Permira Credit - What's really happening in Private Credit | David Hirschmann | Fund Shack Ep. 84

Speaker A: For Pamira, which is a private partnership, there are two strategies, equity and credit.

Speaker B: Private credit is in the news almost constantly at the moment.

Speaker A: There was clearly some space in the market from non, uh, bank institutions to provide that capital, and it was, and it is much needed.

Speaker B: See, this is what I mean almost at every level. The innovations in private credit seem to make far more sense than how things were structured in traditional banks.

Speaker A: Private debt has become a substitute for syndicated, uh, loans, in some cases in the large cap market.

Speaker B: Um, they're predicting a 15% default rate in private credit, which seems like a lot.

Speaker A: This is a very pessimistic scenario. This goes way beyond just the tech or software, uh, industry. And that also means it's not just private credit. In order for the lenders to achieve 100% recovery, we don't need to recreate all the enterprise value that they shareholders paid for initially. If we manage to recover a third or 40% of the initial enterprise value, we're money good.

Speaker B: The evergreens, the semi liquid evergreens, could that, uh, or is that influencing kind of the duration preference?

Speaker A: We don't have huge amounts of capital coming in on a monthly basis that needs to be invested very quickly.

Speaker B: David, welcome to FundCheck. Private credit is in the news almost constantly at the moment, and not always necessarily for the best reasons. Personally, I think a lot of the coverage is quite hysterical, particularly references to 2008. I think that stuff's off the wall. Having said that, when it comes to lending, it's a good idea to be vigilant. And private credit has grown tremendously quickly in the last few years, depending on how you define it. It's a trillion dollar. It's a trillion dollar market. And so my first question for you is kind of big picture. Is the private credit market as we see it today, the result of kind of fundamental structural advantages which should make it somewhat sustainable, or is it more cyclical, uh, plugging a temporary gap? Which one is it, would you say?

Speaker A: Well, first of all, thank you for having me. Um, it's great to be here and great to be talking about private credit today. You're right, it's in the news in particular these days, um, and not always for the best reasons. And I'll come back to that. But if we look at the historic growth of private credit to about 1.6, $1.7 trillion on a global basis, um, there are some fundamental and structural reasons for that. If we go back to, in fact, just after the global financial crisis, this was the main catalyst for the emergence and the Growth of private credit as an asset class banks had to retrench from lending to mid market companies both in North America and in Europe. The main reason was the uh, inadequacy of short term deposit long term liabilities. So short term assets, long term liabilities and more stringent regulation which has limited and still does limited banks capacity to use their balance sheet and provide six, seven, uh, uh, year term loan uh, facilities. And so as a result of that there was clearly some space in the market from uh, non bank institutions, what we at the time called alternative lenders to provide that capital. And it was, and it is much needed um, and it funds the mid market, the private equity uh, industry. And that is very much a long term structural trend. Then over time private debt has become a substitute for uh, syndicated loans in some cases in the large cap market. Uh and so what we've seen is the growth of the industry, the asset class funds um, have become uh, larger, uh, and therefore underwriting capacity and average deal size has gone up accordingly. Um, and that in our view is here to stay because there is a need for financing for transactions of any size in the market. So the private capital market is growing and it's fueled by private equity growth and private debt. Now what we hear uh today, or what we see today is um, and you're talking about the headlines and what we hear about redemptions in particular in some of these semi uh, liquid um, sometimes multi strategy uh private credit funds uh, which have been a way for the industry to raise capital from uh, private wealth. And this at the moment, and I think this is perhaps just in the spur of the moment where there is this fear caused by AI, the impact on software and the market's reaction or perhaps overreaction which is um, is this safe? For a long period of time the narrative was lending to software businesses is the safest uh, investment you can make, safest credits. And it has turned now to um, exactly the opposite, the opposite, which is to say all software businesses are doomed and are going to disappear. That's also wrong. That is the overreaction I'm talking about.

Speaker B: So that's a great summary of what's going on at the moment. And so what it sounds like to me is there's a collision of novelties because private credit itself is relatively new at this scale. That's a novelty. You've got the evergreens, the semi liquid evergreens, they're a novelty. And you've got AI which is like the ultimate novelty and they're all kind of colliding at once, which creates a bit of uh, an information gap, which creates, which creates fear. And so maybe we can look at evil, each of those in turn. So if I can go back to the premise of private credit itself, it's filling a gap you say, particularly in the mid market, but also it's pushing up I guess into kind of public debt to some degree. Private managers pushing into that realm. Um, where do banks sit in all this? Are they permanently disintermediated? Are they competitors, are they suppliers?

