Ep 71 | Brian Murphy | What Does AI Disruption Mean for Private Credit? | ROI Podcast

Artificial intelligence has emerged as a disruptive force in the economy, as investors race to identify companies and industries that could be disintermediated.  Brian Murphy, Co-CIO of First Trust Capital Management, breaks down the implications for private credit, including potential risks and opportunities for investors.

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Transcript

Why Everyone Asks About Private Credit

Ryan 0:09

Well, it seems like every day there are more questions being raised about what's going on in the private credit market. Investors are concerned about some of the downstream effects of artificial intelligence, maybe industries that could be disrupted by that, like software, and what the implications might be for private credit. Today I am joined by Brian Murphy, portfolio manager and co-chief investment officer of the First Trust Alternative Investment Research Team at First Trust Capital Management. Brian and I are going to discuss some of those issues, some of the risks and opportunities in the private credit market. Thanks for joining us on this episode of the First Trust ROI podcast. Definitely a lot going on to talk about. You know, it's funny. I'll tell you, I was mentioning before we started recording that I was traveling around Europe last week for work. And one of the questions that I got repeatedly, and the same was true when I was I was in Tokyo the month before, and I've traveled all over the country this year. And I always get questions about private credit. And you know, it's like I'm I'm not a private credit guy, you know that, right? I'm an ETF strategist. I mainly talk about equities, but there's always that question uh that comes in about private credit. So uh I'm glad we were able to uh have you on the podcast to hopefully explain all the issues and we can figure all that out.

Brian 1:36

Yeah, I know absolutely happy to be here today. And certainly private credit's been a been a big topic in the alts landscape for several years, but certainly seems to be top of mind uh broadly in the last couple months.

What First Trust Capital Management Does

Ryan 1:46

Yeah, there seems to be connections and it seems it seems to be sort of maybe there's some problem and people don't quite understand what it is, but we'll talk about all of that before we uh before we dive in though, Brian. Um, there's probably some people that are um familiar with first trust but not familiar with first trust capital management, um, and maybe they've not met you before, but you're you're uh a portfolio manager, co-chief investment officer of the first trust alternative investment research team. Um so for anyone who doesn't know you um and maybe is less familiar with the the um first trust capital management, um, tell us a bit about what the relationship is with First Trust and a bit more about what your team does and and um you know your role on that team.

Brian 2:33

Yeah, absolutely, and and thanks for the opportunity. Um First Trust Capital Management is really the alternatives arm of the broader uh First Trust Portfolios asset management business. We have two primary verticals to our business. Uh one is our own asset management firm, in which we're the advisor to mostly interval funds and tender option funds and other kind of similar interim liquidity uh uh 40 act wrappers, where we deploy capital into alternative strategies that my research team uh sources and diligences and and and uh ultimately approves. Uh the other side of our business is an advisory business. Uh, and that business we face the RAA community and really help them build custom portfolio solutions uh within the alts landscape. So that's hedge funds, private equity, real estate, illica credit, and structure credit, which is where private credit would of course fall. And so I I get the benefit of getting to run the broader research team today. That's about 26 individuals on its way to 27. We have a junior joining us in two weeks uh out of school. Um and that team is responsible for canvassing uh today, largely North America and Europe, uh, for what we think are the highest quality alternative operators across that full spectrum of strategy. Uh and so once we find an operator that we think is best in class, uh our our team does a deep dive diligence on them, both from an investment diligence perspective as well as ops diligence perspective. And some relatively small percentage of those GPs will get across the line with us and approved uh at IC for our team then to deploy capital in either from our advisory business, our custom fund advisory business, our asset management business, or increasingly both.

Ryan 4:09

So that's that's very helpful in kind of framing um you know who you are and what you do on your team. Um, but I want to circle back to my question. My question was um that I've gotten from advisors all across the country, even around the world. Um, and the the question I've I've gotten is usually very broad, and it's difficult to answer broad questions, but it usually goes something like, you know, what's going on with private credit? And I and I follow up with my own question, well, what do you mean? What's going on? Can you be more specific? And it's usually some form of, you know, well, maybe I'm uh not quite sure what I'm what I'm asking about, but I've heard grumblings and in the back of the advisor's mind, maybe there's something, you know, they they remember back in 2007 and 2008 when you know the the run-up to the the financial crisis and there was debt instruments involved, and they weren't really sure about those either. So there's all sorts of connections being made. Um, so as you answer that question for me, let me let me specify it a little bit better. And I want to start off with, you know, for those that maybe aren't familiar with what we're even talking about with private credit, because we there's a lot of people that watch the podcast or listen to it. Um, what what do we mean? How do you how do you specify exactly what we're talking about with private credit? What makes it private? Um, tell us a bit about the asset class.

