We hear these stories about, you know, basically, private companies can kind of dictate the terms of the deals because there's so much overwhelming investor demand. And you get this vision of people, like, literally pounding down the door to get in on a particular loan. Is that was that accurate in the past?
No, I think, even even the managers of private credit would tell you, in honesty, maybe not on the record that they're surprised how quickly this has grown. You know, so if you look at some of these funds that have, you know, grown ten x over the last five, ten years, I don't think that they have grown their sourcing abilities by 5 to 10 x. So if you contrast it to, say, private equity, the way the private equity fund works is they find the investment opportunity and then they go call the funds from their LPs private credit. Most of these funds work where they've taken the money first, and then they go out and find the investments. So they're under much more pressure to find investments, which creates this competitive environment that you alluded to. You know, some of the issues that we talked to that may have been in the public markets in the past tell us that when they go to the private credit market, it's just a competition for, you know, who will jump the highest for the piece of meat. And what that translates to in the credit world is either lower interest rate, weaker covenants or a combination of the both.
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway and I'm Joe Weisenthal. Joe, I think it's fair to say that if we didn't have the situation with Iran, yeah, we would be talking a lot more about private credit.
Yeah. For sure. Jamie Dimon, you talked about the cockroaches. We keep getting these headlines over the last several weeks, maybe months, various, many, you know, not not blow ups, per se, but many something between a hiccup and a blow up in some cases, you hear about redemptions being slowed down, etc. Not great headlines and not great charts often too, when you look at the various publicly traded instruments that one would associate with private credit.
Right. So I love that you said something between a hiccup and a blow up, because this is the difficulty I have in talking about the private credit space at the moment, which is you either find people who are, you know, often very close to the private credit industry or in it who will argue that this is just, you know, a tiny bump in the road. This is maybe a few cockroaches, like, nothing to worry about, although a single cockroach would worry me in my own household. But anyway, or you get doomsayers who are like, this is financial crisis 2.0, right. And it's very difficult to find nuanced commentary in between.
Yeah. And we were always looking for nuanced commentary. So this was a problem for the old Lords. This. That's right. Okay. So we're trying to rise to the occasion with some nuanced commentary on private credit. And trust me, I have watched and seen and read a lot of things on this topic. And one thing that stood out in particular to me was a particular seminar or lecture that came out from a firm called Osterweis recently. And we had a couple of sort of old, old school bond hands talking about the rise of private credit and how to think about it in the context of the history of the bond market. And this is something that I think is often missed, is what exactly is private credit's role. When you think about overall corporate credit, that's a good way to put it right. Because we can look at the various funds, etc. But within the broad history of the evolution of the bond market and within the current just sort of landscape of fixed income, like what is private credit? What, you know, the the way I like to frame a lot of questions is from the perspective of the investor, what problem does the existence of private credit solve for a portfolio? Right. Because that is the consistent thing. We talk to endowment managers, we talk to investors, etc. Every instrument in theory like it solves some sort of problem. Maybe you have a lot of money. Also for a long time it's like, okay, you're willing to trade that away for some extra premium. It's that what problem does private credit solve?
Well, I was going to say also from the perspective of the issuer and from the right, because the issuer, if you're a company looking for financing, you have a bunch of different choices. And one of the ones that has become very popular in recent years is private credit. And in fact, you could I mean, there's a dynamic here where both investors are demanding it, but issuers are also very, very happy to lend into that market for various reasons that we are about to get into.
Let's do it. All right. So we do, in fact, have the perfect guests. We're going to be speaking with John Sheehan. He is Portfolio Manager at Osterweis Strategic Income Fund. And Craig Manchuck. He is also a portfolio manager at the Strategic Income Fund. So thank you so much, John and Craig, for coming on Odd Lots.
So maybe just to begin with, how long have you guys been in the bond space?
The firm has had a fixed income strategy for 20 years. Coming up on 24 years, actually. Started by our one of our other partners, Carl Kaufman. Originally the firm here was started as an equity only firm. And as the firm's clients started to get older, founder John Osterweis wanted to expand into the fixed income space, brought Carl in, and the fund has been in operation since April of 2002.
What kind of fund is it when we're talking about it? Is. Tell us about the general the mandate and the structure of the fund and maybe who is like the sort of like the moral client for whom this would be a a vehicle that they would put their money on.
