I'm sure you're familiar with the term

adjusted IBIDA which is only getting

more and more adjusted. Your MMO needs

to be that I want to try and find every

single red flag and you should assume

there are red flags. If you look at just

the US and Europe, um I think energy

demand is going to grow 40% plus over

the next two decades and grids cannot

keep up. So there's going to be a lot of

need for financing uh energy and

infrastructure. I think investors are

looking to diversify away from the US

including from from a lending

perspective. We have to all appreciate

the fact that uh you know AI and large

language models it's a paradigm shift.

You have to recognize that paradigm

shift and I think caution is warranted.

>> Today's episode is brought to you by

Kaya NXT. Later in the show, you'll hear

more about how you can take the next

step for your clients with Kaya NXT's

alternatives education courses. But for

now, let's get into today's interview.

Very pleased today to be joined by Ragav

Kana, managing director within Oak's

global private debt strategy. Ragav,

welcome to Monetary Matters.

>> Thanks, Jack. Thanks for having me.

>> It's my pleasure. Ragav, I want to start

off by giving you my rough sense of the

credit world over the past few years,

and you can tell me to what degree you

you agree or disagree with it. My

characterization would be as follows.

that for the past several years, credit

has been performing extremely well and

judicious underwriting such as the type

that Oakree uh attempts to and does

engage in has has been uh performed well

and and has been rewarded and you know

obviously there are other judicious

underwriters within the credit world but

also uh credit's been performing so well

whether it's because inflation's been

high because company's cash flow is so

high or variety of other reasons credit

has performed so Well, that to an extent

um unjudicious lending and perhaps

reckless lending has also performed

extremely well and I would characterize

that that in my sense has been true up

until the summer of last year 2020 uh

25. Um to what degree would you say my

characterization is accurate? And to

what degree do you think we might be in

a new era where reckless lending is

punished uh as it as it has been

somewhat over the past few months and

that the ability to judiciously

underwrite is going to be a

differentiator in the credit world.

>> Yeah. Look, I mean you make a great

point and I would say I would even go

back further. It's not just the last

three years if you think about it,

right? like u uh certainly private

credit as opposed to uh you know high

yield or broadly syndicated loans is a

relatively newer asset class right like

um a lot of managers started off in the

early 2000s but it really took off in

earnest post the global financial crisis

right because of retrenchment from banks

because of DoddFrank and other

regulatory pressures and if you think

about it we haven't had what I would

call a real recession um since the GFC

right you had some uh you had some

volatility around 2014 16 with the

energy uh crisis. You had COVID which

was pretty short-lived if you really

think about it and then you had uh some

issues in 2022

uh where the market was concerned I

think rightly so for a period of time

about stackflation but then you know the

market if you look at kind of N2021 what

spreads were in in the liquid credit

market as a proxy for risk and where

they were call it end 2023 uh they were

basically flat uh over that time period.

So, uh, we haven't had a real recession.

Uh, we haven't had like, you know,

anything beyond a a, you know, a

dislocation is what I would say. So,

you're absolutely right that, um, the

market really hasn't been tested,

especially for private credit, which

doesn't have as long a history of

showing performance over cycles as, uh,

you know, certainly IG, but also in the

below IG market and high yield and

broadly syndicated loans. Now, you are

starting to see some of those uh,

issues, right, with what you call as

reckless underwriting. show up in the

news, in the media. Uh I'm guessing

you're talking about forest brands,

you're talking about triricolor. Um

there was a Sachs bankruptcy recently.

Um and you know what I would say is one

I don't think this is a like a systemic

issue where I'm seeing a lot of reckless

underwriting like through the system. I

do think these are idiosyncratic issues

and I also think these are idiosyncratic

issues which um you know certainly some

lenders managed to avoid completely um

and you know some were able to stay away

from all three of those situations. So I

would say that certainly uh not not just

with the benefit of hindsight but in the

moment there were enough red flags which

each with each of those three issues or

each of those three issuers where to

your point about you know judicious

underwriting if you had done the

judicious underwriting done the

appropriate background checks on you

know the founder of first brands or

trickleor uh and done other underwriting

you could manage to stay away from them.

Uh the other thing I would say which is

why you know I'm not concerned that this

is a a big like asset class issue.

Certainly there are certain managers

that I think will be punished more who

haven't done the right uh uh type of

underwriting is that if you look at it

you know asset class level um defaults

and like shadow defaults and you know we

can talk about that right like pick uh

as an example uh it kind of peaked out

in 2024

and I wouldn't say it's like

tremendously better but the the kind of

the the path is getting better in terms

of you know the what I would call like

risky assets in the industry

um overall

>> that's really interesting. Thank you.

that you at Oak Tree and other folks at

Oak Tree are always constantly uh

assessing risks and for example last

summer I was lucky enough to have on

Wayne Dah from Oak Tree and he talked

about how when the tariff thing happened

in in April of last year he and all his

colleagues you know sat around the table

and talked about okay what's the

exposure to these companies what's our

exposure to companies that have you know

tariff exposure and obviously that was a

very good practice to do but I I I don't

think it's fair to say that you know

that um that the tariff risk arrived in

credit. You know, I know in the stock

market it certainly hasn't. However,

when it comes to this first brand issue,

you know, I do know because uh chairman

of of Oak Tree, Howard Marx, wrote in a

November uh memo called uh cockroaches

in the in the uh in the in the Canary

coal mine or something like that. um

that that basically the implication was

uh that you know Oakree did a lot of

work on first brands in the summer and

again the implication was that they uh

exited that portfolio and and avoided

avoided that risk. So can you tell us

just about uh you know if you can any

any specifics on the potential red flags

that you or other colleagues saw within

first brand to avoid this massive

default and also just generally what is

the process to avoid those red flags and

what are red flags that uh you think

should should be avoided in the past but

also in the future.

