Episode 272: The Art of Credit Underwriting: Lessons from OHA and Missouri Teachers

 

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name’s Stewart Foley, I'll be your host. Hey, welcome back. It's nice to have you with us. This one's a little different today. We've decided that it would be beneficial to create something that was an educational series and we reached out to some friends and family and we came back with this idea of best practices for underwriting private credit. And we've got two folks on today who are both neck deep in this industry. Victor Debenedetti, principal Oak Hill Advisors. Victor, welcome. Thanks for being on. It's your first podcast. We're thrilled to have you.

Victor: Good to be here. Thank you, Stewart.

Stewart: And we have Anthony Vikhter, who was a former student of mine at Lake Forest College, who is a senior investment analyst at what's known as Missouri Teachers. But it's actually... The name's a little longer, isn't it, Anthony? Welcome and tell us what the right name is before we get going too far.

Anthony: Yeah, you hit the nail on the head there, Stewart. But the public school and education retirement system in Missouri. A little bit of a mouthful, but effectively managing the retirement benefit for any certified and non-certified education employee throughout Missouri.

Stewart: Craig Husting is a good friend, he's the CIO, he's been on with us. He was gracious enough to lend you to us for a few minutes here today. Missouri Teachers is a highly regarded pension system that is running about $60 billion and based in Jefferson City, but they also have an office in St. Louis as well. And that's where you are today, right?

Anthony: That's correct.

Stewart: So before we get going too far, let me start it off this way. I know a little bit of this history for you, Anthony. So I'm going to start with Victor. Where'd you grow up? What was your first job, not the fancy one. And tell us a little bit about your journey to being a principal at Oak Hill Advisors.

Victor: Yeah, for sure. Well, I have a little bit of random history. So I was actually born in France. I grew up in Paris. I moved to London when I was a young child and you'd be surprised to know, but English is my second language and you may hear throughout the podcast that there's certain words that I cannot pronounce. So I just make that disclaimer now. My first job, I always wanted to be in finance. I always knew that. My first job out of college, I worked at Morgan Stanley doing emerging market credit trading, which was very different than what I do today. I started at Oak Hill in 2016 and moved around a number of different roles from trading to then underwriting. And then within underwriting, I've evolved across a number of different industries. So started really in services and financial services as well as insurance brokers. And now on my full-time role, I lead the underwriting for healthcare companies or anything that is healthcare related and credit related, I will be leading that underwrite.

Stewart: Super helpful. And Anthony, tell us a little bit about where you grew up and your first job, but if you can work in a little bit of that hockey roughing background, that'd be helpful, too.

Anthony: Sure, absolutely. And actually, much like Victor, believe it or not, English actually is also my second language. I'm a son of two Ukrainian immigrants who came to Chicago just before I was born. But anyway, I grew up in Chicago, was there for pretty much my first 24 years of life. Went to Lake Forest College, was lucky enough to come across you, Professor Foley, and I still call you Professor Foley and I always will, so you won't convince me otherwise.

Stewart: Thank you.

Anthony: But anyway, had a great experience there. Identified what I wanted to do in finance and was also lucky enough to get the Kemper scholarship, which was another great avenue to understand the different career paths in finance and business generally. But coming out of Lake Forest College, I started my career with Allstate Investments, had a great experience there across public markets, private markets, and spent some time with their opportunistic investment group, which was a great experience.

And then from there, I made the jump over from the LP side to the GP side and worked with Principal Asset Management with Principal Alternative Credit, which is their direct lending group. Had a great experience there, learned a ton. And they came across one of your friends, Craig Husting, and he's been another great resource and mentor for me as well. And now I’m with, what you mentioned before, Missouri Teachers, PSRS/PEERS is a short acronym for the name I gave earlier. But basically, my role with the private equity and private credit team here is to effectively primarily help manage our private credit portfolio. And then I also help with other initiatives across the plan. So been a great experience here so far.

Stewart: And you're a D1 hockey ref, right? You've been doing this for years, reffing hockey, haven't you?

Anthony: Yeah. So I've been a hockey player my whole life. Started reffing when I was 12 and I'm lucky enough to referee and suitable a D1 hockey. So it's a little fun thing I do and it's given me a lot of joy.

Stewart: So inside baseball, Victor, Anthony, my daughter goes to the University of Denver and her name's Maggie, she's actually coming in tomorrow so everybody's excited about that. But we were out there for their home opener. So University of Denver won their 10th national championship in men's D1 hockey and I was out there for the home opener when they raised the banner and all of that stuff. And it turns out that Anthony was reffing the game, so we got a chance to get out on the ice after. And it's a little different than Lake Forest College.

