Vivek Mathew
Private debt is still quite an attractive asset class, and we think about that through a few different lenses. First, let's talk about spreads, so I'm not talking about spreads over the last quarter or two; I'm talking about spreads over the last few years where capital has been coming in more and more into the private credit space. So, spreads have not just crashed in, right, so that typically happens when a segment gets oversaturated. And what's been happening here is while capital has been coming in, the opportunity to lend has been growing at a faster rate than the capital has been coming in, so that has kept spreads relatively healthy. And so, the next thing we think about is, well, why has the opportunity set been expanding? And part of that reason is because private equity has been really successful; they've shown great results and they've raised a lot of capital, and so the opportunities to lend to private equity have been growing because private equity has raised more money than private credit, and so that's a good technical in the favor of private credit. And then finally, you know, we like to go a step even deeper than that, which is just because private equity can raise the money, we want to make sure that they have the runway to spend that money responsibly. And so, what we did is we did a study on companies in what we call the core middle market, and we looked at the penetration rate of private equity and we found the penetration rate's really, really low. It's under 15%. So that suggests to us that private equity can raise capital and spend it in a very healthy way and that gives us more and more opportunities that are growing at a very fast rate as we describe. So that's all a lot on the technical side. From a relative value standpoint, we are making still double digit returns in first lien private credit. If you're able to do that even with rates a little bit lower, it still presents tremendous relative value. So, you take that technical with sort of the relative value, and it's still an excellent place to be for a portion of anybody's portfolio.
Typically, over a cycle, we find the most value in the core middle market, which I'll define as $50 to $100 million of EBITDA, but we like to go wherever we see value, and we have the flexibility given our size and scale to do that. And so, for example, after Russia invaded Ukraine, when the capital markets really weren't functioning properly, we saw a real opportunity in kind of the upper middle market, and so there was really a good relative value there as well as in the BSL space, and we've been augmenting our capabilities on the BSL side. But then when the capital markets start coming back and functioning more properly, then that market with increased competition tends to be a little bit less attractive and we recede into that core middle market where we find, again, value over a long period of time.
So private credit has been in a great position where we've been living in this Goldilocks period where interest rates have been high to where returns are quite attractive, but not so high where they cause big problems overall in a portfolio. And so, if base rates go a little bit lower, as you described, which we all expect them to do, we're still quite a bit in that Goldilocks zone and arguably maybe even in a better place, right. Because if base rates go lower, obviously interest coverage rates will go higher and debt service will be easier for companies, and so that will make it easier for them to grow and expand. Secondly, we think that lower rates might spur additional M&A, and so there are a lot of reasons why M&A may pick up, including the desire to return capital to limited partners, but with this decrease in interest rates, that probably pushes that more in that same direction, that increases supply and that's probably good for spreads. So even if base rates go down, you've got those couple really positive factors and you're still at an absolute return that's really attractive for investors. So overall, if base rates move in the way you describe, I think that's a positive for the industry.
The most vital factor to the success of what we're trying to do on the private credit side is really the health of the overall U.S. economy. So, you asked me before about rates coming down a bit. And so, if rates come down a bit because we feel like we have a better handle on inflation, that's good, right. And so that's good for private credit, and so if the capital markets start working properly, does that remove some opportunistic aspect of what we're trying to do? Perhaps, but a functioning capital markets is a really good thing for the overall U.S. economy and really the financial system. So, we look at it as a clear positive. I think the impact is probably a little bit more on managers choosing to focus on large corporates, but for us we're focused on the core middle market.