Episode 68: Private Debt Update: Don’t Shy Away from Volatility
Joe McCurdy, Head of Private Debt, and Rusty Parks, Portfolio Manager on the private debt team, join Macro Markets to discuss their 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. Let's get started. As extreme volatility whipsaws the markets, private debt has served its role well in investors’ portfolios by providing strong floating rate yields and diversification against market swings.
Here to dig deeper into the current dynamics in the private credit landscape are Joe McCurdy, head of our private debt team, and Rusty Parks, a portfolio manager on the team. Hi, Joe and Rusty, and thanks for taking the time to chat with us today.
Joe McCurdy: Hey, Jay, thanks for having me back.
Rusty Parks: And thanks for having me, Jay.
Jay Diamond: So let's just start with a level set on some basics. For our newer listeners who might not be as familiar with the private debt sector. So, Joe, to begin, what is private debt? How big is the market? How is it different from publicly traded debt?
Joe McCurdy: Sure. So what I'd say is the way we look at private debt in the group where rusty and I sit, we're focused on corporate credit. So corporations that are borrowing and when we talk about private debt, we're really saying we're lending directly to borrowers. So cutting out the middleman who's typically the banks in a syndicated environment, whether that's high yield or broadly syndicated loan.
And instead we're building a relationship direct with the borrower, with the business owner. And that's where our loan will be originated. Now, it's something that's been in the headlines the last few years. That sounds like a new concept. It's really something we've been doing for over 20 years. But the market's developed materially over that time to the point where today it's about a $1.7 trillion market.
To put that in context, similar if not bigger than the high yield market. Same with the broadly syndicated loan market. A lot of the origination and the deal volume that we see get done in the market is fueled by private equity owned companies. And to put in context, the capital that's been raised, there's about, depending where you read it, about half a trillion of dry powder in the private credit market available. There's 2.8 trillion of private equity. So it's dwarfed in comparison when you think about a 50% loan to value. There's a ton of demand that will be needed over the over the coming years for the product. So again, a lot of headlines about the growth of the space. But I think it's it's largely untapped as far as how much capital that's been raised to address it.
And then a few just core tenets of why we like it while we've done it for the last 20 years. Better pricing, better documentation and more access to information during the diligence process. And so I'm sure we'll get into all that.
Jay Diamond: Yes we will. So, Rusty, who are the typical borrowers in the private credit space and who are the major investors or lenders?
Rusty Parks: Sure. With respect to corporate lending, you know, typical borrowers, we break down into three categories. The first is public companies. The second is non sponsored or family owned companies. And the third is private equity backed companies. In the middle market where we focus, most borrowers fall into the last categories just given the cost of being a public company.
But those are the typical borrowers. With respect to who are the major investors and lenders to that space… Major investors in private credit include insurance companies, pension funds, sovereign funds and retail investors. Historically, retail investors have had access to private credit through business development companies. These investors typically outsource the origination credit underwriting, portfolio management to asset managers. Over the last few years, retail investors have gained access to the asset class through registered investment advisors who have engaged with retail customers, aggregated that demand, and then partnered with asset managers like Guggenheim to to collect private credit.
Jay Diamond: Now, Joe, where do you find these deals? How are they sourced? How are they structured? How are they priced?
Joe McCurdy: So as I mentioned, private equity is a big user of the product. So the vast majority of the market sourcing from private equity firms and companies that they buy financing LBOs. We're fairly rare in that we also in addition to that will do non sponsored transactions. So companies that aren't owned by private equity as rusty mentioned could be founders, could be families, could be public companies.
And those are harder to find. But you tend to get a premium when you do find them. So it's a place where we like we like those deals. We like the relative value. As far as structure, primary diligence is one of the main elements on why we like it are you get to work directly with the company. There's no filter, whether that's from the bank that's originating or some other intermediary.
