Amid boom in private credit, Oaktree's Panossian eyes opportunities in private markets

Private credit is having a golden moment. Increasing numbers of pension plans, foundations and endowments have been committing huge allocations to this exploding asset class. Pensions & Investments spent some time with the newly named co-chief executive officer of one of the most influential credit investors in the U.S., Oaktree Capital Management, co-founded by Howard Marks.

Armen Panossian, who will become co-CEO of the $183 billion manager in the first quarter of 2024, 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 2019, Brookfield Asset Management agreed to acquire about 62% of Oaktree. In announcing its leadership evolution, Oaktree also named Robert O'Leary, portfolio manager for the Global Opportunities strategy, as co-CEO.

Panossian's success at Oaktree comes against the backdrop of his four degrees (Yes, no typo).

"I made my decision to become an investment professional probably later than most," he said. "I feel like people that come through Oaktree decided when they were 12 years old. They wanted to be an investment manager. But I thought I wanted to be a doctor, I thought I wanted to be a politician, I thought I wanted to do all these different things."

He holds a bachelor's degree in economics with honors and distinction from Stanford University, where he was elected to Phi Beta Kappa; a master's degree in health services research from Stanford University School of Medicine; a Juris Doctor from Harvard Law School; and an MBA from Harvard Business School.Questions and answers in this Part One of the interview have been edited for conciseness, clarity and style.

A: It's a very exciting time to be taking over the leadership of Oaktree. Obviously, the markets are pretty volatile. There are economic pressures just given rates, given the pandemic and inflation but Oaktree really shines in those types of environments. We have a very long history of investing in below investment-grade and unrated credit dating back to the 1980s. But now with the rapid rate increase, inflation, the pandemic, there is a dispersion in performance and opportunities for those investors who are cautious and careful, but also have the reputation and history of investing in this type of market environment. I don't think there's really anything to change about Oaktree. But there are certain areas of step outs of strategies that we've been investing in for many, many years as part of larger, more flexible areas of investing that are now an opportunity because of the dislocation in the markets. So private credit, an obvious area.

A. Before the global financial crisis, there was only $250 billion in market size; today it's $1.5 trillion. There's been a lot of growth there. We've grown in that space, but I would say not to the level of some of our peers. With the dislocation of the market now, we are seeing the best risk-adjusted returns in corporate private lending than any time over the last 13 years, so that's pretty attractive. That's a great way to invest capital for our clients, that's risk-adjusted or downside protected. And then another area that I think is showing signs of dislocation where we have been very active over the last 20 years is in asset-backed finance, so this is really stepping in where the regional and commercial banks, both in the U.S. and in Europe, have been the traditional or incumbent lender.

But given some of the regulatory pressures coming their way, given some of the portfolio pressures that they're already feeling and are coming their way, specifically in real estate-oriented debt, we are finding that those lenders are stepping away from other areas of lending and investing that were traditionally active places for them.

For example, equipment finance, trade factoring, aircraft leasing, or aircraft lending, rail car finance, shipping vessel finance — there's just there's a lot out there that had been traditionally a "banked environment" or "bank opportunity set" and now those borrowers, those platforms are finding a contraction in access to capital, and they need replacement capital from institutional investors like Oaktree. That's something that we've been active in, but not on a dedicated basis, it's been part of other strategies, but we are finding that this makes sense and in other areas like it where they're adjacent to what we've already been doing.We then say, well, now is the time for us to, you know, maybe do something more dedicated. Another example of that in the last few years has been in life sciences direct lending.

A: Private credit to life sciences companies … this was an area that we were active in as part of other strategies or other kind of broader direct lending mandates. And we found that there was a reason for it to be a stand-alone strategy as well, with dedicated funds under management, and so we raised a dedicated life sciences-focused fund as a step out. We had already done 30 transactions before even launching that dedicated strategy, so that is something that Bob and I are focused on as co-CEOs.

