The Lure of Alternative Credit Opportunities in Global Credit Investing David Snow, Privcap: Today we re joined by Glenn August of Oak Hill Advisors. Glenn, welcome to PrivCap. Thanks for being here. Glenn August, Oak Hill Advisors: Thanks for having me, David. You are a credit investor. You ve been a credit investor for a long time, so I m fascinated to hear your views about what s going on in the investment opportunity for credit globally. Let s start with what you find most striking about the current investment environment for credit. As you talk to people in the market and as you pursue your investment strategy, what really stands out as being different about this point in time? I ve been doing this for 27 years and if you told me the German 10- year was going be below 1%, I wouldn t believe it. If you told me the 10- year treasury was going be at 250 or less for three years, I wouldn t believe it. That market, the slowness of the economies in Europe and the modest recovery in the U.S., is keeping rates very low. And that is creating an incredible backdrop for investors and a really incredible challenge for investors and what to do with their capital. Because if you have a pension plan and you have an 8% or a 7.5% target return and you put your money into treasuries, you make 1% or less in Europe and you make 2.5% in the 10- year in the U.S., then the question is how do you ever get yourself to 7.5% or 8%? We are seeing today an enormous amount of capital looking for yield. There s essentially a global search for yield, sovereign wealth funds, large pension funds, large institutional investors who are afraid of duration risk in the U.S. and, at the same time, need to make return. So I ve been doing this for 27 years and, for many of those years, it was kind of alternatives fit in between a core fixed- income portfolio and a private equity or public equity portfolio. But, in the last few years, alternative fixed income has become an incredible,
exciting piece of the market and we ve raised substantial capital and to pour substantial capital on behalf of our investors. We re seeing so many other investors allocate capital there. It s an interesting backdrop we re at right now. Do you have any stories you can share, without necessarily naming names, of conversations you ve had or deals you ve pursued that have really driven home to you the points you ve just made? Yes. We are a multi- strategy credit firm, so we look across U.S. credit bank loans, high- yield distress direct lending, residential mortgage credit, CLO debt equity in Europe. We look at distressed stress performing some rescue financing. And I would say there are a few areas that are particularly interesting and really timely to talk about. In the European distressed market, we think there is a very exciting opportunity and I ll give you an example of how an opportunity creates itself. Europe was essentially a market unlike the U.S., where the banks bought to hold as opposed to syndicate. The high- yield market was kind of a one- off market that was primarily telecom driven in the late 90 s and early 2000 s. So, a real institutional market didn t develop. So, you end up having the banks hold substantial portions of debt in transactions. When those transactions get troubled, when debt needs to get converted to equity, the banks run for the hills. There s a very large German real estate situation that we were a very large investor in, where a 5- billion euro company had 4 billion euros of debt, 1 billion euros of equity and the company announced that they needed to restructure the debt into some equity. Within one month, 2 billion euros of debt traded to us and to a host of other distressed investors. So, the opportunity to play that effective and efficient holder in transition, distressed to restructuring in Europe, is a great opportunity. We ve got a team of almost 20 people in London and across northern and southern Europe, we re seeing a lot of opportunities. That s one area where we re focusing a lot. The second area that s been of real interest to us in terms of a niche well, part of it is niche, part of it is broader is in the mortgage market in the U.S. Over the last six years, we built up a $3- billion business in residential mortgage strategies. It started out trying to seize on the busted RNBS market.
We developed with a team of what is now about 15 people and some incredible technology where we ve got home and loan data on 75 million mortgages in the U.S., and we can really pinpoint where there s been investor fraud, lender bad practices and so on. So, we end up raising a fund to focus on NPL portfolios, which we ve been buying from banks, from Fannie and Freddie and from HUD. These are non- performing loans that we buy about 70 or 75 cents on the dollar. They have been tremendously underserviced in part because the banks have had their hands tied a bit in the servicing. We invest 10 to 15 cents for the special servicer who works with us exclusively. Then, we can convert that into the short sales modifications. We can securitize it. We can sell it. Interestingly, whereas if the bank were to hold those loans, 90% of them would go to foreclosure because that s the only way they can end up executing on them. In our case, less than 30%, or about 25%, go to foreclosure. So, it s very efficient for both the homeowner or borrower and for us and it s a very attractive opportunity to make 10% or 15% returns. I d be interested to learn where in the country you see the most trouble. Maybe that s proprietary information, but are they the obvious places that were talked about so much, like the Inland Empire and North Miami and places like that? It is certainly a regional, region- by- region market and prices of course, to use a cliché, is a great equalizer. And there are certain markets where you ve seen substantial home price appreciation in the last couple of years. There are some states that are called judicious states where they have long foreclosure processes. But where it s also the opportunity for us and for others is the ability to seize on what we call a servicing arbitrage. Again, it s striking to have so many banks that have these very large servicing organizations who cannot service those loans very well. That s really why they re selling. In many cases, they re selling to us where their expected return might be a 3%, 4% or 5% return if they held the loan. But, when we look at what we can do on the servicing side, we think there s the opportunity on levered basis to make 10% type of returns and with some leverage, making a 15% type of return.