>> Right. So, uh, you're right like, uh,

that was a pretty interesting memo from

from Howard and, um, big picture, there

were three red flags that, you know, if

if a manager had like picked up on,

frankly, any one of those three, u, they

would have stayed away from the first

brand situations. And, you know, if you

picked up all three, you certainly

wouldn't, you know, go any anywhere near

that that that company. The first red

flag was um, you know, for for for the

benefit of your listeners, First Brands,

they make aftermarket auto parts, right?

like windshield wipers, brake pads. Um,

not stuff that I would say is like

highly R&D engineered or has massive

barriers to entry. It's certainly not

like an, you know, Apple or like a

Facebook with like a very incredibly

strong moat. Uh, so given the barriers

to entry, you would expect that their

margins would be in line with other

similarly sized businesses in similar

industries. um and their margins were uh

uh several hundred basis points higher

at least the way they presented it. And

then again, you know, you kind of do

your basic like, you know, MBA first

year kind of thinking, you're like,

well, if the barriers to entry aren't

aren't incredibly high, if the moat here

isn't isn't isn't is in a big moat, then

there's no reason why they should be

earning these call it excess margins.

So, that was issue number one. issue

number two which um you know I'm

sympathetic to some managers uh in how

they did not see this but um but for

managers who invest in both liquid

credit and also private credit uh they

were able to pick up on the fact that

this company was constantly raising

financing

um in different markets that normally

the participants in those markets don't

talk to each other so as an example they

would go to the broadly syndicated loan

market which is dominated by CLOS's race

financing there. They would then go to

the private credit market to raise, you

know, a private loan against certain

assets and then they would go to the

asset back finance market to raise

financing against, you know, their their

their receivables or their inventory,

right? And for managers who are in all

three of those markets, they were able

to actually see that, wait a second,

one, this company claims it has

incredibly high margins and a lot of

cash flow, but second, it is going and

raising financing from these different

markets and is almost deliberately

targeting markets that for most managers

don't talk to each other. So, no one can

see kind of the full picture. Um, so

that was red flag number two. And red

flag number three was frankly just the

the the the founder. Um the fact that

you know the senior management team were

was a founder and like a bunch of his

family members, no professional like

outside management. Uh you know if you

did a background check on on the

founder, Patrick James, you would see a

lot of red flags there as well. So from

a governance perspective, if you did

that background check, you would say,

well, this is not a person uh that I'm

comfortable lending to. And then you

know for those managers who were able to

put all of these three red flags

together you know they were able to see

that you know clearly there was

something very deeply wrong with the

situation. Thank you Ragav. all of those

three red flags. Is it would it be fair

to say that for someone who's just

looking at um you know the the the six

statistic checklist of debt to IBIDA and

other debt coverage ratios that that did

pass that initial sniff test but that

uh there were additional additional

factors to to be considered.

>> That's absolutely right. um um you know

u when when when like in the credit

business um you know our job is negative

selection right um we don't have the

upside of equity um uh you know if

you're if you're making a loan even at

you know rates right now of like high

single digits you're really looking at a

1.2 2 to 1.3 times mock um because you

know these loans usually repay quickly.

Um so it's really about like managing

your losers or avoiding them completely.

And so certainly when you're doing that

as part of the underwriting you do look

at the KPIs, you do look at the metrics

um you do look at you know what is

leverage but then you also start digging

deeper into things like well I'm sure

you're familiar with the term adjusted

IBIDA which is only getting more and

more adjusted u and how different is

that from you know what the cash flow

statements uh show. So you then have to

look at well it's not just leverage that

I'm looking at and the debt service

coverage ratio that I'm looking at or

the LTV based on some implied sometimes

madeup number by the way um by the bank

uh or the borrower but then really start

to you know pierce into the three uh uh

statements the balance sheet cash flow

statement and the income statement to

really you know get a fuller picture of

what this business does from a cash flow

perspective because in the end you know

as we like to say you don't eat uh ibeta

you eat cash flow. Um, and then beyond

that, it's all of these, you know, other

non-KPI related uh things that I talked

about, which is you have to spend time

uh speaking to suppliers. You have to

spend time speaking with customers. The

other red flag that I did forgot to

mention with first brands is um when if

you spoke to their suppliers, they would

consistently complain about the fact

that they would be late on payments and

and ask for very aggressive terms which

were inconsistent with the rest of the

market. you have to speak with former

employees uh to try and turn up red

flags there. Um if anything, you know,

your MMO needs to be that I want to try

and find every single red flag and you

should assume there are red flags. Um

and and you know, it's only at the end

of that underwriting process, including

both the KPIs, but also some of these

like more subjective uh questions that

you have to raise including, you know,

governance uh that you can be

comfortable or not comfortable making a

loan.

>> Thank you, Ragav. So I'm, you know, I'm

quite familiar. I see all the time how

adjusted IBITA figures do sometimes

bamboozle investors in the equity

market. Could you tell us how they uh do

lead to some confusion perhaps in the

credit markets um and and how you try

and avoid that? Yeah. So adjusted IBIDA

um you know it's it's it's a concept

that's been used uh for several years um

u you know going back a decade um and

initially it was a somewhat innocuous uh

term because uh predominantly private

equity sponsors would use that to

normalize for you know truly one-time

events. Let's say they close a facility

which was underperforming. It cost them

some severance and some cost to you know

relocate equipment truly once in like

five years and they would say hey you

know this doesn't reflect my performance

my run rate performance so let me add

that those costs back uh but over time u

the adjustments that are being added

back to gap iittita have become one more

aggressive in the sense of you know the

number of things that are now being

captured and added as an adjustment and

they're becoming more reoccurring in

nature. So when you start seeing you

know adjustments which are you know

sometimes 40 50% of gap IDA and then if

you start seeing those reoccurring like

persisting year after year after year

you know talking about red flags that's

again a red flag and as a manager in

credit again where you have limited

upside and a lot of downside it behooves

you to start by looking at the cash flow

statement and build up to you know what

I like to call casha

Um and then look at you know how

different is that from the adjusted EBIT

figure. If you you know if managers just

did one thing if they started lending on

the basis of you know a cash IATA figure

uh perhaps normalized for you know truly

one-time events like a factory closure

uh as opposed to relying and levering

off an adjusted IA. I think that change

in behavior just that change in behavior

itself will lead to much better uh uh

default uh uh and recoveries uh for for

for credit managers.

