The One Credit Newsletter You Need to Read
It's not mine..
I started The Credit Crunch to learn from great credit investors and managers. Over the last two years, I’ve shared thousands of articles and thought pieces on private credit. With the benefit of hindsight, if you asked me, “What is the one piece of content I would recommend you read?” Without a doubt, there would be only one answer. And that would be read In the Gaps.
In the Gaps is a newsletter written by The Ares Alternative Credit Team and published three to four times a year. The team uses stories and insights to highlight risks and opportunities that are not easily identified. They’ve shared tales of “Squealing Pigs”, “Flaming Gerbil Wheels of Death,” and many more. Each story corresponds to new and emerging opportunities. These opportunities are spread across a wide range of assets, from traditional assets such as auto loans and consumer credit to niche assets like music royalties and Amazon aggregators.
In the Gaps delivers analogies without the fluff. Market commentary without the sales pitch. Insights that you can implement.
I had the privilege of speaking with Joel Holsinger a few months ago. Joel Holsinger is a Portfolio Manager and Co-Head of Alternative Credit. He is also one of the authors of In the Gaps alongside fellow Portfolio Manager and Co-Head Keith Ashton.
Joel is extremely passionate about credit investing. In fact, he was so engrossed in our conversation that I had to remind him of his hard stop—20 minutes past his scheduled stop.
Ares Alternative Credit’s Top 15 Lessons Learned.
The Ares Alternative Credit Team’s mantra is “Kaizen investing with purpose.” Kaizen is about improvement as a process – gradual, methodical, and self-reflective. At the end of every year, the Ares Alternative Credit Team answers 10-15 questions designed to provoke self-reflection. The main goal is to learn from their mistakes and embed these lessons when evaluating new investments or working in difficult conditions.
This reflection has allowed Joel and his team to develop a list of 15 (Originally 13) Top Lessons Learned. These are the foundation of In the Gaps and are regularly referenced across the newsletter.
Below are three of my favorite lessons:
Lesson 2 - Buy assets and cash flow, the rest is noise: FOMO on the “next big thing” is often the pathway to the next big bubble. In credit, we are measured not by our wins but by avoiding losses. We believe sticking to fundamentals and ignoring the noise is the only path to long-term returns. While compounding has been called the eighth wonder of the world, it can’t overcome high severity losses (which often begin by ignoring rule 2).
Lesson 8 - Risk is exponential. The market often prices it as linear: Investors focus on the valuation but often ignore where they are investing along the risk curve. Imagine a company worth 10x with leverage through 6x including a second lien that starts at 2x. Compare this to a company with the same 10x valuation and leverage, but a second lien that starts at 4x. The market often prices both seniors and second liens within bps of each other even though the risks are dramatically different. Analyzing investments by unit of risk and by attach/detach allows you to see mispricing and inefficiencies. Credit investing is about avoiding the losses; the best way to avoid the losses is to take less risk for similar returns.
Lesson 10 - Money makes the world go around; credit makes money go around: All assets—from cars to companies—are valued not by the equity markets but by the availability of credit. The arb between assets and liabilities (credit) is economics’ version of gravity, and gravity always wins in the long-term. It is why default cycles and economic recessions are just a story of credit expanding and contracting.
Before you start reading In the Gaps, I recommend you read and reflect on these. You can read the full list of lessons here (Page 19)
There have been many times this year where I wish I had spent more time reading these lessons before I acted.
Read Lesson 9, if you’re wondering why their newsletter is called In the Gaps.
Best Articles
For anyone wanting to read In the Gaps I’ve created a Google sheet that allows you to:
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If you’re looking for a place to start, below are five of my favorite insights:
VENTURE CAPITALISTS AND UNICORNS (Q4 2021)
Context: Ares published this newsletter in Q4 21 when public market valuations were at all-time highs and software valuations looked particularly frothy. Consensus at the time was that software was “eating the world” and many, including Howard Marks, published arguments on why these valuations may have been justified.
Lesson: “Buy assets and cash flows, the rest is noise.”
