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 latest episode of the Alternative Allocations podcast. I'm thrilled to be joined today by Anant Kumar, Global Head of Research of Benefit Street Partners. Anant, welcome.
Anant:
Thanks, Tony.
Tony:
And you and I have been talking about private credit, it seems like, for the last year. And candidly, in the marketplace, there's a lot of noise around private credit, some of which is true and deserves more careful attention. Some of it is not true. It's just, you know, rumors, innuendos, and speculation. And some of it is just a lack of understanding.
So, I thought what we'd do today is do a little bit of a deeper dive and maybe talk about what we're hearing in the marketplace. How do we help advisors? But let's start with the big one up front, and that was, I recall you and I talking right after Jamie Dimon made the cockroach comment. What people assumed is if there is one problem, there are multiple problems, and we're going to have a systemic risk to private credit overall. I think you and I would say that's not the case. We both spent a lot of time analyzing and looking at it.
But maybe let's just start there. What happened with First Brands and how did that create this snowball effect?
Anant:
Yeah, so First Brands is a bit of a unique situation where the popular media characterized it as a private credit problem. In reality, it was not private credit the way most people think about it, which is corporate direct lending. It was in the ABS market where that issue happened.
And similarly, around the same time, there was a situation with a company called Tricolor, which was also an ABS situation, where you had the company double-pledging the same collateral. And that's just outright fraud. That doesn't speak to systemic issue with direct lending. That says you have to do a good job underwriting to avoid fraudulent situations.
The way I think about it is just because Bernie Madoff committed a Ponzi scheme doesn't mean you stop investing in US equities. That is an isolated incident. Similarly, the founders in both these companies committed outright fraud and they're probably going to go to jail because of that. Unfortunately, what happens is it's a catchy headline. The popular media picks it up and runs with it.
And there's an element of schadenfreude because private credit has been the hot ticket on Wall Street for the past few years. And all of a sudden, you have this fraudulent headline and people are like, aha, I told you this is too good to be true. So I think we have to guard against that tendency too.
It's never as good as people say, it's never as bad as the headlines say, right? So to me, the First Brands situation was isolated. It was idiosyncratic and it actually wasn't even corporate direct lending. It was in the ABS market.
What then followed was Jamie Dimon's comment. And he has since clarified that during one of his lunch roundtable at the JPM conference. And he was talking about cockroaches in JP Morgan's kitchen, not in the broader industry. So he did make a point to clarify that. But obviously that nuance gets lost in the headlines sometimes.
Tony:
Speaking of nuances, I want to pick up on something that you said and you and I constantly have this dialogue around private credit and direct lending are often conflated. People use terms interchangeably. Of course, direct lending is one of the verticals and definitely has been the vertical that has raised the most capital.
But we'd argue that asset-based finance and commercial real estate, that are other ways of getting exposure to the private credit. How should we think about private credit and how do we avoid just painting everything with the same brush?
Anant:
It's an all of the above approach. Private credit is this all-encompassing term, but as you pointed out, commercial real estate, asset-backed financing and direct lending, and even special situations would fall under that private credit umbrella. I think when you're investing in private credit, you want to pick managers who have specialization in each of these areas.
A direct lending specialist is not necessarily going to know how to do commercial real estate or asset-backed finance. So, you want to find managers who have expertise in all of these areas because they are distinct. They all have different correlations with the markets. They provide different diversification benefits. So, for example, asset-backed financing, if you're looking for low correlations with the public markets, that's probably one of the best places to go to. Direct lending has a higher correlation with the public market.
So again, it depends on your portfolio needs, but I think an all of the above approach is the right way to go to build a portfolio that can weather various market conditions.
Tony:
And I love how you described it. It's the same sort of fixed income discussion. Buying corporates is very different than high yields, which is different than leveraged loans.
We don't treat all fixed income the same. Similarly, we shouldn't treat all private credit the same. And based on the work that we've done, certainly you get different risk return and correlation characteristics.
And for those who have already invested in direct lending, which is a lot of the wealth channel, that's been the preponderance of the assets have gone into direct lending. You'd argue that asset-based finance and commercial real estate debt actually can be a complement because of that low to negative correlation.
Anant:
Absolutely. You don't have to pick one. They're not mutually exclusive where you have to pick one lane and go with that.
I think good prudent investment advisors and investors in general will think about various market conditions. They think about a probability distribution of outcomes, and you build a portfolio that can withstand the tail events and also take advantage when things are going well, which is why I think a multi-asset approach is the right way to go.
