Private Credit’s Other Lanes Still Offer Value with Lotfi Karoui

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GREG HALL: Hey, everybody! Welcome to another edition of Accrued Interest PIMCO's podcast, dedicated to serving financial advisors and their clients. As usual, I'm your host, Greg Hall. I lead the wealth management business for PIMCO here in the United States. Today, as always a real treat to be with you and to have with you and here in the studio with me, Lotfi Karoui who just joined us, what, six weeks ago, Lotfi?

LOTFI KAROUI: Yes. Six weeks ago, exactly. Yeah.

GREG HALL: Six weeks. Lotfi comes from Goldman Sachs. He was Chief Credit Strategist there, most recently. Had been at Goldman for just about 20 years before?

LOTFI KAROUI: Eighteen years. Yep.

GREG HALL: Prior to that, Lotfi had not only published widely in academic journals related to financial subjects. He has a PhD in financial economics from McGill, a master's in financial engineering from HEC Montreal, and his undergraduate degree from IHE Carthage in Tunisia.

LOTFI KAROUI: Great to be here. Thanks for having me!

GREG HALL: It's great to have you Lotfi. It's great to have you at PIMCO. Your role here, you're a multi-asset credit strategist.

So kind of continuing in the vein of the work that you were doing at Goldman Sachs, you're also the co-head of our client solutions and analytics business, which many listeners probably won't recognize, but it's a very, I think, cool part of PIMCO where we work hand in hand with clients on how to optimize and improve their entire portfolio.

So not just around a specific investment solution that we might provide, but actually how to think about their full portfolio in light of their objectives or circumstances or what might be going on in the world around them. So you have an incredibly broad view of client portfolios and the tools at their disposal.

LOTFI KAROUI: Yeah, yeah, that's right. I mean, the goal is to sort of provide the full suite of service a little bit and alternate between tactical conversations like the one we're about to have now. And then longer term conversations about, you know, how should you position your portfolio in light of whatever forward risk distribution might prevail.

GREG HALL: Right. And you just published a piece with a colleague that draws on kind of both sides of your role.

The title of the piece is Private Credits, Other Lanes Still Offer Value. I thought it was a great read because in it, you definitely outlined some of the issues that the private credit universe is facing right now, and we're going to talk about that.

But you have a hopeful note and you point out as the title suggests, that there are still a lot of areas of that market that are underpenetrated, that are less competitive, that aren't facing, you know, some of the issues that are in the press right now. and still, like you said, offer value to clients. and hopefully today we can kind of talk about both aspects of that,  not get too dark and negative. What I was hoping to do, because there have been so many headlines on pressures in private credit of late.

I feel like we run the risk of getting very caught up in the minute to minute. I was hoping we could zoom out and just remind listeners where all this came from. The journey that we've been on and why, what's going on today can be seen as a pretty natural evolution of markets, or a pretty natural outcome of cycles.

Certainly not something to be complacent about, but also not something that is a bolt from the blue and thoroughly unpredictable. So maybe, you know, maybe we can just start at the beginning where did what we call private credit today come from.

LOTFI KAROUI: Yeah. I mean, well, the first thing I would say is that unfortunately, private credit and direct lending are oftentimes used interchangeably. But acquiring credit is a lot more broader than just direct lending, you know, it includes other strategies like mezzanine financing, special situations, distressed, asset backed finance, which I'm sure we'll talk about a little bit, you know, mortgages, commercial real estate, et cetera, et cetera. So it's a much broader asset class than just direct lending. Now, I think the reason…

GREG HALL: And what, just for anybody listening, that's not as steeped in the distinction, what's direct lending, just so people know that.

LOTFI KAROUI: So, direct lending is essentially senior secured lending to non-financial corporations, you know, typically middle market borrowers, sometimes upper middle market borrowers and then increasingly what we've seen over the last couple of years is that, you know, larger borrowers have, you know, turned a little more reliant on direct lending markets, you know, relative to certainly 10 years ago. But what is true is that direct lending has been the growth engine of private quantum markets.

GREG HALL: Is it like they're usually like a private equity element to the borrowers.

LOTFI KAROUI: Sure. It's a market that is dominated by sponsors. And I would say the, you know, the primary engine growth has been essentially the LBO machine, you know, there's a natural feedback loop between the two. If you're a sponsor and you own a company, you value the flexibility that private markets give you on the debt side, you know, to, you know, certainty of executions and things like that.

And so we've had an LBO boom from the end of the global financial crisis all the way to 2020. Then we had a little bit of a pause with a COVID shock, and then we started over again. And as a result of that, you've had direct lending AUM growing from $37 billion year end 2009 to a little less than a trillion dollars today.

