00:00Back in 2014, a new technological change happened for oil and gas.
00:05It's called horizontal drilling or fracking.
00:08And that technological change did a couple things.
00:10Number one, it changed the pricing structure for how oil and gas and oil and gas services would work.
00:17And number two, based upon all the capital that was raised,
00:23now all of a sudden capital dried up because the pricing structure collapsed.
00:26And so what we have in software is very similar.
00:31We have a technological change, which is forever going to change how software is going to be priced.
00:35Now we should think about that industry.
00:38And based upon that technological change and how much leverage is in the broader syndicated loan market
00:43and then more importantly in the direct lending market, leveraging up these software companies,
00:49the capital is now drying up.
00:50And so what did we see as a result of that technological change in oil and gas?
00:56We saw a 15% default rate in the subsequent years, 2016 and 2017.
01:03So for me to say that software, which is the biggest sector within the direct lending business,
01:09couldn't get to a 15% default rate, I think is actually missing the mark
01:14because I think that's exactly what's going to happen in years 27.
01:17And it has a chance of happening in 27 and 28 to have back-to-back years.
01:22So although the industries are very different, there's a lot of similarities because of technology,
01:27technology changing how pricing structure works at a time when too much capital has been flooding into the sector.
01:34Just think about this for a second, Matt.
01:36Only 1% of companies in the U.S. are software companies and only 7% of all publicly listed
01:42companies are software.
01:44Yet, 23% of the direct lending business is software.
01:50How did we get there?
01:51It was a gold rush to finance these software companies and these buyouts.
01:55And the public companies are sitting in good shape because their debt,
01:59and we'll look at NASDAQ, S&P, Russell 2000, the debt that these software companies have with really good margins,
02:06the debt that they have is only 0.5, less than one turn of leverage.
02:10In the broadly syndicated loan market, you have five turns of leverage, 10 times the leverage.
02:15In the direct lending business, you can have 20 times leverage.
02:18So you don't have the companies that can generate the free cash flow to reposition for AI.
02:22They're in a very tough position.
02:25So, Bruce, what is the effect of that?
02:27I think a lot of investors are reading your research and starting to wake up to the fact that this
02:33could become a reality.
02:35And as a result, we're seeing redemptions.
02:38People are trying to get out of these illiquid private credit funds.
02:43And what we see some of these companies doing, Blue Owl, for example, is,
02:48OK, we're going to sell a ton of these assets.
02:50We're going to sell these loans.
02:52And they want to be able to say, we've got 99%, we've got 98% of the par value for
02:59that.
02:59So they can't be selling those 20 times EBIT software loans, right?
03:04They must be selling their best assets.
03:06Yeah.
03:07So I can't speak to Blue Owl or others that have liquidity crisis or liquidity issue right now in their
03:14funds.
03:15It's, you know, something I'm not focused on.
03:17What I am focused on is the availability of capital on the back end of this to extend these loans.
03:22And I believe that there won't be availability of capital.
03:26So I think the next round in the years 27, 28, what a lot of these loans come due is
03:31in the direct lending business to extend and amend or extend and pretend.
03:38Yeah.
03:38To pick those loans because it won't have the cash flow.
03:41Payment and kind financing.
03:42And so, and you won't be getting, you won't get paid back in interest.
03:46And because you've extended the loans, you also won't be getting paid back in interest.
03:51What does that do to an entire industry that is both private credit and private equity that has loved software,
03:57that has gotten it to 23%?
03:59If all of a sudden they can't go to capital markets and they can't get those loans, the financing ceases
04:05to exist.
04:05What does that do to the industry?
04:08I think the industry is fine because I think direct lending is a big industry.
04:11And I think that there are other sectors of the economy.
04:15Again, software is only a few percent of the overall economy.
04:18But it sounds like you're saying software lending is over.
04:20It's done after this episode.
04:21I think when you lend in software, you have to lend it very conservative, multiple because the business itself is
04:27an uncertain business.
04:28And so, four times debt to EBITDA, not ten times, is probably the right number.
04:34And getting paid a little bit more for that risk, an extra 100 base points on your loans.
