Podcasts Private Credit Through Market Cycles: Lessons from Three Decades

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Damian Cilmi: 0:04
Hi listeners, welcome to another episode of the Praemium Investment Leaders Series podcast. I'm your host, Damian Cilmi, Head of Investment Managers and Governance at Praemium, one of Australia's leading specialist platforms. Today, we're back looking at credit markets, and in particular, with a guest and a group that has a strong presence across public and private credit markets. It's fair to say that private credit has seen a number of new entrants over the last few years, but we're fortunate to be joined by Clark Koury of Oaktree Capital, who have been specialising, and some would say leading, in this space for over 30 years.

Clark is Managing Director, Credit Product Specialist and Head of Oaktree’s Product Specialist Group. In this role, he supervises Oaktree's product management activities across credit, equity and real estate, oversees the effort for Oaktree's private credit strategies and has led initiatives across performing and opportunistic credit businesses.

And about Oaktree — Oaktree Capital is a global investment firm specialising in alternative investments, particularly credit strategies. Founded in 1995 by a group of executives who left a rival group, Oaktree has grown to become a major player in the alternative investment space, with a focus on distressed debt, corporate debt, real estate and listed equities. Oaktree employs over 1,200 staff around the globe and manages over US $200 billion for a range of investors.

Damian Cilmi: 1:36
Hi Clark, welcome to the program.

Clark Koury: 1:36
Thanks for having me. It's great to be here and really appreciate the partnership.

Damian Cilmi: 1:40
Excellent. Thank you. And welcome all the way from Los Angeles. How was the travel?

Clark Koury: 1:47
Travel was great. The length of the flight is perfect because you can unwind a little bit, watch a movie, have some dinner and still get a good night's rest. 

Damian Cilmi: 1:59
And just one continuous flight as well. That's very nice. You know, the 14 hours. Very good. And before we delve deep into private credit, tell us how you got here today — and please don't tell me that you walked down here. But how did you get down into the space and into the role that you're in today?

Clark Koury: 2:17
I started my career in investment banking and specifically within leveraged finance, first at Barclays, later at Goldman Sachs. So my foundation was really built in and around the credit markets and specifically in below investment grade, which really dovetails nicely into what Oaktree does and where we really specialise.

So I did that for about seven years. When I left Goldman in 2016, I made the move over to Oaktree. I was actually based in New York for that time and then made the move to Los Angeles with Oaktree. Over my time at Oaktree, I have supported pretty much the full range of our credit platform, starting from liquid to private to opportunistic and sort of back to private credit, which is really where I spend most of my responsibilities as a player, but, as you mentioned, I’m also very much a coach for my organisation. Our team is about 35 people globally across LA, New York, and London, and we support really the full range of Oaktree's products.

Damian Cilmi: 3:30
So how was the move from New York across to Los Angeles? And I suppose something about the investment community in Los Angeles.

Clark Koury: 3:40
Yeah, so I am not from New York. I grew up in the Midwest of the United States. I went to university in New York and then stayed subsequently after. I was there for about 11 years. At that point in my life, it was a great city, great opportunities, a lot of fun to be there. My mom actually was a big influence in me going there. She had basically said that her biggest regret was not living in New York at one point during her life. And so that was a big catalyst for me to make that move.

But I was definitely ready for a change and the move out to LA was very welcome. The finance community in LA is a lot smaller, but I found with Oaktree that it was really a pretty special culture in the finance world where there was just a lot of support. And you couple that with more of the LA lifestyle, the beaches — this will resonate with the Sydney crowd, I’m sure, given the beach community there. It was a really excellent move for us and for my family.

Damian Cilmi: 4:56
Yeah, and so it is smaller, but very high quality. Some of your peers out in Los Angeles, so it's a very interesting market over there. So we'll get into about, I suppose, what you've found with Oaktree. You've been there quite a while. The firm is celebrating — it's been 30 years, I think, this year.

Clark Koury: 5:17
Yeah, April. A big party. It was great. Yeah, it was a very nice time.

Damian Cilmi: 5:27
Oaktree has now 30 years under its belt, and has seen, I suppose, the evolution of the private credit market, being at the front — the forerunner, if you will. And you've seen a journey across market cycles. So how has that kind of shaped the way that you invest today, that 30-year journey?

