Macro Markets Podcast Episode 50: Investing in Private Debt

Joe McCurdy, Head of Origination, gives an overview of the private debt market.

March 25, 2024


Macro Markets Podcast Episode 50: Investing in Private Debt

Joe McCurdy, Head of Origination, gives an overview of the private debt market.

This transcript is computer-generated and may contain inaccuracies.

Jay Diamond: Hi everybody and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. Now before we begin, I want to thank our listeners for tuning in, and remind you that if you have any questions for our podcast guests, please email us at macromarkets@GuggenheimInvestments.com. To get right into it, our topic today is Private Debt, a sector that has attracted a lot of interest and, more importantly, a lot of capital. There are a lot of newcomers to this space, but Guggenheim Investments has been an active participant in the market for over 20 years. In fact, we have a new white paper on the sector that will be available soon on our website. Here tell us all about Private Debt is Joe McCurdy, our head of origination. Welcome Joe, and thanks for taking the time to chat with us today.

Joe McCurdy: My pleasure. Thanks, Jay.

Jay Diamond: To begin our discussion, let's start with some level-setting basics for our listeners, some of whom might not be as familiar with private debt. So, what is private debt? How big is the market? How is it different from public debt?

Joe McCurdy: When we're talking about private debt, we're talking about loans originated by the holders of the debt. So, in the traditional market, whether that's broadly syndicated bank debt, high-yield bonds, typically you have a bank acting as a middleman. They will originate the transaction with the borrower and then go sell it to institutional clients. In the case of private debt, investors will go out there and originate the transactions themselves, they'll package it up the way they want, and then they'll own the risk. So, a couple of things happen there: you cut the fee out that the bank's going to either capture some of that or the borrower captures some of that, and you end up pricing the risk that you want to hold versus the bank distributing to a broad array of investors. You mentioned about the size -- the size of the market. One thing about private debt that you're going to learn, the deeper you look, there's different numbers all over the place. Rough math from the numbers that we have and frequent in other places, it's about a $1.4 trillion market. That's about the size of the broadly syndicated loan market. And to compare it to private equity, which is where a lot of this deal flow is coming from, that's about a $4.7 trillion market. So, versus $1.4 trillion for the other markets, still a lot of equity capital behind these various institutional markets.

Jay Diamond: Who are the typical borrowers in the private debt market and who are the major investors and lenders?

Joe McCurdy: Borrowers can be -- oftentimes it is private equity. Private equity drives the bulk of the market. Probably not a surprise based on where you see loan issuance of other kind of syndicated liquid products. It can be non-sponsored, which incorporates public companies, founders, family offices, others that aren't institutional or aren't true private equity firms. Major investors are a broad array of institutional investors. BDCs are some of the first and probably the most headline grabbing based on a lot of those are public. But in addition to that, there's a large array of institutional investors and they run the gamut in size. Some folks are lending to companies that are rather small, doing maybe $5 to $10 million of EBITDA. The average is probably out there doing deals in the $15 to $35 million of EBITDA, and then that goes higher and higher. We tend to play in the upper middle market, which would be, call it $40 plus of EBITDA, but that could be $100 or $200 million of EBIDTA. So, pretty big companies.

Jay Diamond: How are these private deals typically sourced? How are they structured and how are they priced?

Joe McCurdy: Most institutions are set up similar to us where they have dedicated origination personnel. So that's a team of people out having conversations with whether that's the borrowers, the private equity firms directly. The market's evolved to a place where most private equity firms have a dedicated person or people that are out looking for debt capital for their companies. But there's also a long list of intermediaries, brokers who, unlike the investment banks, aren't going to hold any of the risk – aren’t going to underwrite the risks. So, they're not competing for the syndicated business. Instead, they're helping companies find investors. And so, our team will go talk to that long list, although what I'd say is private equity is going to drive the vast majority of the deal flow for most direct lenders.

Jay Diamond: And how are these structured and priced? How do they come up with the levels for each loan?

Joe McCurdy: Like anything else, it’s a negotiation. One thing to jump into, there's a couple different flavors, right? There's first lien, often referred to as unitranche. What I would define unitranche, which is a name you're going to hear thrown around a lot if you're spending time on this market, is it's really if you take a first lien loan plus a second lien loan, a unitranche kind of encapsulates both of those things. A direct lender might do only first lien, they might do only second lien, they might do both. They might do unitranche. If you go back in time, 5 or 10 years and you've heard unitranche, go back then, people would do the unitranche, they do the first lien loan, and then find a bank to finance it for them. That doesn't really happen anymore, or it happens quite rarely. So, when you hear about a unitranche, you're really talking about first lien loan. And then there's other flavors, obviously, preferred equity and other junior capital mechanisms that people use in the market. I think the conversation we're having, most of my comments and most of what we're doing right now, based on where we see the relative value, we're focused on first lien or unitranche debt.

