CJ Doherty:
Welcome to the Lending Lowdown. I'm CJ Doherty, Director of Market Analysis at LSEG LPC. Today we're discussing a new topic for us, portfolio debt securities. We'll aim to explore what they are, how they fit within portfolio construction, and approaches to risk management. Joining me today to share his expertise is Kyle McGrady, Senior Principal and Head of Client and Partner Solutions at Eagle Point Credit Management. Thanks for joining me, Kyle.
Kyle McGrady:
It’s nice to be here.
CJ Doherty:
So let's begin, Kyle, by, I'll ask you to provide an overview of your background and responsibilities at Eagle Point and give our audience a brief introduction to the firm's area of focus.
Kyle McGrady:
I'm one of six senior principals at Eagle Point. I also sit on the firm's investment committee. My day-to-day is actually interacting with some of the largest institutional investors across our entire platform. And then also involved in product development and also as we bring on new teams to the platform is expanded over time. I've been intimately involved in that as well.
Eagle Point is a $14 billion investment manager focused on private credit. At a high level, we believe we are the largest holder of US CLO equity in the marketplace. One of the largest non-bank lenders to credit funds, which we'll talk about today further. And then other areas within private credit that we're focused on. We have a team now focused on lower middle market infrastructure credit, especially finance, inclusive of regulatory capital relief, and then what we call strategic credit, which today is principally equipment finance.
CJ Doherty:
Now let's start with the basics. For those who may be less familiar with the asset class, can you explain what portfolio debt securities are and how the market has evolved in recent years?
Kyle McGrady:
Sure, CJ. So we joke internally that if you Google portfolio debt securities, you won't find anything other than now you'll be redirected to the Eagle Point Credit Management website. But what portfolio debt securities are, this is debt issued by credit funds to finance a portion of their portfolio.
The key attributes of portfolio debt securities. The first is something called an asset coverage ratio requirement, which is effectively like a NAV covenant that protects our position as a debt holder. And typically, we are lending either senior secured or senior unsecured. And effectively what happens if you breach this asset coverage ratio requirement, we need to get delevered. or in a situation where we're senior secured, it could result in event default and we'd have the ability to accelerate our position as a senior lender within the capital structure. The type of funds that we ultimately lend to is pretty much any credit vehicle. So, this could be private credit funds, it could be commercial mortgage REITs, BDCs, closed end funds, or we could provide really flexible financing and lend to an SPV of a credit fund as well. That's in the broader portfolio debt security strategy.
CJ Doherty:
And I know portfolio debt securities are often discussed alongside NAV lending. How do you differentiate the two and in what situations might an investor prefer one approach over the other?
Kyle McGrady:
This comes up when we describe portfolio debt securities. So, what is it? And it's kind of, it's a hybrid really between traditional direct and middle market lending and NAV lending. So, we are lending directly and originating investments to credit funds, which would be, you know, very similar to what you'd see in traditional direct and middle market lending.
Although what we're doing is we're not lending to a company at a multiple of EBITDA. We're actually lending to a credit fund based on the fair value of their portfolio today. The similarities with NAV lending is we do have that asset coverage ratio requirement, which is effectively like a NAV covenant, which requires the fund to maintain at least 150% asset coverage on our debt. A couple of differences between what we're doing and NAV lending, we're lending to a highly diverse portfolio of credit assets rather than lending to, you know, traditionally NAV lending, it's a private equity portfolio. NAV lending, you'd have more concentration, more risk compared to portfolio debt securities, that's one. From a covenant standpoint, we're often getting much stronger covenants that you typically get within NAV lending as well. To be balanced, the LTV that we're lending at is generally higher than what you'd see within NAV lending. I'd say 40 to 60% would be the LTV, and NAV lenders are generally lending at about half of that.
And from an LTV standpoint. With that, we still have about 40 points of structural subordination below us at a minimum within the fund that we're ultimately lending to. And we have greater diversification. And as I said, generally are regretting greater covenants or better covenants than you would get in traditional NAV lending. I would say also NAV lending, to be balanced as well, has gotten a bad rap just because of the use of proceeds. The market identifies NAV lending as use of proceeds as to pay a special distribution back to LPs. Our understanding is that's a minority of the transaction. But moreover, in terms of the use of proceeds, when we're lending to a credit fund, is to either take out a bank that no longer wants to continue lending to the credit fund, or we could provide greater flexibility than the bank could ultimately provide, or it's a fund that actually has never used leverage because they haven't been able to get it historically. So, we potentially lend to the credit fund or maybe even SPV of the credit fund. Both would be very well structured.
CJ Doherty:
So from an investor's perspective, where do portfolio debt securities fit within a broader portfolio allocation? What role can they play in terms of income generation, diversification, and risk-adjusted returns?
Kyle McGrady:
Yeah, so the investors that we've worked with historically, and just to frame, we launched a strategy in 2020. We've deployed about $10 billion since 2020.
To date no portfolio debt security investment has experienced a credit loss.
To our knowledge, we’ve had about 1.4% of our portfolio that has covenant breaches.
So, we actually described the strategy under the defensive income strategy at Eagle Point. And the two ways in which institutional investors are implementing this are, one, within their fixed income portfolio. So one thing I haven't mentioned is the investments that were originating are about 80% of that $10 billion that has been deployed has been in investments that are IG rated.
