Dynamism in credit: blending public and private credit

Terry Simpson:  Good afternoon, everyone, and thank you for joining us today.  My name is Terry Simpson and I'm the head of wealth strategy for BlackRock Alternative Investors.  I'm joined today by two of my colleagues from our credit business, Jeff Cucunato and Mark Lawrence.  Jeff is the head of our multi-strategy credit business.  Mark Lawrence is a portfolio manager for the investment team focusing on investments in special situations, direct lending, distressed debt, and the secondary markets. 

There are many flavors of credit, ranging from public, private, liquid, to illiquid.  Whether investors allocate to one type or across the full spectrum of credit, we think it is important to be dynamic in one’s credit allocation.  So today, we’re going to discuss dynamic credit allocation.

We’ve heard many themes earlier today on what’s happening in credit markets that can influence a portfolio manager’s investment process.  Jeff, I'm going to start with you.  As a manager that invests across multiple sectors and industry, it would be interesting if you could discuss how you think about relative value and how you employ a global investment process to be dynamic in your credit allocation.  And I would say maybe also if you can add too how that may or may not have adjusted in this COVID investment environment.

Jeff Cucunato:  Sure.  Thanks, Terry.  I would say that the growth and the evolution of the credit markets over the past 10 to 15 years has provided a tremendous opportunity set for relative value across credit.  And when we look at relative value, that could be anything from top-down asset allocation that is looking at public versus private.  It could be across the different asset classes within credit or it could be across the various geographies, whether that’s the US, Europe, Asia, or emerging markets.  It could also be sectoral or industry themes that cut across all of these different markets or it could be simple bottom-up security selection.

And so, what we have done is really set up a philosophy and process that leverages all of the resources of the firm, as well as our global credit platform to, in essence, identify the sort of top-down broad investment themes that exist across the global credit markets and really capitalizes on the opportunities within those different opportunity sets.  I would say that this philosophy and process hasn’t really had to change because of COVID.  COVID introduced, you know, certain top-down themes that we have developed, and it is certainly impacting sort of bottom-up relative value decisions. But it was really more changing of the strategy rather than having to really adapt our philosophy and process, which was able to, you know, fairly effectively incorporate what was happening with regards to COVID.

Terry Simpson:  Mark, you focus on the illiquid credit space.  How do you weigh and kind of measure the myriad opportunities across the private credit landscape? 

Mark Lawrence:  Sure, Terry.  So, you know, we’re very integrated with Jeff’s team of understanding what the risk/reward is in the public market and then going into the idiosyncratic private names that we’re invested in to understand are we truly getting a premium for the risk we’re taking for the illiquidity. So, we spend a lot of time examining the public markets, seeing where risk is, working with Jeff’s team, working with our capital markets team to understand where the market is so that we can be reactive when we’re talking to private companies to make sure we’re getting the right risk return for the risk for the companies we’re investing in.

Terry Simpson:  And let me follow-up on that liquidity kind of point.  And it’s how do you think about being dynamic in private credit when the average investment life of these funds is really two-and-a-half to three years? 

Mark Lawrence:  Sure.  So, I think it’s important to have the dry powder through time.  When you have a two- or three-year investment period, you don’t want to spend all the money day one and you don’t want to save it all for the last day.  The idea is to be patient and take advantage of opportunities when they come up. 

Sometimes it’s more interesting for us to be investing in more growth kind of companies looking to expand, whether through acquisition or through project finance.  Other times, it’s more interesting for us to be looking at deals, for instance, that could be hung on a bank’s balance sheet.  And then, with a time like COVID, it’s really introduced a time when capital markets closed where we go could invest in companies that are probably higher quality or … than we were used to, but then also kind of pivot into the public market where it made sense with our funds, as well as be able to provide capital to companies that need it in a time, because there’s always a company looking to grow, always a company looking to expand.

But, I think the real key is to be patient with your capital through a two or three year investment period to make sure you’re pacing it out and have dry powder when the opportunities really come up and not force investments just because you have the dry powder

Terry Simpson:  And guys, the ever-changing landscape makes it all the more important to be dynamic in credit investing, really setting up your portfolio to capitalize across the full credit spectrum.  Can each of you maybe elaborate on areas across both public and private where you see the greatest opportunity today?  And Jeff, I’ll start with you.

Jeff Cucunato: 

I would say over the past few months we're still constructive on credit, but we have been moving out of investment grade more towards global leveraged finance where we feel the all-in yield differential is important, because we feel that given that retracement that we’ve seen in credit spreads, that more of your return is going to come from incoming carry.  So, we favor global leveraged finance given the higher all-in yields relative to investment grade.

