BlackRock Insights

00:00:03

JAY WYCKOFF: Welcome, everybody, to the Valentine’s Day edition of BlackRock’s Alternative Outlook webinar. We appreciate everybody’s time and certainly hope that everybody is getting off to a great start to the year. My name, as this slide just shows, is Jay Wyckoff and I am the National Sales Manager for our alternatives business within US Wealth Advisory and today’s topic is going to be around demystifying the private credit conversation.

00:00:27

The intended outcome of the next 30 minutes is fairly straightforward. It’s to help the financial community navigate an asset class that has seen a proliferation in new offerings coinciding with an increase in interest from both the financial intermediary community as well as the end investor. But with that comes some unintended consequences where there is some confusion in the marketplace as advisors try and sift through what many feel is a sea of sameness, which in fact is absolutely not the case.

00:00:56

One important thing that I would like to point out is that at BlackRock we do not view private credit as an alternatives investment. We view it as something that needs to be in many client portfolios given its amplification and diversification benefits and it should be viewed, frankly, as an extension of a fixed income portfolio and as that integral building block. A picture paints a thousand words. And so, one key takeaway that I'd ask for everybody on this phone call is post-meeting visit the BlackRock Advisor Center Private Markets landing page, where you have the ability to model in what an investment in private credit would do to the efficiency and efficacy of a portfolio alongside of the public securities that you also manage on clients’ behalf.

00:01:40

With that said, let’s jump into the discussion and let me introduce my two colleagues on the phone. The first is John Griffith. John is the Senior Product Strategist representing the Global Credit platform. And we have Patrick Wolfe, also Managing Director and Senior Portfolio Manager for the Global Credit platform and direct responsibility for our Credit Strategies Fund, or CREDX, as well as our non-traded BDC, or BDEBT.

00:02:06

Gentlemen, thank you in advance for the time and I'm going to throw it right over to you, John, at the onset with a question that we’re getting quite a bit, which is private credit seems like a catchall phrase, yet there’s a lot of nuances to what lies underneath that. Could you kind of unpack what it means and what the different components of private credit are and maybe what some of the pros and cons or benefits are to each of those subsets?

00:02:30

JOHN GRIFFITH: Sure, Jay. And thank you. Look, private credit has become very topical and in the, you know, the simplest basis it’s lending to companies, but really primarily outside of the traditional banking channels, right? So, you’re not thinking about public debt markets. You’re not thinking about banks lending to companies. You’re going direct.

00:02:54
You know, it’s become so topical because the private debt markets have more than doubled in the last five years and are now around $1.6 trillion in size. So, if you think about that, it’s similar in size to the US high yield or broadly syndicated loan markets and about two-thirds of private credit assets are in North America. So, there’s a lot of activity here. There’s a lot of focus.

00:03:18

You know, despite that growth private credit as a asset class is real – it’s only about 12% of the alternatives market as we’ve thought about it, most of that being, you know, 60%-plus of that is private equity. So, it’s a big market, although still kind of small in an alternative sense, but it’s similar in size to some of the other big markets that are out there.

00:03:41

The other thing I would say is that, you know, we at BlackRock believe that we’re going to see that market expand to around $3.5 trillion in the next five years. So, it’s growing, and we can expect it to continue to grow. The growth has come from a variety of different places. You know, significantly the focus on businesses being private and staying private longer, the growth in private equity, these have all been important factors.

00:04:09

You know, for borrowers there’s an attraction to this space. The certainty of execution, the closer connectivity with lenders, you know, all of these things that create the ability to customize essentially the borrowing terms. And I would also say that not all transactions sort of fit in the public sphere and so this is a place where we can get creative and where the market has evolved significantly. We – and we expect that to continue.

00:04:41

The other thing I think’s important is the availability of credit from banks has declined. I think this is, you know, more widely understood. But you’ve seen more than 500 banks fail in the last really since 2001 and including five last year and over $550 billion of assets from those banks. So, there is an environment where less lending is available to a big section of the market. We’re going to talk more about sort of what that looks like. But that’s really factored into the growth of the space.

