ED HARRISON: Welcome to Real Vision Access. I'm your host, Ed Harrison. And we are starting live here with Dan Rasmussen of Verdad Advisors. He has been actually on our platform twice in the recent past. The first time he was talking to Jim Grant in the Jim Grant series. I warned him I was going to mention this. But he was in the list of the Forbes Under 30 back in 2017. He's over 30 now, of course, he tells me.

But he's still whip smart. And we had him on Real Vision just this past month, January 22. We published something called Fool's Yield and The Wild West of Private Credit. And so we thought this would be a good opportunity to follow up on that interview with some questions from the audience and from myself. So Dan, thanks for joining Real vision. Access.

DAN RASMUSSEN: My pleasure.

ED HARRISON: I was just looking, actually, at some of the questions that we had. I'm going to start out-- I think it was telling you that it sort of jives with what I was thinking about in terms of what you were talking about. Everyone's talking about the coronavirus right now and the jolt that that is to the potential downside risk in the markets going forward.

And I saw something recently that said, actually medium-term risk to the economy is not really that great. But nonetheless, it does beg the question in terms of what you're talking about. I think 1 of our questioners here, David T said, what's the catalyst that will change the comfortable status quo liquidity events aside? And so that's really kind of where the rubber hits the road for this.

That is, is that we're talking about something that you've been looking at for a number of years now and that really, it's really waiting for a pin to prick it. Well, can you sort of describe what's going on in the private credit markets, in particular?

DAN RASMUSSEN: Yeah, and it's really interesting, Ed, because you take sort of news events, like coronavirus or other things that affect the public equity markets and the public debt markets, right? And they have no impact on the private equity or private credit markets, because they don't mark their portfolios daily or hourly or minute by minute like we do. They mark it every quarter. And they mark it based on what the accountants think it's worth.

And so you have a much lower level of reactivity to daily news events and volatility. And that has a few different effects on the private markets. 1 is that it leads people to think in some sense that these markets are more rational. They make more sense, because 1 of the things that every market participant knows, the markets are way too volatile-- much more volatile than fundamentals would imply.

And, yet, in private markets, you don't see that. Things happen according to accountant's judgment. NAVs are smooth. Things flow freely. And 1 of the things that encourages is more and more risk taking because people don't understand the risks that are being taken. And they think it's less risky because it's less volatile, right?

Coronavirus happens. The US stock market down 5% or something. Private equity didn't move. Well, doesn't that make a whole lot more sense to the average endowment or institutional investor? And isn't it much better to be able report that to your committee? And I think Nassim Taleb talks a lot about this that the things that you should be really worried about are not the things that are seemingly to be the most risky because everyone's aware they're risky.

The real risk is in things that no one thinks are risky that are too smooth. They get inflated, inflated, inflated, right? And what you're seeing in private credit markets and private equity markets is exactly that. This smoothing effect has induced this phony happiness in allocators and investor where they don't get negative feedback about their mistakes.

And so they take ever more risk. And they take ever more risk. They're taking on ever more debt and investing in at higher and higher multiples. And now what's the catalyst? What causes that to change? Andrei Shleifer has a theory that financial crises are caused by a combination of 3 things-- consensus. So everyone's got to agree.

And if you survey institutional investors-- pension fund people-- they love private equity, and they love private credit. I'd say 90-plus percent of them love it. You need leverage, right? And we've got that in spades. And you need liquidity, right? You need a small exit door that everyone tries to get out of at the same time, right? And that creates a pressure of a fire sale.

But what Shleifer says is that you have this process where for all those 3 things, as they're happening, you've got sort of complete consensus on the risks. The people's expectations or understanding of the risk curve actually shifts. So they actually think what they're doing is lower and lower and lower risk. And you certainly see that in private markets.

I actually did a survey of institutional allocators. And about 25% of them thought private equity was investment grade and quality and private credit was investment grade. Another 50% thought that it was BB in quality. And only about 25% said single B or below, even though Moody's says 98% of this stuff is single B or below, right? So there's a massive misunderstanding of the risk.

What you need is salient events. So we need salient events-- things that like WeWork blowing up that was sort of an alarm bell in the night for venture investors, right? You need things like that that show people that this private credit stuff really can blow up that a private equity fund really can blow up, that you need these big salient events that cause people to reassess their risk to realize what's actually going on. What that is, I don't know. But it hasn't happened yet.

ED HARRISON: Well, I thought you bring up a good point, because you mentioned some other markets in there. You talked about a BB. A lot of people have been talking about BBB-- this private equity, private credit. We know about high-yield leverage loans. Can you put all of this together? Because you and I, we were talking about this sort of in a pre-interview call.