Clark Koury: 5:49
Yeah, I think it's a really interesting question. And in hindsight, with the benefit of investing through cycles, you see a lot of erratic behavior. You see things where investor sentiment and psychology really take over. Fear and greed can lead to big swings in the public markets, whether they be debt or equity. And so one of the things that we focus on is really understanding the sort of fundamental performance, bottom-up underwriting, as we call it, where we're looking at each individual business and really trying to identify what are the risks — whether that be at the company level, financial, operational performance. We also take into account what's happening within the industry and understanding the fact pattern there.

But I think, more importantly, I would say three things about sort of what we've learned over those times. I think a willingness to step in when others are pulling back has really rewarded us in a lot of ways. And we've seen that sort of time and time again when the markets really become choppy. We are one of the few managers that are sort of catching that falling knife, so to speak, and that can lead to really excellent outcomes for Oaktree and, of course, for its investors.

From an underwriting standpoint, we touched a little bit on the bottom-up fundamental underwriting that we do, but I think the way in which we think about stress testing our investments, we really think about what is that scenario, that two-sigma or two-standard deviation situation, and how will that impact this business? How will it impact the capital structure of this business? I don't know that a lot of other managers necessarily do that. They might tinker with some sensitivities around input costs or labor or supply chain and maybe try and recreate a recessionary environment and what the subsequent impact might be. But I don't know that many are necessarily sensitized for that sort of draconian scenario.

Damian Cilmi: 8:07
So I was going to say that'd be a function that many of your peers haven't seen a cycle, let's say. I mean, I know it's a big kind of call but, just given the age of some of these businesses, they really haven't seen much of a credit cycle out there. And then you dovetail that with the experience of many of your founding partners, et cetera, that have been throughout all of that. That, I'm sure, permeates through the business.

Clark Koury: 8:35
Yeah, it's a great point, Damian. If you look at the growth of the manager space in private credit, probably more than 95% of those managers did not exist pre-crisis, pre-GFC. And so have they invested through a cycle? 2020 was probably the closest thing that we got, and that was three, four months, and you were sort of back to levels pre-COVID. And obviously that was very much tied to government stimulus and supporting the economy in a meaningful way. But there hasn't really been, within private credit at least, a true sort of credit cycle. And so the good times have been rolling, and a lot of our competing firms have really built very, very large businesses around that space.

For that reason, the last point that I would just make on the question of things that we've learned — Oaktree, being a function of having really what is the world's largest opportunistic credit business, and certainly probably the longest standing one in the marketplace. When we are structuring a deal, we are thinking about: how can we restructure this business? What does asset value look like? What are the levers that we can pull if something doesn't go right? And does the documentation of that loan or that investment offer the right protections and give us flexibility when we need it? And we certainly saw this in 2020, where other firms out there were in the marketplace looking for workout professionals, looking for those restructuring experts. We at Oaktree were pretty uniquely positioned because we have all that expertise in-house already. And so that's another thing that I think is really beneficial that we've certainly learned over three decades of investing.

Damian Cilmi: 10:33
Very good, very good. The market's getting a bit crowded now. We just touched on earlier about new entrants. But I suppose the question worth teasing out is: what truly sets apart a private credit strategy when you look at peers? We touched on some of the stuff around documentation and so forth, but let's unpack that — and, especially during periods of market stress and dislocation, what sets the good from the great apart?

Clark Koury: 11:04
Yeah, what sets the good from the great apart. I think what you'll hear most commonly — and let's start with sort of what the party line is around what differentiates a private credit manager. What you'll hear most often is relationships — the power of relationships. You have to have relationships. You've got to be in the deal flow, you've got to see all the opportunities, and having those relationships with private equity firms unlocks that.

Oaktree's position on that is it's certainly true to an extent. When you think about our business within private credit, we were one of the earliest managers within private credit. Private credit pre-GFC meant really junior capital to private equity sponsors, and that coincided with the start of our mezzanine business in the early 2000s. And so we have grown up alongside many of these private equity firms that we continue to do business with today. So that relationship has now spanned 20 plus years, and so we have a lot of those relationships.

The other thing that really, from a relationship standpoint, is important for Oaktree and we think is a differentiator for our business is we have capital across liquid credit, private credit, opportunistic credit. We can be a counterparty with these companies across any market environment, and that is valuable — particularly to the point that you are making.

In periods where there's market volatility, what happens if capital markets see certain lenders in the marketplace sort of close for business? Who do you go to? You go to Oaktree. And so having that relationship, whether it's in the good times or the bad times, we are a really important counterparty. And that allows us, in a lot of ways, to punch above our weight in the private credit space where we are quite sizable — we have about $40 billion in private credit assets under management. But that pales in comparison to many of our largest peers, who are well north of $100 billion in a lot of instances. But we can do some of the same things that they can do, and we benefit from being part of that broader Oaktree platform.