Jay Diamond: What's the typical return profile for private debt and how does it compare to other sectors of the fixed income market?

Joe McCurdy: It's a market we entered going back 20 years ago because the relative value versus what you could buy from the banks in the liquid market was compelling, and that relative value is defined in a couple of ways. You can look at the pricing -- you tend to get a pricing premium for the illiquidity of the loan. You tend to get a better document, so better protections as a creditor, and you get more control and more access to information. So, all those add up to what for us has been good relative value versus liquid markets. What that premium is can change based on where the market is, and whether that's 50 basis points, 100 basis points or up. To the underlying loan, if you just want to say like a what I would call a vanilla unitranche loan performing company, high quality company, sponsor-backed, right now you're probably getting somewhere in the range of SOFR plus 550 and a point or two, probably two points of fees upfront with some call protection. So, where SOFR is today call that 11 percent plus with upside from amortizing the fees and call protection.

Jay Diamond: And what about credit performance, delinquencies, defaults, recoveries? What kind of protections and power do you have as a lender in private debt that you might not have in the public markets?

Joe McCurdy: It's hard to find great returns data. We obviously have a long track record so we can look at our own or we can look at what we've at least heard from others. In general, from the stats I've seen, you don't see much of a divergence from broadly syndicated loans versus private debt. You're going to get similar recoveries; they’re all first lien, senior secured products. Private debt, while less liquid, you can't sell out or it's harder to sell out in an underperforming scenario, you do get some documentation benefits that can often help recovery, so covenants are probably the most widely discussed item. But remember what I said at the outset, these are loans being originated by the holders of the loans, so they actually care. Like we as the originator of the loan that we are going to hold for the next 5 to 7 years, we care what's in there and we negotiate hard on the document to make sure it protects us in all of the ways we need to be protected, whether that's covenants or leakage or all the other things that go with that. The problem that you run into, in our opinion, in the broadly syndicated loan market is often that the banks, acting as middlemen, so long as they can move the risk to a large, diverse population of institutional investors, it really turns into a sales mechanism of can they get a worse document, so the borrower is happier. And so you end up with some adverse focus around who's originating the loan and who's buying the loan. So that's one of the reasons I think when you look at default rate data, you see pretty similar, if not better on the direct lending side based on the private debt side, based on the fact that there's real protections in those documents.

Jay Diamond: What's in it for the borrower? Why would a borrower choose the private debt market over public debt, or a bank?

Joe McCurdy: It depends, is the short answer. Where the private debt market started--so we've been doing this for 20 years--where it started was deals that didn't fit, didn't fit for the commercial banks, maybe they’re too much leveraged, or too complex a business, or too big of a capital need for the commercial banks to fund, and maybe too small for the broadly syndicated banks, and so there wasn't a good home for them. Or too complex to explain in a two-week roadshow to a bunch of institutional buyers. That's where it started and that still exists. And then it's evolved such that private equity firms have gotten to a place where they are very comfortable. They like the certainty – you have certainty on price. In a typical broadly syndicated loan, the banks offer you on price, they have flex to widen if it doesn't go well, not to mention your information's out in the public domain. There's hundreds of people that are going to look at that information. You need public ratings, so you have to answer to the rating agencies, and that information's out in the public domain. So, timing, trying to move quickly, certainty on pricing and on capital, and then on incremental capital. You think about what we've been through over the last four years and the volatility in the market, there's been, I think, more quarters where the broadly syndicated market has probably been effectively shut versus open. You need incremental capital to do that next acquisition. You can't necessarily trust the broadly syndicated markets to deliver that because the banks aren't actually using their balance sheet to give you capital. They're, as I said, middlemen looking to sell down. If the market doesn't want to buy, they have nothing to sell you. One of the attractive elements of the private debt market for borrowers is they know there's incremental capital there to grow with the business.

Jay Diamond: What is it about current conditions that is making the private debt option so attractive right now for borrowers and for lenders?

