Animal Spirits Podcast - Talk Your Book: Investing in Private Credit 

Episode Date: October 10, 2022

On today's show, we speak with Michael Reisner, Co-CEO of CION Investments about investing in private credit in this environment, how CION can be publicly traded, how a recession may affect floating rate credit investments, and much more. Find complete shownotes on our blogs...  Ben Carlson’s A Wealth of Common Sense  Michael Batnick’s The Irrelevant Investor  Like us on Facebook  And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.  Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Scion Investments. Go to cyaninvestments.com, that's C-I-O-N, to learn more about their diversified credit fund and their publicly listed BDC that focuses on senior secured debt. That's cyaninvestments.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson, work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be

relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. Michael, we've talked to a handful of companies now that effectively are lenders and they're doing things that the banks either don't want to do or just don't do anymore because of financial regulations. So we talked to a company like Ground Floor who's doing loans to real estate companies that are building homes. And today, we talked to sign investments. And one of the things that they do is they do middle market companies, which you ask the question, what is middle market? I honestly don't know if I would have been able to answer that. I guess it's mid-sized

businesses. The way that I thought about these companies, these are not small businesses. However, they don't have access to public markets. They're not able to go to Morgan Stanley as an underwriter. And so they need companies like Cyan investments and the other sort of big players in the space that might go even a little bit upstream further. So I don't know where the line is with middle market, but these are, I think, what do you say, $50 million in EBIT? These are big companies.

Big-ish, but that's still small. So I guess you have regular huge corporations, Apple and Amazon and Microsoft, I can essentially just do their own corporate debt. they pay a very small spread to treasuries. Then you have little riskier ones. And you have high yield debt. And this is probably a different step from high yield. But it's just because they're smaller companies. So this is effectively, I don't know if you want to call it small caps or microcaps essentially. And it's just harder for them to borrow from the banks these days, which it seems kind of crazy to me that banks don't want to play in this sandbox because that they couldn't do

their credit checks. I don't know if it's regulatory. I don't know if it's that they don't want to or I don't even want to speculate. I really don't know. But there's two things to consider, I think. with these investments. There's one, the underlying holdings. And because these are publicly listed, there's full transparency, you go to their site and look at everything that they've invested in, all of the companies that they want money to geographically, revenue, all that sort of things, industry, everything like that. But the other thing to consider is the nature of the rapper. And these things trade very much like a closed end fund, where depending on investor enthusiasm or the opposite, which is where we find ourselves today, they could trade at a discount. So I asked

him 15 plus percent yield, that sends my antennas up a little bit. There's a reason why something's yielding 15 percent. And what he mentioned was one of the reasons why it does that, it's not 15 percent on NAV. But this fund is trading at a discount, pushing the yields of, call it, eight, nine percent, up to 15 percent, which makes sense. And that's an interesting thing about understanding these investments is I know certain people who still playing that closed-end fund space, which it's a much smaller space than ETFs or anything, obviously. They've been or on for a while. But they kind of track these premiums and discounts to get a better sense of when this stuff is over or undervalued. And a lot of times those discounts can get even

larger than you assume. But I think that's the kind of thing you have to understand before investing in something like this. Oh, that's a good point with the discount of premium as opposed to like measures of overbought or oversulled indicators in the stock market. This is a pretty explicit way to measure that. It's a sign of risk tolerance. I would say, yeah, that when things are going to trade for less than their net asset value, when people are just really scared and don't want to take a lot a risk, which kind of makes sense. So here's our talk with Michael Reisner, who is the co-CEO of Sion Investments. We're joined today by Michael Reisner. Michael is the co-CEO of Sion Investments. Michael, thanks for joining us today. Thank you so much for having me, guys. We appreciate it.

