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Good evening and welcome back to Anand talks in Howard Marks has been writing a memo every month for the last several years. Shashwat and I read them quite often and whenever there was something very interesting Shashwat points out. The last memo which I read in great depth was nearly one one and a half years back or sea change.
That has left in my mind. Sea change is basically what he said is nobody in the private industry or the fund managers was ready to for a raise of nearly 400% in interest rate. For the longest of time interest rate was zero. From zero it went to 5.25. It's now dropped to 3.75 now. But zero to one is 100%.
One to two is 200%. Two to three is 300%. Three to four is 400 and above. Now it comes three to four is slightly but when it cut touches 5.25 it hits us 400%. Yeah, none of the private equity structures were designed to take a hit of 400 point increase in interest rates. Did happen. In India though people don't make the connections the 400 point rise made sure that there was no more private equity and startup mania ended and all the private guys went into public markets.
The guys who are not healthy enough to come into the public markets died. One of the most notable deaths is of course Byju and some companies have been sold off and are in good shape. The most famous among them is CaratLane. Incidentally when we record I'm told today is CaratLane's 18th birthday. It's a part of the Titan family and is profitable and doing well.
But when you read that history for the last 10 years Tatas have invested in it. First they came as financiers then came as investors and finally bought out that company. What I'm trying to tell you is when risk appetite is low, capital is easy to find. When rates increase, capital is very difficult to find.
You had a company like Lenskart, which is supposed to be a star performer. I looked at the balance sheet and found that the reserves and surplus have 8,000 crores. All the expenses they have made has been capitalized. There's an enormous 2,500 or 3,000 crore entry for goodwill. I don't know what goodwill there is.
Anyway, even if they continue to make profits for next 7-8 years, they'll have to reduce that whatever they have shown as capitalized expenses, and so not much cash flow is going to come to the investor. In most cases like Zomato and others, like they raised another 10,000 crores money they issued to institutional investors, and their promoters have jumped off the ship.
I don't think these companies are sustainable when interest rates keep going up. So, this is a clear definition of companies that did not expect interest rates to go up by 400%. The current memo which Shashwat and me are going to discuss is about private credit. Now, private credit, the article comes in two parts.
One part is the the history of private credit, and the second part is what the fund managers should do. But, we are going to keep what fund managers should do to the next part. And today discuss about the history of credit. For many years, there were only two ways by which credit was given. Either banks lent you money, or you raised money through high-grade bonds.
If your company was rated below double B, you could not raise money from the market. You had to go to a banker. In countries like India, we have what is called as a shadow banker, which is basically an NBFC. The NBFC would give money to the people who don't have access to banks. And even NBFCs took money from banks.
So, you had a high-grade bond yield. A high-grade bond yield is like a triple A plus company like Tata Steel or something like that, which could raise money at Sundaram Finance, or you had going to banks. In 1970s, Michael Milken, he is the man who created a category of funds called as junk bonds. These were bonds which were which had interest rates less than triple B minus.
And you could charge very high interest. And most of these companies paid off. These were called high-yielding bonds or junk bonds, and a lot of money flew into this. He got caught with Securities Exchange of In- SEC Commission. And he was banned from the market for a lot of time. He holds an annual conference to which Howard Marks goes.
Howard Marks was introduced to credit markets by this gentleman. And that is why while most people have forgotten him, Howard Marks always pays his tribute to this man wherever and whenever possible. So, you would come across him here. If you Google him, you will find not so pleasant things about him.
Now, in the 1970s, people moved to high-yielding bonds or junk bonds. This is where it stayed till about 2000, I think. And that's how he met this gentleman, Milken. And over a period of time, the he detached himself from the bank and created this Oaktree Capital, which in turn has been now sold. So, this is his history.
In 2000 to 2003, when the market really dropped, the stock market dropped. And when a market drops, nobody is interested in the markets. So, the money moved away from the markets for a substantial period of time. And so, private equity investors started to compete with banks in giving credit. And also, this private equity business had started at that time.
