Marathon Asset Management

Recession or No Recession: That is the Question The WSJ Survey of 66 leading Economist says, ‘No Recession”. These leading economists reported their probability of recession in 2025 is a mere ~25%, down from ~65% likelihood just last year. 25% is too high, it’s more like a fat tail risk (perhaps 10%) based on the strength of the U.S. economy (see chart below). The Fed’s unwritten rule is to only ease by 50bp when starting an easing cycle when recession is imminent. Fed was wrong to go -50bp on its first cut and they know it. Despite all the strong data (discussed below), the Fed is boxed in to 25bp on November 7th since it would look foolish to pause right now despite the data suggesting that they should. Markets still expect the Fed to ease at its next 8 consecutive meetings over the course of the next year, however, it is my view that the data will require the Fed to take a pause at some point, taking a tad longer (4-6 months) to arrive at 3% than market expect. I call it the Tennessee Two Step. The Atalanta Fed maintains the best GDP predictive models and their 12-factor economic forecasting model now predicts +3.2% real GDP in Q3 of ’24. S&P 500 earnings are growing at a double-digit pace y-o-y with forward earnings forecasted to grow >10% as profits rise across a broader range of industry sectors. Consumers in aggregate remains strong with wealth creation soaring to record levels (US consumer have accumulated more than $165T of asset value more than debt) as asset prices rise. Strong job growth and wage increases allow for greater consumer consumption. Retails sales (ex-autos) blew past consensus estimates, rising .7% last month (~7% – 8% annualized), as consumers remain strong. Strong growth, expanding employment and Fed easing. So, despite predictive indicators such as 1) inverted yield curve, 2) Fed tightening financial conditions by raising Fed Funds by 525bp 3) collapse of CRE sector 4) rise in corporate restructuring/defaults 5) regional banking crisis -> the U.S. economy is alive and well. Unprecedented fiscal stimulus/sheer size of the stim programs that the Federal Government unleased fully negated the impact of the Fed. Now that the Fed is easing, it’s risk on for markets. I remain bullish and credit is a winner. Be selective, but my advice to capital allocators is to continue to lean in to credit.

Marathon Asset Management & Webster Bank are pleased to announce the financing of PK Companies. “Marathon's partnership with Webster Bank is powerful offering reliable, tailored, and creative financing solutions to middle market companies and private equity sponsors,” said Bruce Richards, Marathon's CEO. “Marathon’s leadership and expertise across our Private Credit programs: Direct Lending, Capital Solutions, and Asset-Based Lending, coupled with Webster Bank’s exceptional middle market sponsor lending program and broader commercial banking services, offers a highly differentiated suite of capabilities.” The acquisition financing for PK represents the first completed middle-market financing transaction since announcing Marathon and Webster Bank's Private Credit partnership.

Best Performing PE Sponsor Deals are…… Conventional wisdom suggests that when PE sponsors take on additional debt to fund a dividend payment, it increases default risk. Logic holds that dividend deals add debt and lowers a sponsor’s equity commitment thus resulting in greater credit risk. Therefore, some private credit lenders tend to avoid participating in dividend recap financings under the assumption that additional debt is potentially detrimental. A recent report by Moody’s Ratings provides an in-depth analysis of the leading PE Sponsors where Moody’s studies PE fund holdings and the simple fact is that these large PE sponsors who were most active in dividend recap deals exhibited the lowest default rates. Remarkable! Holding all things constant, more leverage adds risk, no doubt about it, but as Moody’s points out, recent observations paint a nuanced picture that illustrates that common wisdom does not necessarily apply. Lenders are so disciplined that they only granted the best performing companies where earnings/enterprise value grew the most with the right to take out a dividend. Since 2022, only 3 PE sponsors among the top 12 had zero defaults. In fact, these 3 PE sponsors who did not have a single default did the most dividend recap deals among their peers. Warburg Pincus, Leaonard Green and American Securities may have been the most aggressive sponsors doing dividend recap deals (Table below) but these 3 PE sponsors had 0 defaults. Bottom line: put away the bias, judge a Direct Lending transaction or BSL based upon the merits of the credit and the company’s ability to service its debt. Likewise, judge the private credit lenders based on the quality of their deals and the percentage of defaults in their portfolio.