You're working directly with the company, getting access to all of that information. And then that carries over into the documentation. When you think about a broadly syndicated loan, the banks are really, again, playing middleman and negotiating that document, but they're not going to hold the risk. So they don't really have a vested interest in pushing for every term the way a direct lender may.
We like the access you get, the control over the document. And that's both up front, and then in the future when there's amendments that need to be made. You have a real voice because you control the debt. And then on pricing and touch on structure a little bit with this, on average, at least in our portfolio, 40% loan to value plus or minus. Right. So big equity cushion 60% plus equity cushion, leverage less than five turns for true like first lien loans and then a pricing premium versus broadly syndicated of somewhere between 250 and 350 basis points. So to sum it up, you get better access to information in the diligence process. You get a better document. You get a comparable, if not better structure from a leverage perspective. And then you get a nice pricing premium. So adds up to a very good risk adjusted package.
Jay Diamond: Joe, I have a follow up question for you. You mentioned the sponsor versus non sponsor market. I imagine the sponsor market is very efficient. You deal with a certain number of private equity firms. But how do you find and source the non sponsor deal. You said it's a little bit harder. Can you tell us how you guys do it?
Joe McCurdy: Yeah I mean one thing is just the fact that we've been around for 20 plus years. My email address hasn't changed at Guggenheim in over 20 years, and a lot of deals tend to find us, based on how long we've been in the market, how consistently we've been lending to these types of borrowers.
It comes from all over. Right? Whether it's brokers who, you know, I'm not talking about the Houlihan's and Lincolns, although they're a source as well, but I'm talking about that guy in Saint Louis that might have one deal every two years. Right? We've got a network of folks like that that are out scouring the earth looking for deals. We'll go direct in the companies. We've got a 60 person research team. They know their industries inside and out. We'll leverage the relationships they have with management teams to go find other companies that are similar that need our capital. So you have to cast a wide net. The deals take a long time to to percolate and close. It's not like a typical private equity, “hey, we're going to sign the deal on this date. It's going to fund on this date. Off you go.” It can sometimes take years to develop, but the nice thing for us is we’ve been around long enough that we have this pipeline of deals bubbling up every year such that we can have a pretty consistent origination volume. And just to maybe go a little deeper and talk about the kind of risk adjusted return when you look at the recent history of our origination of non sponsored, they tend to have versus sponsor deals about 100 basis point premium on price, about a turn less leverage, a much tighter document. And these are not small companies. Don't think mom and pop. These are—80% of the deals in the profile I just described are $50 million of EBITDA or above. And then the last piece here is when you think about all right, talking about the downside because that sounds risky, our loss rate over the last 12 years is no different between the non sponsored and the sponsored businesses that we've financed.
So again I go back to the risk adjusted return premium. You're getting less leverage better price similar outcomes as far as your recoveries.
Jay Diamond: Thank you for that background. We're going to get into the current market in a bit. But Rusty, can you just give us the typical return profile of private debt and how does it compare to other sectors of the fixed income market?
Rusty Parks: Sure. Maybe just for the listeners I’ll just describe some of the basic components of return. Private debt is typically a floating rate product. And so private asset managers private credit lenders when they structure a deal typically we're charging the borrowers a couple points upfront according to 2% upfront. The interest rate is a function of spread or risk premium over SOFR. SOFR stands for the secured overnight funding rate, and then the risk premium or the spread over SOFR is based on the creditworthiness of the company. So the higher the spread, the the riskier the investment may be. SOFR currently is around 4% today and spreads range about 4.75 to 6.25%. So when you add those two together, you're about an 8.75 to kind of ten and a quarter on the cash rate that these companies are paying.
And then there's call protection, which is to the extent that a borrower prepays the loan, typically in the first couple of years of the loan’s life, there's a prepayment penalty that that inures to the investor. And when you factor all that stuff in, the returns typically result in about 10 to 12% gross return to the lender. And that compares to a couple different asset classes. So when you think about high yield, which is basically a fixed rate product, that's 7 to 9% typical kind of return. And then for the syndicated bank debt market, the returns there are typically 6 to 8% over time. So private credit is delivering relative to high yield, somewhere between a 3 to 500 basis point premium over time. And then for bank debt, it's delivering somewhere between a 400 to 500 basis point premium relative to those markets.
