Oak Hill Advisors' Eric Muller - operating at the intersection of public and private credit: live from iCapital Connect

Speaker A: There's moments where there's great opportunities in liquid markets and there's other, uh, opportunities where private credit is more interesting. And I think we've got a really good lens into making those trade offs.

Speaker B: This episode of Altgoes Mainstream is brought to you by Altimus, the full service fund administrator and transfer agent powering asset managers in private and public markets. As alts go mainstream, you need real expertise to handle complex fund structures, connect with key distribution partners and handle sophisticated compliance reporting and transparency demands. That's Altimus High Tech Tech High touch Solutions for over 450 clients and 2,500 funds with over 775 billion in assets under administration. Backed by an expert team of over 1200 employees. They place client service at the core of their business, helping you navigate complexity during your fund structuring or launch, and then supporting you through every stage of growth. Whether you're already in the market or thinking about entering private wealth. You can trust their team's deep expertise in retail alternatives to help you reach your goals. Learn more at ultimusfundsolutions.com or email info timusfundsolutions.com we're going mainstream, Eric.

Speaker C: We're live from iCapital Connect. Welcome to the Elkos Mainstream podcast.

Speaker A: Great, thanks for having me.

Speaker C: Pleasure to have you. We have a lot of really interesting things to discuss. Your background is fascinating how that has also dovetailed with the evolution of private credit and the credit industry more broadly. And then some of the things that you're doing at T. Rowe Oak Hill as it relates to productization in the credit space. I think it's pretty emblematic of a lot of the things that are happening around public private convergence. How do you think about single ticket solutions combined liquid illiquid credit? So a lot to discuss first. I'd love to get into your background.

Speaker A: Well, thank you, thank you for having me. I spent the beginning of my career at Goldman Sachs and initially I was in investment banking and just kind of a generalist investment banking experience. Experience. I left Goldman for a few years, went to a private equity firm, but then had the opportunity to go back in 2006 when Goldman had raised a very large mezzanine finance fund and it was private credit, but we didn't call it private credit. It was just a mezzanine fund that was doing kind of private high yield. It was an alternative for an LBO to do it in a private way. And Goldman had a lot of really interesting advantages just given its investment banking franchise and its connectivity with private equity firms. And so I thought that was a great opportunity. And I went back to the firm and that was in 2006. And you may have heard about the great financial crisis. And so coming out of the GFC in that time, Goldman had also raised a senior direct lending fund right around that time. And we hadn't deployed a dollar before Lehman Brothers went down. And so it turned into this just amazing. From a, uh, market timing standpoint, that fund turned out to be remarkable. And so, anyway, at Goldman, I had the opportunity on the credit side to invest up and down the capital structure, and everything was going great. I love Goldman. I was one of the partners helping run the private credit business there. I got a call from a mutual friend and client of Oak Hill in 2017, said, hey, you should talk to this firm. You'd really like it culturally. And our founder is a guy called Glenn August, who's kind of a legend in the leveraged finance markets. And I thought it would be to meet Glenn, but you never think these things are going to go anywhere. And we ended up dating for a year. And I, uh, just got excited about the opportunity. I thought oha, its history was in distressed debt and in liquid markets. It had been doing private credit since 2002, but it was more opportunistic. They did it as part of multi strategy, separate account mandates. But the firm had a great reputation, known for being really strong on credit, had a great kind of distressed debt capability and good relationships. And I believe that it had the, uh, opportunity to take real market share in direct lending. And so I ended up leaving and joining oak Hill in 2018 to help build up the private credit business. And we've had a great run.

Speaker C: Two interesting things that I want to pull out from there, one from your own background and one from OHA's heritage and how that relates today, because I think both are interesting, coming at it from different angles. So one thing I found interesting was you had a bit of a private equity background before going back into credit.

Speaker A: Yes.

Speaker C: What do you think you learned from having that experience in private equity that has informed how you think about credit?

