Doherty, CJ
Welcome to the Lending Lowdown. I'm CJ Doherty, Director of Analysis at LSEG LPC. In today's discussion, in what is our 34th podcast in the series, we'll be discussing the US private credit market and BDCs. In order to do this, I'm delighted to be joined by Michael Gross, co-founder and co-Chief Executive Officer of SLR Capital Partners. Michael, thanks for taking the time out of your busy schedule to join me.
Michael Gross
Good morning, CJ. Thanks for having me.
Doherty, CJ
As a starting point, can you tell us a bit about your career path that led you to where you are today, plus a quick overview of your firm and its area of focus?
Michael Gross
Sure, I'd be happy to. I've actually been investing in private equity and private credit now for almost 38 years. I began my career with my co-founder back in the late 80s at Drexel Burnham, working under Michael Milken, which is really where I learned credit for the first time and then I was fortunate enough when Drexel blew up to co-found Apollo with Mark Rowan and Liam Black and some others.
And I spent 16 years there doing private equity and then built out the beginnings of Apollo's credit business by creating their BDC Apollo Investment Corp back in 2003. In 2006, I left to co-found SLR Capital Partners with my co-founder Bruce Fuller. And what we built is really a boutique private credit firm that focuses entirely on lending money to US middle market companies. We've been doing this as a firm for now 19 years.
We've invested about $20 billion since inception with an annualized loss rate of only two basis points. And we do it by a multitude of lending strategies that span from life science lending to asset-based lending to lender finance. And we also opportunistically lend as other private credit providers do on a cash flow basis to private equity backed companies.
Doherty, CJ
Thanks for that. Now to move on to the questions. We've had a sustained period of rapid growth in the private credit market for many years now. And at the same time, you know, I think the market has become even more competitive driven by new entrants. But we also have higher interest rates relative to a few years ago and some degree of economic uncertainty.
So given this backdrop, is the golden age of private credit coming to an end or will the growth trend continue?
Michael Gross
The answer is both. We can argue about when the golden age of private credit really occurred or if it actually occurred, but we can't deny the fact that there's been a tremendous growth of capital into the private credit space that has become a very active alternative for borrowers.
The benefits of private credit obviously is speed to market, flexible structuring. But I think to the point you made earlier, the vast majority of the portfolios that have been created were created in benign credit environments in a 0 interest rate environment.
And lo and behold, we're no longer in a 0 interest environment. In fact, we're in a higher for longer environment, longer than people expected and you are beginning to see strains in the system, companies who have not achieved their growth targets who've been able to kind of grow faster than the increase in interest rates.
And so, I do think you will see an increased level of defaults over the next couple of years in traditional private credit lending portfolios, but I don't think that's going to slow the growth. The growth is coming from an influx of capital from the retail channel that’s providing more and more capital to the private credit managers who will have to find a place to invest it.
Doherty, CJ
Great. And you just mentioned there that you know a feature of the market in recent times is, you know, the strong investor appetite for private credit across institutional investors, insurance companies and increasingly just as you mentioned, retail and wealth investors. Can you talk a bit about what you're seeing now in terms of growth in the wealth channels via public and private BDCs?
Michael Gross
Yeah, it's a it's a great question because in many respects it's really changed the dynamic of traditional private credit direct lending. If you go back over four or five years ago, you know, non-listed private BDCs didn't really exist and all of a sudden in the last five years you've had an explosion.
And there's billions and billions of dollars that have been raised and billions of dollars every month coming into the system. And one of the issues with that is twofold. One is that it's forced people who have had a crazy amount of success in raising capital to change their strategy. And what I mean by that is instead of focusing on the traditional Middle market, in order to put all that capital to work, they've had to lend to larger, larger companies who actually have other alternatives in the public markets.
And so, the larger people become, the more stress that's put on returns because of the need to put capital to work quickly.
The other thing that it does, it does is it's kind of changed the nature of our industry. Our perspective as a lender is private credit should always be treated as an alternative asset class. And what I mean by that is there are times to lend and there are times where it doesn't make sense to lend.
And historically, before these, these, these private BDCs cropped up, virtually all capital raised for private credit were in drawdown funds, which allowed the investment manager to have the market judgment to decide when and when not to invest.
When it makes sense to invest, you call capital. When it doesn't make sense, you don't. These non-listed perpetual BDCs that is fueling the retail growth are structured very much like mutual funds in that when the money comes in, it must get invested.
Otherwise, the yield on those portfolios come down and yields good on our investors. So, the alternative asset manager is forced to invest in both good times and bad times, whether things are frothy or not. And that's really, I think, changed the dynamic of our industry.
Doherty, CJ
And related to that though, and you know, private BDCs obviously play a critical role in middle market lending, but just following on from what you said, to what extent are private BDCs forcing greater participation in larger deals, you know, due to that huge jump in the amount of capital raised, etcetera?
Michael Gross
It’s a great question. I'll give you an example without naming names. A certain firm started a their non-listed BDC five years ago. There were already very large participants in private credit and at that time before they launched it, the average EBITDA in their lending Portfolio is about $100 million.
At $100 million, you're firmly in the middle market because at 5-6 times leverage, a $500 million to $600 million facility is too small for the syndicated loan market. So, the borrower can't play the private market off the public market to get better terms.
