An intro to the inefficient world of Portfolio Debt Securities with Dan Spinner of Eagle Point

Stewart: Welcome to another edition of the podcast. My name’s Stewart Foley, I’ll be your host. Welcome, Dan. Thanks for being on.

Dan: Hi, Stewart. Thanks for having me.

Stewart: My pleasure. You are a Senior Principal and Portfolio Manager at Eagle Point and you’re responsible for the firm’s defensive income strategy that invests in something called portfolio debt securities. And I’ve got a lot to learn here today. But before we get going too far, where did you grow up? What was your high school mascot? And what makes insurance asset management so cool?

Dan: That’s great. So I grew up in Whippany, New Jersey.

Stewart: Oh wow, okay.

Dan: We were and are the Whippany Park Wildcats. And what makes insurance asset management so cool? We have the opportunity to add significant alpha for our clients in this asset class as compared to investment grade corporate bonds. And we’re doing it in an asset class that most, frankly, haven’t heard of, with a risk profile that’s comparable to lower than the risk on investment grade bonds, yet we think we can generate meaningfully higher returns. That makes it pretty cool. And if the clients are happy, that’s a good thing.

Stewart: Absolutely. That is Cool. So for those of us who may not be as familiar, can you give us a little bit of background on Eagle Point?

Dan: Eagle Point is a specialist fixed income manager. We’re focused on income-oriented credit investments in niche and inefficient markets. We’ve got about $8 billion of assets under management and 60 professionals. So as a firm we’ve been investing for quite a long time, over a decade, in inefficient markets including CLO equity, CLO debt, strategic credit, and portfolio debt securities.

Stewart: That sounds like a recipe that some folks we know in the insurance business may find appealing. So let’s talk about that. I’m one of the people who is not familiar with portfolio debt securities, so can you help me understand the asset class, start with the big Crayolas so that I can get my arms around what we’re going to be talking about today?

Dan: So at a high level portfolio debt securities are debt securities issued by credit funds to finance a portion of their portfolios. So fund level financing as opposed to company-level financing. And the types of funds that we provide financing to include BDCs, closed-end funds, private funds, commercial mortgage REITs, et cetera. And our overarching philosophy for the asset class is that we believe portfolio debt securities offer a better, more defensive way to gain exposure to private credit. In any market environment, but particularly in the current market environment in which credit expense is increasing. And then high level from a risk and return perspective, we believe a well-structured and managed portfolio of portfolio debt securities can generate returns of over 9% in today’s market and importantly with an expected zero or near-zero loss rate on the underlying assets. So this 9% plus return profile is about 4% to 5% in excess of the return on investment grade corporate bonds, which is the benchmark for investment grade rated portfolio debt securities.

So that was pretty high level. Maybe what I’ll do is go into a little bit more detail so we can really put some meat on the bones and understand the asset class that we’re talking about here. And first I should preface by saying that portfolio debt securities is Eagle Point’s moniker for the asset class. So if you were to Google it, you wouldn’t find any definition. The way we define it, there’s really four key characteristics and I’ll use BDCs as the portfolio debt security issuer type example here.

So the first is that they benefit from significant credit enhancement in the form of a minimum asset coverage ratio or embedded asset coverage. And I’m going to come back to this because this is really the most important of the four. Two, they generally occupy a senior position within a fund’s capital structure. So portfolio debt securities can be senior secured, senior unsecured or in some instances preferred equity. They’re typically investment grade rated and they typically have five-year maturity. So relatively short duration.

Now coming back to the asset coverage ratio or embedded asset coverage, as some of your listeners may know, BDCs are governed by the Investment Company Act of 1940. And so by law, they have to maintain a minimum asset coverage ratio of 150%. And what that means is that the fair value of their assets has to exceed the principal value of their debt by 150%, otherwise there’s a severe ramification. And that ramification is that the BDC, if it was in breach, could no longer declare dividends to its common shareholders. And that would be a bad day for the BDC because BDCs are yield vehicles that pay out their income. And that income, that NII, that otherwise would’ve been paid out is then trapped within the BDC for the benefit of debt investors and is ultimately a credit positive.