The Machine is Working Well The CLO machine is cranking out deal flow at a steady pace that is well ahead of 2023. CLO global new issue volume will likely exceed $225B (~$180B through Q3/’24), which is well above $144B issued in 2023. AAAs are trading at their tightest spreads of the year, and this not only includes BSL, but also privately issued loans. CLO issuance in the U.S. has been running at a pace of ~4x the issuance in Europe. There are ~100 credit managers issuing CLOs in U.S. market and ~50 managing CLOs in Europe. The CLO market is open for business. CLO managers are evaluating >600B+ originally issued in 2018-2023 to assess the value-add of a potential 5-year additional maturity reset with added potential to tighten spreads on their liabilities which can be a big boost for CLO equity returns. Looking forward, the next vintage of CLO deals looks favorable as expectations for improving credit metrics will likely result in lower default rates in the next 2 years compared with the past two years. The CLO machine is working well, cranking out deals as AAA-BB tranches are performing strongly, while the Equity tranche is generating impressive cash flow.

High Yield: Strong Credit Quality, Low Duration The High Yield (HY) Bond sector is stronger than ever, characterized by robust BB-rated bonds and improving credit profile of single B-rated bonds. HY bond spreads are tighter than its historical average for two key reasons that 100% justify tighter spreads: - HY bond duration for US and Europe is at an all-time low, with effective durations under 3 years, for the first time ever as can be seen in the chart below. Shorter duration strong credit trades at tighter spreads than the same names with longer-term maturities. Fundamental improvement in lower-quality borrowers whose debt trades yield-to-call plus higher quality borrowers delaying refinancing existing debt, waiting for better market conditions are the technical reasons. Spreads on BB and B-rated credits are within historical ranges when adjusted for duration. - HY bond defaults remain relatively low while recoveries are above long-term averages, reducing the overall impact of defaults on high-yield portfolios. A large cohort of HY borrowers will likely issue bonds in the coming quarters, with the net impact that the average coupon for US HY market will adjust higher. The average coupon has already risen from ~5.7% in 2022 to ~6.5% today, with more to come. HY managers are well-positioned to benefit from higher interest income with credit fundamentals improving further. As long as the economy remains vibrant and earnings growth continues, tight HY spreads will prevail. HY bonds are an important component for Multi-Asset Credit (“MAC”); one of the four sectors along with Broadly Syndicate Loans, EM Bonds, and Structured Credit. Institutional Investors or large Capital Allocators recognize the merits of MAC as managers are able to navigate across the 4 major sectors of global credit to uncover value.

90% Do you know that ~90% of the companies in the U.S. that generate $50M to $250M of revenue annually are private companies? Do you know that there are ~200,000 private middle market companies in the united States? The cohort of companies with $50M to $250M of annual revenue represents companies that Marathon focuses on in the Middle Market and nearly all are privately owned: ~90%! Marathon Asset Management estimates that there are 10,000+ Private Equity Sponsor-owned Middle Market Companies in the U.S. I believe next year (2025) will prove to be a strong vintage year for Direct Lending funds as the stars are aligned. The LBO machine will turn it up a notch, Fed is easing rates/credit conditions, default rates will decline, and corporate earnings and GDP are trending well. Capital Allocators must differentiate between managers and strategies: - Middle Market Loans (tight covenants & wider spreads) vs. Upper Middle Markets (weaker covenants & tighter relative spreads and also faces competition with the Broadly Syndicated Loan market). - Middle Market Loans backed by PE Sponsor have a loss rate of ~70bp TTM vs. Middle Market Loans backed by Non-PE Sponsor have a loss rates of 1.3%; nearly 2x sponsor-led deals. - Quality of Deal Flow (debt-to-EBITDA ratio, LTV, fixed charge ratio, free-cash flow, amortizing debt, cash-pay or PIK, cyclical vs non-cyclical business, etc.) and how it translates into better performance and lower losses? - What is the Private Credit manager's Historical Loss Rates? - What is the Private Credit manager's sourcing edge? With over 10,000 PE owned companies, a Private Credit manager can be highly discerning. It is a great time to lender in this market environment and Private Credit can be a great diversifier for investor’s portfolios.

