Show V/O:
This is Alternative Allocations by Franklin Templeton, a monthly podcast where we share practical, relatable advice and discuss new investment ideas with leaders in the field. Please subscribe on Apple, Spotify or wherever you get your podcast to make sure you don’t miss an episode. Here is your host, Tony Davidow.
Tony:
Welcome to the Alternative Allocations podcast series. I'm thrilled today to be joined by Rich Byrne, president of Benefit Street Partners. Rich, before we get started, maybe talk to us a little bit about Benefit Street Partners and your areas of focus.
Rich:
Sure. Thanks, Tony. And thanks for having me. Benefit Street Partners is an alternative credit manager. We're about 80 billion in assets under management these days, but we have several different product lines under one umbrella, which we like to think is like a really good secret to success because each of the strategies sort of inform the other. But we have private credit. That's probably the biggest thing and maybe what we're best known for. We have distressed credit. And in our more liquid strategies, broadly syndicated loans and high yield bonds, we also have a real estate lending business. And with our recent acquisition of Alcentra, we are now global with most of those same product lines in Europe as well.
Tony:
That's exciting. And I think private credit in particular is really getting a lot of attention. Earlier this year, you wrote an article and you talked about this incredible opportunity and drew some parallels to the global financial crisis. What are the parallels and what are the opportunities? And why are you so excited in today's environment?
Rich:
Well, let's start off with the good news. It's nowhere near the opportunity, in retrospect, of the global financial crisis and certainly aren't going to see anything as calamitous. But I would say it this way, Tony. Two things can exist at the same time. There's going to be a big challenge for existing portfolios, but at the same time, we think for new capital, there's going to be one of the best investment opportunities we've seen, maybe even since the global financial crisis.
Tony:
Yeah, and I think that's where I wanted to kind of pick up, because there seems to be some parallels. If we think of the global financial crisis, the banks kind of stepped away, and that's really where private credit took off. A lot of the growth followed that. Probably the same sort of situation here. And I think if we think about the market environment, maybe in 2021, where you're putting capital to work, you are probably on less favorable terms. Now you can negotiate favorable terms. I know you've talked about things like better covenants and things like that. So why is this so important to you as you source opportunities in private credit?
Rich:
So I think it's important to answer that question, maybe to take a step back. In the paper you're referring to, we use the colorful metaphor of the Titanic, also a little bit of an overdramatization, but nonetheless the Titanic comparison in that you're just looking at the tip of the iceberg. So the problem doesn't seem so severe at the time, but needs to play out over a period of time. And that problem is interest rates, plain and simple. It's kind of funny, Tony, because everybody is thinking about this big next shoe to drop. Is it going to be giant recession? A hard landing? Is it going to be inflation? Is it going to be interest rates? Is it going to be war in Europe? Et cetera, supply chain? But the truth is we already hit the iceberg. The iceberg was the rise in interest rates. The base rate on the loans that we make went up by infinity percent. Think about that. They were close to zero. [Tony] Right. [Rich] And now over 5% on Sofer or Libor. That has profound implications for existing borrowers. And we always say the credit world is a good place to study second order effects that will affect equity markets and other markets. So I'm sure we'll get into that. But what happened is the margin for errors of borrowers just widened. A company that borrowed money did so with, assuming it was a floating rate loan, did so with interest coverage of let's say two and a half times. Well just mathematically adjusting for the higher base rate that dropped to about one and a half times. That company's not defaulting. But if you look at that over thousands of loans of course it's going to increase the default rate for the weaker performing loans because they just don't have that margin for error. So to answer your question, that all kind of scared away a lot of buyers. Banks, in particular, got caught up in that and we can talk about its impact on real estate and a lot of other asset classes. And the banks are not lending. In fact the banks are going to have a whole host of portfolio problems which could create second order buying opportunities for firms like us. A lot of the people that typically we compete against to make loans into our various markets are sitting on the sidelines for lots of reasons. One, they're a little scared. They're concerned. We saw during COVID the need for liquidity during troubled times was very important. Also prepayments are down. Why would any borrower prepay a loan at yesterday's interest especially if they locked it in at yesterday's interest rate and prepay it today? So remember lenders in certain type of fund structures can only invest the money obviously they have. And if fewer loans are maturing or prepaying then they have less money to invest. The capital markets…it's harder to raise money now so there's not a lot of money. So the simple answer after that long backtrack is demand is down. When demand is down there creates a bit of an imbalance even though supply is down too of deals. Whereas the people with the capital like us, I mean just viewing it as a great opportunity right now can start to dictate terms. And what does that mean? Better choices, better credits, better rates, better covenants.
