Alternate View: Your Guide to Private Investment Asset Classes

Welcome to "The Alternate View" podcast, where we discuss the world of alternative investments with Verdence Capital Advisors Managing Director Matt Andrulot. In this first episode, Matt is joined by Adam Hagfors from Silverview Credit Partners to unravel the mysteries of the private credit markets. As co-founder and CIO of Silverview Credit Partners, Adam specializes in navigating the non-sponsor-backed private debt market, catering to family-owned businesses and entrepreneurs seeking capital. Together, they explore the evolving landscape of private credit, from its exponential growth over the past decade to its diverse range of financing options across sectors. They discuss the value proposition of private credit, emphasizing its role in filling a void left by traditional banking institutions and providing speed, certainty, and direct relationships for borrowers. Amid rapid expansion, it's more important than ever to scrutinize specific sub-sectors to assess long-term viability. 

Good afternoon everyone. This is Matt Andrulot, Managing Director of Verdence Capital Advisors. I want to welcome you all to the Alternate View. I have Adam Hagfors here from Silverview Credit Partners, joining me to demystify the credit markets.

Thanks, Matt, excited to be here and talk about private credit.

The Alternate View is just a podcast that we have here at Verdence Capital Advisors talking about what the value is of alternative investments within a set of portfolios. I felt that having you on today and talking about the private credit environment would be something that would be very beneficial to our listeners and viewers. I'll turn it over to you and let you talk a little bit about yourself in terms of who you are, and what firm you're with, and then we can jump into kind of demystifying the private credit environment.

That's awesome. Thanks, Matt, appreciate the invitation and excited to be here and speak with the audience. My name is Adam Hagfors, co-founder and CIO of Silverview Credit Partners, where an alternative asset manager that specializes in the non-sponsor- backed private debt market, so we work with family- owned businesses and entrepreneurs seeking $10 to $30 million in capital.

Obviously, you and I have known each other for quite a period of time, so I'm glad you're here in our offices doing the podcast. I thought you were the perfect person to talk about the private credit markets. I get this question all the time what is the private credit markets? To me, it's gotten so vast and expansive that defining what the private credit market is is very important. Now your view of the private credit market might be very different than someone else's view, but what I want to hear is kind of what you look at as the private credit market itself. Then we can talk a little bit about how you focus on that part of the market itself.

Yeah, private credit has been a growing part of overall capital markets, especially over the last 10 to 15 years. When I think of private credit, it's typically non-bank lenders, so those are traditionally asset managers that focus on all the traditional sectors of credit. Just coming from a non-banking institution, it's pretty incredible that investors today can participate directly in those types of transactions. All types of finance, from shipping finance, music royalties, various enteric aircraft finance, but also more common things like financing very, very large businesses supporting private equity companies or smaller firms like ours that are more boutique, focused in the traditional credit markets, focused on smaller sized companies.

Yeah, I mean it's a good point, right. So the market has grown significantly. I think the last statistic I saw was like $1.3 trillion and that it's supposed to more than double in the next couple of years, which it's amazing to me. I mean, obviously we've had a lot of banking issues over the last couple of years, to say the least, as well as the feds kind of putting some regulation on the banks. As you look at the size and growth of this private credit market, what do you think the value is with inside of that?

Yeah, I think really where people gravitated towards private credit was one the availability of capital. Banks have gone through some challenging times since the financial crisis in 2008, and that really is what hearkened private credit and really saw it start to blossom is where banks were just pulling back. Something we're really starting to see now, again, is banks never fully came back to where they once were. You're starting to see a bit of slowdown and lending from the traditional sectors you may have seen a significant slowdown in that Private credit is proliferated across all asset classes, whether it's real estate or some of the ones that I mentioned previously. What private credit besides just the availability of the credit offers is typically an aspect of speed, certainty and direct relationships. That has served both the borrowers and the private credit market well.

Is it concerning for you how fast this market has grown? The private credit markets have been in existence forever. The size of the private credit market today relative to, let's say, 20 years ago, is enormous compared to that. Is that concerning to you? From things like that, when it expands so fast, it gets concerning to me at least. How is this gap going to be filled? What do you think about that?

