Note: The webinar transcript has been edited for clarity and brevity.
Moderator
Ryan Lynch joined Golub Capital in 2024 after spending more than 13 years as an award- winning sell-side equity research analyst covering business development companies, or BDCs, for an investment bank. Considered a leading voice in the sector, Ryan had a front seat to the expansion and evolution of the direct lending industry in real time during his tenure as an independent observer of BDCs. So you are in for a real treat as we delve into Ryan’s lessons learned, given his unique perspective and experience covering the industry. So, Ryan, while I figure you’re probably most comfortable being the asker of the questions as opposed to being on the receiving end, a lot of our clients are increasingly wanting more and more education on private credit. Give us a sense of what they’re going to learn during this webinar.
Ryan Lynch (Managing Director, Golub Capital)
While I wasn’t an allocator of capital, I consulted and gave investment advice to allocators of capital, and so I really sat in a similar seat as many of our clients. I was flipping through pitch books, hearing managers pitch their story, and digging through industry data, talking with other industry participants, and in my 13 years, I’ve seen the good, the bad and the ugly and really everything in between. So, let’s go ahead and jump in.
BDCs offer a unique window into the world of private credit. BDCs are managed by private credit managers, and these managers, they originate and manage the investments that go inside of a BDC. BDCs are also evergreen vehicles, and they provide a very robust set of disclosures. As an analyst, this was great, because I could dive deep into the different performance metrics of a BDC and measure them over a long period of time.
My experience, immersed in the world of BDC managers and data, has led me to several takeaways that I believe are going to be helpful for those allocating capital into the space today.
The big four lessons I’ve learned are:
Now, I know firsthand there’s a lot of noise to cut through in these pitch books to distinguish the real experts from just the mere asset gatherers. So, at the end of the presentation, I would like to tell you what I think matters most in a manager.
Moderator
Let’s get started with your first lesson, which really peels back the onion on this expansion that we’ve seen in private credit and the amount of allocation that has gone into both private credit and direct lending strategies. I think a lot of people in the audience are familiar with a chart probably showing the growth in assets under management in terms of allocations to strategies that are private credit or direct lending, but that’s also attracted a lot of new managers. Walk us through that dynamic.
Ryan Lynch
Absolutely. I started covering the business back in 2011, and I can tell you, you can feel a noticeable difference in the growth of managers entering over the last five years. I think everybody’s probably felt this, but I’ve never seen the data compiled to really back up these claims.
I compiled the data, and I have to say the results are pretty stunning. What I did is, I utilized Preqin’s database, and I found 535 managers who have entered direct lending since 1995. And here’s what I found: Almost half or 45% of managers have entered direct lending only within the last five years.
Only 21% of managers have 10 years or more of experience, and only 5% of managers were in direct lending prior to the global financial crisis. So, the data powerfully backs up that a lot of new managers have been entering direct lending recently.
At the end of the day, we want to know: What does this mean? What does this tell us? Well, later in the webinar, I’m going to walk through my next three lessons that I’ve learned, all which are backed up by data. And those are (1) loss rates determine the level of returns, (2) returns are persistent and (3) manager selection is really important, because return dispersion is really wide.
Now, all three of these points underscore the importance of picking the right manager with experience and expertise in direct lending. And the data on this chart shows that most direct lending managers do not have that experience, and they certainly don’t have that experience through a credit cycle, which can be a very scary proposition for those allocating capital today.
Moderator
I just want to underline a point that you just made, which is that 45% of the managers in direct lending have entered into this space in the last five years. Were you surprised by some of the numbers that you’ve dug up through your data here?
Ryan Lynch
I was. I had a sense of what I was expecting to see, but I would say the results more than confirm my expectations. We’ve all seen a lot of AUM growth, and I think the assumption has always been that most of this is coming from the same old managers, but that just wasn’t the case.
Moderator
A lot of new entrants—that’s a really good takeaway and probably something that’s very interesting to many allocators. Let’s get to the next lesson, which really focuses on the most important driver of returns: credit.
Now, that may sound sort of obvious or self-evident, but of course, there are a lot of other factors that go into return and affect return: things like spreads, management fees, G&A expenses, leverage, other drivers of return.
Tell us: How impactful are those other factors when you’re thinking about what really moves the needle in terms of BDC returns at the end of the day?
Ryan Lynch
Absolutely. I started covering the business back in 2011, and I can tell you, you can feel a noticeable difference in the growth of managers entering over the last five years. I think everybody’s probably felt this, but I’ve never seen the data compiled to really back up these claims.