And the delta and returns there is really meant to compensate investors in private debt for a perceived lack of liquidity, the ability to go sell your investment and get paid back if you chose to exit the position. Our team and Guggenheim’s view really over the last 20 years is liquidity is really only there when you don't need it. It can be transient, and if you really need to sell, the market conditions aren't going to be there for you to go sell at an attractive price. So our view is historically we've been short liquidity and we just view this premium that you're getting relative to these other markets. It's just extra yield for effectively the same risk you're taking in those markets.
Jay Diamond: Let's talk about market conditions right now. Obviously the tariff policy proposals and execution and a lot of policy changes coming out of Washington are having an impact on all markets. So, Joe, one impact has been the probability of a recession has risen. So what is your view on this and how do you generally prepare yourself as a portfolio manager and as a lender for, the kind of, environment that we believe you might be heading into?
Joe McCurdy: Yeah. So, Jay, I'm sure you've been talking to our macro team, and I'm sure they've been provided some good content, and anyone listening to that will hear they echo what you're saying. As far as probability of recession is certainly gone up based on the policy initiatives from the Trump administration. You know, that team is very helpful. We lean on that team. You get a top, top down view on things like policy and what's going on in the more broad economy. We tend to be very bottoms up, folks. You know, we're going unit by unit looking at companies. So we combine those two. It's pretty powerful and how we underwrite.
And specifically on policy, that's something we've been tackling since forever but particularly around Trump since the campaign trail. So the announcement of a few weeks ago weren't a shock to us. Maybe the way he did it, maybe the size, the potential impact. But that really all we were doing there is refining work we had already done. And go back to the recession, unfortunately for Rusty and I and all of our colleagues, we have to invest, assuming the worst. Every deal that we do, we assume a recession is looming. And those are where we spend time looking at the model and stressing and looking how the companies performed under various circumstances in the past. So while we watch what's happening in the macro, we have to always live for the worst. And that's how our team has been trained.
The good thing is we've been doing this for a long time. This isn't new to us. Tough markets aren't new to us. It's something we've been trained for and prepare for on every investment we do now.
Jay Diamond: Rusty. Still, there are direct impacts of tariffs that we will see in different industries and regions. So how is your team evaluating this specifically from a credit perspective?
Rusty Parks: With respect to our team, we've encountered tariffs before. This is not a new economic tool that the governments have used to protect their industries. Trump has also been very publicly vocal of tariffs for quite some time, well ahead of his first administration in 2018. He implemented tariffs and we worked through those tariffs and began to, you know, analyze how they might impact companies.
As Joe mentioned, with respect to his current plan, we started evaluating the impacts to tariffs well ahead of his actual election in November and his inauguration in January. So in our underwriting process, our research team looks at supply chain constraints, dependencies, and then pricing power in each of the investments we make. So underwriting is really kind of the first line of defense with respect to unexpected kind of changes in trade policies.
I think the other thing that's important is given how disruptive Covid was to supply chains, most companies of scale and the companies that we've invested in have had to examine and de-risk their supply chains, particularly manufacturers that had exposure to China. So in our approach to credit selection, we look for companies with products or services that have high barriers to entry from competition, diverse supply chains, high customer switching costs, and product and service differentiation relative to peers offering the same services or products. And those characteristics typically lend themselves to high pricing power, which allow our borrowers or the folks that we've invested in to offset that direct impact to tariffs by increasing pricing. With that criteria in mind, we've ended up being underweight the sectors that have the highest tariff exposure.
And so the industries that really don't possess those characteristics are automotive, building products, consumer apparel and electronics, metals and mining, and retail. These sectors are going to be impacted the most. And we relatively underweight these sectors given our investment criteria. And then on portfolio management and how we manage the day to day with respect to our time and then our analyst time, we scored every one of our private debt investments for direct and first order impacts before our inauguration in January, and then twice over the last 60 days as new announcements come out.
