[00:02:25] Clay Finck: And then I wanted to tie in here a point you made, I heard you make last it was that essentially you said we’ve seen the death of the 60 40 portfolio. In light of what’s happened recently with the bond market, I’m super curious to hear your thoughts on why you believe this 60 40 approach is inappropriate going forward.

[00:02:45] Nelson Chu: Yeah, absolutely. And I think 6040 was made a very long time ago. Let’s be perfectly honest here. And I think the entire premise of financial market efficiency is that you’re going to see more and more products come to market naturally. So before it was just individual instruments, and then you can invest in mutual funds that became ETFs.

[00:03:04] Nelson Chu: And now there is a slew of private market activity in terms of just investing in things that aren’t nearly quite as liquid, but can give you a lot of premiums that you couldn’t really get anywhere else. And so with that as the backdrop, the reality is that I think 6040 has been dead for quite a long time, actually, especially, I think, in light of even like ETFs, for example, you can get some really weird esoteric concentrations into like certain commodities or certain sectors or certain geographies that just change the game, I think, in terms of how you do asset allocation.

[00:03:35] Nelson Chu: And so if you just were to buy like SMP for your 60%, the 40 percent of like corporate bonds and call it a day, you’d be missing out on so much alpha. And you would have for the last I would say several dozen years or so, give or take. So with that in mind, I think in this new world that we live in today, where you have a lot of different financial services, companies, FinTech companies, really pushing the envelope on providing access to what once was considered an alternative investment.

[00:04:01] Nelson Chu: You’re seeing a world where I think optionality has never been higher for all these different investors and the ability to essentially diversify across a bunch of different things has never been easier than ever before. And so if that’s the case, why stick with 60 40, even all those things in the back of your mind.

[00:04:18] Nelson Chu: And you mentioned like corporate bonds, obviously, yeah, the long dated corporate bonds are going to get hammered. They’re going to continue to get hammered in this type of market and market volatility on the public market side is going to continue to remain very high. And with all that being said, then I think it’s time to look at alternatives.

[00:04:33] Nelson Chu: It’s time to look at private markets to really bolster the portfolio to find things that are either counter cyclical uncorrelated to the broader market. That’s a great place to be. 

[00:04:42] Clay Finck: And it’s really interesting how investors have had this 60 40 sort of playbook. After the great financial crisis, we saw interest rates essentially go to zero.

[00:04:53] Clay Finck: I just checked the U. S. federal funds rate today. At the time of recording, it’s sitting at 5. 3%. It’s slightly higher than what we saw in 2007, and it matches the federal funds rate we saw all the way back in 2001, 22 years ago. Economic theory would suggest that As interest rates rise, investors are going to start looking for those other options that you mentioned there, especially if a lot of their money parked in say stocks they want to go and find yield elsewhere bonds, corporate bonds, or other types of fixed income securities being an option.

[00:05:27] Clay Finck: Do you think that dynamic has played out to the degree that many would expect? Because it doesn’t seem like equity markets have really moved all that much over the past year or so in light of. interest rates increasing at the pace they did in the degree they did. 

[00:05:42] Nelson Chu: Yeah, it’s a, it’s an interesting time, I think, especially in the equity markets.

[00:05:45] Nelson Chu: They don’t really behave the way you’d expect it to. And so it’s never been harder to just try and predict where the general public markets are going to go. And you’re seeing that I’m not the only one that said that by some very intelligent people that are far more successful than me have also said that it’s becoming a very choppy and unpredictable market just in general across the board.

[00:06:04] Nelson Chu: So I think that’s really more indicative of where people’s heads are at, especially since you have this like retail trading population that. definitely doesn’t abide by 60 40, definitely doesn’t abide by buy and hold. They’re actually causing a lot of ruckus in the market, which is kind of their intent.

[00:06:20] Nelson Chu: That’s what they wanted, but it makes for more conventional investors. It’s a much more difficult path for them, and which means that it’s all the more important to find yield and alpha from somewhere else when this game that they used to play doesn’t really, the rules aren’t the same anymore. 

[00:06:33] Clay Finck: A while back on our show, I wanted to mention global macro economist Richard Duncan.

[00:06:38] Clay Finck: He explained that we don’t live in capitalism anymore. The rules of the game have changed. He actually explained it that the world more so resembles a world of creditism, which essentially means that the economy lives and breathes on the availability of credit. And it’s hard to disagree with that.

[00:06:56] Clay Finck: So given where we are in the world of credit, how things have changed over the past 10, 20 years, as we described here, how would you say the state of credit is today, given where you’re at in this and what you’re seeing? 

[00:07:10] Nelson Chu: The concept of credit has changed a lot over the years in, there’s always been like waves because you had the high yield market that really transformed how things were done in the 80s.

[00:07:19] Nelson Chu: I think you had obviously CDS’s derivatives and those types of products coming out to market, which changed a lot of things, but those weren’t necessarily, I think, like retail oriented in some respects. It was very much like institutional paper trading hands among institutions, which is fine. And they became very big markets in their own right.

[00:07:36] Nelson Chu: It really took the global financial crisis in 08 to really change the way credit is perceived in a lot of different respects. Back in the day, pre 08, there was a whole lot of banks and bank activity around small business loans, consumer loans, that was their bread and butter ultimately.

[00:07:52] Nelson Chu: And now, ever since the 08 crisis came into effect, the regulations came in as well. They basically said, you got to stop lending what you did. We’re going to make it super expensive just to keep your, the activity that you had before, because it obviously got you in trouble. And with that in mind, then we had all these banks saying, all right, you know what?

[00:08:09] Nelson Chu: Can’t do it anymore. Got to pay her back. But the demand from these small businesses and consumers didn’t change. So you have a huge gap in the market. And so what became what originally was a very institutional solution with institutional lenders became almost like anybody could actually become a lender.