At Lake Forest College, you could just walk out there, and DU, it's a little different. They've got quite an arena. And we went into the bowels of the place and Maggie and I were able to get a couple pictures with Anthony on the ice. So, super cool. But the business at hand today is best practices and underwriting private credit. And so what would be helpful, Anthony, if you wouldn't mind, is if you can give us a high-level overview of private credit markets. More specifically, what are private markets, why do they exist and why do institutions invest in them?

Anthony: Yeah, you bet. Before I get going, Victor, for your benefit, announcing a penalty in front of thousands of fans, it's actually quite similar to presenting a deal in investment committee. You can imagine that. So I just wanted to make that connection for everybody on the online, but no, Professor Foley, great question. The way I would describe it is we'll touch on public versus private markets, but as market sophistication grew, so did investor sophistication. And so where those have really intersected is a lot more capital being deployed in private markets. And a lot of this obviously predates my time, but this is what I've learned in my experiences. But another thing to keep in mind is each investor has their own individual goals. Those goals are usually pretty complex and so we're the private market investor, whether you're a GP, LP institutional investor to make the return profile that you need to get the liquidity that you want or lack thereof with private markets and just the return of capital private markets provides differentiation for that.

And so there's lots of benefits in public markets, but to be square over time, I think a lot of institutional investors realize that there were certain things that weren't cutting it from a return perspective or other factors. And so private markets came in and has pretty much become a larger and larger part of each investor's portfolio. So I'd say in short, private markets is everything that's not public, which sounds a little simplified and we'll touch more on that throughout our time here today. But I think the main point there is that growth in private markets has been driven by the growth in the industry itself, the amount of investors, but also just the sophistication and complexity that's been created as a result of everything.

Victor: If you think in general about... If today you're just managing your own portfolio, your go-to investment tend to be mutual funds, tends to be ETFs that are levered to public markets like S&P 500, which are publicly quoted companies. When you think about the private markets, especially in private credit, what we're really talking about is there are companies that are private that will be maybe owned on a private basis, so not publicly listed, but the debt can be considered somewhat public. So syndicated markets, meaning the debt has an active trading markets effectively for that debt.

When we're really referring, I think, to private markets here in this podcast, it's really this idea of loans that are not going to be quoted. You cannot actively trade the loan. So once you own it, you own it for a much longer period of time. And that market, obviously, to I think the point Anthony has said is that one of the reason why you tend to see spreads in that market be wider than call it the traded market, I'll use that term, is because you get paid for that complexity in solving that complexity. And what you're doing with that private credit is you're really serving to disintermediate what has a market that has traditionally been managed by bankers, the intermediary. Now you go directly to institutional investors who are able to provide capital and solutions that are actually best suited for the company's need.

And I think that is one of the reason why you've seen a lot of that growth in that market is because us being more nimble, like some company, I think to talk to Jess Anthony or Jess Victor means that we can be much more flexible in the solution that we offer versus having to go to all three of us, if not 10 other people, and finding what is the common denominator across 10 people that they will work. So that's a little bit as well, I think, why this market has grown so quickly.  
Stewart: And what do you want to talk about with regard to private equity versus private credit? Are there some points to make there?

Anthony: Yeah, and I think this is a great opportunity to even take a further step back and the way that I would frame up private equity versus private credit and to the listeners that maybe are earlier in the careers in college, I was asking myself the same questions. I sometimes ask the same questions today just given how diverse the industry really has become. But the way I describe it is, and this is on the heels of what Victor mentioned and how I started off everything today, but everyone has their own stock portfolio or most people do. And you can go out and buy stock of Apple. And if you buy one stock of Apple, one share of Apple, you're technically a part owner of Apple. So you are literally an owner of Apple amongst probably millions of other people or hundreds of thousands of people or thousands, whatever the number is. But because you own one stock of Apple and you're owner, it doesn't mean you can come knock down doors and make a bunch of changes to the operations of the business and the financial operation of the business.

So that's where private equity comes in, where private equity is effectively buying the stock of a private company, the ownership of a private company. But it works differently because private equity is buying the outright ownership typically, the majority ownership, so most of the stock, if you will. And then now they're in a position where they can take control of the business, make changes financially, operationally, and governance, meaning management, to improve that business. But their goal is effectively the same, buy low sell high. You want to buy to certain valuation you think is appropriate and sell at an evaluation you think is appropriate. And so I think comparing from the everyday public stock to private equity is a helpful way to frame it.

