What's driving the demand for private debt?

Oscar Pulido: Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido.

Private debt, private credit, direct lending. Why are these asset classes capturing investors' imaginations around the world? Are they a viable option for individual investors or restricted only to the large institutional investors?

In this episode. I'm joined by Jimmy Keenan, chief Investment Officer and global head of private debt for BlackRock. We'll dive into the enigmatic world of private debt. Ask why it's having a resurgence in these particular market conditions and explore the risks and opportunities that are inherent from this alternative asset class. Jimmy, welcome to The Bid.

Jimmy Keenan: Thanks for having me, Oscar.

Oscar Pulido: So, Jimmy, we're here to talk about, private credit and I'd like to hear more about what is this asset class, but also private credit, private debt, sometimes I hear the term direct lending. Are these all different asset classes or are they the same thing?

Jimmy Keenan: Thanks Oscar. Yeah, I would say when you think about private debt in general, it’s as simple as it is. They are debt instruments that are done in the private market and most of the world is used to seeing the public equity markets or, public debt. Think about Investment grade market or the broadly syndicated loans or the high yield market, those are all securities or loans that trade publicly, and dynamically where you can get information on those borrowers.

The private market is really just referring to a similar type of loan or risk, but it is done in, I would call it more of a bilateral private negotiation between one or a few lenders, with a borrower.

So, the terms of that contract or that loan may not be available to the broad public, as well as the information of that borrower or company may not be as public. And so that is a private, negotiation with that, and that's essentially all that means. The evolution of the private debt space, is continuing to grow and I would say it incorporates a lot, but it’s as simple as that - it's a loan that is done that is not done through a bank, and the information associated to it is privately placed and not well known.

Oscar Pulido: So, the information is known by fewer parties. that's one difference. The similarity is that it's a loan, in this case less a bank involved and more a private lender. And so, it sounds like there's, a premium that is earned by that lender. And so, talk a little bit about like the risks and return differences with this asset class.

Jimmy Keenan: If you think about it, if you're a company, if you are a real estate developer, you're going to look and say, how do I finance my company? Or how do I finance this building? And there are different ways you can do that. You can go to a bank and the bank may. put together a financing package, and they may go to the public markets to syndicate that out. And that's typically what you see in the public markets.

The borrower may look at that and say there are positives associated to that but in many cases, they may look at it and say, what are my other options? And they may seek out a private debt provider as somebody like a BlackRock that might step in and say we'll offer you directly something that will give you a different package, meaning a different way to finance that real estate project or a different way to finance that company.

In that situation, that borrower or that corporate may opt in to having a direct relationship with BlackRock or any other private debt and provider, as opposed to going through a bank which might get syndicated out and there might be 50, a hundred plus people that are in that capital structure. And so there are a lot of different reasons why a borrower might choose one or the other it's just a marketplace that exists.

Oscar Pulido: I think it used to be, and correct me if I'm wrong, but particularly maybe before 2008, banks were the primary lender, right? But then the financial crisis hit, and I'm also thinking about even more recently, some of the recent bank failures that we've seen in the US and abroad that, that this development of the private debt ecosystem has been going on for a number of years, but that 2008 was an inflection point. Is that the right way to think about why this market has grown?

Jimmy Keenan: Absolutely. and that's a well-known fact and quantitatively you can look through that just with regards to the size of the banking systems. And even today, you mentioned it before with regards to some of the bank volatility, you've seen deposit flights of up to a trillion dollars coming out of the banking system. You're seeing risk management change, in which case it's reducing the size and scope of the banks that's changing regulatory environments, risk management and so, for a company or a real estate developer or an infrastructure project, finance, that doesn't mean that they don't need the capital.

It just might mean that their traditional lender or somebody at the bank, that relationship they might have, might not be there. So, what you said back in 2008, we saw a huge gap in financing post

the Lehman crisis, in which case credit dried up completely. And so, if you are a corporation, a middle market company, a real estate developer, like your ability to access capital, dried up.

