WATCH SOFTWARE DEBT

“Please note private credit and direct lending aren't synonymous. The latter is a subset of the former. The many stories mentioning private credit these days are really about direct lending. I'll try here to be conscientious about making the distinction. Most who comment aren't.”

“My take from 1929 was that three things in particular were primarily responsible for the bubble that ended in the great crash, the sale of stock to the public without regard for suitability, the provision of heavy leverage to the buyers, and the mismatch between the illiquidity of the assets bought and the short term nature of the loans that finance the purchases.”

“As Charles p Kindleberger wrote in Manias, Panics, and Crashes, a history of financial crises, there is nothing so disturbing to one's well-being and judgment as to see a friend get rich. Envy just might be the strongest force in the world. The possibility of great success inflames investors' hopes. Possibility is confused with probability and then morphs into certainty. Skepticism and risk aversion go out the window.”

“For these reasons, private credit represents well under half of Oaktree's performing credit assets, and direct lending represents less than half of our private credit book. Thus, direct lending is only around 20% of Oaktree's investments in performing credit and less than 15% of our overall assets under management.”

“That might have let their advocates say, they'll deliver high risk adjusted returns, but it wasn't right. They could reasonably have been expected to deliver high volatility adjusted returns. That's what shock ratios are. But I insist strenuously that risk and volatility aren't the same thing. Direct loans embody no less credit risk than liquid credit instruments such as high yield bonds and broadly syndicated loans. It just isn't reflected as readily in prices.”

“In the last fifteen years, something like $2,000,000,000,000 of direct loans has been made. The whole private credit sector was only about $150,000,000,000 twenty years ago. Thus, I imagine some direct lending managers accepted too much money and invested it too fast, applying standards that were too low and setting the scene for a correction.”

“As a result of all the above, a significant portion of direct loans were made to software companies, which were often acquired at high EBITDA multiples of around 20 x and with high leverage ratios. Now suddenly, software company debt is in the news. Over the last year or two, artificial intelligence has significantly reduced the need for humans to write code, that is program computers or write software, largely relegating coders to instructing AI models what to do.”

“That's roughly when Citibank CEO, Chuck Prince, was moved to say, as long as the music is playing, you've got to get up and dance. What a choice for a manager. Join in when feverish investors are lowering their standards in order to put money to work or sit on the sidelines and not invest, watching as other managers pile up AUM and likely causing clients to close their accounts in the seemingly interminable period before your skepticism and discipline finally pay off.”

“In December 2022, I wrote a memo called sea change. In it, I talked about a bank loan I had outstanding in 1980 and the slip I got in the mail informing me that my interest rate had risen to 22 and a quarter percent. Then I said I was able to borrow at two and a quarter percent in 2020. I consider that forty year, 2,000 basis point decline in interest rates the most impactful event in the financial world in the last half century, but one that has received inadequate attention.”