Ludovic Phalippou:
Hello, welcome to Private Equity Laid Bare podcast. Today my guest is Blair. Blair works at Ares. And I've been around for a while and I've always heard of Ares. So it's an old firm which seems to be in private debt, and so it looks like private debt started long ago. And so maybe Blair, if you can tell us a bit about the history of Ares and what you guys do. And thank you for being here.

Blair Jacobson:
Great. Thanks, so happy to. Today Ares is a group, manages around 200 billion of assets, we're a large diversified alternatives manager. However, as you said, our core and largest businesses are in sub-investment grade corporate credit, and in particular private debt and middle-market direct lending, which is really about half of what we do. We trace the roots of the firm back to the early 1990s when Ares was incubated as the credit arm of another alternative manager. We gained our independence around 2000 and continue to grow meaningfully from there. But you're right, we've been involved in the private credit markets for well over 20 years.

Ludovic Phalippou:
And so that's what's confused me because we had these previous podcasts with [inaudible 00:01:49], and not the usual story about private debt showed up after the financial crisis, because the banks didn't want to lend anymore, but then you guys have been around forever. So what were you doing before 2008?

Blair Jacobson:
So that's a great question. I listened to the James interview, and I think his perspective was a bit more of a European perspective. Ares was founded in the US in Los Angeles. And the perspective on private credit from the United States is it has been around for a very, very long time. And it's not simply an outgrowth of what happened from the financial crisis. In fact, if you look back probably 30 years or so, in the 1990s in the US, the banking sector went through a very, very significant merger and acquisition and consolidation wave.

Blair Jacobson:
And what wound up happening was all these banks got together, they got a lot bigger. And when that happened, basically they started financing larger and larger companies, but they left the middle market behind. And there are some really interesting statistics there. For example, the top five banks today in the United States hold over 50% of banking assets. Go back to 1990, the top five banks were less than 10%. Some of the really big banks like Bank of America, that's 12 plus big banks merged. JP Morgan Chase, more than seven big banks merged. So again, the dynamic was that there was a big gap to fill in the market. [crosstalk 00:03:36] happened.

Ludovic Phalippou:
And is it because the bank is becoming bigger when they say, "Okay, we can not be bothered with small stuff anymore,"? Is that really how it works?

Blair Jacobson:
That's indeed what we saw. Yeah.

Ludovic Phalippou:
Amazing. And so you guys had space already back there, and then you were doing what? Were are you doing [inaudible 00:03:53] back then, or what kind of things were offered in the US in the 90's and 2000's?

Blair Jacobson:
Yeah, sure. So what happened was number one, the US is a large country, it is a massive market. Unlike some of the other markets we'll talk about today, there's a single currency, there's a single bankruptcy code. So there was a lot of opportunity created through this consolidation wave. And as a result, BDCs started. Again, those are government sanctioned, tax advantaged, publicly listed loan vehicles. There were also private debt funds created. Probably early as well, there were insurance companies that would buy these assets directly. There's even a middle market CLO market, which we don't really see anywhere else in the world, it just shows the size and maturity. But way back then, a lot of it was [BBC 00:04:51] driven, some institutional investor driven. And I'd say were Ares made its name very, very early on. I think we take some pride, because we believe we invented this Unitranche market that you're speaking of and that James described on the last podcast.

Ludovic Phalippou:
And so you started Unitranche as early as in the 2000's?

Blair Jacobson:
Correct, early two thousands.

Ludovic Phalippou:
And that was your main product?

Blair Jacobson:
Yeah. I think Ares' general view a group and in particular in private credit is we do try to be flexible so we can do lots of different things. Whatever's best for the company and their stakeholders that meets our own risk return requirements. But yes, Unitranche became a very, very significant part of our business.

Ludovic Phalippou:
Okay. And so Ares was number one in the US already in the two thousands. And then what made them come to Europe, I believe even before the financial crisis, when Jim said there was no problem before the financial crisis?

Blair Jacobson:
It's a great question, because back then, you're right, middle market commercial banks literally had 100% market share in this first [inaudible 00:06:00] lending. And I think as James said, there were some mezzanine funds who had come in behind banks when companies wanted a little bit more leverage. But again, Unitranche didn't exist. Now, I will tell you that-

Ludovic Phalippou:
And these mezzanine funds didn't exist in the US, right? So in the US, you didn't have them. So in Europe we had private debt ancestors, but it was really these mezzanine people, many of them, and they got burned during the crisis. So you came in in Europe and you [crosstalk 00:06:27].

Blair Jacobson:
Well, so we came in Europe. And maybe just to spend a moment on it, we did not have a crystal ball. We entered the markets in direct lending in 2007, pre-financial crisis. Obviously after that, the crisis was a huge way to turbo-charge our business. But at that time, Ares is a business building type firm looking for opportunities. And at the time, again, it wasn't obvious because nobody else was doing it. However, what we did know is that Europe has a lot of great middle market companies, Europe has a very, very well developed and mature private equity market, and they are large consumers of leveraged finance.

