Dear Valued Clients and Friends,
In this week’s Dividend Cafe:
- We look at why those doing market strategy out of perceived military strategy are dangerous.
- How the private credit narrative of contagion risk is grossly misunderstood.
- And how the current private credit drama will lead to some very good things in the end.
Let’s jump into the Dividend Cafe …
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What this week’s Dividend Cafe is Not About
There continues to be a highly elevated volatility across risk assets as the Iran military operation continues, and stocks endured their fourth week in a row of negative price action. I’ve done my best to offer relevant information in the last couple of Friday Dividend Cafes, as well as throughout the week in our Monday edition and Daily Recaps. There is prudence in exercising restraint in commentary right now, as so much “market analysis” of where things stand requires “military analysis” that is laughably impossible to offer with any sense of true knowledge since, you know, all the people offering it are market people who don’t have the foggiest idea what is actually going to happen on the military side. It is not just market commentators who do not know where things are going in terms of geopolitics and military strategy – it is every single person in the media offering their “analysis,” and it is all regular people sitting around with armchair speculating. Now, such conjecture and thought experiments have their place, and banter is part of what we do. But formulating market analysis from the cheap seats of amateur hour military strategy or prediction is, well, stupid.
I do think a “base case” and some form of “probabilities” exist. But I can’t and won’t turn Dividend Cafe into one of the many impostor investment commentaries where a fake inside connection to the Pentagon war room is concocted. No such thing exists for anyone – anyone – writing about markets. Everyone writing about markets and the war implications for it is either reporting what they see on the news (30-70% of which itself might be questionable for accuracy and thoroughness and objectivity) or they are practicing rank conjecture. I find both unhelpful. I’ll continue to frame things around base-case expectations and reasonable probabilities, and I’ll continue to reiterate the major takeaways (particularly the expectation for continued elevated volatility). But I do want to keep writing about other investment matters besides the one (Iran) where additive commentary is most reliant on me making things up out of thin air.
Speaking of Making Things Up Out of Thin Air
I wrote three weeks ago about the fallacies embedded in current coverage of “private credit” – namely, the conflation of two unrelated stories, and the inaccuracy embedded in one of those two stories. In other words, I posited that credit risk is one story, liquidity is another story, and they are not the same story. And I suggested then (and emphatically continue to affirm) that in the case of that second story (liquidity) it was a feature being presented as a bug (gates and limits on redemption of what is an inherently illiquid, long-duration asset class). But what about the first story – the idea of credit vulnerability throughout the space? Is private credit riddled with cockroaches waiting to surface, creating mass writedowns and losses for debt investors, even those debt investors who belong in the asset class and have the duration patience the investment requires?
And much more importantly, are these private credit vulnerabilities and events, if real, actually contagious? In other words, is the media right to be talking about all this as some sort of systemic event that threatens to damage the core of the financial system and entire economy?
The Challenge in Commentary
A frustration for someone like me who, first, is an actual asset allocator actually managing money and actually deploying many billions of actual dollars on behalf of actual clients, and then second, is offering market analysis and commentary as part of the work we do at The Bahnsen Group (trying to benefit our clients and readers with our authentic perspective and thought), is that sometimes I have to offer commentary on things that don’t remotely match what we see inside the market.
“What do you think about all the defaults in private credit?”
“I don’t see a lot of defaults in private credit.”
“Well, what do you think about the defaults in private credit that you don’t see?”
“I think my head hurts.”
Conjecture about what may happen gets conflated with reality on the ground, and pure punditry doesn’t ever have to reconcile the truth on the ground (inside markets and portfolios) with what they are writing or speaking about, because they have no “other side” to reconcile to – it is a make-believe world of pure punditry. And I admit that must be a lot easier, especially for a fiction writer (IYKYK). But how am I supposed to write about a media narrative as if it were true when my own portfolio reality, at least for now, suggests it is not (yet) true? I can certainly write about hypotheticals, but that is not the framing currently being proposed. We are talking about a wave of private credit defaults that do not yet exist, caused by a catalyst (AI putting SAAS companies out of business) that has not yet happened, creating a firestorm that is almost impossible to conceive of (contagion impacting the entire economy through non-bank lenders).
But I will try my best.
This is Not a CYA. This is Real.
