Saâdeddine Yahia - The Allure of Private Credit

00:00:08 [Saâdeddine Yahia]
The current high interest rate environment, the so-called higher for longer, is also coming at a time where we have a more challenged economic environment. But these days, it's a bad omen for private equity. There's no doubt about it. When we talk about private credit, we often use the term illiquid credit, which is a more encompassing, broader asset class.
00:00:31 [Vincent Weber]
Hello everyone, I'm Vincent Weber and this is Resonanz Spotlight, the podcast where we explore investment strategies, learn the story behind them and meet the experts who create them. Welcome to today's episode where we deep dive into the world of private credit, an investment category that has continuously held the attention of investors for over a decade, weathering the ups and downs of the global macroeconomic climate. The allure of private credit is undeniable. but it comes with its complexities, not least of which are the myriad of cryptic acronyms that can baffle even seasoned investors. Today, we aim to shed light on this field, exploring the why behind its prominence and exploring the opportunities that lie ahead. I'm delighted to welcome as our guest Saâdeddine Yahia, Investment Director at Resonanz Capital.
Saâd leads our firm's illiquid credit initiatives, having dedicated over a decade to this sector. His experience spans direct credit investment and strategic manager selection, covering a diverse array of structures and strategies. Saâd, welcome to the show.
00:01:43 [Saâdeddine Yahia]
I'm glad to be here Vincent, thanks for having me.
00:01:46 [Vincent Weber]
So I may be playing the devil advocate during this interview. I don't know where to start because I'm lost. I think it's full of acronyms and buzzwords. So you have to help me. So what do you mean when you talk about private credit?
00:02:08 [Saâdeddine Yahia]
So what the market means when they talk about private credit is the counterpart to private equity. So it's as simple as that. Bilateral, privately originated loans from a non-bank lender to a to a corporate, basically, most of the time. Not to the corporate directly, but oftentimes to the PE sponsor behind that corporate. That's where the lender relationship lies. When we talk about private credit, we often use the term illiquid credit, which is a more encompassing, broader asset class. It includes private credit, i.e. a loan relationship between a lender and a borrower. but also other strategies that can pertain to the world of public credit rather than the private credit only. That's the typical distress and dislocated capital markets and so on.
So if we had to map the private credit landscape, we think of it in three buckets, the same way like we use for hedge funds, three broader buckets. Lending, i.e. I make a loan, I look at collecting a coupon and getting my money back. Amortizing a bullet that's up to me or between me and the borrower, me as a lender. On the far hand side, on the other end of the spectrum, we have the capital gains game, which is a typical distress and special situations. So lending, special situation, lending. distressed and special sets and everything in between we kind of bucketed in the catch
00:03:54 [Vincent Weber]
-all bucket what is true called opportunistic credit so these are all the kind of specialty strategies like specialty finance and pls before we go deeper into this this variation of by what you call illiquidity helped me long time ago i remember there was these things called leverage loan this was already a big market so is it Is it what we're talking about? Or is there more to it?
00:04:23 [Saâdeddine Yahia]
Yes. So bank loan and leverage loans are very similar in terms of the economics and the risks taken and the analysis to private credit. The only difference is that private credit proliferated in a different area of the market, which mainly consists of what we call middle market or smaller and middle market. stretching up to the upper middle market in terms of EBITDA this means companies anywhere between 10 million of EBITDA to probably if you stretch it very far can make 100 million of EBITDA or 125 million 150 million of EBITDA those companies cannot access the traditional leveraged loan market the LBO financing type market And that's what created this private credit as we know it today, which deals most of the time with middle market companies.
00:05:24 [Vincent Weber]
So when I hear like big name asset manager launching like billion fund into that asset class, are they still targeting this mid-market company?
00:05:34 [Saâdeddine Yahia]
For the most part, yes. If a large dedicated asset manager raises a fund that's pursuing, let's say, direct lending, that's what they do. Basically, what they do is lend in to private equity backed companies' money. So that's all they do, basically. There are some funds that do a certain proportion of non-sponsored backed deals, but by and large, what drives the market is sponsored backed deals. So that's what they do. The more multi-strats, the ones that we like to allocate, that do a bit of direct lending, but also a bit of distressed and special situations, etc. These guys navigate in and out between private credit in the lending definition of the term, but also stretching out to public markets where you have discounted paper, process-oriented distressed opportunities, and so on.
00:06:41 [Vincent Weber]
Sorry, I understand you prefer to talk about illiquid credit. You prefer to look at it from a larger point of view.
00:06:48 [Saâdeddine Yahia]
Exactly, because the only common thing across all of these things, it's not the credit risk, it's not the illiquidity risk, it's not the regulatory environment or whatnot. Really, the main theme, if you were to find one common denominator across all these types of strategies within what we call illiquid credit, is actually the illiquidity of the strategy. The underwriting IRRs are hugely different, but the commonality between them is that these are very illiquid.