Tony:
So again, just to restate, we don't believe there's a systemic risk. We do think there's a difference between the various verticals and how they're going to perform and respond to market conditions. And to pick up on a point that you brought up, which I think is so important, and that is that private credit managers, privately negotiated transactions, underwriting due diligence is absolutely critical to identify the best asset and avoid those that are more trouble to nature.
Anant:
Absolutely. And just the nature of credit is it's all about avoiding losses. You're not going to have massive upside. So underwriting is the key, and avoiding those losses is how you generate alpha in this business.
Tony:
So let's go to the next one that certainly got a lot of headline, and that is software as a service. Claude, and now everyone knows who Claude is, but Claude apparently made this bold pronouncement that all of a sudden software is going to become obsolete, and the software sector overall took a real hit. And when people started to look under the hood, they started to recognize, well, private credit managers had lent a lot of capital to the SaaS sector.
But I love the way you describe, we shouldn't, again, treat everything with the same brush, there's a difference in how you think about software depending on where they fit in the tech stack. So maybe just kind of walk through what's happened there and talk to us a little bit about whether advisors should or shouldn't be concerned.
Anant:
Yeah, so this is going to be a little bit of a long-winded answer because there is nuance and I don't want to brush that over. So first of all, when you think about what has happened, AI is going to fundamentally alter a variety of industries. It's not just software.
Anything with a knowledge industry component, anything which involves the use of a computer is going to be disrupted. I wouldn't say all those industries are going extinct, but there will be a change in the business model in a lot of these industries. Software is just the first of the dominoes to fall.
And even within software, there's nuance, which I'll get to. But to address something you'd mentioned about software exposure in the direct lending world, even there, there isn't this homogenous exposure across managers. So, as you and I have often spoken about, we think of the market as segmented into three segments: the lower middle market, the core middle market, and the upper middle market.
The upper middle market is what often garners the attention and headlines in the popular media. That upper middle market has a higher exposure to software than the other two parts of the middle market. So when I think about upper middle market, which again, people define differently, but I'll say it's companies with EBITDAs above 100 million, that has been the venue of choice for software companies to finance themselves over the last four or five years, these SaaS companies.
And what we found is managers in that space typically will have software exposure ranging from say 20 to 25%. You can tweak that a little bit depending on how you classify software, by the way. Sometimes it's a healthcare software company that you classify as healthcare and not software. So there's a little bit of playing games that happens there, but overall I'd say about 25% software exposure. Again, there are some managers who choose to have a tech focus fund that could have 50% software exposure, right? But as a general result, let's say about 25%.
Now, if you come to the core middle market, and again, that's the place we play in, it's just a much smaller piece of the pie because the software companies don't tend to finance in the core middle market. Our top industries tend to be industrial services, business services, healthcare, professional services, financial services. So it's a different mix.
And software is there. I'd say software is maybe the fourth or fifth largest industry. Just speaking about our book, we have about 10% exposure to software.
So you can see there's a great degree of dispersion between managers, even within direct lending. Obviously, the bigger managers get more headlines, as I mentioned. So the press has run with this narrative that 25% of private credit is going to be vaporized with AI.
Now, even that is not really the case because when you think about software, the lazy take is that AI eats software. That's the easy headline. The reality is AI will eat some software, but there is going to be software that comes out stronger and has moats around it.
So I'll spend a couple of minutes talking about that. Now, there's two kinds of software. When we think about software, there's vertical and horizontal.
And just for your listeners, many of you are familiar with this, but I'll just give you a quick primer. So horizontal software is software that can be used across multiple industries. Think about a generic, general-purpose software, like something from the Adobe suite, Microsoft Teams or Excel or PowerPoint. Many different industries can use the same piece of software for their use cases. That is horizontal software.
Vertical software is more niche. It is tied to a particular industry and is specialized for that industry. So the industry I work in, finance, Bloomberg is vertical software that is applicable to financial services companies. If you are in the healthcare field, if you run a hospital, for instance, there's a piece of software made by a company called Epic. It's your electronic health records. Now that company has a complete lock on that market. There's one competitor called Cerner. But that is a vertical software company, right?
So there's this distinction between horizontal and vertical software companies. And I think what we are seeing is the horizontal software companies are the ones most ripe for disruption because they're making generic software and the cost of making software, which used to be their moat, has come down.
The marginal cost has come to nearly zero with things like Claude and Codex. So I think that's the fundamental shift that's happening. But again, in the popular narrative, it's like all software is bad.