So the fund was set up to be the only fixed income fund that our private clients needed. So we have an extremely broad mandate. We can go anywhere. And so it was it was a very, very early unconstrained bond fund, which has some distinct advantages. And some distinct disadvantages. Advantages are we get to go where we see the best opportunities. And so our mantra is to look for the most attractive parts of the market, and then we look for the least risky ways to play those most attractive parts at any given time. And so that as the cycle changes, as business cycles are stronger, we would gravitate more towards credit. And as it weakens, we could gravitate more towards treasuries. So the fund has over its life cycle moved back and forth. But by and large, since the financial crisis, we've been largely in high yield, IG, and convertible bonds. Our client base has predominantly been RIAs and wealth management firms and and individuals. Some of those are the existing private clients of the firm right now. So fund is about $5.8 billion. And it is structured as a 40 Act open-end mutual fund.
So once upon a time, if you were looking to invest in credit, say, in 2002, you would have had a limited set of options. So you basically had investment grade, which are bonds issued by people always use the word blue chip companies, which sounds so old fashioned to me nowadays, but companies with relatively strong balance sheets that are rated by the rating agencies as investment grade, or you would have the option of bonds in the high yield market, aka junk. So companies with weaker balance sheets, and weaker credit ratings. Tell us about how the sort of, I guess menu of credit options has expanded post the 2008 financial crisis. That's basically a long winded way of me saying, where does private credit come from?
Private credit, you know, had been in existence prior to the financial crisis. But really saw expanded growth after the financial crisis. So, if you go back into even, you know, the 80s with the growth of the high yield market, prior to that, highly levered companies, you know, companies that didn't have investment grade balance sheets, couldn't really borrow much in public markets. So either they, you know, financed internally or relied much more heavily on the bank market. As you know, the high yield market grew famously with the help of Milken, and it allowed more companies, more highly levered companies to access public markets. That evolved into the leveraged loan market. The leveraged loan market, once upon a time used to be held on the bank balance sheets. They began to syndicate those loans. And what was really the step function there was the evolution of the CLO market, where the banks could take those loans, put them into a securitized structure, which became CLOs, which led to the growth there. But then after the financial crisis, the bank regulators really did not want banks lending to highly leveraged and or risky entities, both corporations and individuals. So you saw pretty strict capital requirements. There is an explicit prevention from banks lending to companies with greater than six times leverage. So that created this need for lending outside of the bank market. You know, those companies didn't go away. Their borrowing needs didn't end. So that that vacuum was created by private credit. So you saw many of the same entities that were lending in the private credit market previously in the private equity market. So, they also saw a need to finance their deals that was no longer able to be done at the banks. So they started a number of different fund structures. The BDC standard structure had been around prior to the financial crisis. But these dedicated private credit funds really began to proliferate after the financial crisis.
Could I just add something to that? Just just from an historical perspective, I also think that we've been talking about private credit, you know, as it stands today. But it started so much earlier, and it started in an area that I think most people will tend to forget about, which is GE Capital was one of the largest providers of private credit under the umbrella for many, many, many years. They were financing lots of different things, though. They were financing rail cars, they were financing aircraft engines, they were financing the purchase of MRIs and other, you know, health care equipment. And they they were extraordinarily successful. And what it did is it created a large body of of really experienced lenders who ultimately splintered off and went into different areas and businesses. And one of the areas, one of the businesses that that started from them was a company called Heller Financial, which had been around for a while, but they hired some GE Capital guys to come in, and they really kind of took the original Heller business, which was financing yellow equipment and rail cars and things, into the middle market LBO space. So they became critical providers of financing for that space at a time when there really weren't many away from the banks. So, you know, a lot of this has been around for a long time. People just forget about it, because there's not as many people out there that are as old as we are that remember those guys from the 80s and 90s.
Yeah, we saw that with with a lot of the consolidation of the financial institutions away from GE, you know, and CIT was a big lender in that space. Even in the aircraft lending space, an organization, IFC was owned by AIG. And the regulators, you know, wanted that highly leveraged, riskier financing out of the systematically important financial institutions.
Well, speaking of people not realizing some of the history here, it took me an embarrassingly long amount of time to realize that all the stories that I'd written about shadow banking in the aftermath of the 2008 financial crisis were basically private credit.
Yeah, it's interesting to think about like, yeah, you you know, I'm familiar to some extent. I don't know the full history of like GE Capital, but I had certainly heard of it. I knew that it became a big profit center for GE itself, and it would make sense that a company like GE, GE or GM even, but GE would have its own lending arm and then like do its own financing on the side. But I never really thought of it as like private credit per se. Right. But it's interesting to hear that. Yeah. Like this was like an origin that a lot of the lending form types, etc., that were sort of emerged out of these practices in-house. Then where did it go from there. So you mentioned, okay, like real asset investing, maybe it's like aircraft lending or, you know, aircraft finance etc. When did it sort of when how did it splinter off into all of these different fields and areas beyond just the sort of like the tangible goods financing?
