The Dividend Cafe - How Heavy is this Shoe?

Episode Date: March 1, 2024

Today's Post - https://bahnsen.co/4cbq1G7 This last week appears to (as of Friday morning’s press time) not been a particularly active one in equity markets. The Fed had no big announcements. Bond yields barely budged. Earnings season is very close to complete, and companies doing reporting of results have become few and far between. We are in a market news cycle lull, which is the perfect time to talk about alternative investments. “Huh?,” you ask. “What does the news cycle have to do with alternative investments like private credit?” All will be revealed. But in the meantime, I guess I should clarify that I never believe Dividend Cafe should be tied to a particular headline or market event. I may choose to do so here and there. But even then, those “ad hoc” news events become relevant to the Dividend Cafe only to the extent the lesson or message itself is a permanently relevant message. Some may be delivered in a more “timely” context than others, but what I want every week’s Dividend Cafe to be is something that can be read any time past, present, or future, and stand up. Day-to-day market reporting and analysis has its place (barely), but the Dividend Cafe is my baby for macro, evergreen truth and perspective. It will be the last thing I ever give up in this full-time endeavor, and by give up, I mean something rather morbid. So I write in today’s Dividend Cafe about something unrelated to the news cycle, the headlines, and big market noise, not merely because it was a quiet week on the western front but because every week should be a topic divorced from noise and focused on substance. Noise is the enemy of investor success. Links mentioned in this episode: TheDCToday.com DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to another edition of the Dividend Cafe. I am sitting in our Newport Beach office studio and I don't think I have recorded a Dividend Cafe from here since maybe the second week of January. I mean, it's really been quite a whirlwind. I've been in New York office a lot, and then there's been travel around the last couple of weekends at different hotels and offices and other sites. And so it's nice to be here at the home base and record in the comfort of this beautiful studio. And it's also nice to be doing a Dividend Cafe for you today on a topic that we don't address a whole lot. We talk about the Fed. We talk about Japanification. We talk about monetary policy, the macroeconomic picture, growth expectations,

applying all of this into the orbit of dividend growth. These are things that are pretty frequent topics in the dividend cafe. But something like private credit can seem more niche. It can seem a bit more bespoke. Yet it's a pretty substantial part of portfolio strategy at the Bonson Group. And it's become a very big part of what a lot of high net worth and ultra high net worth investors are looking at generally as a source of return and a source of risk and reward as non-correlated to traditional investments like stocks and bonds. And so that broader rationalization as to why we own alternatives at all has always

been the diversification benefits that come from non-correlation and the use of private credit within alternatives has picked up just in terms of our view of the opportunity set. It's something we've been mostly very right about for a long time. First of all, not only just in the return sense, targeting high single-digit returns in an asset class with lower relative volatility. It's tough to do, and it's been happening for quite some time. And frankly, because of the floating rate nature of a lot of private credit, we accidentally got into some low double-digit returns.

The private credit space saw not only its NAV, its actual underlying value hang in there, but then saw the yields it's paying off increase as a lot of the loans that make up private credit saw their interest rate go higher because of the rate cycle over the last couple of years. So not only has the return profile been really impressive, but the overall opportunity set has grown a great deal. And I wrote a dividend cafe last year where I made the case that this was a tremendously positive thing happening, not merely for investors, not just, oh, there's this new investment opportunity out there. It's doing well. What a great thing for us. That's all well and good.

But I was making the argument that the substantial increase in a host of non-bank lending capital markets was itself a wonderful thing in de-risking systemic contagious risk in the economy, de-risking systemic contagious risk in the economy, removing some lending risk and default risk and credit risk from the banking system through direct lending, through structured credit that is more asset-backed, through private credit that is cash flow-backed, that all of these different elements of non-bank lending, different categories and silos, we're all things being equal, moving some degree of risk. It never replaces risk. It never lowers limits, eliminates. It moves. And in this case, the movement of risk from the depositor base of the banking system to investors who have a capacity for absorbing losses, I view as systemically a marginally better thing. capacity, that there's only a certain amount of borrowers out there that are high quality,