Now, even within horizontal software, there are sometimes cases where a company could have a moat. It could have a regulatory moat. These moats tend to be more concentrated in the vertical software where, for example, in the healthcare space, you need to have it blessed. There's compliance concerns, HIPAA concerns. So not all software, something that someone vibe coded in their apartment over the weekend can't really be used for patient data. So there are some moats that exist.
And even horizontal software, there could be some moats. So I think it's tempting to say that AI is going to destroy all software, but the reality is much more nuanced.
Tony:
And I think that's such a good point because again, the headlines often get all the attention, but it's very nuanced, very diversified. Not all software companies will respond the same way to the changing AI race. And AI is much bigger than just software.
It's endemic, it's everywhere. It does remind me a little bit, you know, just being in the industry for a long time that people were responding, well, the internet, you know, how that's going to change things. And a lot of these things just make us more efficient and a lot of those businesses are forced to kind of evolve. And that's a healthy thing.
Again, avoid the headline, focus on what's really happening, dig a little bit deeper, get into the portfolio and understand the types of exposures.
Anant:
Yeah. I think when you're thinking about your software exposure, there's two questions to ask. Where does my data live? And what is it that the software is actually doing?
And that first question is actually pretty important. Where does my data live? That can be a very strong moat against AI disruption. So for example, there's this concept called the system of record. That's the source of truth that exists within the company. That's the database where everyone goes to, to figure out what's going on, the state of the company.
If you have software that has control of that system of record, it is very hard to disrupt that with AI. AI can build on that, but it can't replace that system of record very easily. So there are software companies that have control of this system of record. So I think that's another element. Where does your data live?
If it's a growing and compounding dataset, again, I'll go back to the example of the company Epic. That company is fantastically protected against AI because not only does it have a strong market share, but it has a regulatory moat and then the data that it collects is a compounding and growing dataset. AI needs that data, it's proprietary data.
This is why Epic is probably going to be one of the winners when AI disrupts various parts of the software industry. So those two questions, where does my data live and what it is that my software does, which is what I addressed with the horizontal versus vertical question. I think those two axes will help you figure out if AI is going to disrupt a company or maybe even help the company.
Tony:
So I want to go on to the other question that we both get a lot and certainly has garnered a lot of attention, and that is the whole redemption and gating issues with funds. And I'll just upfront say, I think that advisors need to be more aware of how these structures and strategies work and the evolution from a drawdown, which was 100% illiquid sort of structure, to an evergreen perpetual structure, which provided some liquidity provisions. And I always emphasize the underlying investments are still illiquid and that 5% liquidity provision is there for a change of circumstances.
Now to think of them as a mutual fund, I'm in today, I'm out tomorrow. Certainly, if you did, you wouldn't get that long-term illiquidity premium. But I think that has definitely garnered a lot of attention and I think part of it is we as an industry probably didn't do a good enough job preparing them for the underlying investment being illiquid. The 5% threshold is there. It's there to actually protect those who are invested in the fund who are long-term in nature and don't want to force a fire sale. But maybe talk a little bit about that because I think that gets a lot of attention. And I think sometimes the narrative is there's something wrong with the fund or there's too much money in the space and that's why we're having this liquidity issue.
Anant:
Right. One of the, and this is a slight pet peeve of mine, but when people talk about gates in this industry, it's not really gates in the way you think about what happened in 2008 with the GFC and hedge funds putting up gates. This is more proration and the funds are working exactly as designed.
And that's cold comfort to an investor who wants to get their money out and like, I wasn't told this was going to happen. So, to your point, there is a certain mea culpa where I think the industry as a whole hasn't done a good enough job of educating the retail investor on what semi-liquid means. Now semi-liquid is in the name.
Tony:
We hate that name by the way.
Anant:
But that is something that involves explanation because you see the headline of 5%, you're like, great. But your experience has been when I want my money, I can get it out because typically less than 5% of people ask for their money back. So if you put in for a withdrawal request, oftentimes you're fulfilled on the entire request.
So you get habituated to that. You think, okay, this is actually a pretty liquid fund, but that would be financial alchemy if we figured out a way to take a fundamentally illiquid asset class and give you 100% liquidity. That just doesn't happen. So that 5% cap was designed for scenarios like this when everybody wants to withdraw their capital.
Now, like I said, that is great in theory, but there's a human element you have to explain to people. They have cognitive biases. They get used to getting their money out every quarter. So we as an industry, I think need to do a better job. And look, this industry is going to grow. You're going to have more people from main street, not just institutional investors investing. So it's incumbent upon us to do a better job in educating people when they first come into the asset class.