Now I think the best and most intuitive way to think about the minimum asset coverage ratio of 150% is that it’s equivalent to a maximum debt-to-equity ratio of two times. So if a BDC has $100 of equity, it can’t, by law, issue more than $200 of debt. That would be two times debt to equity. And this is an arbitrarily low leverage limitation that we as debt investors are the beneficiary of. So why do I say it’s arbitrarily low? Well, let’s compare it to other credit vehicles in the market. Banks are about 10 times levered. Broadly syndicated CLOs are about 10 times levered. Middle market CLOs are 6 times levered. And by virtue of this law that was put in place in 1940 to protect mom-and-pop investors in mutual funds post-Great Depression and BDCs are a type of mutual fund, BDCs are severely limited in the leverage that they can use.

Now of course BDCs did not exist in 1940, they were added many years later. But that’s really the dynamic that we benefit from. And as a result of this, there has never been an impairment on any debt to a BDC. And I’ll conclude in just a moment. There’s really two reasons why that’s the case. There’s two reasons in our mind why there’s never been an impairment. The first I just went through, which is that we have significant credit enhancement by virtue of the low leverage involved here. And the second I didn’t touch upon, which is that the BDCs or the funds have diverse portfolios of credit assets and that’s really the formula. So when you think about portfolio debt securities, in our mind it’s meaningful credit enhancement provided by the equity of the fund, which takes the first loss and then diverse portfolios of underlying credit. And with that, we can withstand idiosyncratic credit issues as well as meaningful cyclical credit risk.

Stewart: That’s really helpful and it really helps me get my arms around what it is that we’re talking about. It’s very unique and I’ve got a couple of questions I want to get to about capacity in the asset class because that becomes an issue for some of our listeners. But I understand that there’s an interesting genesis for how the strategy came about at Eagle Point. Can you walk me through that?

Dan: So the strategy was really born out of our experiences as both investors in and issuers of portfolio debt securities. So back around 2015, a few of the partners at Eagle Point and myself were investing in baby bonds personally, and we can come back to what baby bonds are and probably define those. We were buying those personally because we didn’t have a strategy focused on it at the time and we thought that they offered returns that were well in excess of what was warranted by the risk. We knew there had never been an impairment on any debt to a BDC, so we were buying them. And then separately, Eagle Point manages a couple of publicly traded FORTE Act closed-end funds. And I’ve been the partner at the firm that has historically led the capital markets exercises for those funds when they’ve wanted to issue portfolio debt securities or said differently when they’ve wanted to borrow.

And what I was really struck by is that the banks who lead these transactions, the banks charge a relatively healthy 3% best efforts, non-underwritten placement fee for placing these. And that’s really where the light bulb went off for us. And we thought, “Wow, we can do this better and create a better return for investors by forming capital at Eagle Point, approaching issuers directly with scale of capital and certainty of execution and simply taking those fees they otherwise would’ve paid the banks, taking them in the form of OID, original issue discount, for the benefit of our investors.”

So we’d really be taking this asset class that we thought had embedded alpha on just a standalone basis, paying the market price and then enhancing their returns through capturing incremental economics. That was really the genesis. And when you think about it, it’s very much a direct lending strategy except not focused on companies but focused on funds. The last point I’ll mention, which we had always anticipated, but we frankly underestimated how potent it would be. Unlike corporate direct lending strategies and corporate private assets, a meaningful percentage of portfolio debt securities actually trade in the market. So there’s a secondary market component of the strategy, which has been very potent, particularly during these periods of episodic market volatility where you have big sell offs because this is such an inefficient market. That’s been a very interesting aspect of the strategy.