doing a certain amount of activities in the production of goods and services that define economic activity. There's always a certain amount that have economic or financial ratios, debt to value, debt to cash flow, the margins within a business to justify a certain amount of credit taken and the capacity for payback. And it's a large opportunity set. It is like we're talking about a few hundred billion and then it goes away. There's a huge space out there for corporate borrowings and some will go to the bond market and some will still go

to banks. But we have seen a big growth in what we call private credit. And with a big growth in private credit comes two things. One is media incompetence and covering it. And the other is legitimate concerns around Johnny-come-latelys. And I want to address both things here in the Dividend Cafe. The media incompetence issue is simply taking headlines from other stories and applying them to this story. Other things formed in a bubble, this thing's doing well, therefore this will become a bubble. Other things ended this way, therefore this will end this way. As a general rule of thumb, I'm all for trying to find parallels. I myself have drawn certain connections between the dot-com moment and the AI moment. Now, I try to do a little more detailed and nuanced analysis and commentary around all that.

But in theory, I can understand just wanting to look at the lessons of history. That's not what I mean by media incompetence. But not understanding and not properly portraying the reality of what's going on is, I think, sometimes unhelpful. of what's going on is, I think, sometimes unhelpful. There's a bit of a hubbub right now about marks, M-A-R-K-S. How a loan, a value of a loan is marked on the books of a fund or an asset manager or portfolio of loans. So what we refer to as mark to market. You know, you, with stock in Apple, you don't have to worry as mark to market. You know, you with stock in Apple,

you don't have to worry about mark to market because it trades a gazillion shares a day and everybody's trading back and forth and it's so liquid and so public that people know what the thing is worth. And then you take your own house and your realtor can guess the price and you can look at what your neighbor

sold their house for three months ago and you can put in your mind what you think it's worth because you love your backyard. But ultimately, you don't really know what it's worth until you sell it. or might have started yourself, or any other private market asset that doesn't have a heavily liquid, heavily traded back and forth, what we call a market clearing price. This applies to private debt, private credit, loans. It applies to private equity, something like my lemonade stand or my son, or a very large multibillion dollar company that nevertheless is not actually traded in the marketplace. And real estate's the greatest analogy.

So I wrote this at Dividend Cafe last year about the reality of mark-to-market. I don't believe it's a problem. It's a problem to the extent that people don't understand it or that they think it's supposed to do something it's not supposed to do. That there isn't a readily available price for something that doesn't have a readily available price is called a tautology. It is what it is. So you don't say, hey, what do you think about things that don't have a readily available price? Oh, I'm a little concerned because they don't have a readily available price. What you have is either a good intentioned, decent attempt to come up with a mark for the sake of having one, a bad intention mark that you have for the sake of misleading someone, or you have a well-intentioned one that is just simply wrong. To the extent the

investor base of people in private assets is supposed to have the sophistication and awareness that those numbers are make-believe to some degree because they're not connected to a clearing price, that's a given. That's part of the deal. Critiquing private credit saying, well, those loans may not really be worth what they're saying, misses a very fundamental point here. The first one being that all private assets are guilty of this. You could throw the baby out with the bathwater on all real estate. And by the way, real estate is 50 times more guilty of people making up a number out of thin air. But I digress. I've seen some things. but I digress. I've seen some things. With loans, you have three issues going on at once. Number one is the probability of a default, okay? Because the interest rate pricing for a floating rate loan is embedded. If it's a fixed rate, like a treasury bond, so now you don't have default risk,

but you have interest rate risk. You buy a bond at $100 and it's paying you 4%. Then the interest rate in the market goes up to 5%. Your bond is worth less money. You buy a bond at 5% and the interest rate in the marketplace drops to 4. Your bond is worth more money. So that's just a byproduct of a bond going up or down based on how the change in that reference rate, the risk-free rate is moving. In theory, private credit is primarily 99%, it might be 97% to 99% floating rate. So it is not trading off of the up and down movements of the interest rate because it's going up itself with rates that move higher and lower. The value is going to be some combination of the probability of a default risk, the magnitude of what that default may be, that

