At the recent PDI New York Forum, a packed room heard several leading lights of the asset class – (pictured from left) Howard Marks of Oaktree Capital, Jim Zelter of Apollo Global Management and Lawrence Golub of Golub Capital – share their current concerns and predictions.
Zelter: Expect a slowdown but no crisis
Apollo Global Management co-president Jim Zelter expects an economic slowdown. However, he is not expecting a downturn on the scale of the global financial crisis.
“If you take 100 CFOs last June 2018, on a conference call, 75 or 80 percent would be positive and maybe 15 percent would be conservative,” he said. “This June, if you did that same CFO report – not that we do it scientifically, but just anecdotally – I think you’re seeing a much more muted enthusiasm for the future.”
Should another acute downturn be in the offing to test managers’ mettle, he noted, Apollo would be ready.
“If you’re in credit, you’re paid to worry,” he said. “We spend a lot of time thinking about market structure and credit lines.” He added that the firm does “fire drills” where all positions are hit with a market crisis stress test, including for liquidity.
“I think you’re seeing a much more muted enthusiasm for the future”
Apollo Global Management
He considers global events as, if not troubling, then certainly something to keep an eye on.
“We see the populism around the globe expressing itself in lots of different geographies. You have to be attuned to that as an investor. I can’t remember a time where so many governments have been in flux.” He added that investors “have to be very focused on what’s going on in Washington”.
Zelter said that distressed investing, a hallmark of Apollo, would look different in the future. “The crowd that should complain about cov-lite the most is the distressed community. With cov-lite, [the] day of reckoning is further out. The playbook in distressed in the past is much different.”
When Zelter joined the firm in 2005, credit was a small portion of Apollo’s assets under management: private equity consisted of around $18 billion, while credit was only “several billion”. Today, the picture is completely different. Apollo oversees $311.9 billion, which Zelter said was perhaps even greater than envisioned; and credit, at $201.2 billion, is the firm’s largest AUM driver. The bulk of Apollo’s credit AUM comes from insurance company Athene, which accounts for $119 billion. Private equity only makes up $77 billion of its portfolio, while real assets account for $33.5 billion.
“When LPs allocate to private credit, they find that the allocation ends up in middle-market sponsored direct lending, and those allocations have faced a challenge deploying scalable capital,” Zelter said. “The question is how will these asset classes perform through the next downturn.”
Marks: You need to get the odds on your side
“This is not like any other cycle,” said Oaktree Capital co-chairman Howard Marks. “No one is fully confident and complacent today. No one is self-assured. Indeed, the lack of confidence is one of the best things the market has going for it.”
However, Marks said this should lead no one to assume that investors were all acting in rational ways. “Even though they’re not thinking bullish, they’re acting bullish. They’re not doing what they want to do, but rather what they feel they have to do. They have to keep putting money to work in an environment where there is too much capital.”
Marks described these investors as “handcuffed volunteers”.
Marks felt the best response to challenging market conditions was to try to get the odds on your side by understanding where we are in the cycle and acting accordingly.
“The lack of confidence is one of the best things the market has going for it”
He said there was always a balance between the risk of losing money and the risk of missing opportunities, and that the key was identifying the right balance between the two. Today, it was “important to worry about losing money more than missing opportunity. It’s hard to see what the missed opportunity is today”.
He urged managers to be disciplined by only raising the capital they need and insisted there were no giveaways in today’s market. He said, to nervous laughter, that the best any investor could do was to “buy the least worst”. Asked for estimates of what returns investors could reasonably expect from a range of private debt strategies, he suggested around 6 percent for senior debt, 9 percent for junior debt and “somewhere in the middle” for mezzanine.
Known as a contrarian investor, Marks said the key to success was not quite as simple as just doing the opposite of everyone else. “You first have to try and understand what the crowd is doing and why before you think about doing the opposite.”
Marks questioned whether central banks should still be stimulating the economy “in the 11th year of an expansion” and suggested it was not their job to prevent recessions from occurring naturally.
He also said he thought it unlikely that any Democrat candidate espousing “extreme” left-wing views would win an election against President Donald Trump, though holding such views could make it easier for them to win their party’s nomination.
Golub: Diversification is key
Asked how his firm, Golub Capital, was coping in “hyper-competitive” market conditions, Lawrence Golub said things could be a lot worse: “Imagine what it would be like if [Democratic senator and presidential hopeful Elizabeth] Warren gets her way and the private equity industry is squashed.”
He added that a Democratic president and senate could bring a “significant” increase in tax rates and said “I think you have to worry” with an impeachment process against the president having been launched. “Anyone who thinks Warren or Sanders could not possibly be a nominee is wrong,” he said.
But far from having a downbeat view of current conditions, Golub provided the forum with an early view of his firm’s third-quarter survey of portfolio company performance. This showed Golub’s companies delivering a revenue increase of more than 10 percent and an EBITDA rise of more than 13 percent during the quarter – the highest rate of EBITDA since the survey was first conducted.
He said healthcare companies in particular had shown outperformance over the last three quarters relative to the previous four years. However, he put this down to the prior underperformance of healthcare businesses as they struggled to keep costs under control, and said there was some “catch-up” going on. Industrial companies, meanwhile, have been having a hard time owing to the rising cost of labour.
Golub said diversification was key to avoiding downside risk and that it was important to diversify in all sorts of ways, including by industry and private equity manager. However, the firm intended to retain its focus on North America as “so much of Europe is controlled by banks and ultimately by sovereign governments”.
As a leading protagonist of unitranche deals, Golub was asked whether the size of individual deals would continue to grow. He said the limiting factor would be the point at which these deals needed to be syndicated – at which point the value of negotiating with just one or a small number of parties would be lost.