Give us a little background on Sion, what it is you do and maybe what you do for the firm. We know that you guys are affiliated with alternative investments, but what exactly is it that you do and who do you work with generally? My firm is Sion Investments. I am co-Cio of Sion investments. We kind of view ourselves as kind of a solution. provider, open architecture for alternatives. We believe we're probably in a second inning of retail investors accessing alternatives. Here at Sion, we're an integrated alternative asset manager. By doubt, I mean, not only do we have an asset management team where we run our own fund, but we also have a distribution team where we raise retail capital through independent

broker dealers, through RAs, and through the wire channels for all these firms that we partner up with. Is this explicitly for retail investors via an intermediary? Yeah, so right now we have two primary funds. We have raised institutional capital for our student housing strategy. But right now, we have a business development corporation, a BDC called Cyan Investment Corp, which I believe is the 15th largest publicly traded BDC. The ticker is CION, strangely enough, on the New York Stock exchange. And we also have a fund, which is an interval fund, and we can talk more about that, which is called Sion Aries Diversified Credit Fund. That fund, we partner with Aries Management. They are a large alternative asset manager of about $350 billion. So we partner with them on

that strategy. So the BDC, we do ourselves, we do it in-house. We didn't have all the expertise in-house to do a diversified credit fund. And by that, I mean BDCs focus on the U.S. middle market primarily, our diversified credit fund. We focus a lot more not only on U.S. middle market, but European middle market, broadly syndicated loans, bonds, CLO, debt and equity, a lot more diversified depending on where the relative value is. And as we go forward, we're looking to partner with other institutional asset management firms. So I think a lot of people in our audience might not be familiar with what a BDC is. So why don't you start there from a broad level. What is a BDC and what is exactly that you guys are doing in that security?

Business development companies was created back in 1980 by Congress to encourage investment in the U.S. in the market. By statute, 70% of the assets in the BDC have to be either private companies in the U.S. or publicly companies with a market cap of less than 250. I believe the original intention was to act more as almost a venture capital firm, to provide capital to these companies, to provide them financial advice. So even though they've been around since 1980, they really became a lot more popular, probably after the global financial crisis. When banks started or stopped lending as much as they were, and obviously going through what we're going through right now, you're seeing the curtailing of lending by the banks, where it's really a fund. Think of almost

like a mutual fund, which is governed by the 1940 Act, but it's a little bit different. It'll allows certain types of fees to be taken by the asset manager, certain types of leverage, i.e. more leverage than a typical mutual fund, if the asset manager invests in the U.S. middle market. So as we sit here today, our BDC, we have something like 150 diversified companies all in the United States, all middle market. We invest in the senior secured loans of those companies. So companies that need financing, that 10, 20, 30 years ago, may have accessed their local banks or even some bigger companies that used to access Wall Street in the broader capital markets. With that kind of being closed right now, they need alternative

sources of financing. On the other hand, you have retail investors who for many years have been shut out of high yield direct lending opportunities. They always thought of bonds as a way to get credit. These retail investors, obviously thirsting for yields, could invest in a BDC. The BDC manager then takes that capital and makes, hopefully, smart investments in the loans of companies. Certain BDCs are different. There are venture BDCs out there, venture capital BDCs that do highly speculative loans to high growth companies. There are BDCs that go down the capital stack.

And by that, I mean, do second liens and designate-type debt and equity to try to get higher yield. Our BDC, we are, again, rightly or wrongly, sometimes people think we're too conservative. We are very conservative. We're a fairly low lever. We are over 90% senior secured and floating rate, which floating rate means obviously as interest rates rise, we charge our borrowers more and then we pass along that income to our investors.

Can we talk about where that yield comes from and where the tipping point is off? So floating rate securities have done very well this year because credit has done fine. There's been very little in the way of bankruptcies. But if I'm looking at this right, it looks like you've got a distribution rate. of 15.7% as of the end of September, which red flag might be a little bit too harsh, but that's a high yield. How are companies able to service that debt? Or is that high yield coming because you're using a decent amount of leverage? It's a good question, Michael. It's a little misleading. One of the reasons our BDC is giving such a high current yield is because it's

trading at such a discount to NAV, which your listeners out there compare our BDC. And by that, mean, look at our holdings, look at our default rate, look at our leverage, look at our non-accruals. And by that, I mean, the borrowers that aren't paying, we compare extremely favorably to a lot of other BDCs that are out there that are trading at a higher multiple compared to the NAV. So obviously, we're almost 95% retail investors. Retail investors, they tend to sell when they shouldn't buy. That's wrong times. So we have a lot of panic selling.