That ultimately built in the fact that the ecosystem changed, I would call it private debt providers started to build infrastructure on how to face sponsors, corporates in a different way, directly. In the same way most of them set up shops that they can call it up. So instead of in the early two thousands, if you wanted to borrow money for an M&A deal or making an acquisition, you generally called the bank that you had that relationship with. Now you might look at a handful of options It doesn't mean that banks aren't significant and probably the biggest providers of capital and credit, but it means there are other options that you can look through and again, goes back to, the last comment, the reason somebody might, do a floating rate loan or a public high yield bond or private, direct loan may vary based off of the situations and circumstances, both for that company, but also where we are in the

Oscar Pulido: And maybe you can expand on that a little bit. You've alluded to where the financing might be utilized for, you mentioned like a toll road and real estate, but who are these borrowers? and what are the trade-offs they're evaluating between whether to use the public markets or whether to go through the private markets?

Jimmy Keenan: And it's not just price, right? often you can sit and say, why would somebody pay a higher price? At the end of the day in some cases, pricing looks fairly similar, right? And some of the premium that you get in the private market is reducing the fees that might be paid, if going through a bank process and ultimately syndicating it out, so that is generally an earned premium that private debt investors might get. But there are a lot of other reasons why, if you're a middle market company, in order to think about operating their business, dealing with a publicly syndicated loan or a high yield bond, means that you have to engage with a variety of different investors that are in your capital stack. And in some cases, if there are periods of volatility or you're going to be active with acquisitions that may be more complex in managing your business.

And those small companies typically have smaller teams, and so in some ways that might be easier and better for them from a long-term perspective to have a single or handful of lenders that might be in that capital structure.

Another example might be companies that are going through transition. they might be in a late-stage development project that have yet to kind of see more stable earnings. They might be transitioning different contracts or parts of their businesses, in which case they prefer to either have, show that concentration or that shift in the private markets as opposed to in the public domain.

So are strategic reasons beyond. I would call it pricing or structural reasons, in order to do that. And so, the bigger companies, you'll see more of that opportunity where sometimes they might issue a public deal and then, yeah, at other times they might move that and shift that to the private market. And you've seen more larger capitalized companies that might either go public and private and there'll be some pretty big headlines this year on that.

Oscar Pulido: Okay, so you've defined the asset class a bit and we've talked a little bit about, why it's come of age, particularly over the last sort of 15 years post 2008. You've talked about some of the different types of borrowers. But in your position, you're sort of the lender, right? You're the one

providing the capital and you're the investor. So where do you see the best opportunities? Is it across the entire asset class or there are subsets of the asset class that you find interesting?

Jimmy Keenan: I think all investors should look at it, at the end of the day, every investor's going to be a little bit different between how they think about their own risk reward and that includes liquidity.

But you think about the private debt markets as a whole, this is something that, for all the reasons that we just talked about, was not necessarily as broadly available of an asset class to invest as somebody might want to build their portfolio.

And now that for all those reasons, that supply that's been unlocked and based off of what's gone on this year, is only going to grow substantially over the next several years is going to provide an opportunity for people to build their portfolios in a different way. And you think about the risk reward or even the risk characteristics of some of these and how they fit in somebody's personal strategy, that they should be looking across all of this, because it is something that they can get a premium.

I think there are a couple things that are really interesting today because of the supply dynamic. Obviously, that banking system turmoil was met with some policy response in there and liquidity that was provided.

And so, there's not a fire sale per se that is going on, but you do have a shift in how those regulatory and risk management have. And so, over the next several years, you're going to see balance sheet downsizing, and we see a significant amount in the trillions of assets that are going to have to be reduced from the banking system.

And what that means is, as that balance sheet is reduced. There are really good deals that are coming at a very nice spread per unit of risk, meaning the yield that you can get relative to that underlying risk is going to look very attractive. And so, the stable income type products based off of that supply dynamic, I think are really interesting across the entire ecosystem.

