Earlier this week, I spoke with Deborah Orida, President and CEO of PSP Investments on their new partnership with AIMCo to explore and invest in private loans.
I told Deb to read my Outlook 2023 to understand why I am very bearish and foresee major dislocations across public and private markets this year, including private debt and credit in general, "so those double-digit returns you were getting since inception of the program at PSP are going to be much more difficult to get in the next 2-3 years."
I told her I expect more pain in high yield credit (HYG) and the leveraged loan market (BKLN) and this will spill over into private debt:
Deb replied:
In terms of the market, we have a highly diversified portfolio that has good exposure to some things that are well-positioned in this market like credit, like natural resources.
Our credit book as you know, the vast majority is floating rate so our existing portfolio is in good shape and going forward what we are seeing is only the best recession-proof businesses are getting financed and they're now getting financed at higher rates and on better terms.That's why we think the private credit market is really exciting and our sophisticated platform will continue to get a lot of calls and this partnership with AIMCo positions us well to be able to pick and choose to play across that credit opportunity set.
She's right floating rates will help them in a higher inflation/ higher rate environment. I asked her about the link between private debt and private equity over the last few years and how sponsored backed deals were critical to PE deals:
I would say over the last couple of years, we increased our collaboration between our private debt and private equity teams. And that will continue under the new leadership with Oliver and Simon.
But they're still addressing independent markets. So, we work together where it makes sense but they are two separate groups that existed under David and now we are elevating Oliver, and he will continue as he did before running global credit, and we are elevating Simon who will continue to run global private equity.
At the end of that comment which has garnered over 17,000 views on LinkedIn, I stated I had a conversation with a private debt expert who raised a lot of interesting points on the embedded risks of unitranche loans that many investors are unaware of:
He said this about unitranche loans:
Within the past several years, this has been a popular mode of financing for the sponsored-backed group. They are a single loan that encompasses both senior and junior into one product.
Typically you would have a senior loan -- let's say a bank or private credit institutional fund would provide financing for -- whereas the junior loans which would be the more aggressive opportunistic loans.
With unitranche loans, you now have a product that is averaging this into one product, so what we end up getting is a senior loans with inherent junior credit risk embedded in it.
I asked this person if this is similar to the subprime credit crisis when they were packaging all these subprime mortgages together and then the credit rating agencies would slap a AAA credit risk rating on them so investment banks can sell them to institutional clients hungry for yield:
Exactly. And this is one of the issues I see permeating the industry. We see a lot of funds marketing themselves as senior type funds but when you look at the nitty-gritty details and their underlying exposures, there's a lot of untitranche product in there.
So then the question becomes are they properly accounting for that junior exposure in their OMs (offering memorandums) when they're talking to potential investors? So I think we are going to start to see a wave of defaults hitting a lot of funds or hitting a lot of asset managers that thought they were in senior only type structures.
I asked him who oversees these structures and whether they are truly investing in what they claim:
So, let's look at the two key parties. You have the underwriter originator which is the portfolio manager and then you have the investor. So the originator and portfolio manager are aware of their exposure but my question for the broader audience is if the investors are aware that there is unitranche exposure that has inherit junior credit risk or is that portfolio manager calling that unitranche in senior only loans?Stunned, I naturally asked: "Are you telling me there's no third party validation of these unitranche structures and whether they have junior credit risk exposure?!?!?":
Exactly Leo and that is why I fear a lot of investors whether it be your portfolio manager or mutual fund manager buying private credit exposure or structures, are they aware of the true inherent risk of a unitranche loan?
My answer would be only sophisticated private credit managers like a CPP Investments, like myself who understands what a unitranche is would be able to look at that and say wait a second, what is being classified as a senior product actually has like you said 10, 15 20% or more of equivalent junior credit risk but because untitranche loan packages first lien and second lien into one product, most asset managers who fell into this kind of glossed over that point.
He told me investors should always ask about what exactly is in the unitranche loan (what percentage is first lien, second lien, equity) and whether that changes the credit risk profile:
Again, this has been glossed over in many marketing materials. Remember, it's the junior guys that will fail first. The tide will turn. I think we can all say with certainty, defaults will start increasing. So any holder of second lien paper are going to feel the hit first but if you're holding unitranche, you too will be exposed to second lien default risk that you didn't know was embedded in your product.This is why it's important to have a sophisticated investor like CPP Investments or PSP Investments as a partner because they have an experienced team that is able to dig into these unitranche loans to see what exactly is their risk profile in terms of second lien loans.