We think we're very oversold. and thus we're given a high dividend. Our dividend rate on NAV, if we're trading at NAV, is closer to that, I think, 8.5% number, not the 15% number you mentioned. But yes, a couple of things. We do utilize leverage, absolutely. Right now it's about one to one.

So for every dollar of equity, we borrow a dollar, and we juice up the yield that way. But also, again, a lot of the companies that we are lending to, you've seen obviously LIBOR and so far go up, A lot of these companies are fundamentally good companies, but they're bearing the brunt of higher interest rates. They can't access the bond market because in many instances they're too small. They can't access the broader capital markets. And by that, I mean they can't call Morgan Stanley or Goldman Sachs and do a broadly syndicated loan.

So we're able to get good companies, we think. We're top of the capital stack. But yes, if I saw somebody trading at 15% and it was at NAV, there'd be some alarms that would go off in my mind. that's not what we do. So this is effectively like a closed-end fund, though, in a lot of ways. Because it has a high yield, there's some leverage and also it can trade it a premier discount. Correct. And that's a way to think of it.

It's certainly a fund. It's a fund that our fund is traded on a daily basis. There's certain technical distinctions about the types of assets that can invest in. Like most people, when they think close-end funds, they think ETFs, they think of securities that have a Q-SIP. They're not necessarily direct loans. And by that, I mean, we sit down across the table, we and or a couple partners directly with our borrower, negotiate the document, negotiate covenants, negotiate the structure. But essentially, for your listeners, it is another fund, another investment out there.

But again, we call it kind of an alternative investment because for many years, retail investors have been able to access these types of direct loans to middle market companies. It's always been the bigger institutions that have done that. But that's an asset class that's growing immensely. And I think especially the environment we're in right now where banks are getting stuck with loans. You're seeing loans that are hung in the market and banks are taking losses. We as a BDC and other BDCs out there, we buy and hold. We originate to hold to maturity.

We're not reliant on the broader capital markets or insurance companies or CLOs to buy our participations. So it is a fund. We consider more of a alternative fund, more of a fund. diversifier or a portfolio diversifier, I should say. So these loans that we're talking about sitting near the top of the capital stack. These are senior secured debt, the overwhelming majority of the portfolio. But my question is, you keep mentioning middle market. How should we think about the size of these companies, whether it's EBDA or whatever

metric we're talking about? Sure. So another good question. The EBITDA of a lot of the BDCs of which companies they invest in, it's public information. Hours, we are around 50 million of EBITDA. will go as low as 10 to 25 and as high maybe as 100 to 150. Traditionally, middle market was the level which a company was fairly sizable, but a $50 million EBITDA company could have $300,500 million of revenue.

They were still too small to access the broader markets, the capital markets, the syndicated markets. That definition is obviously changing now as you're seeing bigger and bigger companies go up market. And by that, I mean, you see $100 million, $200 million, $200 million. companies going after BDCs for their financing. We don't go after there. We're playing in what we consider the traditional middle market, which is around that 50 million, even that number. These are very diverse investments. I'm just looking at like the allocation by industry. You've got services and businesses and healthcare and pharmaceuticals and media and consumer

services and financials. And it's really a wide swath of companies. You've got retail in here. Who are you competing against? Because I understand that the giant banks that are giving out loans might not be operating in the space, but there's lots of alternative credit companies out there. How do you think about competition and securing these deals? Obviously, everyone's got competition. I like where we play. And by that, I mean, some of the bigger players in the space, the Apollos, the Aries, the Blackstones of the world, their BDCs, they have so much capital that for them to put

it to work, they have to go after the banks and take market share from the banks because they have to put $100,000, $200 million, $500 million to work. At $2 billion of assets, our BDC could be a major player in that kind of a small end in the pond, the middle market. There are certainly other BDCs out there. I think there's something like 60 or 70 BDCs, business development companies out there. We think we're one of the better ones. We think we're one of the larger ones in that space.

