HYH Interview - Nailing Interviews with a Private Credit Professional

Welcome back!

It’s been a minute since I last had a credit interview, so I’m excited to kick another edition off with an anonymous Private Credit professional.

For my next set of interviews, I’d love to get some Private Equity or Hedge Fund folks on board, so if you’re in that space and you’re a VP or higher, let’s see if we can find some time to chat.

I’m very grateful for the folks who spend their time giving back and providing great insight for the professionals and prospective professionals who read these newsletters. At this point we have a pretty robust suite of credit professional interviews on my site.

Before we get into it, tis the season for Finance Meme Merch - if you haven’t already, make sure you check out my merch store for a ton of cool holiday gifts.

I’ll run through merch more at the end of this piece, but let’s get into today’s message:

A message from Octus: Announcing Portfolio Analytics

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Please see the interview below. Questions are asked by Harry, and answered by the Anon professional.

1) Can you give a vague, but anon, sense of what you do?

I'm a mid-level professional at a private credit fund that invests across the capital structure, specifically in the LMM/MM.

2) Current thoughts about the Private Credit landscape in general, and your general view on Private Credit over the next few years?

In general, I think it's hard to argue that Private Credit hasn't been a hot space for what feels like quite a while now. From the success of continued multi-billion dollar fundraises, steep AUM growth, consolidation at the top of the industry, GP stakes sales (at all tiers of the market), and banks attempting to buy market share back via "partnerships" with direct lenders, there are a lot of good fact patterns that point not only to the growth, but the durability, of the industry. All of this said, testing the industry at its current scale through a few credit cycles will probably shake out a few of the more aggressive upstarts trying to undercut the market or those that treaded where they shouldn't have. Overall, I'm positive on the next few years (and long-term) for Private Credit, which will hopefully feel like a more normalized environment (whatever that means), with M&A volume returning as rates come down (unfortunately) and sponsors being induced or compelled to sell. Beyond the inevitable challenges of competition in an attractive industry, I do think there are some regulatory headwinds that will start being felt in the next few years, both from an industry perspective, as Private Credit has grown into a $2 trillion plus asset class more or less unimpeded by any meaningful regulation, to more nuanced considerations around things like pockets of AUM concentration in increasingly scrutinized sectors (e.g. PPMs). There's also probably some pain to be felt on a few over-levered covid-era deals reaching maturity that have been kicking (or PIKing) the can down the road, which only works for so long.

3) There's been a decent amount of headlines lately on private credit firms looking to sell themselves and it seems like a lot of firms are running processes - what do you make of this trend?

I'm definitely not surprised, for a few reasons. First, Private Credit firms are great businesses: predictable fee streams paid by an effectively zero-risk LP base, with all of these management fees mostly uncorrelated to deal volume (unlike banks where there's heavy fee volatility). From a macro perspective, direct lenders have a lot of tailwinds behind them, so the future prospects should get a large buyer universe excited. We're also at a point in the industry's maturation/scale where it's becoming increasingly difficult to greenfield a direct lending strategy -- I know of more than a few firms that have tried and failed to achieve the scale needed to make them successful endeavors. Therefore, this means it's much easier to buy an established manager than build the business yourself. There have been a few bad marriages that have come out of the wave of GP sales over the last several years, but that's not the norm.

I think these sales are a net-positive thing for the industry, but on a personal level, I'm not as excited about it. On one hand, it bolsters the credibility of Private Credit as an asset class and provides liquidity to owners that up until not that long ago were holding effectively illiquid stakes in their firms with no buyer universe except the firm's existing partnership. GP stakes sales started mostly with PE firms, as they were in a more established industry, but Private Credit has gained the same hard-earned credibility that has led to a much more liquid market for its management companies. This is great, if of course you are an owner of the firm. If you're not, the prospects can look quite different. Private Credit firms aren't like "normal" businesses, in that the majority of their staff are highly-compensated people who have big long-term incentives via carried interest. Selling the management company of these firms not only gives these people a new boss, organizational changes, etc., but also now reduces the carry pool. Without some sort of enormous fundraising boon/capital commitment from the new owner to right-size that equation, the economics of this transition can be hard to swallow. All of this can be a tough sell for the employees, and specifically for more senior folks who didn't make any money in the sale.

4) PIK is a delicate tool to provide relief for borrowers - but do you think PIK is getting out of hand, are we in an okay enough environment for borrowers elected to defer cash interest payments?