Now comes in private credit where private credit is just as it sounds, it's lending to private companies and those are the exact private companies I just mentioned in the private equities transaction where the way I frame up private credit to the everyday person is most people own a home or have owned a home in their lifetime, maybe a car as well, but stick into a home, you take on a mortgage, that's the credit side of it, the lending side of it. But you also put down your own cash down payment, which think of that as your equity initially in the home and you're hoping that home appreciates and you repay the debt over time. Private equity leverage buyouts work the exact same way. The L in the leverage buyout is the credit, so think of that as the mortgage provider and then the buyout side is the equity. So that's, I think, how you frame up the differences. And later in the podcast, we'll touch on why you would want to be potentially in one side of that transaction versus the other or both or neither, right?

Stewart: So given this is an educational series and just for whatever it's worth, I learned something on every podcast, there's no doubt about that. And so I have every expectation and I'm going to learn a few things on this one as well. Our world is insurance investors, but your world is pensions, Anthony. How do I invest in private credit? Maybe we'll go to Victor to kick this one off. Can you start us off with actually investing in private credit?

Victor: Again, to the point that Anthony has said, one, what matters the most in private credit and where we specialize at Oak Hill Advisors is really upper middle market private credit, so large cap lending, which is really something that has emerged quite in strength over the last 10 years or so. And what does that mean? That means larger companies that are $75 million and plus of EBITDA, that's effectively where we tend to spend most of our time. There is a very large private credit market as well that is sub 50 million for smaller companies. The growth in private credit has also come from some of these mega companies or large companies trying to source direct funding.

When you think about your choices, and especially as someone that's looking for different solutions, you have to think almost like, who are the different parties? You have the company that's borrowing money or the sponsor that is effectively leading the transaction, which is the private equity firm. You have the lender, which is Oak Hill, and then obviously, you have institutional investors who are picking a manager. From a company's perspective, you tend to go and look for an entity that can be a one-stop shop.

So when we have a relationship, we could get a call from a large private equity company called KKR, Blackstone, Carlisle, wherever it is, being, "Hey, we're trying to buy this business, can you provide financing for it?" And their view is that Oak Hill knows the industry that we're going to be investing. We can underwrite the credit and the credit risk, which we're definitely going to be talking a lot more after later in this podcast. And at the same time, we can lead the deal, lead the documentation, lead the whole process. The thing is it's almost a virtuous... I mean, a beneficial circle is that you need to have scale. And I think that is what you really want is you want to find investors that have scale and that you know also on the underwriting side are going to underwrite with quality underwrites, i.e. pick the winners and avoid the loser, which is a little bit of what we're going to talk after.

Stewart: Okay, that's super helpful. So Anthony, if I'm an insurance CIO or a pension CIO, how do I invest in private credit?

Anthony: Great question and I think that the thing that sets up the question and the answer is really to think about how private credit has become so massive. And we talk about it all the time nowadays how big it is and how many people are pouring capital into it. And if you think about just the roots of it, lending has obviously been around since the existence of mankind. Banks have been around forever. What's happened is over time banks requirements have heightened from a liquidity and capital requirement perspective and just an underwriting tightness perspective. And so that's created an opportunity for these alternative or private credit lenders to come in and take up a lot of the market share, but their capital isn't coming from deposits. Their capital needs to come from somewhere else and that's created effectively what private equity has become on the private credit side where you have a general partner relationship and then they're the limited partner in that relationship as well.

And so what those two terms really mean, general partners are the investment firms, so they're the ones going out finding the opportunities and investing directly in the companies. They're doing all the legwork from the initial screening of the company, talking with management, underwriting the company and the industry which Victor will talk in more depth about, but they're also going to do all the legal documentation and work with the company there. The limited partner has, as the name suggests, more of a limited role in all this where they're finding the best general partners to allocate their money to. And so the job of the limited partner is more about vetting the general partner and what types of investments they're doing, the risk appetite, et cetera.

And so to answer your question more directly, there's two main channels as you heard through that answer to invest in private credit just as there is in most asset classes, you can allocate your money to one or several general partners who have a fund will do private credit investments and you monitor and track those investments as a limited partner investor in that fund or as what's becoming a lot more popular from an access perspective, which is the co-investment market.

And so general partners have created a problem solver for themselves and have created an opportunity to enhance relationships with limited partners by providing individual opportunities to invest in companies and funds. So a general partner will call up a limited partner or several limited partners and say, "We want to do this investment, we want to allocate it across several funds potentially or just one fund and we need more capital, we would like more capital in this fund or we just want to help you as a relationship." And that's created additional access which usually comes with lower or no fees for the limited partners. So the types of private credit is expanded, but the access has really just become deeper and deeper.

Stewart: Victor.

