With Morgan Stanley’s European Leveraged Finance Conference
underway, our Head of Corporate Credit Research Andrew Sheets
joins Chief Fixed Income Strategist Vishy Tirupattur to discuss
private credit, M&A activity and AI infrastructure.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley
Vishy Tirupattur: And I'm Vishy Tirupattur,
Morgan Stanley's Chief Fixed Income Strategist.
Andrew Sheets: Today, as we're hosting the
Morgan Stanley European Leveraged Finance Conference, a
discussion of three of the biggest topics on the minds of credit
investors worldwide.
It's Thursday, October 16th at 4pm in London.
Vishy, it's so great to catch up with you here in London. I know
you've been running around the world, quite literally, talking to
investors about some of the biggest debates in credit – and
that's exactly what we wanted to talk. We're here at Morgan
Stanley's European Leveraged Finance Conference. We're talking
with investors about the biggest debates, the biggest
developments in credit markets, and there are really kind of
three topics that stand out.
There's what's going on with private credit? What's going on with
the merger and acquisition, the M&A cycle? And how are we
going to fund all of this AI infrastructure?
And so maybe I'll throw the first question to you. We hear a lot
about private credit, and so maybe just for the listener who's
looking at a lot of different things. First, how do you define
it? What are we really talking about when we're talking about
private credit?
Vishy Tirupattur: So, Andrew, when we talk about
private credit, the most common understanding of private credit
is lending by non-banks to small and medium sized companies. And
we probably will discuss a bit later that this definition is
actually expanding much beyond this narrow definition. So, when
you think about private credit and spend time understanding what
is the credit in private credit, what it boils down to is on
average, on a leveraged basis, the credit in private credit is
comparable to, say CCC to B - on a coverage basis to the public
markets.
So, the credits in the private credit market are weaker. But on
the other hand, the quality of covenants in these deals is
significantly better compared to the public credit markets. So,
that's the credit in private credit.
Andrew Sheets: So, Vishy, with that in mind
then, what is the concern in this market? Or conversely, where do
people see the opportunity?
Vishy Tirupattur: So, the concern in this market
comes from the opaqueness in these deals. Many of these private
credit borrowers are not public filers. So not much is well known
about what the underlying details are. But in a sense, a good
part of the public markets, whether it's in high yield bonds or
in the public, broadly syndicated leveraged loans are also not
public filers. So, there is information asymmetry in those
markets as well.
So, the issue is not the opaqueness of private markets, but
opaqueness in credit in general. But that said, when you look at
the metrics of leverage, coverage, cash on balance sheet…
Andrew Sheets: Because we can get some kind of
high-level sense of what is in these portfolios...
Vishy Tirupattur: Yeah. And we look at all those
metrics, and we look at a wide range of metrics. We don't get to
the conclusion that we are at a precipice of some systemic risk
exposure in credit. On the other hand, there are idiosyncratic
issues. And these idiosyncratic issues have always been there and
will remain there. And we would expect that the default rates are
sticky around these levels, which are slightly above the
long-term average levels, and we expect that to remain.
Andrew Sheets: So, you may see more dispersion
within these portfolios. These are weaker, more cyclical, more
levered companies. But overall, this is not something that we
think at the moment is going to interrupt the credit cycle or the
broader markets dynamic.
Vishy Tirupattur: Absolutely. That is exactly
where we come down to.
So, Andrew, let me throw another question back at you. There's a
lot of talk of growing M&A, growing LBO activity. And that
could potentially lead to some challenges on the credit front.
How do you look at it?
Andrew Sheets: So, I'd like to actually build
upon your answer from private credit, right? Because I think a
lot of the questions that we're getting from investors are around
this question of how far along in this always, kind of, cyclical
process; ebb and flow of lending aggressiveness are we? And, you
know, this is a cycle that goes back a hundred years – of lenders
becoming more conservative and tighter with lending. And then as
times get good, they become somewhat looser. And initially that's
fine. And then eventually something, something happens.
And so, I think we've seen the development of new markets like
private credit that have opened up new lending opportunities and
then also new questions. And I think we've also seen this
question come up around M&A and corporate activity.
And as we start to see headlines of very large leveraged buyouts
or LBOs, as we start to see more merger and acquisition – M&A
– activity coming back; something we've at Morgan Stanley been
believers in. Are we really starting to see the things that we
saw in the year 2000, or in the year 2007, when you saw very
active capital markets actually coinciding with kind of near the
peak of equity markets near the top of major market cycles.
And in short, we do not think we're there yet. If we look at the
actual volumes that we're seeing, we're actually a little bit
below average in terms of corporate activity. There's really been
a dearth of corporate activity after COVID. We're still catching
up. Secondly, the big transactions that we're seeing are still
more conservatively structured, which isn't usually what you see
right at the end. And so, I think between these two things with
still a lot of supportive factors for more corporate activity, we
think we have further to go.
