
Good morning, everybody. What's left of it. Um, I just wanted to take a moment to recognize our panelists. It takes some courage to get up here and make predictions about the future of private credit. Um, about a month ago, Howard Marx of Oak Tree published a memo called "What's Going On Private Credit?" It is, for those of you who haven't read it, an excellent primer on the history of non-bank lending. So, I highly recommend it.
One thing that Howard does in the memo, and which I'm going to do now, is draw a distinction between private credit and direct lending. What everyone is concerned about, and presumably the reason you're all here in this room today, is the latter, which I suppose we can broadly define as non-bank loans to leverage buyouts and private equity-backed companies. So that's where we're going to spend the majority of our time on this panel.
Now, for my panelists, as you all know far better than me, in fact, there are a number of competing narratives right now about the current state and future health of direct lending portfolios. To varying degrees, they all concern at least five things: the creditworthiness of the borrowers themselves, the companies; the quality of underwriting, what Howard would call a lack of discipline; the amount of leverage, some of it hidden, supporting this lending; the disruptive impact of artificial intelligence, mostly on the enterprise software industry; and finally, the structure of the investment vehicles holding the loans. And then, of course, there's oil prices, the cost of gasoline and diesel, inflation, the economy, and interest rates on top of it all.
So, the question I'd like to pose to all of the panelists to get us going is this: Is there or isn't there a problem in direct lending?
>> I I think this is a a moment which I've seen in other markets before and that is tremendous growth. And we saw, you know, in the dot underwriting boom in the 1990s where it was ridiculous. I mean, companies that have no revenue were coming at big prices to markets, and that that didn't end well. And then there was the mortgage problem where suddenly we were turning triple triple B non-G guaranteed mortgages into AAA's and pocketing the difference, and that doesn't look really good. And now we have this problem with the mismatch of assets and liabilities. And it really came into play with the retail market with the so-called semi-liquid feature, which I suspect is going to be a significant problem because my belief is that a lot of these products were sold at very high commissions. And while it's clear that prospectuses talked about the gating mechanisms, I have a feeling that the financial intermediaries, not all of them, of course, but enough of them didn't explain. And I think many of the owners of these of these interval funds think they thought they could get all their money out every quarter, not really understanding that it's on the aggregated fund level. And so whenever there's a really big boom in a market, things start to deteriorate.
I use the analogy of the Wild West. So, you're in 1840 and you've got a nice agrarian town out on the frontier, and everybody's living off the land. They're all god-fearing. You got a sheriff with a heart of gold like Gary Cooper in High Noon, and everything's going fine. There's no crime. There's no hardly any murders. People don't even bother to lock their door. And then something happens. Somebody discovers gold three miles away from the town. And all of a sudden, in comes the strike-rich crowd, the quick-buck people. And they come in, and they're not all quick-buck people, but a sufficient number of them are scoundrels and rap scallions. And all of a sudden, the crime rate is through the roof. There's murders. You now have to lock your door and barricade it. And the sheriff can't control the lawlessness. And that's what happens. And that's that's what happened in the dot-coms. That's what happened in the mortgage market. Certainly the co market. Hey, we turned triple triple V's into AAA's and pocketed the difference. Hey, we made illiquid assets liquid and pocketed the difference. And this is going to unfold because, uh, I have I I have a feeling that the opacity of these products was not was kept opaque and was not granularly described. And that's where the problem is, and that's why everybody suddenly wants their money back. They're starting to realize that they might be the bag holder.
And, you know, if you thought one one thing that characterized the first quarter of 2026 was ever-increasingly large redemption requests that ended up in one being a 41%. If if people can't get ask for 41% and get five, the next redemption request cycle, they're going to ask for a lot more. >> A lot more. It's like a bond allocation deal where there's a good bond with a good credit, and it's a $300 million deal, and everybody wants it. So you you put in for a hundred million when you're going to get 10. That's the way these things tend to work. So this is going to be an interesting period because the data points aren't as frequent as you got in this those past prior booms that I referenced. So I don't know what systemic means, but people are going to lose money here. And I heard yesterday that the SEC is investigating a couple of private credit firms, plural, for fraud. I have no idea what that means, but it doesn't sound good.