Victor: I think Anthony has hit on a lot of the big points. I think the one other thing I will add is when you think about the private credit markets, I think that's a term that's often used, and again, it's a very broad term. And so if you do a little bit of a deeper dive, there are different areas. You have... One is lower middle markets, so those are smaller companies that tend to not have access to deeper pockets of capital and they need direct relationship. That's where a lot of private credit has existed historically. As you move up into the larger companies and where we specialize in Oak Hill, upper middle market companies, so larger, $50 million up of EBITDA, that's where you start having a little bit of differentiation amongst, one, you can either fund yourself in direct private credit, and within that, that means going to someone like Oak Hill and having a direct loan from us.

Those can really take two forms. And again, you have what you call the sponsor back type of transaction and those are what Anthony was talking about earlier in terms of private equity, what is private equity and their involvement? You tend to have a reasonably sophisticated financial buyer that has a dedicated capital markets and team that's going to go and buy a company. So you're going to have a process that can be a little bit more competitive at times, but effectively going directly to the lenders.

You also have the non-sponsor angle of private credit. That is when you have a company that can be owned by a family, can be owned by an individual and they want to get direct financing and they can also go direct. Those tend to be a little bit more customized because the owner of the business may be very good at running their business may not be as well versed in credit documentation. So that involves a little bit of a different skill set. And then as you move more broadly and even the largest company, you can get what you call the broadly syndicated markets. Those are, again, what I was touching on earlier, which is it is a traded market but it is still private, it is still lending that is done on a private basis, but it is traded and typically a bank, it's led by a bank, and bank disseminates information, but that's how the process works.

The two other things, I think, would be remiss not to touch on is you also have asset-based lending, as well as asset backed private credit, which is a little bit different where you tend to have customized securitization or customized receivable financing you can also do. That's not something we do a lot of. So I don't know, Anthony, if you have anything to add on those categories, but that's the broad spectrum of private credit in different pockets that you have.

Stewart: Super helpful. When you are underwriting private credit, the term that often is brought up is something called due diligence or we had a podcast series that is called Due Dilly, which is slang for due diligence. So do you want to talk a little bit about... And this is really where I want to focus is, can you talk a little bit about or a lot about the due diligence process in private credit?

Anthony: I'll start this one off and then I'll hand it over to you, Victor, but I think the best thing to start off with is many people are potentially newer to private credit and then the due diligence process for private credit, especially for investors looking to enter the asset class. And I think it's helpful to set up how you actually learn about the asset class and what kind of world do you need before you even open an Excel file or a PowerPoint to start analyzing a company.

The good news is today, there's plenty of resources in the digital age even on things like social media where you can learn about the asset class and how to understand the asset class. But honestly, the best way to learn is just by doing and also by networking. Doing is obvious. You go and underwrite the credit and figure it out from there. But personally, I've learned a lot about asset classes and underwriting private credit, private equity, whatever it is, by talking to others and understanding how they go about it. Investing is an apprenticeship business and I think you learn a lot by talking to people internally and externally around you. But to set up your question, Stewart, Professor Foley, I think you got to think about it this way and this is at least how I think about it for my seat when I'm underwriting private credit versus private equity.

As an investor, private credit, you effectively start with the solution and you're trying to find the problems, right? You know what the stated upfront price is and the stated interest rate is on the investment you're making and the returns are relatively within that band of outcomes and you're trying to find the problems through your underwriting process and understand what can go wrong. With private equity, you're trying to find maybe not the problems but the opportunities and then you're figuring out what the outcomes could be based on the outcomes of those individual opportunities to improve the business.

I think by coming in, just stepping in before you even open up an Excel file, I really think it's important to put yourself in the right mindset of you're looking at the upside, you're looking at the downside. That's very important when you open up your process for a private credit deal.

Stewart: That's super helpful. And I think it's always good to get started from the right perspective. Victor, where do we go next?

Victor: Yeah. And I think this is... Thinking back on what Anthony just said, which is super important, is when you do credit underwriting, it's about focus on downside. It is focused on what are the risks that are going to break your loans because, ultimately, the best you can do is you get your money back that you lend plus your coupons. That's the best you can do. In private equity, if you bought Apple or if you bought some small company and 10 extra money or 20 extra money, you can afford more losers. That's not the case in private credit. So you have to be very focused on downside risk and I think Anthony highlighted that.

The question is, how do you become focused on downside risk? And I think you hear that a lot, I think that's thrown out, and what is the actual process? And so what's really interesting, and we also have this training here, is we often talk when we have new people joining is like how do you approach due diligence? Because everyone receives a big presentation with the company. How do you understand and go through the presentation to really dive in and understand, "Okay, is this company good or bad business?" I think ultimately, what you have to first identify is you're trying to first understand, one, what does the business do? And understanding what a business do really requires you to understand how does the business make money, what are the costs, who are the competitors? Who do they sell to? Who do they buy from, right? It's a little bit of this concept of Porter's five forces and where do they sit within the competitive ecosystem that they work?