>> Earlier you referenced shadow default so

pick or or payment in kind. So in other

words uh credit investors u lenders

being paid not in cash but in debt or

being paid you know the right more

bonds. uh describe the trend that rise

that that you saw over the past few

years and

did you say earlier that that rate

peaked actually in in 2024? Is that what

you said?

>> Yeah. So it peaked in 2024 and again I

wouldn't say it's down like a lot where

you know I would say hey there's no no

problems here like let's move on but it

is like moving in the right direction

and um a pick or like shadow defaults uh

you know what I mean by that is um and

this is frankly one of the uh critiques

of private credit and I think it's a

fair one uh whereby because it's private

because it's you know bilateral where

like there may be there's obviously one

borrower but there may be like a handful

of lenders on the other side. Um and and

there is uh there is sometimes

incentives on both sides where there are

issues with cash flows or

underperformance of the business. There

are sometimes incentives on the side of

the private equity sponsor that owns

that borrower but also uh on the part of

the lender who wants to manage how many

defaults they show to have a agreement

where they say look there's not enough

cash flow to service the debt. Let's say

the cost of debt is 10%. Why don't we do

this? Why don't we reduce the cash

portion of the 10% to making up numbers

here 2%. And let's say we pick the

remaining eight points every year. Um

the incentives are obviously clear. You

can still show this as a not a not a

defaulted loan from a lender

perspective, but for all intents and

purposes, you know, if you cannot

service your cash coupon and can only

service 2% out of 10, to me that's a

default. So when we look at you know the

health of the industry the health of of

the asset class we look at one just

nonacrruals which are true nonacrruals

but then second we also look at which

loans were originally designated as cash

paying loans and are now being

designated as pick loans and how much of

the coupon has migrated from cash pay to

pick uh to look at like what is the

overall health of the industry and

that's probably the portion that I think

is uh least understood by the market.

Yeah, I think it is uh not understood. I

uh was not familiar with it. So, I got

to ask a follow-up question just so just

so I can understand. So, you're saying

that the coup um the uh the principal at

the end of the day is still going to be

paid in in cash, but that you're being

the coupon that you're getting a

percentage of it is going to be paid in

cash, a percentage of it is going to be

paid in additional debt. And that's what

that's what you're describing.

>> Yeah. But it's it's actually slightly

worse than that in that there is a hope

like again using my example of a 10%

cash coupon being split into a two cash

and eight pick. The eight is really

think of that as a hope note

because at the end of year one if you

have $100 of debt and eight points of

pick at the end of year one uh your new

principal balance is 108.

So the reason it's a hope note is if

there's a situation where the borrower

cannot service $100, certainly the

expectation that they will service $108.

Um I I I I wouldn't have that

expectation. And so I think of that as

kind of a hope note where you know in

some ways you know it's a classic um uh

kicking of the can. You're just hoping

something miraculous will happen. uh you

know either someone will come in and buy

this business at a mass value or if it's

a cyclical business you're hoping that

you know the cycle will turn in favor of

the borrower but like again like you're

just hoping there's not not a not

necessarily a strategic plan and I think

of that pick portion as a hope note

>> and is the maturity of the pick note the

same as the m often the same as the

maturity of the principal.

>> Yeah. No, it is it's exactly the same.

The other thing we look at by the way is

you make make a good point which is uh

what's happening to maturities are

maturities being extended. Now if a loan

is uh cash paying uh but the matur

maturity is being extended it's usually

not a sign of you know an issue in

someone's portfolio. Um if the maturity

isn't extended but the coupon is turned

partly into pick that is an issue. I

think the worst uh sign the biggest sign

of an issue in a portfolio is when you

have both when you have a maturity

extension and you have you know the an

agreement to convert uh some or all of

the cash coupon into a pick

>> and those maturity extensions

I I know for a fact that they happen

because um you know company A had a loan

either to the leverage loan market in

the high yield bond market or a a

private credit lender and then another

private lender comes and refinances that

deal. I know that is maturity extension,

but were you hinting at a maturity

extension between an already existing

borrower where there's a little bit of a

um modification? In the banking world,

they call that modification.

>> That that's that's exactly right, Jack.

So, so the lingo in like private credit

is slightly different. Like the first

instance you described where a new

lender comes in and refinances another

lender, we just call that a refinancing.

So, that's like, you know, totally part

for the course. There's no issues there.

uh because a new lender again you know

assuming to use your word a judicious

lender is exercising caution that's

they're reandwriting the business and

saying it's a good business uh the issue

or the concern that I'm highlighting is

exactly what he talked about which is a

loan mod uh where the existing lender

not a new lender existing lender

existing borrower agree on a maturity

extension uh you know and if combined

with a uh a mod on the on the coupon as

well that's clearly a sign of okay this

is there's some stress in this business

>> and so you said that the rate of pick

had actually peaked in 2024 and is down

modestly not huge but modestly in terms

of the rate of loan mods what are you

seeing there

>> so again like you know when when we look

at shadow default rates we kind of

combine um you know all of these like

modifications um to kind of look at one

headline number and um the the the

stress in the system is um uh is is

getting better. Um, by the way, you

know, one important note is, um, I would

make a distinction between loans made in

2021

and loans made, uh, in subsequent years.

And the reason is, you know, some of

these loan mods, by the way, that we're

seeing are actually good businesses. Uh,

but what's happened is a lot of these,

you know, good businesses took on debt

in 2021 when rates were zero and there

was an expectation that rates would stay

at zero indefinitely. And so you know

those 2021 vintages um have pretty high

leverage for where rates are today not

for when what where rates were back in

2021. So uh you know a lot of times

these businesses were levered at six six

and a half times uh you know cost of

debt was it was labor back then plus

let's say 500. So Libbor floor was 1% so

6% cost of debt. So for obviously peaked

at you know five and five and a quarter.