A: When does it make sense for us to create a stand-alone strategy, based on skill sets that we already have at the firm and deployment of capital in that area, that predates setting up that strategy? We're not gonna, you know, do anything unnatural. The good news about being part of Brookfield is that Brookfield has a very well built-out platform in areas where other managers are looking to get into. So an alternatives manager that is not in private equity, may look to get into private markets, an alternative manager in private equity may look to get into debt.

An alternatives manager that is in neither or both, is looking into get into infrastructure or infrastructure lending or renewables, or transition finance, and Brookfield already has very large, scaled strategies in all those areas, and we are their creditor. There really isn't a reason for us to do anything unnatural that steps out of our, you know, I would say our credit comfort zone. But within that credit comfort zone, there's a lot of white space for us to expand organically and sensibly where we have a track record, history, and capabilities that support that type of step out.

A: I think that's going to be true. That would have been true in 2023 but for the fact that investors have found themselves either having a denominator effect issue or a liquidity issue, or both. I'll explain. In terms of denominator effect, institutional investors have asset allocation parameters where they say a certain amount needs to be public, certain amount needs to be private in terms of value of my portfolio. And when the public markets went through volatility in 2022, they found that their public to private mix was out of whack. They had too much private because the public had fallen and the private marks hadn't moved, so as the opportunity set in 2023 was put on hold, and there was this, I think, a pretty attractive pricing opportunity in private assets, private credit in particular, they were not able to move as quickly because the asset allocation model did not suggest that was right.

So even though when you would talk to these investors or the employees at these institutional investment firms, they saw there was a lot of head nodding that "private credit made a ton of sense but an acceptance that we just can't do it right now or not in the scale that we think it makes sense to do it, just given our asset allocation model." Then a separate but related consideration is liquidity, especially in the U.S. and to some extent in Europe. Institutional investors have made really large commitments to private equity funds and to some extent, a private credit fund, but their private equity allocations and investments were predicated off of a pretty high velocity of turnaround of capital over the last six or seven years.If you were a private equity investor in a 2015 or '16 vintage fund, you saw a pretty fast return of capital because the markets were quite fluid for that — it was easy to get borrowing, valuation multiples were going up, there was a lot of sponsor-to-sponsor transactions, and so if you made a commitment to private equity, you sort of got used to a cadence of return of capital that informed how you would commit to future funds. What a lot of investors have found themselves, the condition they found themselves in now, is that their commitments that they made, especially in maybe 2019 or 2021, have big uncalled commitments, but not enough return of capital from the 2017 or '18 or '19 vintage funds. That's causing a bit of a mismatch and assets and liabilities, in terms of at least liquidity and assets and liabilities, and therefore an inability to commit to new private funds, even though they make a lot of sense.

A: Especially since June, there's been a pretty nice rally in public markets, at least on the credit side. We are seeing investors interested in credit, both public and private because of a few very compelling facts. So look, we could talk about investment-grade bonds, we could talk about below investment-grade and then we could talk about unrated private credit.

There's a very strong pitch for all three and there's a lot of current themes. There's a lot of things that run through all three, but some have some nuances and are different than others. In the case of IG credit, that's largely a very high-quality but very long-duration asset class. IG borrowers in late 2020 and early 2021 did a very good job of extending their maturities and so IG at the end of 2020 was the longest duration it had been in years. So with the rapid rising rates, IG bond prices fell considerably because of technical, not fundamentals. Fundamentals, one could argue, are actually stronger for IG credit today than they were in 2019 or 2021 because these businesses tend to be very, very large, they tend to be pretty lightly levered, so the cost of borrowing going up or down in a short period of time has no impact. If you're a large company going through an inflationary period over a medium term, it's actually a good thing for you.

