Ron Kantowitz – Direct Lending's Evolution and Invesco's Edge (EP.457)

Ron Kantowitz is the Head of Private Debt for Invesco's Private Credit platform, where he leads a team that manages middle-market, senior secured, direct lending. The Invesco Private Credit Platform manages $46 billion across Direct Lending, Syndicated Loans, CLO's, and Distressed Credit/Special Situations. Our conversation traces Ron's path to lending and three decades of experience alongside the evolution of the lending markets. We discuss his direct lending strategy, investment process, and perspectives on competition, the role of banks, and opportunities ahead for private credit investors. NA4597908 Capital Allocators and Invesco are not in any way affiliated. This information is intended for Institutional Investors that are US residents. Click here to view the full Disclaimer https://www.capitalallocators.com/podcast/direct-lendings-evolution-and-invescos-edge. Learn More Follow Ted on Twitter at @tseides https://twitter.com/tseides?lang=en or LinkedIn https://www.linkedin.com/in/tedseides/ Subscribe to the mailing list https://capitalallocators.com/ Access Transcript with Premium Membership https://capitalallocators.com/signup Editing and post-production work for this episode was provided by The Podcast Consultant (https://thepodcastconsultant.com https://thepodcastconsultant.com/)

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:05Ted Seides?

  Hello, I'm Ted Seides and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at capitalallocators.com.

• 0:32Speaker 01

  All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions in securities discussed on this podcast.

• 0:51Ted Seides?

  My guest on today's Sponsored Insight is Ron Kantowitz, Head of Private Debt for Invesco's Global Senior Loan Platform, where he leads a team that manages $50 billion focused on middle-market, senior-secured, direct lending. Our conversation traces Ron's path to lending and three decades of experience alongside the evolution of the lending markets. We discuss his direct lending strategy, investment process, and perspectives on competition, the role of banks, and opportunities ahead for private credit investors. Before we get going, every now and then, a fan of the show asks me to share more of my investment views. I get it.

• 1:34Ted Seides?

  I've been around the block a few times and often have something interesting on my mind. But I prefer not to insert myself in the podcast every week. There's a difference between an interview and a conversation that often gets blurred on many podcasts. Capital Allocators is an interview show, so instead of talking so much you can barely stand to hear my voice, I occasionally take a turn on the other side of the mic and share it that way. I also record my blogs on the podcast, aptly named What Ted's Thinking. I'm doing more of that with shorter pieces this year. Lastly, I've come up with a new way to share more with our premium members. We've added amusing section to our weekly emails where I'll share brief investment ideas

• 2:17Ted Seides?

  with a high signal to noise ratio. As examples, I've written about what's really going on with endowment secondary sales and how institutions may use interval funds in the future. If you're interested in keeping up with my thoughts from the many conversations I have with investment leaders, sign up for our premium content at capitalallocators.com/premium. It costs far less than a cup of coffee a day, and I'm highly confident, in a Michael Milken "highly confident" letter kind of way, that you'll return a large multiple of your investment. Thanks so much for encouraging me to share more of my investment thoughts and for supporting the show through our premium membership. Please enjoy my conversation with Ron Kantowitz.

• 3:01Ted Seides?

  Ron, thanks so much for joining me.

• 3:04Speaker 02

  Thanks for having me. Appreciate it.

• 3:06Ted Seides?

  Why don't you take me back to your very first job?

• 3:08Speaker 02

  When I graduated college, I went to work as a systems engineer for a company called Electronic Data Systems. EDS was Ross Perot's company. It was a technology company that provided IT facilities management and business process outsourcing to companies across a wide variety of industry sectors. And the model was one where you co-located with your clients. So when I got out of the systems engineer training program, I was positioned at a regional bank on the East Coast. By the end of three years, what I'd figured out is I was much more interested in the finance side than I was the technology side, and so I decided to try to make a change. But without the benefit of traditional finance training prior to that, it was very difficult to move into investment banking, so I decided to go back and get an MBA.

• 3:51Speaker 02

  And at the time, the two best schools, if you wanted to focus on finance, were Wharton and the University of Chicago. I was fortunate enough to have the opportunity between the two, and I decided to go to the University of Chicago. Absolutely loved it there. You got to study with legends in finance, guys like Merton Miller and Eugene Fommer, at least with the guys who actually wrote Corporate Finance Theory. I had a great two years there. And then when I graduated, I got a job at Chase Manhattan Bank in the leveraged finance business. So I made the transition. But while I was in the training program, Chase sort of went through a little bit of a restructuring and they combined three groups. They combined the leveraged finance group, which was the traditional acquisition finance business that we all think of when we think of banks, with their mezzanine finance group and their equity investment group. And we rebranded it Chase Merchant Banking.

• 4:35Speaker 02

  For me, for somebody learning their skill, it was a really unique opportunity because not only were you tasked with evaluating companies, taking them apart, figuring out if they were investable, but at the same time, you were looking at them across different types of assets where you could invest. So you had to think about relative value, risk-adjusted return, really think about these businesses, not just from a credit perspective, but from an investor perspective. It was a wonderful education process and it's informed my investment process and methodology for the rest of my career.

• 5:08Speaker 03

  When you had that breadth of looking across the capital stack, a lot of different businesses, what did you find most resonated for you in the types of investments that you were most drawn to?

• 5:22Speaker 02

  Maybe it's part personality, maybe it's part going through intense credit training, but we support private equity. There's a very different risk when you're a private equity investor than when you are a senior debt lender. What was unique about this opportunity is we could pick our spots. We could decide, you know, we don't want to lend senior here, we're going to do junior capital, we're going to do mezzanine, we're going to do equity. When I make an investment, I want to be able to sleep at night and not worry about it. What types of businesses did I tend to lean in on? The stable businesses, the businesses that were predictable, were less volatile, the businesses that lent themselves to traditional senior debt lending.

• 5:54Speaker 03

  What were some of the landmarks of your time at Chase and since, leading up to when you joined Vasco?