Uh so you know in some cases the coupon

went from 6% to 10 11%. And these

businesses the underlying borrowers in

some cases they've like continued to

grow at a modest like 2 3%. Uh which I

would say is okay performance not great

performance but certainly not

underperformance but it's just the cost

of debt has gone up so much because

these are floating rate structures that

you know the earnings haven't grown in

line with the massive increase in cost

of debt. So um a lot of the uh the the

issues we're seeing in the asset class

in the industry is actually centered

around that 2020 and 2021 vintage. Um I

would say subsequent vintages are are

actually doing performing very well.

>> That's that's interesting and yeah uh

you know you framed it in kind of a

negative that okay a company was paying

6% and now it has to pay 11% but as from

a credit investor perspective that that

you know drastically enhances the the uh

return. So, it is it is a it is a

trade-off.

>> Yeah. No, it's a trade-off, but you

know, from a credit manager's

perspective, you have to balance and you

know, a lot of your questions were were

were kind of lead up to this, which is

you have to manage your coupon that

you're collecting, which is great. It

goes from 6 to 11 with your losses. If

in the uh if in the the change in the

interest rate rate regime you're going

from 6 to 11 but then you're starting to

see a lot of losses because you were not

careful about which companies you made

loans to and you'd made loans to

companies that don't have pricing power

for instance that can increase pricing

to accommodate this now higher interest

rate. Well you you get a lot of coupon

but then you kind of give it back on the

other side through a higher losses. So

the trick in really kind of any cycle,

whether it's an economic cycle or an

interest rate cycle, is is to be is to

make loans to companies that you think

can operate under different types of

business and macro conditions such as

tariffs. You mentioned tariffs, right?

Like that's another kind of big although

short uh shock to the system. Interest

rates was a big shock to the system. A

recession, which again, you know, we

talked about, but we haven't seen a real

one in a long time, would be probably

the biggest shock to the system. So, as

long as you're making loans to, you

know, good quality companies, um, you

may have some kind of, you know, bumps

in the road. You may have some issues,

but generally these businesses have

enough pricing power against tariffs or

interest rates where they can manage and

they can be okay. And then if you can

get that higher coupon and also manage

losses, that's the best of both worlds.

>> Now, I want to ask you about the general

ecosystem. uh you you've talked before

about how there's a merging between the

world of liquid credit uh you know high

yield bonds and and to some extent also

leverage loans and private credit talk

about that the the blurring of those

worlds the merging of those worlds and

then I am also curious about the

relationship and the ecosystem between

private credit lenders um such as

yourself and the sponsors so the private

equity companies that own the equity of

these companies whereas you would be

owning the credit of those companies

>> right Right. So, so uh um that's a

pretty interesting topic. So, happy to

talk about that. But maybe before that,

uh you know, I'll spend a minute just on

private credit because it's sometimes

confusing what is private credit and

which parts compete with the liquid

markets and which ones don't. So, it's

obviously, you know, and as an asset

class, it's grown a lot. Uh it's about

$2 trillion in size in just the below IG

part of private credit. Um uh that's my

focus. Uh but you know the IG part is

like multiple times bigger. Now within

um uh below IG private credit um excuse

me the biggest piece is senior direct

lending.

Now senior direct lending you know when

we talk about how private credit

competes with liquid credit or broadly

syndicated loans. It's really the senior

direct lending part of the private

credit uh universe that competes with

broadly syndicated loans. And that's

where you are seeing convergence. Uh

you're seeing convergence across uh

leverage. Uh you're seeing convergence

across u uh uh covenants or lack

thereof. And you're seeing convergence

across um credit agreement terms away

from covenants. Um where you haven't

seen convergence is that you still have

a 150 to 175 basis points premium uh in

senior direct lending. uh versus broadly

syndicated loans and you know that's

warranted like you need that premium

because obviously this is an illlquid

asset class so investors LPs need to be

paid for that illi liquidity premium but

u you know as broadly syndicated loans

have tightened from their 2022 wides uh

senior direct lending has also tightened

pretty much in lock step which is why

you know these are like very much

adjacent asset classes they're

predominantly used by private equity

sponsors or new LBOs Um but there are

other parts of private credit where

there hasn't been conversions and I

don't see that happening anytime soon.

So um the other flavors are you know

there's asset back finance um there's

real estate debt there's infrastructure

lending there's non-sponsored lending um

and so some of these areas are you know

previously were niche but they are

growing pretty rapidly in some cases

such as infraet and um asset back

finance but they have a high degree of

complexity

either from an underwriting perspective

or a structuring perspective and you

know oftentimes both where the barriers

to entry if you will to make loans in

these sectors uh uh uh in a risk control

manner is is much higher.

And so in these areas of the market you

will sometimes get you know 250 to 350

basis points premium over over broadly

syndicated loans. Now the interesting

thing is you know if you kind of push

that the thinking uh senior direct

lending will kind of move in lock step

with broadly syndicated loans but you

still get like a 150 basis points

premium which is okay. Um, but if you

can create a portfolio where you can

combine all of the elements of private

credit, not just senior direct lending,

and you have senior direct lending

giving you a little bit of yield

premium, but then you combine all these

other areas of private credit to create

a very diversified portfolio where

you're getting, you know, 300 base

points more than BSLs. Well, now you

have a portfolio which is one very

diversified, but second is is generating

call it, you know, 200 to 250 base

points over senior direct lending uh

over broadly syndicated loans, excuse

me. So that's like what's interesting

and that what's been interesting to uh

uh to to LPs. Um, in terms of

relationships with uh private equity

sponsors, I think the other trend we're

seeing is private equity sponsors want

managers that do not just everything in

private credit

um where they can lend to a you know a

regular way LBO but they can also lend

against uh certain you know hard assets

uh through real estate debt or lend

against you know some other assets that

they have. They want uh managers who

have all those capabilities so they can

be a one-stop shop. But the other thing

they want is they actually want managers

who can do private credit but also

liquid credit because to your question

right like in senior direct lending you

are seeing that convergence with broadly

syndicated loans. Uh there's about 60 to

80 billion dollars of paper annually

that moves from uh the broadly

syndicated loan market to the private

credit market and back and forth. and

they want lenders who can offer like

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just everything within private credit

but also liquid credit wor versus

private credit.