I would say we’ve also, consistent with that theme of more income and more carry where we have the flexibility in portfolios, we are moving more towards the private side rather than the public markets.  And then lastly, while I mentioned that we are allocated to global leveraged finance and earlier we were more allocated to the US, I would say over the last couple of months that while US, something like US high yield is still the – one of the largest risk factors if not the largest risk factor, we have been moving more capital outside of the US primarily to Asian high yield, where we’ve been able to find some really interesting opportunities I would say in things like Chinese property companies, as well as moving money to European high yield, where we have felt a bit better about Europe given the European Recovery Fund.

This is also reflecting a little bit of expectations of some additional volatility in the US potentially around the elections.  So, we have decided to diversify a little bit more than we had been earlier in the year.

Terry Simpson:  And Mark, same question to you, greatest opportunity across the private space.

Mark Lawrence: We see kind of I would say three themes right now.  The first is companies looking for growth but just can’t access other markets or what they would have to pay for kind of private equity doesn’t make sense for the development of the company.  So, everything from companies building out aluminum can plants to package beverages as that market has gotten really hot to a company that packages organic waste out of a Wal-Mart or out of a grocery store and actually seeds it, sells it to farmers, to spending time in the electric vehicle markets where there’s been a tremendous amount of growth and companies are starting to tip towards that cash flow positive where we can fund them.

The second theme is the COVID theme.  There are a tremendous amount of companies that I think everyone is expecting companies to be desperate for cash April/May/June.  We saw an initial wave, especially in the travel industry.  But now over, you know, kind of August/September, we’ve seen a tremendous inflow of regular weight companies that as they look out and say the COVID recovery may be end of ‘21/beginning of ’22 for them, they’re looking to raise kind of 18 to 24 months of liquidity.  So, we’re spending a lot of time around companies that are COVID impacted kind of longer-term and then figuring out which ones are going to be survivors and which ones our liquidity could help.

And then, the third theme I would say that we’re focused on is kind of bank balance sheets.  Banks have put out a tremendous amount of capital and we’re getting phone calls on a regular basis because they’re – many of them are now over their capital allocation models, are getting into other levels of capital treatment.  So, whether it’s reg cap trades through more of the structured market or looking to do package deals to take hung bridges off banks’ balance sheets, there’s a tremendous opportunity right now to kind of both in the US and Europe, it’s a global phenomenon of banks kind of looking to reposition the assets they own and to be their partners as opposed to just kind of be the buyer and that’s a lot of time where we’re spending time.

Terry Simpson:  Great.  And obviously no investment is without risk.  So, what are the biggest risks that you see to your portfolios today or maybe that you’re trying to anticipate for the future?  And Jeff, I’ll come back to you to start.

Jeff Cucunato:  Sure.  Look, as credit investors I think the largest risk to the portfolio is always some sort of recessionary environment where you get a meaningful, you know, increase in defaults and you get real credit loss.  I would say we’ve been relatively sanguine around that risk despite what’s going on, just feeling fairly comfortable that the massive amount of accommodation that we're seeing, the massive amount of fiscal stimulus that we’re seeing is going to continue to be supportive of risk assets and credit in general. 

The other thing I think that has occurred is just that with capital markets as open as they have been, you’ve really allowed companies to access capital needed and liquidity needed to get through, you know, a few quarters or even a year of really challenging kind of growth conditions.  So, I would say that, you know, recession is always the biggest risk.  We’re slightly less worried about that.  I think there are some potential volatility events coming over the next couple of months, you know, volatility around reopening, especially as we go back to school, volatility around things like US elections, maybe some performance protection. 

But I think all of those things will be volatility events.  They’ll be more mark to market risk rather than something that really increases the chances of real loss.  I would say the thing that I personally get a little bit concerned about is just what are the unintended consequences going to be of all of this sort of massive policy accommodation and stimulus that we’ve seen in terms of, you know, we’re running massive deficits, we’re monetizing debt.  I think some of the longer term implications of that, whether it’s, you know, potentially at some point an issue with inflation or something that leads to higher interest rates, particularly longer dated interest rates, to me that’s probably the risk that is out there that I worry about in terms of is just sort of the second and third order impact of what’s happening and like I said, perhaps an unintended consequence of all of this stimulus and all of the accommodation.  And I think about, like I said, something like inflation or higher rates as being something to be at least have it on the radar if you will.

Terry Simpson:  And given those risks I guess, as you mention, it seems like a long list a little bit.  What are you doing right now to manage I guess for the – for potential downside?

Jeff Cucunato:  A couple of things.  I think the reality is that whatever risk is going to emerge very well is likely not to be one that we’re thinking of.  So, I think having some diversification in your portfolios always makes sense in terms of protecting against that.