Vishy Tirupattur: On that point, Andrew, I think
if you look at the LBOs that are happening today versus the LBOs
that happened in the 2007 era, the equity contribution is
dramatically different. You know, equity to debt, these LBOs that
are happening today [are] of a substantially higher amount of
equity contribution compared to the LBOs we saw pre-Financial
Crisis…
Andrew Sheets: That's such a great point. And
the listener may not know this, but Vishy and I were working
together at Morgan Stanley prior to the Financial Crisis, and we
were working in credit research when a lot of these LBOs were
happening, and…
Vishy Tirupattur: And I used to be tall and good
looking.
Andrew Sheets: (laughs) And they were just very
different. We're still not there. If you go back and pull the
numbers, you're looking at transactions still that are far more
conservative than what we saw then. So, you know, this activity
is cyclical, and I think we do have to watch deregulation, right?
You saw a lot of regulations come in after the Financial Crisis
that led to more conservative lending. If those regulations get
rolled back, we could really move back towards more aggressive
lending. But we haven't quite seen that yet.
Vishy Tirupattur: Absolutely not.
Andrew Sheets: And Vishy, maybe the third
question that comes up a lot. We've covered private credit, which
is very topical. We've covered kind of corporate aggressiveness.
But maybe the icing on the cake. The biggest question is AI – and
is AI spending?
And it just feels like every day you come into the office and
there's another headline on CNBC or Bloomberg about another mega
AI funding deal. And the question is, okay, where's all that
money going to come from?
And maybe some of it comes from these companies themselves.
They’re very profitable, but credit might have to fill in some of
the gaps. And you and some of our colleagues have done a lot of
work on this. Where do you think kind of the lending story and
the borrowing story fits into this broader AI theme?
Vishy Tirupattur: Our estimate of simply data
center related CapEx requirements are close to $3 trillion. You
add the power required for the data centers and add another
$300-400 billion. So, a lot of this CapEx will come from –
roughly about half might come from the operating cash flows of
the hyperscalers. But the rest, so [$]1.5 trillion plus, has to
come through various channels of credit.
So, unsecured corporate credit, we think will play a fairly small
role in this. Of that [$]1.5 trillion plus, maybe [$]200 billion
to come from unsecured credit issuance by these hyperscalers, and
perhaps some of the securitized markets, such as ABS and CMBS
that rely on stabilized cash flows may be another 1[$]50 billion.
But a different version of private credit, what we will call ABF
or asset based finance, will play a very big role. So north of
[$]800 billion we think will come from that kind of a private
credit version of investment grade, or a private credit markets
developing. So, this market is very much in the developmental
mode.
So, one way or the other, for AI to go from where it is today to
substantially improving productivity and the earnings of
companies that has to go through CapEx; and that CapEx needs to
go through credit markets.
Andrew Sheets: And I think that is so
fascinating because, right Vishy, so much of the spending is
still ahead of us. It hasn't even really started, if you look at
the numbers.
Vishy Tirupattur: Absolutely. We are in the
early stages of this CapEx cycle. We should expect to see a lot
more CapEx and that CapEx train has to run through credit
markets.
Andrew Sheets: So, Vishy, there's obviously a
lot of history in financial markets of larger CapEx booms, and
some of them work out well, and some of them don't. I mean, if
you are trying to think about some of the dynamics of this
funding for AI and data centers more broadly versus some of these
other CapEx cycles that investors might be familiar with. Are
there some similar dynamics and some key differences that you try
to keep in mind?
Vishy Tirupattur: So, in terms of similarities,
you know, they're big numbers, whichever way you cut it, these
numbers are going to be big dollar numbers.
But there are substantial differences between the most recent
CapEx boom that we saw towards the end of the late 90s, early
2000s; we saw a massive telecom boom, telecom related CapEx. The
big difference is that spending was done by – predominantly by
companies that had put debt on their balance sheet. They were
already very leveraged. They were just barely investment grade or
some below investment grade companies with not much cash on their
balance sheet.
And you contrast that with today's world, much of this is being
done by highly rated companies; the hyperscalers or between, you
know, A+ to AAA rated companies, with a lot of cash on their
balance sheets and with very little outstanding debt on their
part.
On top of that, the kind of channels that exist today, you know,
data center, ABS and CMBS, asset-based finance, joint venture
kind of financing. All of these channels were simply not
available back then. And the fact that they all are available
today means that this risk of CapEx is actually much more widely
distributed.
So that makes me feel a lot better about the evolution of this
CapEx cycle compared to the most recent one we saw.
Andrew Sheets: Private credit, a rise in M&A
and a very active funding market for AI. Three big topics that
are defining the credit debate today. Vishy, thanks for taking
the time to talk.
Vishy Tirupattur: Andrew, always fun to hang
with you
Andrew Sheets: And thank you for listening. If
you enjoy Thoughts on the Market, please leave us review wherever
you listen and tell a friend or colleague about us today.
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