Marathon is pleased to announce the financing of a leading cybersecurity company. “Marathon's Direct Lending program works collaboratively with middle market companies and PE sponsors across industries to provide creative and reliable financing solutions,” said Bruce Richards, Marathon Asset Management’s CEO and Chairman. “Marathon’s Private Credit platform is designed as a one-stop shop, offering corporate, asset-based, and capital solutions, including senior and junior financings ranging from $50 million to $250 million.”

Two Opposing Forces Co-Exist in Unison: Commercial Real Estate Loans are experiencing their highest default rates in a generation, as noted in the graph below. In the U.S., we estimate 10,000+ CRE loans are 90+ days delinquent or in default. It will take years to work out all these loans, much of which will transition to creditors/sold by liquidation. Last week, credit rating agencies downgraded 91 CMBS bonds while there was not a single CMBS bond upgraded. 91:0 is a stunning ratio of downgrades vs. upgrades………talk about being behind the curve, investors like Marathon Asset Management have run this analysis well in advance and the only surprise was how long it took rating agencies to act. Lenders who got through the last few years without recording losses have proven to be the disciplined. The default rate/loss rate associated with an asset managers CRE loan portfolio from the last vintage is revealing. Warren Buffet was right (as always) when he said: “only when tide goes out, do you see who’s swimming naked”. IYR is the most liquid REIT ETF and it is up 33% in price (adding the dividend, its >40%!) during the past 12 months. In other words, while default rates have moved higher and a greater number of downgrades are occurring, the real estate market has bottomed and is now in recovery mode. REITs are the first movers, while property prices lag, taking a long time to recover. CRE Property Funds will likely take longer, its an arduous process, however, the bottom for valuations has been set. Banks which represent the largest collective lender to the CRE property sector will lower their exposure going forward for the ~$6T CRE debt sector, so Private Credit lenders will step up. Commercial Real Estate Lending is much less risky today than it was during the last vintage; during the previous vintage, valuations were too high (cap rates too low), assumptions too aggressive, LTVs had too little cushion. Today, it’s the opposite. It’s a great time to be a lender. The value proposition compared with property ownership favors the lenders. As the Federal Reserve lowers Fed Funds further it will be helpful for CRE valuations as borrowing costs decline, however, Cap rates (multiple of NOI that a property trades for) are tied to longer-term interest rates, priced relative to 10-year UST, which will be higher for longer relative to short-term rates, despite future fed funds cuts.

Marathon Asset Management has arranged a $210 million refinancing for the Ritz-Carlton Dallas, following renovations, through a joint venture with Trinity and Partners. #Refinance #PERECredit #commercialrealestate #venturecapital #privatecredit https://okt.to/uPL7lf

Today is the Day: Today, we’re hosting Marathon’s State of the Markets Investor Call, where I’ll be joined by our highly respected CIO, Lou Hanover. Together, we will discuss important topics that are critical to understanding the current economic landscape, our investment outlook, and the global credit markets, providing insights on Public Credit markets, and Private Credit including Direct Lending, Opportunistic Credit with a core focus on Capital Solutions and Asset-Based Lending. Our goal is to offer our investors a thorough analysis of the risks and opportunities in today’s market. Below are the key areas we’ll discuss: 1. With the Fed starting its easing cycle, key implications for credit 2. Forward guidance for growth (GDP, Earnings) 3. Policy implications arising from the Presidential election & impact for markets 4. Our outlook for default rates 5. Our outlook for Direct Lending 6. Our outlook for Asset-Based Lending 7. Our outlook for Public Credit markets 8. The intersection of Public & Private Credit 9. Keys to our Sourcing Channels. 10. Marathon’s Investment Programs & How Marathon remains well-positioned to deliver (available only for Marathon Asset Management’s investors) If you’re unable to join us, this webinar will be recorded and available on our public website this Friday. Good luck navigating the markets & remember the golden rule: stay bullish on credit.