Episode 39 | Private Credit – A Perspective on Current Market Conditions

CJ, Doherty Welcome to the Lending Lowdown. I'm CJ Doherty, Director of Market Analysis at LSEG LPC. Over the last few months, the headlines around private credit have largely been focused on the impact of AI on private credit valuations in the software sector and other sectors. And the question of whether there will ultimately be a deterioration in private credit loan quality. So, I thought it would be a good time to get some perspective on all this and also touch on structured capital as a financing option. And joining me to provide this perspective is David Fann, Partner and Head of Capital Formation at VSS Capital Partners. Thank you for joining me, David. David Fann Good morning, CJ. Great to do this with you. CJ, Doherty Great, thanks. And so, to kick it off, can you tell us a little bit about yourself and give some background on your role and the focus of your firm? David Fann Sure. I'm a veteran in the private equity, private credit industry. Started my career at Citicorp, Citicorp Venture Capital, and then I ran the alternative investment business for the United States Trust Company, which is now a part of Bank of America. I ran two private equity consulting firms, one called PCG and one called ToriCove Capital Partners, which I sold along with my colleagues to Axia, was vice chairman of Axia, and then became vice chairman of New York Live's private equity and private credit businesses called Apple Gem. And then joined VSS about two years ago, VSS Capital Partners, based in Midtown, New York. So that's pretty much it. I've seen multiple cycles, a lot of ebbs and flows into both private equity and private credit, as well as venture capital. So, I have maybe a different perspective than some of the folks that you've spoken to recently, CJ. CJ, Doherty Yeah, definitely, definitely quite a varied career there. So, let's start by talking about the headlines around private credit and fears around the potential impact of AI on private credit valuations in the software space and other sectors. How do you view these fears? David Fann Artificial intelligence is for real. And like any of these exogenous disruptions that have occurred, hard to figure out, truly potentially impactful in ways that none of us had ever contemplated. The noise around AI is a recent phenomenon. I would say, while it's been around for over 40 years. I remember taking AI class, artificial intelligence classes back in college, way back in the 80s. At VSS, we take this seriously and we've been studying the impact on companies, both in a positive and a negative way. There are clearly business models that are potentially facing some existential threats from AI. But there are more companies, we feel, that are going to be beneficiaries of the AI as it improves, let's say, revenue generation or cost management and things like that. I think as it pertains to the private credit industry, which is where you're going with your question. I think AI is, as I said, both a beneficiary and a challenge for some companies. Now, obviously, the software lending business has been potentially in the headlines a bit. And there's a couple of reasons for that. AI clearly has software disruption, but not all software companies are going to be put out of business by AI. In fact, I think a lot of the software industry is going to be a beneficiary of AI. But where it challenges, I guess, lenders and investors in lending funds is the thought that maybe AI could displace software utilization at companies. I think this whole idea of annualized recurring revenue lending, which began as a phenomenon, maybe a little bit less than a decade ago, had vulnerabilities that nobody ever thought about. For instance, most ARR loans get generally treated as a mezzanine or junior capital security in most capital structures because there's usually a lender with a first lien. And it's really hard to create a lien against a software contract. And it's very difficult to actually transfer software contracts to a lender if you read the way software licensing agreements work. So, I think that might have caused some investors and even potentially some lenders by surprise. It probably has more of a profound change in that segment than any other part of the private credit industry. Now, that's a really long-winded answer to your question, CJ. I hope I didn't get too deep into the weeds on that. CJ, Doherty That was good. And I just want to stay with ARR or annual recovering revenue loans that you mentioned. Are these widely understood by investors? David Fann I don't think so. I think it caught the secular thesis that software was a great place to be. Certainly, a market segment that has generated terrific returns to private equity firms investing in software as a service as a general theme. I don't think investors caught the nuances of software annualized, you know, recurring revenue loans, I think they thought they were just catching the wave, you know, a market segment with significant tailwinds got decent rates of returns but didn't realize the downside risk. And it happens when you get caught up in the frenzy of a new activity. It's like a young child with a new toy. It's fascinating. It's everything you want to do at some point the toy doesn't necessarily continue to intrigue. And I think that's, we're at that point right now with ARR loans. I think there's maybe some suspicion, some disappointment. And two your earlier point, some valuation concerns. CJ, Doherty Given the market backdrop, what is the fundraising environment like now? Are investors asking more questions and doing more due diligence than before? David Fann It's a great question and highly topical to us for other reasons. In every investor meeting I have today, questions about artificial intelligence come up. It's everything from how are you due diligencing artificial intelligence and its impact on companies. In