I mean, that's staggering growth, basically, I mean, if you compare that to other segments of credit markets, whether it's the broadly syndicated loan market or the high end market, it's night and day. Like you cannot even compare them.

GREG HALL: Lotfi, you mentioned a trillion dollars of direct lending. The number I see quoted in the press most frequently is $1.8 trillion for private credit. Can you break that down for us?

LOTFI KAROUI: Yeah, I mean, that's a great point. And then that just goes back to the point I made earlier, which is private credit is not direct lending.  So direct lending is a subset of private credit. That's one trillion out of the 1.8 that you just mentioned.

The other 800 billion, you know, is, you know, spans a lot of other strategies. You know, mezzanine, distress special situations, infrastructure, real estate, et cetera. And so, and the other thing I would say is that that is also a global number. And so it includes North America, Europe, and APAC.

GREG HALL: Gotcha. Alright. Perfect!

So let me, so the financial crisis is obviously a pivot point here. Why was the private sponsor lending business so small leading up to the financial crisis, why has it become so big in the wake of the financial crisis? 

LOTFI KAROUI: Yeah. I mean, there are a variety of explanations that, you know, are typically put forward to explain the growth of direct lending and how come, you're right, like, why did you go from 37 billion year end 2009 to a little less than a trillion, today? I like to separate the drivers of growth in terms of the supply side and the demand side.

You have to remember, in the aftermath of the global financial crisis, we had you know, a much tougher regulatory environment for the banks. And so there's a lot of the lending that used to be done in the banking system cannot be done to them now. Nature of wars [UNCLEAR] void, if you can't underwrite a loan, someone else is going to do it.

And so I think that was a big driver in my view, the second driver, and oftentimes it's less appreciated in my view, is that the entry barrier to public markets has increased, actually in leverage finance. Like, if you look for example, at the average deal size in the broadly syndicated loan market, on the high yield bond market, you know, it's well north of 600 million, 700 million. So that leaves out a lot of companies, you know, from sort of entering those markets. And then,...

GREG HALL: What do you think is behind that? I'm curious.

LOTFI KAROUI: I think changes in index methodologies, you know, to be index eligible today, you need a minimum denomination of around four to 500 million. And so, there's been, you know, liquidity correlates with size of the capital structure as well. So there's been a lot of sort of changes that have sort of fueled that.

And then at the same time, look, the growth of private credit itself has kind of created a little bit of this segmentation between the two. On the demand side, you know, at least when you talk to institutional investors, you know, people value the smoothness of returns.

The fact that, you know, these are non-market to market assets, and they give you the illusion that volatility is low and a lot, you know, that aligns with the incentives that a lot of these institutions you know, have. Now the thing is that every time you have that type of growth, you know, 37 to a trillion dollars, you develop imbalances.

Basically, there's a limit to how much capital you can deploy without fueling some friendliness vis-a-vis borrowers and a loosening of underwriting standards. And I think to your point about all these negative headlines that we've seen, I think that is playing a big role.

What we're discovering today is that, you know, the early vintages that were underwritten, either pre-COVID or in the early years after COVID were probably good vintages from a credit quality and from an underwriting standard standpoint, I think some of the most recent vintages were basically discovering that, you know, the bar has been lowered a little bit. and again, it shouldn't come as a surprise, you know, if you have an excess amount of capital, you start underwriting bad loans.

GREG HALL: Yeah. I, so it sounds like what you're describing post-financial crisis, you have a huge capital gap as the banks have to step back. and like Wall Street does better than virtually any industry, it knows how to fill a capital gap. And so, some entrepreneurial folks created private credit businesses, either independently or as part of another business and began to fill that gap, of course, benefiting from the absence of competition.

They put up great numbers and generated excess returns, and that brought more capital into the space. And I think kind of the final part of your argument, that at some point you've got too much capital, it's become too popular, and it's just chasing a smaller number of opportunities, or the same number of opportunities with just too much money sloshing around, right.

LOTFI KAROUI: Yeah. and in fact, one interesting evolution of direct lending is that, you know, phase one of the growth of direct lending market was all about middle market borrowers. And then we got to the point where there was so much excess capital that actually we started to write bigger checks and fund companies that would normally be funded in the broadly syndicated loan market.

So in 2022 and 2023, you know, conditions in the broadly syndicated loan market were actually quite tough because we had a hiking cycle, et cetera. And so private debt managers kind of stepped in and started to write these bigger, you know, bigger checks and fund those companies. These are $1 billion plus type of, you know, type of transactions. That was a, you know, an inflection point essentially that we had.