• 6:00Speaker 02

  Yeah, I spent about six years at Chase and worked with some really great people, many of whom are not just friends today, but many of whom run private equity firms that are my clients today. Six, seven years post my time at Chase, I was offered the opportunity to go build for the Royal Bank of Scotland, a middle-market leveraged finance business focused on private equity. Nobody knew what RBS was in the US. But if you actually looked at the bank, it was the fifth largest bank in the world by market cap. Perhaps more importantly, they were the dominant provider of acquisition capital in Europe. You had this huge bank that had decided that they wanted to come into the U. S. and replicate what they'd done in Europe in the U. S. And it was absolutely fantastic.

• 6:43Speaker 02

  I built out sponsor coverage, execution, portfolio management, sector expertise and distribution. And over a period of five or six years, we built that business to be one of the leading middle market providers in the U. S. So it's a wonderful time to be in the business. Unfortunately, all good things come to an end. When the GFC hit, RBS felt pretty hard, like many other banks across the globe. In the case of RBS in particular, what exacerbated the challenges for them is they had just bought ABN AMRO the prior year in a competitive process with an all cash market topping bid. When the GFC hit for RBS, the consequences were pretty significant. The bank went through a restructuring whereby they created two banks. They created what they called the core bank and the noncore bank.

• 7:28Speaker 02

  And the noncore bank at RBS housed all the highly structured assets. They weren't necessarily bad performing assets, but they were the assets that required significant regulatory capital, the capital with which the bank didn't have. I was put in charge of the noncore bank in the U. S., which was about a $30 billion vehicle, and my task was to figure out how to liquidate and monetize those assets so I could return capital to the core bank to sort of fix the balance sheet. It was in those times that I got my first exposure to private credit. I would get calls from platforms. I hadn't heard of many of these, but they always had a similar theme. We've raised a lot of capital. We're here to help you solve your problem. defined as we'd love to buy your assets at 50 or 60 cents on the dollar.

• 8:09Speaker 02

  What I discovered in the process is that you had some very, very sophisticated investors who had managed to accumulate significant pools of capital. They weren't burdened by a lot of the regulatory dynamics that the banks were now suffering from. It just became very obvious at an early point that this was where the market was going. Back then, We called it shadow banking and then we called it non-banking and then ultimately we landed on the more eloquent direct lending. So after I did what I could to help bring that non-core bank down and shore up the balance sheet at RBS, I decided it was time to move to the shadow banking or the non-banking side of the market.

• 8:44Speaker 02

  I took a position at a opportunistic credit platform that was looking to expand into more traditional direct lending, covering private equity firms, and I spent a handful of years there helping them build it out. But for me, I sort of had the itch. I wanted to get back to build something myself. And then that brings me to Invesco. I got a call from Scott Baskin, who runs Invesco's private credit platform, which today is about a $50 billion credit platform. At the time, Scott was running a series of strategies within that platform, but was interested in thinking about whether he could leverage that platform into direct lending. He and I had known each other over the years, and I remember we had this breakfast where really at that time, he was just trying to understand what I thought it would take for Invesco to break into this space.

• 9:29Speaker 02

  After back and forth for probably about six months, I made the decision to go build it. And that's about a little bit less than eight years ago at this point.

• 9:36Speaker 03

  What was the attractiveness of doing this at Invesco?

• 9:39Speaker 02

  It starts with big institution. At the time, we were a mere trillion dollar asset manager. Today, we're approaching two. We had a really large private credit platform. The private credit platform had been in existence for 20, 25 years. We were known in the industry. Invesco has great brand recognition, and importantly, the infrastructure was in place. When I thought about what it would take for me to build a successful direct lending platform, one of the key things that I believe you must have is sector expertise. The beauty of this platform that had been built was they had one of the largest private side sector teams in the market. We have 22 dedicated sector research analysts who focus within their dedicated sector on everything today from distressed to liquid to direct.

• 10:24Speaker 02

  As I thought about coming in, I could build the origination execution team. We could leverage off this built-in wealth of knowledge, IP via existing portfolio companies and experience across all the sectors. I came on board. I brought a handful of my partners from RBS, all of whom are with me today. Great sponsored coverage folks with tremendous credit skills. We put the business in place as if we'd never stopped working together and called up all of our old relationships and picked up the business right where we left off.

• 10:53Speaker 03

  I'd love to take a step back and talk some about direct lending as an asset class.

• 10:58Speaker 02

  Yes.

• 10:58Speaker 03

  Hear a lot more about it now. You've been at it really for the whole time. What are some of the things you've seen in changes and evolution of this sub-part of the market?

• 11:09Speaker 02

  I often get asked, this is a pretty new asset class. How do you think it's going to perform with the market cycles, things like that? To that, I always say, this is not a new asset class. What has changed is the constituency that provide those capital solutions. If you go back before the GFC, middle market finance was the purview of banks. They dominated it. They were great at it. They had tremendous relationships. Post the GFC, the OCC Leveraged Lending Guidelines came in place and Basel III was put in place. The intent of those regulations was to make it more difficult and more expensive for banks to participate in that asset class. So what you saw happen was simply a shift in the providers of that capital from the regulated banking side to the non-regulated private capital providers.

• 11:51Speaker 02

  The reason for that is when you think about the world we live in today, the volatility in the markets, this is an asset class that across cycles has demonstrated stability, consistency, low default experience. Initially was treated as a nice asset hedge for investors across a more liquid portfolio. But as the asset has grown, it's become just a key component in many individuals' and many entities' portfolios.

• 12:20Speaker 03

  How has the nature of the capital providers and competition changed within that? You have the movement from the banks to asset managers. What's happened in the market for lending among the asset managers?

• 12:32Speaker 02

  Post the GFC, your direct lending for the first 10 years was singularly focused in the middle market. Banks were still doing the large syndicated deals. There was this huge gap in the market to be able to provide capital to middle market sponsors, middle market companies. You started to see capital come in and it was very successful. If you look at the entities that were dominant in the middle market 10, 15 years ago, they don't play in the middle market anymore. As their AUM their capital base has grown, deployment pressures have become so significant that they've had to find more efficient ways to deploy that capital. The evolution of this market is whereas maybe for the first five, 10 years it was predominantly focused in the middle market.

