Jim Zelter
Subject: The Spectacular Growth of Private Credit Markets
Bio: Co-President of Apollo
Transcript:
Larry Bernstein:
Welcome to What Happens Next. My name is Larry Bernstein. What Happens Next is a podcast which covers economics, politics, and history.
Today’s topic is The Spectacular Growth of Private Credit Markets.
Our speaker will be Jim Zelter who is the co-President of Apollo. Jim will discuss the growing dominance of Private Credit lending and the disintermediation of banks. Current corporate capital expenditures require enormous sums of long-term capital to build computer chip factories, data centers, and energy projects. These long duration assets should not be funded by short-term depositors.
I want to learn from Jim why the preferable long-term lenders should be insurance companies. I ask Jim about Apollo’s growing annuity business and how those contracts are a better approach to funding these capital expenditures.
I held a conference in Washington DC with a bunch of my friends where we chatted with Jim. This podcast will be different from normal because some of the questions will be asked by my friends. The conversation will be a little more technical than usual and my hope is that you will get a flavor of what its like to hear a discussion with a group of sophisticated hedge fund investors.
Jim, can you please open with six minutes of opening remarks.
Jim Zelter:
Larry asked me to come talk about private credit. A hundred years ago in the U.S. there was this massive building of utilities. At that time, insurance companies were the key funders and not the banks.
I got in the business in 1985, the globalization, financial deregulation, and rates going down for decades. fueled all the growth around the globe. Today, we are on the cusp of huge needs for data centers, utilities, power, energy. Who is the long-term investor? Private credit.
Private credit is everything on a bank’s balance sheet: residential mortgages, commercial mortgages, inventory finance, trade finance, business that had been the purview of the banks. A couple of years ago with SVB what you thought was the right funding model really has an ALM (asset/liability) mismatch. But funding long-term capital off those types of balance sheets is not the right place to do it.
Banks in the US in my career have gone with providing about 65% of debt for companies to about 35%. In Asia, it is 90%. Europe, it is 75%. With the massive demand for capital there are not enough long-term investors.
You go back 40 years ago, you went to Mike Milken, you could do high yield bonds. and in the early nineties, they traded bank loans and that worked for 15 or 20 years. But then as banks took a step back, some enterprising folks came in and said I will offer a guaranteed loan at 9.5% or 10%.
Today in US leveraged finance is approximately a $5 trillion asset class. 1/3rd of it is high yield bonds, 1/3rd is leveraged loans, and a third is direct private lending.
I am here to talk about the role of market structure and the role of private credit. We are a big player, we are obviously an issuer, but we are also a buyer of private credit. We are one of the largest buyers of private equity firm sponsored private credit, which is just a tool for sponsors to buy companies.
The bigger opportunity is in the investment grade world. Intel has a $95 billion market capitalization today, and they have been public saying that their capital expenditures plan for the next five years is $150 billion.
How are you going to fund that? You are not going to issue enough shares; you are not going to put your Investment Grade credit rating at risk. The capital that is needed in the investment grade world right now for power utilities. If you are running Virginia Electric, you are not going to go to the state regulator and say, let's take up the rate base so I can build this massive gigawatt facility to take the power away from your people in town.
I grew up in a world that we all thought that public debt markets were safe and liquid and private was risky and illiquid. We run a small Investment Grade Bond Portfolio about $90 billion. It is not liquid. If you own the most recent IBM bond or Walmart bond that got issued in the last couple months, that's liquid. And if you look at 75% of the trading that goes on in IG it is block program trades. Your ability to trade one or two bonds, it is like trading the equity market. So, when people say, the IPO market's not coming back because of its market structure. We have created a world because of indexes, multi-strategy hedge funds that all work very well, but are trying to accomplish different goals. So, with that, happy to have a conversation on private credit, market structure or Apollo.
Larry Bernstein:
When I started at Salomon Brothers capital markets in 1987, I said it is the end of the banks. Now, I may have been a little early.
Jim Zelter:
You were about 35 years too early.
Larry Bernstein:
I was wrong. Bank balance sheets increased by a factor faster than nominal GDP. When I worked in Tokyo, there was no corporate market. All the corporates in Japan were funded by the banks. To this day, European corporate markets are still heavily funded by banks. And I was waiting for the American capital market model to take over around the world.