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Kaya. Thank you for that. That's that's

really interesting. And in terms of the

relationship between private credit

lenders and that the private equity

sponsors, how important is the

relationship and does the relationship

and perhaps the scale and size and

pedigree and background of the sponsor

take into account? Let's say for example

I I uh you know I'm lucky enough to have

a giant private equity firm and I've

delivered extraordinary returns to my

investors and to lender companies who

have lent money to my companies I have

uh you know historically not defaulted

on that as well. How much would that

impact your analysis at if at all versus

just the pure raw underlying

fundamentals of the company? Yeah, look,

I think I think you make a great point

and and you know, we didn't talk about

this, but um if you if you think about,

you know, Jack, you or I like buying

buying something and getting financing

from a commercial bank, right? The

commercial bank uh like a Wells Fargo

will look at well, what asset are you

buying? Are you buying uh a primary home

versus a vacation home? there's a

different risk profile of the asset

you're buying, but they will also look

at, you know, yours or mine FICO score.

And what you're saying is, well, if you

think about uh the correlary to, you

know, private credit, um you have to

look at the fundamentals of the

borrower, the asset that the private

equity sponsor is buying, but you have

to quote unquote look at well, what is a

FICO score of the buyer, which is a

private equity firm. Obviously, there is

no such concept, right? like uh there's

no number that I that we follow or track

but there is a subjective FICO score

that you have to look at for the private

equity sponsor that's actually doing the

buying of the asset and you have to look

at their track record and um you know

again I think if you're a manager who's

been doing private credit or direct

lending for a long time because there is

no publish FICO score this knowledge is

very proprietary and built up over many

years and decades of relationships with

these private equity sponsors ers in

terms of you're absolutely right like

how do they behave if there's an air

pocket? Do they walk away or do they put

in more equity? Um do they engage in

what's known as and becoming you know

increasingly popular an LMT or a

liability management transaction? Uh do

they pit creditors against each other?

Do they you know take assets away? So

that kind of behavior is absolutely part

of the underwriting and the the part of

the uh questions that uh you know

private credit managers should be uh

should be asking on a deal-by-de basis

>> and the LME or LME uh and the LME or LMT

liability management exercise. Um I

thought that was creditor one uh having

a loan to a company and then creditor 2

comes comes in and sort of takes that

deal in a way that's unfavorable for

creditor one. Um, but you're you're

talking about a the actual equity

holder, the the sponsor doing that.

Describe what that might look like and

why that might be an adverse scenario

for a lender.

>> Yeah, so you're not wrong at all. By the

way, uh Jack, it is like creditor on

creditor, but in order for a liability

management exercise to happen, uh it has

to be initiated by the the the

management team, the board and

ultimately the equity owner, which is a

private equity sponsor. So you know two

common examples of uh LME uh one is you

you the being the sponsor use um the

lack of protections in the credit

agreement of the loan that you had

raised when you did the LBO to move

assets specific assets away from the

collateral package of the incumbent

lenders. And then to your point, um,

either an existing like kind of chosen

creditor or a new creditor more likely

comes in and and provides financing

against that that asset that has been

moved away from the collateral package

of the of the other uh lenders. Um, so

now obviously as an existing lender,

your collateral package has changed.

It's gone down. It's declined. And so

any recovery you were hoping to get will

be lowered if there's a if and you know

likely will be a restructuring. Um the

other uh common path is again initiated

by the equity where they say that they

will uh basically get to the same place

but through what's known as an up tier

where they will take again a chosen

group of creditors and move them higher

in the capital structure and leave the

other creditors behind uh in the

original part of the capital structure.

So again, now your the the capital

structure has been reoriented in a way

where if you're not part of the chosen

group, your recovery is going to be much

lower. Um but it it takes a you know a

willing lender either an existing or a

new one and a willing private equity

sponsor to actually engage in something

like this.

>> Okay, that thank you for clearing that

up. That's that's interesting. And

Ragav, how does it feel or uh what's the

experience like or does this happen at

all of

the private equity sponsors who I'll

just explain the the background for our

for our audience here? Um you know they

they in general have very high uh on on

paper returns. you you use the term MOIC

multiple uninvested capital but in terms

of the capital that they've delivered to

back to their LPs in investors in terms

of dividends that has been uh a little

bit lacking and there have been you know

widespread headlines about that fact and

so they're eager to deliver cash to

their shareholders

and to to their LPs their investors um h

talk about is there any sort of

competition for cash flow and does it

ever you know I know I know a lot of um

you know there are a lot distributions

from private equity and I know there are

a lot of payment in kinds in the

creditors to those private equity

companies but does it ever happen at the

same time and what's the experience like

of if if it is does happen of you know

being being told oh I can't pay you back

while at the same time the equity holder

is actually getting a a distribution

>> yeah that almost never happens um so you

know even though there are there has

been certainly loosening of terms in the

credit agreements of broad both broadly

syndicated loans and senior direct

lending

Um there are certain things that are

just like sacred and uh you know thus

far thankfully the the market the

participants in the market have not

given up on those you know what I would

call sacred rights and one is thou the

equity doesn't get paid before the

lender gets paid. Now of course there's

always like some level of distributions

that are allowed uh the equity may have

to pay some taxes and and whatnot. uh

but in general um uh you don't see

scenarios where uh a company which is

underperforming is also you know somehow

using its cash flows to pay out

dividends and enriching the equity. Uh

what you do see though is um there are

some highquality companies owned by

private equity and high quality private

equity sponsors um who say look um you

we have four turns of leverage today.

