(Click on here to subscribe to the new Delivering Alpha newsletter.)
Lawrence Golub runs one of the largest private credit stores in alternative finance. His namesake company, Golub Capital, has $45 billion in assets under management. This is no small feat in a context where AUM private debt is expected to total $2.7 trillion by 2026.
While private debt has spiked recently, inflation and rising interest rates could pose new challenges. Golub spoke to CNBC’s Delivering Alpha newsletter to discuss the impact of these headwinds on his company’s lending strategy and why he thinks the Fed got it wrong in reining in of inflation.
(The following has been edited for length and clarity. See above for the full video.)
Leslie Picker: Private credit is at floating rates, so it can still be an attractive asset for investors in a rising interest rate environment. But how does the broader macroeconomic context change the way you allocate capital?
Laurent Golub: We look for borrower resilience against things that could go wrong. Thus, when interest rates rise, it reduces the safety margin somewhat, given the company’s ability to service its debt. It has to be seen in the larger context of what’s happening with the economy as a whole and the economy is doing really, really well. Inflation is driven by strength, not weakness. And in this environment, our portfolio performed among the best ever, in terms of very low default rates. And it’s been a very robust and healthy environment.
Picker: What’s interesting is that your lending covers a part of the economy that we don’t always see – it’s private companies, middle market, bigger and bigger companies. What can you tell us about their resilience, particularly in the face of inflation? Is it starting to creep into their margins?
Golub: We pride ourselves on being extremely careful in choosing our partners. Absolutely, inflation fuels business performance. We segment the various industries we lend to and we have a quarterly report. And in the industrial sector, even though there has been robust demand, this is an area where profits have not been as strong because companies, due to supply chain issues, have had to struggling to respond to all of their customers’ requests. Still, in the middle market, earnings were up almost 20% year-over-year, so they’ve been very robust.
Picker: Do you feel like the Fed is ahead of the curve here, that they’re on top of where inflation is and will be able to bring it down adequately from these levels ?
Golub: The Fed will eventually be able to bring it down if it has the will, but the Fed is way, way, way behind the curve. When inflation was 1.7% against its 2% target, the Fed expressed great concern: “Oh my God, we’re not at our target levels. We’re not going to raise rates until we see the data with inflation above 2%. Now that inflation is above 7%, the Fed is slowing down. He does not take the measures he announced. I think that’s a mistake. Larry Summers on Friday said the Fed should call a special meeting and end quantitative easing immediately. I think he’s right.
When you look at things like the quit rate and job opening rates, we have an economy that is closer, by historical standards, to what you would normally consider an unemployment rate of 2% or 3% , rather than what is measured. So we have a lot of unmeasured inflation. We have housing costs that are not properly reflected in the CPI. We still have a few more months ahead where month-over-month comparisons to last year are going to be beaten and the headline inflation rate is going to rise further. So the Fed will tighten, it will tighten a lot. I don’t think anyone really knows when the Fed will start letting its balance sheet shrink, but they will have to take action and it remains to be seen how much of a soft landing they can stage.
Picker: How likely are they to be wrong and we end up in some kind of recession?
Golub: There’s a good chance that will happen. The question is more when, then anything else. We see enormous strength in our business results and in our order books, we don’t see much chance of a recession this year. And that momentum will likely continue into next year. One of the side effects, however, of supply chain issues is that businesses of all types increase their targeted inventory levels. So as they add to inventory when they finally start to catch up on receiving shipments above sales, at some point there is the risk that they will overrun. In the US, we haven’t had a classic inventory recession in probably 30 years. I think there is a good chance that there will eventually be a stock recession in the next five years.
Picker: What does an inventory recession look like compared to, say, a recession caused by a financial crisis?
Golub: Much sweeter. An inventory slump is actually a somewhat more severe reduction in orders than weak retail sales. And historically, inventory-related recessions have been adjustments of only a few months. They’re still painful when you’re in them, but not as much to worry about.
Picker: I would like to ask you about the industry you operate in, sometimes known as private credit. The direct loan is a pocket of private credit, probably the most important pocket. You had a banner year in 2021 – $36 billion in commitments. There have been others who have jumped into this space as well, lured by the prospect of those investors who like an alternative to fixed income creating these similar returns for them. What does the picture of competition look like right now in this space as its prevalence has just grown to help fund the LBO boom we’ve seen recently.
Golub: Well, private credit is bigger than it’s ever been and growing fast. There have been new entrants and those of us who have been in the industry for years have grown. The private equity ecosystem is probably about $2 trillion and falls under private credit, or should I say private credit is gaining market share at the expense of public credit, heavily syndicated loans. As we and others have grown in the private credit business, we are able to offer larger solutions for a wider range of private equity firm operations. And our industry has gained market share in at least two ways. We are gaining market share by replacing large-scale syndicated loans in traditional senior debt. And there has been phenomenal growth in one-stop lending, which is very good for investors and good for private equity firms as well.
Picker: Do you believe that with the growth of private credit, it creates too much leverage in the system? I ask because there was this recent Moody’s report that warned that this embedded leverage in the “less regulated gray area” of private credit, quote, carries systemic risks. Do you believe these concerns are justified?
Golub: First of all, I don’t see any systemic risk. Private credit is not intertwined with the financial system, the banking system, like other types of credit are. So even if we’re dumb enough to make big mistakes, there’s really no plausible way that turns into systematic risk. Second, private lenders are much smarter about the fundamental recovery, the fundamental value of the loans we make. You can go back decades and our credit losses, we in the industry, Golub Capital, are doing better, have lower credit losses than our industry. But even the industry as a whole has lower credit losses than banks have ever had in their private equity lending at lower leverage ratios. And it has to do with the alignment of interests, the long-term orientation, a real lending-to-value orientation, as opposed to a few credit metrics determined by regulators.
And that said, debt levels have increased just as business values have increased. The stock market, the private equity industry, the multiples are very, very high and there is no change in sight. We see no reduction in these multiples. So you have this balance between high growth rates and high profits, increasing the value of companies, the fact that private equity firms do a very good job in general of managing the companies they lend to, the fact that private lenders do a very careful job and we have our money where our mouths are, balanced with what is the right long term amount of leverage. At Golub Capital, we focus on lending for resilience, not lending for perfection. But it is absolutely something that investors should seriously think about, especially when choosing an investment manager.
Picker: What is the difference between resilience and perfection?
Golub: Resilience is what you need because you can’t have perfection. If you are lending against a financial model, and pushing the amount of leverage to the limit of rising LIBOR or SOFR, and not factoring in the possibility of a recession, you’re pricing to perfection or structuring to perfection as opposed to structuring for resilience… When we take out a loan, we don’t look at credit ratios. We look at what we think a company’s distressed selling value will be if a bunch of things go wrong. And if we lend within that expected distress sale value, that’s resilience, at the end of the day, because it gives everyone the opportunity to find solutions.