Oscar Pulido: Right. So, some of the investment opportunities are because of regulatory shifts that impact the banks and therefore mean, some of what's coming off of their balance sheet is now available to investors like you. And then some of it is just the last 12, 18 months of interest rate increases have exposed some companies.

You touched on institutional investors and also individual investors now both have ways to access this private debt market, but there's probably a lot of investors who are approaching this for the first time. So, what are the things they need to know?

Jimmy Keenan: Private debt is a very wide-ranging term, when you're entering the space or even viewing the public and private markets where are you trying to anchor your risk? What types of risk you're looking for? And if you think about. private debt being a core part of your portfolio. Then you have to think about any private assets, which is what's your ability, to have illiquidity in your portfolio?

How much illiquidity are you willing to have in order to garner those either differentiated risks or that extra premium that you might get in the private market. And then you go to the private debt strategies of which one do I want which one fits in?

So, liquidity is a big portion of that again, balancing what you need and what you're trying to accomplish with what is the strategy? And then what's the vehicle.

That's probably the first thing somebody should be looking for of matching what they're trying to accomplish and what they're ultimately doing. I think the other things then fall down into those strategies of what are you trying to accomplish in that?

Then you start to realize, okay, alright. I'm going to look for the certain product, now I got to look for the manager. There's a lot of different products, there's a lot of different managers. But trying to find a product that you can kind of look through that it has a history, you want to look through that track record of that team, that product, to understand, has this historically acted in the manner that I'm thinking about investing or underwriting to and is the future of that consistent with how I want to invest?

Because at the end of the day, like if you're going to make that investment, you're in that product or in that manager you want that output to have a similar, return profile and potentially volatility profile that you're looking for in your portfolio. So those are like the two main things that I would recommend people try to dive into.

Oscar Pulido: Jimmy, you've been associated with the fixed income markets, your whole career and, particularly in credit and both public and private markets. you've, you're obviously very excited about the opportunity in private markets. So, take us five years ahead. What is, what does this space look like or beyond, maybe, if you can see that part? ahead?

Jimmy Keenan: I think it's something that has become far more of a common name associated to how people think about it, private equity 30, 40 years ago might not have been thought of the same way it is today.

So, I think, five years from now, people are just going to view this as part of their allocation in the institutional and the retail markets. I think from today's standpoint, like 2008. It's hard not to get excited, at the end of the day you have both a supply, a significant supply shift that is going on because of what's happened and what we just talked about in the banks, where trillions are going to come out, and a lot of those trillions are actually good deals, but the funding source of that from a banking system is changed, in which case they're now going to make their way to probably both the public and the private markets. That's a huge supply that it's going to ultimately come. That's going to grow demand, right? At the end of the day, it's going to create capital formation because you'll step into good deals and good financing and stuff like that.

So, from a business perspective, this is a huge opportunity that is going to be multi-years. and I think that because policy shifted, and we've seen this since the financial crisis where most central banks and governments around the world are acting quickly to try to continue to mitigate that risk of a significant credit crunch that dries up in economic activity.

So, I view this as something that is going to be significant for our clients and our investors, it's an opportunity to grow a strategy that they can ultimately get outsized returns relative to the risk profile. So, it's hard not to get excited about.

Oscar Pulido: Well, it's been a couple years since we had you on the podcast. We'll try to, not have it be that long of a gap this next time and that way we can. See whether your predictions are coming true So Jimmy, thank you for joining us on The Bid.

Jimmy Keenan: Thanks for having me, Oscar.

Oscar Pulido: Thanks for listening to this episode of The Bid. If you enjoyed this episode, check out the episode, 'Are you leaving Cash on the table?' Featuring Beccy Milchem, where she provides the top three things to consider when thinking about cash and volatile markets. Subscribe to The Bid wherever you get your podcasts.

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