[00:08:24] Nelson Chu: Have a lending license. And you had all these non bank lenders come to market and face the consumer, which means that you had a lot of fintech startups, you had a lot of VC backed companies really coming front and center for consumers, which changed the way access to credit was essentially made.

[00:08:40] Nelson Chu: So everyone knows now, buy now pay later, you’re seeing it all these different checkout things online. You can get a student loan, not from the government, you can get it from SoFi, right? So all these different things. are making credit feel more accessible to the consumer. And it definitely is because there’s never been more optionality than ever before.

[00:08:55] Nelson Chu: And so all that has made for a very interesting time where the consumer has relied upon credit more than ever. Small business have relied on credit more than ever, and they’re getting it from all these different places that used to be reserved for banks and is now any random place can lender and provide them the credit they need.

[00:09:11] Nelson Chu: And so inherently, it doesn’t surprise me that I think credit has taken such an important role in people’s lives these days. Maybe to the detriment of their own financial health in some respects, especially in tough times for sure, but it is something that I think is very much here to stay, and it’s going to be, I think, a bellwether for the general economy as a whole.

[00:09:29] Nelson Chu: You start to see delinquencies tick up, default rates tick up that’s a leading indicator of what’s to come, because there’s going to be other shoes to drop. Usually the house or the mortgage or the car is going to be the last thing that people basically stop paying, and so they’ll stop their credit card first before they do that.

[00:09:44] Nelson Chu: And that inherently means that if credit cards are having trouble right now, then you’re going to see then a lot of things also start to change for the worse in the near term future. 

[00:09:52] Clay Finck: People love to focus on the treasury market with the U. S. ‘s massive fiscal deficits and whatever the Fed is doing with their interest rate policy.

[00:10:00] Clay Finck: But I think one overlooked asset class is exactly what you’re mentioning. which is private credit. And I think this is a good transition point to talk about private credit because this is the epicenter of the work you’re doing at Percent. So how about we start with just talking about the key characteristics investors need to understand about private credit to get a better grasp of this asset class.

[00:10:23] Nelson Chu: Yeah, for sure. So that’s I gave a little bit of a primer for it because banks stopped lending private credit, non bank lenders came in. That’s all well and good. But what exactly is it right? Because it is a catch all for all things credit that I would argue, I think powers a lot of the global economy.

[00:10:38] Nelson Chu: It just doesn’t get a lot of credit for it. No pun intended. You have things like small business lending, you have things like consumer loans, you have things like factoring invoices for a granola bar company at Whole Foods, you have equipment leasing for, could be, like, aircraft engines, it could be, like, heavy equipment, heavy machinery, you have litigation finance, so all these things touch so much of the broader population, they just don’t realize it, ultimately.

[00:11:03] Nelson Chu: And so it used to be done by banks. Now it’s being done by these non bank lenders and because non bank lenders in their name don’t have a balance sheet because they’re not a bank, they have to raise this money from other places. So historically, there’s been a lot of different lenders that actually provide capital to these non bank lenders in the form of like credit funds, or it could be like asset managers, or even like insurance companies.

[00:11:25] Nelson Chu: But slowly but surely, in recent years, there’s been the ability to access this asset class through startups and other kind of alternative investment platforms. And so consumers, regular retail, accredited investors, family offices can get access to private credit through these types of platforms that just really wasn’t possible before.

[00:11:43] Nelson Chu: So what do they look for? I think it’s more complicated than a traditional corporate bond. That’s for sure. There’s a lot of kind of bells and whistles associated with it, but the bells and whistles associated with it are almost like a necessity because you’re investing in a pool of different assets, right?

[00:11:56] Nelson Chu: It could be have a pool of student loans, a pool of consumer loans, a pool of small business loans. So the natural diversification from a pool means that you’ll be able to actually ensure that hopefully the product performs that you invested in, because if one defaults, you’re not totally out. But even still, there’s ways to essentially protect investors through, for example, like advancing them a lower percentage than the total amount that’s outstanding.

[00:12:18] Nelson Chu: So for example, if there’s 1 million in loans outstanding, they could only provide 800, 000 worth of capital. The other 200 has to come from the lender, right? So there’s things like that, that you can control. So think of it as a very structured, heavily, I think, financially engineered product to be able to better protect the person who’s providing the capital.

[00:12:36] Nelson Chu: That’s the best way to look at it. 

[00:12:38] Clay Finck: Do you know how big the private credit market is? 

[00:12:42] Nelson Chu: Yeah, it’s about a trillion and change. I think about last time it came out was like 1. somewhere around there, but growing very quickly. It was only a couple hundred million pre global financial crisis. So you can see how fast it’s accelerated.

[00:12:54] Nelson Chu: You can thank the likes of KKR, Apollo, Blackstone, Ares, in bringing a lot of attention to the space, and they’ve been doubling down on private credit, because especially in this market, where it’s this hard and difficult to get returns, private credit has been almost like a safe haven or safe harbor in terms of just being able to find yield in places that is arguably slightly more predictable than the broader markets.

[00:13:16] Clay Finck: Would you say the great financial crisis the kind of stricter regulation on the banks, that’s been the primary driver of this growth ever since then, or is there other factors that need to be considered here too? 

[00:13:29] Nelson Chu: No, that was definitely a 100 percent the largest driver of the growth. You’re seeing it too, even more recently with the demise of SVB and that whole debacle earlier this year.

[00:13:40] Nelson Chu: The. Fact that the regulators are now looking at their activity and their behavior and saying, yeah, you can’t really do that anymore. You can’t for example, tie the interest rate that you’re giving someone for a loan to the fact that they give you deposits like that is quite a bit of conflict of interest there.

