Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley, and I'll be your host. Today, we're talking about investing across the credit spectrum with Bryan Krug, Managing Director and Portfolio Manager on Artisan Partners Credit Team. Bryan, welcome.
Bryan: Thanks, Stewart. Glad to be here.
Stewart: It's great to have you, and there's a lot to talk about in the credit market these days for absolutely sure. Before we get going too far, what is your hometown, the one you grew up in? What was your first job of any kind, not the fun, fancy one? And a fun fact?
Bryan: Sure. So, I grew up in Milwaukee, Wisconsin, a suburb outside of Milwaukee. So, I was there basically from almost three until I graduated from high school. And so, it was a great place to grow up. My first jobs were not very glamorous. I used to mow lawns and then take leaves and rake leaves. And so, I did that as my first job. I did that when I was about 14 years old. And so, that really taught me some of the benefits of hard work, doing real work. So, those are my first jobs.
In terms of an icebreaker, interesting thing about me, fun fact. I guess my fun fact would be twofold. They're both interrelated. The first is I'm actually an NFL owner. I was given a $200 preferred stock instrument in the Green Bay Packers as a Packer fan. So, that's one fun fact. And it was the first security that I ever had an investment in. Ironically, it's a totally worthless security. It's actually a donation. So, you don't get any capital, no return on it. It's totally worthless, and it's nontransferable. So, that's a fun fact about me is I'm a Packer fan, and that was my first security and my ownership interest that's worthless.
Stewart: Here's my fun fact. I am, as well. We both are a shareholder in the Packers.
Bryan: Are you?
Stewart: Absolutely. My most recent one, my Chicago friends will be horrified at that, but I don't know what it is. I grew up outside of St. Louis, and I've always loved the Packers. Just always loved the Packers. I don't know what it is. But that's my team. I mean, to the extent, I'm not a huge stick and ball sport guy. I'm much more of a racing guy. I'd watch two people race lawnmowers in a parking lot. I mean, I love racing. But when it comes to football, definitely Packers is my team.
Bryan: There we go. Talking to a fellow owner.
Stewart: I love it. Yeah. That's a good fun fact. All right. So, here we go. So, let's talk a little bit, I mean, your world is credit, right? And I guess, as a big picture question, how and why have the credit markets evolved over the course of your career? It's a big question, but I think it's a great place to start.
Bryan: Sure. So, I originally started in the credit markets in '99, and so I've been in the business now for approaching 24 years. And in my time period, there's been a lot of really substantial changes, and there's some interesting drivers on what caused some of the changes. So, if you were to go back 23 years ago, what you would find is that the high-yield market as a market was essentially between 1/4 and 1/5 the size as it is today. The leverage loan market, at that time, was a market that was really nascent. It was one where banks actually used to lend, and when banks would lend, they would retain the risk as opposed to syndicate the risk. I really think when we're talking about the credit markets, you need to include both the private and the public markets because there is a fair amount of substitution and competition between the two markets.
And at that time, the private credit market was, typically, it was what it had been for decades. It was basically an insurance direct-lending market. And if you look at the market, it would be a bilateral agreement between a large insurance company and an issuer. If you look at, to your question, what's driven some of the change and how have things evolved? So, if we start with the high-yield market. The high-yield market, as the cost of capital has come down, you've seen, quite frankly, issuer size increase. You've seen private equity expand materially in terms of its size, and just look at the fund sizes. The fund sizes before, a $1 to $2 billion fund was a reasonably large-sized fund. And today, the funds are $25 billion. And so, when they have more capital to buy companies, then the companies are larger. And since that explains part of the growth, there's also the corporate markets, with low rates, were more inclined to incur high-yield debt.
And so, what we've seen broadly, over the last 24, 25 years, is the size of the businesses, the quality of the businesses, the amount of financial leverage has actually resulted in really a high grading of what the market was, and it's really accelerated the last 10 years. If you look at the loan market, the loan market was predominantly held by banks, and what they would use is a junior capital solution, the high-yield market, to basically offload the incremental risk they weren't willing to take. And as that has become more of an institutional market, you've really seen convergence between the loan market and the high-yield market. And that convergence has resulted in leverage profiles increasing slightly, maintenance cabinets have gone away, but pricing has also improved. And as you think through it, there's been a very sizable growth in that market from a syndicated perspective.
I mean, it's probably at least 20 times larger from a syndicated perspective of where it was before. Over the last 10 years to 15 years, the biggest change has been in the private market. Some of these private lenders have become just massive institutions. I think a lot of the private market is really not as well understood because, in my opinion, it's explained very simplistically. And as you look at the private market, what you've seen is the private market has evolved a little bit. If we were to go back, the growth has really accelerated. It was really after the Great Financial Crisis in 2008. And at that point, the market was really trying to fill the void, the void with middle market companies. So, let's say $75 million of EBITDA-type companies. And with the banks really reeling, there really was a void.