What I thought was interesting about that inflection point is that the market has de facto move to a quasi-syndicated structure. And so when you talk about private credit, usually it's one lender, one borrower. I mean, that's what makes it, you know, pretty unique is that, you know, you give a lot of flexibility to the lender to fix a broken capital structure if they need to.

Because we had that excess amount of capital with de facto evolved into a structure that looks a lot like what you have in the broadly syndicated loan market, which is, you know, a few lenders, 3, 4, 5 lenders, and then one borrower. And so that has fueled some erosion in whatever excess premium you're getting.

And it just goes back to the point we made earlier, which is every time you have more supply than demand to capital, you generate imbalances. And that means, you know, I don't like the word alpha, but like, less success return relative to what you can get elsewhere.

GREG HALL: Yeah. I mean, I think Alpha's a tricky one in the context of a business that is designed to avail itself of what's available in the market. In part, it started at a time when what was available in the market was just really great relative to other things. But it's, alpha's a little tricky because you're, you know, you're not really making a lot of relative value decisions when there are few deals and a lot of money.

LOTFI KAROUI: Exactly. You don't have the luxury of deploying $1 here versus $1 there.

GREG HALL: It's kind of, it's interesting, like, I was trying to think, you and I were talking earlier too, I was trying to think of analogies that would be readily accessible to somebody listening again, who isn't just steeped in this stuff, which maybe everybody is at this point, 'cause it's been such a prominent piece of the news.

But, you know, it sort of reminds me, I mean, I hate to bring up, you know, the commodity markets at a time like this when those are clearly quite volatile. But, you know, it, there are other industries that follow cycles like this, you know, if, as oil prices go up people who are drilling oil or refining oil have more of an incentive to bring more supply online to take advantage of the higher prices as they bring more supply online, of course you've got more supply and the price goes down as the demand stays static, right.

And so again, what you're describing is just a very typical cyclical phenomenon that a lot of industries go through, the financial industry, we used to have cycles, you know, we'll see. What's…

LOTFI KAROUI: We still do, they just take longer?

GREG HALL: Maybe they, yeah, yeah, yeah. We'll see what's in store for us. But, so why do you think the, you know, as this part of the credit market goes through, what is a relatively natural and common phenomenon for financial markets?

Why all the drama, why are we seeing headlines? Why is the press reacting? Why are investors reacting the way that they are? And I'll add some thoughts on that too, but why do you think it's sort of a different reaction?

LOTFI KAROUI: Yeah, I, you know, I'd like to sort of go back to 2022 and the start of the hiking cycle because we had an sort of an unprecedented rise in funding costs in 2022 and 2023. And when I look back at that period, I was actually pleasantly surprised by how resilient corporate credit, not just direct lending, you know, was in the face of a dramatic rise in the cost of capital.

And so, here we are fast forward, you know, two years later, and we're talking about a confluence of headwinds. One is question marks around sort  of the, you know, the fundamental outlook in those portfolios, you know, what are, how well are those companies, you know, doing.

The opacity around the  Marx is another one. And then three, let's, you know, not forget that, you know, in aggregate, you know, software is 20% of direct lending portfolios, so that's completely exogenous.

No one would've been able to forecast that. But because AI displacement risk is top of mind today, that ended up putting even more pressure on direct lending portfolio. But leaving that aside, you know, to your question, why now? I think it's two forces at play. One, there is probably a lagged effect from tighter monetary policy these days.

These things take a little while to kind of find their way, you know, you know, through the system, and then the second thing again, there was probably a loosening in underwriting standards back in 22, 23, 24. And as a result of that, you know, you have more vulnerabilities in portfolios, you know, today now, of course, investors have been paying attention to those headwinds. And I guess, you know, the other source of pressure that you're seeing today is pressure on redemptions and liquidity.

And so I think the big lesson of all of this is that from an investor standpoint, this is a little bit of a wake up moment where I think people will think a little more carefully about where they deploy you know, capital when you look at, at private markets and how much illiquidity risk they've really taken, and whether they're getting the right compensation for it. And so that's something that will play out. I think over the next couple of years, we'll have a deep rethinking on how much illiquid risk we take in a multi-asset portfolio.

GREG HALL: Yeah. It's a really good point. I can vouch for the advisors I speak to. I just got back from a trip through North Carolina, actually to see a bunch of advisors. And, you know, I think they're doing exactly what you suggest, which is just rethinking some of the assumptions that underlay these investments.

And I do think that as an industry maybe folks got a little complacent, because like you said these numbers were good for a very long time. They were at least quick for, you know, for the short term, quite resilient in the wake of the rise in rates in 2022. And there may have just been a false sense of security.