04:38Now, to the extent that financial conditions tighten a little bit on this in the direct lending space because of
04:44what's going on,
04:45we can get paid more for loans that we're making in the marketplace with tighter covenants.
04:50So, I think for lenders that aren't in a bad position that actually can extend credit, it's actually a good
04:56place to be.
04:57And so, I wouldn't let software, just like oil and gas, when you had that problem with those companies back
05:03in 2016, 2017, 2018,
05:07didn't tank the economy.
05:08The economy is just fine.
05:10I think economy will just be fine without having to deal with the default rates that are coming, the problems
05:16that are coming,
05:17because the economy is so much bigger and diverse than this.
05:19And so, it's not going to do anything to cause any kind of disruption to the broader private credit markets
05:25or the broader credit markets or the economy.
05:29I don't believe that at all is the case.
05:31But what it will cause is religion to come back in, a discipline to come back in, because quite simply,
05:38you know, Danny and Matt,
05:3923% of software is just too much exposure to one industry group when it only represents a very small
05:46part of the overall equity markets.
05:50It's only 1% of all companies in the U.S. are software companies,
05:55and only 7% of all publicly listed companies in the U.S. are software companies.
06:00So, it's too much exposure for them to have had.
06:02Everyone regrets it now.
06:04We're thankful that we have 1% exposure.
06:06We agree with us.
06:07And not that type of exposure.
06:09It's going to represent some really good opportunities for us as lenders in the years to come, Danny.
06:15I'm wondering, you know, where those opportunities are going to be,
06:18and specifically in software, because religion has already set in with some of these names.
06:24Are there some you think that are oversold?
06:27Are there some that you think, you know, the debt is cheap enough to go in and pick it up?
06:31Because that's historically where you've made a lot of money, Bruce.
06:33First of all, I think in the public equity markets, they're going to be in a really good position to
06:38buy a lot of this.
06:39At pennies on the dollar.
06:43Because they're the ones that are going to have the capital, the cash flow, the margins to be able to
06:47do so.
06:48Smart private equity will also come in and recap lives and buy new companies.
06:53But they'll pay a lot less.
06:56The whole ratings of where, you know, what multiples you pay for the company has come down substantially.
07:02And private equity traditionally doesn't pay more than 12 times for a company, traditionally.
07:07And so getting the whole sector repriced based upon this existential risk that you have,
07:15look, private equity is important, and that's where we're moving towards.
07:19And the second thing is private equity has all the upside.
07:22Imagine a company through creative disruption that they can reposition.
07:25Instead of making two or three times their money, they make five or six times their money.
07:29So they can afford a few zeros, right?
07:31And it still come out okay.
07:33Private credit can't afford the zeros.
07:36They only get paid back part.
07:37They don't have the upside.
07:38So what you need, Matt, is certainty when you lend.
07:41It's an uncertain business right now.
07:43And that's why capital will not become available.
07:46So are you not buying anything then?
07:48Not right now in software.
07:50What we're focused on are businesses where halo is the effect.
07:56Hard assets.
07:57Hard assets, low obsolescence.
07:59I'm talking about in lending, our last private credit lending deal in DL was a concrete deal with rebar.
08:06The deal before that was sod.
08:08Sod for commercial and residential.
08:09You lay on the lawns, right?
08:11And so these are real asset lending opportunities.
08:16And our last asset deals in our ABL business, hard assets, low obsolescence, our aircraft, maritime assets, turbines, cranes, and
08:29engines.
08:29Because you're bullish to the economy.
08:30Because we love the economy, and we want to be able to lend, say, a $300 million asset pool, $200
08:38million on an LTV basis, a 66% LTV, that nice margin of safety with that hard asset where we
08:45have a perfected interest in that hard asset.
08:47It's not software where the recovery value will be close to zero if there's a default.
08:51We get full recoveries in the event of a default on most of those assets.
08:57And we very rarely have a default because they're missing critical assets for these companies.
09:02And so it's a very different dynamic when you talk about halo.
09:05And with halo, that's why you see industrials and materials up 25% in the year.
09:11When a lot of the software companies are down 25% to 40% in the year when you talk
09:15about the mid-market software companies.
09:17And so we're in a very good position at Marathon as a lender with capital available to lend and with
09:23how our position is currently positioned.
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