Speaker A: That's a great question. So it's interesting, I think, that when you're analyzing a business and it's actually even true for being an investment banker, you get all the same information, but you're trying to answer a different question. So if you're an investment banker, you're trying to answer the question of, can I syndicate this risk? What's the right way to price this risk? If I'm Doing a syndicated deal or uh, what's the best advice to give if you're a private equity firm? You're saying, what's my upside? What's my right tail? What's my optionality here? But as a lender, and I think actually the reason that I like the business the best of the different things I've done in my career is that the question I'm trying to answer is can you pay me my cash coupon and can you repay me at par? And so if the private equity firm makes a triple wonderful, I get my coupon, I get par. If you just get your money back, as a private equity firm, I do great because I get my coupon at par. The only time I don't is if I've lent through value. I lent you a billion dollars because I thought the company was worth 2 billion and it turns out it was only worth 800 million. That's when you get in trouble. And so I like the risk reward trade offs in credit. And I feel like as a business matter, as an investment matter, I always like private credit relative actually to private equity because I thought the risk adjusted returns made a lot of sense.

Speaker C: So it's interesting you say that. So one of your former colleagues, James Reynolds, when we did our podcast, I kind of encapsulated the conversation by saying he was the optimistic pessimist because that's kind of what a credit investor is. He came from a credit background. Ah, you came to some extent from a private equity background. And listening to you talk about this, do you feel like as you think about private equity, you have to be the optimist?

Speaker A: Yes.

Speaker C: As you think about credit, you have to be the pessimist. Think about downside. Having a private equity background, where do you sit on that spectrum of optimistic pessimist?

Speaker A: I've become a pessimist. I mean I've been doing private credit now for 20 years. And so you're always looking for the downsides, but uh, part of the way that we think and we do invest up and down the capital structure and I think that there are moments in time where I might think the equity story is really interesting. And so maybe that's a situation where we can do something that has downside protection but has some right tail, maybe you get some warrants or an equity co investment or something. And so maybe I'm somewhere in the middle. But after 20 years, probably more of the pessimist.

Speaker C: You bring up another really interesting point, which is today's private credit people are concerned about certain aspects of the market, particularly direct lending. Now, there's also a distinction between the issues in a private credit investment and actually having to do the workout and actually owning and operating that business if you have to. How do you think about some of those nuances of private credit as it relates to how you make sure you, A, protect your principal and B, create value?

Speaker A: I think that that skill set is something that I do think investors should be asking about for their managers, and it's not all the same. So there are certainly some managers that have real workout capability, real distressed debt capability, and it is a different skill set than just picking credits on the front end. We've been in a really benign credit environment for a very, very long time. And so I think that not every firm necessarily has the same level of quality or experience, frankly. By the way, it's also true for private equity firms, where there are many private equity firms that have not experienced a lot of stress over the last 10 or 15 years, and so they're going through it for the first time. I do think that when you contemplate, uh, private credit and direct lending relative to the liquid markets, I do believe that you're going to have higher recovery rates because you're going to have defaults in both markets. You make mistakes, and that's just kind of how it goes in the credit business. But I think that on the private credit side, the fundamental difference is that in private credit, all of the lenders generally go in at the same time. They have the same basis for their investment, and their interests are aligned. In the liquid markets, you can have multiple players in the same tranche that came in at different times at different price points. And then you have intercreditor issues, and sometimes you have cross holders. And so the value leakage or the diminution and value risk for the enterprise that you're trying to fix is much greater. There's much more risk of that in the liquid markets takes longer. And so I think in the private context, you actually get to the table faster. And I think in a lot of cases, you have a depth of relationship with the private equity firm that you don't have in the liquid markets. So I might have a problem with one portfolio company, with that sponsor, I might lend to 15 of their companies. And so they're a fiduciary, I'm a fiduciary. But there is a basis to have a conversation because there's a broader relationship.

Speaker C: I think that's a really important point because that gets to a nuance in private credit that the Liquid credit markets don't necessarily have, which is how do you think about picking your partners and vice versa. How do the private equity firms and sponsors think about picking their lending partners? Because to your point, if you have to get to a situation where you need to figure something out, you're probably both going to want to make sure it yeah. Works out rather than doesn't.