That's around the time when private equity venture capital became private equity. So, the evolution of private credit is a '70s was when there was an acceptance of non-investment grade debt. Then in '80s, he says popularization of leveraged buyouts and increased corporate leverage. This is where George Soros writes in his book about the idea of leveraged buyouts and the conglomerate boom.
And then then in the 1990s, we see syndicated loans and tranche securities. 2000s, he says the rising trend towards alternate investments, subprime mortgage lending, and mortgage-backed securities. 2010s, he says expansion of direct lending, and that is during the low interest rate period. And 2020s, he says marketing direct lending vehicles to individuals and retirement investors.
So, between 2000 and 2003, the thing was public markets were not doing well. There was a substantial drop, and that's when private equity, and as we know, Saswata says alternate investment started taking off in a big way. After the great financial crisis of 2008, banks had to sort out their balance sheets and all that.
So, bank withdrew from lending, and direct lending took off in a big way. Initially, all the people who were providing the capital for direct lending were from institutional investors. Over a period of time, when the going gets good, everybody wants to join in the party. You had individual investors and retirement accounts joining into this.
And this is how the boom started. Now, where they are today, according to me, there are two classes of companies which are doing this AI business. One class of company is Alphabet, OpenAI, Microsoft, [snorts] Oracle, these kind of big companies, which have no problem in accessing public markets in whatever currency they want to buy stock.
The second group is small companies, and the company that that AI debt that Central Bank of AI talked about is core values. That company will have to take credit at the cost of two times that of Anthropy or Google. So, that that company's name is CoreWeave. CoreWeave. So, it has investments from Nvidia.
And for some of the loans, Nvidia has acted as a backstop. Even with this, you will get if Intel is getting 5.5, these guys will have to pay double that. This is where private credit has played a role in AI. They are not at the top clients. They are not at the top end of the companies. They are with the bottom companies.
So, any shake happens, these guys are going to get bankrupt. In 2025, two companies, one's name was First Brands and Tricolor, they went kaput. Then there was another company called Blue Blue Owl, which stopped The rules are very clear. Because in in equity, I can do a fire sale, get the money back, and give it to the client.
When your investors start panicking and want to pull out funds, there's a retrenchment, stop of taking repatriation. So, that the investment manager under pressure not does not dump your every loan. Yes, I see. Fire sale liquidation. There is no fire sale liquidation. They have clear rules by which they have stopped the withdrawal or redemption of funds.
There are companies like Blue Owl, which have put those guardrails in place. Now, at the same time, while this is all playing out in the uh AI field, why this is of great importance is bank government yields are refusing to die down, are continuously going up. That is predicating everything that that we're discussing because if for a long time you didn't have attractive enough yields on T-bills or equities, you wanted to do you wanted to go into private trade.
So, you know, pension funds wanted to secure higher returns so they were pushing into higher risk territory. But today, the game seems to be different. The field has changed. What do you think? Yes, the field has changed. A 30-year bond gives 5.3. Yeah, 10-year bond gives 4.8. I rather take 4.8 from Uncle Sam than to put money into a unknown software company.
Now, this unknown software company which was getting 9% last year will now get at 12% now. This is really moving up very fast. Now, there is a possibility that if rates go higher, the United States will end up paying more than 3% of GDP as interest on bonds. That is the trigger point because America is not having a nominal growth of more than 3%.
If you are generous, it is 3%. Interest payments is less than nominal growth. That means you have to borrow to pay interest. That is all your revenue is not enough to pay interest. Because your tax revenue is not going to grow fast enough. Yeah, your tax revenue is not going fast enough to service the income.
But then, the devil's argument that is they move some money around and don't spend much. But no government is willing to say, you know, I want to spend less. I don't think that's going to happen. No, that's not going to happen. So, they will rush to pull out money from guys who have collected this money and invested in AI.
You move along the risk curve. You come back. You come back. You come back. You take less risk. The most famous case this happened in India is is in IL&FS. For years, IL&FS was basically what they were doing is they were funding roads, power plants and everything at a 25 to 30 year period of repayment and their liability that what they were had to pay back was in terms of 90 day T bills.
So, they were lending out their asset was for 25 years. Their liability was for 90 days. So, they were doing maturity transformation. They were doing maturity transformation. For nearly 30 years this run smoothly. Then one one particular day IL&FS did not pay one interest payment and then the whole market collapsed.