00:07:20 [Vincent Weber]
So what's the reason for this huge boom experienced by that market over the last decade?
00:07:27 [Saâdeddine Yahia]
Over the last decade? So the main boom over the last decade was twofold. So since the GFC, we experienced near zero interest rate environment for a decade. And there is a huge pool of capital waiting, the so-called yield-hungry investors. Large institutional investors were hungry for yields, which they could not find as easily in the high-yield market because those are driven by rates. And so this created this alternative lending market or direct lending. you can call it however you want, that actually offer the solution for large institutional investors to spice up their fixed income portfolios, basically. That's the main thing that drove the private credit.
00:08:23 [Vincent Weber]
And what role did banks play in the development?
00:08:27 [Saâdeddine Yahia]
They played a big role by not playing a role. So after the GFC, tighter. tighter lending conditions, banks divesting from non-core assets, non-core activities created a void, especially in this smaller end of the spectrum in terms of company size. So if you were a bank, you were incentivized to get rid of your smaller, often sometimes less profitable assets that were creating a burden on your balance sheet. So you exit the lending to the smaller companies, and that created the opportunity for non-bank lenders to step in and provide financial solutions, thereby charging companies higher interest rates, and at the same time offering attractive yields to those large investors that saw their corporate bond or fixed income portfolios not performing as they would have liked.
00:09:34 [Vincent Weber]
the boom was created by the zero rate environment so now we have higher rates and so what's what happens to that space yeah so if we were to speculate on what will happen to that space if if i am let's say if i'm a pension fund i'm insurance company and i have i have a target rate of return that i need to generate on my fixed income portfolio the attractiveness
00:10:04 [Saâdeddine Yahia]
of the average plain vanilla direct lending fund may not be there anymore because rates are base rates are in the five percent give or take in the us so maybe do do i need to keep lending to smaller companies to generate my target return i'm not so convinced of that the current high interest rate environment the so-called higher for longer is also coming at a time where of a more challenged economic environment and so Can I keep affording to charge smaller companies high interest rate and ignore the potential risks of that? Not anymore. So really the way I see it is that the opportunity going forward to play in liquid credit in a high interest rate environment is more on the middle bucket, so opportunity credit, and the far right-hand bucket, so-called distressed credit.
Because we are primed for more volatility here. that's that's for sure so landing is not so easy anymore as it used to be in a lot it used to be low interest in right interest environment booming economies or for artificially booming economies we can debate that so that made for an easier landing game now now lending is not so more easy we need the investors need to pivot to other strategies okay so okay can you help me what
00:11:31 [Vincent Weber]
What's opportunistic credit?
00:11:33 [Saâdeddine Yahia]
So opportunistic credit is an area where we bucket the hard to classify strategies. Specialty finance, for example, is also could be the category because it includes many different sorts of specialty lending, royalties. pharmaceutical royalties, music royalties, et cetera, intellectual property. So you lend to companies that specialize in this area. There is another subcategory of opportunistic credit, the so-called NPLs, especially in Europe where banks are behind the curve in terms of deleveraging and getting rid of their non-performing loan. So there are funds out there, asset managers that specialize on buying those loans and monetizing them, buying those books of NPLs and monetizing them. Private capital solutions is kind of where, or special situations lending is where asset managers step in, provide bespoke financial solutions to a company to avoid it.
filing for bankruptcy or getting into trouble. So liquidity provider. Oftentimes by stripping out the most valuable assets and lending against those assets. And a final category, broad category that we place in there is dislocated capital markets. So this is your March 2020 Corona markets tanking. So it's more so kind of a public markets game where you pick up paper at a heavy discount when the opportunity presents itself. It's more sporadic in nature. So those categories are not present all the time. So hence the name opportunistic. They come and go. They're very cyclical. And now we believe now it's the time to go after the private capital solutions and dislocated capital markets.
00:13:37 [Vincent Weber]
Okay, this seems all interesting, but you're describing, I mean, in your own words, a lot of sporadic opportunity. So as an investor, it's all good, but how do I build an allocation there? How do I fill up my book? What do I have to do to get there? To say I want to have like 600 million in that bucket.
00:14:05 [Saâdeddine Yahia]
how how can i do that yeah so what we what if you are if you want to allocate and tick probably all the boxes your best your best shot is going multi-strat or trying to replicate the multi-strap portfolio through individual specialist areas so the way we do it for our clients is basically we started off at a time with high volatility building, at times of higher volatility, you might turn to distressed and special situations. these days, we're talking about
00:14:39 [Vincent Weber]
- Are you talking about open-ended structure? So we're talking about fund structure? Is this the open-end or close-end structure?