There are other BDCs that we go against. There are other just credit funds. You're seeing more and more traditional asset managers, maybe ones that have always focused on private equity or in real estate now get into the credit space. don't necessarily do it through a BDC wrapper. They do it through just a typical LP funds. So we run into those as well. And there are obviously relationships with some banks. So there's no doubt there's competition. But we kind of like the fact that we could be the strategic player because we have a big enough fund to be relevant to those middle-sized players.

Michael, how should investors in this fund think about risk? So I guess if you're talking about yield, some of the risk could be interest rates continue to rise, inflation continues to rise, maybe the economy slows. Should investors think about this kind of fund structure like a high yield in terms of if the economy goes south and some of these loans might go bad and spreads could blow out, that kind of thing. So how do you think about risk when you talk to clients about investing in something like this? Listen, I think every investment has a risk once you're just doing kind of treasuries. What we think obviously interest rates doesn't necessarily scare us because that passes through the higher interest income that we connect in order to the benefit of our retail

investors. That being said, we have to make sure our companies can pay the rising interest. We think we've personally done a very good job in asset selection. We have a 10-year track record to prove it actually with low defaults. We're high on the capital stack as we've discussed, which means if someone is not going to get paid, we're the first to get paid. It's equity, then junior debt, and then us. But listen, a prolonged recession is something that could concern everybody. However, going back just a couple years ago, the pandemic, where essentially the world stopped for a couple months, we survived fairly well. And the reason for that was we think we fundamentally picked good companies.

If you pick a good company with a good owner, preferably a kind of a private equity sponsor backing them, you can work with them. They'll put some money in to get through the tough spots. we can work with them and lower our payments temporarily, restructure things and collect something on the back end. And that proved out during the pandemic. And it's worked out fine. So listen, I think there are definitely risks. We have this fund. We have the other fund. You always have to look at the asset manager. And by that, I mean, too often we hear, oh, I already have BDC exposure, or I already have an integral fund in my platform, or I already have a wheat. They're not all the same.

That's like saying, I already have a stock. No one would think that. Everyone makes up an individual stock security individually. Sometimes people lump all these alternatives together. So at the end of the day, it's about a credit fund. It's about credit selection. You're never going to drive huge returns in credit, but you have to avoid the mistakes. We do think not only our BDC, but the whole sector is a little bit oversold because people are somewhat panicking because of what they're perceived as a pending recession.

But again, a lot of these companies are still doing fairly well. from free cash flow coverage. They're not as levered as maybe they were in other cycles. And fundamentally, we think we're going to be okay, assuming it's a typical recession, let's say a 12 to 18 month correction. One of the obvious risks is just price. This thing trades like a stock. It's down almost 40% from the highs. So this is not a bond, even though these are debt instruments. This thing trades very much like a stock. I'm more curious about the actual business risks because with floating rate loans and rising interest rates, surely there is a tipping point. I don't know where that may be, but what if rates get to a level that would be punitive

to your company, but there's not enough spread for you? How are you all thinking about that potential nightmare scenario? So I'm not sure I fully follow because some of our leverage is floating rate. We have more assets than we have floating rate leverage. So we left. So we left. money, we just have to make sure our borrowers can pay that rising interests. That's the tipping point. It's not necessarily at our fund level. It's if we have 150 borrowers, what happens if the interest rates get so high that they can't make the payments? That is the real risk, I believe, in a fund structure like this, where we flow through the income that we collect to the retail investors. But because we have more floating rate assets on the left side of the balance sheet than

we have floating rate debt, we're not as concerned about that, and because we have a lot of confidence in our credit selection ability. Now, you raise a good point, though, there's also the risk for the investor who bought us at a 20% discount, and it went back to a 40%, went down to a 40% discount. At some point, I believe markets are efficient, and I believe people are going to look through our portfolio and see that they were oversold because that fear has not come to fruition. We don't have a spike in defaults and things of that nature. But you do raise the point about, you do have this other fund.