Blair Jacobson:
And I think thirdly, by bringing over a product like Unitranche, which again, it was described I think pretty well, banks might tap out at 30 or 40% loan to value. We might get more comfortable with a single instrument going through 50% or 60% loan to value. Costs more, but again that's the company's decision, whether that's attractive for them or not. But we did feel that that was going to be a differentiated offering in the market. Little did we know that the financial crisis was around the corner, that again would really accelerate our opportunity set.

Ludovic Phalippou:
I see. And so how would you characterize a nowadays European market versus the US one? How the US was accelerated after the 2008 crisis and Europe is catching up and getting to the same place in the US? What would be the difference?

Blair Jacobson:
Yeah, I think that's a fair comment. I'd make a couple of observations. Again, the US market, it's a good market. It's mature, it's large, it's a single currency, but going to what I had said a little bit earlier, it's at a point where institutional investors probably have 90% market share versus the banking system. And what that means is it is a very competitive and crowded markets. I'd say by our estimation, there are something like 150 direct lending managers, there are 50 of these publicly listed business development companies, there's even over a hundred middle market CLS, which again is something we never even see in Europe, at least at this point.

Blair Jacobson:
So it's a large and mature market. And I think what that has led to, perhaps is a little bit of muting of returns in that market compared to other parts of the world, which I'm sure we'll get to. It's probably led to a little bit looser documentation and lender protections, nothing terrible. But again, in the US for companies 50, 75 million [inaudible 00:09:11], it's not that uncommon for the best ones to be done on a covenant light basis. Where again, we'll get to it, but in Europe you really don't see it all that much. So again, US is a great market, but it does show some of the signs, both positive and some considerations around its maturity profile.

Ludovic Phalippou:
Yeah. It seems it's always the case that the US is just like Europe with Wilder. They always take more risks, they play closer to a fence, it feels. [inaudible 00:09:43] closer to wind.

Blair Jacobson:
Indeed.

Ludovic Phalippou:
And for Asia, when you guys have gone this way as well recently, so going global?

Blair Jacobson:
Yeah. So again, we started in the US in the early 2000's, came to Europe in 2007. And Asia is definitely a bit more of a nascent market. And Ares got involved in the private credit markets there through an acquisition we made about a year, 18 months ago, about a 7 billion AUM business. Now this group, however, had been around since 2009. So a lot of experience in there in many, many different countries. So I'd say with Asia in particular, it's a little bit hard to generalize, again, because each country's a bit different, but I can make some comments there. I think when we think about Asia as a market, it's still something like 75% bank driven. So again, direct lending is still very much in the minority. And to compare, in Europe today, we think that direct lenders and banks each have roughly 50% market [crosstalk 00:10:57].

Blair Jacobson:
Yeah, it varies a little bit by country. That said, this non-bank lending space, we think is growing about 15% per year, so we're gaining each and every year. But when we look at Asia, a couple of thoughts. The banking sector in our estimation is that a bit of a competitive disadvantage there. And this is one of the reasons why we think things will grow. A lot of the banks in Asia, for example, they're state owned, quite bureaucratic, quite slow. If you compare that to how private lenders operate, we think we have a very, very clear value proposition. And again, a lot of the bank lending is more to larger corporates, state-owned company. And it's almost like a policy directive that-

Ludovic Phalippou:
[crosstalk 00:11:49] some favors and things like that. Relationship, but in that literal case. And so maybe there's a case for somebody to come in and say, "I don't care about your relationship, I'm going to look at your fundamentals." And then they create an arbitrage for you, no?

Blair Jacobson:
Yeah. And I think that's what we've found. Again, it'll vary a little bit by geography, but again, there are even certain sectors that the banks find completely off limits. Like short-term working capital financing in China has to be renewed every year. In India, banks can't lend to the real estate sector, finance local M&A. There're just a lot of restrictions. And if you're smart and you have local people who've been in those markets a long time, they know the stakeholders, you can build a really nice business there. And I think the observation we've seen is on a relative basis, Asia probably has some of the strongest lender protections for private lenders, very tight documentation. Part of that is that despite the fact that there is a fairly good sized private equity market in Asia, which I'm sure you're aware, probably more of the deals in Asia compared to Europe and the US are family owned, non-sponsored deals.

Ludovic Phalippou:
Yeah. [crosstalk 00:13:06], right. So then it means you're [inaudible 00:13:08] unsponsored deals, right?