Tony:
And it makes sense. The one thing you mentioned that maybe we should just pick up on is not a lot of people are fully aware that private credit is predominantly floating rate. So as rates went up, you talk about going from zero to wherever it ends. Right? We anticipate rates to at least go up one more time. What happens when we reverse? And I'm not suggesting it's reversing anytime soon, but could that be a headwind for private credit?
Rich:
Well, higher rates is both a headwind and a tailwind for private credit, liquid credit as well. Why do I say that? Because the higher underlying base rate on our loans means we're going to generate more interest income, hence more net interest margin. For example, a BDC, which is a publicly traded vehicle for private credit dividends haven't changed, but the net income on all of the BDCs has gone up every single quarter. So it creates a really interesting quagmire for investors. They look at a BDC and they will see, oh look, this net income just keeps growing and growing and growing every quarter. Why? Because the base rates grow. I mean, it's just mathematical, but the negative is what does that mean? As we just said, that means the margin for error for the borrowers is down. So some of the borrowers can't afford to pay that higher rate and that's going to result in higher defaults. Which is better, the amount that rates are going up or the amount that defaults could knock it down? I think that'll depend on the portfolio, the type of manager you have. So there's some of each. So you say, what's the rate forecast? Well, first, we're not economists, but we follow Franklin Templeton's guidance, but we're not smarter than the Libor core curve. And as you said, there's pretty high likelihood rates will go down at some point. But our investment thesis, and the way we're thinking about it now is rates are going to stay high for a while before they come down, but when they come down, that will give some more breathing room to borrowers on that margin for error. But it'll create less interest income.
Tony:
And I think embedded in a couple of your comments, there is a real important point, which is a seasoned manager who has been doing this for a long period of time will find opportunities in all environments. I wanted to maybe pick up a little bit on where you see specific opportunities. You talk a little bit about default rates. That kind of leads to the discussion of distressed you mentioned real estate earlier. Where across the alternative credit spectrum do you see the best opportunities and why?
Rich:
So I think the best opportunity, I'll start general and then we can drill down a little more specific. Generally, I think fresh capital right now to invest in credit markets. I'll say credit markets overall, we see some pretty good sailing right now. Specifically, where we're very focused is private credit. Let's talk about that one first. So what happened with this lower margin for error (the higher base rates) is the new deals are starting to adjust. This is Darwinian. Almost. This just happened organically. New deals are starting to adjust. If rates go from base rates go from near zero to 500 base points, it's almost mathematically impossible to get back to that interest coverage you underwrote a deal maybe in 2021. Let's say that two and a half times interest coverage. That means the cash flow over the interest expense that you're contractually obligated to pay. The only way we can toggle with our new loans to adjust for this higher rate is to lend at lower leverage points. So I’ll give you an example. A lot of private credit deals are buyouts. They're private equity firms. Underwrite will buy a company and they'll look for debt financing to help them pay for the financing. They'll look to us for the middle market buyouts. That is private debt. That is middle market lending. The average private equity firm, when they bought a company literally a year and a half ago, wrote a check of about 40% of the purchase price. So if they bought something for $100 million, they'd write a check for $40 million and they'd borrow the other 60 from a private lender like us. Today it's exactly inverted. That average check is closer to 60% and the debt amount is 40%. Regardless of what's going on with purchase prices, you're looking at deals that are just less levered. We think of it as a loan to value, which is the inverse of the equity check. So deals are coming now that private debt market is originating at 40% loan to values. I mean, that's super attractive. In other words, the company's business can decline by more than half, up to 60% theoretically, before you would incur a dollar of loss, in theory. That's a lot of margin for error to make up for the conditions in the market today.
Tony:
Less leverage, better covenants seems like an opportunity.
Rich:
And you're pick of the litter of companies too, correct? Because when there's less lenders, we used to show up for when we would be asked to submit a proposal, let's say to a sponsor deal, some of the bigger, more popular sponsors that have capital markets, people that focus on that and there'd be half a dozen or more competing bids. All of a sudden there's not those half a dozen folks anymore showing up. Of course things will change and markets will correct to the opportunity. And this is very moment in time specific. But you're getting your pick of the litter on top of those better rates, which you did mention, lower rates, better covenants and lower leverage.
Tony:
If we can we'll talk a little bit about the democratization of alternative investment? Your firm really began focused on the institutional marketplace, and we've started to see increasing demand coming from the wealth advisor community. What sort of lessons can advisors pick up? When we think about institutions allocating to private credit, they're making big bets they're investing in real estate debt. How can individual investors kind of learn from what the biggest invest have done over time? How do they think about allocating? Where do they source? If they're thinking about allocating to private, where do they source that from?