Joe McCurdy: Market volatility is a great thing for private debt, right? When the markets shut down, the syndicated markets shut down, private debt can soak up a lot of that capacity. If you look over the last 12 years, rough math, about $100 billion a quarter is issued in the broadly syndicated market. When we see these pullbacks, and usually these pullbacks last a quarter or two, you'll see about on average $50 billion not get done -- about $50 billion gets done versus $100 billion average. So that's a lot of deals. That's a lot of opportunity for private debt. And in the last six quarters, we've had something like $200 billion that hasn't gotten done. That's how impacted in that market has been. So, you think about the pent-up demand that's out there, it's pretty exciting from a private debt perspective, but that feeds a lot of incremental volume into the private debt market. I think there's one other trend that's happening, and obviously a lot of headlines about all the capital raised in the space. What I think people fail to point out is that capital has allowed larger deals to get done in our market. You go back a handful of years ago, it took like five or six of us linking arms and working really hard and stretching to get $1 billion deal done. Now you can call multiple guys and they can individually do $1 billion deal. So, the opportunity set for deal flow is much bigger than it used to be and broadened the addressable market for private debt.

Jay Diamond: Do you think this is a structural, secular change in the way credit is allocated in the market is going to stay, or is it cyclical and it'll go back?

Joe McCurdy: It's been a pretty steady climb for the 20 years we've been doing it, that's for sure. I see no end in sight for that, and there have been couple of things driving that, right? Private equity continues to raise massive amounts of capital and they like availing themselves of this market. You have the banks more so than ever being unpredictable in their ability to serve the market. And there's pockets of volatility that these deal flow into our market, but also it introduces us to new borrowers who say, “you know what? This is not that bad. Yes, I'm paying a premium, but I can deal with one person. I don't have to do all this other stuff that comes with it. And guess what. They deliver on what they tell me they're going to do.” So that trend feels like it's going to continue. And the last thing I'd say is it just kind of makes sense. The people lending the money, originating that loan are the ones holding it. They're pricing risk that they think is appropriate for them. There's no risk in between of guessing if the market's going to be there the next day or not. So, I think it just kind of makes sense longer term. Now, granted, the counter to that is when the broadly syndicated market is functioning and when that market is open, that's the cheaper place to raise capital. So, yes, no doubt private equity is smart and they're economic animals, and for many of them, if that's the cheapest way to go, they are going to think hard about it, especially for the very large deals. So, I don't think that market's going away by any means, but there's an obvious trend that will continue to have those two coexist.

Jay Diamond: So Joe, does all the capital that has been raised recently for private debt concern you? Has the increased capital meant more competition for deals? Has it affected values?

Joe McCurdy: We've always had competition, and for 20 years we've had competition. For at least the last 10, I've had people asking if I’m concerned about all the capital being raised. Maybe there's more headlines now where the dollar sizes are bigger, so they're maybe hitting more people's radar, but this is a trend that's been happening our whole existence. So, it's not new to us. You're always competing on deals. There are always reasons you have to pay attention to what others are doing, but couple of the key trends I think that we've talked about are still there and are going to continue to be there, which is the opportunities that's grown. We can do bigger deals; the whole market can do bigger deals. That's a lot of dollars. The volatility in the liquid markets is not going away. Private equity is very comfortable with the product, and increasingly so. Folks like us that also do non-sponsored transactions, that borrower group, I think actually all the headlines are actually good. That borrower group now, you don’t have to explain who you are and what you are anymore. People kind of get it, which opens up the opportunity of a whole new market, frankly. And right now, as you look down the barrel of the next couple of years, there's a lot of pent-up M&A, and deal volume kind of has to come back. There's private equity, there's LPs that need their money back in order for private equity to raise their next funds, and so we're going to see that deal volume with or without rates coming in. I think there's a real motivation to get that off the shelf. So, I think there's probably two ways it can go near-term. There can be volatility which will push volume into our market, or private equity will push forward to get the pent-up M&A volume and you've got about a year's volume sitting out there waiting to come to market. So near-term, we feel good, and then longer term, I think it's a continued trend of what we've seen, and what's helped is the market's grown with it.

Jay Diamond: Okay, Joe, so what is your outlook for private debt?

