00:00So where do we stand now? You've warned about underwriting. How poor does it look?
00:05Sure. So I think what we're starting to see is just a normalization in this space. For far too
00:11long, there was lax underwriting standards in direct lending and with too much leverage put
00:17on companies that really didn't need that much leverage on them. What we're seeing is not really
00:23a crisis, though. What we're seeing is a cooling in this market. And what we're seeing is a move
00:29in default rates from low single digits, call it, you know, it was 1% to 2% a year,
00:34moving up to probably 4%, 5%, 6% a year, which brings your returns in this space from what it
00:40was
00:40as a great years of 10%, 11%, 12% returns are going to be in the mid single digits now.
00:46So it's not
00:47that necessarily things are hitting a wall and that there's an extreme crisis in direct lending.
00:52What there is, though, is, you know, is a realization that returns are not going to be
00:57as perfect as they were for long. Now, of course, there are also the questions around
01:03what happens with some of those software exposures in direct lending? What happens
01:07with some of the cyclical energy and consumer related names if we do see a protracted crisis
01:15in the Middle East? And a realization there that, you know, things have to work really well
01:20for direct lending to deliver those high returns that they have over the last several years.
01:24And that's what the market is grappling with now.
01:27Let's talk about the consequences of that, Christian. If some of that does come true,
01:31where you see issues around software, for example, what are the consequences look like for the industry?
01:38Well, you know, what's going to happen in software is going to be a very mixed bag. There will be
01:42many software companies that do extremely well with applying AI tools. And you could say even
01:48the majority will do quite well. The problem is that in lending, the majority isn't good enough.
01:54You know, you need the vast majority to do fine because all of your upside is getting the yield
02:01on your loan. And if any of them go bad, of course, then you start to lose money. And that's
02:05probably what
02:06we're going to see is that over time, there are going to be winners, great winners, and there are
02:10going to be losers. And those losers, unfortunately, will have very low recovery values because they're
02:15simply going to be eaten away by AI. It's probably too early to say exactly which ones those are going
02:20to be and how big it's going to be. But in an industry that has 20, 30, sometimes even more
02:25percent
02:26of their loans in software, you have to imagine that, you know, some significant part of that is going
02:32to get into trouble. And there will be losses in that space. How long it takes and just how bad
02:37it is,
02:38is going to be seen. And unfortunately, you know, you've got a lot of investors who'd rather not wait
02:42around to see how bad it gets. Is there any concern that this could morph into a structural issue,
02:49Christian? Bill Dudley says, no, this won't turn into another 2008. The I guess the major systemic
02:58problem is if insurance companies have too much of this stuff and it starts to go bad.
03:05Yeah, well, we always over all credit cycles, you always have to look for leverage on leverage.
03:11And that's, you know, leverage is OK. Borrowing is OK. It's where you borrow to make loans that can be
03:17difficult. And that was the hallmark of 2006, 2007. And going into 2008 is there was that leverage on leverage,
03:24especially short-term borrowing against longer-term assets. It's night and day difference today in
03:31terms of the systemic risks that we saw in 06 or 07. There is borrowing, there is leverage on leverage,
03:38and that's an important area of focus. Insurance companies, some insurance companies are exposed to
03:45that to some extent. But it is nothing like what we saw with the banks and with the securitization
03:51problems that we saw in 06 or 07. That said, you could still have real second-order impact here from
03:58a credit tightening. And that credit tightening will come. There will be less and less growth in
04:04direct lending. There will be less and less growth in lending below investment grade, which has been
04:08the source of credit extension over the last several years as households have been paying down debt.
04:14Corporates have been levering up particularly below investment grade corporates, whether it's
04:17private or public corporates. And that is going to slow. It's slowing already. It's going to continue
04:23to slow. And that credit tightening is going to trickle out into the rest of the economy. Now,
04:29that doesn't necessarily mean that it moves into a very serious shock to the economy by any means.
04:34But we have to be realistic that this has been the source of credit growth in the economy over the
04:40last several years. And it will be a source of credit tightening for the next years to come.
04:45So there's some real economic consequences of this, Christian. I also just wonder,
04:49you know, you've talked about this idea before that it's not just an image problem. It's a
04:53fundamental problem, too. Again, going back to the bad underwriting. But what you're also describing
04:57is a return to normalization and a credit cycle at the very point that everybody is trying to sell
05:03to retail investors. What happens if there's an erosion of trust?
05:09Sure. Well, what what happens if you play this forward is that, you know, the default rate may
05:14not be that bad and the returns may not be that bad. But there will not be growth in the
05:20stock of
05:21investment in this space that that is that is slowing fast. And it may even be negative in some
05:28places. And that's just going to mean that it's gonna be that much more difficult for troubled
05:32companies with maturities of their loans coming due to be able to renew those loans. And that's how
05:37this accelerates some of this normalization in default rates and will keep this default rate in
05:43this kind of mid single digits, not just last year and this year, but out into 2026 and 2027 and
05:492028
05:49as well. So you're going to have this multiyear, not an extreme peak in defaults, but a multiyear
05:56process of burning through some of these weaker loans. And that will be driven, of course, because
06:02there's not going to be the net new buyer of these loans. If anything, there's going to be a retreat
06:06of
06:06capital from the space.
06:07Well, actually, I was wondering about just just that, Christian. I mean, aren't there opportunities here
06:12after, you know, Boaz was started offering 60 or 70 cents for some assets. We heard Robin Dumar
06:19yesterday. He was pretty excited about putting cash to work here, said a lot of stuff looks very
06:25interesting lately. Do you see the same opportunities?
06:29Well, a lot of the loans that are out for sale right now are pretty bad loans. So, you know,
06:34we've
06:34we've seen some blocks of those and they're not clearing at a price where yet where we would be
06:41interested in buying them. You know, this is becoming more of a stress distress type of opportunity.
06:46And in those areas, you really need high teens type of returns to make them make sense. But what's
06:52interesting, I'd say, is that it has refocused the market on other opportunities and a credit
06:59tightening somewhere will lead to a credit tightening everywhere. And, you know, what we're
07:04seeing is emerging opportunities in what's called asset based finance. So this would be residential
07:08mortgages. This would be consumer lending. This would be aviation finance, things like that,
07:14where that's a much more resilient profile. There's been much less leverage. In fact,
07:19there's been deleveraging in those spaces for the last several years. But when the system as a whole
07:25has a credit tightening, that creates a higher cost of borrowing for the system as a whole and
07:31creates more interesting opportunities in those higher quality opportunities that are kind of
07:36babies getting thrown out with the bathwater. So that's really where we're looking for the most
07:39opportunities rather than pivoting into distressed sectors and trying to guess which software company
07:45is going to be the survivor. Christian, we only have a minute here, but I want to ask more about
07:50this tightening because you've also seen in public credit markets and leveraged loans that there have
07:54some been wobbles there. JP Morgan, for example, pulling back on debt that they were of Qualtrics that
08:00they were going to put into the market. What sort of mix does that create? And is there any degree
08:04where
08:05that could be a saving grace for private credit if more public and liquid markets start to pull back?
08:11Well, it's really interesting. I mean, what we're what we're seeing is a divergence in quality and
08:15performance, fundamental performance between IG and high yield bank loans, direct lending. Most, if not
08:22all, IG software companies are going to do just fine through the AI shock. And so to the extent that
08:28this
08:28credit tightening drives spreads everywhere higher, including an investment grade, it creates that much more of an
08:34interesting opportunity in investment grade where there isn't much real risk of fundamental impairment
08:40and defaults the way that there really is in some of the more levered spaces in direct lending.
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