Now, what does that require? One, it requires as you go through your lender presentation or other presentation that've been prepared digging through and trying to identify, "Okay, what are they telling me about the company?" Secondly, it's about leveraging all the resources you have and, obviously, to the point Anthony, I think, said very elegantly, this is an apprenticeship, this is where my ESL is coming up, apprenticeship business, and you really, experience has a lot of value. And as you see more, as you do more, then you learn more. And I think that is something I hold to heart where I've learned stories from when I started in the US-level finance markets in 2016 where I still remember, "Oh, I should be on the lookout for this particular entity or for this particular problem."

And so that is a huge part, and especially why we at Oak Hill also have an industry focus, is because since I only cover healthcare, you're very in the weeds on what's going on from a regulatory standpoint, what's going on from a competitive standpoint, what's going on from a margin standpoint, how does your company compare versus the peer? And I think that's actually quite relevant and important to know because you want to be able to position that company within the broader ecosystem. The way the actual process works on private credit... And I'll maybe differentiate a little bit versus broadly syndicated loan.

Typically, when you do a private credit deal, you get access to a lot more information. And I think that is something that is beneficial of the private credit landscape is that you can go much more in depth. Because you're directly working with a management team, you tend to be able to have real time with management to ask some of the questions and try to identify the problems. You get access to a lot of detailed financial and often one of the things of going through financials is not just looking about what is margin stability, what is revenue growth, but trying to understand the drivers of it. What does the customer retention look like? What does the customer trend look like? Where are they growing into? That's a huge part.

The other big part that you get access to typically is third-party resources. So what I mean by that? Private equity firms tend to get higher consulted firms like Bain, McKinsey, DCG to basically do these commercial due diligence assessment of the market. So to try to answer a little bit more about what does the competitive landscape do and what those reports typically reflect is Bain or the consultants will interview hundreds of different people across the value chain, customers, former employees, competitors, all sort of a different scope of people to try to understand and ascertain what does the company do or what do they sell and is what they sell valuable to customers, I think? 

And is it more valuable than what the competitors have? So that's a big part of the third party. And then the last one, and I think this goes back to one of, I think, called the other language that finance uses, which is accounting. It's understanding the number and you tend to have auditors like KPMG, EY, or others basically do an assessment and try to value, are the numbers you're looking at real? And I think if you listen to Warren Buffett who always says EBITDA is made up, it is, and I think we're all aware of that and sometimes EBITDA can be inflated.

And so the question is, what is real and legitimate addbacks to EBITDA? What are not real and legitimate addbacks to EBITDA? And what do I mean by that? If a company wants to put in place a cost saving program, there is a question, is this going to be achieved? If you say, "I'm going to replace all of my software and upgrade it to a new software and I'm going to save money," there's a huge cost to that and there's potential for disruption. If you said, "Hey, we used to have two facilities or two offices, one of them was empty so we stopped the lease on the other one," that's going to start flowing through numbers, that seems to be more legitimate and it's all about figuring out what's legitimate and what's not.

Anthony: I think Victor expressed that very nicely. I'll bring in a quick cocky analogy just to help frame up what I'm about to say, but before my first division one college game, one of my biggest mentors reached out to me to help ease my nerves and one of the things he told me was, "Listen, the puck's still around, the rink's still same size, and everyone's still going to disagree with you." And the connection I'll make to that is effectively every financial statement and every model you open up and all the information you're looking at is generally going to be the same. I mean, there's going to be some differences, maybe the accounting and how things are formatted and set up, but everything starts with revenue and goes down to profit and then goes down to cash flow. And so I think for private credit investor, when you're looking at an opportunity, you're looking at several opportunities over time.

One of the things that really helps me is to really understand how the dollar flows through and modeling is a great way to do that. You start with just $1 of revenue, what are the economics in that $1 from a gross profit perspective and then from an operational EBITDA perspective. So from there, you can then derive what the cash flows are and what cash flow implications are. And as Victor was saying, cash flow is the most important thing that we need to understand as credit investors and one of the most important things because we're looking to get repaid for interest and any repayment of principal over time. And so the way you do that is obviously the cash flow of the business. So modeling is a great way to understand the different outcomes of a business quantitatively.

The next thing I'll add, which I think is a pretty underappreciated part of the investment process, is actually what happens after the investment process, which is the post-closed monitoring part of it. And a lot of investors, I'd say, do a deal and then maybe they keep tabs on the company, but I think there's a lot of insights you can glean from understanding what's within your portfolio. Arguably, it's more important than the underwriting process itself because now you're actually in the deal and you're getting so much information, so much data, and what you do with that data can really help you not just in the current but in the future and helping construct a well-diversified and ultimately successful portfolio. So I think that's an important piece of the process as well.