And I just want to go back to kind of where you started this sort of whole history conversation we've been in. Because what I sort of hear you saying is there's this sort of continuum or spectrum of credit and you don't really consider direct lending or private credit even more broadly, as totally different than the public variety. It sounds to me…

LOTFI KAROUI: No. Yeah. Yeah. Yeah. I mean, look, the way I put it is that where there's premium, there's risk, right? So that's really important to keep in mind.

GREG HALL: Where there's excess return, there's,..

LOTFI KAROUI: It's a compensation for risk, right? Yes. And sometimes that compensation is attractive, sometimes it gets mispriced. Now, I would put direct lending as part of a broader umbrella, which is leverage finance markets, and, you know, the high end market as we know it today, has been around for a little over four decades now.

And we know that every recession, every big industry shocks tend to translate into higher defaults and higher losses. And I think it's wrong to portray direct lending as a bulletproof asset class. There's no such thing, basically. You know, it's leverage lending and leverage lending is prone to losses in portfolios.

Now the asset class is young in the grand scheme of things, you know, it's, and it hasn't really experienced a full blown default cycle, but eventually it will. And whether the catalyst for that default cycle is a recession, whether it's an industry shock, like software, for example, or simply an abrupt change in sentiment where, to your point about imbalances, you end up correcting that imbalances by pulling a lot of capital out of the system.

We'll see what the catalyst will be, but eventually it will be tested for sure. And I think that will probably trigger an increase in defaults and losses in aggregates and possibly more dispersion, you know, across managers too.

GREG HALL: Yeah we had Christian Stracke on the pod last week, and we talked mostly about macro and events in the Middle East, but we did you know, he was our head of credit research for a long time and we got into private credit and he noted that regardless of the cause, the redemption cycle here, and there've been some notable redemptions in these vehicles that offer quarterly liquidity that's a credit tightening, right.

And these things can, they can become self-fulfilling, where if your investors lose confidence, your access to funds dries up. You have to step back, and so, I'm curious about a couple of aspects of more, you know, kind of the fundamental, this is more tactical as we get into it, but, you know, if I'm a levered private equity sponsored company over the next three to five years, does my access to borrowing and refinancing improve or get worse by virtue of what we're seeing in the private credit market today?

LOTFI KAROUI: Yeah, most likely the latter. I mean, look, we went through this in the commercial real estate market in 22, 23, 24. And we know how it kind of played out. You know, you had the same amount of pressure on redemptions, you had a large funding gap, and in the end, you ended up dealing with that via and then extend and things of that sort, which are mild forms of defaults.

And my guess is that that will probably be the path of these resistance, you know, going forward, but you're absolutely right, I think even if you keep macro conditions steady, the fact that capital is leaving that ecosystem, you know, you're de facto depriving borrowers from, you know, debt capital in the future when the time comes for them to refinance. I think the additional complication though, for direct lending is that, you know, in theory you can go to other options, right?

Like you can go to other markets and knock on other doors and see if, you know, whether there's other ways to address that funding gap. That's what borrowers and the broadly syndicated loan market actually did back in 22 and 23. They went to direct lenders and they got funded. The problem is that making that trip the other way around is a little bit more complicated because of all the reasons that we discussed earlier, which is the entry barrier on the public side is a little higher.

GREG HALL: Right. And that's interesting! 'cause you've argued both previously to your time here and since being here, and I think you agree with a lot of folks here at PIMCO, that by virtue of the private market pulling some of these borrowers in at times of stress, like in 2022, and prior to that, the high yield markets actually become a very different higher quality market than we once would've recognized, right. And so, what in your mind, how do you now differentiate between high yield, broadly syndicated loans?

LOTFI KAROUI: That’s a great point! So I think if I take the broad leverage finance universe, there's, you know, three buckets. You got the high yield bond market, the broadly syndicated loan market, and then direct lending, right?

Now, the high yield market is a much higher quality market in my opinion, than the other two, you know, it's morphed over the years into this large cap large to sort of mid-cap market. Mostly public companies, you know, sponsors are not that involved. And high-end they are, but not to the same degree as the broadly segregated low market. And then, if you look at, you know, metrics like credit quality it looks, you know, very healthy by historical standards. If you look at the sector composition, actually, there's a lot of talk about owning asset heavy versus asset light firm.

The high-end market is very asset heavy. You know, it's a lot of energy, it's a lot of basic materials, it's things that actually, that investors value in the current environment. The loan market and direct lending, you know, they've sort of become over the years close cousins.

I never liked the word convergence because there isn't really convergence, but there's been growing overlap between the two or over the years. We're seeing they're  sure got to going back and forth between, you know, the broadly syndicated loan market and direct lending, you know, issuing debt here and then  refinancing it there, depending on conditions, et cetera.