Question is why does this structure exist the way it does outside the US?
Jim Zelter:
Nine years ago, we created this business in the U.S. called Athene. It is a fixed annuity insurer. We do not protect your house, your car, anything. It is just retirement savings. We sell a hundred thousand dollars policy to Joe Jones in Iowa. We promise that individual 6%, we take the money upfront, we run it for 8, 10, 12 years with that money, I take that dollar and I put 95 cents into investment grade rated debt and I take 5 cents and I put it into alternatives. That is the US risk-based capital model. If I do that over in London, I take that dollar and I got to buy 75% of sovereign debt. And most people do not buy the core (Germany, France, Netherlands), they buy the proverbial PIGS (Portugal, Italy, Greece, and Spain sovereign debt) and lever it 10 times. That is called social policy lending. At its core, they are making insurance companies and retirees buy the government debt so they can go on a fiscal stimulus joyride. That does not end well.
Draghi is trying to push the European banks. Who would have thought that the two biggest banks in the investment banking trading model today are BNP and UniCredit? They are the top two banks in Europe. It's not Barclays, it's not Deutsche Bank.
Draghi has been very public in the last six months with his big white paper where he said, we have lost a generation of capital formation and that Europeans do not want 23-year-olds to become billionaires. It is too hard to start a business in Europe, and you cannot fire people.
We like to raise money at Apollo and when we do it over in Europe, you got to go to 11 different countries under 11 different regulatory regimes.
In the U.S., I can open a private BDC and start raising money in 90 days. If you look at France, they are the folks that have their energy act together because of nuclear. They should be the AI center of Europe, but they are trying to figure it out between legislation and regulations they will probably be too late.
Mike Gorzynksi:
Speaking as someone who looks for yield and holds to maturity, why is private credit a good thing? Why is it better than buying a public bond with a Cusip? I do not see why it is better to own a private bond versus a publicly listed bond. Like you do not get a mark on the securities?
Jim Zelter:
Whether it is primary, secondary, public credit, private credit, I am totally agnostic. I am an equal opportunity investor. When you have a marketplace right now that is run by non-economic buyers at the margin such as ETFs or other indexes, there is not a preponderance of great risk/reward in the public markets. If you run small, if I had a $4 billion balance sheet, I would not need to do a lot of originations, because there is probably enough in the marketplace that I could find the odd CRE (Commercial Real Estate) loan or the odd residential loan.
When you're thinking about the scale that we have right now in our business, to be able to go out instead of buying the Intel Holding Company bond with no covenants, and so I can get completely eviscerated with the rest of the world when they take any corporate action, I go to Intel and say, I'll loan you $11 billion on the plant you just built for $24 billion in Ireland. It is one of two fabrication plants in Europe. I will charge you 7 7/8% for that. I have a full covenant package. That is a better risk/reward.
We come in every single day wanting to find the cheapest opportunity. And that is why the mighty Apollo, I have got a $6 billion long/short credit hedge fund in the middle of the floor. It keeps everybody on their toes. So, we do not end up as the boiling frog because to your question is, oh, it's not marked. It must be riskier. Yes, on companies that are $10 or $15 million in EBITDA, which is part of private credit that is risky.
I started out as a high yield trader in 1985 at Goldman Sachs. Back then the high yield market was $150 billion in size and probably $25 billion of trading capital. Today you have got $1.7 trillion of a US high yield market, and trading capital probably $25 billion. So, there is no liquidity in the marketplace. And to your question is, well, if it is private, it's got to be bad. It means it is mismarked, it means the consultants want to buy it and show a better Sharpe ratio. There are some people that probably believe that. This whole idea of a liquidity premium that you think you have in the IG world is completely not there. We are active in the IG marketplace.
Unless you are trading a program, it does not exist. So, for you to be able to manufacture safe, scalable, spread yield on the terms that you want to do with covenants. There is an opportunity set, especially when you describe the banking model that I just described (with the loan to Intel).
Ray Iwanowski:
My long investment career has always been following the flavor of the day is dangerous. And so there was the SPACs, you guys do seem like being the flavor of the day right now in terms of what people are buying.