Speaker A: Banks still play a key role in different areas. Um, and banks can play different types of roles in the industry. Um, in the mid market they provide short term facilities but they also provide what is called fund leverage. Um, so some of these private debt vehicles are levered, uh, which effectively gives incremental return to investors. We're talking about typically around one to one leverage. So if you think of a 50% loan to value at the fund level, it gives investors a higher return. And this leverage is provided by banks. So that's an area where banks still play a key role.

Speaker B: Do credit funds not provide that leverage for other credit funds? You're not getting specialized funds doing that.

Speaker A: Some do and that is nav financing. But the vast majority of the fund gearing, the fund leverage is provided by banks still, uh, to date then in the large cap space where you have competition between public or private, uh, effectively syndicated loans, uh, the BSL market and private debt, sometimes it can be a combination of both in the same transaction. But I would say most of the time it's either a syndicated loan or a private debt structure. And so in that sense there is competition between both. And it's not unusual for a borrower of a certain size, a large cap company, to run a dual track and see what terms they can get from a club of lenders, private debt funds, and also a few banks who are underwriting a, uh, financing with a view to syndicating it and therefore this becomes a syndicated loan.

Speaker B: You spell out for me what the competitive advantage is, let's say between a club and a syndicated loan.

Speaker A: In a syndicated credit, um, typically the advantage will be a lower cost of capital. There is however some execution risk which is linked to the syndication, um, because syndication is never guaranteed. And there are events such as what has happened in the last few days which can derail uh, or undermine for sure a syndication process. And the other aspect is there is um, no follow on capital available. So if the company, if the borrower needs additional capital to finance an acquisition, then typically they will need to do what is called a tap, effectively go back to the market, maybe a mini roadshow, a new credit rating in order to raise another uh, 50 million, perhaps 100 million euro or pounds of facility to fund some acquisitions. In contrast, in the private debt um, structure you will have either a sole lender but let's assume more likely a club deal, perhaps a small club of lenders. But you have the certainty of execution, the speed of execution. Because there's no syndication process, you effectively have uh, lenders, it's effectively a relatively quick process, um, and you know exactly what capacity those lenders have, including their capacity to provide a committed acquisition or capex facility. So that means that on day one when the deal is signed, you already have that capital available to be drawn to fund uh, add on acquisitions. There's a premium for private debt transactions. This can be depending on, you know, there's a little bit of volatility but uh, typically it's going to be around maybe 200 basis points or up to 200 basis points of premium. But speed of execution, certainty of funding, no, um, uncertainty with regards to the syndication, um, and the availability of following capital.

Speaker B: Right. So there are clear benefits from a borrower perspective and that borrower is often a sponsored company, a gp.

Speaker A: Correct.

Speaker B: It sounds like actually to coin a term, relationship lending, which is a term that the banks always used but ah, it's not so kind of clearly justifiable if you're just originating in order to syndicate. But it's more justifiable if you're originating to hold look, so that all sounds great and a benefit for the borrowers, but also for the economy at large to have this um, community of lenders who are engaged, they're in partnership, they understand the asset. But to be pernickety, does that not leave you slightly open to, I don't know, being almost too borrower, ah, friendly and too lenient on them, given that it is a kind of, you're looking for repeat business let's say. And so you could maybe you might pull the plug on a, on an asset earlier if you didn't take a relationship approach, for example.