00:05:13
The other point I think, Jay, that’s important is, as you highlighted, not all private credit is the same. There are a number of different sort of categories. And just, you know, kind of running through the main ones, we’re going to spend more time on direct lending, but this is the biggest part of the market and, really as the name implies, right, is directly originated loans between borrower and lender, and that really represents about half of the private credit market today.

00:05:41
Other types of credit in the private credit space, opportunistic lending. So, you can think about typically capital solutions trying to solve a financing need that doesn’t sort of fit in a traditional lending relationship. Distressed I know is, you know, one that gets a lot of headlines, which is, you know, obviously targeting businesses that are in some sort of challenged environment.

00:06:04
You also have things like mezzanine and junior capital or venture and growth lending, which is, you know, is a hot topic. Also, real assets, so infrastructure, real estate debt; there's a wide range of types of credit that live within the private credit sphere.

00:06:22
I think the, maybe the major takeaway from that is the common theme among them is a direct relationship between the lender and borrower. You know, the loans not being widely distributed in the market means that you know who you’re borrowing from and it’s, whether it’s one lender or a small group of lenders, you have a relationship and, you know, I think the historical sort of parallel to private credit was relationship lending if folks remember that far back. And this is, you know, this is – allows you to create the level of customization that you’re not able to obtain in the syndicated market.

00:07:03
So, there’s a lot under the surface there. But I think, you know, for the focus today the direct lending experience is really where the majority of the – of that market is today.

00:07:14
JAY WYCKOFF: Great foundation for the rest of the conversation, John. So, thank you for doing that. And to that point, that is also the direct lending space where we’ve seen the proliferation of new offerings in the marketplace, specifically in the non-traded BDC and interval side of the equation. 

00:07:30
So, Patrick, let me throw it over to you. Why are investors so attracted to this asset class? And, frankly, with this proliferation how should they start to think about separating the wheat from the chaff or even just differentiating one offering from another?

00:07:47
PATRICK WOLFE: Yeah, no. Great, great question. Thank you for having me here today. So, people have been attracted to this asset class for almost two decades. It just hasn’t been as widely known about, to be honest. But there was a small group of managers that were financing middle market borrowers that the banks would not finance pre-global financial crisis and it was just really kind of viewed as multi-strat, private credit. You know, it was very much a smaller universe of opportunities to finance. 

00:08:17
But kind of post the global financial crisis, as John kind of highlighted, banks have really stepped away from lending and companies had to find private financing to kind of meet their objectives and the growth of private equity also kind of grew the market as well. And when rates were really zero for a majority of the last ten years, it was really hard to find yield. So, private credit was a place, a marketplace where an investor could find some yield and a zero-rate environment. So, when rates were zero and liquid loans or high yield was only returning a couple percent, private credit was returning, you know, 7-8% type returns. And with the new rate environment and the new products out there today to access private credit, you're really seeing private credit really start to grow and kind of become a mainstay, you know, allocation. 

00:09:03
It used to be, like you mentioned, maybe an alternative. But now it’s really become kind of a main allocation. So, as the asset class continues to benefit from floating rates, and even if rates do start to get cut later this year, you’re still going to see a couple hundred basis point premium to your liquid markets. And I think it’s not all about economics. 
It is more than just earning an incremental spread to what you could find in the public markets is I think the credit quality has materially changed in the public markets over the last ten years. You know, pre the global financial crisis, a lot of the liquid loans had financial covenants and financial covenant kind of helped protect the lender. You know, if the company is not performing that well, you could really be at the negotiating table and really help drive the terms and the restructuring, just kind of a better outcome. 

00:10:36
And kind of post the global financial crisis with the broadly syndicated loan market, you’ve seen those covenants really disappear. About only 10% of the liquid loan market has a financial covenant. So, you really do not have any leverage if the company is not performing at its expected, you know, at its expected budget. Where private credit, I think people really are starting to see over the last ten years how much, you know, better credit quality there is as well with the increased economics. 

So, you know, we have about 90% covenants in our market. You know, we’re really able to drive and manufacture an investment. So what people are starting to see is the benefits of private credit markets. You know, you’re going to have much more that know who your lender is, have that direct dialogue with the management team. You know, we’re on a first name basis with our CEO/CFO of the borrower. 
When you look at the broadly syndicated space, you might have a few hundred investors. You have the broadly syndicated CLO market who’s buying into these loans. You have loan funds buying into these loans. You really do not know who your lender is. It’s really just a group of people and there’s really no one driving the greater outcome. 