[00:13:54] Nelson Chu: You don’t want to make sure it doesn’t happen again. Whenever regulators come in and regulate the banks, You’re going to have a natural reaction from the private markets that tries to fill that need, right? And so you’re going to see probably another wave of private credit comes through in terms of interests, in terms of capital flowing into it, and it’s going to be a really interesting time to be in the space.

[00:14:15] Clay Finck: And it’s pretty easy to see why investors would be interested in private credit. One, it offers higher returns than a lot of other credit markets. And to some, it’s probably a good sort of risk return profile, and it tends to be shorter duration. So that can give you a bit of uncorrelated returns.

[00:14:33] Clay Finck: So I’m curious to get your take on just the overall benefits of what else has led to this growth and people seeing private credit as a viable option in their portfolio. 

[00:14:44] Nelson Chu: Yeah, I think it’s everybody wins in many respects, right? Because the borrower actually also wins. Everyone knows going public is very complicated on the equity side, right?

[00:14:53] Nelson Chu: There’s a lot of work involved. There’s a lot of costs involved, things like that. The same is true on the debt side as well. Issuing a publicly rated instrument is not as taxing, I would say, as trying to go IPO, but it’s still a lot of strings attached to it. Why not just do it on the private market, right?

[00:15:08] Nelson Chu: And so a lot of borrowers are saying, why would I issue a public bond when I could just do it on the private markets? Raise it faster, don’t have to go through all those challenges, and essentially get what I need from a very, I think, liquid market that’s becoming even more liquid by the day, right? And in terms of just demand.

[00:15:23] Nelson Chu: Borrowers naturally see that as a great option, and they’re seeing it as a great option, which means that investors are also seeing that they’ve had more diversification capabilities than ever before. But in terms of what makes it so interesting, it’s an asset class that historically has generally been quite uncorrelated to the broader markets.

[00:15:38] Nelson Chu: If only for the fact that it’s pooled or it’s anchored by a bunch of collateralized assets underneath it, right? Could be small businesses, could be consumer loans, could be student loans, you name it. And much of that can be essentially directly, not indirectly or almost not at all associated with public market activity, which is great.

[00:15:56] Nelson Chu: If the assets perform, if you picked great small businesses to lend to, Whether the macroeconomy goes down or up, it doesn’t really matter. You’ll still be fine, right? So they like that level of uncorrelation. On top of that, the protections afforded by this is actually pretty interesting. So even for us, like we provide products that have almost like 52 different levers an investor can choose from to be able to actually structure a product in a way that suits what they’re looking for.

[00:16:19] Nelson Chu: People have different risk thresholds. People have different size thresholds. People have different just in general demands for what they expect. And so when you give them that optionality and that customization capability to do it the way they want it, it becomes supremely powerful. So all those things tied together is really helpful and interesting for an investor and you hit on duration as well.

[00:16:39] Nelson Chu: Public market bonds, super long duration, generally, private market bonds, way shorter duration. So you can go as low as a couple of months, really. And so that in and of itself is interesting. But it also means that because it’s so short duration, it actually reacts faster to general market changes, right?

[00:16:55] Nelson Chu: Because it’s going to have to reprice in a few months time. At that point, then the private credit market ended up spiking their yields significantly faster than the public markets did because most of the public market just held on for dear life and said, I’m not going to go back out to market right now because it’s been more expensive than the last time I did it.

[00:17:10] Nelson Chu: So let’s just sit tight. Stig Private markets don’t have that luxury. They got to go. And if that’s the case, then you’ve seen the yield spike. I would say several hundreds of basis points as a result of the Fed raising rates. 

[00:17:22] Clay Finck: And when we say shorter duration, give us an idea of the typical timeframe a private credit deal is structured.

[00:17:30] Nelson Chu: Yeah, it depends on the segment of the market that you play in. So the larger, this is I think pretty intuitive, but the larger the size of the deal, the larger the size of the issuer, whatever you want to call it, it tends to be longer duration for a lot of reasons, right? The issuer doesn’t want to keep doing this over and over again since they’re so big.

[00:17:46] Nelson Chu: So it makes sense. The lenders they attract also don’t want to keep doing this over and over again. And so it is inherently going to be longer duration. For the lower middle market, which is the space that we play in, it’s significantly shorter to the point where we do have stuff that’s just a few months.

[00:18:00] Nelson Chu: And that’s by virtue of the fact that oftentimes these are growing companies, and so inherently they want to also grow as well. And the only way they can grow is to not have this loan sit out there for forever. Instead, they can refinance it, raise more money, and they keep continuing their path. So all that together makes for basically an easy way to think of it as like the smaller the deal, the smaller the issuer, the shorter duration, longer the deal, longer the duration, and larger the issuer.

[00:18:24] Clay Finck: I’m also really curious to get your take on the primary players. in this space. On the one hand, I can see this is a higher interest rate credit line. Why not just use like a line of credit at the bank that’s probably easy to tap into has a lower interest rate. But on the other hand, I can maybe see the flexibility that private credit offers in terms of not having to deal with the bank, maybe not have to do as much paperwork.

[00:18:50] Clay Finck: So I’m curious to get your take just to better understand where the product market is here for business and what segment of the market it’s a. addressing and maybe how that fits into their corporate structure. 

[00:19:02] Nelson Chu: I think it used to be easier to get it from a bank. It used to be easier to get it at a level at the bank that was meaningful for you, right?

[00:19:10] Nelson Chu: These days way harder, just in general and the regulators made it a lot harder intentionally. So it’s much, much easier to get it from a non bank lender. They’re going to be more, I think, loose in terms of their covenants and restrictions and things like that. It really is actually much more beneficial, even if it’s going to be, to your point, more expensive to do it privately, that optionality, that choice, that flexibility is definitely something that I think the private markets will benefit from.

[00:19:35] Nelson Chu: From an issuer’s perspective, it’s definitely usually more advantageous to go to a private market lender. Having said that. Everybody who’s on the private markets or who has taken capital from private markets knows that their end goal, their holy grail, their dream is to raise money from a bank in time, basically.

