Marathon Asset Management

Private Credit takes the Cake Over the past 5 years, estimates for Private Credit capital commitments by LPs total ~$1T. Private Credit has measured up well, generating strong absolute risk-adjusted returns, low correlation and volatility to the public markets, portfolio diversification, and strong/steady cash flow distributions. The major alternative private market sectors are a mainstay and will continue to capture returns and capital allocations, however Private Credit is gowning at the fastest relative clip in recent years, while the other sectors have underwhelmed in the past 2 years as capital deployment, IRRs, and distributions are running behind expectations and historical averages. High SOFR rates and wider spreads have led to strong Private Credit performance as revenue and EBITDA growth has mitigated tail risk, despite marginally higher loss rates. Most allocators I have spoken with have increased their commitment to Private Credit and are pleased. Public Pension Funds represent the largest capital allocators to Private Credit, while private wealth channels represent the fastest growing/incremental fund investors. Private Credit will continue to grow as GDP grows, capturing market share from banks in direct lending, real estate lending and a myriad of asset-based lending strategies.   The seven largest publicly traded Alternative Asset Managers are actively raising capital across all the Private Market Verticals shown below. As the public alternative managers raise bigger and bigger funds, Private Credit is leading the way capturing 62% of the allocation pie over the past 12 months. These mega alt managers have built strong investment teams, however, mega funds require $1B-plus LBOs in order to build their investment portfolios for their funds and BDCs, and these larger loan transactions must compete with the BSL market since Private Equity sponsors typically run a dual track when shopping financing for acquisitions of this magnitude. For the larger loans that compete with BSL, the loans are structured at tighter spreads with looser documents and less covenant protection compared to middle markets loans, which carry wider spreads, stronger documents, and robust financial covenants. As a result, my preference is clearly in favor of Middle Market Loans.   There are early signs of a noticeable pick-up in deal flow which should continue in the coming year(s) given SOFR relief is now on the horizon with pent up demand for Private Equity to deploy capital. Given the strong absolute and relative performance for Private Credit and increased deal flow on the horizon, capital allocators will likely continue to favor Private Credit as an asset class. Do you agree? 

Tomorrow is employment day and Friday’s jobs report will be an important data point for the markets and the Fed alike. A strong print will give investors confidence that the economy is robust but will limit the Fed to a 25bp reduction, while a weak print (<+100k jobs, higher unemployment rate of 4.4%) might push the Fed to move more aggressively, something they are hesitant to do given the Presidential Election in November. Market consensus is +160k jobs and a slight reduction in unemployment to 4.2%. The market is pricing in the Fed to cut by 100bps in 2024, more than the 75bps I expect, so the market is a bit ahead of itself I believe. September 18th the Fed will begin an easing cycle for the first time in 5 years. The bond market has already eased, pricing in the Fed’s next few moves with 10-year rates lower by 100bps over the past 10 months. It will likely take 1-2 years for the Fed to settle in at 3% Fed Funds rate, a rate that is commensurate with 4.00% 10-year notes so, most of the price action from here will be the front end of the curve shifting lower under my base case assumptions of 2% inflation/3% Fed Funds. If rates were to fall further, the economy and inflation would likely exhibit a harder landing, which is not my base case assumption at this juncture. Last Friday’s PCE inflation report, the most widely reference inflationary figure the Fed relies on showed that the 3-month annualized pace is now below 2% for both core and headline. Now that inflation is back down to 2%, unemployment will be the key guiding measure for the Fed. Meanwhile, corporate earnings remain strong for both tech and non-tech. GDP for Q2 was revised stronger to 3.0% led by consumer expenditures, with consumers saving less/spending more. The Fed’s Economic Bulletin on “Why Higher Interest Rate Policy has not slowed the Economy by more” was an enjoyable read for me over the long Labor Day weekend. This report that discuses “Why haven’t higher rates slowed the economy more?” missed the point since we all know that the federal spending bills were so ginormous that the fiscal stimulus offset the Fed’s monetary tightening, as inflation and growth remained robust much to the dismay of the Fed. Of course, the Fed can not be critical of the government spending, so the Fed continues to explain away the issue by focusing on matters within their control. In this report they show Chart 1 below which highlights private-lending spreads relative to the 2-yr UST securities (proxy for the short-term policy rate) for both households (conforming 30-year fixed-rate mortgages) and companies (AAA and BAA rated corporate bond yields). From March 2022 to June 2024, spreads fell which was an offset to higher policy rates, so private-lending rates have risen by less than the policy rate. Spreads will likely continue to be tight as long as growth remains strong. This condition should be more the reason to lean into private credit and gain confidence in fixed income assets.