Blair Jacobson:
A lot in Asia. And again, from a documentation perspective, you have to be very, very tight. You need pledges over everything, property, assets, shares. So I'd say on average, those loans are a bit tighter in terms of documentation. But also from a risk return perspective, certainly on the return side, we would seek to make a couple hundred basis points higher return in Asia for a roughly equivalent loan, certainly than what we would see in Europe or the US. In Europe and the US, Europe might be a little bit higher on the risk return scale. Not a lot, but there's a decent sized gap then when you look at what we're seeing in Asia.

Ludovic Phalippou:
Yeah. Because I was going say that when casually for me, I'm not as close to you, but casually the banks lending in Asia, even for multinational companies and the like, the interest rates are super high. And it's always a puzzle that why a global company that is located in India can hardly raise any, any debt. And he, they just relocate the headquarters to the US, same company, same markets saying global exposure, then suddenly they can borrow 60% of the asset values because now they are based in the US. It feels a bit strange. So you could say, "Well, it's because of creative protection," but I'm not sure [inaudible 00:14:38] in the US, especially [inaudible 00:14:39]. And so it's always hard to understand why when you are in a country like this, when suddenly people tell you, "Oh yeah, but it's hard to borrow." And you're like, "Why?"

Blair Jacobson:
Yeah. I think there is some arbitrage there. For example, you know, we've been approached by some of these diversified conglomerates, in particular in India, who are looking to get financing out of the UK. I think where we struggle sometimes is if the assets are indeed in India, just enforcement, if things get challenging, can be a bit difficult. But I think what's important to consider is, again, the local regulations that they do face. Not only do the local banks have to deal with the Basel regime that's global and frankly makes it less interesting for banks to lend. But more importantly, again, the security packages can be different, the ability to enforce can be different, and sometimes there is some arbitrage on that elsewhere in the world.

Ludovic Phalippou:
And then the next step, so [inaudible 00:15:41] in the US, [inaudible 00:15:42] in Europe, and 10 years later, Asia. So in five, six years, do you go Africa or [inaudible 00:15:49]?

Blair Jacobson:
Yeah. We'll see. I think, frankly, we're still digesting, there's still a lot of organic growth we're finding in each of our core markets. I think we are always questioning, what is that next step? And in particular, as it relates to emerging markets, we have to remember, we are lenders after all, we do want to make sure that documentation is robust, court systems and lender protections are robust. Because again, our whole goal in life is don't lose money. We're not the equities, we don't have this asymmetric upside. And I think there is a school of thought that says, "The more you get into the emerging markets, the more your debt looks a little bit more like equity." And that's something we're always considering. However, on the contra, you've also seen some countries improve. And actually we've seen this in certain European countries, we saw it in India as well. They've actually improved lender rights. So they've been proactive, they understand that this capital is out there and valuable, but they have to make some changes before it becomes a mainstream, attractive place to do business.

Ludovic Phalippou:
What's an example of something that is really key for lender rights, and you don't see in other countries, what is it?

Blair Jacobson:
Sure. It can be something, it's not simple, it's actually quite complicated. But for example, the insolvency regime. Again, if a company is in violation of its credit documents, either from a covenant perspective or a payment perspective, what is the path for a lender to exercise their rights? What can be done by the borrower? Also very importantly, how long does that take? In any restructuring situation, I always say time is your enemy because you need to do things as soon as possible. But if there are regimes where it takes two years with companies being zombies in limbo, while the lenders try to enforcement actions, that's a real problem. And again, in an asset class where getting real par recoveries is so critical to our returns and to ourselves and our investors, that's something we don't take lightly.

Blair Jacobson:
So what we've seen is we've seen some developments to streamline those restructuring regimes. The other thing I would comment on is how our different stakeholder's claims are valued, what weight of importance are they given? For example, there are some countries in Europe, which you may be aware of, where for example, the employees of the company are basically treated as a meaningful stakeholder when they don't have a financial risk directly in the business. And again, things that make it easier, more effective for us to lend money and importantly get it back are viewed very favorably by groups like Ares.

Ludovic Phalippou:
I see. And you were talking about the new frontiers. When we talked a bit with James, he was saying that because you guys are becoming so big, you can learn to go higher in the spectrum of sizes. Nowadays you can lend 1 billion to someone. So that seems to be a natural progression. So when you're so big, the same way, as you said, the banks were getting bigger and they couldn't be bothered with small guys. Nowadays for you guys to sign a $50 million check is boring and too costly even.

Blair Jacobson:
We still do that. I'd make two comments. One is, we are real observers of what we call the convergence between the private and the, in the public or liquid credit markets. Again, started in the US, however, it has come over to Europe. And we've been on the forefront of that, we've done a handful of deals with over a billion of loan value. The challenge though, is if I were to do that to make, say 6% on the loan, when I tell my investors I want to do better, it really doesn't help. So I still need strong return profile, very good risk profile. And again, if I find a deal that doesn't match it, it's not a good fit for us. So I do view that as a bit more of an opportunistic opportunity. However, what I would tell you is, we're seeing more of it today certainly than we did 3, 4, 5 years ago.

