CJ Doherty: Welcome to the Lending Lowdown. I'm CJ Doherty, director of analysis at LSEG LPC and we've covered a range of topics in our recent podcasts from M&A most recently to the banking crisis to leverage finance and beyond. And today we're gonna go back to the world of private credit, direct lending and BDCs. And I'm delighted to be joined by one of the best known people in the direct lending market, Craig Packer, co-founder of Blue Owl and CEO of the Owl Rock BDCs. Welcome, Craig, and thanks for joining me.
Craig Packer: Thanks, CJ. Appreciate your having me.
CJ Doherty: Thanks. And so today, we're going to stay true to the name of the podcast and get Craig's views on the lending side of his business, the current environment and where things are headed. But before we get into the nitty gritty of the market, Craig, can you give us an overview of Owl Rock size, focus and product offering? You know, just for anyone who might be less familiar with this segment of the market?
Craig Packer: Oh, sure. So l rock is the direct lending division of blue owl blouse, a publicly traded alternative asset manager was traded on the New York Stock Exchange with assets of about 110 billion. And the our rock direct lending division is the largest division of Blau, we have almost $70 billion of assets under management. The focus of the direct lending business at our rock is primarily on providing first lien floating rate loans to upper middle market companies. When I say upper middle market, our average EBITDA or cashflow is about $175 million. So these are large businesses, typically owned by private equity firms. We'd like to lend to companies in recession resistant sectors and businesses that are leaders in those sectors. For example, the largest sector that we participate in or the sector that we have the most exposure to is software. We are we are probably the largest lender, to software companies being acquired by private equity firms. And in fact, several of our funds are dedicated technology funds primarily engaged in software lending. We also have funds that do diversified lending across all industry groups. We have a fund that primarily does firstly lending an opportunistic fund, and then we have a clo business as well.
CJ Doherty: Okay, great. So now to move on to current market dynamics. What is origination activity look like your date, you know, has it changed and what kind of deals are getting done?
Craig Packer: Sure. So probably this won't be a surprise. It's an environment with very modest origination activity, given the market volatility that we've been experiencing across all the markets, given the interest rate environment, given generally lower A&A activity, not surprisingly, that's leading to lower origination activity for direct lenders. Just to give you some sense last year, M&A was down about 40%. And when when the numbers come out for the first quarter, I think you'll see M&A activity has slowed even further. In addition to generally low M&A activity, it's really not a very robust refinancing market probably intuitively with rates being higher. Companies are not opportunistically going out to refinance their debt in this environment and holding off in the hopes that rates may come down in the future. When direct lenders report results for the first quarter, I think you will see a drop in activity compared to fourth quarter activity, and more like the activity we saw when COVID first happened and sort of the spring and summer of 2020. So it's a very light deal environment. Having said that, all the deals that are getting done are getting done with direct lenders, as opposed to the syndicated markets. So direct lending is market share is extremely high right now, because the syndicated markets are going through some real difficulties. So low deal environment, but but but Nick's shift towards direct lending. You know, I would just say that it's not because there isn't financing available, there is financing available. Certainly our firm has a lot of capital to finance attractive deals, and I think other managers do as well. But a lot of our activity is driven by by M&A and right this is an environment where in particular, owners of assets that might want to sell them or holding off on selling them, given some of the uncertainties out there. I think the private equity firms would be very interested in buying assets but they want to get lower prices given the current valuation environment, and that's leading to a bit of a standoff between buyers and sellers. In terms of the types of deals that are getting done, the software space, which I mentioned earlier is one of the spaces we like the most is the most active, both in private transactions, as well as a trend we saw last year, which was quite compelling, which was private equity firms taking advantage of depressed valuation in the public markets. And using that as an opportunity to acquire some extremely high quality software businesses. And taking them private now is an area we're extremely active in and like a lot, other areas of activity, we are seeing sponsors take existing portfolio companies and wants to grow them through acquisition and coming to us to help finance those acquisitions. That's those are very attractive deals for us, because they're credits, we already know we've underwritten, usually the acquisitions bring to that bring with them synergies and economies of scale. And so those are some of some of the most attractive deals, we're seeing a little bit of what I'll call extension trades, companies, sponsors coming to us saying, hey, you know, I want to push out a maturity or euro to buy some time with appropriate economics for good companies. So those are a little bit of flavor of where deal activity has been even in this lower environment.