Defining Private Credit And Direct Lending

Brian 5:30

Yeah, and I think that's the most important question when you begin to ask about kind of what's going on from an opportunity set perspective, certainly what's going on from a risk perspective, is really to begin with exactly that. Private credit is a completely generic term. It's a massive industry that encapsulates a whole host of different types of non-bank lending effectively. Now, with that said, most of the headlines that have been written, honestly, over the last several years, although with with more frequency over the last couple months, about a quote unquote bubble in private credit, the segment of the market they're really referring to is direct lending. And even within direct lending, which itself is a generic term, they really mean mid-market direct lending. And so I think it's very important to know exactly what that market is and why that exists with non-bank, non-traditional lenders today, uh, especially to your comments about the the GFC or the 2008 crisis. So the vast majority of middle market lending is lending by private sponsors to private equity-owned businesses. Those private equity-owned businesses have EBITDAs that range anywhere from historically, that core middle market would be anywhere from $25 million to $100 million in EBITDA, but increasingly, as private credit as a market has grown, even much larger businesses that might have, say, $100 to $250 million in EBITDA might face a private lender. That lending historically was done by commercial banks. And it was the post-GFC regulatory environment and the shifts in how bank capital is treated that drove that lending from money center banks and super-regional and regional banks to the private credit markets. And so there is nothing inherently new about mid-market direct lending. The nature of who is making those loans has been very different over the course of the last 15 years because of this regulatory change for banks. And so one of the things that I actually always really enjoy, I think Jamie Dimon's been very uh vocal about cockroaches within the private credit community. A reality for the money center banks is that they, if they were allowed to buy the regulator, they would love to participate in mid-market direct lending. It is the fact that their capital ratios have changed in a way that prohibits them from participating in that business that has boxed them out from that market. It is not that that market somehow came up overnight and the banks have made a choice from a risk perspective, they don't want to face those types of borrowers. Now, what has happened over the course of the last couple months that has really brought this from maybe more of a niche uh thematic or concern within Alts Investing into a broader uh you know front page of the Wall Street Journal uh topic has been the AI disruption. So if you go back to COVID, and the back end of COVID in mid to late 2020 and early 2021, there was a massive wave of very large uh leverage buyouts that were done within the software space. Those buyouts were done in the software space because, frankly, those were the healthiest businesses at the time. For those of us that were that were active at the time, the software as a service business model really caught fire in COVID as everyone went remote and worked from home. These tech businesses really saw huge fundamental tailwinds, so top line growth and profitability improvements. And there were a bunch of large private equity sponsors that that bought some of those businesses and took them private. At that time, the broadly syndicated loan market, which is the public loan market, so that is the loan market that is effectively book run by the large money center banks, was dislocated and dysfunctional. And so a huge cohort of borrowers that very likely otherwise would have been facing a JP Morgan Chase or Bank of America for their first lien loan package ended up going to the private credit markets to get slightly more expensive execution, but much more effective execution in a moment in which the broadly syndicated loan market was not functioning that well. And so now, and with the benefit of hindsight and AI disruption, there are a bunch of fundamental concerns that some of these software as a service business businesses and platforms may actually be meaningfully uh negatively impacted by AI disruption. And and and the overwhelming majority of first-lean lending to those types of platforms from that vintage or that era were done by the very large private credit lenders. And so I think there's a whole host of nuances where that's not really the core middle market. These were very large businesses, that's that's really upper middle market or or or uh ultra upper upper middle market. Uh, but there is a real fundamental risk that to the extent that AI disruption is uh meaningfully negative for some of these software as a service businesses, there is going to be a cohort of private credit loans that probably face outsized risk, even though they're in a first-lean position. That is very, very different than the majority of the mid-market direct lending market. That's then incrementally different than non-mid-market direct lending uh private credit. And so I think it's very important to understand uh what portion of the private credit market you're referring to as far as what actual fundamental risks you're facing.

Ryan 10:32

So those SaaS businesses on the equity side have also had a lot of pressure. Valuations have have come way down from where they were even six, seven months ago. Um, mid-summer, they were trading at huge premiums to the rest of the equity market. Now they're trading um in line in some cases, discounted to the the equity market as people worry about those cash flows. Um, and so it makes sense that if you're if you're a private uh lender to those businesses, that you could be be concerned as well. Um are there concerns about what those are actually what those what the debts of those SaaS businesses in particular, but maybe some others in that cohort are actually worth. I mean, that's one of the features of of private credit, right? That it they're they're not publicly traded, so you don't really know what the public is saying these um, you know, what what this debt is worth.