[00:19:53] Nelson Chu: So they know that I want to start here. It’s going to be expensive. I’m going to get a little bigger. It’s going to be less expensive. We get bigger and bigger until finally a bank comes in and says, Hey, I’ll give you the lowest cost of capital you can possibly ever imagine. And that’s going to be a great day for them, but because the banks don’t do it on the smaller side anymore, they have to go to somewhere else.

[00:20:10] Nelson Chu: And they’re basically unbankable at the outset. And that’s where private credit has stepped in very nicely to fill that void. Used to be bankable, not bankable anymore. 

[00:20:19] Clay Finck: Now, one surprising I should say really surprising aspect of private credit is the interest rates that investors are able to get on many of these deals.

[00:20:29] Clay Finck: So talk to us about how interest rates are determined for private credit. And maybe how those interest rates have been affected over the past couple of years as well. 

[00:20:39] Nelson Chu: It’s like pretty simple supply and demand, right? And I think it’s, and that’s how generally things are priced. If the trade off from an investor or lender perspective is that I can earn 5 percent nowadays or whatever it is for doing absolutely nothing, then any risks I’m taking better be way worth it, basically.

[00:20:56] Nelson Chu: That’s the math that’s going on in their head. So the. Smaller you go, similar to piggybacking off the last thing we talked about, the smaller you go, the higher risk it is, the more that investors are saying, I need to get paid significantly higher for this return. And because the duration is so short, they can demand that very quickly.

[00:21:14] Nelson Chu: And so as much as we are a marketplace that offers private credit, we’re also a data company. And so we see this, right? So you saw the original rates used pre fed rate hike was hovering around like 11, 12 percent for all these different lenders looking for private credit. And then because the fed raised rates, it’s now at 17%, 18%.

[00:21:33] Nelson Chu: So you can almost pretty much see that like investors are looking for the math is the same, about 12 to 13 percent higher than the free rate they’re getting, right? That’s almost like the norm here. Specifically for retail, at the very least. Institutional investors definitely don’t expect quite as much.

[00:21:49] Nelson Chu: And the larger you go, like for example, Blackstone’s private credit fund is definitely not printing those types of rates. So it’s just, it comes with the territory of how small you are, how large you are. But a good proxy is if the risk free rate is X, then I want significantly higher than X.

[00:22:03] Nelson Chu: For private credit. 

[00:22:05] Clay Finck: Yeah, totally makes sense. The retail exposure you mentioned 10, 11% prior. Now it’s in the 17% range, so just running the quick numbers. If a company that’s taking on private credit loan at 10% a couple years ago, if they’re rolling that debt over and not really paying it off, they’s issuing a new private credit deal issuing at 17%.

[00:22:26] Clay Finck: Then their interest expense is up 70%. Just looking at the interest, say year over year, whenever they’re rolling over that debt. My question is, are you seeing higher default rates in light of that? 

[00:22:38] Nelson Chu: You are, absolutely. And it’s almost like a, it’s a waterfall, right? Where if the original source of capital is now more expensive, the lender then who needs to extend the capital, the private credit lender needs to raise the rates on their underlying borrower, the small business or consumer or whatever.

[00:22:55] Nelson Chu: And the underlying small business or consumer is going to feel the crunch in their profit margins or whatever it may be. They may raise prices to offset things. And you see the underlying client or customer that like, for example, one of us going to buy something is going to see prices go up, right?

[00:23:08] Nelson Chu: So it is like a direct correlation across the board and you’ll see a flow all the way through. So you have seen for sure the lenders themselves tried to raise their rates to the underlying borrowers. And the reaction has not been great, right? So because we track all this information, definitely you’re seeing repayment rates go down from these borrowers.

[00:23:26] Nelson Chu: You’re seeing delinquency rates go up. You’re seeing days past due of a loan increase and get further and further out, right? So this is all happening. Now, there is just a question of how long it’s going to be for, how long it’s going to take. But the Fed has, I think, signaled predominant, pretty much that they would want to see material recessionary.

[00:23:45] Nelson Chu: Indicators before they try and drop rates again, right? So there’s going to be, I think, a world of hurt for at least another few quarters before it starts to come back again. 

[00:23:54] Clay Finck: And since you have this marketplace giving investors the opportunity to invest in these various private credit deals and a bit later, I want to get into the blended products, but I want to stick now with maybe just like looking at an individual deal.

[00:24:07] Clay Finck: How do investors go about judging the risk in investing in a deal and then what sort of due diligence do you think needs to be done prior to making that investment? 

[00:24:17] Nelson Chu: Yeah, we try and basically give investors as much information as they would need. And we try not to rush them either, right? So there’s a lot of platforms that are first come, first serve, definitely not the case with us.

[00:24:27] Nelson Chu: You do have pretty much ample time to look at anything and understand it really well. But we almost took a public market lens to these private market transactions with, for example, like setting up a comparisons table where you can actually compare it against another deal that’s on the platform for its structure, for its credit enhancements, for its asset modeling assumptions, things like that.

[00:24:47] Nelson Chu: You don’t normally see that in private markets and we’ve pushed for that standard. We also do reporting every week and every month on the underlying assets as well within potential borrowers portfolio. And so to that end, they have, they can see reporting from historicals and see how it’s been trending.

[00:25:00] Nelson Chu: That’s something that’s of interest for them. And then we also have the obligatory private placement memorandums to be able to basically see how we’ve looked at the risk associated with it. And so I think the answer to that is for us, at least, and this is not the case for everybody, we offer a little bit of something for everybody, right?