CJ Doherty: Okay. And notwithstanding the lower level of activity that you've referenced, for the deals that are getting done, even if there's not a lot of them, you know, what are you seeing in terms of loan pricing structure and documentation? You know, how has it changed in the last 12 months, for example?
Craig Packer: It's extremely attractive, this is the best environment we have seen for writing new loans, you know, in our seven years in our in the business, you know, for all the reasons, I think you're sort of touching on in terms of economics, obviously, the base rates on the loans are up with higher interest rates, so base rates are up, you know, 4% or more on but in addition to that, we're getting higher spreads than we have seen in the last 12 months or so. So, just to dimensionalize that for you. The most typical type of loan that we make is a is what's called a unitranche. It's a first lien term loan, which is combines elements of the first and second lien risk profile, that a first lien term loan Unitron structure, where today on average, we're getting anywhere from 650 to 725 over SOFR, SOFR is about 5%, we're typically getting two and a half to three points of upfront fees on that loan, which means we're earning 12 to 13%. And that's extremely attractive for dollar one risk at a loan to value of about 45%. A year or so that 12 to 13% might have been as low as seven to seven and a half percent. So you're seeing a very significant increase in economics. In addition, we are typically getting two or three years of what's called call protection, which means if the loan gets repaid in the first two or three years, we're getting additional call premium that could add a one or two or 3% return to the loan. Beyond the economics of the leverage levels, we find to be very reasonable in this environment. Documentation is extremely important to us as direct lenders is we're a buy and hold investor, we negotiate our documentation directly with the borrowers and private equity firms. And we're continuing to get really terrific protections for our loans to to make sure if there's a problem that we get to see to the table very quickly. So as is a combination, while deal flow is down the deals that we're seeing are extremely attractive. It's one of the best learning environments that we've seen.
CJ Doherty: Okay, so it sounds like a good vintage of the recent deals. But that said, you know, from talking to people in the in the broader loan and credit market, you know, I think credit quality is very much a focus these days, you know, given the uncertain economic backdrop. And so Craig, what is your outlook for credit quality? Do you know, to what extent our portfolio portfolio companies seeing stress from higher rates, inflation and other pressures? You know, are there differences across market segments or even sectors?
Craig Packer: So, credit quality continues to be very good in our portfolio. And I would say direct lenders portfolio in general, we're not yet seeing the kinds of signs of pickup and stress. Typically, what those would look like would be covenant amendments or defaults are rising, not accrual rates are rising mortgage REITs. We're not seeing that yet. I do expect that we will see that as the course of the year wears on. But I think that it will be manageable in the context of how much we're earning from all the rest of the portfolio. But I want to make one important point. direct lending we have a luxury that really many public loan and bond managers don't have, which is we can lend to only the sectors that we like, and we can really avoid and do avoid the most recession, cyclical parts of the of the economy. And so direct lenders like Owl Rock. And we simply don't have homebuilders and metals and chemicals and drilling and retail and restaurants, which are the kinds of businesses that will be the early warning signs of the economy, we are not a good early warning sign for the economy, because we'd like to lend to businesses that if they cycle will cycle very modestly. And so I think that direct lending portfolios will hold up very well. Although I do expect there'll be some pressure, given the higher rates that you're alluding to, that that will take effect over the next six to 12 months, in the overall context of how well the companies are doing and the higher rates, we're running for the whole portfolio, I think it'll be very manageable.
CJ Doherty: Okay. And just moving on a little bit, we've seen retail capital, enter the market in greater volume in recent times, you know, attracted by the relatively attractive yields on offer, to what extent has retail capital, you know, impacted the private credit markets?