But then, the other thing that we’re doing is we do look at some sort of downside protection.  And one of the things we’re looking at, and to be honest it’s fairly cheap to protect against, is some types of insurance against or protection against higher longer dated interest rates over the next sort of one to two years.  So, you know, utilizing the volatility markets and the options markets to, in essence, find a little bit of downside protection is something that we’re employing here.

Terry Simpson:  And Mark, how do you think about risk right now or how do you think about risk going forward on the private side?

Mark Lawrence:  So, you know, I would say we run downside models assuming kind of recession, bankruptcy in just about all of the deals we’re doing on the private side.  And over the last six months I think we’ve been pretty surprised with how resilient the companies have been, kind of outperforming our recession cases.  And I think the real – when we dig in with the companies and understand what’s happening, the real driver has been the kind of government stimulus holding up the consumer.  So, I guess, you know, we do worry that to the extent there’s a pullback in stimulus because of political reasons or there’s just a true recession where the consumer gets hurt, that could cause some problems in the portfolios going forward, though we’re very diversified and we’re willing to own all the companies we’re invested in kind of through a cycle. 

And then, as we look forward and as we’re underwriting fresh companies, I think we, especially in kind of the harder COVID hit industries, think this is going to be a longer kind of 18-24-month recovery.  It’s not going to be a March 2021 snapback and everybody’s back on airplanes and flying around the world.  So, we look at a lot.  When we’re looking at a lot of companies, if they don’t really have the liquidity to kind of get themselves back to a steady state cash flow 12 to 18 months, we’re kind of just walking away from them.  And anything we’re willing to put money in has to kind of have that liquidity to go 18 to 24 months to really weather a second wave, a vaccine failure, kind of true downside protection.

So, as we look forward, that’s really where we’re focused is how much liquidity, how much costs can a company take out if they have true problems.  And then, as we look at kind of investing in rebound companies, I think we’ve taken a bit more conservative approach than the market probably has on the loan side and I think the private market’s been a little more skeptical than the public market has and I think that’s causing kind of better returns where you can get them than we would’ve expected at this point in the cycle.

Terry Simpson:  Interesting.  And guys, as portfolio managers at BlackRock, again both investing in public and private companies, how does being part of a globally integrated platform benefit your goal of being dynamic in your credit allocation?  And Jeff, I’ll start with you on this. 

Jeff Cucunato:  Yeah.  I think it’s absolutely crucial to be honest.  To look across all of the global credit opportunities, being connected is of paramount importance and I don’t know how you could run this type of mandate without it.  The number, you know, when we think about asset allocation, it’s very much incorporating both our sort of macro sort of top-down views that we develop.  But then, also, it’s very much taking into account what the individual investment teams from a bottom-up standpoint are telling us. 

And I can tell you that there are numerous examples of where we may have, you know, thought about a particular strategy or an investment from a bit more of a top-down asset allocation standpoint, but maybe the timing of it or even the efficacy of it was brought into question based on the information that we get from the teams on the ground.  There’s really just no substitute for, you know, sort of boots on the ground if you will and getting the real sort of local color of what’s going on in terms of these individual markets.

And so, and the other thing is that sometimes, you know, our investments may be driven from a more top-down standpoint . But a lot of times it’s also proactively the investment team’s coming to us and highlighting the opportunities that they’re seeing in their markets that we may not see from a little bit more of an asset allocator standpoint.

Terry Simpson:  And Mark, for a globally integrated platform when we think about private investments, strong deal flow is obviously a very big part of the process.  Can you talk about maybe how a globally integrated platform helps on the private side?  Because it’s a lot about deals, right?  We understand that.

Mark Lawrence:  Sure.  So, I mean it’s from start to finish for us.  You know, between our capital markets teams, you know, the 50-plus high yield analysts globally, they’re all feeding us deals, as well as our own team feeding deals.  So, having the biggest pipeline showing the deals allows you to be very choosy and, you know, we do kind of 1% to 2% of the deals we see a year and we may look at 500 deals a year.

So, having that ability, for instance, to just not invest in energy even though it’s kind of 25% of the market, because we’re seeing such a diverse inflow from sourcing channels, it’s amazing for us.  And then, our ability to underwrite as a global team while we have folks on the ground, to not have to be the experts.  If we see a new industry, if we’re picking up a new retail name, more than likely someone in the high yield team covers the industry, maybe even know the company.  So, our ability kind of to use the baseball term to kind of start on second base allows us to be much quicker, much faster in our underwrites and not have to go relearn a name.

