Chapter 1: What is the main topic discussed in this episode?
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Subject to credit approval, Apple Card issued by Goldman Sachs Bank USA, Salt Lake City branch. Terms and more at applecard.com. Bloomberg Audio Studios. Podcasts. Radio. News. Our next guest says that highly leveraged software default rates could hit 15% in private credit. Joining us now is Bruce Richards. He's the chairman and CEO of Marathon Asset Management.
And you just put out a LinkedIn post saying, This morning, Danny and I were reading it before the program, likening what happened in energy in 2016, 2017, 2018 to what we're looking at in software now. Is it fair to compare those two industries? Because I think Scott was saying, hey, there's a different ball of wax here.
It is a different ball of wax, and Scott's right to say there's no comparison between the industries. Well, let me explain why I come to that parallel. So back in 2014, a new technological change happened for oil and gas. It's called horizontal drilling, or fracking. And that technological change did a couple things.
Number one, it changed the pricing structure for how oil and gas and oil and gas services would work. And number two, based upon all the capital that was raised, now all of a sudden capital dried up because the pricing structure collapsed. And so what we have in software is very similar. We have a technological change which is forever going to change how software is going to be priced.
Now we should think about that industry. And based upon that technological change and how much leverage is in the broadly syndicated loan market, and then more importantly in the direct lending market, leveraging up these software companies, The capital's now drying up. And so what did we see as a result of that technological change in oil and gas?
We saw a 15% default rate in the subsequent years, 2016 and 2017. So for me to say that software, which is the biggest sector within the direct lending business, couldn't get to a 15% default rate, I think is actually missing the mark, because I think that's exactly what's going to happen in years 27, and it has a chance of happening in 27 and 28, to have back-to-back years.
So although the industries are very different, there's a lot of similarities when it comes to technology, changing how pricing structure works, at a time when too much capital has been flooding into the sector. Just think about this for a second, Matt.
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Chapter 2: What are the main concerns regarding highly-leveraged software default rates?
Only 1% of companies in the U.S. are software companies and only 7% of all publicly listed companies are software. Yet... 23% of the direct lending business is software. How did we get there? It was a gold rush to finance these software companies and these buyouts.
And the public companies are sitting in good shape because their debt, when you look at NASDAQ, S&P, Russell 2000, the debt that these software companies have with really good margins, the debt that they have is only 0.5, less than one turn of leverage. In the broadly syndicated loan market, you have five turns of leverage, ten times the leverage.
In the direct lending business, you could have 20 times the leverage. So you don't have the companies that can generate the free cash flow to reposition for AI. They're in a very tough position. So, Bruce, what is the effect of that? I think a lot of investors are reading your research and starting to wake up to the fact that this could become a reality. And...
As a result, we're seeing redemptions. People are trying to get out of these illiquid private credit funds.
Chapter 3: How does Bruce Richards compare the software industry to the energy sector?
And what we see some of these companies doing, Blue Owl, for example, is, okay, we're going to sell a ton of these assets. We're going to sell these loans. And they want to be able to say, we got 99%, we got... 98% of the par value for that. So they can't be selling those 20 times even software loans, right? They must be selling their best assets.
So I can't speak to Blue Owl or others that have liquidity crisis. Of course not. or liquidity issue right now in their funds. It's something I'm not focused on. What I am focused on is the availability of capital on the back end of this to extend these loans. And I believe that there won't be availability of capital.
So I think the next round in the years 27, 28, when a lot of these loans come due, is in the direct lending business to extend and amend or extend and pretend. to pick those loans because it won't have the cash flow. Payment in kind financing. And you won't get paid back in interest. And because you've extended the loans, you also won't be getting paid back in printing.
What does that do to an entire industry that is both private credit and private equity that has loved software, that has gotten it to 23%? If all of a sudden they can't go to capital markets and they can't get those loans, the financing ceases to exist, what does that do to the industry? I think the industry is fine because I think direct lending is a big industry.
And I think that there are other sectors of the economy. Again, software is only a few percent of the overall economy. But it sounds like you're saying software lending is over. It's done after this episode. I think when you lend in software, you have to lend in very conservative multiples. The business itself is an uncertain business. And so four times that EBITDA, not...
10 times is probably the right number, and getting paid a little bit more for that risk, an extra 100 base points on your loans. Now, to the extent that financial conditions tighten a little bit on this in the direct lending space because of what's going on, we can get paid more for loans that we're making in the marketplace with tighter covenants.
So I think for lenders that aren't in a bad position that actually can extend credit, it's actually a good place to be. And so I wouldn't let software, just like oil and gas, when you had that problem with those companies back in 2016, 2017, 2018, didn't tank the economy. The economy's just fine. I think the economy will just be fine without...
having to deal with the default rates that are coming, the problems that are coming, because the economy is so much bigger and diverse than this. And so it's not going to do anything to cause any kind of disruption to the broader private credit markets or the broader credit markets or the economy. I don't believe that at all is the case, but what it will cause is...
religion to come back in, and discipline to come back in, because quite simply, you know, Danny and Matt, 23% in software is just too much exposure to one industry group when it only represents a very small part of the overall, you know, equity markets. It's only 1% of all companies in the US are software companies, and only 7% of all publicly listed companies in the US are software companies.
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Chapter 4: What technological changes are impacting software pricing structures?
And the second thing is private equity has all the upside. Imagine a company through creative destruction that they can reposition. Instead of making two or three times their money, they make five or six times their money. So they can afford a few zeros, right, and still come out okay. Yes. Private credit can't afford the zeros. They only get paid that far. They don't have the upside.
So what you need, Matt, is certainty when you lend. It's an uncertain business right now, and that's why capital will not become available. Are you not buying anything then? Not right now in software. What we're focused on are businesses where halo is the effect. Hard assets. Hard assets, low obsolescence. I'm talking about in lending.
Our last private credit lending deal in DL was a concrete deal with Rebar. The deal before that was sod. Sod for commercial and residential. You lay on the lawns, right? And so these are real asset assets. lending opportunities. And our last asset deals in our ABL business, hard assets, low obsolescence, are aircraft, maritime assets, turbines, cranes, and engines.
Because you're bullish of the economy. Because we love the economy. And we want to be able to lend, say, on a $300 million asset pool, $200 million on an LTV basis, a 66% LTV, that nice margin of safety with that hard asset where we have a perfected interest in that hard asset. It's not software where the recovery value will be close to zero if there's a default.
We get full recoveries in the event of a default on most of those assets. And we very rarely have it at default because they're mission-critical assets for these companies. And so it's a very different dynamic when you talk about Halo.
And with Halo, that's why you see industrials and materials up 25% in a year, when a lot of the software companies are down 25% to 40% in a year when you talk about the mid-market software companies.
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Chapter 5: What implications do high default rates have for the direct lending market?
And so we're in a very good position at Marathon as a lender with capital available to lend and with how our position is currently positioned. Hello, I'm Stephen Carroll. I'm in Brussels, where many of Europe's biggest decisions get made. And I'm Caroline Hepke in London. We're the hosts of the Bloomberg Daybreak Europe podcast.
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