But five years later, if you go to around 2013, 2014, the Fed, through the OCC, which is the regulator of the banks, basically wanted to limit and prevent another financial crisis from occurring. And so, they came up with a concept of criticized assets for leverage finance investing. And leverage finance originators, i.e., the banks, basically had certain limits, financial characteristics as to what they could lend up to from a leverage level generally. And, honestly, some of these things didn't make sense because not all assets are the same. And the private market really expanded and really took more of a junior capital role. I think of it more like a mezzanine role in addition to serving the middle markets. You really saw this next leg of growth from the private market there. And then, over the past, I don't know, three to five years, what you've seen is this attraction to the asset class because theirs low vol because the assets aren't marked, and you've really seen these large private credit managers become alternatives as they move upstream.
And what was a $75 to a hundred million opportunity, they've really gone upstream, and they've really competed more head-to-head with the banks in what was, traditionally, a syndicated market. And the way they would initially start to do it was, when banks would make financing commitments for a buyout, they would provide alternative financing provisions, and the banks that they thought there was going to be an 8% execution would, basically, provide the issuer 10% cap. And when a transaction was announced, but before it was consummated, the sponsor would basically send out decks to private lenders and private lenders would bid on this. And so, to some degree, as all these lenders have gone upstream, the uniqueness has just deteriorated, and it's really become a pricing arbitrage, in my opinion, relative to the public market. And then, it's just really a way for a private equity owner to make a judgment. Do they want to take market risk as they've moved upstream relative to a public solution? And so, that's what we've seen in the leverage credit market, especially as the lenders have moved up upstream.
Stewart: Okay. Bryan, that was a great summary. And I understood where you were headed there, and it is a really interesting evolution over the last 23 years or so. Specifically within the high-yield and the loan market, how do you see the opportunity there today?
Bryan: As you look between the high-yield and the loan market, I think you can't, with a broad brush, just paint the high-yield market and the loan market as one. There's different constituencies and parts within each part of the market that we see opportunity. So, as we look across the high-yield and loan markets, we really spend a lot of time investing across the risk spectrum. And so, where we find value, obviously, in some of our core holdings, our companies with strong resilient business models, really a foundation of income. But then, selectively, we like to compliment those with companies that, because of the industries that operate in or because of what we believe as a profit improvement plan is, we think through that, those implications.
We see material credit leveraging, and often those are in the lower grades, the more levered capital structures, where we can see not only strong, high single-digit yields, but also we see the opportunity to have appreciation where we can buy bonds at discounts. And that's through a very selective approach where we see the opportunity. So, we think investors need to go across the risk spectrum, and when they go across the risk spectrum, they can truly find where some of the inefficiency exists.
Stewart: That's helpful. So, you were talking about the public market and private market. We just had a podcast with someone. Their strategy goes across the public and private markets. So, what determines if a company issues privately, or they become a public credit issuer? And how do the companies look different?
Bryan: Sure. When you invest, predominantly the private credit market is serving private equity owned businesses. They have a very limited exposure to public companies, very limited exposure to family-run businesses. It tends to be much more of a private equity owned asset. And so, that is one lens that I think a lot of people don't appreciate. And if you look between a private and a public solution, I think issuers, no one wants to pay extra on their expense. Think of it as a mortgage. You want the cheapest cost financing you can earn. And so, what you'll look at when you're determining your capital structure, you'll look at where the quantum of debt, where the availability is from a private versus public solution. In general, the public solution is actually less debt relative to a private solution. You'll also look at interest rates, if it's fixed or floating, and what breakage you may have.
In general, you have more breakage, i.e., call protection, on a high-yield bond than you do a loan. The loans typically have very limited call protection. Typically, a year, maybe two, versus a bond could be up to four years. And the prepayment penalties are typically higher on a bond. Then, the person will look at, or the company will look at, what sort of covenants that they want to have or lack thereof. And if you look at both markets, especially as you move upstream, effectively in currency covenants. And then, as you look, the smaller companies, obviously, pay a premium for spreads versus larger companies. But regardless of size, you do pay more for leverage. So, I think, in general, what you'll see across when companies are weighing what they want to do, if it's a smaller company i.e., under $75 million of EBITDA, it's probably more likely to go to a private solution if it's piggybacked. If it's a larger company, a private equity owner will basically look between the two markets and see what financing package provides them the most leverage at the lowest cost.
Stewart: And are there advantages and disadvantages to private versus public solutions there? I mean, just the way that you look at it?
Bryan: So, I think there's two lenses to look at it. The first lens is from an investor perspective. If you look at an investor perspective, you want to look at a couple of things. One is what the leverage, or LTV, is and what you're paid for, what the liquidity that you're offered in those instruments, and what the return profile is, and that's before I would look at any structural aspects in terms of how much of the return is actually generated by underlying investments, and how much of it's generated by formal leverage. Those are some important things that I would look at from a buyer perspective. From an issuer perspective, I would try to marry it with what my strategy is to grow my equity value. If I wanted to do significant M&A, do I want to be beholden to one party? That may not be the right move. If it's something in there, what's my cost to capital and what's my flexibility? It goes back to those terms. So, I think it really depends on the transaction and what the strategy is to strike or your equity value.
Stewart: And so, if we just take a step back here, and maybe change direction a little bit. So, from where you are today, how do you think of risk and reward for the intermediate return streams of various markets? And what are you cautious or careful of right now?
