Business Breakdowns
· Matt Reustle, Hunter Hopcroft
[00:00:00] S0: I think you gave a very good distinction between the growth of private credit and there is so much focus on the sponsor-backed market, which in reality was fairly straightforward. I don't want to say easy, but that was something where you were part of a growing TAM. It is more difficult to find the higher-quality deals that are not sponsor-backed and that require a relationship with the businesses. And when you describe that perpetual motion machine, I think you hear about several forms of dollars creating leverage in the system. What that can often lead to, through financial complexity, is inherent risk in the system. Whether it's leverage or something that, once there is a break in the dam, creates a ripple effect through the organization that's not felt only once, but is felt multiple times and can bring things down. I think that is probably not the right way to categorize this. But just thinking about risks with the leveraged portfolio, or what is inherent from a standard company perspective in terms of how much traditional debt they have, and also the liabilities that exist within the system. Are there hidden things here that are worth paying attention to when you run something that has that complexity? [00:00:00] S1: I'll perhaps editorialize a little bit here. [00:00:00] S0: Please do.
· Hunter Hopcroft
[00:00:00] S1: Which is what you're asking me to do: I think that, especially because of the muscle memory of 2008, there is a tendency to believe in a building systemic risk—that there will be a Minsky moment, as they say, where all those credit dominoes start falling. And I actually disagree with that. I think the regulatory response following the Great Financial Crisis has, in fairness, made risk far more diffuse than it was before, when it was housed in a somewhat concentrated banking system. And now it's spread across these many asset managers in these many structures with many underlying investors in them. I think the bigger risk here is not fallout; it's that this truly self-perpetuating demand for debt leads to a degradation of returns over time, where there's a clear definition of financialization: it's the demand for debt securities and the absence of productive uses for that debt. And we have this structure here. In fairness, annuities are still a very small slice of the global markets pie. But I do think they speak to something where we are heading for an era where fewer and fewer people want to take equity risk. They want to feel higher up the capital stack. They want to feel they're in some sort of secured position. And that creates a tremendous demand for assets that can check the credit box. And there are only so many lending opportunities out there that meet those requirements. The bigger risk here is not some fallout, not some Minsky moment, not some dam breaking event. It's just a slow degradation of returns as debt eats more and more of the benefits of asset ownership or the activities of these businesses.
· Matt Reustle
[00:00:00] S0: And it's a little bit of an ongoing dance in terms of what the cost of capital will look like. But a big piece of how I think about certain markets is that you have banks who are getting deposits— their cost of capital is incredibly low, which allows them to make loans at fairly low interest rates and still collect an attractive spread. Once you start bringing in players that don't have that same deposit base or have a very different profile in terms of their capital structure, their attempt to compete is going to be more challenged, in the sense that if they don't have that same cost of capital advantage or equivalent cost of capital, the spread calculations, the math, is going to look different. So I imagine that number has come down significantly as you brought something like Athene onto the balance sheet. Where would you say that stands today in terms of Apollo's cost of capital and their ability to compete in that world of investment grade and still generate attractive returns?
· Hunter Hopcroft
[00:00:00] S1: Well, private credit has never made a cost of capital argument for itself. It's made an argument for itself on the basis of a one-to-one lender, borrower relationship and an ability to be creative. And I think that's continuing, especially as some of these companies need a creative solution. CoreWeave is a great example of this about lending against GPUs for a business that probably would not have checked many other credit boxes on its own. It's worth noting this interaction with the banking system, though, because while banks have largely been forced out of a lot of these higher-octane lending relationships, they're still very much providing back leverage to private credit funds and to the Apollos of the world. So they found a way. They've explicitly found a way through synthetic risk transfers. But banks have found a way to coexist with private credit and with this private capital lending market in a way that probably raises some additional regulatory questions. But they've fallen into symbiosis, not necessarily.
· Matt Reustle
[00:00:00] S0: Into competition, just bringing this all together with an investor hat on. With all of these changes in the business, I think we have certain rules of thumb or frameworks in terms of banks. You look at an ROE and use that to instruct what the multiple on book value should be. That's just loose framing. But is there an approach today in terms of how the market goes about evaluating and valuing these businesses, whether it's separating fee-based earnings and putting a multiple on that versus everything else? Do you think there's a general framework that's being used by the market today?
· Hunter Hopcroft
[00:00:00] S1: There's certainly a framework that has been established to date. And these have typically traded on a multiple of fee-related earnings. For these companies, earnings per share is pretty noisy. And fee-related earnings, a market cap multiple on how much they were earning from fees, was the way the market priced their growth in assets. And the biggest driver of their growth in assets was their perceived ability to fundraise new and larger funds. There was some degree to which it was the carry accruing from performance, but for the most part, those multiples were a projection of future fundraising ability. Apollo has really broken the mold here by saying that fundraising is no longer an issue. And so I think the way that they are going to be valued is closer to a bank, albeit an unregulated one, in terms of the spread-related earnings and how much spread the market is offering them, and for Apollo specifically, how much spread they're able to originate. And then I think, in the fullness of time, the known unknowns are where credit losses settle out for this type of activity. And so Apollo has really changed the mold in terms of how at least they are being valued, as they've successfully found the exit ramp from perpetual capital raising.