Craig Packer: So this is a relatively new phenomenon. And I think it's a very positive one for, for the private credit space, there are new structures, and we're a leader in the space that really provide funds to allow the high net worth investor to access these illiquid loan investment opportunities, where they would not have otherwise had those opportunities previously, because the structures didn't exist. And we've seen a tremendous response from the partners that we work with the firms that we partner with to put the funds on their platforms and bring them to their clients. And it's been a real growth error area over the last few years. You know, it has the funds that the way we structure them, they typically have monthly inflows that allow investors to write a check and start earning a dividend right away. And you know, these are these are assets are invested in illiquid assets. And so these funds very quickly provide very limited liquidity to the investors. And that's something that's very clear, if you want complete liquidity, you should invest in a mutual fund that will give you daily liquidity, these funds don't do that. Instead, they offer very modest quarterly tender offers. And we've seen continued appetite for our funds in the retail space on continued inflows. And you know, while the tender offers have been modestly increase, we haven't hit our caps of those tender offers. And I think it really speaks to a pretty healthy investor appetite and comfort with the products. It is an area of focus because some funds have experienced higher levels of tender offers, I generally view this as all very healthy development of investors understanding the way these products work, and long term, I think we're going to continue to see a growing appetite from the high net worth investor that does not need that type of daily liquidity and is willing to trade off that liquidity for the substantially higher yields that these funds can provide, I think we'll continue to see growing appetite from our partners that want to offer these products to their clients. And they'll continue to be a growing part of the direct lending space.
CJ Doherty: Okay. And on a topical note, last month, we saw trouble in the banking sector kind of hit the headlines with the collapse of Silicon Valley Bank and Signature Bank. Has there been much impact on the private credit market from the bank crisis that hit in March?
Craig Packer: There really hasn't? We certainly, you know, with as with everyone in the market, you know, when those developments happen, we all paid attention to that. But I would say in summary, we and other direct lenders did not have really meaningful exposure to the banks that were most impacted. They weren't a lender to our companies. They were not a lender to our funds. Certainly nobody welcomes any type of financial contagion. So we're watching it closely. But it's had very modest impact. Once we were able to provide information to our clients, I think they were very pleased to see that the impact has been very minimal.
CJ Doherty: Okay, what about when it comes to leverage lines?
Craig Packer: You know, has there been any change in the availability for private credit funds of leverage lines from banks, but we haven't seen that. We continue to see tremendous support from our existing group of lenders and new lenders that want to work with us. We work with an extremely large group of lenders across all of our funds and haven't seen any contraction in the availability of funds. You should know this is a huge area of focus for us from the beginning over the last seven years. And we built out extensive lending groups across each of our funds in a variety of different forms, including many of our funds have access to the investment grade bond market, but we really try to diversify not only on the asset side, but on the liability side. We haven't seen any change to it. I think if anything, what we're hearing from lenders is that they will continue to support us but if anything, I think you may see a focus from lenders on working with the largest platforms which we're fortunate to count ourselves amongst and think for the largest as platforms, lenders will continue to have lots of appetite for for the space.
CJ Doherty: Okay, so before we wrap up, then let's look ahead to the future. So Craig, what's your outlook for the rest of the year? What can we expect to see?
Craig Packer: Well, I expect to see continued benefit from this higher rate environment, it's quite powerful. Almost all of our loans are floating rate rates are higher, and that translates itself into our existing investments earning more. And we can take those higher earnings and pass them on to our investors in the form of higher dividends. And so we have been raising dividends across most of our funds and, and I expect to continue to be able to provide very attractive dividend yields in this environment. Understandably, with higher rates that will provide some additional stress on the portfolio as the year wears on, I expect that I don't think it's imminent. But certainly by the back half of this year, we should all be prepared to see some increased level of stress. But I would just caution, I think that the level of stress, given our focus on recession resistant sectors, given the low loan to value of our companies, and their ability to withstand higher rates, I think it'll be very manageable and more than offset by the higher rates that we're experiencing, across the across the whole portfolio. Lastly, I think at some point, it's hard to pinpoint when, let's call it fourth quarter, I would hope to see and expect to see improving inflation numbers lead to a change in tone by the Fed on the rate outlook, which at which if that were to take place would lead to a resumption in m&a, we'd start to see m&a activity hope pick up hopefully by the end of this year. And so so those are some of the themes I expect to see for the rest of 2023.
CJ Doherty: Okay, so, on that note, that's all we have time for today. They're certainly you know, much to for us to monitor and keep an eye on in the coming months across the direct lending markets. So Craig, thanks very much for sharing your insights with us. And thank you all for tuning in. I invite you to check out our direct lending and BDC analysis at loanconnecter.com. Follow us on Twitter at LPC loans. I'm CJ Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.
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