Many of our competitors, the first thing they’ll do is set up a GLG call to go find an outside expert to get them expertise in an industry or a company.  The first thing we do is start calling around internally, whether it’s, again, it’s the high yield team, whether it’s our equity teams.  We do a lot in the metals and mining space where we partner with Evy Hambro’s team out of London who are one of the biggest metals and mining investors in the world.  We do a lot in the power and the energy space where we'll spend a lot of time with our global renewable power private equity team or we’ll spend time with our – the private equity guys.  We also got to rely, you know, use our – the PEP team, our private equity team where we know many of the sponsors that we’re investing in, they’ve likely seen some of the companies. 

And then I think even bigger to that is not only the sourcing and the underwriting.  What we’re seeing, especially in a time like COVID, is BlackRock is a trusted name and there's many sources of capital out there that come with a bias of, you know, loan to own, vulture investors that we compete with.  And when we show up and start talking to people, people view BlackRock as a partner.  That's why they call us on the sourcing side.  It’s why they’re willing to talk to us on the investing side.  And it really makes a difference. 

When we engage with management and we engage with boards as BlackRock and we’re coming to them as investors and we can show examples of how we’ve worked with companies that could be having, you know, liquidity crisis, but two or three years down the road we’re helping them transition back into the high yield and leveraged loan market through our capital markets teams is quite powerful and makes BlackRock just kind of a different platform when we’re out talking to companies.

Terry Simpson:  You know, up to this point we’ve kind of talked about public separate, private separate.  How do we think about bring illiquid and liquid markets together and kind of the benefits of that for clients?  And, you know, feel free to also chime in on maybe where you see client strategies going forward in the future.  And, Jeff, I’ll start with you.

Jeff Cucunato:  Sure.  I would say that the blending of public and private makes a lot of sense and we’re seeing more interest in it.  I think there’s two sort of key things or two big benefits.  One, by blending the two you more effectively mitigate this J-curve where you have this issue of while capital, if you’re in a – if in private credit, for example, where capital is being drawn down and you have a cash drag because you’re uninvested for some period of time as you ramp up your private allocation.  When you blend the two, you can be invested in the public liquid markets while you’re getting ramped up on the private side.  Or as things mature and you’re harvesting things on the private side, it can go back into the public side. 

So, the ability to be fully invested by blending the two I think makes a lot of sense.  And then the other thing is I think just having the flexibility to be in one market versus the other market at times really allows you to better take advantage of opportunities in the market.  And I think there was no better example of that in sort of the – that sort of March/April timeframe this year where there was a tremendous opportunity on the public side.  If you were only investing in the private side, it was much more difficult to take advantage of the – that market volatility and the snap back that which happened rather quickly.  But if you have the ability or the flexibility to invest in both, you could’ve really capitalized on the opportunities that we saw in March and April versus being in the the private side alone.

Mark Lawrence:  I’ll jump in as well and kind of say for us I think you have to look at the history of how we’re here.  You know, pre-great recession the average credit hedge fund was, you know, a third to a half liquid, a third to a half illiquid.  It was only after the crisis where they, those hedge funds kind of were forced to go fully liquid and you lost that ability to blend that kind of liquid and illiquid. 

And then in the mutual fund world, again, you know, post the Third Avenue event in 2015 when the SEC kind of changed the, some of the rules in mutual funds, it’s post those kind of two big events where you had a creation of much more liquid vehicles and there was kind of a demand for more illiquidity.    And I think you need to have that flexibility to bring the illiquid and the liquid together, because to Jeff’s point like, you know, an average liquid/illiquid deal may take us three to six months.  And while we’ve had a tremendous opportunity on the backend of COVID, you know, the private side really shut down April and May where we kind of switched into more of the public markets.

And then, as far as the investors, I think it’s as investors are getting more and more comfortable with the illiquid private credit side of the world, I do think there are questions in their minds, whether they’re institutional investors or personal investors, because I see it with my own investments, you know, how do you fund this open commitment?  Do you sit on cash?  Do you use leverage?  Do you sit on a more liquid kind of high yield leveraged loan portfolio?

I do think it is something that we all have to acknowledge and help each other solve whether, you know, as investors, GPs, and LPs working together to kind of find the right solution for our clients that balances that undrawn commitment but doesn’t have them sitting on cash or isn’t requiring them to go find liquidity facilities to make sure that they’re getting the true return that we’re talking about and they’re balancing their own liquidity needs across their portfolio.

Terry Simpson:  Excellent, Mark.  This concludes today’s program, but the conversation on credit is ongoing.  We hope that you have found the discussions engaging and insightful.  And we’ll continue to navigate these uncertain ever-changing times.  But, please consider BlackRock your partner.