And here's what's been going through my mind, and I suspect the minds of others in this room and elsewhere. One of the things that we learned in the global financial crisis is that stress in one corner of the credit market can migrate. It could become contagious and eventually infect, right, not just the rest of the credit universe, but spread to other markets and eventually the whole economy. So, what if things do get messy? Uh, how might a run of defaults and a loss of investor confidence in this asset class metastasize into something bigger, even if it isn't as big as the GFC?
When it comes to how something unfolds, I think one of the problems here is credit is based upon trust. I think the word credit comes from the Latin word for trust. And I feel like there's eroding trust that's been happening. And I think there's going to be more of it. I think the the mismatch of the the the quarterly liquidity with the reality of the gate, that that that erodes trust. I I think marking down a fund overnight from 100 to 81 that erodes trust. It's like, what what do you mean? Did you mark all your loans down 19% yesterday? When when did you when did you catch catch wind of that? That seems awfully abrupt, you know? And was it all of the loans down 19, or was it half of the loans are rock solid and the other half are down 38, or is it since I keep hearing that everything's fine, is it 75% of the loans are rock solid and so the other 25% is down, you know, to 24? Which one of those is better? And when this happens overnight, and it happens, it seems to be happening with some routine, uh, occurrences that erode trust.
I think when you write down an equity position in, uh, from, uh, down 98% overnight, and it goes from multiple millions, nearly $100 million position to an $800,000 not even position, and you got the pick bonds that you own 56 million of, >> and you're still calling them current. In the old days, when somebody defaulted, we called it a default. We didn't call it a paying kind. They're not performing, but they're on the books as performing. And what what's really going to erode trust is what they're doing is saying, yes, the borrower cannot pay cash. So what they're doing is adding, let's say it's a 10% payment, just to make life easy. They add it to the back of the loan. Well, what happens? You should be marking that that loan down very significantly. The equity was just completely wiped out. You've got nothing here, and now you're accruing interest. And you're you're you're if you look at it, they keep marking the bonds at par. So what the best month you could possibly have for some of these funds is every bond defaults and picks because they'll leave them at par, and you'll have a 10% monthly return in this example. That's going to erode trust.
The the reporting on what really is going on in terms of concentration and say software is very much in the news. These are all starting to build up. It's sort of like I I keep hearing admissions that there's problems, that there's going to be losses, but everyone says, "Not with us." This is Lake Will Be Gone on steroids. Every every firm is top decile, and nobody has any losses. Well, they're going to they're going to show up somewhere, and that's going to erode trust. And so I I feel that this could be very significant.
I I remember just a story. It's such a good story, I want to tell it about the Wild West in real time. In the co boom, we were issuing. Cos were pretty careful about it, but the industry was booming and booming, and the biggest underwriter, I won't say their name. They, um, were not doing deals with us anymore. And I had dinner with their co team, and they all came out. And I said, "What's going on here? You're the biggest issuer, and we haven't done a deal in two years." And he says, "We don't want to do a deal with you. We want to do it with startups." I said, "Why do you want that?" You know, "Well, they'll buy what we tell them to buy, and you won't. And they'll, and to boot, they charge less than half the fee that you charge." And I thought, my golly, are you kidding me? So, I went and had lunch with the number two guy at this at this investment bank, the biggest co issuer. And I said, "You've got a problem. These guys are off the rails. I mean, they are just they're just shoving stuff out the door." And he says, "You know, we're underusing our our balance sheet. We've only done $25 billion of deals. I want to make it 50." >> And I said, "You you got to you're going to blow this place up." And we're at a sushi restaurant, and the guy is just eating very calmly. And I'm like, "Why can't I get a rise out of this guy? His firm's about to blow up. He's the number two guy." And he resigned that Friday after getting a bonus of over $200 million and went back to Asia. That's the Wild West.