But there's quite a lot of similarities between the two. And to the point you made about, you know, the real test for direct lending will ultimately come when you have a full blown default cycle.

I think the surprise is not going to be that, you know, losses and defaults are up, that will go up. It's a, when, not an if in my view, but I think the real test will be how direct lending as an asset class fair versus the broadly syndicated loan market.

Because for a while I think the belief was that, you know, direct lending, you know, benefits from stricter controls, tighter covenants, et cetera, there's better oversight. I think that was probably true in the early years of growth of the asset class. It's probably less true over the last, you know, couple of years, but we'll see how the two asset classes kind of compare to each other.

GREG HALL: No, that's a, I mean, look, that's a good point. I, we've had a crisis of confidence. We've yet to sort of see the fundamental loss metrics play through in these portfolios. And so there'll be an opportunity to judge the underwriting prowess of these firms relative to the, a pretty similar asset class out there in the broadly syndicated market.

Yeah, that's a very interesting point. I think the other thing that, you know, maybe on a more hopeful note it, I 'd used the oil analogy before you know, and it is just to maybe, beat it to death. I don't mean to, but it's just the best one I could think of, you know, my sense of that market is that, you know, the price goes up and down, it leads some players to increase supply or constrained supply as the price moves.

And of course, that affects the price. And then when the price is really high, when returns are really great, obviously you've got people flood into the market and little fly by night organizations and I think they're called wildcatters, you know, and they go out and explore for because the excess return is high enough to stomach all of that risk.

And then usually when those returns go down and when capital in the space begins to dry up, then you have winners and losers, you have survivors and people that, you know, probably get consolidated in or just find themselves out of the industry.

LOTFI KAROUI: That's right. That's the nature of cycles, right? Yeah.

GREG HALL: So we can look forward to a vibrant hopefully, you know, private credit and direct lending industry. But I would imagine, based on what you're saying, probably smaller than what it's become.

LOTFI KAROUI: Yeah, and in fact, I also like, always like to look at fundraising activity, and if you look at fundraising activity in direct lending, it peaked two years ago already. So I would argue that we're there, basically.

GREG HALL: Yeah. Right. Just to...

LOTFI KAROUI: There’s a lag effect, but we're kind of there. Yeah.

GREG HALL: That's a good framing of it. Like we're in, instead of this being something that, you know, the headlines have to be all doom and gloom it can be understood as a very natural right sizing of the capital to the available opportunity, right?

LOTFI KAROUI: That's correct.

GREG HALL: Well, let's talk about, I mentioned a, you know, a more positive note on an even more positive note. I mean, the real, the whole point of your piece was that other lanes in private credit offer value. And so we’ve kind of talked about direct lending, which I think is really important.

I just want to make sure advisors listening have as fulsome a sense of, kind of what's going on there and where it comes from as we can offer them. But let's talk about some of the other lanes of private credit, some of which I think are actually in your view, bigger than the direct lending opportunity.

LOTFI KAROUI: Well certainly in terms of addressable market, there are a lot bigger than that. Absolutely. Yeah.

GREG HALL: Let's talk some examples. Yeah.

LOTFI KAROUI: Yeah, I mean, look, we're obviously late in the cycle even though cycles don't die of age, but we are late in the cycle. And so I think from the perspective of an asset allocator, it's really critical to, of course, you sort of avoid chasing pockets of the market that are expensive, but think about risks that are sort of less correlated to the corporate earning cycle, or the ebbs and flows of the business cycle.

Asset backed finance is actually, you know, a great example of an asset class that can offer you those sort of risk characteristics.

GREG HALL: We've done one podcast on this topic. It was, gosh, it was nine months ago with Chris Kraus who is one of our fellow managing directors  who leads asset based efforts. He's based out of London. It's still one of our most popular podcasts. So I would, we will link to it. I'd refer listeners to it, but for folks who don't want to drop everything they're doing and go back and listen to that one, let's define asset based finance relative to direct lending.

LOTFI KAROUI: Yeah. So direct lending, like I said earlier, it's basically senior secured lending to typically, you know, middle market to upper middle market, non-financial corporations. So what you're owning effectively is corporate credit risk, asset backed finance, you know, the cash flows that you receive are typically backed by a collateral, whether it's a physical collateral, like a hard asset or a financial collateral like, you know, aircraft leasing or contractual collateral, like, you know, music royalties is another example.

And so you know, the cash flows are in other words, a lot more predictable than what you would otherwise get, you know, in direct lending, but it's also higher quality. I mean, you know, I often like to say that the financial engineering behind asset-backed finances, actually not that different from public securitization markets that have been around for 40 years now.