Stewart: So let me ask you some sort of somewhat basic questions. When I taught finance, one of the things that... I mean, at the base level, you're basically discounting future cash flows at some interest rate and that interest rate should be reflective of how likely you are to get those cash flows. So the risk matters. And when we talk about risk in finance, I mean, sometimes we're talking about left tail risk, but really in private credit, we're talking about the risk of losing money, right? A loss. So how much of it is which model I'm using? In other words, do firms have a modeling advantage or is it based primarily on the inputs to a given model? That's maybe a nuanced question, but I think you understand what I'm trying to get at here.

Victor: I think you understand and I think everyone has a different approach there. I think my own view and I think our own view here is that we're very focused on the inputs because, ultimately, to your point about losing money, if a business, let's assume that it generates on schedule, but if the business stays stable, there's going to be value. And if you're really comfortable that the product that you sell is not going to go away, that is a good way to... Again, you can value it however you want, but that is something that is almost a prerequisite condition to the not losing money in private credit. And I think that is a very important component when you talk about left tail is that that input, that understanding of the stickiness of the value that you have is critical.

I think the problem is, and I think we can all have our debates, Anthony said it as well, understanding how the profit flows and the modeling is super important. I often say projections aren't very useful, but projections at the end of the day no one is going to hold you to is your number that you put in seven years from now, true or not, and I think we can all agree that estimating something seven years from now is incredibly difficult. That being said, writing and putting pen to paper to trying to understand why did you put that number there and what do you need to believe to get there, I think, is super important. And then it's a question of your degree of confidence. I think there's often a question of what makes a good business, what makes a good investment. I do think that if you can really understand the risk return and narrow and have a high degree of confidence around that investment horizon, that is how you really can get comfortable with an investment.

Stewart: Super helpful. So anything to add on the post-close monitoring credit metrics M&A before we move on to distressed and restructuring?

Anthony: I think it's a good segue. The whole point of monitoring, especially for a credit portfolio, is to limit surprises. The less surprises you have of negatives and honestly sometimes even positives, that's the first goal is to limit those surprises and be able to get ahead of issues and potentially if you have a seat at the table to exercise that right. But then like I was saying earlier, the information you can get from a portfolio, especially if you have a larger portfolio, there's a lot in there that you could understand internally as to what types of industries you might prefer, types of capital structures and honestly lessons learned both on the good side and the bad side, but then also looking forward where else you could potentially deploy. So Victor, go ahead.

Victor: No, I totally agree with that and I think one of the obvious things with private credit, which makes things sometimes why the underwriting is so much more, call it, intense at the beginning is because if you have a broadly syndicated or traded loan, if your thesis changes because something happens, you potentially can sell your position. If you're in private credit, you're in the investment for a much longer period of time. And so that's why you need to get it right at the beginning, because if regulatory changes hit that really impact your business, you're not going to have the ability to go turn around and find a seller. And by the way, if you turn around and try to find a seller, it will be a very, very, very low price because of what you fear was going to happen.

In broadly syndicated land, you can monitor the situation a little bit better and be more aware and then try to predict and then try to get out ahead of it or manage it, which is just also a little bit of a difference when you think about underwriting private credit to your point, I think, Stewart, that you asked earlier versus some of the more liquid markets that are out there. But I think Anthony hit on the right, you do not want to have surprises. And especially in private credit, you hope that you don't have surprises after you did the original underwrites.

Stewart: And just going there, what leads to distress most often? I mean, we've had a period of a significant increase in interest rates over a reasonably short period of time and I know that that can create financial distress where the circumstances under which you lent changed and there's also with technology and what's possible changing businesses go in and out of favor. So what usually leads to distress in your mind and what's that process like?

Victor: I think you just said something that's super important and I think there is two types of distress. There is financial distress, call it, and then there's structural distress. The thing you want to avoid at all costs is structural distress because that's how you really lose money. If you had a business that was, I don't know, printing bills and that were call center business for telephone lines and you had a massive business there for years and then suddenly technology changes and everything goes to chats and that goes away, that's how you lose a lot money and that's what you want to avoid at all costs.

It's really where there's more correlation between equity and credit risk. What causes a lot of distress, I think, in general and I think investors are pretty aware of structural and non-structural, but what tends to cause a lot of distress from what we've seen is really that financial leverage. So there's two things that happened. One is in a period where rates went from zero to 5%, the impact the cash flow has been significant and that just meant that some companies just run out of money and that's a problem and you need to address it.

The other thing is you have businesses that can be more cyclical in earnings and you tend to want to correct for that cyclicality by adjusting your leverage. So if you're a commodity business or a miner, for example, where you have boom and bust cycles, you'll control for the peak and trough and try to figure out at what point in the cycle you are when you provide the financing. The problem is it's not always apparent whether you're at a peak or a trough and you have to be doing your work to the point of financial work to figure that out. But I would say it's really those two things.