• 13:15Speaker 02

  When we now talk about direct lending, we start to talk about the core middle market and we talk about the large end of direct lending. And the large end of direct lending today is probably comprised of eight or 10 huge, very sophisticated lenders who are managing massive sums of capital. And don't spend any time worrying about the middle market because it just doesn't work for them. And instead what they've done is they've set their sights on the banks. I remember the first couple of times we would hear about a billion dollar unit tranche. Everybody scratch their head and go, oh my God, how are they going to do that? Today, I mean, you know, billion dollar unit tranches, there's nothing unique about them. You know, five billion dollar unit tranche deals are getting done. And so the evolution of the market, I think the market's just gotten bigger.

• 13:55Speaker 02

  As more capitalists come in, you've just seen the bigger players continue to accumulate significant pools of capital and push on the wider end of the market.

• 14:02Speaker 03

  So did you talk about those differences between a direct deal and a syndicated deal, from the advantages of direct? What do you see as the distinctions in the two?

• 14:09Speaker 02

  What is a syndicated deal? A borrower or a sponsor hires a bank. The bank puts together documentation, you know, goes to market, figures out what they think the structure should look like, and then they go out and they syndicate that deal. And sometimes they'll commit to it and sometimes they'll do it on a best efforts basis, but they'll give the counterparty an indication what they think the deal is going to look like. They run a bank meeting, they go to the rating agencies, and ultimately, if they're successful, they'll syndicate, they'll sell that deal down and they'll bring in, depending upon the size of the deal, five, 10, 20, even 50 participants into that transaction. It takes time and it is, in most cases, beholden upon where the market says it's going to clear. Now you contrast that with a direct lending deal in the large end of the market. You will have one counterparty sit across the table from the sponsor or the borrower.

• 14:54Speaker 02

  And they'll say, I'll tell you what, I'll do your deal. Two billion dollars, you're done at so for plus six. Here are the terms. I don't have to go to the rating agency. I don't have to sell it to anybody else. I'll get it done next month, not in three months. You have certainty and you're done. Now for that, you'll pay a premium. But at the end of the day, if you're the borrower, you know who your counterpart is going to be. And it's not just the efficiency of getting the deal done, but banks, they have certain regulations, lots of boxes that they have to neatly fit their deals within. When you're dealing with direct lending, they have the flexibility to be more pro-business thinking and they can move with companies. They can be more responsive and for pricing, you know, and it costs a little bit more to do direct lending.

• 15:37Speaker 02

  It is a competitive offering relative to the traditional syndicated bank.

• 15:41Speaker 03

  Now, if you look at the universe of sponsored companies and industrial companies that are known by a private equity sponsor. What are some of the subtle differences between the two?

• 15:51Speaker 02

  Today, at least 70% of all direct lending is sponsored. Why is that? And what are the differences? Well, sponsored by its nature means you're working with a private equity firm, a private equity sponsor. And the attraction of doing deals with private equity sponsors is, number one, they bring governance, they bring sector expertise, they bring best practices. And most importantly, they invest significant sums of equity in these businesses in front of your debt. Typically, loan to values today are running in the mid 40s. If you're aligning with some of whom you think are the smarter private equity investors in the U.S. And you're lending senior secured debt, they're providing more than half the value of these businesses in first loss equity.

• 16:32Speaker 02

  And so when you think about it from a risk perspective, things have to go pretty bad before your senior secured loan starts to be at risk for being impaired. And typically what happens when you work with a sponsor, if a company does have some type of operating performance challenges, unless these are truly dynamics where the business is permanently impaired. Your sponsor is going to come up with a solution because they've got to protect their significant investment. Now you contrast that with a non-sponsored deal. Typically there, you're dealing with private companies, family owned businesses. There is no equity coming in beneath you. There is no private equity firm providing oversight. You are the lender. If something goes wrong, you are the entity that's got to fix it.

• 17:17Speaker 02

  Why would you do that? There's a couple of reasons you do that. Number one, because you're probably going to get a better return. Because you're not facing off against a very sophisticated private equity investor who's very, very savvy in terms of exactly what terms are clearing in the market and how to negotiate that. And equally, you're probably getting a tighter document, perhaps leverage is a little bit lower, the terms are a little bit tighter. I've done both in my career. They're very different. There's opportunity for both, but certainly from my perspective and from our perspective, when we think about risk and we think about capital preservation, we love doing deals with private equity. We love to partner with firms that we've known forever. We know how they're going to behave when things don't necessarily go according to plan. For us, it's all about risk mitigation.

• 18:01Speaker 02

  The opportunity to pursue non-sponsored deals for the right type of investor, you can do very well there. You just need to make sure you've got the resources to be able to support it if things don't go well, and that can be very resource intensive.

• 18:14Speaker 03

  I'd love to talk about the risk reward of the senior loan. You mentioned earlier in your career, there were senior loans and there were mezz loans and there were junior loans. You had converts, everything in the capital stack, which seems to have evolved to more these big unitranche deals. How have you thought about the benefits and drawbacks of playing in the senior space when that part of the capital stack has gotten to some extent simplified but also bigger?