And we all use this as a tool to to focus our time. And as you can imagine, the process is iterative changes daily with the announcements coming out of both the US and foreign governments, and we've been very comfortable with how we've positioned our portfolio as a result of the disciplined underwriting approach that we've taken.
Jay Diamond: So, Joe, to follow up on that. So what do you expect to see in terms of credit performance, delinquencies, defaults, recoveries as a result of these higher tariffs?
Joe McCurdy: Yeah, I mean, as Rusty mentioned, the first order impact for our portfolio is really not much at all. So we feel very good about how the portfolio will perform from tariffs. And I'd put it broader, policy. Right. When you think about Medicare cuts or labor shortages based on immigration policy, these are all things that we're digging in. But the way the portfolio is situated, none of this is a huge surprise. And these are things we've always looked at. So we feel good about how the portfolio is positioned today across the board on those points. You know, the later the second order, third order impacts, well, that's where you lead to that recession. Comment. Right. And so no company is going to be immune to that. But what I'd say is we like the industries that we're in or, you know, we're thoughtful about how we're positioned there, the cash flow dynamics of those companies.
And then also, feel like starting at a 40% loan to value blended across our portfolio gives us a nice head start on whose risk it really is. It's really the equity’s risk in a lot of these scenarios.
Jay Diamond: Rusty, have you seen any changes and pricing or liquidity in the wake of these new tariff announcements and the aftermath, the volatility since?
Rusty Parks: That's a good question. I mean, the markets certainly traded off the equity markets in particular, trade off since the start of the year due to the policy induced uncertainty. I think the one thing that that we've noticed is in the broadly syndicated market, you know, the leveraged loan market went 19 days without launching a new deal that's been basically the longest dry run on record since the onset of Covid, when there was a 27 day stretch with no new deals being allocated.
So when you think about how off guard the leveraged loan market and the issuers of credit, it's a pretty stark reminder of the potential volatility uncertainty that these tariffs can create. Now, that being said, with respect to credit, I agree with Joe, this is largely going to impact the equity first and then credit. So as a result you've seen spreads have pushed out 25 to 50 Bps.
But for really high quality companies and tier one companies where we're focused and others are focused, it really hasn't moved that much. And there's a recent transaction, a large transaction in market. Boeing sold a division called Jepson, acquired by Thoma Bravo, the pricing on that transaction, you know, done by private credit large $4 billion private deal really broadly syndicated plus was SOFR plus 475 and 99 which is really relatively tight given market conditions. We didn't play in that transaction, but it is a high quality company. But it just goes to demonstrate that high quality companies could still access private credit even in this environment.
And then just on volatility, like market volatility, has created some of the best employment opportunities for Guggenheim over the last 20 years. When the syndicated market pulls back, the private credit market typically flourishes. And as a result of the syndicated market pulling back, we're able to set better pricing, better loan to value, better documentation, better prepayment penalties. And so we actually welcome volatility. Well, we have to, you know, manage our portfolio and make sure that they're not overly impacted. And taking appropriate steps to protect capital, volatility typically leads to very good deployment opportunities for us.
And so we're actually pretty excited about the current environment.
Joe McCurdy: Yeah I agree with rusty. As far as opportunities set of new deals becomes fantastic. And frankly, we get rewarded for the discipline that we show on our underwriting. We're not trying to do every deal. That's not who we are. And markets like this reward that.
Jay Diamond: So picking up on something that, Rusty said that the deal volume has largely stalled. It's really hard to commit capital in such an uncertain environment, but this has reduced the possible investments in the sponsor channel. So how would you characterize the volume and quality of the volume and and the various channels that you have available to you?