It's maybe the company had too much leverage on too high of an EBITDA and EBITDA came down because it was cyclical. Maybe it was because, to the point Anthony said before, there wasn't enough cash flow and part of the thesis was the company could have grown a little bit maybe and you felt really, really good about the growth and it didn't grow or sometimes you can have also what just happened over the last three years, this period of great inflation where suddenly all the costs were going up dramatically and you couldn't really pass those costs on to your end customers.

And so that also creates a strange dynamic where if sometimes you get this massive amount of margin erosion, just because you set a three-year contract, you set it in 2020, all your costs went up in '21 and '22 above what you expected and suddenly you have an issue. So I would say those are the real factor and the biggest one is financial... I would say the bigger one that you see in general is that second part, that tends to be controllable and I think then you have to ask the question, to Anthony's point about monitoring, is that, one, is the thesis still intact? Did margins go down or did EBITDA go down because they're explainable factors and I still believe or am I starting to drift into the structural item? And I think you have to adjust and that tends to also impact how you're going to negotiate and approach the problem.

And I think it's a good segue as well into the question, I think, that is posed as well as like, what do you do when distress happens? Because inevitably, it does happen for companies. And the question is, how do you address it? And I think if you think you're drifting really in the financial distress, the nice thing about private credit is you have a direct relationship with the sponsor. You have a smaller group, so people tend to be more cordial to each other and tend to work together to try to get to the best outcome. Whether that be the sponsor puts in new money, whether that be you pick some of your interest, meaning you pay it in kind, you capitalize the interest versus pay that out in cash.

Those are different options that you have to try to come up to a solution that is beneficial for everyone in the capital structure. Because, ultimately, if you look at syndicated markets, for example, you have seen historically more aggressive liability management move that move lender on lender. There's a lot of cases out there, sort of the envision. These are transactions that happen where some lenders got massive benefits and others were basically hurt as a result of this transaction. And so in private credit, you tend to have more of a collegial people working together to come to the right solution and also assess, what do we do if we think it's drifted towards the structural reason is going to be very different than, "Hey, let's work with the company and try to provide more flexibility," because we know it's just a cycle thing and, ultimately, we can get to a solution where everybody is helped out.

Stewart: Victor, that is super helpful. Anthony, anything to add on that?

Anthony: Not really. I think Victor expressed that in a lot of great detail. I'd say private credit terms change over time. And when you think about one of the terms that Victor mentioned, which is financial leverage, you think about debt to EBITDA, that's obviously a very important metric because that shows you what the debt load is on the business, but in and of itself, it only tells you one part of the story. Equally, as important, if not more important, is also looking at loan to value, which is effectively how much debt you have over the valuation of the company. And just like I said, private credit terms change over time, valuations do too. And so if you have a business that cuts its EBITDA in half and you were five times levered on a 10 times business, well, if you use that same valuation metric and leverage hasn't changed, you could be underwater.

And so it's really important to understand both the L part of the equation and the V part of the equation as well as obviously the operating performance of the business. And the last thing I'll mention, too, is when you're doing private credit investing, you're effectively signing onto what legal contracts called a credit agreement. And much of what Victor said is houses itself in that credit agreement where there's certain things that the borrower has advantages and disadvantages and the lenders have advantages and disadvantages and it's really important for a private credit investor to have sound due diligence and understanding of both sides of that transaction and understanding what can and can't be done.

Stewart: Super helpful. In just wrapping up here, what about the future of private credit and the why?

Anthony: I think it goes to a lot of what we talked about upfront, which is, what is private credit and why has it grown so much? Why do institutions invest in it? Why has there been a growth in private capital lenders? If you really think about it, private equity has been a large part of plans over time. Private credit's joined along the way. And I think if you think about where in the capital structure you're investing, we talked about private equity being long-term capital, you're locking that liquidity up and getting it in the future. While private credit provides, while you can't necessarily trade in and out of it efficiently, it does provide returns along the way. And I think a lot of private investors or institutional investors that invest in private markets really appreciate that return profile where you do sacrifice a little bit of return, but you do get more coverage being higher in the capital structure as well as returns over time.

On top of that, you think about how capital markets have evolved, and we touched on that earlier, credits evolving, too, and traditional direct lending is just one type of credit exposure on top of maybe investment grade high yield or other types of public/safer types of credit. But we talked about earlier, and Victor touched on some of these, but asset-based lending is another one. Special situations, opportunistic investing to companies that need capital needs. Those types of investments are continuing to grow and innovation capital markets will only continue, especially to think about just intermediate trends with elections and credit cycles and supply chain disruptions, those are more recent ones, but over the long term, things to consider with technology and industrial shift and also just investor sentiment. So private credit, I believe, has a lot of room to grow and a lot of room to change and I think investors ought to embrace that because there's a lot more runway to come.