The reason is because if you're a $10 billion company, and you have $5 billion of annual revenues and $1 billion of EBITDA, it probably means you're the leader in your industry, and it means that although you might experience volatility due to inflation over a short period of time and your costs go up all of a sudden, rapidly, given a medium-term period or long-term period, you're actually able to raise your prices if you're as big a business as I'm describing.If you have a lot of diversity in your supplier base, a lot of diversity in your customer base, you're the leader in your sector and you must exist for the supply chain to persist. Then you will benefit from inflation because your nominal dollars of revenue will go up. Because there's inflation, you should be able to pass through inflation. So, your $5 billion of revenue should grow at least with inflation, if not more. Then if you're a strong business that is as diversified as I described and as important to the value chain as I described, you should be able to defend your profit margin as a percentage as well. These bigger businesses will weather a recession better, but also, if there is a recession rates will decline. And so the long-duration IG bond asset becomes more valuable in a duration-rallying event like a rate-reduction period.

A: In high yield, it's a similar set of circumstances, and that both IG bonds and high-yield bonds are fixed rate and fairly long duration. High-yield bonds are shorter duration than IG bonds, but there's still longer duration than floating-rate borrowers — they will benefit in the same way with inflation going up and given the benefit of time they will also benefit with inflation rising as well. Now, high-yield borrowers are more levered than IG borrowers, so there should be some more defaults in high yield than in IG, but generally speaking, with a higher return, you're compensated for that risk.

It's not like high-yield defaults have deteriorated return such that the entire coupon has been lost. So even with losses, you don't lose your entire coupon in high yield. That's why it still makes sense to invest in high yield and get the benefit of that additional return. The toughest market in terms of quality are floating-rate borrowers, so older vintage broadly syndicated loan portfolios, older vintage private credit portfolios, because those borrowers have a real-time increase in their cost of borrowing, they will not have the benefit of time to grow into their capital structures or to delever with the benefit of time and inflation. That's where you're probably going to see the most amount of stress or default, and we're mindful of that in our portfolios. We're always looking in our broadly syndicated loan portfolios to up-tier to manage risk with that volatility becomes opportunity as well if you're able to properly underwrite and separate out weak from strong credits. When the markets generally have this theme of more defaults in a particular asset class or a particular sector, skill and hard work in terms of underwriting and analysis within that sector or within that asset class can deliver better returns. Because there's sort of a concept of the baby being thrown out with the bath water in those sectors when they're going through periods of dislocation, so we're not shrinking away from those broadly syndicated markets, but we have a heightened level of risk management.

A: Private credit, as you know, similar story in that there is risk in the rearview. There are companies that took on debt in 2018 or 2019 or 2021, never anticipating that their 6% to 7% cost of debt was going to become 11% or 12%. And as time extends and, if rates remain high, then that becomes a pretty challenging capital structure for a lot of borrowers, especially those that took on floating-rate debt in connection with LBOs.

There is risk in the market in old portfolios that one should be mindful of. With that said, with the current borrowing, cost of borrowing being roughly 12% for first-lien private loans and against this backdrop of higher cost and uncertain economic conditions, the new vintage of origination and private credit is the most attractive it has been in many, many years, and at least as attractive, if not more attractive, than high-yield bonds or IG bonds.

The reason I say that is because if you are a private equity firm and you're buying a company today, you're probably paying a lower multiple for that company today vs. two or three years ago. You also are seeing the cost of borrowing at 12%, and you're doing your LBO math and realizing, I can't really make my equity returns work if my cost of borrowing is this high, plus there's sort of existential risk of borrowing it at 12% or over-levering at 12%, I may lose my equity investment if I'm not prudent. So what they're doing is they're writing 60% plus or 60% and higher equity checks for new transactions. That compares to about 40% or 45% in 2019 or 2021, so equity checks have moved up materially, returns to creditors have moved up materially. The private equity firms and credit investors are underwriting as if a recession is the likely outcome in 2024 even if they don't believe it, they're still underwriting to that type of shock scenario and considering that 12% cost of borrowing is here to stay forever. The capital structures are more reasonable, and the companies are, I would say, higher quality and less cyclical than they have been in quite some time.