impairment, and then the expectation for recovery out of an impairment or distress event, a default. But see, private credit has an average maturity across the asset class of about three years. Some could be five, some are shorter, but this is a lower duration deal. What extends the difficulty of pricing probability of default? Longer maturity. The longer timeline there is, the more unknowables there are. The shorter the timeline, the less unknowables there are. So you have an easier situation mathematically with probability. Then the magnitude of the impairment, how much value deterioration can there be, is more known when the loan is senior secured, first lien, when you're the top of the

stack to get paid back versus those credits or loan instruments out there that are somewhere junior, somewhere mezzanine, somewhere subordinated, then it takes a lot more calculation to kind of guess where you are in the totem pole. And then the recovery rate, where you have more optics around the loan to value and also different covenants and conditions that a lot of bank loans may not have. But in private credit, they have different covenants that kind of provide some awareness of what recovery could look like, as well as a lot of times there are sponsors or asset managers that have a lot of experience doing these workouts, taking default events and

converting them into turnarounds or equity or equity hybrid or something like that. So the probability, the magnitude, and the recovery are all on the easier side, which is not to say the perfect side of valuation. They are not on the higher, on the harder end of the curve. In these all three categories, they're on the easier end of the curve. But then there's just the proof in the pudding of history. We've gone through multiple credit cycles, multiple distress periods, and first lien senior secured loans have more or less done quite well. There have been some defaults. And these instruments largely trade a couple points off a par value

to account for some default risk. But they're all within a very, very tight historical range that has absolutely matched reality. Now you could say, well, maybe it gets worse in the future, and maybe it does, but that's predictive. That's not mark-to-market. That's not valuation-oriented. That would just be the other side saying, well, I'm predicting something bad,

so I want to mark it now. It hasn't happened. Don't know that it will. So the issue with private credit cannot be just merely in the marks. The issue must be the fundamental quality of the investment, the ability to return high coupon, high cash, and to also return principal as loans mature. And here the argument is one I'm totally sympathetic to in theory,

which is this asset class has done so well, there's been so many good operators producing so many good returns, that now you're going to get bad investors giving money to bad asset managers for them to loan money to bad borrowers who will use it in bad businesses. And I totally agree that the reality of human nature is that enough good money attracts bad money over time. But this, to me, is not an argument against private credit. It's an argument against bad private credit managers. It's an argument for institutional expertise, institutional track record, underwriting, fundamentals, loan to value, covenants and conditions, quality of equity

sponsors behind the companies that are being lent to, track record of work throughs when there are distress events, maximizing recovery. There's a whole lot of factors that go in. Now, that's our job. I happen to think we do it well, but this should not be coupled to a belief it can be done perfectly. It's just that the existence of some that will not be good in the space does not poison the well for those that should be good in the space. The analogy I use to close out Dividend Cafe, I'm going to use with you to close now here on the podcast and video, is that there is a really strong economic temptation to start a restaurant based on how

well the good restaurants might do. And throughout the course of history, we get a lot of bad restaurants that were driven by the economics that they saw modeled by good restaurants. And at no time when I've gone to a bad restaurant have I ever been tempted to say I no longer want to go to a good one. And by the way, at no good restaurant do you take away the possibility of having some bad meals, some bad experiences. There can be some bad loans and defaults within a good asset manager. There kind of hasn't been a ton of that lately, but there could be. But the difference is that you don't view good restaurants based on what the bad restaurants are doing, even though the bad restaurants got their economic incentives from the good ones.

I made up the restaurant analogies. I as writing Dividend Cafe for no other reason than the fact that I've been dieting and I'm really hungry. But the fact of the matter is that the analogy works. Private credit is not a monolithic asset class. And the desire temptation to mistakenly view any asset class in this monolithic context is okay for the media. It's not okay for investors. Private credit represents not only, in my opinion, a macro systemic solution that has the value and merit I described a year ago in Dividend Cafe, but I think for individual investors. It represents a wonderful opportunity set that has only grown and that we continue to want to gain exposure to for a portion of a client portfolio where there is capacity for non-bank lenders to provide non-correlated risk with non-correlated return. That's the idea, and I hope this is helpful as you think about a holistic portfolio.

Please send questions your way. I'll be doing Dividend Cafe for you next week back in the New York office studio, where at least I'll be sitting still for a few weeks. Thank you for listening. Thank you for watching. And thank you for reading the Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities.

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