Bryan: As I think about where we are today, I think the world is fragile, and I think that it's late March. And so, the regional banking crisis is happening. The Federal Reserve has been raising rates. And so, you've got this dynamic where the economy's likely to slow down because of credit just becoming harder and more expensive to get, and you can buy it at higher short-term rates. So, as I look at today from a macro perspective, I think there's a couple of things that I would be thinking about. One is I think interest coverage ratios are going to be challenging. That entry point of leverage matters. If you were to look at the public market, on average, interest coverage is about twice that of the private market coming into this. Public markets have a combination of fixed and floating rate debt, where private is exclusively floating rate debt.
So, as SOFR has gone from approximately 50 basis points up about ninefold from where it was a year ago, what you're seeing is you're going to see a tremendous amount of pressure on interest coverage ratios for fully levered companies in the short term. And so, I think that's something that I would be very cognizant of. And if you have an environment with a slow economy, you're going to have the scenario where companies will need more cash, particularly in the private market, as they're going to be squeezed on interest rate. You're also going to have a situation where you'll have conversations about deferring interest payments, or what's called a pick. And then, also, conversations about “Do I need to push in more capital?” And it's a little bit of a tough conversation because it's the whole reason why a lot of these private lenders depend on supply from the sponsor. So, you want to make sure they're not too aggressive, but then they have to avoid permanent capital impairment. So, I think, in this environment, that's something that I would be focusing a lot on.
On the public side, the entry point's very important. On the public side, we've started with north of five times interest coverage if you look at the broad market. And with a combination of fixed and floating debt, the impact to rising rates will be far less. So, you will likely see some pressure from the broader economy, but in general, the companies are larger, they have more financial flexibility, and so, we actually are more constructive on the fundamentals on the public side, personally.
Stewart: We did a podcast with another guest, and they were also in the private credit space and the public credit space. They talked about the idea that the bite size of deals, of private deals, are smaller than they were, and that the valuations of these companies, given that rates are higher, are also under pressure. And that may create some challenges for folks if they need another round of funding. Do you see that in the market today? This has been a couple of months ago. Do you see a similar situation there? Or do you have a different viewpoint?
Bryan: I would say, across the board, the cost of capitals as gone up higher, materially higher. And then, I think the question is what is that? If you're comparing like-for-like risk, what does that pricing of that risk looks like, and how would you compare the risk? So, if I were to look at the public loan market, and I were to compare that with the private loan market unitranche pricing, I would say you pick up little to no premium in today's market if you were to say that the private loan market is a 650 to 700 basis points spread for unitranche pricing, which is where it is in today's market.
If you look at the syndicated market on loans, as of today, it's a 658 spread. If you look at CCC indices, which I would put the pricing should be somewhere between the two of them, it's over 1500 basis points today. So, I would argue that the premium that you would get by going in the private market is essentially zero for what you can get in today's public market. And if you look at the B loans, they actually try to add a bigger discount than the OID of new issue unitranche paper that's offered in the marketplace today. So, I think it's actually a no-brainer from that perspective. And if you look at the relative value, it's a no-brainer in the public versus the private market, as we said, today.
Stewart: Are there any covenants or other considerations beyond just yield spread that would offset that relative value in your mind?
Bryan: So, as I look at covenants in the syndicated market, there are effectively no covenants. I would say no covenants from a maintenance perspective. As you look at the private market, they may start to come back, but over the last few years what you've seen is maybe a covenant in name only, and the covenant may be a name only to say they have one, but it effectively is pretty toothless because if you look at the amount of deterioration the company would have to face, the equity would be so far out of the money anyway, they wouldn't put new capital in any way. And so, it doesn't really provide you any benefit. So, yes, they do have covenants, but the covenants are, in my opinion, in name only.
Stewart: Really an interesting discussion. Really, I've learned a bunch today, and I really appreciate that. I've got one final fun question to wrap up with. This is my new question. I'm trying it out. I don't know how it's going to go, but bear with me. Who would you most like to have lunch with, alive or dead?
Bryan: Let's see. That's a good question. A person I'd like to have lunch with, being a Packer fan, I'd say Brett Favre.
Stewart: Oh, there you go.
Bryan: That'd be my person. If you look at what he is done over time, he had a fair amount. He grew up in Mississippi, went the road less traveled, had a significant car accident, has gone through a lot of personal issues, and I've always wanted to just learn more about his experiences.
Stewart: Very cool. It was great to have you on. I really appreciate you taking the time to educate our audience today. So, thanks for being on, Bryan.
Bryan: Thank you, Stewart. I appreciate it.
Stewart: We've been joined today by Bryan Krug, Managing Director and Portfolio Manager for Artisan Partners Credit Team. Thanks for listening. If you like the podcast, please rate us and review us on Apple Podcast. We certainly appreciate that. If you have ideas for podcasts, please shoot me a note at podcast@insuranceaum.com. My name's Stewart Foley, and this is the InsuranceAUM.com podcast.
To contact the Artisan Partners Credit Team, email courtney.stone@artisanpartners.com.
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