The sense that I get is, is that you have the top tier investment grade. Then you have high yield and leveraged loans which are lower credit quality. And then you have this private credit market. Where does that stand in that mix?

DAN RASMUSSEN: Yeah, so it's really interesting. And I'll address all these 3 questions. But over the last 10 years, we've seen a lot of growth in the investment grade corporate lending market, right? And that's led a lot of market commentators to say, well, the US economy, the US markets, they're levering up, right? Look at all this BBB paper being created, because that's where most of it's being issued.

Isn't that going to create a big economic risk when all that stuff gets downgraded or there's turn in the market? Isn't that where all the risk is, because we've seen massive growth in that area? And 1 of their next arguments is this. Well, the high-yield market isn't big enough to absorb all that paper. And look, the high-yield market hasn't really grown over the last decade, right?

There hasn't been as much high-yield issuance, right? And they're missing a few things. But 1 of the reasons the high-yield market hasn't grown over the past 10 years is that all of the crappy credit has gone to private credit. So if you add private credit to high-yield, it's actually grown faster than BBB's and investment grade.

But what you've seen is a mixed shift where the high quality stuff gets issued in the high-yield market. And the low quality stuff goes to private credit. So you've actually, interestingly enough, seen a massive upward shift in the quality of the high-yield market, which I think a lot of people don't understand that that's happened.

So junk debt isn't as junky as it used to be where all the real crap is, where all the really bad loans are is in private credit. So and then if you go to BBB's where everyone is talking about, you've got to rewind, right? In 2000, the recession, only 27% of BBB's got downgraded. And most of those went to BB. In 2006, it was 17%. From 2006 through the '08, only 17% of BBB's got downgraded, right?

And if you compare where the BBB market is relative to 2000 or 2006 right before those 2 recessions, EBITDA is higher. Margins are higher. And total debt to EBITDA is roughly the same. So BBB's-- that's not where you should be worried about. In fact, you shouldn't really even be worried that much about the high-yield market, right?

Where investors need to be worried about and where you always need to be worried about is where's the crappiest, riskiest, stupidest debt being issued? And today, there is 1 answer to where that's happening. And it's private credit.

ED HARRISON: Right. And interestingly enough, as you were mentioning that I was just looking at an article that you had written on the fallen angels. And just to give some people a sense of the metrics that you're talking about, total debt to EBITDA at the end of 2000 was 3.2 times on average for these issuers. But at the end of 2006 was 2.5 times.

Now, or as of April the 30 of 2019 was three times. So that gives you a sense of where they are. Another statistic I see here is the percentage of BBB 3's-- 36.5% the end of 2000, 28.8% at the end of 2006. And then at the end of April of 2019, 34.1. So very interesting that all of those metrics are very much in line.

Let me just go probe a little further before we actually go into more into the private credit. So, I mean, basically what you're saying is, is that you have a 3-tier market. You have investment grade. You have high yield and leveraged loans. And below that, that's where you have the junkiest of the junk. And that is where people are going for private equity, private credit.

DAN RASMUSSEN: That's right. Now, and the funniest response to my interview on Real Vision from a friend who worked in private equity-- and she wrote to me. And she said, well, I want to be clear. There are some good private lenders out there that write really good documents and are really conservative. We just don't work with them.

ED HARRISON: Right.

DAN RASMUSSEN: There's so many bad actors out there today that it's hard for the good people-- and they are really smart good people in private credit, right? There's some really good managers. But what happens is that if you're a private equity firm and you want to go to an LBO, you actually don't want to work with those guys, right?

They're going to write docs with covenants. They're going to have strict leverage level limits that make sense. You want to go with the guy that just raised $500 million yesterday and was trying to get out the door as fast as possible. It's willing to basically write you whatever type of paper you want and whatever leverage level you want just because they want to get the deal done as much as you do.

ED HARRISON: Right. Yeah, and actually, that was 1 of the questions that 1 of our viewers had before we even started this. It's from Nick who had said, has a private debt space witness the same covenant erosion as the broadly syndicated leveraged loan sector? And do you view recovery rates in private debt to be materially different from broadly syndicated space?

DAN RASMUSSEN: Yeah, I think that you've seen it. And the best data from this is from the credit ratings agencies. But they're saying there's been a huge erosion in terms of covenant quality in private credit that's probably worse than what you're seeing upmarket. Again, it's just at all the bad behavior is concentrated in private credit. What recovery rates are-- I don't have a good estimate. But is it worse than it was 5 years ago? Is it worse than it was 10 years ago? Absolutely.

ED HARRISON: In terms of this bifurcation of private credit and also the junk bonds, high-yield leverage loans, I want to pick your brain on that, because in the past, the big private equity firms, that was the junk bond market-- the leveraged loan market-- that's exactly where they would go in order to leverage these companies up and issue paper in order to restructure their capital structure. So what's happened? And what's the bifurcation that you're seeing there between private and public debt markets?