So they're incredibly capital efficient, especially for insurance company clients. And that would fit within their broader fixed income allocation. Since launching the strategy in 2020, the comp would be investment grade corporate bonds for us, and many of our insurance clients are looking to that index as kind of the benchmark.
In our unleveraged strategy, to date we have outperformed IG corporates. Though please note, per compliance, that past performance is not indicative, or a guarantee, of future performance.
And then the second area in which clients would implement the strategy would be on a levered basis. We do apply typically about a half a turn of leverage (which is less than most direct lending strategies) to get you to the same or potentially higher return profile.
So it would traditionally fit within the private credit allocation of an institutional investor. However, I would say it's less correlated and we think safer than traditional private credit, just because, one, from a correlation standpoint, the types of collateral pools that we're lending to could be corporate credit, consumer real estate credit. So we have less correlation between the underlying asset classes. So that's really important. And then also from a structural subordination standpoint, in order for us to typically take impairment, we would need to see 40% net losses at the portfolio level.
So we think this is, once again, a more defensive way to get exposure to private credit for those institutional investors putting it in their private credit portfolio. To summarize, we do see a difference in terms of from an implementation standpoint. Most of our clients are on the unlevered side who are putting in their fixed income portfolio are insurance company clients.
And then for the leverage strategy, that would mainly be public pension plans, endowments and foundations, some corporate pension plans.
CJ Doherty:
Great. And given that downside protection is a key consideration in any credit strategy, when evaluating PDS investments, particularly during periods of market stress, how do you assess and manage risk?
Kyle McGrady:
I think it goes back to the key covenant that we get in place with that asset coverage ratio requirement. So that is both an occurrence and a maintenance-based covenant. So ultimately what happens in a downside environment, this has happened in, as I said, we've had six covenant breaches or about 1.4% of our portfolio have had some form of covenant breach.
Most of the time, it's that asset coverage ratio covenant that would be breached. In the event it does get breached, effectively, we need to get delevered as the senior lender within the capital structure. Another mitigating factor if we are lending senior secured is we have something called a valuation dispute mechanic.
So, I'll be generous with my comments that private equity and private credit, sometimes the valuations could be more of an art than a science, but that asset coverage ratio requirement is only as protective as the value of the assets being marked at fair value. So, if everything is marked at cost, that's not very protective for us.
So we have something hardwired when we're lending senior security generally that allows us to dispute values. And fortunately, we've never had to implement that valuation dispute mechanic, but it'd certainly be something that we potentially may have to implement in a very stressed environment within the broader market.
CJ Doherty:
From my experience, Eagle Point is well known for its expertise in CLOs and structured credit. How does the PDS strategy leverage the firm's broader investment platform? And from your perspective, what advantages does that provide when sourcing, underwriting, and managing these investments?
Kyle McGrady:
The portfolio debt security strategy is very symbiotic with our CLO investing strategy. If you think about the three core competencies required for investing in CLOs, it’s exactly the same for lending to credit funds. So the first is understanding the underlying credit manager is really important, evaluating the underlying collateral being the second. And then the third is where in the capital structure do you want to be. And then from a sourcing standpoint, there's over 100 active US CLO collateral managers in the marketplace today. Many of those collateral managers are part of broader credit platforms and they require financing for their credit funds.
So once again, it has been very, very symbiotic more broadly. The other interesting thing that I've observed over time, just given the strategies that the firm is investing in, oftentimes we will get a portfolio that has asset classes where our portfolio debt security strategy team is interacting with other investment professionals at the firm from an underwriting standpoint.
So we recently did an infrastructure credit deal. So obviously our portfolio debt securities team worked closely with Jen Powers who runs the infrastructure credit business, or there could be specially finance asset or even CLOs within some of the portfolios. So there's a lot of cross collaboration between the broader teams.
And oftentimes we may have someone actually on the deal team that doesn't necessarily sit on the portfolio debt security strategy team more broadly. So that's how we've really set up the culture of the firm as well, to be very cross-collaborative across the organization.
CJ Doherty:
And now a final question for you. In addition to PDS, what other opportunities in credit does Eagle Point find particularly compelling today?
Kyle McGrady:
I think in particular, since the beginning of last year, we hired Jen Powers, who built out GIP's infrastructure credit business. So Jen has now been with the firm for about 18 months. She's deployed about a billion dollars across 13 transactions, and this is lower middle market infrastructure credit. We really like that asset class today. The receptivity from our existing investors have been very good as well, just because a lot of clients within private credit today are trying to find asset classes like portfolio debt securities and like infrastructure credit that are less correlated to just traditional, direct and middle market lending.
So we think that's very interesting today. Within strategic credit, we've been very active there in equipment finance. So that's an area in which we think is interesting and once again going to be less correlated to the broader corporate credit market. And then we've been doing some interesting things within specially finance as well. So broadly across the platform to just summarize, I think investors generally think of private credit as traditional direct and middle market lending. There's other areas of the marketplace, and that's really where Eagle Point's operating today and providing a level of diversification to our institutional client base that we think will be very additive to portfolio construction.
CJ Doherty:
And with that, we'll wrap up for today. Really appreciate you taking the time to join me, Kyle, and sharing your insights.
Kyle McGrady:
Great, thank you so much, CJ.
CJ Doherty:
And thank you all for tuning in. As always, I invite you to check out our private credit news data and analysis on Loan Connector, BDC Collateral, and LSEG Workspace. I'm CJ Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.