• 18:42Speaker 02

  Earlier in my career, it was usually the case when you structured a middle market deal that you would have this first lien tranche, you would see this mezzanine tranche, and then you'd have the equity. Markets are really efficient. So you started to see lenders come in, they'd say, all right, you've got a senior piece, maybe that's priced, back then it was LIBOR, maybe that's priced at LIBOR 4, and you've got a mezzanine piece that's fixed it 12%, it's got a warrant or an equity kicker associated with it. I'll tell you what, I'll just blend those prices, I'll give you a one tranche, the unitranche, and you borrower don't have to deal with an accreditor, don't have to deal with multiple parties. It's just efficiencies of the market. It started there, and if you were a mezzanine lender, it was a challenge because suddenly

• 19:26Speaker 02

  your asset wasn't as valuable anymore because once we moved away from banks, we had the ability to sort of take leverage beyond the traditional three times leveraged threshold maybe that a bank would think about. It's just about competitive forces by the nature of the market opportunity and really sophisticated investors in the market, we started to see that fade away. What's interesting, though, at points in time,

• 19:48Speaker 02

  You ' ve seen it cycle back in different ways. You ' ve got some banks now that will provide something called a first loss tranche within a unitron. It ' s almost reverse engineering that first lien, second lien, we still call it a uni, but there ' s a separate agreement where the bank will say, I ' ll take the first turn of leverage. In return for that, I will take a lower spread relative to what the borrower thinks. You take the incremental, but I ' m first loss on that first turn. There ' s lots of different ways to cut it, but I think what ultimately has driven this change is the amount of capital coming into the market and the desire for current yield and the fact that if you look historically at the performance of this asset class across cycles, it ' s just been fairly compelling. And you look at default rates and loan loss, while you might expect them to be worse, they ' ve continued to demonstrate time and time again resilience.

• 20:37Speaker 02

  It ' s been a difficult market to play mezzanine, unless you ' re playing really at the smaller end of the market where it ' s not as common.

• 20:45Speaker 03

  So you bring all these forces together, you have to set out an investment strategy. Where did you come out and say, okay, this is a strategy that we ' re going to pursue here in your business?

• 20:54Speaker 02

  Yeah. So when I joined Invesco, I put a lot of thought behind this because when I joined, we were in a benign interest rate environment. Skies were blue. Nothing was going wrong. Lenders were being fairly aggressive in terms of how they were approaching opportunities. We looked at the investor base at Invesco. We looked at what Invesco had done across the private credit platform. We decided out of the blocks to skew very much towards the conservative end of direct lending. It starts with structure. Everything we ' re going to do is going to be senior secured. First lien, unitrons. Second lien, we ' re not doing mezzanine. We ' re going to be top of the cap stack. We ' re going to have our money attached to dollar point one. We ' re going to have full collateral and all the hard assets, all the IP of the businesses we lent to. So structurally, that ' s how we thought about it. The second piece of it was, we said everything we ' re going to do, we ' re going to do with private equity.

• 21:42Speaker 02

  We want partners, folks we know, folks who are putting significant risk capital in these businesses in front of us. That ' s a way to mitigate risk. And then we thought about from a sector perspective, myself, my partners, we ' ve spent our careers in the middle market. It didn ' t even occur to us To think about going up market, this is the market we knew. This is where we knew we could generate compelling returns. So we focused on the middle market. And then the last piece of this, it's all about asset selection. There are these two words we use over and over again to define the perfect business for us to lend to. Those two words are stable and boring. We're not equity investors. If you show me a business that's projecting 15% top line growth and 500 basis points margin improvement,

• 22:23Speaker 02

  I'm going to guess there's inherent risks in that that are not going to be consistent with our philosophy of sleeping at night and knowing that capital preservation is at the top of the list. We look for businesses that have long historic track records. When you think about modeling out what that business is expected to do over the next five years, there's no hockey stick projections. Slow, stable businesses do two things really well. Pay your interest to amortize your debt. The thing we talk about all the time as a senior lender, the best you could ever hope for is to get your money back. You're not supposed to lose principal when you're lending senior debt. Everything about our philosophy was oriented around conservative structures. Everything had to have covenants associated with it.

• 23:05Speaker 02

  It wasn't an accident that that's the model we built, but it worked for us. This conservative model served us really well. We've come through this cycle, much like we've done prior cycles and no style drift. This is how we've set out to build this business. This is how we've done it for the last seven years and touch wood, this is how we do for the next seven years.

• 23:24Speaker 03

  You mentioned that when you came here, there was within Invesco, this sector coverage with deep expertise. And you had to build out the origination. How have you built out the sourcing of these opportunities in the private markets?

• 23:36Speaker 02

  First component is I brought with me my three senior partners that I'd worked with for the past 20 years. Between the four of us, we had built businesses together on banking platforms and non-banking platforms. Not only do we know how to do this, but we had a fairly broad base of core sponsors that we knew we could rely upon. This was the other attractive dynamic as relates to our coming onto the Invesco platform. Across the Invesco private credit platform, we have over $25 billion of capital in. invested in the portfolio of companies of more than 200 private equity firms. There was already more than just name recognition, tremendous connectivity with a wide swath of private equity firms,

• 24:19Speaker 02

  many of whom crossed both broadly syndicated and what we were doing in the middle market. In many cases, the named partner at these private equity firms was an associate when we were associates 25 years ago. So there's history there. And as long as you treat these relationships like partnerships and understand their needs and can address those, you should have an annuity of opportunities across a fairly wide base of them.

• 24:41Speaker 03

  What does a typical diligence process on a deal look like?

• 24:45Speaker 02

  It's deep and extensive. It starts with our simple premise, we're lending senior debt, you should not lose money. The way we think about it, everything we do needs to be primary diligence. If we were to get a call from another direct lender who said, hey, we've closed the deal. We're long $50 million. We'll send you our IC memo. Would you guys want to buy it? Not for any reason other than that's just not how we conduct business. We would graciously say thanks, but no thanks. For us, everything needs to be primary. We fly down to the company. We want to look management in the eye. We're going to do our own forensic diligence around the accounting. We're going to go deep into quality of earnings. We're going to engage our own third-party sector experts to make sure we understand all the subtleties around the business. It's a very, very extensive process. It's not just similar to what private equity are doing.

• 25:30Speaker 02

  One of the subtle delineations between what we do on the direct lending side and what's historically done on the syndication side is if you're in the banking market and you're syndicating, you're doing your diligence, but your intent is to sell the business. If you do it right, you risk off pretty quickly. We're going to be in this deal for three, four, five years. The amount of analysis and diligence we're going to do is pretty extensive and we're going to want to drive documentation. You can find the best business in the world, but you can blow the investment on the documentation. Think about a leverage covenant. The definition of EBITDA in a credit agreement is two pages long. If you get that definition wrong, the covenant may be toothless. Everything from start to finish for us is hands-on, primary. A typical deal will take us anywhere from two to three months from start to finish to get it done.