[00:25:17] Nelson Chu: Based on what they’re looking for. We have high risk, high yield stuff, which you can make your assumption around yield versus risk to low yielding stuff that some would argue is potentially a little bit safer. It really is their call. We have asset backed offerings, which means that there is a pool of loans associated with that central product versus corporate debt offerings, which are essentially betting on the success of the single company.

[00:25:39] Nelson Chu: And it’s single obligor risk. So all that’s made available and fully disclosed. And it really just becomes a asset allocation strategy and approach, right? I will say we have some very savvy investors and retail investors on the platform. I’ve seen some of them pretty much bank on the fact that I go for the highest risk stuff.

[00:25:56] Nelson Chu: whatever issues may happen with there’s a default. If there’s a workout, I’ll have made enough money where it comes out to be okay. I’ve also had retail investors say, give me like the lowest yielding stuff possible in this environment because I don’t like the way the macro environment is trending. And so give me the stuff that probably will never default, right?

[00:26:12] Nelson Chu: So there’s a wide mix there. It really just depends on investor appetite. And as long as we have something for everybody and give them as much information as we know, then they can make their best decision. 

[00:26:21] Clay Finck: And then what does the underwriting process look on your end? I’m sure everything doesn’t make it onto your platform.

[00:26:27] Clay Finck: So I’m curious on that aspect too. 

[00:26:30] Nelson Chu: No, it rarely makes it. So we actually effectively stopped the bulk of the underwriting this year. So we actually have relied upon other underwriters who are extremely savvy in the space to be able to bring their products to market, which is not a bad thing, right?

[00:26:45] Nelson Chu: Because if you think about it, let’s say. I’m a credit fund. I had a 10 million position. I don’t want to keep all 10 anymore. I want to downsize like 7 million or 6 million. I can then syndicate out that remaining position 2 percent and they can essentially have investors get access to things that they definitely would not have been able to get access to without the platform.

[00:27:06] Nelson Chu: And so everybody wins. The investors are investing alongside an established credit fund who did the underwriting, and then also the underwriter themselves, the credit fund, has the ability to redeploy their capital into something else and bring down their balance sheet exposure. So it is a win for everybody, and we have definitely a lot of those on the platform, but it really just, yeah, it depends on how it works, but we still do credit review for all these transactions to ensure that they meet our level of standardization around deal structure.

[00:27:34] Nelson Chu: It meets our level of reporting requirements on a weekly and monthly basis, and those things are all kind of table stakes that have to be adhered to, otherwise we can’t do a deal, essentially. 

[00:27:43] Clay Finck: And you guys opened up in 2018. Might’ve went public to the market in 2019. Since then, what sort of default rates have you guys seen?

[00:27:53] Nelson Chu: Yeah, it’s been over slightly over 1 percent in terms of total default rate on the call at 1. 5 billion that’s been issued so far. I think not bad in general across the board. I would caveat that to say that I think the default rate was higher earlier on in our company’s life. And then we’ve learned along the way in terms of how to change our structure, how to better protect investors, adding more credit enhancements, things like that, which is natural and just I think you grow up, right?

[00:28:20] Nelson Chu: You mature and then you learn and the recent defaults that we’ve had is less about default and more about recovery rate or just total loss rate. We’ve had the last 3 transactions all essentially either get to a full recovery or on path to a full recovery, essentially, which is great, right? That means that everything we learned and the structure itself is in fact working.

[00:28:39] Nelson Chu: And we hope to maintain that streak going forward as well. 

[00:28:43] Clay Finck: That’s amazing. I was going to ask about how investors should think about spreading out their bets, diversifying a bit within these deals. But if generally investors are getting their money back, it might not be as important as say, diversifying across 500 companies in the stock market and such.

[00:29:00] Clay Finck: I’m curious to get your take on how investors should spread themselves out if they’re getting into private credit. 

[00:29:07] Nelson Chu: I think it’s still important to be honest, because at the end of the day, the anything that’s in private markets is inherently more opaque than public markets, right? And it’s also more illiquid than public markets.

[00:29:19] Nelson Chu: So the last thing you’d want is a situation where, you know, even though you invested in two things that you thought were very good, you’re now in a workout. Workouts take a long time. Like it you could be stuck there for 2 years, 3 years, right? And yes, you could be getting money back every single quarter, but still there is a opportunity cost to what you could have done with that money somewhere else, right?

[00:29:38] Nelson Chu: So I think diversification is 100 percent still the strategy here, and we do help people with that. It’s been something that we’ve seen a lot of family offices and investment advisors want, naturally, because they definitely want more of a set it and forget it mentality versus a I’m going to manage every single thing and look at every single product and make sure that I like all of them.

[00:29:56] Nelson Chu: That’s definitely not their approach, right? So with the standardization that we’ve been able to create at the structural level, We can actually have family offices come to us and say, I want these specific criteria and then everything that meets that criteria, I want you to algorithmically allocate into it up to a certain limit so that there’s no one borrower that takes up a ton of the portfolio.

[00:30:16] Nelson Chu: And that’s been a great success. And so you get that diversification, you get to penetrate a market or access to a market that you normally wouldn’t be able to do yourself. And you get returns that are materially better in the broader market. But having said that, it’s going to be lower than if you just went all in on the highest yielding stuff we have on the platform, obviously, because you are spreading yourself out a little bit wider, just to be able to ensure that you have that diversification.

[00:30:40] Clay Finck: You mentioned the family offices. And then I know registered investment advisors are also interested in private credit. How are they thinking about adding this to a portfolio? Is it a part of their what was their 40 percent bonds or how are they viewing the asset class generally?

[00:30:58] Nelson Chu: They’re growing to like it more and more. I think the latest, we actually did our own research on this with alongside Coalition Greenwich, but the latest numbers we had was like 63 percent of family offices, asset managers, and investment advisors want to increase their exposure to private credit 2024.