Stewart: That's great. How about you, Victor?

Victor: No, I completely echo what Anthony has said. I think private credit in general solves a lot of complexity issues, whether it's the structuring and the legal terms that Anthony mentioned that you can do with one person, the financing you can do with one person and then when things go bad, the flexibility to deal with a smaller group of lenders, I think, is key for the issuer. And I think as a result as well of the lender solving all of those complexities and making it easier, you end up getting enhanced return. And I think that combination makes the whole package very attractive from a return standpoint as well as demand standpoint on the side of the lenders. And I think one of the stats I saw is that 80% of all LBOs or so are financed with private credit these days. And I think that tells you a lot of why and I think it is because of that complexity being solved.

Stewart: And I do think it's a great match for a lot of the liability structures that the insurance companies need to manage. So great education today on the underwriting private credit and appreciate both of you very much for taking the time today. Just real quick, I usually ask for advice at this point, but what I would say is what are you looking for, particularly you, Victor, when you're looking at hiring a new associate at Oak Hill Advisors? What skill sets are most important?

Victor: I think for me, it's two things. It's to be curious because we talked, and I think Anthony said this, it's about finding problems. And so it's always about asking the next question. It is about, "Oh, I got these set effects, what does this mean?" And always going one step further and that, I think, curiosity is super important to drive, I think, thorough analysis. I think the second thing is ultimately, and I think it's a pretty broad term, but I will say really it is caring. It is about loving what you do and being passionate and wanting to get the right answer because that just means that when you do care, you end up doing everything, I think, a lot better. And I think that's something that you can tell, it's not really a metric space, it's just really does someone really love what they do? Do they really want to do the best possible job? Because ultimately, I think that's what's going to drive a lot of excellent underwriting and excellent work in general.

Stewart: That's perfect. So, okay, last one, fun question. Table for five for lunch or dinner, the two of you, you can pick one guest a piece and then you got to agree on one, alive or dead. Anthony, who's your lunch guest?

Anthony: Can I say Professor Foley? Is that a good answer? I'd love to have lunch with you.

Stewart: You know what? You're the first person out of 265 podcasts that actually named me, so I'm thrilled with that answer. Anthony.

Anthony: I'll take it.

Stewart: Thank you so much. I appreciate it. Thank you.

Anthony: I'm sticking with it. Yep.

Stewart: I'll be happy to go. How about you, Victor?

Victor: I'd probably take Warren Buffett.

Stewart: Yeah. He's got to be our number one answer and I understand why.

Anthony: And that's why I didn't want to pick him because I feel he is the number one answer.

Stewart: You know what the thing of it is, I was fortunate enough to work for a firm that was owned by Buffett and I had a chance to spend a couple of two-hour sessions with a relatively small group of people and he is a fascinating guy. He is really, really, really bright and he has a really interesting way of simplifying complicated things into simple terms. And so I'm 100% with that. Is there anybody that you guys want to agree on as a third party or are you happy with where you are?

Anthony: You know what, I'll start it off. And Victor, you could push back or agree. I've always thought the position of a general manager in sports, and there's several ones that have been very successful, has a lot of similarities to investing where you're picking new players, you're managing existing players, it sounds like portfolio management. And not to stick it to finance too much, but I mean there's some really successful general managers over the years. Scott Bowman with the Detroit Red Wings won several Stanley Cups. Brian Burke worked across several organizations. Those guys just come to mind as having at least some level of success in their professions as general managers and I think there's so many synergies between investing and sports management, honestly.

Stewart: It's so true. Tom Ricketts is the one that comes to mind. The owner of the Cubs.

Anthony: Yeah.

Stewart: He's a UFC guy. They do fundamental analysis and they price... That's exactly what they do. So it's been great to have you both on. I want to say thank you very much. We've been joined today by Victor Debenedetti, who's principal at Oak Hill Advisors, and Anthony Vikhter, senior investment analyst at Missouri Teachers. Guys, thanks very much for being on. It's been a pleasure to have you.

Anthony: Thanks a lot, professor.

Stewart: You bet.

Anthony: You being on.

Stewart: Absolutely. Have a great day, guys. Thank you. Thanks for listening. If you have ideas for podcasts, please shoot me a note at Stewart at InsuranceAUM.com. Please rate us, like us, and review us on Apple Podcasts, Spotify, Amazon, or wherever you listen to your favorite shows. My name's Stewart Foley. We'll see you again next time on the InsuranceAUM.com podcast.