and other alternatives that are non-traded. Our credit interval funds, by being non-traded, it means the investor is always getting in at NAV, and they're always getting out at NAV. So there's different risk rewards. So there are people right now that may want to jump into our BDC and get it at a discount and collect that nice double-digit yield that you alluded to earlier,

and hopefully there's a bounce back in our stock price. On the other hand, there might be people that don't want that volatility, and we'd like to go to a financial advisor and say, how about a diversified, not a BDC, a diversified integral funds that has assets across the credit spectrum, but I know I will always get out at NAV. Always get in at NAV, always get out in NAV. So that's kind of the value proposition of the non-traded market,

which we've seen kind of explode here in the last three to five years as well. Let's talk about the credit fund a little bit. Maybe you could just kind of compare and contrast. Obviously, it looks like that one has a much lower distribution yield. So maybe you could just talk about the credit fund and how that differs from the BDC? As I mentioned before, BDC, by statute, it has to be in the U.S. market.

And one of the reasons BDCs have become so popular and credit funds in general have become so popular is the asset class, quote, works. It kind of survived the global financial crisis and survived the pandemic. There's some pretty good risk-adjusted returns out there. But the way we view that, a BDC, it's a sector-specific fund, that sector being the U.S. middle market. And we thought there would be an opportunity to have some. something broader, more of a core holding for somebody that wanted to have a broader collection

of credit assets, i.e. not just U.S. middle market, but maybe European middle market. We can talk about bonds, whether they're good or bad. There are times they are good, there are times that are bad. But if you're a hammer, everything's a nail. If you're a BDC, you have to do U.S. Mount Market. Are Sion-Aries diverse by credit funds, where it's basically a go anywhere across the credit spectrum, wherever the best relative value is. It's going to be lower lever, it's going to be more diversified. It might not see as high of a distribution rate, but you'll probably see a lot better sharp ratio, a little bit lower volatility, because it's not going to be traded. And at any given time, the U.S. middle market may be great. There may be a great bond

of a company that's traded at 75 cents on a dollar. And BDC traditionally don't do bonds. Now, a bond at 75 cents on a dollar, two things could happen if it's a good company. If it's a good company, it'll eventually pay off at par. Or, God forbid, we talked about this, they have to reorganize and go bankrupt. You can take over the equity of that company and restructure and get even a higher yield. So again, we partner with ARIES. Here at SIA, we're focusing more on private credit, direct landing. We partner with ARIES, which has more of a diversified and deeper breadth and depth credit platform than we do. We'll take advantage of dislocations in the high yield market and the international market as well. At the end of the day, we consider alternative

investments, both credit investments that we think deliver a little bit better risk-adjusted returns than just your typical bond funds that most financial advisors out there kind of gravitate towards. Can you talk about some of the differences between direct credit and alternative lending or private lending? I can't remember what you called it. I'm using them synonymously. Other people might have different definitions. The way I view it is, again, the way the traditional credit market worked was a company would call a bank. And a bank would, my bank, I mean, again, the Morgan's Stanley's and Goldman Sachs is of the world. And that bank would say, yeah, you know what, we'll go out and raise this money for you. They'd put a book together, maybe have a conference call

with a couple potential partners, and they would look to syndicate it out to insurance companies and pension funds and CLO managers. And the bank would look to make a market and trade the security and maybe clip a point or two on the origination. And that was kind of the way the capital markets worked on the debt side. And that has kind of started to change. It's definitely changed, but it's going more and more up market, where now you have more of a relationship, where the bank is now, instead of going to a banker to syndicate a loan, is actually contacting the person who's going to hold his loan and originate the loan themselves. So again, when it's direct, when it's private, by that I mean not multiple participants. There's not going to be an active,

the traded market in the security. Security is never going to trade down theoretically to 70, 80 cents because there's not going to be any panic selling out there. So what you've seen now with going on in the banking environments, because of interest rates going up, everybody is repricing risk. There's people out there, there's bankers out there that said, sure, I will do your loan at 6%, 7%, and then they get through all the documentation and all of a sudden they can't get that loan done at 7% because the people who they thought they were going to sell it to,

no longer want it at 7%. They want it at 8%, 9%. And if you're a CFO of a middle market company, it's a tough way to do business. You want some certainty. You don't necessarily want your loan rated. You want to know if things get a little bit tough. You know the person on the other side of the table.