Obviously, there are many different strategies within credit. Distress also has many different strategies to it, but you mentioned raising lots of capital. Is it time for investors to put capital into distressed credit strategies? Or is the economy headed toward rosier times and therefore it s a bad time to do so? I have been personally a distressed investor for the entirety of my career and was very active in the early 90 s when the first distress wave came. The second distress wave in the 2002 to 03 period and the 2008, 09 and 10 distress period. We ve invested in over $8 billion in distress, grade 30%- plus type of returns. To me, if you look at those three different cycles, in each cycle you had a recession. In two of the three, you had a financial system crisis. In two of the three, you had war- related activities. When I step back objectively and look at the world today and especially the U.S. market, I don t think we re at 2007 right now. The reason we re not at 2007 or 1989 or 2002 today in the three big distressed markets is because the U.S. economy s actually in OK shape. Whether you believe it s going to grow at 2%, 3% or 4%, we have reasonable, if not modest growth. That s number one. Number two, the financial system is not in crisis in the U.S. Number three, the maturity wall that was big in 2008, 09 and 10, and the maturity wall that was big in the early 90 s with really tight covenants as well that doesn t exist today because in the last three or four years, you ve had $4 trillion of refinancing. Now, why are people pounding the table saying, I want to raise distressed money right now? What they re saying, what they re seeing and what I agree with is that credit standards are certainly lower. Leverage ratios are higher, although you can t forget that interest rates are so much lower, so the actual interest coverage is substantially better today. I believe there will absolutely come a time when there s a big distress market again. I think it s likely to be a bit later than sooner. And the only what if is all the series of issues in the world. We all look at what s going on in Russia and Eastern Europe and the Middle East. We all worry about China in terms of it being the incremental grower and its growth slowing down and real estate bubbles and so on. I certainly worry about all the tech bubbles in the U.S. equity markets. Certainly, if any of those were to really explode, then you certainly could have an acceleration.
Let s go back to the point you made about the role of credit in the institutional portfolio today. How have you seen that evolve? What is the appetite of investors to put money to work in credit? And what buckets are they putting it in? You pick up the paper today and discussions of credit, of higher yielding securities, of what s happening in leveraged finance and the buyout market and the distressed market, are all over the place. It comes back to my earlier comment that people are looking for yield. So, the question for investors is, What risk am I willing to take? Do I want to reach out beyond investment grade and go into higher quality BB or bank loans? Am I willing to take a bit more risk and go into high- yield and what distress might be out there? There s a question of whether you want to have liquid alternatives or are you willing to get paid a premium for being in illiquid investments? We re seeing that there are people who are classic core fixed- income investors, large pools of pension fund capital where they re saying, I can t make enough in my core fixed- income business, so I m going to reach out for some yield and take some credit risk and some liquidity risk. You see some classic private equity investors who say, Wow, I don t really like being locked up for 10, 12 or 13 years and my returns aren t as high and there s so much buyout capital. It s become much more efficient. As you look out over the next 10 years, of course, your firm is going to be very successful, but with alternative credit in general, how much room for growth does it have? What role will it play in the overall mix of investment assets globally? Between the large sovereign wealth funds and large pension funds, there s an enormous amount of capital looking for yield. What some of our competitors have tapped into (and we ve been a bit slower at) has been retail demand. An enormous amount of capital from the retail community has gone into alternative credit. And the asset class, because of its durability, because it really is a hybrid, is not taking all the equity risk. It s not a pure fixed- income duration investment, there s active portfolio management. We re going to see the segment of the market grow fairly substantially. Glenn, you have been affiliated for a long time with the Robert Bass Group, with Robert Bass. A number of other very notable investors have always crossed paths with or used to work with
Robert Bass, so it s an elite fraternity to be party of. What is his role in your business and what has his influence been? Bob has been a great partner; he was the founding capital of our initial fund called Acadia Partners back in 1987. There s a great group of people who partnered with Bob Bass over the years and we still manage a substantial amount of capital for the family. He is a modest investor in our management company, but we partner with him on certain transactions. He s affiliated with Oak Hill Capital, which is a former affiliate of ours. Now, we re entirely separate. Oak Hill Capital is the private equity business. Oak Hill Advisors, the business that I run, is a credit specialist firm. We re good friends but separate business. He s been a good friend and been very supportive over the years and I look forward to many more years of partnership with him. What do you think is key to his ability to see good investment trends and to back talented people? Bob deserves a lot of credit for a fundamental principle of alignment of interest, which is certainly an over- used phrase between GP s and LP s. But Bob required each one of us in the early funds, as part of a condition to his capital, to invest a substantial portion and, in fact, he was generous to give some financing in the early years to help us make commitments to the funds we managed. I think his focus on that was incredibly important. It s a principle we use in our firm to this day. Finding that group of people who can identify where the opportunity is and letting them run with it is something Bob was skillful at in choosing.