Damian Cilmi: 13:22
Yeah, and then that, I suppose, gives you the benefit of providing a solution for them.

Clark Koury: 13:40
Absolutely. And particularly in those periods of market volatility, that solution requires creativity. It requires someone that can be a thought partner, and we roll up our sleeves and are happy to do that in those situations. Historically, even looking back over the last — in a period like 2022, or in a period like 2020 — we did a number of those situations and they ended up working out quite well in most instances for us, because we were effectively a lender of last resort. And these companies needed us to fix a problem for them, whether it's a liquidity crunch, a near-term maturity, and they didn't really have other avenues to go down. Capital markets were closed, banks were reeling back in some of their lending activities, and so that provided a really interesting opportunity for Oaktree to step in.

Damian Cilmi: 14:33
Yeah. Now we'll get on to, I suppose, some of the conditions that are out there and also what investors are talking about, thinking about at the moment. So we'll just start with the current conditions. You've got inflation lingering a little bit. There's a couple of questions about impact of tariffs, et cetera, on that. We've also got a bit of global uncertainty at the moment. Always seems to be some level of uncertainty, but maybe a little bit more at the moment in some geopolitical elements as well. So why are investors still comfortable looking at private credit? How is it supportive in this current environment?

Clark Koury: 15:13
Yeah, I think I would point to two key characteristics of private credit that are generally, I view as very beneficial in a portfolio. The first is, when you think about the value proposition of private credit, the key element is what's normally referred to as an illiquidity premium. When you make a private loan or a direct loan, you are in that loan. There's not necessarily avenues, although there are some folks out there trying to create a little bit more of a trading market in these instruments. It's unproven and we'll see whether or not that's actually successful. But when you're in it, you don't have the ability to trade out like you do in a high-yield bond or a leveraged loan or in public equity, and you should get paid for that trade-off.

The other element that you occasionally will see is what we like to call a complexity premium, where there's a situation that's hard to understand, it's not as straightforward, leverage might be a little high, there's some hair around the business, and you can command an additional return premium for that complexity. And so between illiquidity or complexity, you should expect some differential above and beyond — some premium above traditional credit. And if you look back over the last 15, 20 years within private credit, you'll see that private credit has delivered on that. It's delivered two, three, 400 basis points more return over that period than the equivalent high-yield bond or leveraged loan. So that would really be the first one.

The second is volatility. And we talked a little bit earlier about how fear and greed and sentiment can drive swings. The market is always sort of moving in one direction or the other, oftentimes at extremes. The nice thing with private credit is that these loans are marked based on the fundamental performance of the business. So you're effectively pulling out that sentiment element, which can create swings in prices.

So, just to provide a little insight into that process: when we get financials from these borrowers, we effectively send them to our third-party valuation firms. We use four at Oaktree. Those valuation firms will take all that information, they'll put it into their models, and they will provide us with a range of valuation. Typically, we'll take the midpoint of that range. And it's really based on the performance, as I said. So if a business is performing to plan, you should expect that that mark will continue to effectively accrete towards its par value. It's really only in the situations where there's underperformance that you'll see actual marks down. Now, there is an element of relativity here where if the credit markets sell off broadly, there will be some impact to your private book, but that impact is more minimal unless it's a really sustained sort of downdraft for a sustained period of time. So really it's the fundamental performance that drives how these loans are ultimately valued. And that can provide a really nice ballast in portfolios where you kind of lose some of the volatility that you might see in other parts of the market.

Damian Cilmi: 18:57
And we've seen it already this year. I mean even Q2, having a look at that period between April and the end of June — there was a lot of US 10-years round-tripped all over the place. Equities did as well too. I mean just that quarter that’s just passed, that was kind of a reflection of all that uncertainty. But I suppose you've got a position here where, fundamentally, if there's nothing that's changed with your businesses, valuation's not changing.

Clark Koury: 19:58
Absolutely. That's exactly right. So you deal with the uncertainty in a way by just being valued on fundamentals ultimately.

Also, just unpacking a little bit about what you're seeing with companies in this space — how’s everyone dealing with some of the uncertainty out there at the company level? Has there been any opportunities that you've unpacked?