Rich:
Just by background for us, before even being part of Franklin Templeton, we were virtually all institutional. Our LP base was institutional. And you build up your brand and your reputation in that market, then we never really had retail or private wealth as an option to us because we didn't have the wholesalers and all the infrastructure, of course, that Franklin Templeton has. So when we debuted on the Franklin Templeton platform, we were so excited because we were going to get access to that market and lo and behold, nobody knew who we were. So first of all, you kind of have to get initiated into the market. Institutions, pension funds, sovereign wealth funds, endowments have been growing their allocations to alts. And different times, different alts grow faster than others. But it could be private equity, real estate, real estate debt, our product suite. But over the years and over the decades, those allocations have only grown. So the institutional world kind of saw something and it was a way to increase with a very attractive risk reward, hopefully grow their returns over time. The problem for retail is the typical fund we were managing for institutions are lockup funds because our products don't sit very well in like a hedge fund structure because they're illiquid. Private debt loan matures in five, seven years and you want to sell it, you need to meet a daily liquidity vehicle. That's going to be tricky. So the funds that institutions used were typically private equity style funds. You have a capital raise, you have an investment period, and then you just return the capital as the loans come due. That product apparently is not that interesting to retail. They covet some liquidity. So over time, the private wealth market, different wrappers have come into being to have more appeal, especially those without K-1’s and things like that. So it's the same product. But in creating a wrapper that's more interesting with lower minimums, of course, as well, has given private wealth investors access to the same underlying investments that institutions have and just assume that's just going to continue to blow up, blow up in a good way, blow up as far as those allocations are going to grow and grow.
Tony:
That's exactly the message that we're certainly trying to bring to the marketplace. We think, one, the market environment is demanding a different playbook, a more robust playbook. And thinking about some of the tools that institutions and family offices have used for years. Product wrappers need to be more aligned with the way that high net worth investors think about it. 1099 tax reporting, lower minimums, lower accreditation standards. But at the end of the day, I always make the argument that none of it works unless you get access to world class managers, especially in the private markets. It's not something you can dabble in unless you have deep roots in that market. Understanding the opportunities, how to source capital, I don't think you're going to be successful. So I think there's this confluence of events that we see as a great opportunity, which is part of the impetus behind this podcast series. We want to make sure we get that message out to as broad a group as possible.
Rich:
And Tony, let me add to underscore your point. Private credit or real estate lending or distressed investing, all disciplines that we do. Think of what you're doing. You buy a stock, for example. You go on your brokerage account, you buy a stock, you own it, and there's analysts that cover it. You could theoretically, depending on the size, sell it, buy more every day. We underwrite a private debt loan. We make a real estate loan. Sometimes we're the only lender, or maybe we're one of two or three. There's no analysts covering it most of the time. You're doing your own work. So think of how much more intense your infrastructure needs to be to do that job well. That's why there's a better, more times than not, in our judgment, better risk, reward opportunity for this asset class. Because I think anything that requires more labor is usually going to reward you for your labor. We have an enormous team in each of those disciplines. And as I mentioned in the top of the podcast, we have all these different strategies which enable us to leverage resources; for example, a giant research department. Because information is your edge in what we do. And the other edge is having the gray hairs. In my case, I don't have many, hairs, that is, but to have been through the cycles, we saw something interesting during COVID I mean, it was only two years ago. What happened is, for a very short period of time, there was a dislocation in the market and some lenders got hit with some margin calls and some other things, and they learned that, oh my gosh, we should be managing more liquidity, we should have a balance sheet that's a little more flexible or whatnot? And those lessons carried over. All of a sudden, the market dislocates again where we are today, and there's actually a little bit more discipline in the market this time. So imagine what you can learn if you've been doing it for 40 years, like we have. So, yes, I think that perspective, the depth of your team, the experience really matters for alts.
Tony:
Rich, thank you. I think this has been great. We've covered a lot of ground. We talk about the opportunity created by disruption. And I think that's a byproduct of a market that is going through some changes, whether it be the rate environment or the liquidity and the lending in the marketplace. You helped us think a little bit about how institutions allocate capital and the depth of the offering there and then I think you shared a lot of wisdom around, you know, it really is important to have weathered multiple storms in the past. Clearly, this is not your first rodeo, and I think that counts for a lot, especially in a challenging environment. So thank you so much for joining us today. We look forward to following the journey with you.
Rich:
Thank you, Tony. It was a pleasure to be here.
Show V/O:
Thanks for listening to Alternative Allocations. For more information, please go to alternativeallocationspodcast.com, that’s alternativeallocationspodcast.com. And don’t forget to subscribe wherever you get your podcasts.