Speaker A: There is a spectrum and there are some private equity firms that are more relationship oriented and in the context of the documentation negotiation, ask for things that they need or the flexibilities that they need, but they don't ask for things that they don't need. Ways to strip your collateral or drop your collateral into a trapdoor or strip your guarantees or something like that. And then you have some at the other end of the spectrum where it is purely transactional, they view it as zero sum game. And that's not only on deal terms but also on pricing. And the reality is it's a robust enough market now to where there is a market for these types of financings and that's both on the pricing side and on the documentation side. And so I would say that we choose to do business with private equity firms that value the relationship, that don't look for ways to abuse their lenders. And like I said, there's a spectrum there. And then I guess the last thing I'd say is that where it matters are in moments like this where there is a lot of volatility and financing isn't necessarily available. There are other markets where the leverage loan market is wide open and non traded BDCs are raising billions of dollars a month. And so there's a lot of competition and you get bid down to the last eighth or whatever. But it's really in these kinds of markets where those relationships matter because these are the markets where they really need lenders. And the way that you were treated when the shoe was on the other foot is going to impact how we operate now.

Speaker C: Are you finding that the sponsors are thinking about private credit partners as less of a commoditization and more as a. This is going to be relationship driven as we go into a time that may be a little more difficult or challenging from both. It's like private equity ability to create value drive EBITDA, uh, 12 is the new five as Bain would say. Right. So like they need to find partners that the right fits. And are you seeing that kind of move away from just seeing a, a direct lender or private credit firm as more commodity capital to get what they need to get done.

Speaker A: Yeah, it's a bit of a mixed bag. The private equity firms are very sophisticated. They are the most sophisticated users of financing markets. And if you're a capital markets person at a private equity firm, your job is to know what are my options in the liquid markets, what are my options in the private markets. And so certainly they understand the importance of it. But it is also the case that we've had so much growth in the industry that people at private equity firms could spend their entire day meeting with private credit managers that want to finance their deals. So now that we're in this moment where there's less inflows, that's where you're going to see how, uh, people behave.

Speaker C: I want to get to some of the origins of OHA that you mentioned. Levfin Distress debt. How is that DNA reflecting itself today, how you think about operating?

Speaker A: The history of the firm is that OHA was originally part of a family office. It was the Bass family, and they had a vehicle that was family money, but also third party capital. But it had a very flexible mandate. It could do private equity, it could do credit, it could do real estate, it could do liquid markets and private markets. But it was a best ideas, relative value oriented private equity style, deep due diligence, fundamental analysis. You had to compete to get into the portfolio. Our founder, Glenn August, broke away with the credit business about 30 years ago to start Oak Hill Advisors. But that ethos, that fundamental analysis, best relative value, has been one of the real guiding principles of the firm. And so when I look at our capital base, so we're about $110 billion of asset center management, but $50 billion of that sit in separate account mandates, many of which are multi strategy, go anywhere type capital. And I would describe our firm as really sitting at the crossroads of liquid markets and private markets, meaning that our research team is organized by industry vertical. So if you're on the healthcare team, you're looking at loans, bonds, private credit in distressed. And I think it positions us to, one, we think make better investment decisions because we get really deep on the industries and the credits. But two, it gives us a really good lens into relative value. And there's moments where there's great opportunities in liquid markets and there's other, uh, opportunities where private credit is more interesting. And I think we've got a really good lens into making those trade offs.

Speaker C: What do you think is the biggest challenge with being a relative value focused firm where you're unconstrained by where you can go? But what are some of the challenges that come with that.