Yeah, very fair question. It is concerning from the standpoint I believe in mean reversion, and if something gets too large too fast, it usually reverses, but that's where you need to look into the sub-sectors of private credit. There are certain parts of the private credit market which are serving a market better than the banks can, or maybe serving a specific niche that banks just aren't interested in. I would say the part that seems to be growing incredibly rapidly is maybe the very large loans. I think they served a purpose at a time and place where lenders were really replacing the mega banks and speed and certainty was part of it. I think there were other aspects of it, whether it was the direct relationship working rather than working on a club relationship, perhaps it was looser covenants and things like that. So I'd say that part of the market seems to be concerning to me is that much larger part where banks have historically played. Banks still play and I think banks will continue to play in the future.

Do you see, as things rush to certain areas in the markets, you see the opportunity set tend to narrow right. Do you see that happening in this space at some point in time?

Yeah, I mean the whole idea is that if there's an opportunity or excess profits, competition erodes those profits away. So I think you'll see that again in the more highly competitive parts of private credit sectors, like the one we focus on and I think a lot of other private credit managers focus on, don't necessarily have that same competition. There's various moats and reasons why.

So would you say that there's existing opportunity for this smaller lender relative to the larger lender, given what the opportunity looks like in the growth of this? I mean we see it all the time, I mean it's elicited constantly with regards to opportunities in the private credit space, which I think is highly diverse and you have to really understand what you're investing in and who you're investing with and then what that opportunity set looks like as we move forward. The small mid-market space of things people throw those terms out there all the time versus the larger lenders per se. Do you think that market the smaller mid-side lender is going to has more flexibility in that market as this continues to grow?

Yeah, absolutely. That's why we've chosen to focus on that part of the marketplace. We don't work with private equity firms. We like working with the smaller, family-owned businesses and entrepreneurs which are harder to find those deals, harder to underwrite those deals, but we believe we can find better opportunities and better returns by targeting a sector that is less banked. What we have seen is that banking sectors really merged into two different sectors, Diverge really into two different sectors. One is the really small business banks, community banks in particular and then you have the mega banks and there aren't those small regional banks existing anymore. They've all been forced to merge over time.

So if you're doing so well investing in that part of the market, why aren't the small regional banks investing in that market as well? You would think that everyone's a business and you have investors. They potentially have investors, or they're trying to generate a return for their balance sheet themselves, right, why aren't they investing in that space?

Yeah, I often say that what we do shouldn't exist. Banks should do what we do. I think there's a variety of regulatory reasons why the small community banks aren't growing to fill this niche and you don't have those regional banks carging this market anymore. I'd like to point to SunTrust Doesn't exist anymore. P&c recently, about a month ago announced that they needed to get larger. I believe that the sixth largest bank in the United States and they don't think they're big enough. So, largely driven by regulatory changes coming out of the financial crisis, where you're seeing the banking sector continuing to narrow down to fewer and fewer of the very large banks, Now, you think this is beneficial to the investors?

I mean, at the end of the day, we're allocators and help our clients invest right. So as this market kind of gets larger and larger in the private space, is it beneficial to the private investor? I mean, we typically work with large clients as well, and not necessarily institutions have been playing that space for a while. Do you think it's beneficial for clients of ours and investors that are, let's call it, small or I don't want to say that we're small by any means, but smaller than your traditional institutional investor?

Absolutely. I mean, you've seen this growth in alternative credit, private credit, and I think it's an incredible opportunity for investors to get closer to what those investments are, being able to have a pure play. However, they want to access credit, whether it's those very niche opportunities, things like royalties or shipping or aircraft or other targeted credit investments. But even looking at things, whether it's lower middle market non-sponsor backed, like we focus on, there's lower middle market sponsor backed, where you're working with small private equity firms and you have the full spectrum all the way up to the very large firms, I think it's an incredible opportunity. It really lets the wealth manager, the advisor, really target where they see opportunity and serve their clients' needs, and the return profiles are different across the board and in some situations you can get monthly payments or quarterly payments. So it really lets the wealth advisor, working with their client, tailor the product to what their specific needs are.

I think a lot of people don't understand the sponsored, non-sponsored back kind of lending component of things. So I wanna talk a little bit about that, just briefly. In terms of usually that sponsored back lender, private equity provider needs capital for a leverage buy out of some sort. You've seen a lot of different firms creating their own business development companies or BDCs what you say or are in the leverage loan space. Try to provide capital to some of these businesses that are transacting in that private space. Why do you guys typically try to stay away from that? Relative to the non-sponsored back lender, yeah, really two key reasons why.

One is the private equity firms really don't like the covenants that we put on our loans, like too restrictive. You're saying.