One of the places it went was in an area of mezzanine finance. And again, back in the early days of the LBO market, the sponsors were always looking for ways how do we fill in the gaps? Like, we can't get this deal quite across the finish line with the equity we want to put in, where do we fill in the gaps? And there were mezzanine funds and they were hybrids somewhere between credit lenders and private equity investors. So they would take the most junior piece, typically a preferred or subordinated piece of debt, and get a little bit of equity in the form of warrants or something along side, so that they were targeting a slightly higher return profile than the typical debt guys were, that they weren't going to get the full bang for their buck of the that the PE guys were getting. And that lasted for a number of years. But but as the market matured and the sponsors found that they no longer really needed the the mezz guys to the same degree and they're still around, but ultimately mezz funds were niche kind of product that I think over time has just kind of been squeezed out between the size and scale of the combination of leveraged loans and high yield bonds. And, you know, the PE firms desires to keep as much of the equity economics themselves as they possibly could.
So today we're at a point where the private credit market, there are all these different estimates for exactly how big it is. And it is, you know, you're going to get some variation because it is private, like the clue is in the name, but by most estimates it's bigger than the junk rated market, which is kind of crazy if you think about like how large the junk rated market has loomed in the markets collective consciousness for so long, how did we get to that particular point? How did we get to a point where this like relatively new market, although I take the point that it has intellectual roots before even the financial crisis, but why did it grow so quickly after 2008?
I think there's two macro influences that had a large play in that. First, if you if you look back after the dot-com meltdown in the equity market, with three straight years of negative returns in the S&P, it was the first time that happened since the Great Depression. The cumulative returns of high yields for that 20 year period 1999 to 2019, peaked equities. So among investors, there is a desire for something away from the equity market. Your experience in equities was unsatisfactory. So they're looking for other alternatives. And then in the later part of that time period, we went through the zero interest rate environment where, you know, the Fed, Treasury, etc. drove interest rates to zero in response to Covid. So there is a massive desire for yield, and better performing assets. And they had in the early parts of the 2008, in the equity market. So that really led to the slow restoration of the amount of dollars flowing into the product. And then on the supply side, we touched on it earlier, you know, these highly levered borrowers were basically shut out of the banking lending market. And so they needed to find alternatives to to fund their businesses and to refinance their debt. So those two kind of came together at the same time and really fueled the growth of the product.
And I think institutionally, you had, in the LBO world, sponsors were looking to have a real partner that they could go to, repeatedly for all different types of transactions, go back to them, you know, again and again and develop a real relationship and where they or their lender could be very expedient as well. And I think expediency mattered and provided them with sort of that, you know, guaranteed financing, which the banks were providing up until they were, you know, squeezed out from a regulatory standpoint on the most highly levered transactions. So I think that's what it really kind of comes down to, is is the ability to provide more leverage than the banks were allowed to, without running afoul of the regulators.
So one thing that comes up regularly on the podcast is the sort of natural synergy between private credit and insurance and, you know, insurance companies, they have all these assets and they have this advantage that they know exactly when those assets will be withdrawn. It'll probably end like 40 years from now. They do not have to worry and all about, you know, a quick run, whatever. And so they can harvest, they can harvest that illiquidity, illiquidity premium. But they could be they could put their money into assets that do not trade very much. And that's very it's very intuitive to me. Talk to us though. You're operating an unconstrained fund that is a publicly traded 40 Act mutual fund. Talk to us about what it means. You know, you say you look for opportunity. Why are there private credit assets that are all locked up in these long term vehicles? Why does it sometimes make sense for private credit assets to be in a vehicle that is just sort of more opportunistic and, you know, and has a has a daily quote potentially?
We currently actually right now don't have any private credit. We were involved we were involved in it in the past. But I think most of those opportunities have gone to the dedicated private credit funds, because there's just one of the structural differences of the way they're set up versus the way we're set up is we are we are we're we source our ideas mostly from investment banks. Now, some of those investment banks used to come to us with transactions that weren't going to fly in the public market. So they would look and say, you know, this is a small deal. We're not going to be able to find buyers from this among our investors, who are primarily benchmark high yield investors, because it would be outside the index and it would be illiquid. And, you know, there's been a lot of talk about and problems with investing in illiquid securities. One of the real benefits of our strategy is we always have lots of liquidity. We have a historically have managed our portfolio in a short duration with with a short duration focus that creates cash. And we keep a lot of front end ballast. So as our portfolio was always creating cash, we could invest in some pockets of less liquid strategies. But we we haven't done that with the private credit. Guys are set up differently. They need a team of bankers to go out and source all their deals. They have to knock on companies doors or it's a very different way in in their function of having to source their transactions to try to fill up the asset side of their portfolios. And so because of that, you know, over time, I think there's a huge structural difference between the way they approach it, the way we approach it. But you going just going back briefly to the insurance company side, you know, his insurance companies have long been investors in private assets. And they used to have large teams of private debt investors. And and ultimately over time, what they've done is they've shrunken those teams and just said here you guys source the transactions for us, and then we'll we'll give you guys the money. And, you know, you can go do it yourselves, sort of on an outsourced basis. So naturally, it is a very good fit for them because they do have long duration assets, and there's generally not a a rush for those assets.