I do not know pricing in private credit very well, but it does not seem great. When you were responding to his question, you are comparing it to IG (Investment Grade Corporate Debt), but there's also equity, commodities, crypto and stuff. It seems like from a broader asset allocation, there's insatiable demand for the product. Doesn't that worry you from a pricing perspective?
Jim Zelter:
Part of our business, we are a safe spread yield investor. So, of our capital today at the firm, basically half of it is 8- to 14-year liabilities at 5%. I'm trying to make 225 (basis points) over that. I am not trying to make 12%. We get to that net spread. If I had a long/short credit fund, I would not be espousing some of these strategies. But our fixed annuity business is simple spread business.
Larry Bernstein:
Just to clarify this for the people at home. Apollo’s insurance company called Athene borrows money at 5% and invests the money at 7.25% and makes a spread of 2.25%. The assets are typically 10-year bonds, and the liabilities have similar duration of 10 years so that they are match funded. The risk of the business is that a significant portion of the bonds that the insurance company owns defaults.
The typical liability that the insurance company issues is an annuity that is sold to individuals who earn that 5% return on a tax deferred basis.
Jim Zelter:
On the asset side, we can create a portfolio of 95 cents of IG (Investment Grade) bonds and 5 cents of alternatives (like leveraged loans or other high yielding assets), and that portfolio yields me 7.26% today. Then I will go out and issue liabilities at 5%.
Alex Graham:
Question on the origination function. I spent a decade at RBC, and we were, because of leveraged lending guidelines, running into capacity constraints. It was extremely hard to be there for clients. That created the opportunity for the direct lending credit funds. But clients would tell us that it seemed very unlikely that Apollo would ever take one for the team the way a commercial bank would in terms of a tough deal. When is the regulator going to catch up with your freedom of movement and make it as painful for you as it did for the banks?
Jim Zelter:
I spent the morning over at the US Treasury having meetings. Today Apollo we manage $750 billion of capital. $100 billion in private equity, $100 billion in real assets, and $550 billion in credit. On the private equity side, I have got 30 investments. On the infrastructure side, I have 70. On the credit side, I have 4,000 corporate borrowers.
There are businesses that we do not buy that we would have bought 15 years ago in private equity. I think it would be surprising to you is we probably got $50 billion out to KKR, Blackstone and the other multi-Strategy funds.
Who scares me, who I do not lend money to is that bespoke PE firm that all they care about is that deal or the biggest guilty parties in creditor-on-creditor violence, the Double B corporate that CFO does not care! He will burn earth. Look what happened in Lumen, Level 3, and Dish. Those are folks you want to stay away from.
Our origination lending business this year probably 85% of it will be investment grade. The leveraged lending guidelines is a real issue. But that leveraged lending stuff does not end up on the Athene balance sheet because I got to be 95 cents in Investment Grade debt. If you take a step back, what Blackstone, KKR, Ares, Carlyle we all looked similar in 2009, then we all went our different ways. They are all successful models, but for us, we leaned massively into senior secured safe yield.
I had been in the market for 30 years and 2016 happened. What happened in 2016, the day after Thanksgiving, the Saudis oil. I said, you know what? We are never going to invest in a commodity ever again as a creditor. Our decision to push it up to higher quality, safe spread.
We created 16 origination platforms and they make an aircraft loan, or they make a senior CRE (Commercial Real Estate) loan, or they are very industry focused like PK Aviation. Those businesses’ goal is to create safe, scalable yield buying senior secured risk at 200 to 400 over comparable risk.
We are extremely focused on the regulatory issues. I spent time this morning over at US Treasury, I go once a quarter, go talk to them about what is going on in private credit.
We are massively regulated. We have 30 insurance regulators around the globe with UK, Ireland, Iowa, South Carolina. To say that we are unregulated that is not true and there is a lot of regulation around the business.
Ethan Youderian:
That loan to Intel for a chip fabrication plant sounds like a great loan, do that all day long. But what I am confused about is the funding structure and the leverage on the funding. So maybe it could be a little more basic on which vehicle exactly is buying that loan and what is the leverage. Let's say you're funding at 5%. What does that mean?
Jim Zelter:
If you own a U.S. regulated risk-based capital insurer today, you can be lever it eight to nine times. So, the annuity business is levered. The rest of it is managed accounts we have for pensions, sovereigns, and endowments that have taken a portion of their fixed income bucket and on an unlevered basis have given us a mandate in fixed income. Most of the capital is unlevered and then the insurance capital is the leverage that is inherent in the insurance company.