Didn't very you know couple of years ago Franklin Templeton also got into trouble because they were doing maturity transformation. Exactly. In a fund which was the purpose supposed to be on very low interest rates, they took that fund from that and gave it to long term interest rates. And when these people called for the money he could not provide the money.
One thing I've noticed when you know we go around and you give your talks on the economy, some people come up and say sir you talk about bonds and you talk about stocks but the yield that I'm getting on on bonds, I seem to get more opportunities with people who are hungry for credit, new businesses that are hungry for credit but they're coming to me asking me for funding because the formal system is not willing to lend to them or there some hurdles which they need to cross which they're not willing to but they're willing to pay me a premium in terms of the yield.
My always answer to this is very clear. There's a liquidity risk. Your money is liquid, it's in cash. You transfer it to a businessman it becomes an illiquid asset. Where does he put it? He either puts it into working capital which it can exist as raw material, stock in progress, finished stock or outstanding.
Yes, or a deposit in the bank without ever being used. But he won't do that he's borrowing at a rate higher than that. Correct. So, in either none of these cases can you recover the money. So, you are converting what you don't understand is for your greed of few percentage points more, you're converting a liquid asset into a illiquid asset.
Because you're giving it to a single guy who is doing business, so we do not know his cash flow. Whether his cash flow is enough to service the interest. What is the cash flow that you will get the money back? And what if the cash flow fails? That is the cash flow which he's depending on you to return your money fails, how will he give money?
And there's no letter protection. There is no protection. Even if you execute all documents and get a document selling a real estate property and getting an order for an individual lender is very difficult. An organized lender can go to and process the property in the surface I act and sell it according to the surface I act.
Whereas you as an individual lender cannot invoke the surface I act to seize the asset. So even if he has pledged the document, you have to go to the court and say he has not paid. The court has to transfer the property to you or hold an auction and sell it to the highest bidder. So this is very inefficient way of recovering your money.
This is exactly what happened in 1929 when land started to be in the great crisis, the land which was offered in security came up for sale. It was sold at dirty prices. So the debt remained real, asset prices kept dropping. This is what happened in 1929? Yes, exactly. Farmers were forced to sell their lands in America at distress price.
More land came up than what was needed. So the price of land collapsed. This meant the value of loans went higher, the value of your assets dropped. A lot of banks itself went bankrupt. Andrew Sorkin has written a wonderful book called 1929. You can put the cover, I have the book with me, which describes the situation and why nobody saw this coming.
At that time if you read all the papers and everything, nobody saw this crash coming. Even the great Irving Fisher completely missed it. So, we are in a similar situation where we think AI will pay for everything. AI may work, but whether will it work enough to pay this or the excesses have to be cleared off like the great railway bonds.
This is exactly what happened in the railway bonds, and he talks about this in this article. When a new technology comes and there's a kernel of truth in it. So, everybody rushes in. There's a mania for it. So, it expands in size. And then, slowly reality comes. So, the first two, three guys jump off the ship at the top or near the top.
Others are hoping against hope. There's another rally. And then, finally everybody realizes this is a the end. You cannot hold it. And there's a big correction. Railways are still there. Telegraph is still there. Company internet is still there, but very few companies survived. Same things will happen here.
Today morning, you told me Nvidia has got $99 billion in cash, but it is making commitments for $700 billion. Which Which means it has to borrow if all of the conditions it has to pay cash. I think currently the their estimated commitments plus debt everything put together is around $300 billion. Yeah, but they have made some backstop arrangements also.
Yeah, they're looking they're accelerating their the amount of commitments they're making, but I think the current estimate by the economist is $300 billion. Yeah, but even then 99 to 300 is a three time leverage. So, when the market and if they increase it to four, five and it doesn't work out, you have a big problem on your hands.
So, tomorrow we discuss when people withdraw money, we talk about the three conditions which he talks after 1929 and what fund managers should do and what investors should do. Thank you for being patient with us. Thank you for listening to this rather long podcast. I enjoyed doing this. I'm sure Shashwat did enjoy this.
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