[00:31:13] Nelson Chu: So that’s pretty telling in the grand scheme of things. And they want that because they feel that private credit is going to either match or outperform every other asset class on the street. So that’s a great situation to be in. They, I think in many ways, they’re looking for probably more access, better liquidity, things like that, which private credit can do under certain circumstances.

[00:31:33] Nelson Chu: But they’re also looking for more transparency into it as well. Just because it’s normally a black box where you put money in and then you get a statement every month or every quarter and you call it a day. It’s what did I just put my money into? They’re hoping for more details on that.

[00:31:46] Nelson Chu: So from a timing standpoint and from an interest level standpoint, I’d say private credit has never been higher, especially for the institutional investors. Who’s business it is to manage money, they haven’t seen, I think, something like this in a long time where you can provide that level of uncorrelated alpha that you normally couldn’t get access to before.

[00:32:03] Clay Finck: I also think about just like pension funds, endowments that just have these massive amounts of capital at their disposal. And just thinking about so many pension funds, just they’re not going to hit their returns they need in order to pay out their distributions in the future. So I’m curious if you’ve seen any interest there, or maybe there’s a regulatory barrier that they’re not able to cross.

[00:32:25] Nelson Chu: No, not necessarily. So insurance companies is different. Insurance companies generally need to invest in rated instruments. And so that inherently leaves out a lot of the private credit market because much of it is unrated, but they also don’t want to miss out on the party as they’re trying to find ways to essentially invest in rated deals that aren’t necessarily by the big rating agencies the big three.

[00:32:47] Nelson Chu: And so they’re trying to find ways around it. There’s definitely interest, but they just haven’t been able to deploy it en masse like they probably thought they would. From a pension fund standpoint, they got to put a lot of money to work, right? So we’re talking about a 1. 3, 1. 4 trillion market and change.

[00:33:01] Nelson Chu: There’s a lot more pension money than that. That’s for sure. So there is actually right now, I think Bloomberg just came out with this article, which was like, there was a 500 billion private credit problem because there’s not enough place to put the money essentially. So that inevitably means that I think if they need to deploy at scale, you’re going to leave out or ice out a lot of the pension funds and insurance companies who needs to deploy much larger sizes than what the private credit market can handle as of right now, not going to be forever, right?

[00:33:27] Nelson Chu: I think the answer is if there is demand for it, then supply will naturally emerge. And I do expect that to be the case going forward. 

[00:33:35] Clay Finck: And I was also in preparation for this interview, seeing some barriers to the potential sort of growth of the market has grown over the past decade, but there’s been some hurdles that still need to be overcome to enable further growth going into the future.

[00:33:50] Clay Finck: So could you talk more about those barriers you’re seeing? 

[00:33:54] Nelson Chu: So it’s always liquidity, high fees. I think that is the tailor made attributes of a very nascent and opaque market. And in part of the research that we had done as well was literally everyone was saying the fees in private credit are way too high as of right now.

[00:34:10] Nelson Chu: I think, to be honest, if the market is truly efficient, you are going to see the ability for getting more liquidity out on a quarterly or monthly basis. You are going to see the ability to actually drop the fees because you want to be competitive. And that all comes with, I think, just in general, a maturing market across the board.

[00:34:30] Nelson Chu: That’s not going to be the case. What you’re seeing right now is not going to be the case forever. That is for sure. And you are seeing more and more entrants into private credit across the board who are competing on price. And so it’s going to be a race to the bottom at the end of the day. I fully expect that to be the case, in which case it’s really going to come down to who has the better deal flow, who has the better underwriting and who has basically the better know how to be competitive and differentiated in this space.

[00:34:54] Clay Finck: One of the things I like to do when judging any particular asset or say individual company is look at how it did during very tough time periods in the great financial crisis is it’s been 15 years now since that time period. So it’s been quite some time. A lot of companies haven’t been tested to similar degree until March 2020.

[00:35:16] Clay Finck: So could you speak to the robustness of this asset class how it performed in periods like the great financial crisis, like the COVID crash in March, 2020? 

[00:35:26] Nelson Chu: I think it’s actually been counter cyclical in many respects, right? It grew the most during the global financial crisis because they solved liquidity need for a lot of different borrowers.

[00:35:37] Nelson Chu: It grew a lot during COVID as a result of the fact that everyone was absolutely scared and the only people still providing capital was private credit lenders, which is a great position to be in. Now, was it cheap? Definitely not. Absolutely not. But was it still keeping the economy going?

[00:35:52] Nelson Chu: For sure. Even in to put an actual statement on it, the PPE that people needed to get into the door, right? Very few people have the ability to say, I’m going to essentially drop a couple million dollars upfront to basically get this stuff manufactured, get it distributed, ship back to me, and then I can then actually use it.

[00:36:12] Nelson Chu: You would take a private credit lender who could factor the invoice that or purchase order that you have and then advance you the money to be able to get that PPE into the door, right? So it’s, you’re not out all that money and all that risk. So it did well during COVID, that’s for sure. And not just on the things that were on the healthcare side, there was a bunch of growth that we saw in e commerce, that we saw in mobile gaming and all the mobile apps.

[00:36:34] Nelson Chu: And you saw a bunch of private credit lenders step up and basically factor and advance a lot of money to e commerce merchants, right? Because they couldn’t even meet their inventory demands from consumers. You had a lot of companies that are saying, yeah, I’ll take your Apple and Google invoice risk, because obviously that’s like a 0 percent default rate.

[00:36:52] Nelson Chu: effectively just to be able to help you finance your growth, right? So great during that time. And then when SCB went under, who had a huge venture debt portfolio and who had a lot of relationships in the space, you had a lot of people step in and basically say, I will take you, right? I will help you out.

[00:37:08] Nelson Chu: And it became something of a, that was very interesting to observe as someone who’s in the industry, that in times of need, in times of crisis, private credit tends to step up to the plate just because it is far easier to get a transaction done than it would be with a conventional bank and institution.