We've actually performed really well. We

had five turns of leverage when we did

the LBO. We've reduced leverage. Um we

ran a process. We hired Goldman Sachs

and we ran a process and we got bids

which were 10 11 times. But we think if

we can hold on to this asset for one

more year and do XYZ things, we can get

13 14 times. In the meantime, I have

pressure from my LPS as you just

described to return some capital. So

would you, the existing lenders give me

one turn of additional leverage so I can

make a one-time distribution to my LPs

and show, you know, good DPI. And in

that case, you know, you say, okay, you

know, this is fair. They did perform.

They de they delevered. I have this uh

sheet from Goldman Sachs that shows me

that, you know, they can clear 10 11

times. So, taking leverage up from four

to five times to pay a onetime dividend

is not that objectionable.

>> That that makes sense. And it's good to

hear that uh some things are still

sacred in the credit markets.

>> Yeah. when it comes to a few things uh

you you know two two years ago maybe

three years ago I think the following

things were unamiguously true about the

pre private credit market number one

recovery rates were higher so if a high

yield company defaulted a company that

had a high yield bond defaulted that

recovery rate would be X if a p if a

different company defaulted to a private

credits uh loan that the recovery rate

was was often higher than X um because

the covenants were stronger and the the

the second point is is following that

the covenants are were stronger than

they were in the high yield bond market

and the broadly syndicated loan market.

So those two things uh uh were true and

then also I might say that at least in

the regulatory community there was a and

I've heard this you know directly that

oh private credit is good the migration

of credit risk from the banking system

to the private credit ecosystem outside

the banking system it's good because

it's not in the banking system and it's

not levered. I know just looking at you

know some fundraisings uh in terms of

private credit funds and you know not

talking about anything your firm has has

done but just that often you know there

is a little bit of leverage in there. So

in terms of those three things um can

you talk about just the transition uh

over the past several years of recovery

rates of um uh what's it covenants and

also perhaps leverage of the underlying

private credit fund. Okay. So, uh taking

them one by one. So recovery rates in

private credit um and you know in

private credit uh you typically get

covenants with like smaller businesses.

As you get into really large businesses,

you know, 150 million, 100 million, IA

or higher, where again, you know, you

start to think about the adjacency

between the broadly syndicated loan

market, which has no covenants, by the

way, no maintenance covenants, and the

senior direct lending market because

they are converging uh they're also

converging from a covenant perspective

in that there are no maintenance

covenants in those truly large companies

that can straddle either the BSL market

or the the senior direct lending market.

uh when you look at companies that are

smaller let's say 50 million of IBA or

60 million of ITA that company is not

big enough to straddle the direct

lending market and the broader

syndicated loan market so they only have

like one market they can access so there

in those type of size and you know

certainly as you get even smaller you

start to see maintenance covenants and

as you get smaller and smaller um you

you as a lender obviously need more

protections because you know arguably a

smaller company um is more susceptible

to issues in a recession than a larger

company. Right? So that trend hasn't

really changed. Um the only change I

would say is again as senior direct

lending as an asset class is getting

bigger and bigger and is willing to

finance larger and larger companies and

you know provide financing as big as 56

billion. It's competing head-on with

senior and with broadly syndicated

loans. So you've seen a convergence in

terms of uh covenants there. Um, in

terms of recovery rates, um, I would say

you still get slightly better recoveries

in, uh, uh, in private credit. Um, but

with a one notable nuance, which is it's

not because private credit recoveries

have gotten better over time. If

anything, I would say they're flat, but

broadly syndicated loan recoveries have

gotten worse.

>> And the reason is again, you know, this

this new thing of liability management

transactions. So um you know

historically BSL first leans would

recover 70.75 cents now they're 40 to45

cents for a first lean and again nothing

has changed except that you know you are

just lower in the capital structure by

the time the company actually files or

you know restructures. Um so that's on

covenants and uh and and uh and recovery

and I apologize Jack what was your other

question? um leverage how you at least I

don't know whether this was ever true

but but you know several years ago I

know top regulators top former

regulators would say oh we welcome the

migration of credit risk from the

banking system to the private credit

firms because it's not in the banking

system and it's not levered but I I have

made in my you know personally observed

that leverage is a little bit more

common now

>> uh you're you're right like especially

in the senior direct lending part of the

market you get typically all of the

managers when they're raising funds and

accounts, they're levered. Uh in in

certain like other areas of private

credit, uh because the unlevered yields

are so high, uh you as a manager may not

need need leverage or the LP may not

want leverage at all. But again,

focusing just on senior direct lending,

um u most of those uh managers do lever

and they use about one to one times

leverage. So $1 of debt uh and $1 of

equity.

um you know you would describe that as

well you lever basically you know two to

one you have $2 of assets $1 of equity

um the reason I I think and again you

know I'm certainly biased as a manager

in private credit but the reason I think

that's better um than banks is because

you know I'm sure you know this banks

are lever 10 to1

the other benefit of you know from a

kind of societal and economy perspective

for having these loans in the non-bank

bank sector is that uh you saw this with

Silicon Valley Bank right and and

Signature Bank is that managers are

raising close-end funds or they're

raising evergreen funds where they have

the ability to control redemptions.