Joe McCurdy: Yeah, I'll jump in on this one. Certainly M&A volume is down and that's largely a private equity concept. But to Rusty's point, quality is up. So the deals that you see you tend to have a higher probability of liking. And we're not volume guys. Right. We don't we haven't raised 50 to 100 billion like some of our peers. We've kept our capital raise in kind of thoughtful and modest just for this reason. So wouldn't be forced to deploy into markets we didn't like. And this allows us to be selective throughout markets and be less impacted by M&A volume. But we do supplement times like this. You'll see the non private equity sponsor backed company portion of our portfolio tends to go up right. It might go from 30% on average a third on average up to you know 40 approaching 50% in a market like this. Because we just can continue to find more compelling relative value away from some of the private equity deals that maybe are a little more picked over by some of our peers. And so commercial banks, public companies, management teams who know us, they value the industry specialization that we have. I mentioned before, we have 60 research analysts focused on industry, and that expertise becomes very valuable to borrowers who are worried. They're worried about the same things everyone on this podcast is worried about from a policy perspective, from economy perspective. And they want to know that the person lending to them understands their business inside and out and will behave appropriately through markets. So having that 20 year track record helps. Having that industry specialization helps. And as rusty said, we love environments like this because it just opens up more channels to deploy capital.
Jay Diamond: Rusty, one player we haven't really talked about in the lending space is banks, but they have returned to the leveraged lending market more recently. What do you think's going to happen with banks as M&A volumes subside and other opportunities show up in other places?
Rusty Parks: So in the second half of 2024, the banks returned and they have led refinancings of some of the larger unitranches that were done in 2021 and 2022. But that activity has really slowed with the tariff announcements and some of the other policy changes coming out of the white House. With respect to the middle market, where we're focused, the syndicate market really doesn't compete with sub $500 million issuers of credit. It's one of the main reasons why we remain focused on the middle market. There's simply less competition.
Jay Diamond: Joe, spreads have widened recently after having been at historically tight levels last year. So how do you view valuations right now versus structural protections, all in yields and the risks that you're taking as a lender?
Joe McCurdy: Valuations have stayed relatively stable from a private equity perspective. Maybe one of the reason you haven't seen a ton of M&A volume. But when we look at that, we're entering around a 40% loan to value on a typical loan. So maybe valuations are too high versus where they should be. But even if they're multiples off, we still feel like there's ample cushion in the loans that we're setting up.
So we feel okay from that perspective. On structure, we're very focused on maintenance covenants, as are many. But the covenants we get, we view as as real, right? They're set at levels that actually will protect capital. But we go a layer deeper than that and focus a lot on EBITDA definition, because that's going to govern every test in the document; leakage, that's cash flow or collateral for a lot of that the horror stories in the broader syndicated market of collateral leaving your collateral package. Let's not forget, this is supposed to be senior secured lending, where you should be entitled to the collateral that you went to. We make sure we have that; and debt incurrence pari priority debt. Right. We want to make sure that the leverage we're lending to day one is not going to creep up without our allowing it.
So structurally, listen, we'll lose deals over structure points when others aren't paying attention to them or aren't focused on them. But we think it's very compelling. And when I take it and I zoom out and you look at the private credit market as a whole, those structural protections tend to be present across the market, not in every deal, but in most to some degree at a material premium over what's in the broadly syndicated market.
So as you fast forward through the next recession, through market dislocation, and you think about the all in return on a recovery rate adjusted basis, I think private credit's going to look very compelling versus broadly syndicated based primarily on these document protections that we're getting. And then on yields, Rusty mentioned before, but you know we look at this market first lien senior secured risk 40% loan to value and we're making 10% plus. So we think it's super compelling on historical basis versus the 20 years we've done this about what you're getting for the risks that you're taking. And arguably this is at heights on a margin basis on where companies are. So as M&A brings more volume to the business or as there's market dislocation, you’re hedged with interesting opportunity coming your way based on the supply dynamic.
Jay Diamond: Rusty, you talked a little bit before about competition. But you know, there's a lot of capital in the private debt space right now. And then at a time when deal flow is waning and there's a potential recession on the horizon. So how do you think about competing, maintaining quality and managing downside risk in an environment like this?
