Beyond 60/40 Ep. 19: Structured Credit and Scaling Alternatives

I'm Anastasia Amoroso, here in the iCapital studio. On this all new episode of 'Beyond 60/40,' we're focusing on structured credit. And I speak with Greg Lippmann of LibreMax, who explains why the current market environment is ripe with opportunities for structured products. Then I sit down with iCapital Managing Director and Head of Technology Solutions, John Scarpato, who joins me in the studio to answer your question of the month. And as always, I share the one thing that caught my attention this week in private markets, take a look.

In today's private market poll snapshot, the one thing I'm focused on is this. What could the higher for longer rates mean for the US economy? And are there parts of the credit markets that we should be concerned about? Over the course of April, the US Federal Reserve has notably changed its tune from expecting several rate cuts in 2024, to now expecting to stay on hold at current level of rates for longer, because they need to gain further confidence that progress on inflation is in fact continuing. Now, the equity markets reacted negatively to this pivot in April. But in our view, the US economy has figured out a way to function with the higher level of rates because the US consumer isn't as indebted as it once was, has most of the liabilities at a fixed rate, and the jobs market is still going strong. Now, this should continue. However, the question we also need to ask is, how will the various non-consumer borrowers cope with higher for longer rates? In our 2024 outlook, we sized up the various categories of debt across the United States economy, specifically focusing on those with large upcoming maturities, or high percentage of floating rate exposure. And as you can see in this chart, the US government holds and needs to refinance the largest amount of debt at higher rates, and that is likely to contribute to wider deficits. But let's put the government aside for a moment and focus on the private sector. The next area of concern is the commercial real estate. There's approximately 5.8 trillion of notional debt outstanding in commercial real estate, with 20% that needs to be refinanced this year and next. And a good portion of that debt is also floating rate. With rates remaining elevated, this poses an ongoing concern to CRE debt holders, especially in the office space. Office vacancies rose from 17% during the pandemic to 20% most recently and, not surprisingly, delinquencies have followed. For example, office CMBS delinquencies have reached 6.58%, and that is materially higher than any other sector where you can see those delinquencies do actually remain in check. Now, office debt accounts for 27%, or $171 billion of the CMBS market. And the space may continue to see defaults if rates stay elevated. Now, another area of concern that stands out is the rising number of private equity and venture capital portfolio companies that are filing for bankruptcy. And that number has surged to a record high since the global financial crisis. The share of the overall bankruptcies by those private equity and venture capital backed companies has also grown to a record of about 18%. This poses a risk to those companies' debt holders who either purchase publicly traded leveraged loans, or privately held loans. Indeed, there's about $1.3 trillion of leverage loans outstanding, and another 733 billion in private credit. And we have seen those default rates tick up as well for those categories. These risks are worth highlighting and monitoring, as the fed is keeping rates high for longer. But in our assessment, which we had in the beginning of the year, and that still stands today, there are definite pockets of stress that will continue to feel the impact of high for longer policy. But they're not systemic enough to derail the overall US economy because they are relatively small in size and there's a lack of amplifiers, which were so dominant during the global financial crisis. Now, from the opportunity side, the dislocations, such as repricing in CMBS bonds or CLOs, often present opportunities for credit managers who may also like holding consumer asset backed debt because that makes good sense given the strong economy. Now, that's my one thing in private markets this week.

You might recognize my first guest today from 2015 film, 'The Big Short.' Greg Lippmann is here in the studio, and he was the Head of Global Asset-Backed Securities Trading at Deutsche Bank, where he famously and successfully bet on the collapse of the housing market, leading up to the global financial crisis. Today, Greg is the Founder and Chief Investment Officer at LibreMax, an asset management firm with $10.2 billion in assets under management. Greg founded the firm LibreMax in 2010, specializing in a broad range of securitized products, including asset-backed securities. So Greg, welcome. It's so great to see you here today.