Speaker A: There's some challenges in managing that kind of a business, but because our research analysts, their daily work is the liquid markets and earnings reports. But then we get a private credit deal and it's like spike, they have to build for peak capacity and so managing it that way is a little bit challenging. The other thing is people want to put money to work. But uh, as portfolio managers it's our job to say well now is actually not the time to lean in or that is mispriced. Here's a trade off example. So do you want to do the next private direct lending deal at 500 over near par or do you want to buy a high Yield bond, a 6% high yield bond at 80? And so can you get convexity in the liquid market as opposed to doing something new at par?

Speaker C: How do you think about risk in that context? And how do you both define and delineate between the different levels of risk risk both for yourselves as well as for your LPs in that context?

Speaker A: LPs are looking for different kinds of risk and different layers of risk. And we have some products that are on the lower risk end of the spectrum. Maybe it is just a high yield bond mandate or a multi strat liquid credit mandate that's buying high yield bonds and leveraged loans. And we are expressing our views on what we think is more interesting. But we're basically trying to beat or index and outperform that particular market. And then we have some at the other end of the spectrum that are interested in our either higher returning multi strategy products or distressed debt products that are looking for mid to high teens and maybe more. And so we have investors that are looking up and down the spectrum for those different types of return and we have the capability to look for those opportunities.

Speaker C: I think another interesting aspect of the concept of the relative value DNA, it's actually a great segue into talking about one, your merger with T. Rowe. Yeah, that is truly the intersection of public and private.

Speaker A: Yes.

Speaker C: And then I think that relates to a few other interesting things. One is the trend of the creation of products that include both public and private credit with Goldman, which also will include products that have public and private credit. And then also just more generally as it relates to the industry in terms of how investors are thinking about credit. There's now a spectrum of both liquidity and risk that people can choose where they want to play. I think all those things kind of roll up into like very much where we are today in the industry and particularly in credit how do you navigate some of those nuances and challenges as it relates to both the opportunity and the innovation as well as some of the challenges around risk?

Speaker A: The genesis of the T. Rowe deal was historically OHA has been nearly 100% institutional oriented firm. We've got most of the large US state pensions, most of the largest sovereign wealth funds around the world, a lot of superannuation funds in Australia. But institutional global investor base. We saw this trend of the uh, democratization of private markets or alternatives happening. And I would say that the prospect of thinking about building distribution to uh, tap into that market was kind of daunting and seems expensive and not necessarily clear. You're going to be successful. T. Rowe $1.7 trillion asset manager but really all mutual funds for the most part, really no real foray into alternatives. And so I think the idea was bring these together where T. Rowe could offer our products to its various clients. One of which is the Wealth Channel where we had no foray. And so we were acquired a little over four years ago. And as part of that it was creation of products for the channel. And so the first one was a non traded bdc. We just launched a multi strat vehicle which is an interval fund that really uh, is kind of a wrapper for this multi strat product that we've done for institutional clients. We can now offer it to the Wealth Channel. And so I think that it is about access for wealth investors. And the analogy we always talk about, the argument for it is if you think about our institutional investors sometimes being state pension funds. So if you're a state uh, employee, through your 401k you're getting access to alternatives. Why shouldn't a dentist or somebody that works in a local community also have access to those types of products? And so I think that the innovation around these products has created access to something that institutions have had for a long time.

Speaker C: What's been the thought process behind these multi strategy products that uh, include public and private?

Speaker A: So if you think about an asset allocation for an institution, they're going to have some public, some private equities, fixed income alternatives, but they've got professional investment teams and lots of resources to go pick those managers or to express that risk tolerance as an individual investor you don't really necessarily have those resources and you also are probably not making a large enough allocation just from a dollar standpoint to justify going through all that work. And so one of the real I think attractive features of these products is here is a one stop way you can buy a ticker basically that's going to give you access to best in class alternatives managers. And that can be just an alts product which is one of the things that we're launching with Goldman that will have private credit, private equity, real estate and infrastructure in one product. Kind of a best of breed type type instrument. And then we're also launching, you can buy basically one product that's going to give you the mix of public and private all in one vehicle. And so I think it's about providing that type of access and allowing investors to get that type of allocation that you might see in an instant institution.

