A $45 billion credit fund manager says the Fed is 'way, way, way behind the curve' on inflation
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Lawrence Golub helms one of the largest private credit shops in the alternative finance space. His eponymous firm, Golub Capital, has $45 billion in assets under management. That’s no small feat against a backdrop where private debt AUM is expected to total $2.7 trillion by 2026.
While private debt has skyrocketed recently, inflation and rising interest rates could pose new challenges. Golub sat down with CNBC’s Delivering Alpha newsletter to discuss how these headwinds impact his firm’s lending strategy and where he thinks the Fed went wrong in taming inflation.
(The below has been edited for length and clarity. See above for full video.)
Leslie Picker: Private credit is floating rates so it still may be an attractive asset to investors in a rising interest rate environment. But how does the broader macro backdrop change the way you dole out capital?
Lawrence Golub: We’re looking for resiliency in the borrower against things that could go wrong. So when you have interest rates rising, it does reduce the margin of safety somewhat, when you’re looking at the ability of the company to service its debt. That has to be taken in the broader context of what’s going on with the economy as a whole and the economy really is doing very, very well. The inflation is driven by strength, not weakness. And in this environment, our portfolio has been performing at among the best levels ever, in terms of very low default rates. And it’s been a very robust, healthy environment.
Picker: What’s interesting is that your lending covers a swath of the economy that we don’t always see – it’s private companies, middle market, increasingly larger companies. What can you tell us about their resiliency, especially in the face of inflation? Is that starting to creep into their margins?
Golub: We pride ourselves on being extremely careful in who we pick to be our partners. Absolutely inflation is feeding into the performance of companies. We segment the various industries that we lend to and we have a quarterly report. And in the industrial sector, even though there’s been robust demand, that’s one area where profits haven’t been as strong because companies, due to supply chain issues, have had trouble meeting all of their customer demands. Nonetheless, in the middle market, profits are up almost 20% year over year so it’s been very robust.
Picker: Do you feel like the Fed is ahead of the curve here, that they are on top of the inflation picture and will be able to adequately bring it down from these levels?
Golub: The Fed will eventually be able to bring it down if it has the will but the Fed is way, way, way behind the curve. When inflation was 1.7% versus their target 2%, the Fed expressed great concern, “Oh, my, we’re not at our targeted levels. We’re not going to raise rates until we actually see the data with inflation over 2%.” Now that inflation is over 7%, the Fed is going slow. It’s not taking the action that it said it was going to take. I think this is a mistake. Larry Summers, on Friday, said the Fed should call an extraordinary meeting and immediately end quantitative easing. I think he’s right.
When you look at factors like the quit rate and the open job rates, we have an economy that’s closer by historical standards to what you’d normally see as an unemployment rate of 2% or 3%, rather than what’s being measured. So we have a lot of unmeasured inflation. We have housing costs that aren’t properly reflected in the CPI. We still have a few more months coming up, where the month-over-month comparisons with last year are going to be beaten and the headline inflation rate is going to go up some more. So the Fed is going to tighten, they are going to tighten a lot. I don’t think anybody really knows when the Fed is going to start letting its balance sheet taper off some but they will need to take action and it remains to be seen how soft a landing they’ll be able to engineer.
Picker: What’s the chance that they get it wrong and we ultimately wind up in some sort of a recession?
Golub: There’s a decent chance of that. The question is more of a when, then than anything else. We’re seeing in our results from companies and in backlogs tremendous strength, we don’t see much of any chance of a recession this year. And that momentum will probably carry on well through next year. One of the side effects, though, of the supply chain issues is that businesses of all different types are raising their targeted inventory levels. So as they add to inventory when they eventually start being able to catch up on receiving shipments above sales, at some point, there’s the risk that they overshoot. We in the United States haven’t seen a classic inventory recession in probably 30 years. I think there’s a good chance that there will eventually be an inventory recession sometime in the next five years.
Picker: What does an inventory recession look like compared to, say, a financial crisis-driven recession?
Golub: Much milder. An inventory recession is really cutbacks in orders that run a little bit more severely than weakness in and retail sales. And historically, inventory driven recessions have been adjustments of just a few months. They’re still painful when you’re in them, but not as much to worry about.
Picker: I want to ask you about the industry that you’re in, sometimes known as private credit. Direct lending is a pocket of private credit, probably the largest pocket. You had a record year in 2021 – $36 billion worth of commitments. There have been others that have jumped into this space as well, attracted by the prospect of those investors that like an alternative to fixed income creating those similar returns for them. What’s the competition picture look like right now in this space as its prevalence has just grown to help finance the LBO boom that we’ve seen recently.
Golub: Well, private credit is bigger than it’s ever been and growing quickly. There have been new entrants and those of us who have been in the industry for years have been growing. The private equity ecosystem is probably about $2 trillion large and within private credit, or I should say private credit is gaining market share at the expense of public credit, broadly syndicated loans. As we and others have grown in the private credit space, we’re able to offer bigger solutions for a larger range of deals from private equity firms. And there’ve been at least two ways in which our industry is gaining market share. We’re gaining market share by replacing broadly syndicated lending in traditional first lien debt. And there’s been a tremendous growth in one stop loans which is very favorable for investors and also favorable for the private equity firms.
Picker: Do you believe that with the growth in private credit, that it’s created too much leverage in the system? I ask because there was that recent Moody’s report that warned that this leverage embedded in private credit’s, quote, “less-regulated gray zone” carries systemic risks. Do you believe those concerns are valid?
Golub: First of all, I don’t see any systemic risk. Private credit isn’t interlaced with the financial system, the banking system, the way other kinds of credit are. So even if we’re stupid enough to make some pretty big mistakes, there’s really no plausible way that spills over into being systematic risk. Secondly, private lenders are much smarter about the fundamental recovery, the fundamental value of the loans we make. You can go back decades and our credit losses, we the industry, Golub Capital’s, does better, has lower credit losses than our industry. But even the industry as a whole has lower credit losses than banks ever did in their private equity lending at lower leverage rates. And it has to do with the alignment of interest, long term focus, a real orientation on lending against value as opposed to just some regulator driven credit metrics.
And having said that, leverage levels have crept up just as enterprise values have crept up. The stock market, private equity industry, multiples are very, very high and there’s no change in sight. We’re not seeing any reduction in those multiples. So you have this balance between high growth rates and profits, increases in value businesses, the fact that private equity firms do a really good job in general at running the companies that they’re lending to, the fact that private lenders do a very careful job and we have our money where our mouths are, balanced against what’s the right long term amount of leverage. We at Golub Capital are focused on lending for resiliency and not lending for perfection. But it’s absolutely something investors should think hard about, particularly when they’re picking an investment manager.
Picker: What’s the difference between resiliency and perfection?
Golub: Resiliency is what you need because you can’t have perfection. If you’re lending against a financial model, and you’re pushing the amount of leverage to the limit of how much is LIBOR or SOFR going to go up, and you’re not taking into account the possibility of a recession, you’re pricing to perfection or structuring to perfection as opposed to structuring for resiliency…When we’re underwriting a loan, we’re not looking at credit ratios. We’re looking at what we think that distressed sale value of a business will be if a bunch of things go wrong. And if we’re lending within that expected distress sale value, that’s resiliency, ultimately, because it gives everybody room to come up with solutions. More