I compiled the data, and I have to say the results are pretty stunning. What I did is, I utilized Preqin’s database, and I found 535 managers who have entered direct lending since 1995. And here’s what I found: Almost half or 45% of managers have entered direct lending only within the last five years.
Only 21% of managers have 10 years or more of experience, and only 5% of managers were in direct lending prior to the global financial crisis. So, the data powerfully backs up that a lot of new managers have been entering direct lending recently.
At the end of the day, we want to know: What does this mean? What does this tell us? Well, later in the webinar, I’m going to walk through my next three lessons that I’ve learned, all which are backed up by data. And those are (1) loss rates determine the level of returns, (2) returns are persistent and (3) manager selection is really important, because return dispersion is really wide.
Now, all three of these points underscore the importance of picking the right manager with experience and expertise in direct lending. And the data on this chart shows that most direct lending managers do not have that experience, and they certainly don’t have that experience through a credit cycle, which can be a very scary proposition for those allocating capital today.
Moderator
I just want to underline a point that you just made, which is that 45% of the managers in direct lending have entered into this space in the last five years. Were you surprised by some of the numbers that you’ve dug up through your data here?
Ryan Lynch
I was. I had a sense of what I was expecting to see, but I would say the results more than confirm my expectations. We’ve all seen a lot of AUM growth, and I think the assumption has always been that most of this is coming from the same old managers, but that just wasn’t the case.
Moderator
Let’s move to lesson number three, which some may find a little surprising, which is that performance is persistent in a way; past performance can be predictive. Delve into that a little bit.
Ryan Lynch
Let me walk through this slide in more detail. I know there’s a lot going on here. I studied the BDC returns over two sequential time periods. Each was five years in length.
Period one was from 2015 through 2019, and period two was from 2020 through 2024. Then I divided the BDCs from period one into four performance quartiles, then I held those BDCs in their performance quartiles, and then I calculated the average annualized return for period two. The results were powerful and clear, I would say.
BDCs in the top quartile from period one generated a 10.8% annualized return during period two, and then BDCs in the bottom quartile from period one only generated a 1% annualized return during period two.
I know while past results do not guarantee future returns, it has been an effective predictor in BDCs. This tells me that competitive advantages are real in private credit. Those who have them really tend to keep winning, and those who don’t tend to keep losing; this is not an accident.
This is also unusual. Persistence of performance is rare in the universe of investible assets. There’s usually a reversion to the mean over time. That’s not the case in private credit.
Moderator
And your next lesson really builds on that idea, which is that manager selection really is quite important. Delve into why.
Ryan Lynch
To be successful, private credit assets are really handcrafted by the manager who has developed experience and expertise in that asset class. And so, we dug into the data here.
I compiled the 10-year cumulative returns for the BDC sector. There was a 65% cumulative return difference between the top half and the bottom half of performing managers.
So what does this tell me? Well, first, I think this points out the impact of compounding returns over a long period of time. That can be very important. Second, a return of 96% versus 31% is a huge difference. I think this illustrates that expertise is required in this handcrafted asset class.
So, here’s what you should take away. Managing a portfolio of directly originated loans is hard; achieving expertise requires significant time, dedicated resources and hands-on experience.
Having an allocation of private credit is simply not good enough when the return dispersion is this wide; you must have an allocation with the right manager. I think it’s also important to note that private credit is just a different world. There’s a lot more return dispersion, and returns tend to be much more persistent.
This is different, really, than most other asset classes. Private credit is really a young asset class that new managers are just stampeding into. I think the bottom line is that having an experienced manager in direct lending is very important.
Moderator
So, in a way, don’t think of it as an asset class. Really focus on the manager with those competitive advantages, because it can make a real difference, especially over time.
Ryan Lynch
Yes, manager selection is incredibly important in managing this business.
Moderator
Let’s bring it home. Clearly, navigating private credit is not necessarily easy, but you did it for 13 years—successfully, it seems. How can allocators cut through the noise of all of those extremely persuasive pitchbooks?
Ryan Lynch
Managers know what investors want to hear, and they often all use the same catchphrases. In fact, I predict that in a lot of our clients’ next direct lending pitchbook that they see from a direct lending manager, it’s going to include some chart with a wide origination funnel and a low close rate, themes around a defensively positioned portfolio, a narrative on a vigorous underwriting process… Really, these are in everybody’s pitchbook. In fact, they’re in Golub Capital’s pitchbook.
These are all important facets of a direct lending business, but it just makes it really hard to differentiate between different managers in the space.
What has mattered most is (1) direct lending expertise, (2) a strong consistent track record and (3) investor alignment. Let me go through each one of these points in more detail. The first point is direct lending expertise.