So think about, you know, mortgage backed securities or like a commercial mortgage backed security. Effectively, you're taking a collateral, someone takes the first piece for losses, and then there's investment grade like risk that is, you know, sold to investors.

Asset backed finance is the same, you know, is the same mechanics from a financial engineering standpoint. Now, what it offers you relative to public securitization markets is scale, flexibility and access to types of collateral that you wouldn't normally see on the public side. That's really the key.

Now, there's a variety of estimates on how big the total addressable market you know, is depending on the assumptions you make. Some people have it at 40 trillion, which I think is largely exaggerated. Some people have it at 10, 20, but it's big enough that that opportunity set, I think is  definitely worth keeping an eye on for sure.

GREG HALL: Yeah. It's not to summarize you or put words in your mouth, but I do like to think about it, you know, 'cause I, you hear senior secured in the context of direct lending and of course that can lead you to think that everything else is junior and unsecured.

LOTFI KAROUI: Yeah, exactly.

GREG HALL: And, but the words mean sort of different things in different contexts, right. And with asset based lending, you describe music royalties and mortgages, right. I think typically what you have is a granular, a lot of assets, individual assets across a really broad variety of borrowers or risks, if you will with statistically predictable performance, oftentimes going well back in history.

And what you're attaching to from a credit standpoint is the value of that asset and the cash flow as it kicks off. In a corporate context, especially  the sector composition of a lot of direct lending, you're really thinking about the cash flow as the business kicks off, the assets are probably a lot less of,   right.

So, and I guess the other big area within asset-based finance, although it's big enough that it's its own category would be commercial real estate you know, which you mentioned kind of the tribulations back in 2022, but that's a sector that I think in our view has begun to come back around and be pretty interesting investible.  

LOTFI KAROUI: There's a sector that experienced its own recession essentially two years ago. So you removed excess capacity and it also screens, you know, quite attractive in relative terms when you compare it to, you know, other types of products.

GREG HALL: Yeah. We should have some folks on to talk about that specifically because it's a really interesting, but it has those same characteristics that you talked about. It's asset driven, you've got assets that have pretty predictable cash flow associated with them.

LOTFI KAROUI: Yeah. No, the one thing I want to add though is that, you know, so yes, you do have a risk return profile that is very different from corporate credit, but that doesn't mean that asset backed finance is immune from shocks.

GREG HALL: Right.

LOTFI KAROUI: You know, like I said earlier, where there's premium, there's risk, like you're being paid against, you know, some risk. And so it's still important to look at things like structures you know, or how much downside protection you have in your portfolios and things like that.

But it's not immune from, you know, cyclical shocks. It's less correlated for sure, but it's not a hundred percent immune. There's no such thing actually,

GREG HALL: Let me ask you this. 'cause we, you know, we spent, you know, 25 minutes, you know, sort of talking about the path of direct lending from sort of wide open, no competition, unbelievable opportunity to supply capital where there was none to hyper competitive, grinding, spread and excess return, you know, out of deals. Where do you see asset based finance on that journey?

LOTFI KAROUI: We're scratching the surface, I would say on it. So first of all, I think the entry barrier from an asset management standpoint is a little  higher, because it requires, you know, origination capabilities. There's just like, there's a lot of preconditions, I think that pretty…

GREG HALL: Highly regulated sectors,...

LOTFI KAROUI: Highly regulated.

GREG HALL: Data, requirements.

LOTFI KAROUI: Yeah. And so it's a little bit of a different game, I think. So I think there's less scope to see that level of competition that we saw with direct lending. So that's the first point I would make. Now, the reason I think we're in the early innings is, if you think about it, what is the biggest growth driver of asset backed finance? It's the fact that the originators are balance sheet constraints.

Who originates the loans, if I dig, it's the banks and other financial institutions. That is unlikely to change. And so I do think that there's need to free up balance sheet capacity among, you know, lenders that don't have infinite capacity, in my view. So I do think that that's a big driver of it.

And then on the demand side, you know, I think there's demand for investment grade type of risk that brings some diversification to multi-asset portfolios, and that is a little more insulated to the ebbs and flows of the cycle relative to say, corporate credit.

GREG HALL: Yeah. I, well, I mean, a couple of things. One, I'm really glad that you pointed out that we don't talk about asset based finance as being magical, right? It's not immune from the cycle. It just, it's earlier and less competitive.

LOTFI KAROUI: It's younger, less competitive for sure. But I think, you know, the same rigor that is applied to any investment process should be implied to, you know, asset-backed finance. And so things like manager selection structures, et cetera, are attributes that should be looked at very carefully.

GREG HALL: And there may come a day when we say, this has become too competitive. 

