Private markets, particularly private credit, have been the buzz of the institutional investing industry as the insatiable hunt for yield continues. Pensions & Investments sat down with Armen Panossian, who will become co-CEO of $183 billion Oaktree Capital Management in the first quarter of 2024.
Panossian is currently a managing director and Oaktree's head of performing credit, where his responsibilities include oversight of the firm's liquid and private credit strategies. Panossian also serves as a portfolio manager within Oaktree's global private debt and global credit strategies. In announcing its leadership evolution, Oaktree also named Robert O'Leary, portfolio manager for the Global Opportunities strategy, as co-CEO.
P&I asked whether there's money to be made in the battered commercial real estate market as well as the factors behind Oaktree's focus on asset-backed finance, corporate private lending and life sciences. And we asked how long the current boom in private credit will last. Questions and answers in this interview have been edited for conciseness, clarity and style.
How long can this private credit cycle last? Is this for the next three, five or 10 years?
We don't have a crystal ball to tell us the exact duration of this credit cycle, but we believe that the era of easy money is over and that a higher for longer rate environment, when compared to the 2009-2022 regime, will persist for the foreseeable future. We believe a sea change is underway in the market, where the availability and cost of credit will result in credit investors generating more attractive returns relative to recent history. These opportunities are primed for private credit providers like Oaktree, which took a more cautious approach during the low-interest-rate period and can today fill funding gaps without the restraints of legacy portfolio issues. Additionally, we believe there is a secular shift of larger sponsor-backed companies that were traditionally financed in the syndicated loan market turning to private credit, and we believe that will be a persistent trend creating a long runway for private credit to continue its growth and strong performance for investors.
There are a lot of red flags around commercial real estate. I've visited downtown Los Angeles and downtown San Francisco this year, which seemed like ghost towns. Are you looking for opportunities or avoiding this asset class?
There are both risks and opportunities in commercial real estate. The risks are, I think, pretty obvious. Office properties have really gotten hit hard from the pandemic and a slow return to work. Los Angeles, especially downtown, is seeing some excessive vacancies as a result of that trend. That's issue No. 1. Another issue which might not be as obvious: There is a considerable maturity schedule for commercial real estate that is upon us now. In the case of corporate credit, it is a few years, a couple years out.
But in terms of commercial real estate, tremendous maturities in 2023, 2024, '25, '26. It is not like it's ramping up, it's not like we have any sort of breathing room. It is upon us now, and the cost of borrowing, if you compare the maturing loans that are maturing in the next two to three years, those loans originated five years to 10 years ago.
Five years ago, if you think about the base-rate environment, the cost of borrowing, and then you compare to today — the cost of borrowing is roughly doubled or more across the board.
And while there has been rental growth in certain real estate subasset classes, it has not been uniform, and it has not been even across all of them. So there will be, and there already is, pain in office properties. But there may also be pain in nonoffice real estate, again, because not every multifamily building and not every logistics warehouse has had the ability to raise rents to the point where it could sustain a doubling of its interest expense. I would even go so far as to say to think about the most levered real estate asset classes or even just asset classes outside of real estate, the most levered in the last five years were the ones that were considered the highest quality. The higher the quality, the more leverage it would take on at an even lower rate. So multifamily at the time ... was considered highest quality, and the rates were kept really, really low because banks and the various, government agencies wanted that kind of debt.
And now base rates are 500 basis points higher, the cost of borrowing is double. It went from 3% to 3.5% to 7%, 8% for these types of mortgages. I think you're going to see a situation where there are really good, quality assets and just have bad balance sheets. And that's going to be true in real estate, that's also true in corporate credit — certain businesses like health care, like software, were considered high growth or just critically required industries in the corporate credit space, so they were levered pretty high in 2019; and now the cost of leverage has gone up, and it's a real problem. You are starting to see the opportunity set in good-business, bad-balance-sheet investments. Our teams across the board at Oaktree are gearing up for this. I wouldn't say it's here just yet.
The depth of the investment opportunity under this theme is coming in the next couple of years. But the signs are showing themselves; look at maturity schedules, as you look at cost of borrowing, as you look at coverage ratios of interest expense under a rising rate environment; all of those factors are deteriorating. And the worst of that is yet to come, which means the depth of the investment opportunity is in front of us.
Oaktree has been in private markets for decades. Any examples of how private credit has evolved?
It's been a few iterations of evolution … in the '90s and the early 2000s, commercial banks were pretty active. They were the lenders and they did sponsor-backed loans and they did non sponsored. There wasn't this concept of a direct lender, a non-bank lender.
What ended up happening in the early 2000s, the investment banks got into the business of syndication, so they saw that the commercial banks were willing to lever at only three times debt to EBITDA. They realized there was sort of a private investor universe that was willing to go up and leverage from that three or three and a half times and the borrowers were willing pairs of additional interest.
That's when this whole syndication business started, in the early 2000s. The banks would use their balance sheet, they would commit to the loan, syndicate it to funds and collateralized loan obligations and other investors that would own those loans.
Now, in that same period, the early 2000s, private credit or traditional direct lending was really focused on the types of lending that the banks, even through syndication, didn't want to do.
Think of it as a rising risk tolerance motivating the expansion of private assets, it started with commercial banks doing low leverage, conservative loans, to investment banks doing slightly more levered syndicated loans that they don't hold on the balance sheet, too much of it, syndicated out to the market. And at that same time, private credit that started emerging was doing the things that even the syndicating banks did not want to do.