AI Disruption And SaaS Loan Exposure

Brian 11:22

Yeah, it's it's a really interesting question. And so and this is one area where I think uh our team really gets to benefit from the breadth of what we're asked to look at from a research team perspective. So we're we're not just credit investors, we we invest up and down the capital stack, including in growth equity and venture capital and all these other areas, the in and private equity buyout and all these other areas in the market that to your point have have feedback loops to valuations for for private credit. And so I I think the reality is for those those groups that we work with that are probably in the best position to understand the full effects of artificial intelligence disruption on software business models, they will be intellectually honest with you that they know that there is going to be an impact. But the first order effects are relatively easy to identify. The second, third, and fourth order effects are actually really difficult to understand today, where we sit today and where we are in the curve of AI deployment. And there are undoubtedly going to be software as a service businesses that are disintermediated and net, net losers uh relative to AI disruption, but there are also other software businesses that very likely are going to have improvement to their fundamental performance from their own AI uh implementation. And our most sophisticated sponsors within that tech and media telecom, media, and technology space that have the best insight will be honest with you that they're not 100% sure which companies are winners yet and which companies are losers as of yet. And so there's there's this rush by the market to try to discount broad swath the entire sector uh of any software as a service business that that has the potential to be disrupted by AI, where undoubtedly some of those businesses will be fine. The reality for the for the lenders, uh, specific to this cohort of 2020 and 2021 mega transactions that got done is they face a number of risks. One, if they're facing a uh actual operating business that is negatively impacted and fundamental long-term cash flow and earnings are going to be meaningfully impaired by I by AI, most of those deals were done in very covelite uh or frankly no covenant uh loan transactions. They have very little in the way of levers to pull in order to bring the borrower or sponsor back to the table until there's an actual term or uh payment default on the loan. And and some of those situations are gonna end up in very, very messy workouts where uh the first lien does risk actually losing meaningful principal. And obviously you don't invest in mid-market direct lending or upper middle market direct lending with the thought that you're gonna take actual principal impairment on a first lien loan in a healthy and profitable business where there's a meaningful equity cushion beneath you. And so there will be some percentage of transactions that have to go through that meaningful restructuring. And whether or not there's a go-forward uh uh opportunity as a going concern for the business or not is gonna be based on how um constructive the the private equity sponsor is and potentially infusing more capital, how constructive the lenders are and how much they believe that there's real value in that platform on a go forward basis, so how much they might restructure themselves into second-lean claims or convert into equity to actually take and own the business. And those are all options for a private credit lender. Uh there will be another subset of transactions that go through uh more modest restructurings, covenant defaults, uh of what we what we really think of as kind of footfaults on covenants or liquidity, where ultimately the business will be fine. And I think that one thing that's really worth highlighting is that unlike uh because there's been a lot of uh there's been a rat a lot that's been written about kind of the redemption pressures that exist on private credit interval funds, on private credit focused BDCs and other evergreen structures, unlike three or four years ago when the entire non-traded REIT space gated and and and had their own kind of redemption queue issues, uh these portfolios don't own 30, 40, 50-year lived office assets in San Francisco. They own generally five to seven-year term loans uh that have been originated over different vintages. And so there will be hard catalysts that force a realization event of either restructuring with a haircut to the debt, restructuring with incremental equity contribution uh from the private equity sponsor, uh, for sale of some of these platforms in order to right-size the capital structure. Because on the whole, today, and this might not be true two years from now, today, the vast majority of these businesses are still highly profitable, highly free cash flow generative. They have uh very high top line growth. And so even the people that we speak with that are most bearish on the ultimate impact for these software businesses relative to AI implementation, they know they can't short these names yet from an equity perspective, even those that are public, because you're shorting a company that still has 20, 30, 40 percent top line growth. And so now there might be a future in which that top line growth goes to zero and then negative, but that's not that's not the reality that we exist in today. And attempting to read those T leaves, again, even for very specialized groups that are that are solely focused on that, um, the range of outcomes is just too broad today.

Ryan 16:37

Yeah, so it hasn't necessarily shown up in a diminishing um cash flows or or earnings for some of those companies at this point. Those um the the companies that were concerned that you know a few years down the road they're all gonna be disintermediated and uh AI is gonna eat their software lunch. Um it's it's not necessarily present, right?

Brian 16:58

Yeah, and and so I was in New York just last week and we were meeting with a long short credit uh uh manager we work with. So this this is syndicated credit, they they do long short public credit in a hedge fund format. And and he he was talking about how how what a proponent he is of this narrative that AI is going to disrupt, excuse me, a meaningful number of businesses. And it's his business to go out and then short those levered loans in the market or get get short those loans through CDS contracts. And he was candid that there just isn't there isn't enough clarity on timing of when the negative AI impacts are going to show up in fundamentals such that he actually feels comfortable getting sh getting into those short positions, even though he believes that's fundamentally going to be the right trade. It's very difficult to short the debt security of a company that has 30% top line growth. Because 30% revenue growth can fix a lot of fundamental problems within the operating model until that growth runs out. And so undoubtedly we're not AI skeptics, we're actually very large investors uh in AI development, in our venture and growth investing. Uh, but the reality is uh I think the market is way ahead of itself, particularly to your point on multiple contraction for public tech. It's way ahead of itself of what the actual outcome is going to be. Because again, um I'll give another anecdote. One of the venture back businesses that we invest with, which is largely a payroll and HR solution for uh small and medium enterprise businesses. It's it's it's effectively a recurring revenue software as a service business for uh SME businesses. It's the poster child for the type of program and platform that someone would point to and say, well, someone else is gonna develop an AI uh implementation that basically does all the things that you do for your client base, and they're not gonna need you anymore because that AI can be priced much more aggressively. That company is is very aggressively deploying AI within their own system such that they have seen their top line almost double over the last 12 months, and they have not hired a single incremental person. And so when you think about what that impact, what what that impact is on the net profitability and EBITDA margins of that business, it's super positive. Now that doesn't mean that two years from now, that business might not be disintermediated by a competitor that's found a better uh AI widget to go uh to go at their client base, but it's not as simple as, oh, it's a software as a service business and they're net losers to AI. And so it's just a it's a very complicated landscape today, and one, and one that again, I think speaking in monoliths, even about private credit, even about tech lending and private credit, it's just very difficult to do.