Ron Miller:
I am a middle market investment banker in the $100 to $500 million M&A business, the direct lenders just dominate, 90% market share. The banks have entirely lost it. You are a little less in some of that business, but also the banks are coming back. I work at CIBC. We are looking at how can we on balance sheet compete when we have lost that entire market. You have got the BDCs. (Business Development Companies that buy levered loans), you have got this competitive landscape and how are you going to play?
Jim Zelter:
If you are a private equity sponsor trying to borrow a $100 to $200 million bucks, that is a tough business. There will be a credit cycle. I have seen a few of them.
If you are a BDC and you own a lot of second lien paper or own co-investments on the equity side, there is a bunch of public BDCs that have run into trouble the last couple of years because of that strategy. So, there will be a credit cycle. It is not for amateurs, but there is a lot of amateurs out there working.
Ron Miller:
There's good money if you are the first lien and you are in it for 4.5 -5x EBITDA that is a different product than going deeper into a much larger dollar value transaction.
Jim Zelter:
On the surface, you are right. But like adjusted EBITEA, is it 4.5x times of what? You would be shocked at how many folks work in this industry right now that were not around in 2007, a lot of people. There is no doubt there's mistakes being made. I am not of the view like this is going to go on forever and it's the greatest thing, you got to just jump on. No, there is going to be a credit cycle. I have been thinking there will be a credit cycle for the last nine years. We have made mistakes along the way, but they are never systematic mistakes. And we are always focusing on blocking out the left tail risk, match funding, match funding, match funding. That is the risk in our business.
Larry Bernstein:
David Kostin who is in the audience who is the Chief Equity Strategist at Goldman Sachs, and David thinks that the S&P 500 equity market capital weighted will only earn a 3% rate of return for the next 10 years while an equal weighted index will earn like 8%. This morning there was a Bloomberg message redefining Goldman Sachs as Gloom and Sachs. How do you think about equity returns versus investing in private credit?
Jim Zelter:
I attended Duke, and I am currently on Duke’s endowment board. Jeremy Grantham visits every couple of years, and he's told us four times that the world is ending tomorrow. I am 62, since I have been alive, the S&P has returned 10.3% compounded annually which is an amazing performance.
The question you are really asking is with base rates at 4% and the ability to make a bit more with credit risk, I think these are compelling.
When I got to Apollo in 2005, I went to see all the investors and it was two questions. Is high yield cheap? Is it time to do distressed? Two very binary questions. We have a credit allocation, it is going to range between 5 and 15%, where should it be? And so it's a permanent allocation. And I have this high-quality portfolio.
I said, I grew up in Rochester, New York: Kodak, Xerox, Bausch and Lomb. Investment grade corporates are a scary minefield. You have no protections. And while they are big companies; they are ripe for disruption. So yeah, a very thoughtful allocation to credit, and I am being very objective here makes sense.
Larry Bernstein:
Thanks to Jim for joining us.
If you missed our previous podcast the topic was Killing bin Laden. Our speaker was Michael Vickers who was the Defense Department’s top civilian military intelligence officer under Obama. He is also the author of the book By All Means Available: Memoirs of a Life in Intelligence, Special Operations and Strategy.
The focus of our conversation was political decision making under uncertainty. One example that we detailed was Obama’s decision to send special forces to Pakistan to assassinate bin Laden. We also discussed enhanced interrogation techniques and whether they were effective and if it makes sense in the context of American domestic and foreign policy for the CIA to use water boarding against terrorists.
I would now like to make a plug for next week’s show with HW Brands who is the author of the book America First: Roosevelt vs. Lindbergh in the Shadow of War. Trump has indicated that his foreign policy would place America’s interests first, and this follows a long tradition in this country. We need to reconsider the debate prior to America’s entry into World War 2 and the arguments that Lindbergh made about why we should stay out of wars in Europe. You can find our previous episodes and transcripts on our website whathappensnextin6minutes.com. Please follow us on Apple Podcasts or Spotify. Thank you for joining us today, goodbye.
Check out our previous episode, Killing bin Laden, here.
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