There was some good research published recently that showed BDC holdings steadily increasing the portion of PIK interest vs. cash interest over the last few years, which makes obvious sense given the tightening cycle we've been in for the last few years and the impact that's had on underlying cash flow generation. Overall, I think PIK is fine in the right amounts and for the right reasons. It's too much of a generalization to say that PIK is bad -- it just depends on why. If a borrower breached a covenant due to an identifiable, temporary issue, and PIKing some debt for a few quarters will help the company work through it, then I think it makes perfect sense. If you're looking at a situation where, via some kind of default, you've got an entire tranche of sub debt that's being forced to take all-PIK, yes, from an immediate cash flow perspective it's going to help the borrower. The risk is that this situation lags for too long, and creates a death spiral for the capital structure wherein fairly quickly you've got a piece of debt that's now likely out-returning the equity (at least on paper), and if the business ends up needing more capital, it's going to be a tough situation for a sponsor to step up if they don't reasonably believe their new money is going to get the return they want it to (or at least will save what they've already got in it). In my experience, it's very hard to find your way out if a business has been PIKing a lot of its debt for a long time, both from an underlying business fundamentals standpoint, and diminished equity support behind the company itself. Some lenders that invest in the hybrid or PIK-only space (HoldCo notes, toggle securities, etc.) know this is part of the game, so if it's written into the docs, then lenders should have no delusions about it and no complaints if it ends up hurting them.

5) Any thoughts on Private Credit LME, and whether there's any new protective language like the "Pluralsight" protection language that is starting to flow through in credit docs?

In my tier of the market this is basically non-existent and I've never seen it effectuated. I'd like to believe this is because there is more of a relationship angle in this part of the market, but I think if things get tough, almost any over-lawyered, emboldened sponsor can do something they shouldn't. My hope is that some version of a Pluralsight concept makes its way into loan docs alongside its unfortunately memorialized J. Crew, Serta, Chewy, etc. relatives.

6) Do you think LMM/MM Direct Lending is more insulated from LME than UMM Direct Lending?

Definitely. I think LME is much more of an UMM concept that is an unfortunate cost of doing business if you want to be relevant in that tier.

7) What are you seeing in your neck of the woods in terms of the average secured/total leverage profile, typical spread, key documentation, and the average borrower profile?

Leverage has definitely ticked up a bit and overall, there seems to be more confidence in the forward curve -- whether that view will prove to be well-founded or not is TBD. For solid credits, secured/total leverage is in the 4.5-5x/5.5x range -- the one development I've seen recently is more scaled direct lenders coming down market (<$10MM EBITDA) to back a solid sponsor that's looking at a smaller, quality asset, and giving leverage that would be more typical in the core MM. It's not widespread, but is something we've seen a few times. Spreads have probably compressed 25-50 bps from what we were closing earlier this year, but my firm tends to see a fair amount of off-market opportunities where leverage is lower/spreads are wider, though there's usually a reason for it. Documentation wise, things have loosened a bit, but key terms (covenant levels, basket sizes, etc.) are still reasonable overall.

8) How do you think about the direction of direct lending pricing and doc protections? I'm a little worried that competition and spread compression, will weaken documentation.

I think your view is correct and well-founded. Like I was talking about before, the MM/UMM have attracted a lot of capital and there's a finite supply of things to deploy it into. With that dynamic and a depressed M&A environment, lenders have a reason to stretch on refis/dividends where a year ago they might not have had to. All else equal, a lender who can step in with tighter pricing and/or more aggressive overall terms is going to drive the market into a more aggressive place and likely looser docs to boot. Dividends have also seen a resurgence recently as sponsors are keen to drive DPI without selling into a soft M&A environment -- a lender who can step up for that is going to win all day.

9) You spend a lot of time interviewing private credit candidates - what are some of the strengths you see from solid candidates in the interview process? What are some areas people could brush up on? Additionally, there's a lot of back and forth on whether junior candidates are as smart/hardworking as they used to be - what are you seeing from your lens?

The best candidates I've interviewed are capable of showcasing both their quantitative skills (e.g. a solid, well-constructed case study) and being able to present/speak to their views in a thoughtful, constructive way. I've seen quite a few great phone screens turn into disaster final rounds where the candidate puts little to no critical thought into their case study or stumbles over fairly easy questions. My expectations are different depending on the level of the candidate though - at the Associate level, I'm looking more for the analytical skillset and a hard-working personality -- if they've got good presentation skills that's a plus, but not necessary in my book. My view is that you can generally get by with either hard work or intelligence at the Associate level, but you need some mix of both to get much farther beyond it. Work ethic can be the hardest thing to judge at any stage of the process -- even the Associates we've hired out of IB have turned out to lack the hard-working attitude that probably got them their previous job. This is especially true for the cohort that spent their first few years remote because of covid. Now that things have largely reverted to mostly in-office schedules, I think some have struggled to adjust. Candidates at the VP+ level need to have all the fluency/mastery on the analytical side, but need to have the ability to think through higher-level things like structuring, pricing, diligence plans, etc. and importantly, being able to present those views to an interview panel. At all levels, I'd say there's a big emphasis on cultural fit, which is highly subjective, but critically important given how much time you spend working with each other.