Ryan 19:35

Yeah, yeah, it's you're you're always going to give too much credit to one side of uh the equation about who's gonna benefit or be disintermediated, and and um, and then you know the the the crowd follows and you end up seeing big movements in price um or or sentiment. Um and I think maybe that's inevitable at the stage that we're at in the development of artificial intelligence. Um I want to talk a little bit more um from the investor side of things on private credit. Um, you know, mainly you've talked about how it impacts um the fundamentals of the companies of that maybe have borrowed uh utilizing accessing private credit. But if you're an investor in private credit, what's what I guess let's start at the beginning. What's the case? Why why would somebody um want to invest in private credit?

Why Investors Allocate To Private Credit

Brian 20:27

Yeah, so it's a so also a really good question, and this is one that our team thinks about a lot because obviously we don't have a remit or mandate to need to invest in private credit. We certainly don't have a mandate that we need to invest in mid-market direct lending. And so there's a huge spectrum of risk and reward opportunities set within basically non-bank lending. If you were to go back five or six years ago, which was really the beginning of the boom of the asset raise for private BDCs from the mega asset managers of the firms uh of the world, you know, the Blackstones, the Ares, the Apollo's, that all went out to the retail channel for the first time and the RA market for the first time and raised these very, very large perpetual BDCs. Uh that, of course, coincided with a huge boom in mid-market up and upper middle market direct lending because these very large firms with direct lending teams suddenly had a lot of capital to be able to put to work. Uh if you go back before that moment, there was roughly a 250 to 300 basis point spread on the average mid-market, core middle market uh direct loan relative to the execution you would get if you were a large enough company to go and face the broadly syndicated loan market. The broadly syndicated loan market is also historically pretty cov light. And so if you're a large company, high quality borrower, strong free cash flow profile, and you can access the broadly syndicated loan market, you're gonna do that. It is only because COVID came with this big period of dislocation for the BSL market that a bunch of those borrowers actually began to consider facing the private credit market. Otherwise, the nature of private credit borrowers. Were smaller businesses that really can't access the broadly syndicated loan market, or business models that either have too much cyclicality or just are in sectors or subsectors that the broadly syndicated loan market and bank lenders have a very difficult time underwriting underwriting those risks. But in order to, or for putting money to work in private credit, you are getting paid this meaningful spread premium over broadly syndicated loans. Over the course of the last five years, and more as more and more capital has moved into direct lending, and in particular upper middle market direct lending, you've seen that spread compress from 300 basis points to 250 basis points to 200 basis points to today on a lot of transactions, particularly before this big AI disruption, as narrow as 150, 125 basis points over levered loans, syndicated levered loans. And to us as a team, that didn't make a lot of sense. You're taking on meaningful illiquidity in mid-market direct lending that you don't have to take on in the broadly syndicated loan market. You're doing that on a fairly covenant-light basis. And so your ability to kind of protect your downside, if something were to change and go wrong with either the nature of the sponsor, the private equity sponsor, or the business itself are limited. And so from our perspective, we wouldn't have and didn't deploy capital into that very, very competitive environment in mid-market direct lending. What firms that were raising a lot of money for direct lending at the time would tell you is like, well, you're still getting a spread premium over BSL. And by the way, we're like for like risk. The companies we're lending to are actually pretty large companies, they're very healthy business models, they have huge free cash flow generation. And so you shouldn't get paid 300 basis points over BSL, you should get paid 150, and that's and that's worth it from an illiquidity premium perspective. That never really resonated with us, but that that was the story. Now, if you get away from that very competitive end of the private credit markets to what are called non-sponsored opportunities. So these are businesses that are not owned by large private equity sponsors that have big private equity funds full of equity capital. They might be mid-sized and or larger family-owned businesses, where it's the family that only owns the equity to the business. There isn't a financial private equity sponsor there that owns majority control of that business. It might be what we kind of refer to as just messy sponsor situations where there's a smaller private equity sponsor that owns a third of the business, then the family owns a third of the business. There are other external investors that own the other third of the business. Those types of situations don't lend themselves well to the either the kind of core direct lending market or the BSL market because those underwriters are not set up to evaluate non-sponsored or complexly sponsored situations. They want to know that they're facing Blackstone, who owns a healthy business. Because then if something goes wrong with the business, first line of defense is Blackstone can write another check, stabilize the business with incremental equity capital. That's obviously a very different story if you're facing a family-owned business, even if it's a very large and at scale and profitable family-owned business, there might be all sorts of reasons that the family either lacks the capacity or desire to put incremental equity dollars into the business. And so for those non-sponsored situations, even at the tights of private credit spreads, you are getting three, four hundred basis points in incremental spread over BSL. Now, whether or not that's worth it is really up to whether or not the underwriting and the operator you're aligning with is a g is doing really high quality credit underwriting, what their capacity is to work through situations in which there might be a need for a workout or restructuring of that business. But undoubtedly, if you can find a high quality operator that's that's actually achieving real covenant protection within their private credit loan, and you're facing one of these kind of less plain vanilla situations, it might be a great trade. On the other end of that credit spectrum still sticking with corporate credit, we work with ABL lenders who actively and intentionally face stressed and distressed businesses where the business itself might be meaningful and at scale, but it's facing fundamental headwinds. And those headwinds might be cyclical, they might be secular in nature, it might just be that they're operators within energy and materials, which for the longest time just got X'd out by the entire commercial banking system of we can't lend to energy businesses anymore. That's changing now, but it's been a decade of basically JP Morgan saying we can't make loans to ENP companies or uh or uh or oil field services businesses. It was just a top-down decision. And so we work with lenders that will lend to those very asset heavy rich businesses at five, six, seven hundred basis point spreads over BSL, where we might be two times levered into a more cyclical business as opposed to six or seven times levered into a less cyclical business. And where we believe that we're with the right operator and lender, where if something goes wrong with that business, they can actually go in, restructure and or liquidate the business to make us whole. And so we might be making equity-like returns in a first-lean position in that strategy, which is obviously very different than uh what we've been talking about for upper middle market direct lending facing a software business, where you might be 11 or 12 times levered into that business because of how not cyclical SaaS businesses have been historically. So it's very important to understand where you're operating within this space and how you're being compensated for taking on the incremental illiquidity of private credit versus BSL.