[00:37:23] Clay Finck: During this episode, we’ve talked mainly a lot about private credit and the credit markets in general. So Talk more about what Percent is doing and how the sort of deals you’re offering and the essentially all these opportunities to invest at these high rates that you’re offering to accredited investors, these institutions and such.

[00:37:43] Nelson Chu: Yeah, I think obligatory disclaimer, this is not financial advice, obviously, but we’re going to try and give you as much context as possible here. So we provide a private credit marketplace that allows for investors to get access to what we like to think are pretty esoteric and interesting opportunities they wouldn’t really find anywhere else in the private credit space, right?

[00:38:02] Nelson Chu: So you can get access to Latin America consumer credit, you can get access to factoring of mobile app gaming companies, you can get access to a lot of small business loans that are out to quality small businesses in various different parts of the country. Like it’s all very available and it really comes down to what you’re looking for at that point, right?

[00:38:23] Nelson Chu: You can say, I want to invest in only things that are high yielding because that’s a small portion of my broader portfolio, but I need this one to earn a lot of return. And that’s going to be almost like a barbells, like alternatives, high yield strategy. You could say that I’m looking for things that are shorter duration, right?

[00:38:41] Nelson Chu: Cause I actually value liquidity. I have a big financial event coming up, whether it’s to buy a house or whatever it may be. I just want to make sure this earns something along the way while I’m waiting. We’ve seen people do that as well. We have a lot of different places and people that say, I don’t want to manage this at all.

[00:38:55] Nelson Chu: And so just make a theme and I’ll invest it that way. And then I never want to see his money again for 36 months, right? So there’s lots of different ways to play it. And our job is really just to provide access to provide information and to provide diligence capabilities to make the best decision that’s suitable for you as an investor.

[00:39:12] Nelson Chu: It really just comes down to risk tolerance, appetite, size, things like that. And we’ve seen a lot of people invest in different ways. There was one poor fellow before we actually launched this kind of like blended product where you get diversified exposure. He put, I think like 500 in every single deal we ever launched, pretty much.

[00:39:29] Nelson Chu: And so that was his way of getting diversification essentially. So props to him. But I, in my mind, I was just like, I’ll just give me a little bit. I’ll launch you a diversified product that you can then not have to do this anymore. So it’s something for everybody, really, is the way we look at it.

[00:39:43] Clay Finck: Yeah, I want to talk about that blended product you just mentioned. I think one of the best developments in financial markets in general is Vanguard pioneering this way to give rise to ETFs. And it really just gives people broad exposure to the stock market. So just investors can take on that exposure, get the returns.

[00:40:05] Clay Finck: and not have to risk their life savings in one or a handful of companies. And I think this ties well into your blended product. So talk to us about how this blended product works. What are the options and what’s inside some of the more popular offerings you have? 

[00:40:23] Nelson Chu: So there’s two types of blended products.

[00:40:24] Nelson Chu: One is one that we essentially created on behalf of the regular retail credit investor to get access to, and that could be basically like 25, 000 minimums, essentially. And then we also have we like bespoke products and the bespoke products are created for individual family offices or investment advisors who want to customize it their way.

[00:40:44] Nelson Chu: But that has like a 500, 000 minimum, right? So obviously it makes sense. It’s more work to do something fully custom. And for the ones that we create for the platform for the regular accredited investor, those are thematic. And so we have things that are like total market. So every single deal that goes out, it’s going to go into it.

[00:41:00] Nelson Chu: So that is that guy who invests a 500 in every deal, great product for him. We have the senior only ones. So a senior is just where you are in the capital stack. And so you ensure that you’re basically the first to get paid back in the event of something going south. Senior only is obviously a little bit safer than junior or senior and junior mix or anything like that.

[00:41:18] Nelson Chu: We have high yield only. We have U. S. only. We have all these different things that are like basically themes that investors can get access to. And we’ve seen definitely a lot of people invest in multiple different themes that just fit their criteria. Or they invest in one theme that they know is going to anchor their portfolio.

[00:41:34] Nelson Chu: That’s the bulk of their money. And then they have a, almost like a play account where they invest a lot smaller stuff in things that they find interesting. That could be like African credit or Latin American credit or leasing company for consumers for auto loans for consumers in Peru.

[00:41:49] Nelson Chu: Like we got some a lot of interesting stuff on here. The bespoke side is where it’s a lot of control afforded to the investor, but those are tend to be more sophisticated investors who have almost like an investment mandate. And if it doesn’t meet that mandate, they can’t invest. So they tell us what that mandate is based on all those levers that we have at our disposal to create a custom product.

[00:42:08] Nelson Chu: And then we just essentially automatically algorithmically allocate as long as it meets the criteria and then they’re done, right? They don’t have to worry about anything. So it just comes down to how much size you want to put to work. The more you want to put to work, the more we can actually create something much more custom, but to be able to provide diversified exposure for the average investor is fantastic.

[00:42:27] Clay Finck: And then, are the interest rates, the expected returns, are those still in the high teens for these blended products too? 

[00:42:33] Nelson Chu: Mid teens, naturally. Once you diversify down, you’re going to get mid teens, right? Because the, so the weighted average APY of the platform right now is about 18 and change, roughly. And that’s being, I think, skewed slightly by corporate debt.

[00:42:45] Nelson Chu: And so corporate debt risk or obligor of single obligor risk. And that means that they’re going to be in like the 20s right now. We have a lot of family offices who said, I only want the asset back deals. That’s going to be closer to 14, 15 percent roughly, right? So mid teens is where you can expect a lot of the basket products to shake out at, because there’s just so much diversification underneath it all.

[00:43:07] Clay Finck: My next question here is the liquidity aspects. Once someone invests in a private credit deal, do they typically have to hold it to maturity or is there some liquidity there for them? 