DAN RASMUSSEN: Yeah. So if you're going to issue a high-yield bond as a private equity firm, you want it issued it single B, right? So you're not going to issue CCC paper, right? No one's going to buy CCC inception paper. But they'll buy a single B inception paper. So you're going to try to print a single B bond.

Now, a single B bond these days probably maxes out at about six times debt to EBITDA and probably needs to be a $200 million in size in order to get done, right? So you're basically looking at a six times leverage level, would imply about a 10 times EV to EBITDA multiple on the equity.

So you're basically looking at the big and cheap relatively to today's private equity markets, sort of the cheapest 40% of 30% of private equity deals. And you're looking at the sort of higher size range for private equity, right? So where the intersection of cheap and large for private equity is, that's a dwindling space, right? The larger stuff is generally more expensive. And certainly the leverage and acquisition multiples just go up and up and up.

And so because that's roughly the limit of what you can do in the public high-yield bond market is that single B type paper. Anytime you want to go say pay more than 10 times EBITDA, put more than six times gap EBITDA of debt or by a smaller company, which, again, the high-yield markets don't like smaller companies, you're going to get pushed into private credit.

And those guys will write crazy loans. They'll write loans on revenue multiples. That's actually 1 of the biggest growth areas writing these annual recurring revenue loans to software companies is super hot. You don't even have profit or cash flow to do it.

ED HARRISON: We've been talking to a lot of pension companies and actually private investors over the last year and, in particular, the last month or 2, because we're going to be talking about a retirement crisis that's coming up. And very much, pensions are involved in that. And 1 of the takeaways that I've had is, is that pension companies are very much involved in this space.

That is, is that when they look at private equity returns compared to other returns, they see a much larger returns, number 1. Number 2, they also see that returns or for bonds at a minimum where they're heavily concentrated are going down. So to meet their targets, their hurdles, actuarial hurdles, they need to go out the risk curve or get some uncorrelated returns. And they think private equity is 1 of those.

And then finally, they can reduce their fees by becoming principals in this market as opposed to going through private equity companies, like KKR or whoever it might be. So who are the players in this space in terms of driving these multiples up and also driving down the credit quality? Are pension companies playing a part in that?

DAN RASMUSSEN: Yeah, absolutely. So I think there are 2 separate issues here, but they're very interrelated. First is this big explosion of private credit that's funding the private equity boom that's leading to a lot of these high multiples, right? And you're basically the logic behind that is you're a pension fund. You look out the investment grade corporate bond market and say, OK, I can get a 3% yield, maybe a 4% if I'm willing to go to BB, right?

So that's sort of the max I can get. That's not attractive, right? I have a 7% return. Bogey, I need to hit. If I'm lending at a 3 or 4, buying 3% to 4% yielding bonds, I'm falling behind every year. So what I need to do is find stuff that yields more than 7%, right? So I'm going to go out. And I'm going to go find private credit lenders that are promising me a 7% yield.

And there's just a fundamental logical error with that. And this is what we call fools yield. It's a very simple phenomenon. And it's happens across every single lending market known to man, which is that at a certain point-- and it's relatively sooner then you think-- incremental yield does not translate to incremental return because the loss ratios are too high.

So you see in credit across almost every branch of credit, whether it's consumer lending, corporate lending. You can see it in the bond market. You can see it in the consumer lending market. You can see it everywhere. You have this sort of u shape, right? So the yields go up-- up, up, up, up, up. And the total return goes up to a point and then actually goes down, right?

So if you find someone who's willing to borrow from you at a 25% rate, you're not going to get a 25% return. You're actually going to get a worse return than if you lent to a very credit worthy borrower at 4 or 5, right? And so these pension funds and endowments are making 1 of the stupidest oldest mistakes in corporate lending. They're falling for fool's yield.

And in doing so, they're tricking themselves. And unfortunately when those loss ratios happen, they tend to be correlated. And they happen all at once. So you're adding a huge amount of volatility to your portfolio by doing this. It's a really stupid error. It's a very basic error in fixed income. You're much better off just accepting the yield and say, hey, the best I can do is a 3 or 4.

Lying to myself and going for 7 or 8 isn't going to work. And then when you start saying, OK, well, I'm going to lend at a 7% or an 8% rate, think of who has to borrow it. In 2020, who has to borrow it? Who can't get any better paper than the 7%, right? Who is so risky that that's the best that they can get? And basically what you're looking at these days to a large extent is these private equity buyouts.

That's the big chunk of the loans that are willing to be financed at that level. And there's a reason why they have to pay that much, which is that this stuff is really, really high risk, much higher risk than the private equity guys understand.