Ryan 27:28

That's a great, great way to think about it. Compensation for risk, uh, doesn't matter what your investment is. That's are you being compensated for the risk that you're taking? Um you mentioned um illiquidity a few different times, and that is um that is a feature of some of the private credit funds. Uh I was just reading an article that talked about uh some of the gating that has taken place and um how how that works. So maybe uh break that down a little bit for us. How does this feature of private credit with respect to liquidity, gating, uh pro ration of private credit funds? Can you explain that for us?

Where Risk Reward Looks Better Now

Liquidity Rules Gating And Fund Structures

Brian 28:03

Yeah, absolutely. So and I think this is this is worth kind of setting the landscape for how it is private credit firms are capitalized. So uh the majority of private credit firms really raise money in a handful of different structures. One is there's a middle market CLO market. So not dissimilar from the broadly syndicated loan CLO market. The CLO market is one of the largest participants in in just the public-levered loan market. There is a middle market CLO market uh where uh private credit lenders can go out and raise uh equity capital to capitalize their CLO and go and buy a bunch of different loans or originate a bunch of different loans to populate a diversified pool uh of loans within that CLO. That's one vertical of how they raise capital. Many of those firms also raise private funds. So these can be drawdown funds, uh uh which are capital call vehicles, uh, where they they will go largely to the institutional investor community. We're very active participants in the drawdown fund investment wrapper, uh, but but largely it's it's very large, uh both uh international and and and domestic institutional investors who will say, I will I will lock up my capital for the next seven to ten years with you, uh, for you to go bank a bunch of five to seven year private credit loans, uh, and then we'll split the proceeds of how that portfolio does in some ratio between the GP and the LP or the the or the investors. So that's another way that they capitalize themselves. In the course of the last decade, many of those firms have also launched other uh registered and registered like products. And so that's been the largest influx of capital into the private credit space, has come from the uh private BDC market uh as well as um uh interval fund wrappers. And so something that I think is very and that's the the way that the overwhelming majority of the advisor community accesses private credit is through one of those two or both of those vehicles. And so I think it's very important to understand it uh the distinctions between these entities. Uh private BDCs, uh almost all of them, their liquidity features are 5% per quarter on a best efforts basis by the advisor to that BDC. What that means is it's really up to the advisor, whether that be Blackstone or any of their ilk, of in any given quarter, if we have redemption requests or or or tender requests, do we want to meet those requests and is it a prudent thing for us to do as the advisor to this aggregate fund? And so what you've seen over the course of the last several redemption windows is an elevated degree of redemption requests. In the very early days of that, a handful of private BDCs tried to satisfy even more than 5% in that initial uh redemption wave in a way to calm their investor base of saying, hey, listen, we can generate liquidity off these portfolios. It's fundamentally nothing wrong within our private credit book, uh, and we're gonna we're gonna give you your money back if you want it. Uh that redemption cycle accelerated to a point where almost every sponsor within the private BDC wrapper has simply said, maximum you're gonna get is 5% per quarter. And for some of the more tech focused and more levered BDCs, they've said, you know what, we actually aren't gonna provide any liquidity right now. This for that wrapper, there are a couple things that are important. Most of those private BDCs run with one turn of leverage. So for every dollar of equity I have invested in that fund, I own $2 worth of loans that they've put out the door. So that's one thing to consider. Uh the nature of that leverage is actually pretty term-matched for the vast majority of sponsors. So it's not as though they have 12-month financing on these five-year loans. They generally have non-mark-to-market facilities that have terms that match the duration of their loan portfolio. So the leverage provider, pulling leverage or changing haircuts or all the things that led to forced selling in the global financial crisis, don't really exist within this private BDC wrapper. Those private BDC sponsors also over time will generate natural liquidity through pay downs and realizations. Now, some of those realizations might be through restructurings that aren't good outcomes for them as lenders. But again, going back to my comparing and contrasting the private REIT market to the private BDC market, there will be a terminal outcome for these loans. And for companies that are in a stress or distressed positions, there's ultimately going to