It's good to see you and, Greg, I know you've been in this world of securitized products and asset-backed finance for 30 years. So my first question to you is, why structured products? Why structured credit? Why does that belong in a client portfolio, especially in a private wealth client portfolio today?

Right, and the yield that we're talking about, is it the low double digits?

Right, and when you look at things like high yield bonds, for example, pure high yield bonds, the yield to worse on that is probably now, you know, eight, maybe 9% depending on the month. But, you know, clearly yield pick up potential there, and sounds like it's safer, or more better risk managed securities today versus what they were during the financial crisis. But to go back to the financial crisis, obviously you successfully, as I mentioned, bet against the housing market. And, you know, you were essentially betting against these various securities that you are now thinking about buying. So, what's changed today? What's the opportunity set for you now in securitized products?

Right, and when we think about the broad securitized product space, it's about $19 trillion. And some of that includes the asset-backed securities that you mentioned that are backed by some of those consumer loans. But then there's the corporate side of that, and then there's the commercial real estate side of that. So the commercial mortgage backed securities, the CLOs. So if you were to think about the risks that are lurking in the economy today, fine, the consumer's resilient. Fine, the consumer can stomach the 5.5% interest rate, but can the leverage loan issuer, can the commercial real estate operator, can they continue to operate with this level of rates without defaulting?

Well, let's expand on that a little bit. So, you know, when we see a jobs report that's stronger than the market expectations, the knee-jerk reaction in the equity markets is to move lower because presumably, the fed is not going to cut rates. But what does a strong labor market mean for your portfolio? And do you see that strength continuing?

How concerned are you about the risks there? You know, do you think it's well enough talked about to where it's already in the price? Or do you think there's more of a downdraft?

Right, and that's the pricing that you see on some of those securities. And to that end, you know, there's no exchange for, you know, securitized products. You know, there's no ticker, there's no, you know, intraday fair value that you can see on the asset class. So talk about how you have the ability to create value for investors, for shareholders, you know, not only through the income component, but also trying to figure out what is the right price to pay for this?

And just give us the flavor of how wide can the spread be, you know, between price A versus price B for the same asset.

You know, I'm sure there's a lot of misperceptions, misconceptions about your market. So what would you say are some of the biggest misunderstandings about this?

And the fact is, it's been since the global financial crisis, that it doesn't actually blow up every couple of years. But in the meantime, it does showcase some economic resilience. And especially in today's market environment, where you have strong consumer and this sort of insulated from the industry environment economy that is quite supportive for the asset class.

Well, Greg, with that, thank you so much for your perspective. And thank you for breaking down parts of this interesting and fascinating and important securitized product market for us. And, you know, I'm taken away from this that investors can be looking to the space for a pretty significant yield opportunity of low double digits. You also have the resilience in various economic environments. And, of course, today with a solid consumer backdrop, this is an asset class certainly worth looking at. So, Greg, thanks so much for your time today.

Today in our 'Spotlight' series, we answer your question of the month. And I've invited iCapital Managing Director and Head of Technology Solutions, John Scarpato to the studio to help us answer your question. John, welcome.

Thank you Anastasia.

It's great to have you here. And, you know, John, as you head up the technology solutions, I thought this question was perfect for you, which is a common question that we get from all of our clients. Which is, how do I actually scale my alternatives business? What do you say to that?

Yeah, it's critical, right? I mean, to state the obvious, using alternatives as part of your practice when recommending alternatives to clients, that can oftentimes be a very difficult task for advisors. These are highly complicated products, they require an awful lot of documentation. There are a lot of stakeholders involved in managing the implementation of these investments. The data itself can be difficult to access over time. And so, that requires a certain degree of technological sophistication in order to be able to manage all of those processes in ways that are consistent and repeatable and reliable.

Right, so clearly using technology to create this repeatable process, that could be a game changer and that's the path to scale. So give us a couple of tangible examples of what kind of technology products we have to still scale alternatives within iCapital.