Stewart: That’s interesting. So when you noted the return profile of 9% for the asset class, which is a high yield number with what you’re describing as investment grade risk, why does this opportunity exist, first? And is it inefficiency, is it a lack of knowledge across the broader institutional segment? And I’ll just throw on the top of that, what’s the capacity in the asset class? Is there an upper bound that you go, “Yeah, if I got an allocation of X, we’d have a hard time getting that put to work.”

Dan: So there’s a couple of reasons I think why this opportunity exists and the inefficiency exists. The first is that it is a very small market, so our best estimate is that the size of the portfolio debt security market is about $75 to $100 billion dollars. And I’ll circle back to that in a moment. But if that’s directionally the size of the market, and let’s compare that to some of the other fixed income markets. Broadly syndicated loans and high yield bonds are about a $trillion and a half. I think direct lending’s about a trillion and a half. So big markets, this is tiny. And it also takes a lot of time and resources to underwrite investments in this space. It’s very labor-intensive, so I just don’t think it’s worth the time for really large asset managers. I think that’s part of it.

And then the second reason is maybe we’ll walk through is the bear case for the asset class. And I gave the bull case before, let me make sure I’m being really balanced here and give the bear case for the asset class. And again, I’ll use BDCs as the example of portfolio debt security issuer. And the bear case might go something like the following. A bear and a potential investor might say, “Well hey, don’t BDCs make below investment grade loans to levered middle market companies?” Yes. “And haven’t underwriting standards been declining for years with fewer covenants, EBITDA, add-backs, weaker documents?” Yes. “And aren’t we likely heading into a recession? And if so, doesn’t below investment grade credit underperform during a recession?” Well, I think we’re likely heading into a recession for what that’s worth. And yes, below investment grade credit typically underperforms during a recession. So stay away from BDC debt or portfolio debt securities says the bear. And that’s the bear case.

Now while those points that I articulated are true, the question it fails to ask or take into account is what is the level of realized losses within the portfolio that would need to transpire in order to erode that equity buffer and put at risk the first dollar of our investment? And the answer is it’s many, many multiples of anything that’s happened historically. But I think that’s part of it. You think of the bull case and the bear case. And by the way, if you don’t spend as much time in this world as we do, do you mind states? I know underwriting standards have been decreasing, we’ll just stay away from it.

So I think that’s the reason why that’s the case. And then finally, you touched on capacity and it’s a really good question and a very important one. In terms of the capacity, again, we think the market is about $75 to $100 billion dollars and most of that variability is actually on the private fund side. And so that’s interesting. What I mean by that is we have been directly originating portfolio debt securities with private funds who wouldn’t have a public capital markets execution option. And when we first started looking at the market a handful of years ago, we estimated the private market opportunity at X and it’s frankly many multiples of that because there’s hundreds of billions of dollars of private fund opportunities. So there’s a little bit of variability within that range on the private side.

Stewart: That’s really interesting. So banks have historically been large lenders to credit funds. With what’s gone on with SVB and others, I think there’s a general consensus, at least it’s one that I hold, is that banks are going to be lending less. And that not only portfolio debt securities, but direct lending in general funded by the insurance industry is not going anywhere. So can you talk a little bit about what you’ve seen post-SVB for portfolio debt securities?

Dan: And it’s interesting, but bank credit was tightening prior to mid-March with the SVB and Signature Bank failures and certainly tightened further since. And by the way, banks are huge lenders to funds. What we’ve seen is that with few exceptions, banks haven’t been pulling lines of credit from their good borrowers and the good funds to which they lend, they haven’t been pulling them. However, it’s been much more challenging for these funds to increase the lines of credit or to put in place lines of credit for new funds that they’re raising. And then when it comes time for rolling them over, of course the cost of capital has unequivocally gone up. And I’ll share an interesting anecdote around this. I was speaking with one of our bank partners who is at a bank that’s been one of the winners out of the regional bank crisis, in that they had a lot of deposits coming in and I was joking with him and I said, “Are you guys building a bunch of new vaults to handle all that cash that’s coming in?”