Speaker A: And that's a uh, really good point. And so I still think that the quality of the relationship is important because we look to partner with sponsors that we know based on our experience, based on their track record, that they are supportive of their portfolio companies. And we would certainly avoid uh, doing a deal with a sponsor who we know is not in that camp, who we know is either maybe will take an aggressive stance on their lenders or will not be supportive of their portfolio companies. The important thing, uh, here is to remember that the average loan to value in traditional direct lending transactions in Europe will be around 30 to 40%. So there is quite a lot of equity, cash equity contributed by the shareholders, which means a few things. The skin in the game is quite significant. Um, that's clearly also a strong incentive for the shareholders to support their portfolio companies if there is a liquidity issue, to provide that liquidity, that new money, and to retain control of their businesses even if they are underperforming. So even if there is a situation of, uh, uh, distress, typically what we will see is the sponsors providing that new money coming to the lenders, asking to relax the covenant, reset the covenants, perhaps amend the documentation, perhaps extend the maturity, and in exchange for a significant equity contribution, which is effectively a way to de risk the lender's position. Um, and the only situations where, in our experience where we've had to uh, step in, maybe convert debt into equity and take control of a business is when the equity owners are, after one or two attempts, after having injected new money as equity once or twice, they come to realize that their equity is written off. In that situation, they will typically come to the lenders and say, you can take the keys. And because of the relatively low loan to value at the start in the transaction, in order for the lenders to achieve 100% recovery, we don't need to recreate all the enterprise value that, uh, the shareholders paid for initially. If we manage to recover, let's say, a third or 40% of the initial enterprise value, we're money good. So it's way easier in a sense. Never that easy because of course the business is in trouble and distress situation. But it's way easier for the lenders to recover 100% of their nominal than for the shareholders to generate, um, a good return once the asset is impaired.

Speaker B: Uh, given that, what is your historic loss ratio of Premier Credit?

Speaker A: Our average recovery on defaulted assets is over 100%. Um, and that's because we're talking about a small number of situations. But in, in some cases we've recovered more than the nominal because once you become owner of the business, you turn the business around and sell it in order to maximize recovery. In other cases, we haven't quite recovered 100%. We had effectively crystallized the loss. But on average in those, the small sample that we're talking about, the average Recovery was over 100%.

Speaker B: I saw uh, an analyst report from UBS yesterday saying that, um, they're predicting a 15% default rate in private credit, which seems like a lot to say the least. Uh, how do you view the threat of AI for private credit portfolios specifically?

Speaker A: I mean, a spike of default rates to 15% would be massive. Um, and this goes way beyond just the tech or software, uh, industry. Um, and that also means it's not just private credit. I think it means generally credit in general. I think this is a very pessimistic scenario. The other interesting thing is the impact of AI, or the AI risk as we call it, is not something new. Um, we've been, um, mindful of that risk for, for a few years already. Even before ChatGPT, uh, became public in 2022, we were conscious of obviously, effectively, what is a substitution risk. Now what I would say is, interestingly, we need to make a distinction between a few things. One, the AI risk when it comes to software and the impact on software. We need to make distinction between what is an equity risk and what is a credit risk. When a sponsor has paid a very high price for a software business, we're Talking about maybe 20 times EBITDA, maybe more so a very high entry multiple, whereas the debt or the leverage at entry is perhaps somewhere around five to six times. So the loan to value is quite low. There's a lot of equity in the transaction. The question for that investor is, will I find a buyer for this business that will pay me 20 times EBITDA at exit? Maybe the answer is no. That's purely an equity risk. We look at it from a credit perspective and think, okay, for the next four to five years, which is broadly the sort of time horizon for a transaction as a lender, um, is this business, um, in a defensible position with recurring revenue, high BDA margin, will it continue to grow or even just maintain its current level of profitability and cash generation? That effectively de risks my position and ultimately what is my refinancing risk after 3, 4, 5 years based on what I can see of the business today. And so it's a very different approach. It may end up being a, uh, suboptimal or maybe a poor return on investment for the shareholders and yet a very good credit story for the lenders because whether the exit multiple is 15, 17 or 20 times will not have an impact on my return or my default or loss rate as a lender.

Speaker B: I wonder if part of the confusion, let's call it, with regards to AI and private credit, is that people are looking at this through a kind of an old industry lens. They're looking at software companies and they're saying well when private credit gets the keys there's no kind of plants or machinery to sell off. And so that you know, you don't have so much physical security but actually you've still got a, presumably a viable business if you don't worry about the multiple that it was originally acquired for.

Speaker A: And even more than that, what's really interesting is that um, when it comes to software the key question is of course we all believe there will be winners and losers. We don't think that the revenue of a software business, of a software as a service will collapse overnight. We think it may be sort of natural erosion uh, depending on which sectors they're in and depending also on whether we're talking about horizontal or vertical software, their end applications, is it easy to replicate or not? Um, and is it multifunction, data rich, et cetera. So these are all factors that effectively have uh, an implication for the long term value and the moat of the business. Really this is where having the experience uh, as an investor, credit investor or equity investor, having the long term track record, having been in the market for nearly 20 years in credit, um, means that we know we can navigate these periods of instability and volatility and uncertainty. So you really need to be able to identify the real um, AI risk and disruption and not just to the tech industry but to all the industries.