I do not believe the private credit asset class will come out of this era unscathed. I do believe there will be defaults. I do believe some asset managers have reached more than others. I believe the huge fundraising capacity that materialized over the last decade, often fueled by easy money, will certainly mean some bad loans were made. There is a basic historical and economic reality at play: on the margin, when “too much” money is thrown at something, the further down the food chain one goes, the lower quality the asset deployment proves to be. This can take the form of bad asset managers deploying too much capital, and it can take the form of good asset managers settling for lower-quality deals as they take on excess capital. The latter is less of a risk than the former, if history is a guide (and for free reasons embedded in the phrase “good asset managers”), but it can happen, and economics is done in the margin – it is entirely possible even for the best of asset managers that loan #1,000 is less desirable than loan #1 was.
So, just for total clarity, I believe there will be the proverbial revelation of some emperors wearing less clothes than others, and I believe that is true of all asset classes and all asset managers at all times. The dynamic behind it is reinforced when an asset class attracts a glut of fast money, and private credit’s floating-rate structure in a period of rising rates, combined with the easy money and attractive spreads that existed over this decade, facilitated rapid fundraising, no doubt.
But “we will see bad loans” is different than “we are seeing bad loans.” The claim of “company ABC just defaulted and was a bust” is different than “the private credit companies we are talking about actually owned company ABC’s loan.” A reference to a bad loan is different than a reference to an entire portfolio of bad loans. And by the way, a “loan in default” is different than a reference to a “final loss to an investor” (that media coverage of this appears to not remotely understand the recovery process in the world of credit, especially senior-secured first lien lending, is one abundantly clear part of the last two months).
Just the Facts, Ma’am
Let me suggest these five statements as guiding factoids in the current moment:
- AI disruptions that impact certain software companies would be impacting the equity of those companies far more than the debt (which, by definition of capital structure, is senior to equity). Isolating this broad narrative to “private credit” is laughably stupid. And then applying it not just to private credit but also to private equity and public equity requires some parsing of each company, each collateral particularity, the cash flow dynamics, each strategy, etc. Monolithic assumptions about AI and software are entirely unhelpful.
- In the only real case of meaningful loan sales we have seen so far (Blue Owl’s sale of loans in non-traded BDC, OBDC II), the loans were sold at 99.7% of par value, with co-investors doing their own due diligence and serving as unrelated buyers to effect these transactions – sophisticated, high-profile investors making a market on the other side.
- If it turns out that there were undisciplined managers during the credit boom who engaged in poor underwriting and took on excessive leverage, the investors in those managers would face losses. They took on a high-reward investment, and that comes with risk. And not an iota of that is “contagious.” It is not in the deposit base of banks. It is not connected to the capacity of our financial system to extend credit. It is not in the context of a universally held asset (i.e., residential housing). It is a “buyer beware” potential loss, not a systemic one. There are no counterparties who then risk repayment loss that then bleeds into the global financial system. These comparisons are simply fictitious, sensationalized, and silly. There is a difference between a bank and an investor.
- But that is not the end of it. I believe any potential wash-out of bad or reckless asset managers fortifies the system. It reinforces the asset class for those who were not in that camp. It reallocates capital more efficiently and productively. It becomes increasingly anti-fragile.
- There is not just a “good versus bad” distinction at play within alternative asset managers and credit managers, more particularly. There is also an “aligned vs. not aligned” distinction. Where managers have an ecosystem, a business model, and a total infrastructure that more aligns their investments with their clients, that has to be thought of differently than managers who do not. Those who underwrite loans to be in business for 40-50 more years are different than those who underwrite to capitalize on a quick moment. Those who have balance sheet exposure (sometimes, heavily so) have different incentives and practices than those who are pure fee collectors.
Conclusion
We are not about to hear the end of private credit drama, and we have not heard of the last default, or impairment, or story that is made to exacerbate clicks and noise.
But the idea of some private credit managers being better than others was true many years ago, and it will be more true on the other side of all this, when pundits and writers get bored and move on to their next amateurish coverage of a topic.
And when all is said and done, some are going to be a lot happier than others.
Chart of the Week
The broader loan universe has seen yields drop, not increase, in recent weeks. The macro conditions in credit markets do not suggest a macro problem.
Quote of the Week
“We see the current phase of the cycle as one defined by dispersion, not distress. Credit quality is differentiating, and capital is discriminating. Opportunity exists for investors with judgment, scale, discipline, and perspective to see through the noise.”
~ John Zito
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A big Monday Dividend Cafe awaits as we go around the horn across all normal topics. In the meantime, may your March Madness brackets be in good order, and may your exposure to any asset class be thoughtful and aware, and may your understanding of it all be in the signal and not the noise. To that end we work.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