Yes, so I think the uncertainty — the most immediate impact within private credit — has been a pretty dramatic slowdown in M&A activity. The most active area within private credit is providing capital to private equity-owned businesses, whether that's de novo LBOs or refinancing. We've continued to see some of that refinancing activity, but M&A volumes are down, and that's because buyers and sellers can't agree on valuation in what is very much an uncertain sort of economic environment.

Where are we finding interesting things to do? I think first and foremost, we are — maybe just to take a quick step back. If you look a couple of years ago, the trade to be in at the time was in large cap lending. That was really sort of a nascent part of the private credit market, and it was fueled by the regional bank crisis in the United States in 2022. What you saw at that point in time was banks large and small — some of the tier one, tier two, tier three banks — basically all collectively said hey, we're out of the lending game. Capital markets shut, and that forced large borrowers that historically only tapped the bond markets or the leveraged loan markets to move into the private markets.

So it was a little bit of a transformative period for the private markets because historically the private markets were really for small and medium-sized businesses, right? Core middle market or sometimes upper middle market, not really the large cap lender. But you started to see that trade. And what was interesting about it was because there was such a void of capital, it provided a really interesting opportunity where you could actually get similar, in many instances better, returns than in core middle market. And from a risk standpoint, at least on paper, you say hey, this large business — more diversified global footprint, larger customer base, much more diversified end markets — on paper, theoretically better able to withstand a recession because it's a market leader, it has more negotiating leverage versus a business in the middle market which may or may not have a need to exist, often a secondary or tertiary provider of goods and services.

So that was really interesting a couple of years ago. We're actually seeing a lot more competition in that space, and there's a lot more of a relationship between what's happening in the syndicated markets and what's happening in the large cap market. And so, as spreads have started to compress on the large cap side, you've also seen spreads continue to compress on the leveraged loan side.

Damian Cilmi: 22:53
I did want to talk about, I suppose, some of your all-weather approach and the fact that you will straddle different markets and have a look at the relativities out of that. So how are you using that approach to protect capital and also find opportunities?

Clark Koury: 23:02
Yeah. So I think one of the interesting things that makes Oaktree a little bit different is we built capabilities beyond just providing that sponsor lending capital. And in periods like today we can still do the sponsor lending stuff — we’re actually skewing more towards the core middle market today because of some of that dynamic, that competition that we talked about in the large cap side.

We also built a really large business around non-sponsor lending, which is primarily providing loans to publicly owned businesses. What's interesting about these is you can typically command a 100 to 200 basis point premium, because you don't have that sophisticated sponsor private equity firm that's validating, hey, this is what this business is worth with a new equity check. And so you have to value that business on your own. Often these situations have more conservative structures, and so that can really provide a nice, interesting value proposition, particularly in strong or benign market environments where you have this law of lowest common denominators — you have a deterioration in terms, pricing and covenants in the sponsor space, and we can pivot into the non-sponsor space to really generate some nice alpha.

Conversely, in weak markets — and this touches on your all-weather approach — because we have that kind of world’s leading distressed debt or opportunistic credit platform, they will see all sorts of opportunities. Some are a fit for them, but they're really targeting sort of mid-teens-plus type returns, so things that are generally going to be out of scope for our risk profile. But there are periods of time where there could be some overlap, and they also see things that are, quote unquote, “too safe.” And so that provides us with really nice opportunities to find these capital solutions — situations whether it's industry-specific or idiosyncratic — where we can be that lender and generate really nice returns in what is generally a very super senior position.

To be clear though, we are not looking to take significant restructuring or equitisation risk in this fund. We really want to avoid that. When we make a debt investment, the idea is that it really remains as a debt investment. And so, if you want that risk of restructuring or workout, there are other pools of capital at Oaktree that could do that.

Damian Cilmi: 25:41
Yeah, no, fair enough. And that's it. You've got many solutions, I suppose, for investors and also borrowers as well out there. We'll start to get towards the end on it. We talked about some of your conviction ideas, but if there's some really outstanding things, love to hear it. But also importantly, what are some of the risks that investors are underestimating at the moment?

Clark Koury: 26:07
Yeah, I think just in terms of compelling opportunities, maybe to start there and then we'll touch on the risks.

As I mentioned, we like the core middle market today — you're getting about 25 to 50 basis points more in spread than in the large cap market. We like Europe a lot. You're actually getting better pricing than what I just mentioned in Europe. Deal structures tend to be a little bit more conservative — so lower LTVs, lower leverage. And Europe in large part is a lot more insulated from the tariff regime that's happening in the United States at the moment. Generally, we're focused on more pan-European businesses within that versus maybe country-specific, but we've had a lot of success there. We actually have a partnership, a joint venture with Lloyds Bank in the UK where they effectively are an extension of our origination efforts. So we see a lot of deal flow through that and that's been really beneficial.

