Talk Your Book: How Private Credit Works

Episode Summary

Executive Summary: The episode centers on Calamos’s Phil Bauer explaining why private credit has surged, how it works, and where the opportunities and risks lie. The discussion emphasizes direct lending, bank retrenchment, floating-rate income, interval fund liquidity, diversification, vintage risk, and why private credit can be a more controlled way to earn credit exposure than public high yield or bank loans.

Main Topics: Why private credit is booming (Priority: 5/5): Bauer argues the asset class has proven itself over 15-20 years, offers attractive excess returns versus bank loans/high yield, and became more accessible through interval funds and non-traded BDCs. Direct lending as the core private credit strategy (Priority: 5/5): Direct lending is explained as bilateral lending to companies, often replacing banks that now syndicate or retreat from parts of the market. The fund uses co-investment with established GPs to access deals. Floating-rate income and 2022’s bond-stock correlation shock (Priority: 5/5): Private credit gained appeal after 2022 showed that traditional 60/40 portfolios can fail when stocks and bonds both fall; floating-rate loans avoid duration risk and provide income. Risk management: diversification, vintage risk, and no forced selling (Priority: 5/5): The fund’s structure aims to reduce volatility through diversification across GP, industry, geography, and loan level, while avoiding forced sales that can amplify losses in public credit. Interval fund structure and investor liquidity (Priority: 4/5): The conversation details how interval funds provide daily subscriptions but only quarterly redemptions up to 5% of NAV, enabling illiquid private credit exposure while protecting against runs. Fee structure and transparency (Priority: 4/5): Bauer explains the fund avoids incentive fees and emphasizes open-architecture co-investing, with costs primarily at the management-fee level rather than layered fees. Where the next opportunities are (Priority: 4/5): The guests discuss the shift away from crowded upper-middle-market direct lending toward lower-middle-market, non-sponsored lending, Europe, specialty finance, commercial real estate debt, NAV lending, and regulatory capital relief.

Key Arguments: Private credit has outperformed traditional bank loan and high-yield markets by roughly 3% to 4% net of fees over long periods. The post-GFC retreat of banks created a durable opportunity for private lenders, especially in lending to small/medium companies and financing private equity buyouts. Floating-rate private credit avoids duration risk, making it attractive when rates rise and when stocks and bonds correlate negatively. Private credit’s biggest advantage is avoiding forced selling; in dislocations, managers can hold loans through volatility rather than dump assets into weak markets. Diversification matters more in credit than in equity because losers, not winners, drive returns. The fund’s interval structure supports illiquid investing while limiting redemptions, which helps preserve portfolio stability. Current opportunity is shifting away from crowded upper-middle-market direct lending into less competitive segments such as lower-middle-market, non-sponsored deals, and Europe. The portfolio is designed to be thematic and dynamic because spreads and competition vary by vintage and market conditions. Open-architecture co-investing is presented as a way to outsource underwriting and gain diversification across managers and risks. The absence of incentive fees is framed as a meaningful cost advantage versus many competing private credit vehicles.

Data Points: Assets under management: approaching $500 million - Calamos’s strategy launched in September 2023 and rapidly gathered assets Long-term excess return: 3% to 4% net of fees - Private credit vs. historical bank loan and high-yield income strategies Investor-access vehicles: interval funds and non-traded BDCs - Structures that widened access to private credit Typical 60/40 bond-stress year: 2022 - Used as the catalyst for interest in private credit due to stock/bond correlation spikes Direct lending market size profile: EBITDA of $10 million to $100 million historically - Typical historical borrower profile for direct lending Upper-middle-market profile: $100 million+ in earnings; even $400 million to $500 million companies - Temporary opportunity when banks stopped lending in 2022-2023 Lower-middle-market sweet spot: $20 million to $50 million in earnings - Current preferred area as bank competition returns Sponsored direct lending share: about 80% - Portion of the direct lending market backed by private equity sponsors Non-sponsored share: about 20% - Lending to private, non-PE-owned companies Average loan-to-value: 40% - Portfolio leverage level implying roughly 60% equity cushion Average holding period: about 3 years - Typical life of loans in the portfolio Portfolio turnover: about one-third naturally runs off - Based on the three-year holding period Quarterly redemption cap: up to 5% of fund NAV - Interval fund liquidity structure Private credit portfolio yield: 10.7% - Net yield of the private credit book (about 90% of the portfolio) All-in portfolio yield: closer to 10% - Including liquidity sleeve such as cash, IG, CLOs, and high-quality bank loans Base rate reference: 3-month SOFR at 4.25% - Part of the yield build-up Credit spread: about 650 bps over - Typical spread in the private credit book Fund-level leverage: 15% to 20% - Used mainly as a pipeline management tool to meet daily subscriptions Historical BDC leverage: about 100% levered - Referenced as a reason private credit yields could stay high in the past Historical private credit credit loss rate: about 1.25% - Referenced as being in line with high yield and bank loans historically Peak GFC high-yield default rate: about 15% - Used to illustrate public credit stress behavior Average GFC recovery rate: about 50% - Used to explain historical loss severity Potential severe downturn default rate: 20% - Worst-case credit recession scenario mentioned Potential severe downturn loss: 10% - Assuming 50% recovery on 20% defaults Current distribution rate: about 9.5% annualized - Monthly distributions from the fund NAV dislocation sensitivity: high-yield spreads at 800 bps over - Used as a rough threshold for public credit stress and potential investor redemptions Public-market volatility comparison: about one-fifth of high yield and bank loan volatility - Historical movement of the private credit book relative to public credit Industry concentrations mentioned: 11% software; 11% financial services - Examples of portfolio diversification by industry Commercial real estate refinancing need: $2 trillion over the next two years - Presented as a major opportunity because banks, especially regional banks, are constrained

Pivotal Quotes: "“why do bonds need to be publicly traded?”" — Michael Batnick: Commentary on private credit’s structure and whether public market pricing is necessary for loans "“there is no more effective way in our minds than diversified private credit.”" — Phil Bauer: Argument that private credit is the best way to generate income within a portfolio "“you are never a forced seller.”" — Phil Bauer: Core reason private credit may suffer smaller drawdowns than public high yield or bank loans

Implications: Private credit is increasingly mainstream because it offers income, lower volatility, and structural protections in a world where banks retreat and traditional bonds may disappoint. For investors, the key is manager selection, diversification, and understanding liquidity limits and vintage risk.