And he laughed and he saw where I was going and said, “Yeah, we’ve had a lot of deposits come in, but that doesn’t mean we’re increasing lending because we don’t know how real those deposits are. I mean, they’ve come in, but could they potentially flow out?” I just thought that was interesting because while they’ve been a winner, it doesn’t mean that they’re saying, “Hey, we’re going to increase credit availability.” So it certainly has gotten tighter. And so as we look at the landscape today, the opportunity for non-bank lenders with capital from insurance companies and other types of longer-term investors to originate portfolio debt securities, we think is really as attractive today as it’s ever been, in part based upon that dynamic.

Stewart: That’s helpful. So you mentioned you have an expectation for recession, what are your thoughts on the health of corporate credit? I mean, where are we in the credit cycle and can you talk a little bit about how you… I mean, I’m a fixed income geek and in my head is always, what are we not looking for? The quality of underwriting for a lot of the direct lending that’s been done, has that been tested to any large extent?

Dan: It’s a good question. Let me first preface by saying at equal point, we don’t invest based on macro views. We all certainly have views and we’re macro aware, but we’re not investing based on a macro view. I do however, think we’re heading toward a recession. And to your question, we touched upon this a little bit earlier, but over the last 5 or so years leading up to the rate hiking cycle, we certainly saw a weakening of underwriting standards. It was a borrower’s market, a global search for yield, all the points I made earlier around EBITDA, add-backs, weaker docs, et cetera. And credit expense has been gradually increasing. I think it will continue to increase as we see the lagged impact of higher rates on leveraged borrowers who didn’t hedge their interest rate risk. And maybe this is to your specific question, our best estimate for the broadly syndicated loan market is that something like 40% of borrowers hedged interest rate risk and the rest didn’t.

So let’s just call it 50/50 high level. And I’ll share what I think is a powerful illustration of a potential pain point for a number of borrowers and potential tail risk in the market. So if you were a company, if you were a borrower and you took out a levered loan in 2021, which many did or they refinanced their debt because it was cheap, they had the opportunity to extend it. If you took out a leveraged loan at 5.5 times EBITDA, which is roughly the average for the market, and you didn’t hedge your interest rate risk because SOFR or LIBOR at the time went up from about 50 basis points, that was probably your floor, it was lower than that, but you probably had a 50 basis point floor, it went up from that level to 5.3% today.

Okay, assuming your revenue and your EBITDA stayed flat, the company’s free cash flow dropped by about 33% and its interest coverage fell from about 3.5 times to 2 times. Let me just repeat that just to make sure it came through. If you didn’t hedge your interest rate risk, if you were 5.5 times levered and your EBITDA was flat, your free cashflow dropped by about a third and your interest coverage, which is EBITDA to interest expense, started at a very healthy 3.5 times and today it’s around 2 times. And historically that 2 times has been a line of demarcation in the markets for comfort level around levered credit.

So I think the question then is what’s the implication of that? I don’t think it’s Armageddon in the corporate credit markets. That’s not at all what I’m suggesting. And a lot of these companies that are well sponsored, if they’ve got good businesses, they can likely manage through, it’s probably a problem for the equity investors, frankly. However, there’s unequivocally, in my view, tail risk. There’s going to be companies that have trouble, that may not be as well sponsored and don’t have businesses that are as stable and there’s going to be increased credit expense and likely mark-downs within private debt portfolios. And so it will impact, we think, the returns on private debt broadly. It’s hard to see a scenario where that doesn’t come to pass unless rates were to drop meaningfully and quickly. Of course, if that were to happen, it’s probably into a pretty tough economic environment.

Stewart: And when you’re looking at portfolio debt securities, what are you looking for when you’re underwriting these things?