Or you can be specific, yeah.

I think our covenants are a bit restrictive. We're trying to protect ourselves and put in place certain tests and requirements that the private equity firms generally don't want to adhere to because they don't have to in this current market where they there's more capital chasing those deals than the non-sponsored back sector. The other thing I think that scares me in the sponsored back community is a bit incestuous. You have private equity firms lending to one another, you have private equity firms involved in the same deals and it's a bit of a circle of who's funding who and who's participating in what transactions. When the world is going up and everything's amazing, that works out okay. Well, I'm for everybody, but when things get dicey it'll be curious to watch how those relationships change over time. When the going gets tough, I think we'll see some true colors out of some of those organizations.

I always say the term club deal, and that is exactly what you're talking about on this one.

Yeah, I would say it's club plus. Club deals typically refer to groups investing together in a single transaction. That also I find a bit funny. When you think of private credit, at inception you think of a bilateral relationship, meaning you have a single borrower and a single lender. That's typically what we're doing. What has really occurred more frequently in the larger portion of private credit is what you're referring to as club deals, and that's where you'll have two, three, five, 10, 15 different lenders providing capital to one single borrower. Again, it makes me scratch my head a little bit, because in the publicly syndicated loan market what typically had happened? Where a bank originates it, banks end up effectively doing club deals and so you start to lose some of the speed and certainty of execution. You learn some of the lose, some of the relationship benefits of private credit, and so that's where maybe you were talking about earlier. You see a bit of morphing of. Is private credit really private credit when it looks and feels just like traditional leverage loans or traditional bank led deals? When you have these club-like situations?

One of the things I think is people confuse is the private credit markets from a credit quality perspective is lower in credit quality, that people have a perception that they can't get regular financing through a traditional means, that they have to go into this private credit market because the quality of their business or what they're doing is not solid enough to almost like a high yield loan kind of thing. Do you want to talk a little bit about that and explain a little bit about the quality component of the private markets and the things that you're looking at relative to what's called the public financing world of credit?

Yeah, I think that is a big misconception. There are a few of them in this industry of private credit and one of them being these borrowers are going to the private markets because they can't access the capital due to credit quality. That's not accurate. They're accessing it for other reasons. Most often times it's some aspect of speed and certainty of execution. They want to know they can get the deal done and they want to find a partner that can accomplish that goal for them and they're willing to pay a premium to get that goal accomplished. We certainly see deals in our space and the deals we focus on one would call bankable deals from a risk profile, but the banks aren't targeting these smaller size loans of 10 to 30 million in the part we plan. So I would absolutely say that that's an inaccurate statement that these deals are so risky. That's why they go to the private markets. There's some other aspect whether the banks aren't providing that type of capital or there's a relationship, need or speed and certainty aspect.

I mean obviously the size you're playing in as well. Right, the let's call it the small, the minimark alone is something that they just don't want to participate in either, right?

Yeah, I mean banks should do this. Community banks naturally won't. They serve us a specific community, we serve the entire United States, and then regional banks used to cover this type of market, but they also grew rapidly and in some cases have found demise. And that rapid growth SVB and First Republic come to mind of firms that might have looked at these types of transactions that we specialize in several years ago but prior to their acquisitions, were sending deals our way.

So yeah, I mean, in order to do that right, speed and certainty, some sort of collateral that might not be straightforward. They have to pay more for that as a borrower, correct?

Yeah, simple supply and demand and there's a service component.

And where does? The other question I get is pretty frequently is like why are they willing to pay so much from an interest payment, you know, an upfront origination or a back end disposition type of fee, to borrow a certain amount of money with that speed of certainty, at that rate?

Yeah, it's interesting. The more sophisticated borrower kind of my experience doesn't think as much about the price and thinks about what the end goal is. That calculation is taking place on any borrower when they borrow capital, what do they think they're going to accomplish with it and what type of return they believe they're going to benefit from. When you're borrowing in the teens type of interest rates, you're expecting to generate a return well in excess of that and you can try and find cheaper capital. You might be unsuccessful. You might lose the opportunity you're trying to chase with that capital you'd raised through debt. So speed and certainty can be really really valuable and capital in the right hands, the right sophisticated hands, is less price sensitive and more about poking at the job done.

What about the Federal Reserve's movement of interest rates? We really haven't talked. We talked a lot about credit in general but obviously interest rates play an impact relative to the private credit markets. You would talk a little bit about kind of how much of an impact that might actually have relative to a borrower looking at an existing rate.

