Asset-Backed Lending in a Higher Rate Environment

Stewart: Welcome to another edition of the podcast. I’m Stewart Foley, I’ll be your host. There’s been a steady march to private assets by insurance companies for sure, and asset backed lending is certainly a part of that. Now, we’re in a little bit of a higher interest rate environment and we’ve got a repeat guest today, Connell Hasten, partner at Victory Park Capital is here to talk about asset backed lending in a higher rate environment. Connell, welcome back. Thanks for being on.

Connell: Hi Stew. It’s great to be back.

Stewart: You are a fellow Chicagoan, and I think you’re in downtown right now as a matter of fact. It looks sunny outside and it’s sunny out my window, so I think we’ve got that going. So you’ve been on before, so you’ve already heard all my icebreaker questions, I got a little bit of a different setup here. So how about this, how about your hometown that you grew up in, that’s the same, high school mascot, and what makes insurance asset management cool?

Connell: That is quite different than the first round, Stew. So St. Louis, Missouri is my hometown, high school mascot is the Spartans.

Stewart: What was your high school in St. Louis?

Connell: De Smet Jesuit.

Stewart: Nice, there you go. All right.

Connell: And the coolest thing about insurance asset management, I’m going to go with the people. Great people.

Stewart: Wow. That is the truth too, this industry does have a lot of great people. That’s great. Okay, so thanks for playing along there with me. So, private credit is so hot right now and I don’t see anything cooling it off, terrific asset class. Can you talk to me a little bit about how your view of private credit has evolved over the last 10 or 15 years, and I’ll add to this, in the last 12 months?

Connell: Good question. So the growth in private credit really came out of the global financial crisis in 2009 when banks were faced with stricter regulations, and that created the emergence of non-bank lenders just like Victory Park Capital. In 2009, private credit AUM, assets under management, was $150 billion, while US commercial bank lending portfolio in total was about $8 trillion. If you look at today, Stew, the total private credit non-bank lending AUM is $1.5 trillion. So it’s grown 10 times since the GFC, while the commercial lending loan portfolios have grown maybe 1.4 times.

So you’ve seen this 10 times increase in private credit, why is this? Well, obviously like I said, the GFC catalyst was banking regulations forced banks to pull back. And then on top of that, from 2010 to 2022, even through the pandemic, we had a long period of economic growth and low interest rates, which increased this private credit demand. And in the last 12 months to today, you’re seeing market volatility, rising rates, persistent inflation, which are some of the reasons for the recent bank pullback. But it forms my thesis that there will be future private credit growth because of the most recent bank pullback, just like there was bank pullback right after the GFC. So healthy businesses are going to seek capital to expand their businesses. They’re probably going to want lower advance rates given the high interest rate environment, and likely shorter durations in this environment to weather the storm.

So in the last 15 years, non-bank private lenders have really developed these track records now through multiple cycles, which is why private credit is a proven asset category and in the conversation of any asset allocation process. And I think that’s here to stay no matter what the macro environment or interest rate environment is.

Stewart: I’m 100% with you on all of that. For one thing, commercial banks do not want to loan to small businesses, period. I mean, we’re trying to fund growth and it’s virtually impossible, a bank is not going to help us. And the second thing I’d tell you about private credit is that it ranked number one for relative value in a CIO survey that we did here in the US, it ranked number one with a relative value survey that we did in Bermuda, and it ranks number one on our web traffic as well. So I agree with you and I think the data backs you up.

You’re a little bit like me in that you’ve been on both the insurance side and the manager side. What would you say are the most important considerations right now for insurance companies looking to allocate to private credit? And let’s do this, let’s go this way, let’s just say that someone is just looking at it for the first time, which I think is possible, and then what about somebody who’s been at it for a minute?

Connell: So if you’re looking at private credit for the first time, I’d start high level. First and foremost, make sure there’s relative value. There must be relative value when comparing to other public fixed income asset classes. And on top of that, you also should be paid for the illiquidity, so we call that an illiquidity premium. I think that holds today. And then another topic for a first-timer would be, make sure you know the manager and make sure the manager has performed in multiple cycles, make sure the manager has workout experience and risk processes in place, and the data infrastructure in place to assist with active investment management, because in the environment that we’re in, which the inverted yield curve seems to think we’re going be in a recession at some point, active risk management and being able to work through defaults is paramount.

For those that have been exploring the private credit space or invested in the private credit space for some time, I would really pick my spot. Private credit is a big space now, there’s lots of different kinds. You can go to mezzanine lending and there’s venture debt, there’s special sits, there’s many different flavors in the private credit space. So right now, I would focus on certain defensive characteristics in the private space, so floating rate versus fixed, given interest rate volatility. Make sure that SOFR floors are high enough to take advantage of a decreasing interest rate environment, because rates are so high right now, if they go back down to where they were, then those floors are going to be very important and a great inflation hedge for you. I’d focus on current interest pay income versus any PIK features. I’d like to be in the senior part of the capital stack versus other parts of the capital stack. From a loan term perspective, I’d focus on shorter terms to mitigate that illiquidity risk I mentioned.