Speaker C: How do you think about that as that relates to some of the challenges in the credit space? As it relates to both liquidity and product structure, also both manager and investor choice. You talk about the various flavors of credit, uh, and there's also a number of different strategies within private credit that have different features, functions and risk levels. How do you think about combining all of those together into a wrapper that may have some level of liquidity? And why would you do that as opposed to kind of keep certain strategies on their own monoline product structures?

Speaker A: Yeah, that's a great question. So I think that these products are a good access point for an individual investor because the concept of getting K1s or filling out subscription documents is daunting. Or thinking about a drawdown fund where you get capital calls over time. And so the benefit is I want to allocate to the asset class. I'm going to give you my capital and you're going to put it to work for me. The downside of that as a manager is I might not have a great private credit deal to invest in that day that you send me the capital. So I have to do something with the capital. And so I think that that's one of the trade offs. And I think that's one of the uh, challenges that the industry has been wrestling with frankly as managers of what do you do with that capital? And then the liquidity piece of it is, I think that it's the 5% quarterly liquidity that a lot of these have I think is a pretty interesting innovation because on the one hand it does give a path to liquidity to the investor, but the 5% limit protects the manager from being forced to sell an illiquid asset at a fire sale price to meet liquidity. But I think a lot of the noise that you're hearing now is I think the market is actually learning what these products are. And I think that people heard quasi liquid, but they Just heard liquid, that was the word that they heard. And it turns out that they're quasi liquid. And it's probably not the place that you should be looking for liquidity if you need that in your portfolio.

Speaker C: How do you think about risk as it relates to the element of liquidity or illiquidity in private credit? Like do you have a view on what is in your mind riskier or safer as it relates to credit, whether illiquid or liquid credit?

Speaker A: The benefit of being in liquid credit is that you can sell it. So if you don't like what's going on, or if you don't like the documentation, maybe it's okay. And if the company starts to underperform, you punch out of it. You really can't do that in the same way in private credit, but you're being compensated in the form of a premium. And so I think that trade off is something to be focused on. And then it comes down to manager selection. What is that manager's credit selection chops? How are they boxing risk? Are they being paid appropriately for the risk that they're taking on your behalf?

Speaker C: On that point, what do you think is the most non obvious question or m observation that an LP can make when diligent a credit manager's underwriting process?

Speaker A: So I do think that uh, there is this bigger question about what are the incentives that are driving your behavior around your fund structure. So if all of your capital is coming from a non traded BDC and you have a lot of inflows, I think it's fair for uh, LPs to be asking the question of what are you doing with my capital in those moments when where you might not have a great private credit deal to do and is there style drift or not? And then do you have a big enough funnel of opportunities to where it can be positive selection as opposed to negative selection? Are you doing the deals that you want to do or are you doing the deals that you are able to do? And so having a big origination funnel and platform I think is a totally fair question for LPs to be asking. And then I do think it's what are your capabilities when something goes wrong

Speaker C: on the origination side, where do you feel like firms can develop a true edge or advantage?

Speaker A: So people have different ways of playing it. So you brought up Goldman, my former firm. Goldman's edge is Goldman is the best investment bank in the entire world. And they've got lots of reasons to win, lots of connectivity with companies and private equity firms. That is their edge if you take some of the big BDC complexes, one of the edges they've had is that they have, at moments in time, infinity capital for a particular investment opportunity. So if they say, hey, it's a $2 billion financing and I'll give it all to you, that's an edge. Right. Somebody like ourselves, it's a little bit different because of the way that we manage our firm. We have, at any given time, kind of 800-900-NAMES, like in the book. Not one book, but in the book. And so when I look at where my private credit opportunities come from, over half of them are from companies where I'm the incumbent lender. So part of it is I already know the credit. I already know what I'm looking for. I already have the relationship with the company. And so my due diligence process can be really streamlined. I can move more quickly. And I would say that, uh, we are big enough to also write a big ticket when it matters. So commit a lot of capital, real knowledge, industry knowledge, and I'd say those are some of our advantages.