Could you say a little bit more about how competitive it's been in the past to source private credit deals? If you're on the investor side, we hear these stories about, you know, basically, private companies can kind of dictate the terms of the deals because there's so much overwhelming investor demand. And you get this vision of people, like literally pounding down the door to get in on a particular loan. Is that was that accurate in the past?
No. I think, even even the managers of the private credit would tell you, in honesty, maybe not on the record, that they're surprised how quickly this has grown. You know, so if you look at some of these funds that have, you know, grown ten x over the last five, ten years, I don't think that they have grown their sourcing abilities by 5 to 10 x. So if you contrasted to, say, private equity, the way the private equity fund works is they find the investment opportunity and then they go call the funds from their LPs private credit. Most of these funds work where they've taken the money first, and then they go out and find the investments. So they're under much more pressure to find investments, which creates this competitive environment that you alluded to. You know, some of the issues that we talked to and may have been in the public markets in the past, tell us that when they go to the private credit market, it's just a competition for, you know, who will jump the highest for the piece of meat. And what that translates to in the credit world is either lower interest rate, weaker covenants or a combination of the both. And that that's really what you've seen with private credit in this hyper competitive environment that we're in now.
Yeah. One of the things that John mentioned, which is actually really important. So the structural side, this is the this is what the liability side of the of the balance sheet for private credit guys is is kind of critically important here. So if you're out there and you're raising an institutional fund, those institutional funds are generally drawdown funds. So they're allowed to go out market and say, okay, we've raised commitments for 5 or $10 billion. We're going to go out and outsource our investments, which is the asset side. The LP commitments are the liability side, so they will take on those liabilities as they find the assets and they end up being matched. And this is in a structure that's typically got a term and it's locked up money that you know, they were will not be providing liquidity for those institutional investors. The problem and this is where we've run into the big problems. And this is what is really circulating in and around the media, is more recently, when we've gone and taken this out into these private VC structures, to market them to the retail or private wealth world, in order to raise the money, they've needed to offer some concessions on the liquidity. Right, because it makes it easier to raise money if you're going to allow people for you to tell them that you're going to allow them to redeem, at least somewhat periodically, that has allowed them to raise money really fast. It's, you know, it's a little bit piggy because they've just said, okay, we can raise a lot of money. Let's just raise the money when we can. The difference is when those dollars come in, they come into the fund, you know, on a subscription basis and need to be invested quickly. And it's it's that that's what's really created a lot of the problems and what's really led to the degradation of credit underwriting. Because if you don't invest those dollars quickly, it creates the lag on performance. In the full minute that dollars comes in, it's part of your NAV. Therefore, it needs to be invested rapidly in an income earning, you know, investment. So that's what's happened. And you you what you had in, really saw a huge proliferation of this. I mean, one of the most obvious examples of these. You could see on there would be the the Cliffwater Corporate Lending Fund, which is CLIP on your Bloomberg. If you look that up, you can look at the asset growth in that. And it really has taken off in the last five years.
In 2022, you know, we would speak to our our wealth management advisors who are investors in our fund and ask them about, you know, what's working for them, because in 2022, rates are going up. Investment grade bond funds are trading off sharply because people didn't understand the duration risk that they were carrying. High yield funds were weaker, but nowhere near as bad as IG. And I'd say, what's working this? Oh, gosh. Private credit. It's been working great. I would say well that's wonderful. But that's because they're not taking their marks. And so they became very, very comfortable because they didn't have to turn around and talk to their existing investors and say, here, you know, you lost a lot of money in this fund. It looks like you've just earned your yield. And your your NAV has been very, very stable. So as a result, their clients were happy, they were happy. And what happened? Money poured in. So as that money poured in, it led to, I think more bad actors is too strong or but really more bad underwriting, weaker underwriting, more aggressive underwriting because they needed to get that money put to work so they would provide more leverage at that. Weaker terms.
Can you clarify again, why is it that with the traditional private asset model that they only call on the capital once it's needed, because what you explained is, okay, once you take on the capital, if it's not being invested, it's a drag on NAV. Very intuitive just to explain why is that? Why is the other and other parts of the private capital world able to do the thing where you only call up the LPs when you have a deal? Whereas that's not the case with private credit, where you taking the money upfront.