So you have longdated capital uh to

support longdated assets because private

credit loans are you know typically 3,

four, five, six year loans. With banks

you have an asset liability mismatch in

that the biggest source of financing is

deposits checking deposits saving

deposits time deposits uh which are very

shortdated liabilities financing you

know what are very longdated assets so

both the leverage is lower in in in the

non-bank sector but then also I think

just as equally important there's a true

m matching of assets with uh the

liabilities

>> thank you ragav so with regards to

sectors you know I think I and maybe

some people watching they think oh

private equity they own a lot of

industrial businesses the steel mills

you know certainly that was true and to

some extent it is true but uh I think a

lot of private equity companies are own

a lot of software businesses and as a

result a lot of private credit lenders

direct lending to those sponsor back

companies make loans to software

businesses and you know ragup I would be

you know very reluctant to take some

minor you know move in the stock market

and ask uh you know experienced credit

investor such as yourself about it But

there is, you know, the bid for software

companies in the equity market is is

definitely down on on the fear that, oh,

all these companies are, you know, going

to be vibe coding their own apps. So,

who needs software names? Um, and then

there was another, you know, not Oak,

but another high-profile credit shop

that actually came out with a, I think

they said they're underweight, uh,

software as a sector. So just you know

your personal view uh just where do you

think uh of of of that of the view that

software is going to be challenge as

well as particularly lending to to

software is it as a favorable risk award

as it was several years ago

>> u you make a lot of very astute

observations including the fact which I

I think many people don't realize that

uh to your point Jack private equity

firms you expect them to be buying

healthcare industrial businesses and

they are but they are uh certainly like

uh you know very heavily indexed to

software especially SAS software as a

service. Um I think you make some good

points and I think you know we have to

all appreciate the fact that uh you know

AI and large language models it's a

paradigm shift and you know I know

there's a lot of questions about what is

the ROI on this spend and like the

trillions of dollars that on data

centers and whatnot but regardless I

think it's a paradigm shift and I think

again you know as a as a lender capp

upside a lot of downside you have to

recognize that paradigm shift and I

think caution is warranted.

Um and you know I think there are three

concerns that the market has and we as

lenders have around you know SAS

business s software as a service

businesses. One is um you know maybe not

right now we're not seeing it but

certainly I think we will see it

customers will start to move their spend

away from the traditional SAS businesses

to AI native companies.

Second is um you know if you think about

SAS businesses their revenue model is

seat based which is how many employees

at XYZ firm are like actually using the

software they charge them on a per head

or per seat basis and I think you're

going to see uh disruption potentially a

lot of disruption to that revenue model

because that revenue model uh you know

under the threat of uh agent AI will

have to move to more of a consumption or

more of an outcomesbased model. So, you

know, customers of software companies

can actually see a real ROI as opposed

to paying on a per se basis. And then

third is, you know, VIP coding, you're

you're right. I mean, I think the

switching cost away from software,

incumbent software is lower now because

AI can, you know, create software and

create lines of code more more easily.

So, I definitely think, you know, uh

caution is warranted. I think software

and SAS businesses I think there will uh

be uh uh there will still be plenty of

winners. Um the ones uh you know that I

think are going to win are the ones that

can show that they have a high ROI uh

and have a lot of integration with a

with a company's overall IT stack. And

then finally, our use kind of day-to-day

like like something like Bloomberg um

you know, it's something that I use rely

on very heavily and um uh you're going

to have to rip it away from my from my

dead hands.

>> So the daily usage and the level of

integration into a company's and an

employees workflows that matters a lot

because think about it right like

software is not just lines of code. It's

also the packaging around it. It's also

the delivery of that software, the user

interface and then the customer support.

It's all those elements that have to

come together. So there will be

companies that especially from a lending

perspective will be okay. I think you

make a good observation that uh there

are question marks around the terminal

value of some of these businesses. You

see Adobe, you see Salesforce, their

multiples have gone down a lot uh

because of questions around the terminal

value. the, you know, kind of the nice

thing from a lending perspective is if

you're lending at 30 40% loan to value,

as long as you didn't get the original

value completely wrong, you know, that

can go down 20 30%. Uh, it will hurt the

equity, but you as a lender uh should be

okay.

>> Thank you. I want to ask about the parts

of private credit that are not direct

lending. So, um, assetbacked finance,

nonh sponsor deals, so lending to

companies that are not backed by private

equity. and then real estate uh deal.

What just what does those three three

worlds kind of kind of look like? And

and would you include real estate loans

as asset back finance or is that

something different?

>> Uh it's typically uh typically

different. So so asset back finance, you

know, think of these as again you're not

lending to a single corporate like a

software company. You're lending against

a pool of assets. So think of it as like

loans, leases, receivables is kind of

what your assets are. Now the nice

things are nice thing is that you know

these the collateral itself the assets

you're lending against they themselves

are you know cash paying uh self-

advertising assets so you get paid down

very quickly and you basically as a

lender take a lot of your basis off

pretty quickly that's from a structure

perspective from an end market

perspective you can you know create

asset back finance deals in all kinds of

different sectors you could do it with

autos uh you could do it with consumer

loans you could do it with uh equipment

uh leasing things. So that's the nice

thing about assetback finance is one is

um the structure is very good in that

you are being paid down uh very quickly.

Uh but then second you can create a lot

of diversification across end markets.

Um that's been a pretty big area of

growth. Um uh certainly in the IG part

of the market but also in the below edgy

part of the market and the reason is you

know those are areas that banks are

stepping away from and have been pretty

dramatically in some cases just selling

off whole different uh whole whole like

business segments. Um so that's been an

area of growth. The other two areas you

mentioned so one is non-sponsored

lending. The biggest area uh um uh the

biggest area of growth uh for us at

least is life sciences. Uh life sciences

is a very highly specialized area of

lending. You need a lot of subject

matter expertise. It's also interesting

from an overall multistrat private

credit portfolio in that life sciences

is asyical, right? Like you're not tied

like the performance of your drug is

tied to the performance of you as a

management team and your R&D team, but

but it's not tied to the overall

economy. Uh so that's an interesting se

segment. And the last one is um which

where I think we're going to see a lot

of growth is uh energy and

infrastructure.

Um, you know, I was listening to Fared

Zakaria over the weekend and you know,

he was talking about, I don't know if

you saw this, he was talking about the

fact that a 5-second AI generated video

requires 3.4 million jewels, which is

the equivalent of running a microwave

for an hour.

>> Wow.

>> And look, if you look at just the US and

Europe, um, I think energy demand is

going to grow 40% plus over the next two

decades. And grids cannot keep up. So

there's going to be a lot of need for

financing uh energy and infrastructure.