Speaker C: How much do you think speed matters as more and more capital comes into the private credit space?

Speaker A: It matters a lot. It matters a lot. Especially in markets that are robust. If people are really needing to deploy, sort of their willingness to do things with maybe less diligence is out there. So I would say that if you can move quickly, it's definitely an advantage. Move quickly, and in size, it's a big advantage. One other thing is that you talked about kind of the fluidity of public and private markets. That is another thing that I think is important to highlight, which is that large companies have the choice between going to the liquid markets or the private markets, and they're constantly evaluating both. And so another way that we differentiate is that we can give you a solution regardless of whether you go to the high yield, the BSL market, or the private credit market. And. And we're sort of agnostic as a firm from that perspective.

Speaker C: I think that's such a great way to encapsulate a lot of what you talked about. You're operating at the convergence of public and private. Another area that my mind goes to in relation to that is you talk about the T. Rowe platform. I think it's about 66% or so of the 1.7 trillion is in, uh, target date funds.

Speaker A: Yes.

Speaker C: I'd be remiss not to talk about how that element of T. Rowe's platform dovetails with what you're doing on the credit side and how that might become a larger part of people's investment portfolios and how credit might make its way into things like target date funds.

Speaker A: There have historically been regulatory challenges to target date funds and retirement going into alternatives. That is changing, starting to change. I would say that I think it's going to get there eventually, but I still think it's going to take some time because there's still some hurdles to overcome. And I would also say that the current climate and what's going on in the media around private credit makes it difficult for a mutual fund board to make that decision, that they're now is the time they're going to lean into private credit. However, one of the products that we're actually launching with Goldman is basically a target date fund product that will have an allocation alternative. Uh, and so you can actively select that as opposed to it being put into an existing targeted franchise. And so that may be the first step. But I do think that it's coming. And it really goes back to the same point about if you're in a retirement account and you think about the swath of the economy that are in private markets, which is like 90% of companies that have $100 million of revenue or more are private, a lot of investors should have exposure to that in their portfolio. Retirement is trillions of dollars. I think it makes sense to have access to those markets, but I think it's still going to take some time.

Speaker C: I want to end on you mentioned talk about the media and there's a lot going on in private credit. What do you think are some of the biggest misconceptions that people have about private credit?

Speaker A: So I think that probably the biggest misconception, by the way, there's a kernel of truth in a lot of what people are concerned about. But I think it starts with the risk of the underlier. What are you invested in? What are these private credit vehicles invested in? And in many cases they are first lien loans to large businesses where there's a lot of equity subordination and the manager had the chance to do a lot of due diligence in making that loan. And they're still making coupon payments. And even if valuations have come down, they're not impaired from an LTV perspective. And as a credit investor, as we started actually our conversation, I care about getting my coupon and getting repaid at par. And so I think that it's totally fair to ask questions about are there cockroaches or is there more risk in my software portion of my portfolio than I thought and that's fair. But I do think that when you unpeel what's actually in there, it's diversified across sectors, it's diversified within sectors. And even if you have higher than expected default experience, it maybe is going to knock a couple hundred basis points off your return, but you're probably not losing capital. And so I think that's probably the biggest misconception. And then the second thing is I do think that this liquidity question, query why people want the liquidity or why are you looking to these vehicles for that liquidity? It's a little bit of, again, I think the market catching up to understanding what it is that you've invested in, which is that the underliers are less liquid. And so you should have that expectation.

Speaker C: I think that's a great way to end. You covered so much ground. Emblematic of the evolution of the credit space, your career and now this intersection of public and private which you're operating at the middle of. Eric, what a great conversation.

Speaker A: Thank you so much. This was great. Enjoyed it, enjoyed it. Thank you very much.

Speaker B: Thanks for listening to this episode of Alt Goes Mainstream. I hope you enjoyed it. You can read more about Alts at my substack altgoes Mainstream substack. Com. Thanks a lot and have a great day.

Speaker A: We're going mainstream.