your portfolio, have you identified AI risk and what are you doing about it? And for us at VSS, I think over the last year we've gone through every portfolio company to identify risk and opportunity and threats related to AI. It is the topic du jour. (7:16) There's no escaping it. It's almost, some of the conversations are almost like the first couple iterations of the Terminator movie (7:24). You know, it's the existential threat of AI and how, and where the ones hiding in the caves trying to run away from AI and its impact. No, there's no escaping it for sure, CJ. It is, it is pervasive. Doherty, CJ Okay, great. And now, David, I'd like to touch on structured capital a bit, as I know I think your firm provides it, but can you define it for our listeners? How does it differ from traditional direct lending? David Fann Sure. Structured capital at the highest level is the intersection and potentially the marriage of private credit and private equity. So, our objective as a structured capital investor is to create a asymmetric risk reward. And what I mean by that is downside protection similar to a private credit structure with private equity upside opportunity. And how we're able to accomplish this is investing through one fund senior debt, junior debt, preferred equity, and having equity participation. If you looked at the average of our last fund, 90% or more of our capital comes in above the common equity security. So, we are senior to common with 90 plus percent of our capital. But yet, I think our approach is to own a minority stake. We own somewhere between 25 to 60 percent of the companies we invest in. So, we get the benefits of private credit downside in a scenario where the companies might not be hitting their business plan. And we get the benefit of private equity upside irrespective of the outcomes as well. So, it's sort of an interesting mix of maybe having your cake and eating it too. I think that's our objective. CJ, Doherty Okay, and I know structured capital is not cheap, so from your vantage point, what specific types of firms or situations are best suited to tapping structured capital financings in the current environment? David Fann Well, we think we're a product for all seasons. So not just the curtain environment, but every scenario, whether it's a recession or inflationary environment, whether it's high growth or low growth, the companies that we partner with best have passionate, management teams. Usually there's a catalyst of some sort for them to need to do a transaction. It might be a one major shareholder, one founder needing to cash out for whatever reasons, but the other parts of the management team feel like they would like to continue and build a business or in some cases, it's a change in family situation or maybe a change in marital circumstances. Oddly enough, some of our transactions result from a CEO going through a divorce, for instance, it's the need for capital. In some cases, it's an acquisition or several acquisitions that they've identified that they need to raise capital to effectuate the acquisitions. But what we're looking for is that management team that is highly passionate about their business, feel extremely confident they're able to achieve their business plan, their projections that they've shown us, and want to own more of the business than what could result from a traditional private equity transaction. So, in most private equity transactions, the new investor, the private equity firm, usually owns somewhere between 100% to 85% of the business. In our transactions, we're typically buying this 25 to 60%. The management owns the rest. And I guess our pitch or the analysis we do for them is to show that if they do our transaction, partner with us, we'll give them all the capabilities of what a private equity firm would typically bring to the table. But they'll own significantly more capital five years later. They'll have more upside in our deal. They'll have stronger economic benefits accruing to them if they truly can deliver on their business plan. So, we're appealing to their sense of economically rational decision where they benefit from sweat and toil of their labor. CJ, Doherty Okay, it's always good to finish up by looking ahead. So, what's your outlook for structured capital and the broader private credit market? David Fann Well, it's interesting. Structured capital has become a popular place for private credit and private equity firms to build out product. So, as we look at our space, over the last five years, there's been new entrants. Because I think most asset managers have this need to grow. And the only way they could grow, you know, the ways they could grow are to raise larger funds or to create new product or sometimes both. And so, we are hearing more and more firms creating structured capital product. And hopefully, CJ, this conversation doesn't catalyze more competitors, but it certainly may. I think within private credit, it is a cornerstone of the asset management business. It is a critical part of company formation globally. I think private credit is a global product, not just North America or Europe, but everybody needs it. It doesn't go away. And it's interesting, even some commercial banks are trying to get back into it despite Dodd-Frank and some of the other regulations that were put forth 15 years ago. Private credit is going to be just a critical component of investments. It is as essential as water is to the survival of human beings. CJ, Doherty Great, that's a great analogy. And that's all we have time for today. Thank you for taking the time to join me, David. David Fann CJ, it was such a pleasure speaking to you and I look forward to doing this again. CJ, Doherty And thank you all for tuning in. As always, I invite you to check out our private credit news, data and analysis on Loan Connector, BDC Collateral and LSEG workspace. I'm CJ Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.