00:11:02
So, I think what you’re seeing today is that private credit now has really a much better public track record over the last ten years as the market has grown substantially post the global financial crisis. So, people feel better about getting into the market now with kind of seeing how the companies performed. But you’ve also seen bifurcation in the segments of the market. For example, we see the US direct lending market into three segments. You have your lower middle market, which is going to be say zero to $25 million EBITDA-sized businesses. And you have your core middle market, let’s say $25 to $100 million EBITDA-sized business. And then you have your upper $100 million-plus type direct lending credit or credit businesses and that’s the market you probably hear the most about.

00:12:27
You know, those are the companies that are doing multi-billion-dollar private transactions that come across Bloomberg and Wall Street Journal. They are really starting to compete with the broadly syndicated loan market, and that market has a reason to exist, but that is a relatively new market. You know, that’s really only about a two-year-old market, where the core and lower market has really been around for two decades. 

00:12:48
It’s we focus in the core at BlackRock. That's where we’ve been doing this for two decades. We really see the benefits of having, you know, a transaction where you could speak for almost all of it, but it’s typically one to three lenders in a loan. So, you know, there’s just – the market’s evolved a lot over the last ten years. But, you know, one thing that hasn’t changed is really your approach in go-to-market and how we underwrite credit. And that’s really important, because over the last ten years you really haven’t seen a major credit test. 

00:13:18
You know, COVID really wasn’t much of a test for a lot of these companies. They, you know, there was a lot of money that flew into the system that kind of helped them going. You know, the energy shock of ’15-’16 really wasn’t a credit test for anything outside of energy and oil. 

So right now, with a higher rate environment, this is going to be a good test for a lot of these companies. How are these companies performing in this market? And to, not to our surprise, but I think to a lot of the naysayers’ surprise these companies have done really well. They’ve done a good job of managing costs. They have variable cost structures. You know, they’ve done a good job managing the higher rate environment and there’s a tremendous amount of value behind our loan. 

So, we’re typically first lien, top of the capital structure, and there’s typically either junior debt or a large equity investment below us. So right now, being top of the capital structure in today’s market feels like the right place to be when investing in these companies.

00:13:32
JAY WYCKOFF: Outstanding and well done operating through a power outage. We didn’t miss a beat there. So thanks. Thanks again. 
What I also want to make sure is not lost is one of the key differences as people are due diligencing the space is going to get to that conversation around where do they play within the middle markets and the nuances between upper, core, and lower and that is something where BlackRock can certainly assist in helping do that due diligence. We will come back to actually where you were going with the higher interest rate environment, because that’s a conversation that we’re getting from a lot of our financial professionals. But before we have that discussion, John, anything to build off of Patrick’s comments?

00:15:09
JOHN GRIFFITH: Yeah. I think just two things to add maybe. You know, I think the non-cyclical nature of a lot of the lending that we’re doing in this space, you know, is one that, you know, shouldn’t necessarily matter where we are in the economic cycle. But as Patrick highlighted, I think the cost of capital is a significant change. And so, it is a test for all businesses, and I think the resiliency of a lot of these businesses is in their ability to be flexible and adapt to the changing market conditions.

00:15:41
So, you know, we’ve seen a number of years here with low rates and sort of a benign environment for lending has allowed a lot of capital to be put to work. But I think we’re going to, we’re just going to see more dispersion here and, you know, frankly that, I think that’s probably a good thing because it will help highlight and differentiate those that are doing their homework and underwriting good deals and those that are not. 

00:16:07
The other thing I would add, and I think, Jay, you, you’ve talked about this is the, you know, the evolution of the available wrappers that exist in the market, the different types of fund structures. You know, historically these types of loans went into funds that – where capital was called and drawn over a multiyear period. And now we’re getting into an environment where there’s more availability of evergreen type vehicles, like these interval funds or non-traded BDCs. 