Still Golden Default rates for High Yield Bonds, Broadly Syndicated Loans in U.S. & Europe have likely peaked. As the Federal Reserve & ECB embark upon its path to lower interest rates, debt service relief is around the corner. I believe we have seen the cycle high for defaults and in the coming months default rates will begin to trend lower. Corporate earnings have proven resilient and speaking for most companies who have survived or thrived through the most challenging rate environment in recent memory, the skies look clearer. What is true for Public Credit will also prove true for Private Credit as Direct Lending will experience a similar trend. In this cycle, High Yield Bonds have faired much better vs. Broadly Syndicated Loans when calculating default rates. In contrast, price performance of BSL outperformed its fixed coupon counterpart in thanks to shorter duration plus ~200bp coupon advantage for BSL v. HY bonds (given the shape of the yield curve/SOFR). Recovery rates are also inching higher as well. Telecom, Pharma, Media, Packaging, Business Services, Software represent sectors where overleveraged companies have had to address their heavy debt loads. Capital Solutions have been a blessing for many equity holders in these industry sectors, especially for issuers who negotiated flexible documents and weak covenants, a condition that has benefited the equity at the expense of certain creditors who become structurally subordinated, allowing new money creditors to step to the front of the line. Despite a positive outlook for HY credit, there is still ample opportunity for opportunistic investors. I expect LBO transactions to pick up as rates decline and the new issue calendar to become robust in the coming months. Marathon Asset Management is seeing robust deal flow across our private credit origination platform and it’s my expectation that Direct Lending will continue to post impressive results in 2025, just as it did in 2023 and 2024. With the credit cycle turning more positive, the Golden Era of Credit is alive and well. I have three suggestions: Allocate, Allocate, Allocate.

Back to School Back to school spending is expected to increase 3.5% y-o-y (see chart below), a healthy clip in-line with inflation and Q2 3% GDP print. Back to school spending has proven to be non-cyclical, buffeted by a healthy consumer appetite benefiting Walmart, Target, Costco, Staples, Amazon, among others. Credit is readily available, and the consumer always ready to spend. There are many types of consumer loans including Auto loans, Credit Cards, Personal loans, Debt Consolidation loans, HELOCs, Buy-Now/Pay-Later loans and Student loans. It is a toss-up between these two last segments, which I dislike the most from an investment perspective. Our data analysis and statistical models regarding credit worthiness, payment history and loss factor for BNPL and Student Loans leads me to conclude that Marathon Asset Management has many better investment opportunities available than student loans. Strong FICO scores, high rates to accommodate loss ratios, well maintained debt-to-income ratios and collateral are always critical to our analysis. Firms such as Navient and Nelnet manage portfolios of student loans, earning fees from servicing and interest income. Nelnet purchased the student loan division and portfolio of Wells Fargo who exited the business, a smart move by its CEO, Charlie Scharf. Most private student loans require parental guarantees; SoFi is a best-in-class issuer. Marathon has a lot of institutional knowledge of this sector and our conclusion is “avoid.” Student Loans are dominated by the U.S. government accounting for ~92% of the market or ~$1.7T vs. ~8% private loans or ~$130B. There are 43 million student loan borrowers with an average balance of ~$40k. Total student loan debt is only second to home mortgage debt. There are 6.8 million federal student loan borrowers now in default or ~16% of the total borrowers. Historically, 10.3% of student borrowers default on their educational loans within their first 3 years of repayment. Students prefer government loans since credit is more readily available for most students, with more favorable terms, lower interest rates, payment can be more easily deferred, with a potential for loan forgiveness. FFELP student loans are government guaranteed issued by private lenders, so if the borrower defaults, the government reimburses the lender on the full balance of principal. FFELP was discontinued in 2010 given the huge taxpayer cost, yet there is still $200B outstanding. The government’s offer to eliminate student loans and temporarily suspend payments during COVID with 0% interest accrual during the 3 ½ year forbearance period provided much needed relief to borrowers, but with the resumption of payments, default rates have surged. Student loans have helped so many of us gain an education, so critical for personal and career development, yet the lesson of the day is avoid investing in student loans unless you have specific knowledge and a true edge.