10) We have a lot of junior professionals reading the newsletter - what's the best advice you can give them?

Always be thoughtful/inquisitive with the work that you create and how you present it, even the lower value stuff. While most of your job is focused on modeling and creating decks/materials, how you present the summation of all your work is going to make an impression on your bosses. Did you have a thoughtful analysis behind why margins have been so stable? How about why that recent add-on traded at such an accretive multiple? The ability to do the work correctly is expected, but mastering that higher level of critical analysis will distinguish you among your peers.

11) We talked a bit about carry and thinking about long-term comp - what advice do you have for the folks that are just starting to deal with deferred compensation?

It's a great way to build long-term wealth and have your employer show you they believe you have a long future ahead of you. My emphasis here is on long-term -- think about carry not only in the context of the amount, but a realistic timeframe to realize it and what discount factor you'd apply to it. Valuing and projecting it is a fairly straightforward exercise, but I wouldn't lean on it as a key factor for major future financial decisions (like buying a house), namely because the time horizon can be much longer than you expect and you don't want to defer important goals based on the uncertain outcome of a carry pool. Some funds go great, and that's great, but deals can go sideways and even if there's a recovery to be had, a few of these in a fund can hold up carry distributions for quite a while.

12) There isn't a lot of compensation transparency the higher up you go in finance - what do you think the typical comp structure looks like for those who get more senior into their private credit career?

At most firms, it becomes more heavily weighted towards variable compensation (bonus, carry, etc.) the higher up you go, and therefore performance is increasingly important -- whether it's originations volume, execution, etc. While the percentage increases in compensation tend to accelerate as you move up, the bigger incentives are significant increases in carry points awarded, which are generally multiples higher at each tier once you hit the VP+ level. There's not great transparency on carry points by level, but the jumps tend to be substantial the higher up you go (anecdotally at least).

13) I like to argue that to the people who think Private Credit is a bubble that surely Private Equity is going to end up a lot worse off - thoughts?

Broadly, I'd agree. Private Credit has been on a huge market share grab from banks for many years now -- some of the reasons are regulatory, but most of it is because Private Credit is simply a better, more flexible (albeit more expensive) offering, but I'm obviously biased. That said, there are certainly lenders that have probably stretched too far in this land grab (especially in the overheated markets of 2021/2022) and it's only a matter of time before some start to feel that pain. I don't think that's an industry-wide phenomenon, however, and even the ones that might have an average/bad fund can probably tell a good enough story to their LPs if they have a reasonable long-term track record. Even with some lenders getting out over their skis, the path to recovering your principal on a bad deal is more straightforward than it is for a sponsor, who is more aggressively fighting both valuation and importantly, portfolio concentration, given most sponsors invest ~10%+ of their fund in a given deal, whereas most Private Credit funds are <3-5%. The last 5 or so vintage years will be great data for Private Credit to prove it can effectively capitalize and ride deals through one of the toughest cycles on record (if you consider the covid period a "cycle") - and arguably the only one where the industry has existed at large scale. For both sponsors and Private Credit funds, the decade-plus pre-covid era was an enviable period of rising multiples/leverage and generally favorable economic conditions; now the deals done post-covid are going to be tested -- more so for sponsors battling the IRR game -- to see if the ultimate return can justify the initial capital structure. I think Private Credit is better positioned through this environment, and I've yet to hear of a credit fund that has generated a MOIC below 1x (though I'm certain they're out there); I know of quite a few PE shops that have failed to return all their LP's capital even in up-markets, and the current one will be a real test for many.

14) Last question - are we still in the golden age of Private Credit?

Sort of? Even just the last few years of higher rates will probably yield some of the best vintage years in Private Credit's history, but it's hard to argue that with rates/spreads recently coming down that returns will stay on par. For funds that capitalized on this period, are established, and have a good LP base/backing, they will continue to grow AUM through any interest rate environment and be the beneficiaries of these market tailwinds, so maybe the golden age is in its later innings, but will hopefully be followed by many more good years.

That’s all for this edition!

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