>> Jeffrey, C, could I just stick with you for a minute on this an important topic? Um, you know, as it were, bad behavior, right? Whether it's bad behavior when it comes to how you mark your book, uh, whether it's other kinds of bad behavior that you've called out, garbage lending, for example.
>> That's been that's been misused.
>> What what I was saying actually was that the high yield bond market is actually better credit quality than it used to be. >> Because in the old days, the the poor credits, the garbage credits ended up in the high yield market. Yeah. >> But now they're not in the high yield market. So, >> best quality it's ever been. It's not even what I was saying. >> It's not even close. The high yield market is way better than it was pre GFC, and and, uh, obviously that's made its way into private credits. I'm not saying all private credit is garbage. I'm saying there's tiers of lending that are poor. How about tree? How about First Brands? You know, I >> what I'm what I'm wondering, to the degree that you've looked at this and studied it and trying to understand it, and maybe our other panelists have a view on the subject as well. How widespread is the bad behavior? Is it concentrated in with a certain number of underwriters and managers?
>> I think is a there's a lot of overlap in positioning. I think where the problems really lie are on firms that don't really have the infrastructure to do the real work on the stuff and tend to join syndicates and piggyback off of scaled entities. And I I think that that's not going to be a major problem because by definition, these be smaller firms, but you get to a point where they have to say, you know what, we did it because XYZ did it. We figured if it's good enough for them, it's good enough for us. At least we're not going to be wrong alone.
>> You're hoping someone did the underwriting.
>> You you know that's that's going to happen. And some of these documents, you know, some of these firms, they have a total of, including the receptionist, of 30 people. And you know, some of these loan documents are 200, 250 pages, and they they're doing, you know, scores of deals in a year. They're not even reading these documents. It's not possible to read the documents. And I think most people, if you read the documents, you don't really know what it says. It's kind of when he reads, you know, if you're not a lawyer and read legal contracts or a prospectus, people don't know what prospectuses mean. So, it's always it's always the, uh, the bad actors that end up causing a a black eye. It's just a just a question of what people think of the sales practices, what people think of the of, uh, you know, kind of the the liquidity mismatch. My eyes really got opened to what was happening here early in 2025 when a big insurance company, a big, big insurance company client of ours, came in, and he had a lot of private credit, which is not uncommon. And he had one position that was owned by eight managers, the exact same loan, eight managers. And he said the most recent valuation period that he got, what the one manager had it at 95, and one had it at 8. So I thought, wow, this might be an isolated incident, although this guy is a big player. Uh, I thought, that doesn't that sounds odd to me, 95 and 8 sitting next to each other in a portfolio. And, uh, so I started following it a lot more carefully. And, you know, it's a moving, it's a, it's like a moving average marking process. Let's just admit it. That's kind of what it is. It it's a moving average until it turns into a step function. That's that's the that's the way it works. And that's actually one of the purported benefits of private credit, and that is it's lower volatility. Well, if you use moving average pricing, you have lower volatility, and it is moving average pricing. And so is the argument really valid? I don't know.