Speaker B: Is there a common fallacy that you often encounter from let's say the investor community with regards to private credit that you would like to address?

Speaker A: There is a, maybe uh, a tendency from uh, certain investors to look at one or two aspects or one or two criteria in a transaction and that may be the opening leverage, the covenant headroom, um, whether a deal is covenanted or cov light um, to assess the quality or the level of risk. And I think that maybe it is partly true and it is relevant, but the misconception is that this tells you everything you need to know about the credit opening leverage, Covenant Headroom, uh, or just uh, the sector maybe going back to for instance software, uh, because there's so much more to it in order to assess the quality of the business and the quality of the credit. Um, and in some cases you may accept more Covenant Headroom, you may accept a higher opening leverage, you may accept certain terms, but there is in terms of the quality of the business, its market position, whether it's diversified from a geographic perspective, there's so many factors that you need to take into account to form a view. Um, and really that's the job of the gp, the asset manager and the credit underwriter.

Speaker B: David, can I ask you, have you got an example of a deal that you did underwrote that didn't go as well as expected or that you learned a lot from?

Speaker A: One example that I have in mind, which is a good illustration that even if it doesn't go as planned, it's not necessarily a bad outcome. M at the end upon realization um, so there's one example of an IT services company which we invested uh, in um, backing a sponsor a few years ago, um, which was part IT services, part hardware reselling um and that part struggled um, after Covid, um to the point where the sponsor, the shareholder um, tried to turn the business around and save their investment. Um, they did inject some money in the business and at one point realized that it was going to be very hard for them to recover and just get their money back. And so as part of a consensual restructuring um, we converted our debt into equity. Not all of it but part of it. Um, and it's really interesting to see in those situations doing a balance sheet restructuring is relatively easy but it's what you do with the business. Once you've become the shareholder of the business, who is going to manage the business? Sometimes and often you will need a new management uh, team um, who is going to sit on the board, what is the value creation plan or turnaround plan, how do you position the business for an exit and how do you effectively maximize recovery? And it's all those uh, elements together that we work on and put together the right team for that uh, to achieve the best outcome in this example because part of the business which was recurring in nature, IT services in fact contracted so the business continued to generate revenue and profit. Not enough for the debt structure that was in place ah at the outset, um, but enough for us to recover our principal investment. In fact 18 months after the restructuring was completed we exited, we sold the business. But this goes to show that even a default can result into a good outcome for our investors.

Speaker B: So I guess an equity investor only ever has to be an equity investor whereas a debt investor has to be a debt investor and then sometimes some kind of at least a low level equity investors to some degree hands on.

Speaker A: Correct. But it's also a different skill set from being a pure credit player. Hence the benefit of being part of Premira being part of a global PE business.

Speaker B: So David, given the prevalence of direct lending club deals, does that not make it harder for LPs fund investors to differentiate between different private credit firms, funds and their skills and track record.

Speaker A: If we look at the European mid market, we see a, uh, core group of players, I would say about 10 players, who are the key market participants. Ah. And who probably represent in volume or value, perhaps 3/4 of all the transactions in private in Europe.

Speaker B: So it's quite a concentrated market. In the mid market then.

Speaker A: The mid market is quite concentrated. Um, having said that, for the LPs, what matters is the length of the track record, the experience. We've been in the market delivering consistent returns to those investors since 2008. So that's quite a long track record, in fact, going back to pre gfc. And on top of that, the fact that we are fully integrated into the private equity business, that we are able to, uh, leverage the knowledge that we have in house from the various sector teams, uh, integrate that into our investment decision process. And that's reflected in the quality of underwriting. Very few players in the market have that capacity and that track record.

Speaker B: So on the experience point, a lot of people talk about experience, but I actually think it's even more relevant to credit than it is to equity. Because in some senses you might want to back the latest shiny thing, inequity. Whereas in credit, because of the importance of the downside, you do want people that have been through times of real stress and tension and know how to behave.

Speaker A: I, uh, totally agree. And it's knowing how to behave, but also deal with the more challenging situations. It's having the dedicated portfolio monitoring team, having our own restructuring team again, also being able to use, um, the private equity, uh, network in those situations, being able to turn around the business once it's, uh, distressed in order to maximize recovery, to maximize the outcome for our investors.

Speaker B: So in the old world, banks used to call those workout teams. Is that a similar thing?