00:16:38
I think this is, you know, this is a good thing, right? We believe that this is an asset class that has a place in your portfolio. And to be able to invest in something on an ongoing basis and to deploy capital and recycle that capital as loans … into new loans I think is something that is an – a strong and, you know, a positive improvement for the market and one that we're going to continue to see grow as more and more investors become sort of educated on the asset class and then look for ways to access it. 

00:17:07
JAY WYCKOFF: Awesome, awesome. All right. Let's tie it right back to Patrick and he’s back. We got you again. Good to see you, your face, in addition to hearing your voice.

00:17:17
So, let’s connect a thread to the next question to kind of where you were going at the end of your previous question, which was around kind of higher interest rates and how some of the borrowers are navigating it. It is a question we’re getting a lot in the marketplace around what does this higher cost of capital mean to borrowers? And similarly, we’re also starting to get questions even though that now it looks like the Fed may be on a pause for a little bit, what – how does the asset class perform in a falling interest rate environment which we haven’t seen in a while? And I think this is where your perspective and our perspective, having been in the space for over 20-plus years through multiple economic and interest rate regimes, can really help the audience get their arms around those two elements. So, Patrick, back to you.

00:17:57
PATRICK WOLFE: Yeah, no. That's a great, great point to highlight and expand on. So, you know, one comment that really gets us frustrated here at BlackRock is that private credit hasn’t existed in this rate environment before. And if people could recall, you know, back to 20 years when we actually have been doing this for 24 years is that we’ve been in this rate environment. We’ve seen risk-free rates at 5-5.5-6% a couple times and invested through falling rate environments. And, you know, so we really kind of go back to our playbook and kind of – could see how these companies handled the falling rates and how they handled higher rates. And what is very true in this higher rate environment really is benefiting the – our clients, our end investors is because we’re benefiting from the full rise in a almost nearly 100% floating rate portfolio. So, you know, for on the first part we’re benefiting from higher economics. 

00:18:49
But how do the companies handle this? And the truth is that it really gets borne by the equity investor. You know, we’re looking at these companies. Majority of these financings that we are getting into are leveraged buyouts and there’s a tremendous amount of equity going into it. For like a, an example would be, you know, we’re getting into a billion-dollar leveraged buyout and we’re only lending about, you know, $300 to $350 million, so about 30 to 35% loan to value and typically there’s $700-$600 million of equity behind our loan. 

00:19:21
And what we’re seeing today is that companies are struggling to kind of service their interest and, you know, what is true is there’s a lot of value behind us. So, the private equity firms or the owner of these companies are stepping up with additional equity, paying us down, negotiating an amendment, and we're really able to kind of move forward. 

00:19:41
And what’s true is that it’s just not rates that put – are putting these companies into stress. You know, when we look at our watchlist names, which is a low percent today, we do not see rates as the primary driver or the only driver of what’s putting a company onto our watchlist. And it’s typically a few other attributes that are driving it to the watchlist, maybe a loss of customer. You know, maybe they have had a supply chain issue. You know, it’s just not rates. 

00:20:08
So, these companies have done a really good job of navigating the high-rate environment. So, if a company is performing as planned but they just have a higher interest expense with rates, they’re doing quite well. You know, they’re finding other ways to cut costs, you know, maybe cutting down on sales, maybe cutting down on R&D. They’ve done a really good job navigating this rate environment. 

00:20:28
And if we kind of see the rates start to get cut, you’d expect to see that turn back on. So, you would see them start to turn on sales, try to really start investing in growth, you know, maybe developing new products. And it really comes back to the equity value, you know, kind of creates opportunity for the equity to kind of hit the return. Because what’s true at, you know, first lien loan paying 12% today, it’s really, you know, the private equity firms are going to have a harder time hitting their model returns with economics of that level going out to the lenders. But that’s to our benefit, and we think in a falling rate environment we’re still to have a premium return to the liquid markets. 

00:21:04
You know, we, we’ve seen that over the years. We’ve put LIBOR floors or SOFR floors into our loans that kind of have a minimum economic return and we think that companies just perform better as rates kind of go down. But we think we could still benefit our clients with kind of a premium yield to, relative to the liquid markets. 

