The Private Credit Unwind Is Coming – Tony Yoseloff

Tony Yoseloff discusses the uncertainty surrounding inflation and its potential impacts on the economy, including the risk of an oil shock. He notes that lending operates in cycles, with significant capital flowing into direct corporate lending, despite true default rates in this sector being around 5-6%. Companies are struggling to adapt to a higher interest rate environment, which has been exacerbated by private equity firms overpaying for businesses during the 2019-2022 period.

Yoseloff provides background on Davidson Kempner, which specializes in opportunistic credit and event-driven investing, focusing on stressed and distressed companies. He draws parallels between the current economic climate and the 1970s, particularly regarding inflation and market concentration, and highlights the challenges faced by the Federal Reserve in managing interest rates. He emphasizes that while high oil prices may not pose immediate threats, prolonged elevated prices could lead to economic difficulties.

The conversation shifts to private credit, where Yoseloff indicates that the recent unwind of this asset class is not surprising. He clarifies that private credit refers to direct corporate lending, which he believes will yield mid-single-digit returns, contrary to the perception of double-digit returns. He highlights issues lenders face, including non-repayment of loans and declining recovery rates, which have dropped significantly from historical averages.

Yoseloff discusses the long-term effects of a 15-year period of 0% interest rates, which allowed borrowers to refinance easily, minimizing losses for lenders. He notes a slowdown in institutional interest in direct corporate lending, with retail investors gaining prominence. Default rates are particularly widespread in software lending, which constitutes over 30% of the asset class, leading to varying degrees of risk exposure for firms involved in direct corporate lending.

The current state of the S&P 500 reveals only a 3.5% decline despite geopolitical tensions and private credit issues, with significant performance disparity among individual stocks. The "magnificent seven" tech stocks have underperformed, indicating increased single stock dispersion, which historically correlates with market tops or dislocations. The public markets are addressing issues in the software sector, with companies like Microsoft experiencing a decline in EBITDA multiples.

Yoseloff contrasts the quality of investments in private versus public markets, noting that private markets often feature lower quality investments. He highlights the shift in US investors' focus towards domestic markets over the past 10-15 years, driven by the outperformance of US equity markets since the Global Financial Crisis. He stresses the importance of global diversification and the challenges of achieving local knowledge from a distance.

Recent investment opportunities in India are discussed, seen as a growing market. While many investors approach India from an equity perspective, few consider it from a credit angle. Yoseloff acknowledges historical challenges in India's credit market but notes recent improvements in bankruptcy laws.

The podcast emphasizes the evolving landscape of private credit and investment strategies, with a focus on credit investments while acknowledging the strength of equities. Event-driven investing is highlighted as a strategy that requires predicting events and pricing associated risks. Yoseloff underscores the importance of experience and data in making informed predictions about mergers, noting that successful investors develop a disciplined understanding of odds through experience.

At Davidson Kempner, Yoseloff outlines investment strategies that include liquid strategies for steady returns and longer-duration, illiquid strategies in credit and asset-backed lending. He reflects on the firm's cultural values of collegiality and teamwork, which have evolved to meet changing market demands. He advises investors to understand potential losses in advance, emphasizing the probabilistic nature of investments and the need for a thorough understanding of risks before committing to investments.