• 26:13Speaker 03

  What are some examples of things that you thought were going to be a deal you're going to be happy to lend to? And you found something that had it fall away.

• 26:21Speaker 02

  Typically, when you start a process, you'll get a SIM, a document that sells you on the deal. It's written by a sell-side banker. So it's generally pretty positive. You'll look at this business and you'll say, you know, revenue grew nicely and EBITDA grew nicely and the ask on leverage is pretty conservative. You start out thinking this could be a really nice business. Most often, where we walk away from something, there's this thing called quality of earnings, which is there are all sorts of adjustments that go into EBITDA. I'll pick the gym business as an example. If a sponsor is buying a gym, they will ask when we first break ground on a box, we spend money on it, we may want pro forma adjustments to reflect the EBITDA of that box when it becomes mature.

• 27:02Speaker 02

  And we say, well, that's great, but today it's doing zero. As we go through our diligence process and we go through the quality of earnings, you start looking at all the adjustments. This is what they're telling you EBITDA is, what was EBITDA? And then it's always a primary discussion for us in any of our credit meetings. What do the adjustments look like? And all too often, what you discover is the actually EBITDA is materially less than what's being portrayed. And sometimes those adjustments are legitimate, but oftentimes they're not. Most often, we'll look at something and optically it'll look great, but when we start digging through the numbers and we start understanding what's happening, pretty quickly we'll back away. And I think the trick to this business, you got to triage. You certainly can't spend time on 500 deals. You've got to be able to pretty quickly figure out which ones you're just going to let go and where are you going to spend time.

• 27:48Speaker 03

  When a sponsor that you have a relationship with is doing a new deal, you have this balance of you want to be accommodative, you want to be relationship, you also want to win the deal in a competitive market. How do you navigate that?

• 28:03Speaker 02

  Competition is a fact of life in our business. So much capital has come into the market, whether you're looking at the middle market, whether you're looking at the upper end of the market, there are a lot of participants and it's competitive. I think there's a subtle difference, though, between the competitive dynamics in the middle market relative to the upper end of the market. If you look at the middle market, the word you'll often hear used is clubby. With maybe the exception of one or two, on every deal we do, we will partner up with one or two other direct lenders. I like doing that for a variety of reasons. We know most of the other middle market direct lenders because we've all been in the business so long. In many cases, we've worked together earlier in our careers at banks. But equally, it's never a bad thing to have more eyes looking at the same transaction

• 28:44Speaker 02

  and looking at it each with your own unique vantage point as a means to make sure you mitigate risk. But the point on competition is one where you're not really incented to be too aggressive where it comes to things like rates. Because at the end of the day, what I want to do is lead every deal I can. If you think about your private equity clients, they may have two or three direct lenders that are their core relationships. So they're going to rotate you. Invesco, you're going to lead this deal. You're not going to lead the next deal, but we still want you in the deal. None of us are really incented to go in there with aggressive pricing because even if you win, you lose. We're all going to be in the deal regardless. You compete on things like relationship. You compete on things like sector expertise. You compete by trying to bring them ideas, value add.

• 29:27Speaker 02

  But generally speaking, we're all fairly regimented when it comes to thinking about things like leverage and pricing. I find it to be much more of a collaborative market relative to the upper end of the market. I don't mean in any way to disparage the upper end of the market, but it's just much more intense. You have huge players all vying for really, really significant positions, competing not only with each other, but also with banks. In the middle market, it is much more collaborative. I mean, most of our competitors are our friends. You treat everybody with integrity. You be transparent with them. And over the long term, it tends to work out. If we win a lead, we'll invite a couple of lenders in and they'll reciprocate when they win a lead. You're not really incented to do silly things to win business. There are always going to be exceptions, and when we see those, we walk.

• 30:12Speaker 02

  We have a bit of a life too short philosophy.

• 30:15Speaker 03

  Once you're in a loan company and a sponsor, think about two different scenarios. One is everything's going fine. Maybe you have to monitor it. And the other is something's not going well. I'd love to get a better understanding of what you're doing in each of those two scenarios.

• 30:32Speaker 02

  One of the nice things about the middle market is you get tremendous transparency in terms of performance. In almost every deal, we get monthly reporting, we get quarterly reporting. Because we have covenants, we get compliance certificates, we get annual budgets. Because these are small deals, we know the management team, we know the sponsor. Every month, our analysts take those monthly numbers and they spread them. And if anything doesn ' t seem right, they ' ll raise it to the deal captain and we ' ll look at it and usually it ' s nothing, but if there ' s something we don ' t understand, we ' ll pick up the phone, call the sponsor, call the CEO. On a quarterly basis, the whole team goes offsite for a day and we do a fulsome quarterly review of the entire portfolio. And then post that, we sit with investment committee and we walk them through any names that we think need to be highlighted for them. And it ' s a fairly extensive rating system we go through.

• 31:18Speaker 02

  All of which to say, it is rare if ever that we ' re going to be caught off guard or surprised by something really bad. If something ' s going wrong, if there ' s a trend, we should see it coming real early and we should be on top of it and we should be aware of it. If something goes wrong, you need to have restructuring capability and resources or you ' re going to find yourselves in trouble. On my team, we have workout resources. One of my partners ran restructuring during the GFC, the bank he was working at. On any deal we do, we immediately drop him in and he becomes captain if we have a problem in credit. But I think more important than that, across our private credit platform, we have significant resources. We have a distressed team that does something all day, but focus on challenged credits, loan to own. There ' s a wealth of resources at our disposal, such that if we find ourselves in a situation, you want to make sure you ' ve got proper resources available to be able to address it.