00:21:23
JAY WYCKOFF: So, can we tease that out just a little bit more perhaps through a, an investment story that brings to life how we found an opportunity that made its way into one of our portfolios, how that opportunity matured during its life in the portfolios and even to the point of a realization of payoff? Whatever you could share there I think will help kind of frame it out and complete the picture for the folks on the phone. 

00:21:48
PATRICK WOLFE: Yeah. I'd be happy to. This one hit close to home, so I like to use it. So, our team is constructed by industry specialization. So, on our underwriting team, we have someone that heads up healthcare, telecom, aviation, consumer goods, and so on. And what that does is creates a highly experienced and highly knowledgeable investment professional that underwrites each credit. They’re really an industry expert. They have typically owned businesses from previous roles or through workouts, older loans. So, they really do have a deep knowledge of an industry. 

00:22:25
And one industry that tends to scare a lot of investors or firms to lend to can be beauty products. And, you know, people hear beauty products, they think very much fad, tied to maybe Instagram or influencers. But there are a lot of products out there that really have a proprietary model.

00:22:43
In this case, we found a haircare product that had really developed a new chemical to treat hair, specifically colored hair, and we were able to diligence that they had truly invented a proprietary better product, so much so that one of the major beauty care products tried to steal their patent or steal their formula and this company successfully defended their patent in the courts and got full recovery and kind of gave us some comfort. We knew that if this company didn’t perform it’d be very likely that that major consumer goods company would step in and buy this company just for the patent because they did have a better product that was unique. It wasn’t tied to a fad. It wasn’t tied to heavy marketing spend. 

00:23:33
They actually were a group of scientists and lacked that marketing knowledge. So, they kind of found a private equity sponsor to come in and buy a control stake in this business to really grow the marketing. And a lot of people heard haircare product and they ran the opposite direction. 

00:23:50
But we kind of dug in. We did over a month of due diligence, went out, spent time with the management team, really got to know the business, and really kind of to prove out that investment thesis that this was a unique product. And we kind of made a, an incremental loan just to begin and what we expected did occur. The product took off; it became a huge hit with minimal marketing spend.

00:24:14
Before we got into the investment, it was only sold directly in salons. With this private equity sponsor it was brought out to more of the masses in different retail channels. And what found – I found really interesting is one morning I get into my shower and my wife has bought all the haircare products. And I was quite surprised, kind of where did you see this? And she’s like all my friends are talking about it. It’s a, you know, it’s substantially better than what we were using before, and all my girlfriends and I love this product.

00:24:44
And this company just continued to grow. We actually made a number of incremental financings to help the business scale and it eventually went out to the IPO market and we were refinanced at a double-digit realization when rates were zero. And just really speaks to how much knowledge is required in this market, because we really, we are manufacturing the credit investment. We had to put in covenants that we thought were appropriate. 

00:25:10
You know, the – a big difference in the liquid loan markets is someone brings you a loan and it’s a yes or no. Do you want to buy this loan at this pricing, yes/no? In our world, we are manufacturing the investment. So, people bring us an opportunity and we kind of underwrite it and say we’re comfortable at four turns of leverage with this covenant package with this level of credit agreement at this pricing. It’s kind of the company has to take it or leave it from our standpoint. It’s not the opposite. 

00:25:39
So, in this situation we were able to structure strong covenants that if this company was not performing, it did not have the success of expanding its retail channels, we would be at the negotiating table really early and could potentially explore selling the company to that major haircare product company to recoup our loan. And that’s really important is we look for multiple ways to be paid back in a loan and it’s not just always that it is a good outcome, but we want to have our principal protected, because as a credit investor we are fully focused on principal protection because we have 100% downside and limited upside. 

00:26:16
So, it’s really important that you get the underwriting and structuring right on the front end to protect your principal investment. And this company was just a great outcome where our industry expertise really created and kind of an alpha stream opportunity where people were scared of the opportunity and we kind of ran to the fire and generated a premium return relative to other direct lending markets. 