Blair Jacobson:
And then the other challenge which you make is an important one, which is to say, "Well, we cannot forget where we came from. We still need to have relationships and lend to small businesses." Because a lot of what we do is we help small businesses become big businesses. We have a company in the UK, we made our first loan when the company had about five million of profit or EBITDA. Today, it's close to a hundred, and we've been with it the whole time. Different capital structures, making acquisitions, two different private equity owners. And for us, that's really good business to stay with these companies. So we can't forget where we came from. I think the other thing we're really focused on is giving our investors very diversified portfolios, because obviously credit's asymmetric. So having lots of positions in our funds is super critical, and having smaller deals compliment some of the bigger ones is a key way that we do that.

Ludovic Phalippou:
I see. Because indeed, this crises shows that if you had the portfolio that was mainly concentrated in retail, it would have been a bit difficult. Retail, leisure, et cetera, would be tricky.

Blair Jacobson:
Very difficult.

Ludovic Phalippou:
But this is where traditional [inaudible 00:21:20], because in private equity deals, private equity did okay because one third of our portfolio were software related, and this did very well and the rest was more in trouble. But the lenders don't lend too much against softwares and the like. So you were probably a bit more into the leisure part of private equity, which is the one which wasn't in depression, no?

Blair Jacobson:
It's interesting, just cause this is a very topical current conversation. I think of sectors in three buckets. The first is stuff that's done very well through COVID. That's telecommunications, healthcare software, niche business services, even things like wealth management and insurance brokerage. And by the way, we have a lot of exposure to those sectors. On the other end of the spectrum are really cyclical sectors and end markets, automotive energy, high-fashion, retail, things like you've said. That's an area that we've historically shied away from. Now, what really needed help was this middle bucket, which are businesses which are economically resilient, but not made for lockdown. That would include things like dentistry, veterinary care, children's care, nurseries, even to some extent, pubs, gyms, et cetera. And the good news is those were closed and locked down 1.0 here in Europe, but when they reopened last summer, they quickly rebounded very, very, very, very strongly. So I think what you're seeing, which is interesting, is the businesses in that first bucket, everyone's running to those now, because they're quite defensive. So you have to be very careful and pick your spots on the risk reward side there.

Ludovic Phalippou:
Excellent. And maybe another frontier that I want to know if you guys explore a bit is, how about looking at becoming also managers of companies? So when you have a crisis, especially like this one, often the equity holder's in trouble, technically the companies should come back to you. And then people say, "Well, all these things are complicated because the debt holders cannot really run companies, banks certainly cannot." But you guys seem to be so big and so experienced that it feels that, from a regulator point of view, you may be a safer hand as a debt provider. Because if a company was in trouble and then would go to you, you would be able to manage it, while if it goes into the hand of a bank, it's trouble. Is that fair?

Blair Jacobson:
Yeah. Here's how I would frame it and echoing what I'd said a little bit earlier. Our goal in life for our investors is don't lose money. So if we make a loan and the company does not perform as expected, we like to sort that out ourselves. We don't sell our loan in a block to a distress fund or what have you, and have them capture that value from where we sell it back to par. We do that ourselves. And the way that we do that is we have invested significantly in our business, both in Europe and the US in particular, in having basically dedicated workout teams with indirect lending.

Ludovic Phalippou:
So you'll be behaving like a private equity guy, right?

Blair Jacobson:
Well, it's not our goal in life. Our goal in life is to have a loan. We get our fee in interest, and company gets sold, we get our money back. But if things don't go as we think, again, that's why we have covenants, that's why we have rights to step in before there's value diminution in the businesses that could ultimately impact our ability to get our money back. And we're not afraid to take the keys if we have to. It's usually consensual, by the way. As you said, a lot of times private equity, maybe they put in money one or two more times, but they're not going to put infinite capital in. And the way I always frame it is, if a company's bought say for 200 million pounds, usually we're roughly 50% loan to value. What that means is, private equity's put in a hundred and we've put in a hundred. Now obviously our break even point is completely different from theirs.

Ludovic Phalippou:
Yeah.

Blair Jacobson:
So there can be real value diminution and we just have to get the company back to a hundred, they've got to get the company back to 200. And again, the question for them is always how much money do they have to put in the business to make that happen, which is different from our view of the world. So what I would tell you is, we do have the ability and have in the past taken over companies when the equity has walked away, and that's okay.

Ludovic Phalippou:
Makes sense. Okay. Thank you very much, Blair. I know it's a very busy time for you, so thank you so much for walking us around the world in private equity and private debt, especially. So this was Private Debt, the global version, Laid Bare. Don't forget to subscribe and to rate it if you liked it. And congratulations on your acquisition of one more piece of knowledge. Ciao, ciao.