Other areas that we like today — life sciences is one that over the last really kind of four to five years has benefited from some pretty interesting secular tailwinds. Most of these businesses historically relied on equity to finance themselves. But if you look at the S&P biotech, just as a sort of a bellwether benchmark for that industry, it's down over the last five years by like 20, 30%. And so that equity option, that avenue, is really shut.

Because a lot of these businesses are sort of saying, hey, two, three, four years from now, if I deliver on some of these new medicines that are in my pipeline, I could be worth double. Not a credit bet, but they're saying I would much rather today have non-dilutive financing versus taking really punitive dilution at a much lower valuation than what I think I'll be worth.

And so generally these businesses are focused on biopharma or equipment and devices in some instances. And generally, when we make a loan, this business has at least one drug or technology that's already received regulatory approval, mostly from the FDA. And we focus on really need-to-have, life-saving medicines within that space. So these are focused on rare and orphan diseases, oncologies, sometimes chronic conditions where there's few, if any, alternatives. And we really like that risk profile because it's not necessarily correlated to the economy or GDP. If there's a fluctuation and if the economy enters a recession, because the development cycle is so long in some of these situations, these companies aren't turning off their R&D. They're still going to need that capital to continue with clinical trials or what have you. So that's another interesting place.

And then the last one I would mention is within private asset-backed financing. This, in a lot of ways, feels like private credit or the direct lending market maybe 10 years ago, where it's sort of the talk of the town, it's in a lot of headlines. We actually think it's really interesting because, similar to this trend that we saw in 2022 with banks pulling back from a lot of their lending activities, that is creating opportunities for non-bank lenders to provide this capital.

When you think about the landscape of the asset-backed financing market, you sort of have three segments. You have really more of the investment-grade component of the market — and banks and insurers still very much like that, so there’s quite a bit of competition in that space. Then on the other side of the spectrum, you have basically mid-high teens type returning instruments that are part of the opportunistic world — and again you have folks that can do that, including Oaktree.

But there's this underserved part of the market that's really unrated in nature, and so therefore it doesn't work with insurers. But it's more like 9 to sort of 13, 14 type return profile, and we think that's really interesting. And ABF is lending against pools of contractual assets. So this is a little bit different than corporate direct lending and can be a really nice diversifier in portfolios.

On the risks, I think what we often hear is: is there too much capital in the private credit markets? I think that's the biggest thing that we often hear about. What I would say is, when you think about the long-term tailwinds behind private credit, we think that those are really here to stay. This is a real market. It rivals the size of the leveraged loan and high-yield markets and is expected to grow — effectively double in size — over the next three to five years.

Where you get a little bit of quote-unquote volatility is really in new originations, and it's primarily driven by the retail audience in some ways. Because a lot of these funds can take monthly contributions, and if there's a big fundraising period — whether that's in a specific month or over a shorter period of time — that can create a slippage in discipline in some instances, where if you have a manager that says, I just raised a bunch of money, I have to deploy it, I might need to be a little bit more aggressive to win this deal.

What does that look like? It looks like giving on pricing. So maybe you're undercutting pricing from where the market is by 25 basis points. Maybe you're giving on leverage and saying I'll give you that extra half-turn. Or maybe it's you're giving on terms or covenants, where you're saying you don’t want that LME protection in there, you want an ability to do LMEs — we’ll give you that. And we don't like that dynamic. And in a lot of those situations, we’ll typically opt out. Because we really want strong documentation. We really focus on protecting our assets.

But that, I think, is a risk that a lot of people underestimate. And going back to what we think Oaktree's value proposition is, it's really being able to take on more of a relative value approach. And that's not just as it relates to returns — of course that's a part of that recipe — but it's looking at things like documentation: where are there real points of deterioration? It's looking at leverage levels. And one of the things about non-sponsors: they're typically much lower leverage, much lower LTVs. And so having those capabilities can really be beneficial at certain points in time.

Damian Cilmi: 33:18
That was an excellent travel around the world, having a look at private credit. Your insights all the way from Los Angeles. Clark, it was an absolute pleasure having you. Thank you very much.

Clark Koury: 33:31
Thanks for having us. It was great to have this conversation. Thanks so much, Damian.