00:26:36
JAY WYCKOFF: Was going to ask you how that hit close to home. So, thank you for clarifying later on in the example, for sure. But what that highlights, among other things, is the fact that there’s a relationship between borrower and lender in this part of the direct lending landscape at least that is very unique and, frankly, doesn’t exist in parts of the highly syndicated loan market and certainly doesn’t exist in the publicly traded high yield market. So, thank you for sharing that. 

00:27:03
Gentlemen, we are at time. I'm going to close the show here with just a few parting comments. But let me reiterate the thanks to both of you for both your investment of time as well as your wisdom on this respected phone call. 

00:27:17
To those that are listening in, there’s several key themes that we want to come out of this phone call. The first is the direct lending asset class is not an alternative anymore. It is something given all of its attributes around increase of yield and, frankly, durability and resiliency that should be in many clients’ portfolios and we do view it very much as an extension of your fixed income portfolio. So that is takeaway number one. 

00:27:42
Takeaway number two is in what may be deemed to be a sea of sameness, there are actually very meaningful differences in the offerings that are coming into the marketplace and we would like to put ourselves on the same side of the desk as you and help you with the due diligence process around these different vehicles, both as it relates to wrapper as well as it relates to the nuances within the interval fund space in the non-traded BDC space. The last element that we would like to leave everybody with is outside of the partner aspect there, we can help with things like AC-360, which is our Advisor Center Portfolio Modeling Tool, as well as BDEBT.com, where we have a dearth of resources to help support your conversation, inclusive of things like an implementation guide which can help you size and source and implement an investment into direct lending. So, a long-winded way of saying please count on us as a trusted partner as you look to implement to a greater degree the opportunities that have presented themselves in the direct lending space. 

00:28:41
I’ll finish where I started. Happy Valentine’s Day. Thanks for the time and we look forward to having a continued great year with everybody on the phone call. Appreciate the time. 
00:28:50

(END)

00:00:01

CAROLYN BARNETTE: Hi, I’m Carolyn Barnette, Head of Market and Portfolio Insights for US Wealth. Here’s a recap of our May In the Know event.

00:00:07

We talked through the three key questions facing advisors and portfolio constructions in today’s market environment. First, we talked about what might be next for the Fed with the general consensus being that market pricing looks really fair. One to two cuts starting later this year. We don’t think a hike is likely to be on the table pending changing inflation data. We do think the Fed is looking for reasons to cut. 

00:00:35

So, within that environment, starting to sure up our positions in core bonds. We like the belly of the curve as a potential way to play falling interest rates once the Fed pivots but are also complementing that war bond portfolio with both diversifying alternatives to manage ongoing volatility with also a tactical overweight to the short end of the curve for those who trade more frequently.

00:01:01

The second question we talked about was how to think about investing in an election year, and the good news is that strategically tend to do pretty well in an election, and the greatest risk that investors face is letting politics get in the way of their investing decisions because the worst outcomes were for investors who decided to sit markets out when their favored political party was not in power.

00:01:28

Third question that we talked about was when might we see equity markets broaden out from here? Will US exceptionalism continue? Will US growth continue to drive markets forward? And the answers we heard were really not quite yet, but it’s something that we’re watching. 

00:01:48

So, we do think that high interest rates, restrictive interest rate policy will continue to disproportionately impact small cap, lower quality companies that don’t have the strong balance sheets to withstand it, that we’re still overweighting quality US companies at the core while also complementing them with some of our favorite tactical ideas.

00:02:08

We the AI theme still has room to run, we think mega-cap tech plus still has room to run and is expensive for a reason. But certainly, watching those markets carefully and introducing some core total market exposure to balance out those tactical overweights.

00:02:24

We had a really great discussion over the hour. Lots to think about, lots to discuss. If you would like to talk directly to someone from BlackRock about what all of these ideas mean for you, please reach out to your local market team. You can also call 877-ASK-1BLK. 

00:02:41

Also highly encourage you to look at our Advisor Center. We have market insights from many of the speakers who spoke today, and also a whole host of portfolio construction tools that you can use to test out different ideas. And we have an advisor outlook homepage, which is blackrock.com/advisoroutlook, which is market and portfolio insights designed for you.

00:03:03

So, thank you all for the time and for the partnership, and we are looking forward to our next In the Know event in September. Thank you.

00:03:12

(END)