Is the Age of Reckless Lending Coming To An End? | Oaktree’s Raghav Khanna on Private Credit, Software, and How Oaktree Correctly Saw First Brands' Red Flags

Episode Summary

Executive Summary: Raghav Khanna of Oaktree argued that private credit is entering a more discriminating phase after years of easy conditions. He said underwriting quality, governance checks, cash-flow analysis, and cross-market diligence are now key differentiators, especially after idiosyncratic blowups like First Brands. He also explained shadow defaults, PIC loans, covenant erosion at larger deal sizes, and why niche private credit areas still deserve higher spreads.

Main Topics: Private credit is moving from easy-cycle performance to true underwriting differentiation (Priority: 5/5): Khanna argued the asset class has not experienced a full recession since the GFC, so recent stress is revealing which managers underwrote carefully versus recklessly. First Brands as a case study in red-flag-driven underwriting (Priority: 5/5): He outlined three warning signs: implausibly high margins, multi-market borrowing that obscured total leverage, and weak founder/governance signals. Adjusted EBITDA vs. cash flow as a core credit discipline (Priority: 5/5): He stressed that credit investors must focus on cash flow, not increasingly aggressive adjusted EBITDA, and should interrogate supplier, customer, and employee relationships. Shadow defaults, PIC, and maturity modifications (Priority: 4/5): Khanna explained that payment-in-kind interest and maturity extensions can mask stress even when formal defaults remain low, and that this became a bigger issue in 2024. Market convergence between private credit and liquid credit (Priority: 4/5): Senior direct lending increasingly competes with broadly syndicated loans on leverage, covenants, and pricing, while still retaining an illiquidity premium. Growth beyond direct lending: asset-backed finance, life sciences, infra, and Europe/Asia (Priority: 4/5): He said non-sponsored, structured, and hard-asset lending should keep wider spreads because of complexity, expertise requirements, and slower return on time. AI and software risk are changing lending assumptions (Priority: 4/5): Khanna highlighted SaaS disruption from AI-native competitors, outcome-based pricing, and lower switching costs, while noting strong incumbents may remain financeable.

Key Arguments: Private credit has been protected by an unusually long benign cycle; a real recession would test underwriting far more severely than recent dislocations. First Brands was avoidable: its margins looked too high for the business, it borrowed across separate markets that rarely communicate, and governance/founder checks were poor. Credit should be underwritten on cash EBITDA, not adjusted EBITDA, because add-backs can become recurring and mask true leverage. Shadow defaults matter because PIC and maturity extensions can hide borrower stress even when loans are not formally non-accrual. Many current stresses are concentrated in 2021 vintage loans that were underwritten at very low rates and now face much higher floating-rate coupons. Private credit still offers a premium over broadly syndicated loans, but senior direct lending has converged materially with liquid credit on terms and risk. Niche lending areas such as asset-backed finance, infra, energy, and life sciences merit higher spreads because they require specialized expertise and structuring. Private equity sponsor behavior is part of credit underwriting; lenders should assess whether sponsors inject equity, cooperate, or use liability management transactions to shift value. AI could pressure software/SaaS borrowers through customer migration, seat-based pricing disruption, and easier code generation, though durable, deeply integrated software businesses may remain strong credits. Greater transparency tools and indices will likely improve the private IG segment first, but below-IG private credit may remain harder to standardize or trade transparently.

Data Points: Private credit market size (below IG): about $2 trillion - Khanna described the scale of the below-investment-grade private credit market. Price premium of senior direct lending vs. broadly syndicated loans: 150 to 175 basis points - He said this premium persists even as the two markets have converged. Premium in more complex private credit niches vs. broadly syndicated loans: 250 to 350 basis points - He cited asset-backed finance, infra, and other complex sectors. Paper migrating between BSL and private credit annually: $60 to $80 billion - He said this amount moves back and forth as sponsors refinance across markets. LP premium in developed Europe and Asia: 50 bps in Europe; 100 bps in developed Asia - He discussed regional pricing premiums on an unhedged basis. Equity dilution of coupon via PIC example: 10% cash coupon split into 2% cash and 8% PIC - Used to explain how shadow defaults can mask stress while principal accretes. Typical leverage for some 2021 vintages: 6x to 6.5x EBITDA - He noted these deals were struck when rates were near zero. Floating-rate debt cost increase example: about 6% to 10-11% - Illustrated the impact of rate hikes on 2021 vintage borrowers. Typical leverage in senior direct lending fund structures: about 1:1 fund leverage - He described manager-level leverage in the non-bank sector. Historical bank leverage comparison: about 10:1 - Used to contrast private credit with banks. First Brands margin anomaly: several hundred basis points higher than peers - One of the three red flags he said should have deterred lenders. Energy demand growth estimate: 40%+ over the next two decades - He cited this as a reason infrastructure and energy financing should grow. AI-generated video energy use: 3.4 million joules for a five-second video - He used this statistic to illustrate rising power demand from AI. Software lending valuation sensitivity: 20% to 30% multiple/valuation decline can hurt equity but leave lenders okay - He said lower LTVs can protect lenders despite terminal value concerns.

Pivotal Quotes: "you don't eat EBITDA, you eat cash flow" — Raghav Khanna: Explaining why lenders should prioritize cash-flow-based underwriting over adjusted EBITDA. "that was a pretty interesting memo from Howard" — Raghav Khanna: Referring to Howard Marks’ First Brands memo and the red flags that led Oaktree to avoid the deal. "the reason I think, and again, you know, I'm certainly biased as a manager in private credit, but the reason I think that's better than banks is because I'm sure you're you know this, bags of lever 10 to 1" — Raghav Khanna: Comparing lower leverage and better asset-liability matching in private credit versus banks.

Implications: Listeners should expect more dispersion in private credit outcomes: strong underwriting, governance checks, and niche expertise should outperform, while aggressive structures, opaque cash flow, and 2021-vintage leverage may keep causing stress. Transparency will improve unevenly, with private IG benefiting first.