00:14:46 [Saâdeddine Yahia]
So it's very hard to replicate a lot of what we're speaking about in open-ended structures. The reason for that is, and that's also the main reason behind which we insist on the word illiquid credit rather than private credit. So in liquidity, you might structure it in an open-ended fund structure, but you would have to gate or you would have to place on the rest liquidity terms on the structure itself. So it's quite like closed-ended, effectively. Why we like the closed-ended structures better for this type of investment is because it affords the manager the luxury of time, basically, not to rush into investments, know that they can invest, harvest, and reinvest during the investment period as they see fit. And the fact of locking capital, not acting as an ATM for investors.
alleviates the pressure on deploying capital on the managers and harvesting and collecting, harvesting too soon. And so to wrap it up, a bit of everything, if you were to, if you wanted to get the best allocation everywhere, there are a number of multi-strats asset managers that do that well. Otherwise, you could still replicate every single component, but by going with the best managers in any given area. Bear in mind that the other difficulty of that is that contrary to open-ended structures, evergreen structures, managers open, they raise capital, then they close, then they raise capital, then they close. So there is this kind of vintage availability or fundability for you to invest. not present when we're dealing with traditional evergreen structures.
00:16:58 [Vincent Weber]
I keep seeing the higher for longer, this expression, higher for longer when reading about private credit. What does that mean? What's behind that?
00:17:11 [Saâdeddine Yahia]
So, there are a number of implications. The most Risk management-minded people will think about, okay, can the current corporate landscape withstand financing their businesses at LIBOR plus 8, where SOFR plus 8, where SOFR is at 5%, where base rates are close to 5%. So that's a real threat to the economy going forward. It doesn't look so good for the economic backdrop. Talks of recession, talks of slowing growth are opening up, and that makes private credit inherently riskier, especially for the strategies that seek to lend money and get it back. So that game is not anymore easy. However, on the flip side of that, managers that are specialized in distressed special situations, high volatility, process-oriented strategies, they would see that as an opportunity. There are walls of maturities coming up.
It remains to be seen if smaller companies can actually refinance themselves at what seems to be a very onerous rate or interest at this stage. So higher for longer, a tale of two stories. Lending is very dangerous. in a higher for longer type of environment, especially for the middle market and below. And an opportunity-rich environment should the economy hit a roadblock and start staking. That's when these stress strategies come to play. And to your earlier point is very good because it's very good to think in terms of, I want to be positioned a bit everywhere for all kinds of scenarios, hence the multi-stranded stack. It's devastating.
00:19:19 [Vincent Weber]
Saâd, you've been allocating to Illiquid Credit Manager now for over a decade. So how has the ecosystem of Manager, how did that change over that time? Were there many new entrants to the games? Or was this huge? opportunity set or are we are the the big boys of today we're still the leading player back then in the old day yeah no it's definitely attracted a lot of newcomers especially so the the biggest trend i would say is that you've had the the big non
00:20:00 [Saâdeddine Yahia]
-bank lending groups from the early days are still pretty much present. They try to diversify away into kind of more niche strategies, more opportunistic, more distressing type of strategies. So these are kind of newcomers into other areas, but traditionally they've been known for being non-bank lenders for a long time, especially the US space guys.
00:20:23 [Vincent Weber]
Okay, so can you name a few for me?
00:20:26 [Saâdeddine Yahia]
Well, I can name the likes of Ares being one of them. Apollo running a whole gamut of strategies, a bit everywhere. Blackstone and so on. So the usual suspects. Blackstone being kind of a pretty much company that started diversifying in a way into kind of private credit and the likes. KKR as well, formerly known for private credit only, that also came to the private credit space. So formerly non-bank lenders. that came to this space, that stayed in this space somewhat. Formerly PE groups that also came as new entrants in the private credit game. And also hedge funds, hedge funds, namely credit hedge funds, the likes of Davidson, Kempner, Anchorage and so on and so forth. So, and it keeps evolving, we see also some new entrants like Sona have also started with.
credit long-short type of hedge fund and then now are offering a capital solution dedicated close-ended vehicle in the private credit space. So yeah, it definitely attracted a lot of new interests.