That's kind of what I mean by direct lending. Traditionally, it's been a higher yielding product, but it's defaulted less. It's recovered more when it has defaulted because of covenants, because of tight and structure in the documentation. Can you talk about the interval fund structure? What does that look like in terms of reporting and liquidity and things like that? Interval funds, you and your listeners should think of it as just like a

mutual fund, which is governed by the 40 Act, everything, all the bells and whistles, the structure of a mutual fund, except for one difference. The liquidity is given at certain intervals. So it's not like an open-ended fund where you've got to run out the bank where all the investors get their money out, not a close end that's traded, where you have the share price volatility we spoke about. Every quarter, and in our interval funds, it's limited to 5% of the outstanding shares can be redeemed. In our five and a half plus years, we've never had to gait that. Everybody who's always wanted out has gotten out. But what it allows an investment manager to do when they have the confidence to know that there's not going to be that run out the bank,

that they're not going to be a forced seller. They could invest in assets that have slightly longer duration and take advantage of the, quote, illiquidity premium. So one of the things we talked about, I guess, the last question, direct lending private credit, bespoke bilateral, one party, two party, three parties. There's no active market. It's often difficult to get out of that loan.

You can't just call a market maker at a Morgan or Goldman or JP and sell it. So by doing credit in an interval fund, you're able to allow the investment manager, and in our case, Ari's management, to take advantage of that illiquity premium and invest in certain interesting opportunities that they may otherwise have not been able to invest in a different wrapper or a different fund structure where they'd have to be fearful of being a for-seller. And again, we're seeing this right now. There's a lot of asset managers that love the dislocation in the market. They love it.

They want to go out and scoop up assets at discounts. But on the other hand, they never know whether their clients, whether they're retail or institutional, are going to be panicking and saying, give my money back. So it really kind of puts one arm behind the investment managers back. And we think in our integral fund, but in all internal funds, quite frankly, it does allow an investment manager to invest a little bit differently and seek a little bit higher yield or a higher risk-adjusted yield, risk-adjusted return, if you will, in that structure. Michael, given these different fund structures, what are the fees on both of these funds?

They're lower than the typical institutional structure. I think in our BDC, we're 1.5% and 15% over 6.5% yield. And our interval fund, I think it's 1.5% 15 over 6. So that incentive fee is solely on income. So by that, I mean, there's no capital gains fee that we're seeking in the interval funds. It's solely based on NII, that interest income. So if we're creating a lot of excess income, we get to take slightly more fees. The beauty about the interim fund, because it's a 40-act fund at a mutual fund, there's an expense ratio.

Both these funds are highly transparent. You know, our BDC, it's a company, it's a public company. There's 10 Q's and 10Ks. The Ineral Fund, they publish a semi-annual report and an annual report with all of our holdings, all the expense ratios, and investors are able to compare. They can see for themselves. And hopefully, the fees that might be slightly higher than we'll take. at 30 basis point ETF or mutual funds, hopefully when the investors look at our returns

and the sharp ratio and the lack of volatility. Michael, if people want to learn more, where can we said that? Sure. So our website, signinvestments.com. We also have a standalone website for our BDC, cyanbdc.com. But both sign investments and sign BDC will, sign investments, we'll talk about our BDC as well as Interval Fund and other hopefully alternative products will be breaking it out. And Cyan vDC will have a list of our holdings, our most recent public information, and things of that nature. Michael, this is great. Thank you so much for coming on. We appreciate your time. Thank you, Michael. Thank you to Cyan Investments. If you're interested in learning more, you can go to Cyaninvestments.com. Send us an email, Animal Spiritspot at gmail.com,

and we'll see you next to you. Thank you.