• 32:07Speaker 03

  How do you use all of the data that comes from all these reports from companies across both your portfolio and thinking about what ' s going on in the markets and opportunities?

• 32:17Speaker 02

  We do a fair amount of analytics and sensitivities across our portfolios. On a quarterly basis, we run all sorts of sensitivities. We look at what ' s going to happen if interest rates go up, what ' s going to happen if margins go down. We look at it on a name by name basis. We look at it systemically across the portfolio. We also look at all sorts of analytics. What ' s happening at the top line across the portfolio, what ' s happening at the margin side When we sit in front of investors, everybody's got the sound bites of what's going on on the market. We can tell them what we think is happening vis a vis our access to the middle market. In many cases, we can sort of front end what we're going to ultimately hear. If something's going to go wrong, we're going to see it earlier and perhaps we're going to see it across the broader market.

• 32:59Speaker 02

  The key thing for me on the portfolio management side is you just don't want to get caught by surprises. If you can get out in front of problems, if you can understand where things are going, you have a far better chance of fixing them, putting yourself in a position for a successful outcome.

• 33:14Speaker 03

  It's been a long time since we've had a real default cycle. You've been through a few.

• 33:19Speaker 02

  Yeah.

• 33:20Speaker 03

  We'd just love to get your sense of how you're thinking about the current environment in light of what you've seen in the past.

• 33:26Speaker 02

  I've lived through credit cycles, market dislocations, great recession. Every time you have a credit cycle, it's different. Every time you have one, nobody predicted it, or certainly nobody predicted why it happened. Today, we're living in a really unique environment, and we have been for the last couple of years. Since 2022, we've been living in this rising interest rate environment where we were worried about inflation. We were worried about recession. We had all these geopolitical conflicts, a lot of things to worry about. In fact, it actually has had a pretty significant impact on M and A volumes and deal flow. But we live with an eye towards the glasses half empty. On every deal we do, we run recession scenarios and we're very, very selective about the types of businesses they were going to invest in.

• 34:09Speaker 02

  We've been living in a higher for longer interest rate environment. We're staring in the face of some type of tariffs. Nobody actually knows where we're going to end up, but ultimately they're going to have some type of impact on the economy. We are trying to figure out, are we going into a recession? Are we looking at stagflation? Are things going to settle out? What's the Fed going to do? You can look at all these macro dynamics in the market. You can handicap them, but at the end of the day, in all those scenarios, where do you want to be in the cap structure? We want to be senior secured. We want to be at the top of the capital structure. We want to have lots of capital beneath us. We want to have full collateral in all the assets of the businesses we lend to. And we're going to be really selective about the types of businesses we lend to.

• 34:53Speaker 02

  If we think we're going into recession, we're going to stay away from highly cyclical businesses. We focus a lot on the health of the consumer. We're not leaning in on discretionary consumer products these days. We're thinking about all the things that could possibly go wrong. We're doing our best to either mitigate those and make the investment or not make the investment. I don't mean to sound draconian here because I do believe at some point we're going to find our way to the other side of this. The markets at some point will stabilize. And what's going to be really unique about this opportunity set then, because of all the uncertainty we've been living in for the last two to three years, you've got private equity investors that are really long assets, need to sell them, but haven't been able to because buyers and sellers just haven't been able to acquiesce around valuation. But when we get to that point where markets start to stabilize,

• 35:38Speaker 02

  there's going to be a huge backlog of opportunities that are going to come to market. Today, we're being really selective. We're keeping our powder dry. We're watching. We're all over the portfolio, but we're also waiting because we do believe there's going to be a pretty significant opportunity coming down the pike.

• 35:53Speaker 03

  Are there any signposts that you're seeing in structures of risk that you've seen in the past or things that you're staying away from, even if you are fine with the sector that it's in?

• 36:05Speaker 02

  The two things that most simplistically are telltale signs for are you going to get in trouble or not, are leverage and covenants. If you start to see leverage creep up, you got to start worrying. If you start to see deals coming without covenants, you should start worrying. There is another red flag in the market and it's something you're hearing more and more about these days. And this is the advent of bringing pick into your transactions, payment of kind. Our deals are all done cash pay. That's the way you're supposed to do seer debt deals. And if you look at a portfolio, it should be all cash. There are going to be times when you structure a deal day one, where for company-specific reasons, maybe you're going to have a pick component. Perhaps the company's got some significant capital expenditures they need to make over the next two years.

• 36:49Speaker 02

  So you'll put some pick in there just to give them a little bit of additional free cash flow relief. But you're doing that knowing why you're doing it. If there's a red flag or a canary in the coal mine in the markets today is if you start to see portfolios that were structured with all cash, starting to suddenly show up with pick components. If you're restructuring your deals where you're converting some of your current cash into pick, there's only one reason you're doing it. You're doing it because the company doesn't have the free cash flow to service your loans. That's a key red flag. If I were speaking to an investor and they said, well, how do I assess this direct lender versus that direct lender or this portfolio versus that one? One of the things I would say to them is look into the portfolios. Look at what opening leverage was. Look at what current leverage is today. Look at what percentage

• 37:33Speaker 02

  of the deals started out all cash and what percentage of the deals today have a pick component. If those things have moved in the wrong direction, those should be red flags. You better dig in a little deeper.

• 37:43Speaker 03

  It feels like in the private equity market, there's a little bit of the bottleneck of capital because you haven't had liquidity. And yet, on the credit side, it feels like there's almost insatiable demand. What have you seen as those two come together?

• 37:57Speaker 02

  There's a couple of dynamics here. Private equity have raised record sums of capital. And it's a challenge for them because we spend about half our time talking to investors and the other half our time talking to our private equity clients. And thematically, what we've heard from them is it's slow. They keep waiting for deal volumes to pick up. So they're sitting on cash. Problematically for them, they're not able to sell these businesses. You think about the cycle for a private equity investor of raising money, investing in companies, improving those companies, exiting, distributing capital back to their investors and doing it again. To your point, there is a bit of a bottleneck there. And we hear it from investors all the time. We're telling us we're just not getting distributions back at the pace we had hoped.