A big one is making sure this loan structure and covenants are strong, that would probably avoid cov-light deals in this space. And then make sure you know the covenants, because sometimes there’s loans with a full suite of covenants, but sometimes they’re in name only. So covenants in name only, meaning the covenants are so wide of what the actual business is doing, they actually basically are cov-light loans. So focus on the covenants and make sure they’re strict.

And then, I might be biased here, but I like asset backed loans as well, given in a rising default environment, recovery rates tend to be a lot higher. And within the ABL space, I want to make sure that the issuer and borrower has meaningful skin in the game so we align interest, so their capital is at risk just like mine, and subordinate to mine. And I want to make sure the collateral is diversified. Those are the things I’d look at with certain loan characteristics, if you have a lot of experience already in the private credit space.

Stewart: That’s really helpful. And so with interest rates higher, can you talk a little bit about the case for continuing to allocate to private credit?

Connell: Yeah, so the market generally and market volatility and recent bank pulled back is resulting in a surge of attractive deal flow, and that attractive deal flow is well positioned for private credit investors. So the market is definitely there, the size is there. I think there’s going to be a lot of good loans that you can make in this environment, just because of the demand.

Also in a rising rate environment, private credit’s a defensive strategy at the end of the day, it’s low volatility, lower correlation to other asset classes, let’s talk about why this is. So again, the floating rate is an inflation hedge, it helps when rates go up. There’s no real duration risk. Also too, senior secured helps with equity valuation volatility. Like I said, if it’s asset backed, it helps with recovery rates in higher default environments. And then the current pay aspect, it’s recurring income. So all these things are characteristics for a defensive strategy.

And as long as you’re getting paid, like I said, relative value is huge. You have to make sure you’re getting paid the right illiquidity premium to compensate you for taking that duration risk. And there’s ways within the private credit space that you can mitigate that illiquidity, shorter loan terms like I said, current pay interest income, et cetera. And not only just the publicly available indices, but also you have to keep an eye on the CLO market, the leveraged loan index, et cetera, to make sure that you’re getting compensated for the illiquidity.

Stewart: So we’re talking about private credit in general, but Victory Park Capital works in the asset backed lending space. Can you walk me through what a typical deal would look like for you?

Connell: Yeah, would be happy to. So I like to break it down like this, there’s cashflow lending and then there’s asset backed lending. In cashflow lending, the lender determines the loan size based on the borrower’s enterprise value, with a particular focus on EBITDA and cashflow. Asset backed lending is a little different, the loan attaches specifically to the borrower’s assets and that forms the basis of the loan size. And then within the asset backed loan market, you have traditional asset backed lending, which is mainly lending on inventory and accounts receivable. And then you have non-traditional assets, and that’s mainly where we play.

And I can get to the types of collateral, but a typical loan, look, it’s a senior secured, delayed draw term loan, floating rate coupon, and always with covenants. We directly originate our loans, and therefore we’re generally the sole lender and always the agent. And our borrower is actually a bankruptcy remote SPV, which stands for special purpose vehicle, which is wholly owned subsidiary of the corporate entity, but we’re lending to that SPV versus the corporate entity itself.

And a little bit more on the structure, so we lend to a max advance rate against the eligible collateral and we define the eligible collateral upfront, and that defines our borrowing base. A critical point here is if the borrowing base moves, meaning it’s a dynamic pool of collateral, so if one of the eligible assets falls out of our borrowing base and it’s no longer eligible, that has to be replaced in kind or with cash. So at any given moment, that SPV holds performing collateral.

And as far as collateral types, so let’s talk about what we’re lending to, I like to break it out for us, either consumer, small business or just alternatives. And in the consumer space, that SPV can consist of credit card receivables or installment loans, there’s a lot more examples in the consumer space, but we’ll limit it to two for now. In the small business, it could be small business loans, working capital, factoring. And then in alternatives, real estate’s a common one that we will lend on. And so those are examples of the collateral that are eligible in that SPV and that we’re lending on at a certain advance rate. And that advance rate fluctuates based on the duration of that underlying collateral, the performance of that underlying collateral, et cetera.

Stewart: That’s really helpful. When you look out today, what do you see as the greatest opportunities and the greatest challenges for private credit managers?

Connell: So the opportunities, the one that comes out to me is just market share. Bank dislocation is a catalyst, we’ve talked about this, for non-bank lenders to continue taking market share. At the same time, you have increased demand from healthy companies seeking short-term floating rate loans from non-banks. So that’s the biggest opportunity right now. I think the opportunity also is, it’s a little bit less competitive right now because it’s an uncertain environment. So that comes with ability to provide the same loans you would maybe at less leverage or attachment point and getting paid more for it. I think those are the main opportunities.

The challenges, I mean the general market is a challenge. We’re in inverted yield curve, the 2 versus 10 right now is -87 basis points, that’s the steepest it’s been since 1980. Stew, last time we spoke, it was flat, and that wasn’t that long ago. So at least to me, it’s inevitable that we will hit a recession, which will or should come with higher defaults in every market, including the private credit space. So managing those defaults and having experience doing so will be imperative.