Yeah, rates have actually gone up pretty substantially over the last few years and feels like it's plateaued quite a bit at this point. My business focused on fixed- rate lending. We're not macro investors. We're not trying to track that a part of the market and what we found is the borrowers in our sector really would rather know what their payment is and not be concerned by rates going up or down. So the Fed plays a role in the broader private credit market by setting that base interest rate that everything price is off of and credit's gotten incredibly expensive and it's been expensive now for a period of time. So it'd be interesting to see how long it sits here and what follow-on impacts could take place there.

Maybe a funny thing to say For the listeners. Probably the reason I'm a credit investor is thank goodness, that would have been a terrible macro investor. But when we set a fixed rate, when we launched the company, we expected rates were going to go up at some point. I think it probably took five years longer than we expected for interest rates to go up. But what we didn't want to have happen was have our borrowers, unaware of the interest rate environment, rates go up and now they're defaulting because they can't afford their payment. And we said you know, we're just going to set a high interest rate and serve our borrowers accordingly. Now we've seen rates move rapidly for a lot of borrowers and it'll be interesting to see. Thus far we haven't seen defaults pick up in the broader credit market. But with rates at the current levels, if they remain here for an extended period of time, I would expect to see an uptick in defaults due to where rates are.

I mean rates go up and down. So I mean you're playing both of those games. I mean if you were resetting interest rates on the downside, it's not as beneficial either if you have a fixed rate correct?

Yeah right, On the investor side, as rates go down, that return profile goes down. On the fixed rate side, they just know what they owe us. We know what they can't afford and can't afford. So it helps in our underwriting.

So, from a private credit market perspective, as a novice investor out there looking at different potential investments, what are the risks that you would say they should be looking at as it relates to the private credit markets? What should they know? That they're not asking, I think is always like what's the question that we don't ask? If you don't ask it, they don't tell you. It's kind of the point I've always made, and I've never seen a presentation deck that was not great and showed the upside potential of everything that takes place. What are those risks that you would tell these folks If you're looking at private credit investments? This is something that you should make sure you understand, just in a broad, general sense.

You know what I mean. Broad general sense is you know the economy has been great for years. Everything's gone up, there have been no problems. So I think it worth while diving a bit into their experience, for challenges, problems, challenges of problems are going to occur in any portfolio, credit or otherwise, and so I would encourage people to ask about their prior experience dealing with challenges. What have they done, what have they seen, and probe that a little bit more. I think That'll be pretty insightful to get a sense not only of the experience but their demeanor and, you know, are they open to talk about challenges they faced?

One of the questions that I have in here is you know, does the demand for private credit dissipate over time? I mean, are we going to revert back to the traditional banking sector? I know I mentioned earlier that you know the expectation is that we go from 1.3 trillion to 2.6 trillion in a couple of years, which I think is amazing. But do you think that demand will ever revert back to the traditional banking system? Is it a fed kind of issue that we have here, or is it more of a demand or supply Like what? Do you think about that?

Yeah, I think you really raised an interesting point. You've done so many different paths here. In one hand, I do believe that the regulators like the private credit market because you do move away some of that systematic risk from the banking system and put it into other hands. Naturally, you're taking away investment opportunities from the banking sector as well. So that's a double-edged sword there. But so I do think private credit plays a role here. I don't know where it shakes out long-term.

I think it's a key part of the investment portfolio on a go-forward basis, something that just it's a new tool that investors didn't have. You know, historically for the fixed income sector of credit, you could go down treasuries or bonds or loans, and I think private credit gives them the ability to be a bit more tactical and focus and express a certain view versus what historically was going through either a mutual fund that typically didn't give you that same level of optionality or targeted focus. So I think private credit has a real meaningful role on a go-forward basis. Does it grow from here or shrink from here? I don't know, but I think the majority of what we know is private credit today will go on for a very long time.

I feel like it's a shifting of risk, as you mentioned, from one sector to another, where you had the traditional banking sector taking on some of that risk. Now it's moving to the asset managers and investment managers. Big, huge investment firms are kind of controlling liquidity, even in the public. We didn't talk a lot about the public markets, but the public markets obviously have an effect on the private markets and vice versa to some extent Absolutely. But you see a lot of shifting of risk between lack of prompt sacks, lack of holding inventory now shifting over to the big, huge firms like Fidelity Investments or Morgan Stanley or Merrill Lynch or someone else that has large individual clients or manages large mutual fund vehicles or ETFs or something of that nature. We're typically invested by retail individuals as well who don't have the same sort of I would say knowledge base, necessarily for that long-term view.