be a maturity default. At a point, the loan is due, you're out of extension options, and if you don't pay it back, you're by definition in default. And that lender can take take you through the bankruptcy process if that's what they choose, if that's what they choose to do. So when we think about the private BDC market, which we are not large participants in, mostly around these dynamics where I talked about we didn't love the risk premium you were being offered in this upper middle market direct lending space, the wrapper itself is not problematic. The nature of the financing they have on their portfolios is not problematic. There's there really is no mechanism to force that sponsor or that that advisor to that BDC to sell these assets. That doesn't mean that there won't be negative fundamental outcomes for a handful of credits, to the extent that that's more pervasive than more narrow. Maybe that outcome's even worse than what we might assume is a reasonable downside case. But it is still really hard to get to a scenario in which those BDCs are are puking assets at 50 cents on the dollar because they need to raise liquidity to pay back their uh their financing counterparties and pay back their investors because the the feature just doesn't exist. Within the interval fund landscape, uh it's different. It within interval funds, which were the advisor to several, you you, and this is the central point for terms on interval funds, is 5% per quarter minimum. And so it's not a best efforts basis, it's not at the election of the advisor. You, as the advisor to that interval fund, must provide 5% per quarter in liquidity, uh, unless you want to put the fund into runoff, effectively, which is obviously not an outcome any sponsor or advisor wants. And so those portfolios need to be managed much more thoughtfully from an asset liability match perspective. Even then, though, uh the vast majority of interval fund sponsors that have private credit funds have term match non-mark-to-market financing. They're not using what we call repurchase or repo financing where haircuts change and the term of those repo facilities is actually relatively short. And so there isn't a there isn't a tremendous feedback loop of uh, frankly, the ironic part, commercial banks that provide that financing, uh getting more conservative on private credit and being able to create for selling within those interval funds. In addition, unlike BDCs that are one times levered, most of the private credit interval funds run somewhere between 0.2 and 0.3 leverage. And so that doesn't mean that you don't have some financing risk. It doesn't mean you aren't levered into the asset class, but you're not nearly as levered as you are in the private BDC structure. And then leverage within actual private funds can be even higher than one turn. And so for our view of our competitors, uh, most of them run these portfolios very responsibly from an asset liability perspective. And so, again, even in this draconian scenario in which you have 5% redemptions per quarter for the foreseeable future for not just one or two or three quarters, but five, six, seven, eight quarters. In our view, the industry is actually in a pretty good position to work down those funds and provide that stated and mandated liquidity without being a foreseller of assets. Now, one thing that this does have a huge feedback loop on that I think actually creates an opportunity is clearly the BDCs that have large redemption queues, the interval funds that are in meaningful proration, uh the direct lenders that are facing more fundamental problems within their portfolios and are now busier on workouts and restructurings than they have been for 15 years, they're obviously gonna be making fewer loans. They're gonna be spending all their time trying to figure out how to kind of stabilize the things they have in place and work through the issues they have within their portfolio. They're not focused on origination. And that's night and day from six months ago. Six months ago, all any direct lender would talk to you about was what their go-to-market was, how differentiated that go-to-market was, how successful they were being in winning transaction volume and deploying capital. And now you hear the exact opposite. And so, in our view, now is really the time that our team is spending a lot of time focused on where are the actual pockets of opportunity being created in uh lending to companies that aren't software as a service businesses, but aren't large enough to access the broadly syndicated loan market. And what if we can actually get three or four hundred basis points in in spread premium to BSL today? Because frankly, liquid credit markets are at pretty, they're not at all time tight spread-wise, but they're pretty close to it. And so maybe, maybe now is actually the time where there is an opportunity set here for direct lending and and private credit writ large, uh, you know, when all the headlines are super negative.

Ryan 36:52

Yeah, that that makes a lot of sense. Are there any specific, I don't know, industries or sectors where you you think the opportunities for, you know, maybe that overlooked opportunity that you're you're kind of talking about?