Rusty Parks: It's a great question, and it's a question that investors and the folks listening to this podcast, should be asking. I think the first thing is, is, you know, we have a very flexible platform, and our private credit funds have the ability to invest in Europe, have the ability to do non sponsored credit, have the ability to do private equity backed credit.
And we have a portfolio on the syndicated side that we can mine for very interesting opportunities. These companies that have been historically reliant on the syndicated market now in a volatile market, may not be able to access that that same market for credit. And so what we found is, is over these volatile periods and they've been strong capital formation in private credit over the last ten years, I would say we've always been able to find very interesting opportunities. But you have to be patient and you have to be disciplined. And so in a nutshell, like we're going to continue to do things the same way we have. The last 20 years. We've produced returns in a variety of different macroeconomic environments.
Jay Diamond: Listen, you guys have been great with your time. I know it's a very busy market right now. But Joe, before we let you go, can you just tell us a little bit about how your team operates? How is the Guggenheim private debt platform organized, and what do you think makes you guys so successful?
Joe McCurdy: Yeah, sure. As Rusty mentioned, mining our broadly syndicated portfolios for ideas—that's fairly unique because our team is integrated across liquid and illiquid credit, which most in the market are pretty siloed. Private credit—they might have both under the same banner, but private credit's a completely different group that may be broadly syndicated loan credit, and may be way different than the European credit team.
The fact that we are integrated across all of that opens up one, a lot of information that we find valuable about companies and two, opportunities and rel[ative] value. We can look at what's happened in Europe versus the US, versus the broadly syndicated loan market, and stay disciplined to creating better risk adjusted return. The research team and the research focus of our group are, I think the ultimate differentiator. We are a research first organization. I think if you look at us compared to some of our peers, I classify some of our peers as origination driven. They want to originate as much as they can. That's kind of who rules the roost. For us, it's the research team. It's the underwriting. It's do we like the credit or not? Okay, now let's talk about who owns it and how to structure it. Having that investment of 60 analysts, having those deals come to investment committee five plus times before we buy them. All all that leads to great selectivity. And at the end of the day, I think the key component is the people that we think of as our clients are the folks that have entrusted us with their capital, not private equity firms that we're trying to do deals with. I think that mentality is quite a bit different than some in the market.
Jay Diamond: So again, thank you both. But Joe if there were any takeaways that you could leave our listeners with after our conversation, what would that be?
Joe McCurdy: I think it's don't shy away from volatility. Volatility has historically been a great time for us to deploy capital. We think it opens up deal flow. We think it opens up better terms. And we're excited about the opportunity in front of us--right at this moment, what's in our pipeline today, but also the prospect of what's to come as presumably the Trump administration creates more volatility for us to all weather.
So yeah, thanks for having us, Jay. I appreciate the time.
Jay Diamond: Well, thanks again for your time, Joe and Rusty, and please come again and visit soon. And thanks to all of you who have joined us for our podcast. If you like what you are hearing, please rate us five stars, that helps people find us. And if you have any questions for Joe or Rusty or any of our other podcast guests, please send them to Macro Markets at Guggenheim investments.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, including our whitepaper on the private debt market, please visit Guggenheim investments.com/perspectives. So long.
Important Notices and Disclosures
Investing involves risks, including the possible loss of principal. Stock markets can be volatile. Investments in securities of small and medium capitalization companies may involve greater risk of loss and more abrupt fluctuations in market price than investments in larger companies. The market value of fixed-income securities will change in response to interest rate changes in market conditions, among other things, investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their value to decline.
High yield securities present more liquidity and credit risk than investment grade bonds, and may be subject to greater volatility. Structured credit, including asset backed securities or ABS, mortgage backed securities and closer complex investments, are not suitable for all investors. Investors in structured credit generally receive payments that apart interest in part return of principal. These payments may vary based on the rate loans are repaid.
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