Sure, we think about our operating platform, our technology in ways that sort of mirror some of the key activities that any advisor is gonna have to go through when managing his or her practice. I'll give you a few examples. Any advisor has to develop an appropriate amount of expertise in whatever product or strategy they're recommending to their clients. These are highly complicated products, and they do require some investment of time on the part of the advisor to be able to understand how these things are structured, how they're priced, how they're positioned in the marketplace. And so, we've got a very robust learning management system in place that allows advisors to consume information in a whole host of different ways. There are thought leadership pieces, there are courses that are constructed, either with respect to foundational principles associated with the asset class or with respect to individual products. By the way, it also comes with a fair amount of governance and control on the part of the firm. As you all know, many advisory firms are now growing in size, they're larger organizations. And so, making sure that there is some control in place. So that when an advisor is recommending something, the leadership of the firm, the management of the firm can be sure that they've done the proper amount of due diligence before recommending something to their client. So that's one bit. I think the second bit, and I know that you've had other folks on this show before that have talked about Architect, which is our portfolio construction tool, what we think is a first of its kind in the alternative space. But think about portfolio construction as another opportunity for advisors to be able to learn about how to recommend these assets, and if, when, and how to use them. The more that an advisor engages with Architect, the more consistent that process becomes, the more operationally efficient it becomes. But maybe most importantly, the more familiar they become with it. Third part I think really revolves sort of around the implementation of an investment. This is a highly complicated process, requires a lot of information, a lot of documentation. Our platform will walk the advisor through every step in that process, and will proactively reach out to the advisor when there is something that he or she needs to do. There's also a fair amount of work associated with all the things that happen after the initial investment is made. I think a lot of people are under the misconception that once that investment is made, the work is done. Not true. But there are activities, like redemptions and transfers and capital calls, all of which need to be managed by the advisor, and our system allows them to do that. The third piece really revolves around delivering a great customer experience. You know, we've had advisors say to us, 'Hey, you know, I'm recommending three or four different investment products to my client, but after that investment has been made and I need to be able to access information, or more importantly, my client needs to be able to access documentation, they're having to log in to two or three different investment portals, sponsored either by the asset manager or by the service provider. Obviously, it's very difficult to be able to retain all those different credentials. And it's quite difficult to be able to sort of learn all the different user interfaces associated with all these different investments.

Clearly, John, what you just mentioned is all about consistency and repeatability. And that's what over time builds scale. And, you know, I like your point about having to log in to a lot of different interfaces and having to remember a lot of different passwords. And I read this article a few years ago from 'The Wall Street Journal,' I believe, that cited that as a human individual, our brain can only retain something like 28 passwords. Do you know how many passwords we're actually forced to remember as we log into the variety of websites in our lives? The count is in the hundreds. And to that end, John, the last question to you is, how do you, as the head of technology solutions, how do you gauge if some of the tech offerings are being successful with advisors?

Yeah, I think the measurement of success, Anastasia, is really tied to how an advisor and his or her client relates to one another, and sort of the essence of that relationship, right? Most advisors, they wanna spend time with their clients. They wanna spend time understanding their needs, their circumstances, their goals, their family dynamics. All of the things that are required in order to deliver a set of investment recommendations are critical, for sure. Accessing information, speaking with other service providers, conducting analyses, all mission critical things, but they are things that take time. And so, the more we're able to sort of help an advisor get through those mission critical activities, but in a way that allows them to maximize the amount of time that they're actually spending with their clients, that's how we define success.

Right. So technology should be easy, technology should be an enabler of ease in other parts of their practice. John, thank you so much for helping us answer that question of the month. And thanks so much for joining us.

Thank you, Anastasia.

And we'd like to hear from you. Send us an email to [email protected], and let us know what questions are at the forefront for you and your clients. I'm Anastasia Amoroso, and thank you for joining us today. We'll see you next time on 'Beyond 60/40.'