Brian 37:05

One, we have always been very active in this non-sponsored world. So businesses that are very uh fundamentally profitable and healthy businesses, but where the nature of the owner base uh precludes them from facing more institutional lenders. And so we love finding groups that we think are really good at going and sourcing that, those types of loans. Those loans are generally done with very heavy covenant packages to the lender's benefit. They're done at meaningful spread premiums to not only the syndicated loan market, but even the core direct lending market. Uh, and they're generally done at much lower LTVs or lower leverage ratios than the majority of the mid-market direct lending market. And so if you find a group that's really good at finding those types of borrowers and making those and structuring those types of loans, uh that opportunity has just become more attractive because of this dislocation in direct lending. From a sector and subsector perspective, what I would highlight is um private equity sponsors have really been very active in buying a couple different types of businesses. So, software and healthcare, so tech and healthcare, uh, were kind of an outsized portion of the private equity buyout market over the course of the last five or six years because those are the sectors that saw the greatest tailwinds fundamentally. And of course, private equity sponsors want to go and deploy capital into the areas that have the strongest fundamentals in most instances. With that said, historically, uh uh more cyclical industries have been uh uh much more pervasive across private equity portfolios. And that's uh cyclicals, industrials, I reference energy, commodities, and materials. These are markets that, because of the cyclical nature of the businesses and sectors, uh they're actually really not great borrowers for commercial banks. And they're really not even great borrowers for the upper middle market direct lenders that don't really have sector specialist teams that want to dig that deep on these businesses that might be great long-term businesses, but of course have some cyclicality to cash flows, which is a lender is is something you need to really make sure you understand and make sure you're on the right side of that kind of attachment point to that business. And so many of those highest quality private equity sponsors that had kind of gone into the software and healthcare sectors are somewhat returning to home of focusing on more core industrial businesses, cyclical businesses, businesses where there's a natural moat as to why they are the right owner of that business as opposed to some other larger institutions, and where almost by definition, direct lenders and private credit are the only people they're going to go to from a first-lean uh lending relationship perspective. And so we are doing some work at the margin for uh if we can access that market at a three or four hundred basis point spread to BSL with really high quality private equity sponsors and really high quality direct lending underwriting, um, that that might be an attractive opportunity today.

Ryan 39:59

Um okay, so my initial question to you, Brian, uh was uh had some nuances that people were asking about private credit, the the you know, is this going to be something that triggers a systemic risk in the overall economy? Um so let's circle back to that again with all the sort of uh you know that you you've set you set up the uh conversation very well. And I think I can anticipate the answer, but let me just ask you straight out is should people be concerned that private credit poses some sort of systemic risk? Is there something that we're missing? Um how do you how do you look at that question?

Brian 40:39

Yeah, and and this is one that we've really racked our our brains about as a as a team, and and I really challenged the team to to s think of and try to understand what we might what we might be missing. But to date, the answer is not really. And a lot of that flows back into a handful of fundamental factors that are typical of this market today. Uh the issues in the global financial crisis were leverage and then and then falsified valuations on in the mortgage market. And so neither one of those things really exists in in direct lending in any meaningful way. Uh because these are private lenders, they're they're relatively lightly levered compared to like what a bank is. You know, a bank might be 10 times levered through their loan book, a private credit lender, the most aggressive ones might be three times levered. And so when you think about, okay, if the fundamentals are really bad and there are a lot of losses that are gonna run through these portfolios, how bad do those losses need to be to create huge systemic risk? It's difficult to create loss scenarios, even in the most draconian scenario, where at that leverage ratio you're gonna have uh private credit-oriented stress that actually impacts the real economy. And it's just not big enough uh from a from a quantum perspective, but but mostly owing to that it's not it's just not that levered. Now, that's more typical of kind of the private equity uh owned uh uh business facing a private credit lender. The areas of private credit that we do see some more meaningful uh real economy risk within is more in what's referred to as ABS or ABF, which is um uh asset backed finance, which can again be a really generic term that covers a whole host of different subsectors. There are all sorts of non-bank lenders that face things like auto lending, uh consumer finance, where the regulatory apparatus that sits on top of these largely tech platforms is very loose compared to what sits on top of regulated bank lender. And those uh uh loan portfolios are levered in a myriad of different ways, uh, sometimes at much more aggressive uh leverage ratios than three times or two times or one point three times. So that market, particularly if there's a real economic contraction in the US, which we've not seen, uh that market could have some really major operating issues and there could be really meaningful losses within some of those portfolios. Uh our best mapping and understanding of the way that that space is capitalized, is it's really diffuse. And so it isn't an instance in which if you if you dig in one layer, two layers, three layers into those lending platforms that you all end up at Citibank or JP Morgan or Bank of America, where you would then be concerned that, oh, well, the real lender to the lender are these large money center banks that could face systemic issues. Um, they're largely not active in that market. And so again, this isn't to say that our team has some sanguine view of what credit outcome is going to be, because I think if anything, we've been more bearish on direct lending than most of our peers for the last five or six years. But even if you get a really bad fundamental outcome and defaults and loan losses are a multiple of what they've ever been, which is I I think very possible, uh the places that that is going to be felt are largely very large institutional investors. Very, very large asset management businesses in which the private credit vertical of their of their business is you know 10, 15, 20% of their AUM, not 90. And then some retail investors who invested in these perpetual BDCs without really understanding the liquidity nature of those BDCs. And where they thought they'd be able to get out any quarter, and in reality, they're going to be along for the ride of what that credit outcome looks like. But again, I think the leverage, the leverage point for most of those portfolios is such that the downside outcome is like bad IRRs, not oh, I lost 50 cents on the dollar. And we're always on the lookout for the ways in which we're being too sanguine in that view, but we we've really yet to find a rational explanation or argument for why uh private credit's going to create these huge pockets of losses that's going to create forced selling, and therefore you're going to have real kind of capital markets function risk like we did in 08 and 09.