I told this person that what worries me a lot, and I alluded to this in my Outlook 2023, is there is a lot more risky debt across public and private markets all over the world that isn't accounted for properly and this could lead to a liquidity crisis unlike anything we have seen yet.
This is what Mohamed El-Erian and others are warning of so pay attention to this unitranche story as we head into a historic and painful earnings recession.
This is why IMCO and others are smart to invest with Antares Capital owned by CPP Investments and why AIMCo is smart to partner up with PSP Investments to explore and invest in private loans.
But let me be clear, we are headed into a very difficult and turbulent period, there might be great opportunities in private credit but there are huge risks too.
That goes for everyone, no matter how sophisticated they are. You can forget about double-digit returns in this space over the next couple of years.
Still, this agreement between PSP and AIMCo just like IMCO's agreement to invest in Antares is a win-win over the long term.
I also think with Marlene Puffer and David Scudellari joining AIMCo, Evan Siddall is gaining two experienced veterans on his senior management team to help him lead that organization.
As an aside, Evan, David and Deb all worked together at Goldman Sachs a while ago and they're all top-notch professionals.
Update: I asked the credit expert if this Horizons Active Floating Rate Senior Loan ETF (HSL.TO) which seeks to provide unitholders with a high level of current income by investing primarily in a diversified portfolio of U.S. senior secured floating rate loans, generally rated below investment grade and debt securities, is worth tracking.
He replied: "Yes, I know it well and would be worth tracking for a private credit benchmark equivalent and perhaps acquiring some after the default cycle (which nobody can predict)."
Now, earlier today after the US CPI report came in as expected, I had a discussion with my favorite currency trader in Toronto who basically agreed with me and Francois Trahan that wage inflation will pick up in the second half of the year as employment falters, forcing the Fed to hike again after a long pause:
Nightmare scenario: Headline inflation keeps cooling in first half of year. The Fed hikes by 50 bps at each initial meetings then pauses for 6 months. In meantime, employment starts weakening BUT wage inflation starts picking up forcing the Fed to hike rates again later this year
— Leo Kolivakis (@PensionPulse) January 12, 2023
He told me: "I've been saying it since last year, wage inflation will pick up this year and if the Fed starts hiking again after a long pause, it's going to kill the market."
He added: "But what I really want to talk to you about is this unitranche debt mixing secured with unsecured debt you wrote about a couple of days ago, it sounds like the subprime debt crisis all over again."
I replied: "Yes, that's exactly what I told this credit specialist who spoke to me."
He was amazed that they're "co-mingling secured with unsecured debt" packaging it as senior loans and no media outfit is talking about this but rather about the boom in unitranchedebt.
He added: "It's private so they don't have rating agencies rating this stuff, nobody really knows what proportion of the trillions in unitranche debt is secured (senior) and unsecured (junior)."
I replied:
Well, I'm sure the data exists from Refinity but it's kind of scary when you think about it and as the credit specialist explained to me, only very qualified senior credit analysts can dig through a portfolio to understand what percentage of unitranche debt is first lien and second lien. Most investors who came late to the asset class don't have a clue of the underlying credit risks.
My friend said: "Same story, every time, do you remember 2008 and the ABCP crisis that almost brought down the Caisse?"
I replied:
Do I ever. Right before I got fired at PSP in October 2006 for 'being too negative' after I did research on CDO-squared and cubed and told them the issuance was off the chart and downright scary, I had lunch in March of that year with Henri-Paul Rousseau, the former CEO of CDPQ, at Molivos restaurant. Gordon Fyfe knew about it because I told him.
Anyway, I remember Rousseau was a gentleman, very smart and polished, and he had a voracious appetite (he's a big guy and Molivos had amazing Greek food). I also remember asking him if he's worried about risks in the Caisse's portfolio and he told me flat out: "Leo, one thing I can assure you, the Caisse has the best risk management in the pension industry."
Well, the rest is history. The ABCP scandal cost the Caisse billions that year when they lost $40 billion and Rousseau was out and replaced by Sabia.
I added:
I kind of felt bad for Rousseau because it tarnished his image and I don't think he fully understood the risks that Luc Verville was taking in money markets devouring ABCP to easily beat his T-bill benchmark or the huge risks that Christian Pestre was taking in his exotic and illiquid long swap strategy using the balance sheet of the Caisse.
But Rousseau was easily influenced and made some terrible decisions. In fact, he gave Pestre free rein to do whatever he wanted back then and told everybody "don't bother him, he's brilliant and knows what he's doing."
It's too bad because till this day I think very highly of Henri-Paul Rousseau, he had political aspirations and I think he would have made a great Premier of Quebec, even better than Legault.