• 38:37Speaker 02

  So then you pivot to the credit side. Why is that asset class just continuing to raise more and more capital? It's a function of the fact that it's a pretty attractive asset class in the environment we're living in today. You look at these equity markets, it's hard to see our equity markets growing 10, 15% from here in the near term, given all the volume in the markets. But if you choose to invest in this asset class and you can deploy... You're going to be sitting there generating low double-digit returns, hopefully without a whole lot of risk to the portfolio. As more capital comes in, it absolutely does create more competitive pressures. We have seen spreads come in 50, 75 basis points. But the reason you're still seeing so much capital coming into the market is, on a relative basis, it's still an incredibly attractive asset class.

• 39:23Speaker 02

  We are consistently generating low to mid-double-digit returns across the cycle. That's a pretty good place to be in almost any environment.

• 39:30Speaker 03

  You've built out this business over the last bunch of years. How do you think about growth where if you raise too much money, you'd almost take yourself out of the mid-market where you like playing?

• 39:41Speaker 02

  It's a huge challenge. Throughout my career, it's always been the dynamic. The more successful you are, the more capital you raise, the harder it is to continue within your strategy. Now that said, we have a lot of private equity investors that have been doing this for 25 years and they have consistently said, "Look, we could raise more, but we like this segment. We're sticking to the middle market. This is where we've been successful and this is where we're going to stay." We have a similar philosophy. I don't aspire to go bang heads with the entities that are deploying 5, 10 billion a quarter. It is a different market. It's not where my expertise lies. It's not where we have fun. It's not where our clients are. We're just going to be really careful and measured about the capital we raise, the capital we deploy. Maybe someday it becomes a problem.

• 40:26Speaker 02

  I guess it's a high-class problem if it happens, but it's not something we're trying to do. One of the terms you'll often hear when you get to a certain size, you become an asset gatherer versus an asset investor. We want to be investors. We like investing. We'd have to raise a whole lot of money before... That would be a problem for us. We've got a long road ahead of us in terms of making hay within the middle market.

• 40:46Speaker 03

  How do you think about capital solutions for the middle-market businesses? On the larger end, you see all different types of financing structures in the large alternative asset managers. You're just focused on the senior secured piece. How's the team thought about, "Oh, there should be a different risk-reward opportunity below that into the equity?"

• 41:07Speaker 02

  So we talk a lot about it. Earlier in my career with my partners, we ran mezzanine funds. We did a lot of aggressive equity co-investing. It was somewhat a function of the market. The path we've set ourselves on at Invesco for now certainly is to stick at the top of the cap stack. We look at our investors and we say, in the context of your overall portfolio of investments, you should think about us as that very safe, secure, low double-digit opportunity. You can tuck it away, you're going to get quarterly distributions from us, you're going to sleep well at night with respect to what we're doing for you. And we like doing that. Is there an opportunity down the road to play in different parts of the cap stack? Maybe. I think it would really be more a function of what the market

• 41:51Speaker 02

  opportunity looks like. For example, if we went into a significant recession and you saw valuation start to plummet, maybe there'd be a better opportunity to play at some of the junior capital and take more of the equity upside. But I think in the current environment, sticking to our mandate, which is orienting around capital preservation, being great stewards of our investors' capital is where we're going to focus.

• 42:10Speaker 03

  What's been your favorite deal that you've worked on?

• 42:13Speaker 02

  I did a deal a handful of years ago. It was a gym business. The sponsor was somebody I'd known for probably 10 or 15 years. We got in a van with the management team and we literally drove for two days from site to site. And we'd get out and you'd just watch the interaction. These guys were just incredible. You'd get out and you'd look at, you got to clean the window there or you'd go in, he'd hug the lead trainer. I hadn't done a gym deal prior to that, and they are really unique animals. The thing about gym businesses, on average, you lose 40, 50% of your clients every year. What business in the world would you lend to or invest in where half your clients quit every year? But notwithstanding that, when you look at the macro dynamics in the US,

• 42:54Speaker 02

  gym membership grows every year. These guys were just incredible operators. And from start to finish, I was in that business for 10 years through three financings, through multiple sponsors, and including COVID, which was, for a gym business, not a great environment. But I came through the other side of it perfectly. We actually just exited the business last year. It was sad to see it go, but it went to a large-cap direct lending strategy without a covenant. For us, that was sadly the point where we shook hands and we said goodbye, but it was a real fun opportunity.

• 43:26Speaker 03

  As you go through credit by credit, how do you put your portfolios together?

• 43:30Speaker 02

  To be most conservative, you got to really focus on diversification. We look at diversification on a single name basis, diversification on a sector basis, diversification on a sponsor basis. On average, our typical investments will represent somewhere in the 1% to 3% position. So across a portfolio, I'm expecting to have 40 to 50 investments. The reason for that, if you think you're doing great credits, more often than not, if you're going to have a problem, it may not be the credit you thought was going to give you a problem. But as long as you diversified the portfolio enough, as long as there's no single name that can actually do any damage, even if you have something that goes sideways, it's not going to impact the overall performance of the portfolio. When we think about construction, it's very much focused on making sure we build a very diversified book of business across all of our funds.

• 44:14Speaker 03

  How have you thought about leverage on the funds?

• 44:17Speaker 02

  Leverage is a really interesting element in the direct lending space. To some extent, it's driven by investor risk tolerance. We have some investors that very early on said, we don't want leverage on the vehicles. And part of the thinking was you're in the double digits. That's all we need. We don't want to take the incremental risk associated with adding leverage on top of these vehicles. And then we have other vehicles and other investors that have asked for leverage. Across all of our vehicles, even where we have leverage, we tend to skew more conservative. We won't put more than a turn of leverage on a vehicle. And you will see some direct lenders go as high as two turns of leverage on their vehicles. And I don't think it's a bad strategy. A turn of leverage will generally afford you somewhere in the neighborhood of 300 basis points plus of incremental yield.