LOTFI KAROUI: Absolutely! Maybe if we have this five years from now, you know, we'll go through the same, you know, cycle that direct lending went through.

GREG HALL: Yeah, the menu of investment possibilities is a lot broader, I think the other thing that we sometimes forget about direct lending is just what a narrowly defined

LOTFI KAROUI: It's one silo. Basically, that's what it is.

GREG HALL: Yeah. Like the ability to dodge and weave is not, you know, is  you can lend to this sponsor's deals or that sponsor's deals, or both of those sponsor's deals, but the, you do tend to see a lot of commonality in the  lending targets, right. Whereas asset based finance is, it's not just bigger by virtue of assets, but just the sheer variety of what you can lend against over time.

The other thing, you know, that I think was super interesting is sort of the ecosystem on the investor side. When we've been talking to advisors of late, obviously many of them are concerned about what's going on in the direct lending world. I think they're really savvy people. I think it's, you know, nobody really knows exactly how credits and defaults will play through and you brought that up too. 

But you know, there's stewards of client capital and there's noise and there's difficulty in getting outta some of these positions. So looking for alternatives and you know, thinking of asset based finance, commercial real estate lending, infrastructure's another topic, that we're not as directly involved in, but I feel like I should mention it for those listening where, you know, we hear advisors saying here, this is a great way to maintain the virtues that I had in my direct lending allocation, but switch the risk factor, right. Does that seem plausible to you?

LOTFI KAROUI: Yeah, totally. It, I mean, I guess another way to phrase it is that you're moving up in the quality spectrum, without sacrificing too much on carry. And I would actually, that's a generic point that I would make across the board. We are late in the cycle. I mean, you look at any measure of risk premium, it's at the very low end of the range of the last, you know, whatever, 15, 20 years.

And so it doesn't hurt to have that mindset, which is own quality over yield. But try not to sacrifice too much, but absolutely I agree. Now, the one thing that I want to add to the point you made earlier about like how to frame the risks a little bit in direct lending, I do think it's very important to separate, you know, concerns over a systemic shock from concerns over, you know, losses and defaults, which are sort of cyclical in nature in my view, right?

I think the cyclical part of that will play out sooner or later, maybe it'll happen this year, next year, who knows? But, you know, we will test direct lending and it will experience

GREG HALL: Credit still works.

LOTFI KAROUI: Yes, absolutely. A hundred percent. It's just a matter of time.  Now, where the jury is out a little bit and you hear this debate all the time, which is, does that pose a risk to financial stability? You know, is there risk that this morphs into something bigger where, you know, instead of having losses on direct lending portfolios, it ends up, you know, creating capital holes in the system and then constraining lending and you know, sort of the play type of playbooks that we had in 2008.

And my answer to that is generally that you can always describe a doomsday scenario in which that happens. They can always describe a state of the world in which losses, you know, in private credit ends up being a bigger problem for the system. But I think the bar is a lot higher than most people think.

And I do say that because number one, like when you think about the two key ingredients for a systemic shock, are usually leverage and mismatches between assets and liabilities, right? Liquidity mismatches. Those are the two things actually that create a backdrop for a systemic shock.

I mean, leverage is obviously used in private credit funds, but it's used typically in very reasonable doses. I mean, for those who are listening who sort of lived in that period from 2006 to 2008, and remember sort of the structural credit machine, it doesn't strike me as sort of the same, you know, type of  environment and then mismatches between assets and liabilities, like we're discovering that, you know, some investors feel like they over allocated to private credit, but redemption limits are there precisely to avoid a scenario in which you have a fire sale of assets and a mismatch between, you know, assets and liabilities.

So, you know, I continue to sort of cautiously err on the benign side of that debate, again, as far as the systemic implications go. And I think it's important to sort of separate the two aspects, you know? I mean, we've had cycles in high yield in the last 40 years. You know, we've had years where the 12 month default rate in high yield spike to 10, 12, 13%, those were not systemic events. I mean, investors lost money, but that doesn't qualify it as a systemic event.

GREG HALL: Yeah, yeah. I…

LOTFI KAROUI: And by the way, we're also talking about an asset class that has a trillion dollars of AUM. I mean, you know, that's in the grand scheme,  even if you make a draconian loss assumption of 10%, okay, that's a hundred billion of losses in the system.

GREG HALL: You know, a hundred billion here, a hundred billion there, pretty soon it adds up to real money. 

LOTFI KAROUI: It could add up. Yeah. But the point is, you know, we have to keep a sense of magnitudes too.

GREG HALL: Yeah. No, I, look, I think it's a really important point. And I 've been in this same camp, I think we have to be really careful to acknowledge that, you know, there could be some real value to the financial system to having this risk diffused, having it in lower leverage vehicles.