That same private credit manager today, because of their fundraising success, has had to go up market and the average EBITDA has tripled. It's now $330 million. At $330 million at five times, that's a $1.65 billion credit facility that puts you firmly in the public market, in the syndicated loan market. So, while yes, in 2023 when everyone spoke about the golden age of private credit, it was a golden age because the syndicated loan market had shut and private credit became the only alternative as a private credit lender lending to $300 million dollar EBITDA companies you could get double digit returns with real structure.
But in 2024 when the market came roaring back and it's continued today, the syndicated loan market has come back strong and therefore all those loans that were done in 2023 have been repriced and restructured to become more akin to public market terms. So, what I'm trying to say in a long-winded way is that this fundraising success has caused people to go further up market and compete directly with the syndicated loan markets. And so, I think we're in a period of time where there's actually become almost diseconomies of scale for being too large in our space.
Because you're forced to compete with the public market, which means lower yields and worse structures for the lenders.
Doherty, CJ
Got it. And let's delve a little bit more into the public and private credit market competition. What are you seeing now in terms of the competition or the relationship between public and private credit markets and what do you expect to see going forward? Will it ebb and flow?
Michael Gross
So it will definitely ebb and flow and that's why when I when I mentioned earlier about our strategy, we view traditional cash flow lending as an opportunistic strategy because we because we run our funds as multi strategy funds, we can flex in between strategies in different environments and so from our perspective, we want to be in aggressive in traditional cash flow lending when the syndicator markets are shut and those markets cycle in and out every three or four years.
And so, for us in 2023, we invest about 80% of our capital in levered loans because it was attractive, but in 24 and 25, we've downsized that to about 15 to 18% because of the pricing. So, it will ebb and flow. And as long as the public market is successful in raising CLO money and the banks are comfortable syndicating loans, if you're at the upper end of the middle market, you're going to be competing with that market because the private equity sponsors are sophisticated enough to know that they can play the private market off the public market. And what's interesting is because it's been so much money raised and because the incentives of the private credit managers, they're going to keep that money invested. And so, they will chase that public market terms to keep investing.
Doherty, CJ
Great. And I'd also like to touch now on the ABL space that you mentioned earlier that you that you play in that space. Can you talk about the difference for our listeners between specialty financing versus direct lending?
Michael Gross
Sure. I mean, for us, specialty finance or ABL is a form of direct lending. We're just not lending against cash flow. We're lending against asset values, which if you look historically both for ourselves and the industry has a much better performance because you're lending against assets that you hopefully can turn into cash in a short-term period of time if you need to.
So, the best examples we lend against receivables. Receivables are traditionally out 60, 90 days. We can underwrite who the counterparty is to make those payments.
And we can get very confident that we're lending on a borrowing base against it. It's a great downside protection and kind of regardless of the economic environment you're in, as long as you're underwriting the proper receivables, you're going to get repaid. And so, one of the businesses that we're building out significantly is kind of a factoring business.
There are thousands of companies across the United States that are too small to be banked by traditional middle market banks. They'd be criticized assets by the feds. The cost of capital is too high to lend to them. But if you peel the onion on many of these companies, you'll find that the receivables are actually investment grade receivables.
So, they're from companies like Amazon or Google or Microsoft. They can’t afford to wait the 90 days or the 180 days to get paid. And so instead they'll factor them to someone like ourselves and we'll generate a 15 to 16% return on those assets.
Financing investment grade assets to kind of triple C rated companies, but it takes, you know, it they're very complex strategies. It takes a tremendous amount of infrastructure to do this. It's not a business that you can be a tourist in. You have to be kind of dedicated in good times and bad times because you have to create the infrastructure to kind of monitor that borrowing base on a weekly basis.
Doherty, CJ
Very interesting. Thanks for that. And last question for you, a little bit more of an open-ended one. What are you thinking about or focusing on in the second half of this year? You know, what are the key opportunities and risks that you see?
Michael Gross
So for us, we're spending the vast majority of our time on asset-based lending. And one of the things we're trying to take advantage of is the fact that there are many, many companies since back to the beginning of our conversation whose capital structures were created back in the zero-entry environment.
They haven't grown fast enough to outgrow the growth in interest rates, and they're beginning to face liquidity issues and they need to raise capital. And they have a choice. They can raise capital either by raising more equity or junior capital, which is very expensive, or in many instances, they can take advantage of the fact that the bank debt structure they put in place is extremely loosely structured and they can carve out the receivables inventory and finance those separately in borrowing based facilities.
So, we're spending a lot of our time with private equity sponsors working on creating financial solutions for them where we can lend against the receivables inventory on a very protected basis and provide them a low-cost alternative to creating liquidity for the companies as opposed to raising additional equity or junior capital.
And for us we go under a structure that, you know, we don't really care how levered the company is or what the prospects are, frankly, as long as we're comfortable that the assets we're lending against are bulletproof in liquidation scenario.
Doherty, CJ
And we will end it there as that's all we have time for today. Michael, thank you very much for joining me. You certainly have given us a lot to think about when it comes to private credit and BDCs going forward, and I hope to speak to you again in the future.
Michael Gross
Thank you, CJ. It’s my pleasure. I appreciate it.
Doherty, CJ
And thank you all for tuning in. As always, I invite you to check out our private credit news, data and analysis at loanconnector.com. And for BDC data and analysis, check out the BDC Collateral platform. I'm CJ Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.