Insights: Only 0.2% of VC deals have delivered performance as public companies commensurate with the risk of those initial capital investments.
Supply and demand drive a business model; once that model is established, while it can be optimized it rarely sees dramatic change. Businesses that begin with 10% EBITDA margins rarely turn into businesses with 40% margins.
Amazon is the notable exception.
The average public software business valuation fell more than 50% in the months following this newsletter.
SIX COMMON MISTAKES OF CREDIT INVESTING (Summer 2024)
Context: The latest edition of In the Gaps is a must-read for any asset-based credit investor. A personal highlight is the section on the most common mistakes when making asset-based credit investments.
Lesson: “Money makes the world go around; credit makes money go around” - The asset-liability arbitrage.
Insights: Most analysts over-index on IRRs and ROEs rather than analyzing the real driver of returns, asset yields. A healthy asset-liability arbitrage allows for risk and value to be distributed across the capital structure (i.e., all stakeholders are fairly rewarded for their risk). A weak or broken arbitrage creates a situation where risk and value can shift or concentrate in one part of the capital structure at the expense of the other part. This trend has been seen in Music Royalty financing (See below).
Mistakes are made when investors have to continue investing in the part of the capital structure where risk has shifted without a compensating quantum of value. This is one of the downfalls of platforms targeting niche assets. These strategies are paid management fees and are committed to investing even if the asset-liability arbitrage is broken. See the trucking analysis of this newsletter.
PULLING BACK THE CURTAIN ON MUSIC ROYALTIES (Q4 2021)
Context: Music royalty financing has become mainstream and asset values have been driven higher at an unprecedented rate. Since 2015, music royalty revenues have grown at an average rate of ~10% per annum and are expected to double by 2030.
Lesson: “Visualize the cash flows to understand drivers and risk.”
Insights: Take a look at Bruce Springsteen’s recent transaction at 30x sales. To achieve an 8.5% investment return, Bruce’s catalogue would have to experience streaming growth that is 3x faster than the market is projected to have, at nearly 30% annually, for the next ten years. Let’s now look at Bruce’s transaction from a downside risk perspective. If Bruce’s catalogue revenues instead grow at only 18% per year, which is still 2x faster than the market’s projected growth, that investment is at risk of losing money. A revenue growth rate of nearly 20% will be required just to breakeven.
RISK IS NON-LINEAR (Winter 2024)
Context: Three or four sectors account for 70%+ of the defaults during credit cycles. The experience of a credit manager will therefore be heavily influenced by its exposure to these sectors, "the tail".
Lesson: “Risk is exponential. The market often prices it as linear.”
Insights: Market default projections are not helpful in assessing loss risk in individual credit portfolios. The size and constituency of the tails matter. Ares believes that some managers and credit funds will sail through the next few years largely unscathed while others will have a very different experience.
Default rates are often where pundits and media focus, but they only tell half the story. The forgotten other half is recovery rates. As an investor, net losses matter… and default rate times recovery rate equals net losses.
As Charlie Munger said, “A majority of life’s errors are caused by forgetting what one is really trying to do.” Investing in credit is not about your wins but rather avoiding losses.
EASY MATH, HARD REALITY (Spring 2023)
Context: As interest rates increase companies must reduce leverage. Failure to do so can have a significant and detrimental impact on its free cash flow.
Lesson: “Buy assets and cash flows, the rest is noise.”
Insights: Below is an example of a middle market company that generates $100 million of EBITDA and wishes today to borrow $750 million as they would have done three years ago in a lower interest rate environment.
The table below compares what that $750 million loan would have looked like three years ago; what it would look like today with the same terms; and what terms would most likely be achievable today.
This analysis also highlights the transfer of value from equity to debt. Higher nominal interest means that debt expense consumes a larger share of earnings. Additionally, companies are increasingly likely to need equity or subordinated capital to address their ‘2021’ leverage problems. This will impact exit outcomes for equity.
I’ve found this particularly helpful when managers talk about the bifurcation between 2021 portfolios and their new funds.
This newsletter is for education or entertainment purposes only. It should not be taken as investment advice.