And also some real value in having great players who are able to step into the gap when the banks, you know, were forced to step back post-crisis, you know, good for the world, good for the American economy or the world economy.

I do wonder a little bit about some of the stuff that we're reading of late, and I don't know if you've developed a viewpoint on this, of course, it's fine if you haven't, but you know, we saw I think a couple of big banks over the last couple of days actually identify their back leverage that the financing they're giving to the private credit industry and as well as one prominent bank saying that they'd be curtailing that activity going forward.

And that's a dynamic that, you know, I've thought about of course, but it's now, it's right in front of us. Is that potentially the next shoe to drop here?

LOTFI KAROUI: Look, there is no question that the interconnectedness between the banks and alternative asset managers has grown dramatically over the last 10 years. And so I'll give you some numbers if you, there's a line in the H.8, you know, weekly table that the Fed publishes on banks’ balance sheets, and it's called loans. I

GREG HALL: Didn't read it this week.

LOTFI KAROUI: There you go. Well, you should read it. It's called loans to Non-Depository Institutions. And that's a really good proxy that you can use to sort of measure how much lending there is between the banks and  alternative asset managers.

So that went from roughly a little more than 300 billion in 2015 to 1.9 trillion today. So significant growth. There's been some changes in methodology along the way. So you have to kind of take that into account, but still, like the growth has been significant. So, you know, to your point, there's no question that the banks and alternative asset managers are way more connected today than they were, you know, 10 years ago.

Now, people call it leverage. I think we have to be a little bit careful with that. It's leverage and liquidity, because actually there's a little bit over 40% that there's just undrawn commitments.

And so that's used as sort of a liquidity backstop. I'll go back to the point I made earlier, which is, you know, if you're very pessimistic, you can always describe a scenario in which there's tremendous, you know, increase or in the demand for liquidity that ends up putting pressure on the banking system. If you remember, that's what we went through in the early days of COVID, for example.

It was not, you know, alternative asset managers, it was non-financial corporations drawing down, you know, on their revolvers that ended up putting pressure on the banks. Eventually it triggered a policy response by the Fed and the treasury. So you can always describe something like that. I would keep an eye on it.

I think it's a much higher bar than people think, but I'll take the point that there's no question that the two, you know, those two sort of sub-sectors of the financial services industry are way more connected today than they were 10 years ago. No question about that.

GREG HALL: Okay.

LOTFI KAROUI: Now, the other thing, you know, to keep in mind is that those loans are collateralized, you know, they're senior secured. And so it takes a lot basically, you know, for that to morph into a bad outcome.

GREG HALL: What does that senior secured? I, one of the things where we I'd actually wanted to bring this up earlier, but one of the things, you know, in talking to advisors, I want to make sure they take the right level of comfort in the phrase senior secured.

I feel like there's a lot of, and we're probably guilty of this too, there's a lot of jargon that gets thrown around. It's meant to be very comforting, sometimes I think it sounds maybe even a little bit more comforting. I remember back in the financial crisis, you know, we talked about super senior tranches, right, and that sounds great. Super senior, like, you know, even better than senior and ended up not.

LOTFI KAROUI: Yeah, I mean, look, what that means is that you have the most senior position in the capital structure. But if you have the most senior position in a bad capital structure, well that's still pretty bad or whatever a bad company, but that's what it means.

GREG HALL: And I think oftentimes just to be maybe a little bit more cynical, you might be the only position,

LOTFI KAROUI: Or you might be the only one. Exactly. In which case it doesn't mean anything.

GREG HALL: Yeah, yeah. And you're senior to the equity, I suppose.

LOTFI KAROUI: Yeah, I guess.

GREG HALL: Yeah. Okay. Alright. Well, listen, Lotfi, what a great debut for accrued interest. We're so happy to have you at PIMCO! Happy to have you on the pod! We will be darkening your doorstep frequently as we go forward  to get your viewpoint on this as we, as the situation unfolds.

I was really happy to take the time with you today to try to pace through this without shying away from nuance and trying to cover both angles of it, 'cause these are complicated issues in an evolving market, and we think advisors deserve, you know, to hear sort of full thoughts on it.

Not just sort of the bull or the bear case. So hopefully you all listening feel like you've walked away with, you know, a pretty fulsome understanding of the issues at hand.

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We will be back to you in a couple of weeks. We are approaching tax season, so we've got some tax themed shows on their way for you. And of course we'll continue to be responsive to events as they unfold in the world so that we can bring you timely information and our thoughts to help inform your client conversations. Thanks so much and good luck in the markets!