Speaker A: It's a similar thing exactly. The interesting thing is in banks, the people who did the deal hand it over to a completely different team, sometimes a different department, different building, and they have nothing to do with the asset anymore. Our business model is, um, the investment team and the workout team will team up and work together, uh, and use help from various parts of the business, including the private equity. And in order to deliver the best outcome and maximize recovery in those situations for our investors. And so it's pulling everything together rather than saying, now it's a defaulted asset, it's distressed, that's not my business anymore, somebody else will take care of it.

Speaker B: See, this is what I mean Almost at every level, the innovations in private credit Seem to make far more sense than how things were structured in traditional. As a private credit lender, you have an information advantage relative to someone that's just buying something that's been syndicated. To what degree is that actually an advantage? Do you have, let's say, influence? Do you have insight into what's going on, uh, at, uh, the board? And are you able to kind of have enhanced monitoring over the traditional bank lending approach?

Speaker A: Very much so. And, uh, it's a huge advantage. By that, I mean, being either a sole lender or one of two or three lenders in a small club deal means that you have constant and direct access to management and to the shareholders. You don't necessarily need to sit on the board, but you still have, um, a very high degree of granular information access to management. And that means that, uh, having a call with the CFO of the company for them to comment on recent performance, current trading, um, that's very easy. And that's not something that you have in the broadly syndicated loan market where you will have one, maybe two annual bank meeting. And of course, you get the monthly reporting or quarterly in some cases, but you won't have, um, access to management or the shareholders to understand really what is happening in the company.

Speaker B: Tell me a little bit about Pamira Credit. So a lot of viewers will be familiar with Pamira, the buyout and growth capital firm on the equity side. You were launched, I think, initially in 2008, so you've been going for quite some time. How do you fit into the broader franchise? What structural benefits does that give you?

Speaker A: We've now grown the platform to be one of the key players in European credit, and we're active in direct lending, opportunistic credit, and clos. Um, clos, both in Europe and North America. The private debt activity is European. Being part of Pemira, which itself on the private equity side has been around for over 40 years now brings strong advantages. One of them being the sector knowledge that I was just talking about. Being able to leverage that, to capitalize on that, and to integrate that into our investment decision process, uh, is extremely valuable. And I can say that based on our knowledge of the competitive landscape. First of all, there aren't that many private debt players who are fully integrated into a private equity business. Um, and number two, not all private equity platforms have the sector thematic approach and the sector, uh, knowledge expertise that we have built as a firm for, uh, over 40 years. Um, so there are. For Pamira, which is a private partnership, there are two strategies, equity and credit. Um, so it's very different from those very large platforms, um, businesses, publicly listed companies who operate in five to 10 different verticals from infrastructure to real estate to asset backed financing, um, and of course private equity and credit. We focus on what we know the best, which is three or four sectors, mid market to upper mid market, liquid and illiquid, uh, and where we can leverage the platform knowledge, um, both from the private equity side and the credit side. I think that helps us to make better informed decisions in general and also to offer investors the possibility to invest across the different strategies. But always with this level of expertise that we have and industry knowledge which I find in our discussions with other sponsors, um, that we work with, but also the managers of the companies that we invest in. I think it positions us really well because we understand the equity story, the investment strategy, um, we are supportive of those. And going back to what I was saying about being a uh, relationship driven market, this is a key aspect of the relationship. Another aspect is in the opportunistic credit strategy. We do primary and secondary trades. Secondary means also some exposure to liquid loans, um, in particular these days as a result of market dislocation. There will be opportunities in the secondary market. By that I mean performing companies that are affected by the indiscriminate sell off in the market. Um, the market is not differentiating, I'm talking about the liquid load market is not differentiating between a very good solid software, um, business which is insulated and protected from the AI risk for very good reasons, from a uh, software business which is clearly uh, perhaps a horizontal, easily replicable, um, that's effectively the indiscriminate sell off. And therefore there are opportunities today in the market to uh, pick up some paper at a discounted price, uh, in very, very good businesses and generate better returns, attractive returns. And that's part of the opportunistic credit strategy.

Speaker B: So that's private and um, public credit secondaries. That sounds to me like a huge opportunity at the moment.

Speaker A: Yeah, exactly. Yeah, absolutely.

Speaker B: David, thanks so much for sparing your time for the chat. That was very comprehensive.

Speaker A: Thank you for having me.

Speaker B: Private credit. Thank you. Thanks a lot, Sam.