Ryan 44:56

Well, that's that's good to hear. And uh I appreciate all your insight that you've uh you've provided. Any final thoughts before I ask you my final question?

Systemic Risk Concerns And ABF Caveats

Brian 45:05

You know, from our perspective, I think it's always it's not as simple as being uh mean reversion focused or counter-cyclical, but I do think there is something to be said for being thoughtful about, you know, again, we cover a huge range of alternative sectors and subsectors that we can allocate to at any given point in time. And certainly there are thematic things that go into that. And you can you can identify these big uh secular tailwinds or headwinds to certain sectors or subsectors, and there are times where at the margin our team will take those views into account and where we want to deploy capital. I think our support of venture and growth equity-oriented AI investments over the last four or five years is reflective of obviously a thematic belief that AI was going to become a more tangible and real thing. But most of what we do is to try to be thoughtful about, to your, to your earlier point, risk and reward. And so if there are areas of the market that have tons of capital flowing into them, where the terms of investing in in those areas are getting weaker, uh, both from an economic return perspective, but more importantly with respect to credit from a covenant and lender protections point of view, our team's knee-jerk is well, maybe we should focus elsewhere where we're not giving on those things simply for the sake of deploying capital into this kind of zeitgeist uh sector and subsector. And so if anything, today, that landscape has shifted a lot because capital deployment by lenders has shifted a lot. The capital raise within the private equity or sorry, private credit landscape is down meaningfully, and uh there there will be net outflows from that space for the foreseeable future. And so, not not to uh be a broken record, but from our perspective, that probably creates more opportunity than it does, than it does risk. And so to give an anecdote to that, uh earlier uh last week, actually, uh we looked at a middle market credit CLO that was coming to market uh uh actively, so on the run. Um we were looking at a a portion of that middle market CLO that's just cuspy investment grade rated risk. A year and a half ago, that tranche from this particular uh private credit lender probably would have cleared at something like plus 500. So 500 basis points over SOFR. We transacted at plus 775 over SOFR. So 275 basis points of spread relative to what the same group would have uh uh would have executed at a year and a half ago. That portfolio of mid-market loans had two percent software exposure. You know, the average within mid-market CLO land is probably 15%. So from our perspective, that's really typical of uh just irrational risk off. Uh because this portfolio is not exposed to AI disruption. It's it has all been underwritten very recently, so from the lender's perspective, with the lens of uh their cost of capital has gone up, so like they need to make more money on these loans. And it's a really clean portfolio, and we're taking almost investment grade risk for you know 400 basis points, 450 basis points over IG credit spread. Uh that might end up being a bad trade. Like I don't know if that's I don't know the future, but but to me that feels like pretty good risk. And we're more focused on finding those opportunities than we are about um kind of panic selling things that that that are exposed to headlines.

Ryan 48:28

Yeah. Well, when the when the baby gets thrown out with the bathwater and there's indiscriminate selling, it seems like that's uh that's a great time to find opportunities. So um my final question for you today, Brian, is um a question that I ask all the guests of the ROI podcast. So uh let me pose it to you, and that is um, what are you reading today? Uh there are any books or uh any anything, it doesn't have to be in in the world of finance. Uh we've had a pretty heady conversation. When you uh you know kick your feet up at the end of the day, what do you uh what do you read?

What We Are Reading And Closing

Brian 49:01

Yeah, it's it's funny uh because I I don't read a lot of financial or capital markets books anymore in my free time. I used to when I was younger. The reality is I have to spend so much time in the weeds on the things that we've been talking about today. Uh that wouldn't be particularly relaxing or engaging for me for the for the for the small amount of time I'm not I'm not on the desk. Um so I've got I've got little kids, I've got a six-year-old and a three-year-old. Uh, and my wife, by training, is a psychiatrist. And so uh one of the things that her and I have really been grappling with just as parents, and obviously way too early, is what do we do about like kids and cell phones? And and what do we do about kids and cell phones and social media? And and obviously, like like most parents, you know, we just want our kids to kind of be happy. Uh, but we also don't want to somehow deprive them of this like useful tool that all, you know, good luck not giving your kid a cell phone if all their friends have a cell phone. And so my my wife read a book that she actually then over spring break uh asked me to pick up and read so we could talk about it, uh, called The Anxious Generation, which is really about kind of the the impact of social media and technology on uh on young brains and and and kind of what the long-term and intermediate term impacts of that might be. So uh a million miles away from uh uh from finance, um, but but certainly important to to me and my family as my wife and I try to figure out what in the world we're gonna do about that.

Ryan 50:25

Yeah, no, that is a fantastic book. I have uh I've read that as well and uh grappled with it as a parent. Um I have four kids, uh three of which are high schoolers. So um it's definitely uh you know right in the moment conversation that we've had with them for the last few years. But uh interestingly, you are maybe the third ROI podcast guest who's recommended that book. So, those watching the podcast, if you haven't read The Anxious Generation uh by Jonathan Hayte, um you should check it out. Um, anyhow, uh Brian Murphy, thank you for joining us on this episode of the First Trust ROI podcast. Thanks to all of you as well for joining us, and we will see you next time.

Brian 51:06

Thank you, Ryan.