The the second argument was a very powerful, very powerful in raising ginormous amounts of money, and that was historical performance, which was really informed by 2020 to 2022, particularly versus public markets where you marked bonds down 18 points during in 2022 in parts of the corporate bond market. So that argument isn't really good because it's, well, it's not working now. It's it's not working now. And then the third argument is the worst of them all. It's a repackaging of the of the volatility argument. It's owning this stuff helps you sleep better at night because you're not stressing up so much over that volatility in your in your, uh, in your, uh, public credit. That's just the first that's cynical repackaging of the first of the first argument. So the argument should be it's higher return. Um, I think it was for a while. Maybe maybe it will continue to be, but it's clear that what's happening is people that can't get loans in the public market are paying higher interest rates to get loans in in the private market. You can't get it in public. And there's this other device, which I think is going to erode trust. And that's one that unfortunately is a is an echo of the CDO situation. And that's these investment grade ratings that are being put on by not the big the big rating agencies. You don't really get an analysis. You get a price list of what rating do you want. And if you if you want an investment grade rating, you're going to have to pay for it. And, you know, I saw a pitch book by a major private credit, they're big firm, private all over the place. And in they had a bullet point that said, one of the their pillars is investment grade private credit. That's a pillar that makes their funds so solid. And they had a bullet point that said, two point two two percent of the of the, uh, of the loan market is rated double B or, uh, single single B+ or lower. Two percent is rated higher than single B+. That's what their pitch book said. Well, that means that a bunch of that 2% is single B. So, it's not investment grade. So, what percentage is investment grade? If two 2% is B+ 2% is higher is B+ or higher? Well, it's not 1% is probably triple B. So, how the how the heck are you having a pillar of your portfolio, and you're you're investing trillions of dollars, and you you're one of your pillars is 1% of the market, and it's got an investment rating off a price list by Dewey Cheetah and how? And I think that that's a systemic problem in that we're trying to turn we're trying to do financial alchemy. We're trying to turn defaulted bonds into payers. We're trying to turn below investment grade bonds into marginally investment grade bonds by going into shadow shadow rating agencies. Uh, everywhere I look, I see handwaving. I I see I feel like I'm listening to that Justin Timberlake song. You know, you dance. There's there's this the facts are that there is problems. Everyone admits there's problems. And when the recession comes, it's clear that there are going to be significant losses.
>> Because this this this area is is not like Silicon Valley Bank, but suffers from the same problem, victim of their own success. Silicon Valley Bank had all that COVID money pile in, and they couldn't invest at zero. It was piling because they were offering an interest rate, and the government wasn't. And so they ended up buying 30-year treasuries because they yielded like one and a half percent in Ginnie Mae's. And of course, people realized that other people were withdrawing their money from SVB, and so everyone's got a phone, and it's instant redemption. So, you know, but this this asset class has the same problem, victim of success. They were so successful in 2020, 21, 22, that all this money came in, and now that's going to have to be refinanced, a lot of it. >> And the rates are going to be higher. If you're picking on loans from 2000, if you're picking on loans from 2001, >> right, >> how are they going to pay loans at the new interest rate that's more reflective and long and treasury rates have have been going up? And there is, you know, if, as I said on CNBC, say, if your if your only argument for risk assets is you're going to get two rate cuts from the Fed in 2026, you're backing the wrong horse. Right now, the odds are higher that they hike rates this year. Although I I still don't think that that's that's odds-on bet. But I'd bet more on a hike than a cut. And that's not going to that's not going to relieve stress.
One one topic we haven't touched on that perhaps we can get into with the time that we've got left is the behavior of the institutional investor. We've talked a lot about the behavior of the retail or the private wealth investor who's been in these non-traded BDCs for example, or stuck in some other credit vehicle with, uh, redemption limits. Um, the, and of course, right, those redemption limits are awfully unpopular with the people who want to get out, but they're totally, you know, within their rights to put them up. They're in the documents. Jeffrey, you've all got institutional LPs. What do you, how are they behaving? What are they telling you? Uh, what you know, what what do you denote I guess, or infer from what you see and hear from them?
>> We've seen, uh, more so outside the US than the US. We've seen a noticeable, uh, ramp-up in demand for diversification products by sovereign wealth funds and things like this. And what I mean by diversification, I'm not talking about gluing private equity with private credit. I'm talking about they want something that there's no corporate credit risk, nothing. They want they want credit risks still because they want spread, but they we've customized portfolios where there it's all non-corporate credit, and it's it's a growing trend. Uh, in the US, we haven't seen that so much. Most our institutional, uh, uh, clients feel like they're okay with their allocations to private markets, and if they get marked down, but with public markets going up, they'll probably re-up to re rebalance. That's their mindset currently. So I I haven't seen a a real aversion from the institutional crowd. It seems to be retail.