00:21:42 [Vincent Weber]
I remember that about one year ago, some people were still talking or concerned about an upcoming wave of default in that space, which somehow, at least on the surface, doesn't seem to have materialized so is it still is that the case or is it the is this this risk still looming on on that that space well it's it's it's the it's the biggest trick that it's the biggest risk that never really materialized the way we were we were expecting
00:22:24 [Saâdeddine Yahia]
Looking back at the last decade prior to interest rate hikes and analyzing what happened during that decade, i.e. from 2008 till about 2022, it's clear that whenever a maturity wall was coming up, a distress cycle, a default cycle was looming ahead, interest rates were so low that any company could refinance without any problem. And so avoid. defaulting on their debt. And so the successive maturity walls or distress cycles were kind of picked down the road. What that provided for is that it provided for a better clarity in terms of who are the managers who can fight pockets of volatility and still operate within an adverse environment.
that 10 years of no distress actually provided a bifurcation or a dispersion between who are the real prayer who are the knowledgeable specialists in this area and who are okay so you are as an allocator
00:23:37 [Vincent Weber]
was about to to gather some data points on on exactly it helped us greatly gather gather data points yeah yeah that it was mentioned i remember it was a big topic i see a big continent they're going there's going to be this big wave of distress in private credit yeah yeah as far as i know they didn't didn't happen and also the second concern was okay when this wave of distress is going to happen as was okay how how is going to work out because it's it's new and there was this this The whole structure that you have been untested in a big distressed environment. I remember earlier last year, this was still a concern.
00:24:20 [Saâdeddine Yahia]
Yeah, that's right. So when we talk to the various managers, they seem to be focused on this kind of refinancing. Refinancing is coming up. It's maturity walls. that will ultimately have to be repaid. And given where interests are, it will be a more difficult task to pull off. I.e., we could start seeing, especially on the lower end of the market, companies having a harder time accessing capital.
00:24:53 [Vincent Weber]
If you make good gains, they're buying the debt side of the company, there's an equity side. So if you make good business on the debt side, somebody else has to lose. everyone claims to be the winner so my gut feeling and my preparation is private debt is the new private equity it's also like it's also a topic that's heavily debated in forums in articles especially on the lbo one is going to be the loser is it the equity provider or the debt provider when when rates go up yeah there is only one loser is the equity provider yeah that becomes more expensive it eats away at cash flows
00:25:32 [Saâdeddine Yahia]
But it decreases the risk of bankruptcy.
00:25:34 [Vincent Weber]
If debt becomes more expensive, the risk of servicing the debt is higher.
00:25:40 [Saâdeddine Yahia]
Hence, our preference of being with the higher octane guys, the guys who can lend. And when things go south, they can take the keys. If you look at our portfolio, this is where we operate. You lend, okay, you get your 15% IR on a loan. You carve out assets to get the mass security in case of a default. Or you take the keys of the company if it defaults on you. But these days, it's bad omen for private equity. There's no doubt about it.
00:26:14 [Vincent Weber]
So why do you say it's bad omen? Because the higher rates are bad omen?
00:26:19 [Saâdeddine Yahia]
So the current companies that exist, that are backed by PE sponsors, these PE sponsors bought them at very high valuations in 2021, where we saw a surge in the leveraged finance issuance. That leveraged finance issuance served private equity companies to acquire target companies.
00:26:44 [Vincent Weber]
So private debt has had this huge run. Investors have earned a nice return on that. And so they are providing debt to companies. So my understanding is if somebody makes a good deal, like on the debt side, somebody else is going to get the shorter end on that part. So if the debt side is winning, who will be the loser? It shouldn't be naturally the equity provider.
00:27:11 [Saâdeddine Yahia]
It wasn't the case five years ago. Five plus years ago, five to ten years ago, it was the other way around. Liquidity was abundant. Private credit just pulled that liquidity and deployed it into the spicier end of fixed income, which was direct. That's what they did. So as a private equity, you had plenty of choice in terms of who you would work with on the financing side of your companies. Until And actually, in parallel of that, equity valuations were going up for, in a straight line for the better part of 10 years, which means you were acquiring companies at higher and higher valuations all the time.
But it didn't matter because liquidity was so cheap, you could afford to do that and still advertise, I don't know, 20, 30% IRR on your private equity fund as a private equity sponsor. Where really the pressure came in is when base rates started to go up to fight inflation, that means that you could not anymore service your debt anymore because your company that you acquired very expensively may not be able to serve the type of debt servicing at those higher rates. So what has to give? Typically, equity gives.
because you will have pressure from you pressures from your lenders banks or otherwise to deliver you will most likely have bridge covenants and so the equity end has to give away and we've seen it in any if you if you follow the environment if you follow the this area of the market typically us as investors we would like that we try to make sure that our investment managers have the capabilities of taking over a company and restructuring it and so while a plain vanilla kind of direct lending manager may not have the skills to operate take over operate and restructure and ultimately exit the command nor are they in the business of doing so because what they promise their lps is we make the best loans possible at the highest interest rate possible at the
safest now standards possible. So for 10 years, you've had Covlight because PE had the choice of who they wanted to work with. And the hunger, the eagerness to do business was more on the private credit side rather than on PE side. And now the tide seemed to have shifted the other way.
00:29:55 [Vincent Weber]
Okay. Thank you, Saâd. Thank you for being with us today. I really enjoyed the insight you shared. And to our listeners, thank you for tuning in to Resonanz Spotlight.