I look for: How long has a manager been investing in direct lending? Do they specialize in direct lending, or are they a multi-asset management firm? How many direct lending investment professionals do they have?
For example, if one firm has double the AUM over another, but a smaller investment professional count, that tells me they’re probably more resource constrained. That’s something I regularly saw with some of the large market lenders. You’d see a large asset base, but a much smaller investment team.
The second point is a strong consistent track record. I want to see if they have a competitive advantage, ultimately. So, show me all your funds, not just your good ones. Show me where you’ve made mistakes and what you’ve learned from them.
I would say bad managers are really in the business of making it hard to see they’re bad. You really have to be a detective. I’ve had managers only show me their investment income returns, excluding credit losses. That’s not really helpful. I’ve had managers include returns from credit funds that are not in direct lending—that can be misleading. You really have to look through these different diversions.
Ultimately, I want to see low loss rates and premium returns over a long time horizon, different vintage periods and through a credit cycle and, maybe most importantly, in direct lending.
The final point would be investor alignment. I want to see managers that have skin in the game and are focused on returns for investors in the fund. I would tell you that’s not always the focus of many managers, especially for some of the large publicly traded managers.
Listen to the conference calls for some of the public alternative asset managers and then count the number of times the CEO says “AUM growth” in the first 10 minutes. Then compare that to the number of times the CEO talks about investment outperformance. I think that will tell you where the manager’s true focus is.
So, what are some things I like to see? Well, I like to see an incentive fee structure that includes credit losses. I like to see a large investment commitment from the GP. I like to see low overall management fees.
Ultimately, I want to see the manager lock arms with investors in all ways possible, because at the end of the day, there are a lot of new managers who are entering direct lending, and I think most of them know what investors want to hear. But they can’t fake experience, track record and alignment.
Moderator
All really great points. We got a few questions from the audience. First question is, are there any other lessons learned that you can share that were not included in the presentation?
Ryan Lynch
Sure. This is a common question that comes up. One other noteworthy trend that I’ve observed over the years is that there’s a bit of divergent performance between these multi-asset management firms with private equity roots versus those with credit roots.
Credit-first firms have tended to perform a little bit better in my experience. I think this ultimately comes from the cultural differences developed during the origins of a firm.
Private equity firms have tended to be a bit more focused on the upside potential of investments. So, not every investment has to be a winner in private equity. You can be a top- quartile fund if seven out of your ten investments work, and you get a three times multiple on those winners, whereas credit firms have to be a bit more focused on downside protection; really, what can go wrong?
This is just a different investment mindset and a different investment approach. So, to be a top quartile credit firm, you have to be successful in 99% of the investments you make. This success requires a culture built on minimizing the downside of these investments. I think this is why I have seen those credit-first firms tend to be a little bit more successful than private equity-first firms.
Moderator
That makes sense. Another one: You had mentioned investment professional resourcing being a really important component of direct lender success. Have you dug into any data around that? Any unique insights you can share?
Ryan Lynch
I dug into the data on this exact point, and I did this because I wanted to get some perspective on how resourced different credit managers are in the space. I studied the number of investment professionals per billion of credit AUM.
And what I found was these multi-asset alternative managers had about one investment professional on average per billion of credit AUM. And when you compare that to the credit specialists with more of a focus on that core middle market, they had about three investment professionals per billion of credit AUM.
So, what does this tell me? I think the data shows that public alternative asset managers are purposely built for growth. What they do is find investment areas where they can deploy large amounts of capital with fewer resources, and that generates these high margins for the shareholders of the manager.
The area of focus tends to be on what we call large market lending for many of these managers. This is different than the credit specialists who are more resourced and can really focus on areas other and outside of that large market lending area.
At Golub Capital we are heavily resourced, which allows us to not have any particular focus on any certain borrower size subsegment of the lending spectrum. We like to find and invest in resilient businesses across the direct lending size spectrum. And we think not being beholden to any one size subsegment is really the best value proposition for investors.
Moderator
Absolutely. And at the end of the day, trying to get the best risk-adjusted return based on the portfolio. Well, that is a wonderful point to end on. Ryan, thank you so much.
It’s been quite difficult to squeeze 13 years of experience into a relatively short webinar, but I think we’ve been relatively successful.
So, let’s just recap the key lessons that we’ve walked through: (1) beware of inexperienced managers, (2) credit drives returns, (3) returns are persistent and (4) manager selection is really quite crucial.
We encourage you to explore our other thought leadership pieces at education.golubcapital.com. And, as always, you can learn more about Golub Capital on our website, golubcapital.com.
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Dispersion & Persistence of Manager Performance in Direct Lending
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