Podcast Summary
Unprecedented challenges in private credit market due to COVID-19: Despite initial freeze, opportunities emerging in private credit market for those with right fund structures and discretion
The COVID-19 pandemic has brought unprecedented challenges to the world of private credit, with many transactions freezing due to the uncertainty and variance of outcomes. The shorter the duration of an asset, the more urgently it needs to be addressed. Meanwhile, some funds weren't set up to make trades as quickly as they were needed. Despite the initial freeze, there have been opportunities emerging in the private credit market for those with the right fund structures and discretion. Ali Hamed, a popular guest on Invest Like the Best, discussed these developments and more during an update on the private credit ecosystem.
Uncertainty and risk in private credit during economic downturns: Focus on portfolio management, derisk, and wait during economic downturns. Understand the importance of originators and servicers in private credit performance.
During uncertain economic times, such as a pandemic, the private credit market can present a significant amount of uncertainty and risk. This is due to the diverse nature of assets in private credit, each with unique domain expertise, and the potential for unexpected behavior of certain asset classes. For instance, a fund making small business loans, like those given through the PPP program, presents a large bag of uncertainty due to unknowns regarding the program's effectiveness and potential default rates. In such situations, it's crucial to focus on the portfolio, derisk, and wait before making new investments. It's also essential to understand the importance of the originators and servicers in private credit, as their stability can significantly impact the performance of the assets. Overall, private credit requires a unique approach and careful consideration during uncertain economic times.
Navigating Economic Downturns in Private Credit: Focus on competent lenders, assets with automatic repayment, and collaboration with originators during economic uncertainty to mitigate risks in private credit market.
During times of economic uncertainty, the importance of working with competent lenders in specialized markets cannot be overstated. In contrast to traditional home loans, where the identity of the borrower is less crucial, the expertise of lenders in niche markets like specialty lending becomes essential. When financing assets, it's crucial to focus on those with automatic repayment and minimal servicing requirements. In the current climate, lenders working with originators may need to collaborate closely to ensure their partners' survival, offering leniency on penalties and lowering advance rates. The private credit world faces unpredictable risks, but the diversity of assets financed may mitigate systemic risks. However, there's a possibility that some seemingly skillful investments could still be negatively impacted by unexpected events. In conclusion, maintaining relationships with competent lenders and focusing on assets with robust repayment mechanisms are key strategies for navigating economic downturns in the private credit market.
Economic downturn leads to increased demand for safe investments, but private credit markets may face unexpected risks: Despite economic uncertainty, private credit markets offer some clarity but may face longer negotiation processes and potential risks due to increased demand for safe investments, with car prices down 11.8% and consumer loans in deferment, leaving uncertainty about defaults and duration of economic conditions.
The current economic climate has many investors risk-averse, leading them to seek out perceived safe investments. However, this flood of capital into supposedly safe assets could result in unexpected risks and longer negotiation processes in private credit markets. Private credit transactions, which involve private transactions and slower default processes, can take 60 to 90 days or more to resolve. Additionally, private credit provides some clarity as it is not subject to mark-to-market valuations or senior lender decisions. Two data points highlight the severity of the current economic situation: Manheim's car price index, which shows a significant decrease of around 11.8%, surpassing the 5.5% drop seen during the last financial crisis; and Ally Financial's consumer loans, with 25% in deferment, leaving uncertainty regarding the actual number of defaults. Furthermore, the high unemployment rate, with 26 million people unemployed, raises questions about the duration of these conditions and the impact on credit markets. Overall, it is crucial to consider the long-term implications of these economic trends before making investment decisions in private credit.
Lenders Reducing Advance Rates to Manage Risk: Lenders are cutting advance rates to minimize potential losses amid economic uncertainty, while some sectors and businesses benefit from changing consumer behaviors and market dynamics.
The current economic uncertainty has led lenders to reconsider their underwriting practices, specifically in terms of advance rates. Instead of pricing loans at higher yields to account for uncertainty, lenders are reducing their advance rates, requiring borrowers to front a larger percentage of potential losses. This strategy aims to limit potential losses, even if the government's fiscal and monetary response continues to support borrowers. The innovation and quickest market changes are happening at the originator level, with some businesses, like STEM and those in the Amazon, YouTube, and Snapchat ecosystems, experiencing increased demand due to shifts in consumer behavior. Traditional media companies, on the other hand, are facing financial difficulties and are willing to sell media assets at better prices, creating opportunities for businesses to finance these assets at attractive rates. Overall, lenders are adopting cautious strategies to manage risk in the face of uncertainty, while some sectors and businesses are thriving due to changing consumer behaviors and market dynamics.
Focus on loan quality during economically uncertain times: Maintain loan quantity but increase pricing, diversify portfolio, and avoid inflated assets during uncertain economic conditions
During economically uncertain times, focusing on the quality and creditworthiness of potential loans, rather than solely on rate of return, is the smarter play for lenders. This means maintaining the same amount of loans but increasing pricing to cover potential losses. Additionally, lenders should consider diversifying their portfolios and avoiding assets with perceived high quality but potentially inflated values. Once the defensive phase is over, identifying areas of potential upside opportunity may require patience and careful consideration.