Joe McCurdy: I think the relative value of private debt is as compelling as it's ever been. I think the opportunity set in front of us is as good as we've ever seen it, and you can get it by taking less risk right now. We were doing this in ’07, ’08, ’09, we were doing is heading into COVID, and other pockets where the markets --when you think about where the markets have gotten strong or hot or where you've been concerned in the past, think ’07, low interest rate environment, very high leverage levels. The debt investor was paying for those higher valuations. That's not happening today. Interest burden on these companies is so big that leverage is kind of capped because of interest coverage. And so, where that leaves you is you're actually lending at least flat, if not less leverage to these companies. The valuations have stayed the same. So, if the average LTV, loan to value, across our portfolio is about 40 percent, 43 percent, that's a lot of equity cushion in these transactions. And so, we don't feel like we’re wearing the risk in a market where you might argue that the V in the LTV, the valuation, is inflated, but that's not really our problem. If we've got, rough math, six turns of cushion, if they're two turns off on their valuation, so be it. We're still 50 percent loan to value. So, we feel pretty good about what the risk opportunity is. I'm not going to predict where rates go, but where rates are right now, you're making double digits for first dollar risk in companies that are performing in high quality, in our case, large companies, $50, $75, $100 million of EBITDA. These are big, diverse companies that are well-positioned to withstand whatever is going to get thrown at them from the economic environment perspective.

Jay Diamond: What are the risks in private debt that might not be available in some of the other places?

Joe McCurdy: What you're giving up when you do a private debt transaction is liquidity. You're going to hold that loan. And so, all the reasons I said that was a great thing, if you made a mistake, if something changes on a company, if there's a reason that you want to get out, getting out is difficult. You can try, but there's no liquid market to go sell it. Now, what I would tell you is in the liquid markets, when you want to sell, they're oftentimes not as liquid as you wish they were. So, I'm not sure how much of that liquidity premium you're really giving up, or how much of that liquidity opportunity you're really giving up, but that is the big tradeoff. So again, it circles back to, “well, you better be right on the underwriting that you do, and you better make a big investment in that team, and you better have the ability to be selective in the transactions you do.”

Jay Diamond: So how does your team operate here at Guggenheim? How are you organized? What do you think is distinctive about the way you do it? Because now there are a lot of competitors out there in the market.

Joe McCurdy: Yeah. So, I mentioned the origination team. We have a big team, big investment in our team there. I think what truly differentiates us and always has in our 20+ year history across all of our asset classes, corporate credit in particular, is a big investment in our research team. We've got 60 research analysts that focus on industry verticals and so they are experts in what they do in their industry. And the other way we're quite different from most of our peers is we're integrated across liquid and illiquid credit from an underwriting perspective. So, what that means is our analyst who's covering, pick an industry, telecom, she's looking at everything that comes in the door, high-yield bonds, syndicated loans, direct. She's got a team to help her get through all that volume because that's a lot of deal volume, but it puts you in a position where when a deal comes in, you can tap into, think of all the CFOs, CEOs, data intelligence that we have from all of those different borrowers in our portfolio. Think about the trends we can see as earnings start coming out, whether monthly or quarterly in the reporting that we get. And then offensively, when we're out looking for transactions, we use that research team as a weapon there to where we say, “hey, listen, which sub-verticals of your industries do you really like?” We should go find more of those deals.” Or you think about the company that's kind of underfollowed, underknown, and it's broadly syndicated, but not a big deal. Not many people in it. They don't like the ratings out there. They don't like having to deal with a big lender group. We have built a relationship with that borrower and guess what. Next thing you know, it's a private debt opportunity for us. So, we think we're differentiated in that perspective. The fact that we're integrated both helps deal flow, helps underwriting, and it also helps relative value, which we think is hugely important. Many of our peers sit in product silos, so the private debt team is effectively, maybe the same name on the company, but a different team from the broadly syndicated team, a different team from the European team. The fact that we're integrated, all that data, all of those deals, all of that work filters through the same team, same process, same investment committee, which helps us find the best relative value across asset class.

Jay Diamond: Well, Joe, this has been great. I really appreciate it. It sounds like you're incredibly busy with all the deal flow you're working on. But before I let you go, do you have any last words for our listeners?

Joe McCurdy: Private credit has been obviously in the news a lot and a lot more often, and I'm getting lot more questions about it. While it’s in the news more, it's not new. This is something we've been doing for 20+ years. It's a product that we know well. And I understand why all the headlines are there: the headlines are following all the capital that's flowing to it. And the reason the capital is flowing to it is because it's fantastic relative value versus other investment opportunities. So, we agree with that. We continue to see it in real time with the deals that we're doing and we're super excited about the future because the opportunity set looks as good as we've ever seen it.

Jay Diamond: Joe, thank you again for your time. It's been great chatting and learning more about private debt. I hope you'll come back again and visit with us soon. And thanks to all of you who have joined us for our podcast today. If you like what you are hearing, please rate us five stars. If you have any questions for Joe or any of our other podcast guests, please send them to macromarkets@GuggenheimInvestments.com and we will do our best to answer them on a future episode or offline. I'm Jay Diamond. And we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership visit GuggenheimInvestments.com/perspectives. So long!


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