Dan: So, a few things. The way we approach it, we have a heavy focus on the skill and expertise of the manager. What’s their historical track record? What’s their skin in the game? Are they good, ethical folks that we can partner with? That’s a component of it. And then we’re looking at, you’ve got to look at both the left-hand side and the right-hand side of the fund’s balance sheet. So on the left-hand side, the asset side of the ledger, what are their underlying assets? Are they first lien senior secured loans, second lien loans, et cetera? What is the risk profile of those assets? Very importantly, how diverse is the portfolio? There’s a saying in credit that concentration kills. So the more diverse it is, the better. We’ll typically re-underwrite the top 10 exposures within the portfolio.

And then critically, you’ve also got to look at the right-hand side of the balance sheet. So take BDCs as an example, where we’re often a senior unsecured note holder in the BDC, there’s a senior secured credit facility that’s ahead of us in terms of the way BDCs finance themselves. So if we’re going to be investing in the senior unsecured note, we’ve got to understand the terms of the senior secured credit facility that’s ahead of us. So the underwriting, this was back to my comment earlier, it’s a pretty labor-intensive underwrite.

But if done correctly, at the end of the day, really the question we’re asking is, assuming we’ve got a strong manager, strong track record, good alignment of interest, skin in the game, understand the portfolio, we think it’s a stable balance sheet, then the question is, what is the level of realized losses that would have to transpire within the portfolio in order to impair the first dollar of our debt? And in most instances, the answer to that question is many multiples of anything that’s transpired historically. And when done correctly, that’s where we have comfort in these portfolio debt securities.

Stewart: I have learned so much. I really appreciate the education on these securities and the opportunity there. So I’ve got one more for you. You can have a choice, you can take either or both. Who would you most like to have lunch with, alive or dead? Or what’s the best piece of advice you’ve ever gotten?

Dan: I’m going to take both, actually.

Stewart: Wow. All right. I love it.

Dan: So, best piece of advice I’ve ever gotten, I actually received in high school, believe it or not, and I still think back upon it. So there was someone who was a couple of years older than me in high school, super successful, he was the valedictorian, I think, of the class, great athlete, involved in music. And I said to him, “How do you do everything that you do?” And he said something like the following, he said, “I do what I do when I’m doing it.” I’m paraphrasing. But what he meant was, when I’m playing football, I’m just playing football, I’m not focused on anything else. When I’m studying, I’m only studying, I’m only focused on that. And as I’ve thought back on it over the years, he’s saying he was being present, which is pretty impressive for, probably a high school senior at the time. So that I thought was really good advice.

Stewart: Absolutely.

Dan: And then in terms of someone I’d love to have lunch with, that would be easy. I would have lunch with Larry David. So if there’s any Curb Your Enthusiasm fans out there. I think he’s really funny. So I would definitely have lunch with him.

Stewart: There you go. That’s great. Thanks so much. We’ve been joined today by Dan Spinner, Senior Principal and Portfolio Manager at Eagle Point. Dan, thanks for taking the time.

Dan: Thanks, Stewart. Really enjoyed it.

Stewart: Thanks for listening. If you have ideas for a podcast, please shoot us a note at Please rate us, review us, and like us on Apple Podcast, Spotify, or wherever you get your favorite podcast shows. My name’s Stewart Foley and this is the podcast.

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Eagle Point Credit Management
Eagle Point Credit Management

Eagle Point Credit Management is a specialist investment manager focused niche, income-oriented credit strategies.  Founded by Thomas Majewski in partnership with Stone Point Capital in 2012, Eagle Point manages approximately $7.9 billion in AUM.  Eagle Point is based in Greenwich, Connecticut, and employs 60 professionals.  Investment strategies pursued by the firm include collateralized loan obligations, portfolio debt securities and other opportunities across the credit universe.

We believe we are:

  • The largest holder of CLO Equity in the world
  • One of the largest holders of CLO BBs
  • One of the largest non-bank lenders focused on providing financing solutions to credit funds

Kyle McGrady
Senior Principal and Head of Client and Partner Solutions
(203) 340 8552
600 Steamboat Road, Suite 202
Greenwich, CT 06830

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