So what was it? It was mezzanine, private second liens and even the odd first lien deal that for some reason the bank said, 'Ah, this is just too small for me to syndicate and it's too levered for a regional, a commercial bank to fund.' The small-cap private loan on a first-lien basis, and in the 2006-'07-'08 time frame, direct lending as an asset class was only $250 billion. It was largely small, sponsor-backed first lien loans or small to medium sized junior sponsor-backed loans.
Then came the global financial crisis?
Yes, after the global financial crisis, the banks completely shut down — [regulations such as] Dodd-Frank comes in, Basel III comes, just a lot of reasons for shrinking balance sheets in support of the publicly traded market of lending. But the trading desks of the balance sheets, these levered vehicles called SIVs — special investment vehicles — that had mismatched assets liabilities, all of those blew up or shrank.
And so there was a need for alternative capital that was unregulated. And so the direct lending market expanded its purview, it became not just this cottage industry of junior debt or the first lien debt that falls off the back of the truck. It also became more regular loans that became bigger and bigger over time and the private market ebbed and flowed with the bank syndication market. There were times where CLO origination was super strong and the private markets had a little bit of a tougher time kind of getting access because there was a competitive and pretty functioning public market. But what's happened over the last two or three years is that the banks suffered such big losses in their syndication book that even really large transactions, that the private credit universe ordinarily was not that competitive on, isn't there now.
Essentially banks have pulled away from private lending and the Oaktrees of the world have stepped into this traditional banking. Did the implosion at Silicon Valley Bank have something to do with it, too?
It's a good question. One can argue that if the regulators are the ones that are causing this contraction to occur from the banks — is that appropriate for private managers to step in and blend into an environment that the regulators think are risky — that is a very fair question.
There will be and there probably have been excessive risks taken by some at times when the markets were more fluid. If you're a private credit manager that was competing head-to-head with the banks, then maybe those managers did take on some excessive risks to generate deal flow, so that's certainly possible.
Today, the issues around commercial banks and investment banks have swung to the point where it's no longer just about regulatory oversight, it's also about some risks that have built up in those institutions at times when credit was easier, when base rates were lower.
If you are a bank that put together a portfolio in 2018 or 2019 when base rates were low, when certain types of real estate were considered bulletproof, the portfolio that looked appropriately constructed back then may not look appropriately constructed now in terms of risk, cost of liability suddenly ratcheting up. So that in itself, which is both a fundamental issue and a technical concern, it's both coming together.
That is resulting in those banks saying, 'I need to just generally reduce the size of my portfolio in every way.' Not just in real estate, but in equipment finance and in trade factory and in corporate lending, everything needs to shrink because I am concerned that there are issues in my portfolio that I will have a tough time handling in the next two or three years. And I need to get as much money back, so that I could be more liquid when these issues occur, and that is, that has less to do with regulatory oversight and more to do with just portfolio management as a bank.'
Regarding corporate private lending, asset-backed finance and life sciences. Can you elaborate on why these are areas of opportunities for Oaktree?
Corporate private lending is lending to companies in need of capital for usually one of two reasons. One is a buyout, so LBO sponsor-backed activity. The other may be a company owned by an LBO firm, or not owned by an LBO firm, but it needs capital for a strategic growth initiative.
But the second reason is, I'm a company that has the opportunity to grow its manufacturing facility because I have a tremendous backlog in my business and I need to supply it, and so I need a $100 million to build this manufacturing plant or to expand. Those are more idiosyncratic and bespoke. It's not to create an equity IRR through funding debt.
The third reason, by the way, is for rescue lending. Rescue lending was a very active area in 2020 for us. I would expect for it to become more active in the next couple of years, because, again, there's this concept of 'good company bad balance sheet.
The existing debt on your balance with respect to some core assets, and that is, I think, going to be, thematically, an important area of investing over the next couple of years. Because the need for capital is apparent, the availability of capital is less available or is less apparent. It's certainly an area we're focused on at Oaktree generally. If you have the skill with respect to structuring and restructuring, you could find alpha-generative opportunities in rescue lending. Your speed and certainty of execution can deliver an investment opportunity that is super attractive because the borrower, in that instance, is in a situation where rescue is needed. The borrower is most focused on speed and certainty around execution of the loan and less concerned about pricing or legal terms.
Let's talk about life sciences against the backdrop of the fact that people are living longer.
There's a lot of reasons to like life sciences as an investment area. One is exactly what you said, people are living longer, they need more solutions. There are more types of cancer than there are solutions, so there's a need for the capital.
In addition to that, life sciences companies are uncorrelated with GDP. But life sciences, if you cure cancer, you cure cancer. I mean, it's like there's nothing to do with GDP. If you solve pediatric epilepsy, it has nothing to do with GDP. And as between life sciences companies, they're not correlated with one another, either.
There's also a good ESG story — they're saving lives, changing lives and the manufacturing facilities for life science companies tend to be quite robust from an ESG perspective, so there's a lot of good things in life sciences.
It's also a hard-to-understand industry, so you get paid really well to lend into it.
And especially right now, if you look at the XBI, a life sciences equity market index, it's down probably 60% from its February 2021 highs, it might be down a little bit more than that, which means that these companies are not willing to tap the equity market to fund these clinical trials.
It's too dilutive. If your market cap was $1 billion in 2019 and now it's $400 million, and you need $100 million to do clinical trials, you're probably not going to want to dilute your equity by that much. So it's resulted in the expansion of the opportunity set for private credit to step into that void.