So that’s one challenge. I also just think in a higher interest rate environment, the biggest concern is your borrower, the company’s ability to afford the debt service, because it’s floating rate. So you have to look for companies with assets that have high excess cashflow, high margin business, and appropriate interest rate hedges in place when needed. So those are the two challenges that come to mind.

Stewart: It’s really interesting. That is an amazing stat that you threw out there, it’s the most inverted it’s been since 1980, right? I was a sophomore in high school. And am I right that Paul Volcker was the Fed chairman at that time? You’re going to make me Google this on the fly, let’s find out.

Connell: He started in ’79, so yeah, you’re right.

Stewart: There we go. I mean, Paul Volcker became famous for breaking the back of inflation by raising short-term rates to previously unheard of levels. It’s a really interesting historical fact that you threw out there, thank you for that.

So I think that we both expect insurance companies to continue to invest in private credit, it’s so accepted today. I think one of the challenges that they face is knowing where the threshold is of their liquidity, how much liquidity can I give? And generally speaking, I think most people would agree that insurance companies are over-liquid. But the challenge comes into is, where’s the line? So what do you think their challenges are? How do you think that insurers are looking at private credit today? Do you think it’s for the most part become mainstream as part of their allocation, which is how I see it? But I see a subset of the market, so you probably have a better vantage point of this.

Connell: Yeah, from an insurance allocation perspective, I do think private credit has become mainstream. I do think that insurance investors are becoming well-equipped and opinionated on where to focus within the private credit space, but I believe the allocation is there. I do think that insurance allocations to private credit will continue to grow, especially in this environment, like I said, it’s a defensive strategy and it’s got low volatility.

And you mentioned something interesting, you said insurance companies are overly liquid, and that’s either through cash or liquid securities. So it really depends on how liquid those liquid securities are, because you don’t want to sell for a loss, right?

Stewart: No, right.

Connell: There’s other ways for insurance companies to obtain liquidity and that’s either through the Federal Home Loan Bank system or other ways. But I think private credit, if you looked at the investment grade corp index, it’s at, call it 175 over, or high yield is at 475 over, private credit is still offering a meaningful spread to these benchmarks. And again, it depends where in the private credit space, but you’re definitely getting paid to take that illiquidity risk.

And at the same time, the insurance business from a margin perspective hasn’t changed, it’s a very low-margin, low-spread business. So as interest rates go up, so do your crediting rates. So if you look at 5 to 7 year MYGAs, they’re at 550, 575, add some SG&A on that, and that’s below these investment grade liquid security options you have, so investing in those asset classes alone won’t cut it. So an allocation to higher-yielding defensive strategies like private credit, in my opinion, is necessary.

Stewart: Yeah, I think that’s right. I mean, there’s a cost to that liquidity, and a lot of folks were talking about how they go about assessing their real liquidity needs. And to be able to stay competitive with other insurers, I think that you’ve got to be taking advantage of all the opportunities afforded to you, right? I mean, it just stands to reason.

Connell: You said it. Hit the nail on the head.

Stewart: Thanks. So I got a final closing one for you, a new one. You can actually have a choice of two. Here we go, you ready?

Connell: Sure.

Stewart: Best piece of advice you ever got, or, could be and, or who would you most like to have lunch with, alive or dead?

Connell: Okay, I’ll take both.

Stewart: All right, nice.

Connell: Person I’d most want to have lunch with alive or dead, I’m going to go with Jason Sudeikis right now.

Stewart: Wow, there you go.

Connell: And then best advice I’ve ever gotten, if you listen, consistently give effort and you’re always prepared, then you have a chance. And the person that gave me that advice later told me it was a combination of a Calvin Coolidge quote, a Bobby Knight quote, and a JFK quote. So I don’t know how unique it was, but I do-

Stewart: I love that. Give me that again.

Connell: If you listen, consistently give effort, and are always prepared, then you have a chance.

Stewart: Yeah, that’s the best you can ask for, right? It’s so great to have you back on, I really appreciate it. I learn a lot whenever you’re on, private credit I think is an important and growing part of insurance company portfolios, and it’s always great to get your insights and your views.

We’ve been joined today by Connell Hasten, partner at Victory Park Capital. Connell, thanks for being on, man. Thanks for taking the time.

Connell: Thanks, Stew.

Stewart: Thanks for listening. If you like us, please rate us, review us on Apple Podcast or wherever you get your podcast content. My name is Stewart Foley and, this is the podcast.

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Victory Park Capital Advisors, LLC
Victory Park Capital Advisors, LLC

Victory Park Capital Advisors, LLC is an SEC-registered, established credit manager. The Firm was founded in 2007 and is headquartered in Chicago, Illinois, with additional resources in New York, Los Angeles, San Francisco and London. VPC provides custom financing solutions across the private capital spectrum, focusing on asset-rich companies with strong corporate governance and a compelling growth trajectory. VPC invests in both emerging and established businesses across various industries in the U.S. and abroad that often cannot access traditional sources of capital.

VPC offers customized investment solutions across its credit platform for insurance companies’ unique needs.

Connell Hasten,
Direct: +1.312.663.7472
Mobile: +1.312.505.1457
150 North Riverside Plaza
Suite 5200
Chicago, IL 60606

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