Trends in the economy amplified by COVID-19: The COVID-19 pandemic has accelerated trends towards e-commerce, tech-enabled assets, and individual monetization through platforms like Amazon, Shopify, Instagram, Snapchat, TikTok, and YouTube.
The COVID-19 pandemic has accelerated trends in the economy, particularly in the shift towards e-commerce and tech-enabled assets. Traditional retail businesses are facing increased competition, while tech-enabled businesses with more variable costs are becoming less risky and more attractive for investors. For instance, ecommerce platforms like Amazon and Shopify have seen a surge in usage, and businesses are turning to social media platforms like Instagram, Snapchat, and TikTok to reach audiences as traditional media consumption declines. The YouTube economy, already significant, is poised to become a permanent part of the workforce with the rise of gig workers. These trends, which were already emerging, have been amplified by the pandemic and are likely to shape investor conversations moving forward. Additionally, YouTube's revenue model, where creators receive 50% of the ad revenue, highlights the potential for individuals to monetize their content and contribute to the economy in new ways.
Digital platforms see increase in views and stable advertising market during pandemic: Despite decreased CPMs, digital content platforms thrive during pandemic with increased views and real-time ad bidding, while ecommerce sectors show varying levels of success
Digital content platforms, such as YouTube and social media sites, have become essential sources for learning and entertainment during the pandemic. These platforms, which include Facebook, Instagram, and Snapchat, have seen significant increases in views, although CPMs have decreased, resulting in a relatively stable advertising market. Additionally, digital advertising exchanges, like the Google Ad Exchange, have allowed retailers and advertisers to bid on ad spots in real-time, providing insights into their spending habits. The digital world also includes non-advertising based sectors, such as ecommerce, which have shown varying levels of success. Luxury brands are struggling due to their inability to lower prices, while food sales have been strong, particularly for non-perishable items. The third-party seller ecosystem on Amazon, which accounts for two-thirds of ecommerce revenue, is another area of growth. Overall, the digital world is proving to be a stable and resilient sector, even as the economy remains closed and people continue to spend more time online.
Ecommerce sector thriving during economic downturn: Small businesses are gaining market share in ecommerce, consumer brand affinity is increasing, and the Shopify ecosystem is poised to benefit. Venture capital firms are focusing on long-term opportunities despite valuations dropping.
The ecommerce sector is experiencing significant growth during the economic downturn, with small businesses thriving and taking market share from physical retail. This trend is expected to continue as consumers develop brand affinity and loyalty to online shopping. The Shopify ecosystem is particularly poised to benefit from this shift. In contrast, the venture capital world has seen a faster reaction to the economic situation, with companies rushing to raise funds due to limited resources. Valuations have dropped significantly, but are expected to recover in the coming months. Despite the challenges, venture capital firms remain open for business and focused on long-term opportunities. Overall, the ecommerce sector and venture capital market are experiencing permanent shifts in response to the economic downturn.
Unpredictable VC Market: Fewer Opportunities, Higher Valuations: Despite market growth, fewer opportunities for new investments exist due to increased resources for insider deals. Valuations reached 2x-3x revenues for SaaS companies, requiring operators to prioritize profitability. Humility and signaling were crucial in closing rounds, and adapting to the unpredictable market was essential for success.
The venture capital market experienced unprecedented growth and valuations in the last 60 to 90 days, but with funds having to allocate more resources to insider deals, there are fewer opportunities for new investments. Valuations reached 2x-3x revenues for fast-growing SaaS companies, and operators had to consider profitability with each round. The best environment for deals was seen in terms of attractiveness for investors, but signaling and humility were key in closing rounds. Operators who were humble and didn't set a price during uncertain times were the most successful. The market was unpredictable, and both investors and operators had to adapt to the changing landscape.
Junior debt market: Uncertainty and opportunities: The junior debt market offers potential investment opportunities, especially in online businesses, but comes with uncertainty due to senior lenders' control. Unique data and insights are crucial.
The junior debt market, compared to senior debt, presents uncertainty and potential opportunities for investors. Senior debt holders have control over their investments and can react based on their portfolio data, while junior debt holders are subject to the decisions of senior lenders. The speaker also mentioned the shift towards online businesses as a significant trend, suggesting potential investment opportunities in enabling or financing these types of businesses, especially within the Amazon 3rd party seller ecosystem and the Shopify app store. However, it's important to note that this area might already be somewhat saturated with players like Shopify. Another interesting point was the speaker's conviction that their proprietary data, which they've been working on for a few years, has become increasingly valuable as the market has evolved, highlighting the importance of having unique insights and data in the investment world.
From creative investing to servicing online economy needs: The investor landscape is shifting towards supporting online businesses, creating opportunities in areas like staffing and warehouse management.
The investor landscape is rapidly shifting from a focus on creativity to servicing the needs of companies in the online economy. The speaker, who was once known for creative investing, now sees a future of keeping up with the market's demands rather than leading the charge. This seismic shift from offline to online businesses is no longer a novel idea but the new norm. As a result, there will be new opportunities in areas like staffing, warehouse management, and other support services for these online businesses. The speaker acknowledges that there will be people trying to invest in these areas, but for now, he sees a leaner, less creative role for himself in the market. It's an interesting time for investors as the world continues to adapt to the online economy.