Bringing out the Big Guns:  The Fed is about to enter an easing cycle that will prove supportive for Private Equity. While PE sponsors do not hibernate like bears in the winter, sponsors have been quiet from an acquisition/exit standpoint since the past two years have proven difficult given equity valuations and higher financing costs (SOFR rose +525bps). Ditto for perspective homeowners who have bemoaned the fact that home prices/mortgage rates/operating costs make ownership less attainable. But relief is coming. Looking forward, I expect SOFR to gradually decline by 200bps in the next two years as the Fed eases and inflation normalizes. Other considerations will come into focus for LBO sponsors: 1) potential for higher corporate tax rates, 2) changes in supply chain cost structure derived from nearshoring and tariffs, 3) slower economic growth, 4) regulatory scrutiny from FTC and EU that impacts (e.g. technology, healthcare) and 4) valuations have risen to all-time highs. Despite this, PE is sitting on $1.2T of undrawn capital globally. $1.2T of dry equity powder with lower future financing rates as lenders are willing to provide a dollar of debt for every dollar of equity. During the past two years, PE has focused on value creation with add-on acquisitions, revenue growth, improving operating metrics, technology investment, CapEx, streamlining costs, improving margins all to minimize/offset higher interest charge. By and large, PE has performed admirably despite the higher interest rate regime, and slower deployment/exits. Going forward, I expect greater exits plus dividend recaps to return capital to LPs. The average LBO PE-multiple is 12x EBITDA with stapled financing of 6x debt-to-EBITDA. LBOs on the rise, the lull coming to an end, the big guns are out and ready for hunt.

Never ZIRP Zero is the value of global debt that now trades at negative yields. $18 Trillion is the value of global debt that trading at negative yields during ZIRP, with peak valuations for government debt during 2020. September 18th is the day the Fed embarks on its path to lower rates in the coming year. Hopefully, the Fed, BOJ, and ECB have learned their lesson from the enormous bond bubble they created during ZIRP, and vast distortion/misallocation of capital impacting vectors of the markets and real economy including government expenditures, bank profitability, corporate leverage, home prices, bond investors, private equity, venture capital, currencies. It is best for central banks to set their bank lending rate, and let the market determine the term structure for interest rates. Since the ECB ended ZIRP in July 2022, European Banks have rallied 55%.

The Tide Has Turned: With Q2 earnings in the books, credit metrics are now on the upswing. EBITDA and Debt-to-EBITDA improving (see box chart below), and debt service charge will begin to improve too as the Fed begins a series of 25bp declines in its coming meetings. While lower all-in yield for BSLs & Direct Lending will decline marginally, defaults rates and loss rates will also decline. I expect the Credit Markets, both fixed and floating to offer healthy risk-adjusted returns. Source: Pitchbook

Today’s TAM: Debt & Equity Markets Market Capitalization for Equities globally: ~$125T. U.S. equity markets represent the greatest percentage of this global number, and given the 2024 rally, U.S is ~ >44% of world market capitalization. If one were to evaluate the attribution from the MSCI World Index, U.S. public equity market cap is 60% of the globe! Global Debt is ~$150T measured in liquid tradeable securities; if one were to count all debt, including bank balance sheets, private loans the total debt outstanding is >$300T or equal to 3x the size of world GDP. U.S. debt is 39% of TAM as shown below, but the U.S. government deficit is adding to this figure at an unprecedented pace of +$1 trillion every 100 days! The TAM for Debt and Equity markets combined is 2.5x greater than the GFC (2008), which one could argue in sync with the growth of the global economy. However, a closer look at the data shows us this: 2008 Global Economy was: ~$65 Trillion 2024 Global Economy is: ~$108 Trillion 2030 Global Economy forecast: ~$140 Trillion The Bottom Line: -Debt is growing much faster than the economy, an issue we must be very aware of; -As the global economy grows in the next 5, 10, 20+ years, the size of the debt and equity markets will grow commensurately, you can bank on it, with 100% confidence.

The Time Has Come Jackson Hole take-a-ways: - Powell dovish comments “the time has come for policy to adjust” whereby it is a near certainty that the Fed will cut in September, likely 25bp rate as I have expected - Other Fed Committee members agree based upon their recent comments - Powell is focused more on employment, less on inflation: "The upside risks to inflation have diminished; the downside risks to employment have increased." - Powell said “ we will do everything we can to support a strong labor market as we make further progress toward price stability” - Powell stated, “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks” - With GDP +2%-plus and inflation on a clear path towards 2%, there is a low likelihood of recession at this juncture, expect 25bp cut, not 50bps - The question is: what’s the Fed Funds neutral rate, how many 25 bps cuts until Fed take an extended pause? Markets are fully pricing in 25bp in September, 3 cuts in 2024. Employment report on September 6th will be all the focus since Powell told us today, he does not want to see further weakening in employment

Bruce Richards discusses Marathon Asset Management's dedication and expertise across Asset-Based Lending and the breadth of opportunities.