These are interesting times, according to Tod Trabocco, co-head of the credit investment group at investment consultancy Cambridge Associates. In conversation with PDI, he considers current market conditions, takes a peek into the future, highlights the specialty finance opportunity – and says that predicting recessions is a “fool’s errand”.
What, for you, is the most interesting thing about market conditions in private debt today?
Consider the Chinese curse: “May you live in interesting times.” Times are bound to get more interesting for private debt investors in the near future as the market reacts to rising interest rates, rising defaults and the rude awakening of marginal, somnambulist borrowers. Loan documents to preserve recoveries may leave lenders disappointed and saddened. So the most interesting conditions, particularly for direct lenders and mezzanine lenders, are the risky EBITDA add-backs and adjustments and weakening terms and conditions in loan documents.
Investors should pay attention to regulation, particularly in Europe, which is causing banks to reassess core holdings and businesses and nudging them to shed those that do not really belong. Those assets and businesses are migrating to private debt vehicles. The US is seeing a similar development, notably in residential mortgages and auto loans. However, these trends are broader than any one geography or strategy and are creating a panoply of new, investable options for institutional investors.
Also, technology is creating a massive market that is not bounded by peer-to-peer to lending. Just as car-sharing apps have normalised getting into a car with a stranger, fintech lenders are making it normal to lend money to strangers. And these lenders recognise the ubiquity of financing opportunities and are cropping up everywhere to finance business, luxury items and car title loans, to name a few.
How do you think the private debt market of a few years’ time will compare with today’s?
The private debt market will continue to grow, which may lead to more industry consolidation, but there are a few hurdles the asset class will face along the way. While the recent projection from The Alternative Credit Council that found the private credit market may reach $1 trillion in the next few years is unsurprising, considering the rapid rate of recent growth, a very real implication could be a credit crisis or a recession in the US.
Higher rates could also slow private credit growth, since it’s likely that if banks could make enough money to cover their capital charges, they would return to certain strategies they’ve recently left. However, lending hasn’t been terribly profitable for a long time – it’s not just because of regulation, but also because rates have been stubbornly low.
Another consideration is that consolidation seems inevitable. Whenever there is a new industry, or one that is growing at light-speed, a shakeout eventually occurs as marginal or high-cost providers eventually exit.
As a firm, you have noted the keen interest in specialty finance. What explains that interest?
While specialty finance is attractive to many investors, it is not a panacea. There are four key instances in which specialty finance can be additive to an investment portfolio. First, much of the specialty finance space is uncorrelated to markets and even the economy. Some, like aircraft leasing and shipping, are correlated to macroeconomics – but movie royalties, music royalties and pharmaceutical royalties are not.
Additionally, many specialty finance strategies can be highly structured and asset-based, providing downside protection for investors. For example, borrowing bases can be powerful tools to protect investors, and specialty finance managers are avid users of these structures.
Next, many of these niche strategies have few competitors. A narrow focus (e.g., aircraft leasing) is great for limited partners because it permits superior portfolio construction, and sector-focused funds tend to outperform generalist funds in the long-term. Finally, many of these managers have huge value-add potential rooted in experience, knowledge and human capital.
A caveat: Some strategies use a lot of leverage, and competition is growing in markets – most notably the Italian non-performing loan space, for example. Moreover, since specialty finance strategies run like operating businesses, investor due diligence must look beyond past performance and explore enterprise-level risks, documentation, operations, and other factors.
A lot of people talk about extended innings/end of cycle etc. To what extent should we be paying attention to that talk?
Pay less attention to the talk, and more attention to the economy. When I joined Cambridge Associates in November 2015, I was greeted by a parade of distressed debt managers heralding the credit cycle’s turn in 2016. They pointed to numerous auguries: the length of the expansion, rising corporate scandals, declining liquidity and others. Two years later and the daily headlines look the same, something along the lines of “Equity Market Hits New High”.
It’s tough to have a broad credit crisis in the US without a recession. Unfortunately, predicting recessions is a fool’s errand. All we can do is track the meaningful indicators and assess them in a historical context. Bob Okun [chief investment officer at Oak Hill Advisors] recently cited Anton Cheremukhin’s (of the Dallas Fed) smart analysis at Oak Hill’s annual meeting which offers a fresh look at the causes of recessions.