Tony:
And I'd argue we shouldn't fear it or brush it under the carpet. We should lean into it to say that's in fact what makes these investments special, the ability to invest for the long run, to unlock value. And oh, by the way, if I'm an advisor out there, I recognize I want my clients thinking long-term and not responding to all the emotional stimuli that comes at them.
So again, I think you're 100% right. We've got to change the narrative. We've got to lead with that. We have to make sure that advisors and investors understand the structure. And the reality is these structures have trade-offs. So they work for managers like yourself and they work for individual investors with lower minimums and all these great features that we do spend a lot of time talking about. The trade-off is they're still illiquid investments. So thank you for that.
I wanted to kind of leave with, we see a lot of attractive opportunities in private credit despite the headlines and maybe sometimes with the headlines, you get this overreaction where valuations come down. So I wanted to maybe turn the table a little bit and ask you, where are you seeing the most attractive opportunities now and what are the sort of things that you're looking at in the marketplace?
Anant:
I think there's two pieces to that answer. First, within the software space, I think there's a little bit of throwing the baby out with the bathwater where there's this broad brush, all software is bad. And as I explained, not all software is bad. There's parts of it that will come out stronger as a result of AI diffusing through the economy. So we're looking at opportunities where the names seem to be oversold within the software space.
I'll give you one example. There was insurance brokers, very steady businesses. These companies have grown very organically over the many years. However, there was a headline with Claude releasing a new feature for insurance brokers and people thought, oh my God, this is the end of the industry. And a lot of the loans in the space sold off instantly. Now we looked at it, we said, look, this is a little overhyped. We bought some insurance brokers when that dislocation happened and now they're back to trading at par. So that's an example of where there's almost a mania where there's a headline, everyone's so afraid that they overreact, they're very quick to pull the trigger. That's one element.
Second, I do think there are investment opportunities in sectors that are protected from AI. This could be experiential sectors, say tourism, for example, people will always want to travel. And more asset heavy industries, less knowledge work, I think those will be resilient. We are going to enter a period of profound change. There will be volatility, there'll be dispersion. So if you want to park your capital somewhere that has less volatility, I think those asset heavy industries without too much of a knowledge work component could be a place to hide while some of the dust settles around this AI disruption. Because the reality is with AI, it's so hard to figure out what's happening next. It changes at a dizzying pace. It's growing exponentially, it's recursive, it's improving itself.
So, anyone who sits here and tells you, I know what's going to happen in a year, they don't know what they don't know. So, part of the story is you protect yourself in the interim while the dust settles. But also if you find something that's oversold, clearly oversold, you can opportunistically pick up some alpha there.
Tony:
And I think it speaks to one of our macro themes that we've been talking about for the last couple of years broadly across private markets, which is the opportunity to put capital to work today versus several years ago. Several years ago, you were essentially buying what everyone else was buying. If you sit here today, you can take advantage of that disruption, buy at more attractive valuations, but you get to dictate the terms and the conditions as opposed to buying somebody else's problem.
Anant:
Absolutely. Dispersion has gone up. The tails have gotten fatter. There was a time when everything was trading in lockstep, everything was super compressed, but now there is dispersion. If you have a strong research team, if you have the infrastructure to take advantage of that, I think this is a good environment to be investing in.
Tony:
Yeah. Great stuff. Anant, this has been terrific. I wanted to address head on all the things that you and I hear in the marketplace. You did a great job. You've also written a terrific piece called “The Four Horsemen”, which kind of analyzes all these issues that we hear in the marketplace. I think it's a great piece. We'll make sure we attach it and make it available at the end of the podcast.
Also I've written a piece on SaaS, which you and I shared some of our notes on it, which I think would be very helpful for advisors as they think through the SaaS exposure. As you point out, not all things are created equally.
Then thirdly, I do think that we need to lean into this whole illiquid nature of the underlying investments. I wrote a paper that I think has been one of the most popular papers I've written called “The Cost of Being Too Liquid”, which really speaks to how we have better discussions with clients upfront before they get in the fund, understand how much they're comfortable to take and allocate for the long run.
So, again, we'll share those tools. Again, I think this is such an important topic. Anant, thank you so much for joining me here today.
Anant:
Fantastic. It's always a pleasure chatting with you, Tony. Thank you.
Tony:
Thank you. For all of our listeners out there, again, let us know what you like, rate us, please share with your friends, your colleagues. We have a growing audience here and we're so excited we get to talk to great guests like Anant and others and really talk about the things that I'm hearing when I'm traveling in the field.
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