Um and there's just a lot of things that

are happening in our economy which are

changing including obviously AI but also

just general electrification. And so I

think that's the other area that's very

interesting. The last one I'd mention

quickly is um away from US senior direct

lending

Europe and Asia developed marketing Asia

are very interesting and it's for two

reasons. point is um this shouldn't be

controversial but I think investors are

looking to diversify away from the US

including from from a lending

perspective. Um and then second is you

don't get a huge premium in Europe or

Asia. It's call it 50 basis points in

Europe and 100 basis points in Asia in

developed market Asia markets like

Australia or Singapore. But the nice

thing is those markets are early enough

where some of the things you asked about

maintenance covenants, you get them.

LMT LME protections, you get them.

Leverage is typically lower. Uh LTVs are

typically lower. Docs are just much much

better. So you get a slight premium in

pricing, which doesn't look like it's

big enough, but on a risk adjusted

basis, I think you're getting a a very

good pricing uh uh both in in both those

markets. And that 50 basis points or 100

basis points premium in in Europe and

Asia. Is that on an hedge basis or an

unhedged basis? Because I know from my

interview with Wayne Doll of Oakree that

at least for dollar investors, Oak Tree

always or almost always hedges the

currency risk.

>> Correct. Yeah. Yeah. So that's on an

unhedged basis. So then you obviously

pick up uh you know a little bit uh on

the hedge as well. So u uh but you're

absolutely right like it's Europe is

pretty interesting. Uh the other nice

thing in Europe is um you know

especially in Germany there's been like

a massive regime change. they've lift

lifted their fiscal break um and not

seeing it necessarily in like full year

2025 numbers but you start looking at um

uh higher velocity KPIs about the

economy I think Germany and broader

Europe um some of the like Trump

administration noise aside I think is

going to have a lot of growth and a lot

of interest in private capital from uh

from uh from from from lenders.

>> Thank you Ragav. Earlier you said

something to the effect I'm going to

paraphrase that the nondirect lending

parts of private credit so asset b uh b

ass assetbased finance and uh um

non-sponsor lending that you said you

didn't expect those spreads to compress

anytime soon. Could you tell us a little

bit why you said that? Yeah, it's

because um u you know these areas of

lending um they require a lot more

expertise

uh again from either a uh industry

perspective like like infra and energy

like you cannot be a generalist right

you have to have a lot of subject matter

expertise same thing with real estate

debt uh or there's a lot of structuring

complexities such as in asset back

finance that you also need and you need

to have that over you know multiple

cycles to be able to do those in a risk

control way that's different from um US

uh or senior direct lending where um

again you know the barriers to entry in

looking at a business services business

which is providing janitorial services

that's very different from a very

complicated you know life science deal

or an infra deal uh where there's a

construction element to it or a asset

back deal where you have to have a lot

of structural protections. So the

barriers to entry in those areas have

are just much higher. The other reason

why you should have persistently higher

spreads in those markets is those deals

take a lot more time and effort to be

able to underwrite. uh if a direct

lending deal takes let's say you know

two to three weeks to diligence um some

of these more niche areas could take you

know 6 weeks in some cases 6 months to

diligence and negotiate and so the

return on time is actually quite poor

and so uh in order to compensate that

like you need and you get a much higher

uh risk adjusted return because the

return on time is poor

>> that makes sense ra my final question

for you is as you know there have been

several uh I guess financial service

providers as well as one asset manager

that uh but in this instance it's not

asset manager it is trying to uh index

and connect all the data points of all

the private credit ledgers. So you know

oak tree has it I'm sure all these

internal docs and all the relationships

and all all this data they're saying

we're going to now do that so everyone

can become a private credit lender and

there's going to be so much more

transparency in the private credit

markets. How optimistic are you that

that is materially going to happen and

be a real change over the next uh uh

several years? And how might that change

the process if if it does happen?

>> Uh sorry, Jack, could you share a little

bit more? I'm not sure what this is.

>> Oh, yeah. Yeah, sure. like um you know

MSCI and uh BlackRock and S&P are saying

you know we're going to not just do

ratings on Moody's do ratings on private

credit deals but we're going to have an

index so that uh you know everything is

is trackable and basically increase

transparency if if if you don't know

what I'm talking about then that

concerns me because maybe I'm just

completely wrong.

>> No, it's it's a I have heard about that.

So I think look I think the one I think

greater transparency is a good thing. Uh

because again as I mentioned like this

critique about private credit not being

transparent is is a is is a fair one. Um

but uh you know I think if you where you

start to see transparency will probably

start with the private IG market

and the reason is you know these

corporates uh will almost always have

like uh uh public corporate bonds. So

from a tracking perspective um from a

ratings perspective it's easier to

create a an index or a shadow rating for

their private loans that they might be

doing uh often times these companies are

also publicly listed where the equity is

publicly listed so they have to file

cues and case right so if if I were to

track and like create a database right

like it's much easier for me to do it

for private IG issuers because they also

have public uh IG issuance and they have

all of the financials out there on the

sec.gov website. I think it's harder to

do um with below IG private issuers

because often times they don't have a

comparable rated bond or loan. There is

no like you know rating that you can

like point to already and then uh the

financials are not available like you

have to be a lender uh an existing

private credit lender to access of those

financials.

Um, you know, there there have been

other ambitious uh uh things as well

such as, you know, trying to create a

trading market for private credit loans.

>> I'm a little less confident that any of

these initiatives will actually take off

in at least the below part of the

market.

>> That's interesting. And in investment

grade private credit, that refers, I

believe, to two things. Number one, a

private credit loan that has been rated

investment grade. Or number two, a loan

to an entity that has publicly traded

bonds that are themselves investment

grade.

>> Yeah. And I'm uh that's that's a good uh

uh nuance you you point out. I'm talking

about the ladder.

>> Okay.

>> Where a company already has a rating and

it has like, you know, uh something you

can point to and say, okay, this is the

spread for this company uh for a liquid

credit. And then you can say, okay,

well, am I getting uh uh properly

compensated for the same credit risk,

but in an illquid instrument? Am I

picking up that illquidity premium?

>> That makes sense. Ragav, thank you so

much for for joining us.

>> Thanks. Thanks for having me. I

appreciate it.

>> Thank you so much for joining, Ragav.

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