• 45:01Speaker 02

  So it's not inconsequential. Of course, the problem with leverage is the obvious one. If things go wrong, you've leveraged the negative. We look to our investors. Some want it, and we're happy to provide it, and many don't. I don't worry about it in the context of our portfolios because I know what's in those portfolios. I know how we're selecting those assets. But the investor drives that decision, and we'll accommodate them either way, whether they want it or not.

• 45:24Speaker 03

  Trying to circle back to bank involvement. A big part of this market moving in the hands of asset managers was banks not wanting to be involved. Now you have banks willing to apply leverage to you and also getting interested again in this business. How do you see the banks playing into the competitive landscape and the risk of banks even lending to direct lending funds going forward?

• 45:44Speaker 02

  If I were working at a bank, I would be pulling my hair out saying, why is it okay for us to leverage these lever deals? But we can't actually do these lever deals. But I think it's treated as an asset-backed risk and it's all in the Basel III regs. I wouldn't even pretend to be able to articulate to you why they're able to do that, but not traditional stuff. Banks are very sophisticated. I think they've been struggling over the last handful of years as this asset class has grown and they are trying to come up with solutions. We've met with a lot of the large cap banks. They're each thinking about it slightly differently. They have significant competitive advantages in that they have tremendous corporate relationships. They have historically great private equity relationships.

• 46:26Speaker 02

  The challenge for banks is to figure out how to navigate within the regs. You're seeing some start to partner up with other direct lenders. You're seeing some start to raise third-party capital. I wouldn't count the banks out. They should and they will find a way to get involved in this business, but it's hard. They're not really able to take these assets on their own balance sheet. All the issues that we all lived through during the GFC, they're muted today, but they still resonate with banks. And I think they've just got to figure out how to manage those dynamics, but they'll be back. I don't doubt it for a second.

• 46:59Speaker 03

  I want to make sure I get a chance to ask you a couple of closing questions. We started with your first paid job at EDS. What'd you learn from that job?

• 47:06Speaker 02

  When you join EDS, the first thing they do is they send you down to Texas for this EDS training program. It's 10 or 12 weeks of really intense training to develop your skills. But the model for that training program is to challenge you from a multitasking perspective, a resource-constrained perspective. You'd go down there, there were 40 of us in the training program, and you'd have eight hours of classroom training. And then you'd have the equivalent of eight hours of project work to do. It was pretty intense. You'd come into class some mornings and a seat would be empty and the instructor would come up to the front of the room. And very matter-of-factly say, you know, so-and-so has been terminated for performance reasons. Over the course of those 10 or 12 weeks, 22 made it through the program.

• 47:49Speaker 02

  I was reasonably convinced if any day someone was going to tap me, I was going to be the next one out the door. But what it taught me was we all underestimate what we're capable of doing when put in challenging environments. To this day, that was probably the most difficult 10 or 12 weeks of my career. I so clearly remember how stressed I was and how difficult it was. You come out the other end of it, you feel pretty good about yourself and you can pretty much take on anything. I learned a lot about myself in that process and what I was capable of.

• 48:17Speaker 03

  What's your biggest investment pet peeve?

• 48:20Speaker 02

  As the market has changed, as so much capital's come in, deals move pretty quickly. What drives me nuts is when people try to cut corners or take things at face value. Everything in our business is a sale, selling you this is a good company. I'm selling you, you should provide this kind of leverage. You can't take anything at face value. You gotta do your work and it's hard because things are moving at lightning speed and it's easy to sort of, well, you know, they like it at this leverage, so it must be okay. But nothing drives me crazy more than you gotta do the work.

• 48:51Speaker 03

  Which two people have had the biggest impact on your professional life?

• 48:55Speaker 02

  When I joined the Royal Bank of Scotland, there were two individuals that brought me on. Their names were Leif Robertson and Ewan Hamilton, two Scots. I was just a deal guy. I had private equity relationships, I'd done a bunch of deals. They gave me a white canvas at the fifth largest bank in the world to build a leveraged finance business in the US. The mentorship they provided, the guidance they provided, I will forever be grateful to them. That job changed the direction of my career. They were incredible bankers. They're still good friends today and I can't say enough things about how grateful I am to them for giving me that opportunity.

• 49:30Speaker 03

  What's the best advice you ever received?

• 49:33Speaker 02

  My mom instilled in us, be kind to people. And don't be kind to people because you're looking for something back in return. Be kind to people because it's the right way to be. My wife and I have tried to instill this in our daughters and I think in the world we're living in today, it's a pretty good ethos to live by.

• 49:49Speaker 03

  Last one, if the next five years are a chapter in your life, what's that chapter about?

• 49:53Speaker 02

  It's easy because it rolls off the last question you asked me. I've got two amazing daughters. They're teenagers. They're both going to be in college in the next handful of years. The next chapter in our life would probably be entitled transition. We spent the last 17 years of our lives, my wife and I, worrying about them, supporting them, doing everything we possibly can for them. I'm a little bit wary of what our lives are going to look like when they leave the nest and we're looking at each other underdog and trying to figure out what we're going to do next.

• 50:23Speaker 03

  How about on the business side, the next five years?

• 50:25Speaker 02

  It's continue to grow the platform. I don't know that it's a new chapter. It's just going to be a continuation of what we've been doing. To build a business from start, there's this trajectory. It takes a while to get lift. We've just gotten to a place where we've got significant lift and significant inertia. If we start to see the market rebound in terms of M and A volumes, I think for us, maybe it'll be called explosive. We're going to see some pretty explosive growth in our platform over the next five years.

• 50:51Speaker 03

  Well, Ron, thanks for this deep dive into the senior securities space.

• 50:54Speaker 02

  Thank you so much, Ted. It's great. Appreciate the time.

• 50:57Ted Seides?

  Thanks for listening to this sponsored insight. Sponsored episodes are paid opportunities for another 12 managers a year to appear on the podcast. If you're interested in telling your story in front of the largest audience of investors in the industry, please email us at [email protected] to apply for one of the slots.