Yeah, I think it's a huge role that firms like Verdence Play, as providing their customer base access and advice along the process for where they can tactically find their in the private credit world yield portion of their portfolio and not be purely restricted to what's in the public markets.

Well, I mean the private credit markets have the less volatile day-to-day market of things, where we see the price of a bond move daily, right? Whether you could sell it or buy it at that price in that market at that particular time, that's debatable, right? As you know, you're in that world for quite a long period where the private markets are very much focused on the economic component or the business that you're investing in, not the actual fluctuation. It's whether can this person pay us back?

It's a bit more of a fundamental value approach than where you might see some technical price swings in the public markets. There is that dynamic that certainly takes place.

I feel like there's less contagion in that market as well. On the private side. I mean, we went through COVID. You were investing through COVID. How was the result? We saw the price of bonds drop exponentially. Right. A lot of that came back over time. How was it like in the private markets?

Yeah, great question. We've always used third parties to value our portfolios and I'll say that first quarter of COVID. I was very happy to have that because I would have had no idea where one should mark private portfolios. Generally, they brought things down as one would expect. There was a trying and scary time but you quickly saw both public and private markets react positively. I think it was another quarter and things were effectively normalized. In t The public markets you saw much more wild swings due to technical factors. You had foreselling. fore selling had panic. What's referred to as bid offers widened out just because people didn't know what was going on. That has an impact on the marks in the public markets, whereas the private markets take much more of fundamental approach. We use market partners and Deloitte the accounting firm for evaluations. They acknowledge there's a challenge in the world and they brought the marks down, but those quickly reverted.

What were your borrowers saying at that particular time? I'm sure you were concerned, Ken. My borrowers pay back the loan that we provided them, plus the interest rate that we're charging them.

It's a pretty funny story. It dives into what we were talking about on the private equity firms and stuff we lend to family-owned businesses, and small businesses, and there are all these articles in the Wall Street Journal at the time about private equity firms going to their lenders and demanding concessions and saying, look, we're in COVID, these aren't precedented times and we're not going to pay. You're not going to force us to pay and give us waivers. I remember a few of our borrowers must have read that article in the Wall Street Journal and called us and said proactively our business is fine but unprecedented times and almost verbatim was written in the Wall Street Journal. I laughed and said I read the same article your business is fine, we're not doing anything of that. It was a pretty good story, but it's one of the things in the sponsor back world. They wave a very heavy stick and I think they can put their lenders in an odd spot in times like that I want to give you a chance to ask me some questions.

I love it. I've done a bunch of these podcasts and I never get the opportunity to turn the mic around.

Mine's different. We have an alternate view. This is the alternate view. You get to now ask me questions if you'd like.

Matt, I think you have one of the hardest jobs in the industry. Your phone's ringing off the hook. People are always trying to sell you and pitch you on something. How do you decide what's worthy of your time to dive into any type of asset class or strategy?

It's a good question. It's very difficult because we have this massive universe Private credit being one of them is just a and there's so many different subsets of that marketplace. We look at it a little bit differently. I mean, we build portfolios here for our client base. There's certain things that we're looking to achieve with that. Then it takes a long time. It's not a short process.

When we evaluate private investments, it's not just the investment itself, it's the people, it's the business, it's the market environment. We have a lot of different things that we're trying to evaluate over that short period of time, which I turned into a longer period of time, because we take it very seriously. When we commit capital to certain firms, whether it's Silverview or anyone else, we look at it as a long-term commitment. The docs say a long-term commitment, but regardless of that, it's a long-term commitment and it's a relationship that we want to have a very good understanding about who the people are, how the investments are going to work, what the transparency looks like, and that just takes time. But to more directly answer your question, we look at things that we want to piece into particular portfolios to round out a very well-diversified allocation, whether it's in private credit or private equity or some other investment.

Wow, I mean it's amazing to watch that all come together. You've done a great job.

We try. I appreciate you spending the time talking about private credit markets. Hopefully we demystified it a little bit for our listeners. I really appreciate it, Thank you.

I'm honored to be here. Matt Gladly come back anytime you want to go on to a part two.

All right, sounds good.

Thank you.