[00:43:18] Nelson Chu: There’s not traditionally much of a secondary market to be frank on the smaller side of the market. There’s definitely a secondary market that happens in the larger institutional side, right?

[00:43:27] Nelson Chu: A lot of those transactions definitely have secondaries associated with it. Once certain lockup periods expire on the lower middle market segment that we play in, investors obviously would love liquidity. And we built in inherent liquidity by the fact that there’s a lot of refinancing capabilities from the borrower.

[00:43:45] Nelson Chu: There’s a lot of shorter duration products. So while you can’t get out of positions, if you invested into a deal that is, let’s say 24 months, but there was a refinancing option within three months, you’re probably going to be able to see opportunities to get in and out of that through that timeframe, basically.

[00:44:02] Clay Finck: And I think a lot of investors, they don’t want to spend their days and nights sifting through details of a individual private credit deal. So what do you think are some of the most important things to know prior to investing in a deal? And maybe some of the important things just to look out for as you guys have learned and seen what’s worked with some of these companies, what hasn’t, and some of the red flags.

[00:44:28] Nelson Chu: I would say you should not make private credit the only thing in your portfolio. I think that goes without saying, right? But at the very least, there’s a lot of information out there these days on these opportunities, especially on platforms like ours and others as well, that we try and make it as transparent as possible so you can better understand what you’re investing into.

[00:44:46] Nelson Chu: I would encourage most investors to understand the structure behind it, right? Because that’s going to be essentially what protects them. There’s a lot of terminology there, like DACA accounts, advanced rates, over collateralization levels, like trailing 12 month default rates, like things like that. Some of it’s, I think, second nature to some people and definitely brand new for others.

[00:45:02] Nelson Chu: Understand what that means. Understand what the impact is on your potential returns as a result of that. So just really getting better well versed on that front would be super, super important. And on the corporate side, there’s a lot of different covenants. You have like leverage capabilities, whatever it is.

[00:45:19] Nelson Chu: Those are all things that again are might be new terminology for a lot of people. So just really trying to try to understand that. I would not invest in any platform that doesn’t provide recurring like reporting capabilities around the underlying asset performance. We try and provide that again, weekly, monthly, where possible.

[00:45:34] Nelson Chu: But look at those reports and see if you can understand how is the actual underlying assets performing as a result of that. You understand the trends that have happened and be able to spot that and see where it’s headed. And then in many ways, private credit, because it’s so broad and diverse, is a bit of a blessing and a curse.

[00:45:51] Nelson Chu: But at the same time, you can actually then have almost like a bet on it, right? Do I have a macro bet here? So we had a lot of investors that double down on e commerce financing. And a lot of factoring of digital transactions during COVID like peak COVID, right? Because that was their macro bet.

[00:46:08] Nelson Chu: We had a very hard time with small business lending during peak COVID, which I don’t blame investors, right? If all businesses are shut down, there’s no cash flows, why would you invest in it? But those ended up. performing extremely well for the investors who took that risk. But they didn’t want 10, 11, 12 percent.

[00:46:25] Nelson Chu: They wanted 17, 18 percent to make it worth their while, which makes total sense, even in a zero interest rate environment. So it really is, I think, just be able to educate yourself on the, how it’s been structured, be able to have your own theses around where the economy is headed and pick a sector that’s interesting for you.

[00:46:43] Clay Finck: I’d also like to just ask for resources. If people just want to learn more about private credit, maybe aren’t ready to invest themselves, but they are interested in this kind of trillion dollar market, still somewhat small. If they want to go to learn more, just like resources that come to mind for you, I’d love for you to share those.

[00:47:02] Nelson Chu: We definitely try and educate as best we can. So there’s a lot of education material on our site alone, but I think just keeping up the news, you’ll start to see a lot of different things. And obviously it is KKR, Blackstone, Aries. in most frequently in the news, which is understanding the types of transactions that they’re doing, understanding where they’re placing their bets.

[00:47:19] Nelson Chu: That’s all going to be super, super helpful. But I would say most platforms have some sort of like research capabilities or resource capabilities. And just dig into it, understand the terminology, understand why things were structured a certain way, and then you’ll be better off because of it. And you can start to make your own decisions.

[00:47:35] Nelson Chu: But yeah, it’s never been easier, I would say, to invest in private credit. It’s also never been easier to learn about private credit, given how much it’s been in the news recently. 

[00:47:43] Clay Finck: Yeah, such a fascinating space. It’s something I’m definitely going to keep an eye on, see what’s happening when markets are going haywire and investors get nervous about providing that liquidity to businesses that need it.

[00:47:56] Clay Finck: And COVID is just a prime example where I’m sure so many people just didn’t have the money. It was a liquidity shock and those investors that step in, it’s just going to be a huge opportunity at certain points. And then especially just during more normal market periods, just the interest rates you can get just seem to be.

[00:48:11] Clay Finck: Incredible. So Nelson, this is a really informative chat. I really appreciate you coming on the show. I want to give you a chance to give a handoff to the audience, how they can learn more about you and check out percent if they’d like. 

[00:48:25] Nelson Chu: Absolutely. It is. Thanks so much for having me. I love these types of spirited conversations.

[00:48:30] Nelson Chu: So we are pretty easy to find. It’s just percent. com. And like I mentioned, there’s a lot of educational resources on there, our customer success team, always happy to chat with you. And that’s just that. Hello at percent. com, or you can always use a little chat bot on the bottom, right? And I’m pretty easy to reach as well.

[00:48:46] Nelson Chu: Nelson at percent. com. If you ever want to learn more and hear from me directly, always happy to chat with anybody, everybody who’s interested in me and what we do. 

[00:48:54] Clay Finck: Wonderful. Thanks so much, Nelson. 

[00:48:56] Nelson Chu: Thanks so much. 

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