I went on:
The same thing was going on at PSP but to a lesser scale on ABCP. Still, we had exposure, Gordon Fyfe never forgave the National Bank for selling us that crap.
In the meantime, I was going through hell because they kept bouncing me back and forth from one department to another knowing I have multiple sclerosis and was very stressed and tired.
At that point, Gordon asked me to figure out where I can add value so I started doing research on the issuance of CDO-squared and CDO-cubed, and looking at the insane issuance, I knew it was only a matter of time before the US housing market blew up and there would be a massive credit crisis.
I was also freaking out because at the time Jean-Martin Aussant (who later became a well known politician) was selling credit default swaps using the balance sheet of PSP and was telling everyone it would take a 20-sigma event for his portfolio to lose money.
My friend asked: "So, what happened?"
I replied:
Well, what happened is I asked Gordon to have breakfast in September 2006 and I hate waking up early to have breakfast with anyone but he doesn't do lunches (goes to the gym).
Anyway, at that breakfast, I showed Gordon the research charts I was working on and told him I was petrified of the credit risks Aussant was taking in his internal credit portfolio. He told me: "Leo, you were my first investment hire at PSP because I know you're very smart but a few people in my senior management told me you're too negative and not a team player. If you're not careful, you risk losing it all but right now you have nothing to worry about."
I knew I was toast. Turnover rate back then was insane and a few weeks later, Pierre Malo (my boss back then) called Mihail Garchev and I into his office to tell us he can't guarantee we will have a job. Soon after, I was fired from PSP even though I had stellar performance records.
Given my health battles, I didn't take it well but like Nietzche said a long time ago:"Out of life's school of war, what doesn't destroy me makes me stronger"
I've also maintained a relationship with Gordon over the years (phone calls and emails once in a while) and it might sound weird to many people reading this but I still think very highly of him even if he too made huge blunders back then trusting people who he shouldn't have trusted (to be truthful, we all made our share of mistakes).
My friend said this:
It's always the same story at these large pension funds, everyone is worried about career risk and they're all looking to game their benchmark using any way they can.
Look at private debt. It mushroomed over the last ten years as rates hit ultra lows and private equity was booming.
So the pension funds invested billions in private equity and these PE funds returned the favor by taking on more unsecured debt which they package with secured debt and have the pensions finance their operations through unitranche debt from their private debt teams.
The pension funds can claim they're making double-digit gains and adding alpha and everyone is happy making millions in bonuses. It's a win-win-win-win for PE funds, senior pension fund managers, their Board and their contributors and beneficiaries.
I interjected: "Yeah, until something blows up."
My friend: "Ah, yes, but by then these senior pension executives are all long gone, retired, and couldn't care less as long as they made millions while at these top jobs. Can't blame them, everyone is looking to maximize their revenues."
I asked: "I wonder what the Board of Directors at these large pension funds know about the embedded risks in private debt."
My friend cynically replied: "They probably don't know anything because they ask their risk managers and senior executives to give them some risk report and they take it at face value without having it independently verified by an expert third party."
I said: "Well I don't think it's that bad."
My friend: "Leo, I'm telling you it's that bad. As you said, ask any Board member at these large pensions what percentage of their private debt is second-lien unsecured debt and I doubt they know and if they do, I doubt it has been verified by independent experts who can vouch for it."
I replied:
And I'm afraid therein lies the truth, while private debt has become a very popular asset class and in intrinsically linked to private equity which sponsors this unitranche debt, we do not have reliable industry data which tells us how much of total unitranche debt issues over the last five years is made up of second lien debt.
My friend: "They should make it illegal to co-mingle first-lien with second-lien loans and market it as senior only."
I replied: "It's too late and I'm really afraid when this private debt boom blows up, it will wreak havoc across the global financial system much like subprime debt did back in 2008 when it blew up."
Let me be very clear to all my readers, we simply don't know where the next credit crisis will come from but as I'm learning more about private debt, I'm realizing that all this "floating rate" inflation hedging is a bit of chimera, hiding the real embedded risks in unitranche debt.
If anyone can find me a bar charts of total unitranche debt issued over the last ten years and then also find how much of that is first-lien and second lien loans, please send it to me asap and I will embed it below right here.
As the Fed tightens and rates keep climbing, you have to wonder however whether there will come a time when one of these Johnny-come-lately private debt funds blows up and credit risk spreads all over the world.
I am also openly wondering why long dated Treasuries are rallying when the Fed is still in tightening mode during a slowdown. Is the bond market sniffing out the next credit crisis which is already upon us?
The bond market is wrong as the Fed is still in tightening mode EXCEPT if it is sniffing out the next major credit crisis...STAY TUNED!
— Leo Kolivakis (@PensionPulse) January 13, 2023
Also why did Libor eclipse the peak it reached in wake of Lehman’s collapse today:
One of the world’s most important short-term lending benchmarks has climbed back to a level last seen before the onset of the global financial crisis in 2008.
The three-month London interbank offered rate for dollars climbed 1.5 basis points on Thursday to 4.82971%, exceeding the peak of 4.81875% it reached in October 2008 when credit markets were in disarray following the shock collapse of Lehman Brothers Holdings Inc. The last time it was higher was in 2007.
The spread of Libor over overnight index swaps — a barometer of funding pressure — was at 16.3 basis points on Thursday versus 17 basis points the prior session.
Much of the recent surge in Libor, which is set to be phased out on June 30, has been driven by expectations for Federal Reserve policy tightening. The benchmark is moving in sympathy with many other short-term rates, but there are other elements that feed into the daily setting, including the backdrop for commercial paper transactions and broader credit conditions.
“It is supposed to reflect bank funding costs,” said Priya Misra, head of global rates strategy at TD Securities. “As reserves are falling, banks are paying up for funding.”
The minutes of the December Fed meeting published this month noted that banks continued to increase their use of wholesale funding, and survey information suggested lenders expected to move deposit rates “modestly” higher in the coming months. Misra said the higher deposit rates are also consistent with higher Libor.
Most Libors around the world came to an end at the close of 2021, but regulators decided to extend the life of some dollar-denominated reference rates for an additional 18 months. A Fed-backed committee designated the Secured Overnight Financing Rate, known as SOFR, as the successor to US dollar-denominated Libor.
Now, the bulk of private debt is in the shadow banking system which includes hedge funds, private equity finds and pension funds, so it shouldn't put pressure on banks' funding cost but you have to wonder if banks are also worried about a major credit event and counterparty risk.
I don't know but if I were sitting on the Board of any major Canadian pension fund with a huge private debt book, I'd ask to see second-lien exposure in unitranche loans and ask that it be independently verified by a highly qualified and independent third party.
And again, funds like CPP Investments and PSP Investments have very qualified and experienced people in their private credit teams, I can only imagine what is going on at US public pension funds farming this out to PE funds or credit funds.
The next major debt crisis, like the previous one, will hit everyone hard but it's always the less sophisticated institutional investors who get clobbered the hardest because they came late to the private debt party and don't have the internal expertise to properly assess the embedded risks in their unitranche debt portfolios.
And the next time someone tells you private debt is a great asset class that hedges against inflation and has little risk, make sure you correct them on the "little to no risk part."
Like I keep warning my readers, this is a year to worry A LOT about risks across public and private markets.
When the next debt crisis hits, liquidity will dry up fast and all these illiquid loans will be selling for pennies on the dollar.
Large sophisticated pension funds will seize this opportunity to buy loans they think are being sold unjustly hard but many other less sophisticated pensions will get whacked hard.
So, maybe it's good that OTPP and HOOPP are only now "exploring" private debt as an asset class, they can sit patiently and invest right after the next default wave strikes. The same goes for BCI.
Let me wrap it up there. If you have anything to add, please email me.
Below, Private equity firms are increasingly turning to an obscure type of loan, once almost exclusively used to finance smaller deals, to fund larger and larger buyouts. Yet a growing number of analysts and investors warn the debt may be riskier than it appears. Bloomberg's Kelsey Butler reports on "Bloomberg Markets."
Also, Warren Buffett is well-known for promoting the clear success of value investing, but one lesser known attitude he holds is his disdain for private equity firms. In this video, Buffett and Charlie Munger explain why they dislike private equity and so-called "alternative investments".
As I stated on LinkedIn earlier:
He's right which is why the bulk of the big money made in private equity at Canada's large pension funds is made in co-investments where they pay no fees, not in their fund investments where they pay big fees. But to gain access to co-investments to lower fee drag, you need to invest in funds and you need to hire experienced people and compensate them properly so they can analyze co-investments fast. Also, pensions have a long investment horizon so they can adopt the Warren Buffett approach and keep good companies in their books a long time, longer than the life of a PE fund (3-5 years).
Third, a panel discussion from the Milken Institute which took place three years ago on the age of private equity and credit.
,p>Lastly, TD Securities Global Head of Rates Strategy Priya Misra says the Federal Reserve is going to be reluctant to stop hiking and predicts a 50 basis point rate increase in February. Speaking with Jonathan Ferro on "Bloomberg The Open," Misra says inflation has clearly peaked but markets are a little too optimistic about the decline in service inflation.