Marathon Asset Management

Bringing out the Big Guns:  The Fed is about to enter an easing cycle that will prove supportive for Private Equity. While PE sponsors do not hibernate like bears in the winter, sponsors have been quiet from an acquisition/exit standpoint since the past two years have proven difficult given equity valuations and higher financing costs (SOFR rose +525bps). Ditto for perspective homeowners who have bemoaned the fact that home prices/mortgage rates/operating costs make ownership less attainable. But relief is coming. Looking forward, I expect SOFR to gradually decline by 200bps in the next two years as the Fed eases and inflation normalizes. Other considerations will come into focus for LBO sponsors: 1) potential for higher corporate tax rates, 2) changes in supply chain cost structure derived from nearshoring and tariffs, 3) slower economic growth, 4) regulatory scrutiny from FTC and EU that impacts (e.g. technology, healthcare) and 4) valuations have risen to all-time highs. Despite this, PE is sitting on $1.2T of undrawn capital globally. $1.2T of dry equity powder with lower future financing rates as lenders are willing to provide a dollar of debt for every dollar of equity. During the past two years, PE has focused on value creation with add-on acquisitions, revenue growth, improving operating metrics, technology investment, CapEx, streamlining costs, improving margins all to minimize/offset higher interest charge. By and large, PE has performed admirably despite the higher interest rate regime, and slower deployment/exits. Going forward, I expect greater exits plus dividend recaps to return capital to LPs. The average LBO PE-multiple is 12x EBITDA with stapled financing of 6x debt-to-EBITDA. LBOs on the rise, the lull coming to an end, the big guns are out and ready for hunt.

Never ZIRP Zero is the value of global debt that now trades at negative yields. $18 Trillion is the value of global debt that trading at negative yields during ZIRP, with peak valuations for government debt during 2020. September 18th is the day the Fed embarks on its path to lower rates in the coming year. Hopefully, the Fed, BOJ, and ECB have learned their lesson from the enormous bond bubble they created during ZIRP, and vast distortion/misallocation of capital impacting vectors of the markets and real economy including government expenditures, bank profitability, corporate leverage, home prices, bond investors, private equity, venture capital, currencies. It is best for central banks to set their bank lending rate, and let the market determine the term structure for interest rates. Since the ECB ended ZIRP in July 2022, European Banks have rallied 55%.

The Tide Has Turned: With Q2 earnings in the books, credit metrics are now on the upswing. EBITDA and Debt-to-EBITDA improving (see box chart below), and debt service charge will begin to improve too as the Fed begins a series of 25bp declines in its coming meetings. While lower all-in yield for BSLs & Direct Lending will decline marginally, defaults rates and loss rates will also decline. I expect the Credit Markets, both fixed and floating to offer healthy risk-adjusted returns. Source: Pitchbook

Today’s TAM: Debt & Equity Markets Market Capitalization for Equities globally: ~$125T. U.S. equity markets represent the greatest percentage of this global number, and given the 2024 rally, U.S is ~ >44% of world market capitalization. If one were to evaluate the attribution from the MSCI World Index, U.S. public equity market cap is 60% of the globe! Global Debt is ~$150T measured in liquid tradeable securities; if one were to count all debt, including bank balance sheets, private loans the total debt outstanding is >$300T or equal to 3x the size of world GDP. U.S. debt is 39% of TAM as shown below, but the U.S. government deficit is adding to this figure at an unprecedented pace of +$1 trillion every 100 days! The TAM for Debt and Equity markets combined is 2.5x greater than the GFC (2008), which one could argue in sync with the growth of the global economy. However, a closer look at the data shows us this: 2008 Global Economy was: ~$65 Trillion 2024 Global Economy is: ~$108 Trillion 2030 Global Economy forecast: ~$140 Trillion The Bottom Line: -Debt is growing much faster than the economy, an issue we must be very aware of; -As the global economy grows in the next 5, 10, 20+ years, the size of the debt and equity markets will grow commensurately, you can bank on it, with 100% confidence.

The Time Has Come Jackson Hole take-a-ways: - Powell dovish comments “the time has come for policy to adjust” whereby it is a near certainty that the Fed will cut in September, likely 25bp rate as I have expected - Other Fed Committee members agree based upon their recent comments - Powell is focused more on employment, less on inflation: "The upside risks to inflation have diminished; the downside risks to employment have increased." - Powell said “ we will do everything we can to support a strong labor market as we make further progress toward price stability” - Powell stated, “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks” - With GDP +2%-plus and inflation on a clear path towards 2%, there is a low likelihood of recession at this juncture, expect 25bp cut, not 50bps - The question is: what’s the Fed Funds neutral rate, how many 25 bps cuts until Fed take an extended pause? Markets are fully pricing in 25bp in September, 3 cuts in 2024. Employment report on September 6th will be all the focus since Powell told us today, he does not want to see further weakening in employment

Bruce Richards discusses Marathon Asset Management's dedication and expertise across Asset-Based Lending and the breadth of opportunities.

Government Can’t Count Correctly -> Does Fed Set Monetary Policy based upon Incorrect Data? Non-farm payroll numbers were revised lower by 818.000 jobs (see chart below). Over the past year, the U.S. government Bureau of Labor Statistics have been overstating job formation. This does not impact the unemployment rate since the rate comes from a different data set. The new job formation is a key component in the Fed’s economic model as to economic growth, which informs monetary policy. The BLS’ Establishment Survey, which surveys 119,000 businesses and government agencies each month is a random selection from the 11.3 million business establishments. Economists usually chalk up small differences to recalibrating estimates, benchmarking, monthly timing differences, and seasonality, however, the BLS data was so grossly wrong due to a big miss on the "birth-death" model, which estimates the new business openings/closures. In the past 12 months, ~63,000 businesses failed in the U.S. Over the past decade, the typical range of business failures in the U.S. is between 20,000 and 30,000 per year. Why did so many businesses fail over the past year when the economy was so strong? Tight financial conditions for small businesses that struggled in a higher rate environment was a key reason, however, many companies that might have failed during the COVID pandemic were kept afloat by government support are now facing financial difficulties as those supports have ended when the debt bill came due. With the technology tools available (thank you Silicon Valley) it’s remarkable that the government process to collect data is manual and antiquated, relying on small sample set surveys to estimate important statistics that impact the Fed/Monetary policy and markets. The Department of Labor employs 17,000 people, but perhaps they need a few thousand to sit around the table to calculate the data correctly. Automation and AI-powered data collection might be more useful (note: every payroll period, business report/withhold for Social Security, Unemployment Taxes, State and local, etc) led by data scientists developing advanced statistical models. Today, Jay Powell and Central Bankers meet in Jackson Hole, WY where he will communicate in ‘Fedspeak’ that: 1) despite yesterday’s revisions in payrolls, job formation is still healthy but softer, 2) GDP continues to exhibit strength, but is softening allowing for inflation to slow, 3) PCE & CPI look well behaved gliding towards the Fed’s 2% target, 4) the first of several Fed cuts to come, but as always, it’s data dependent. So, get ready, it’s almost time -> my expectation if for the Fed to lower rates by 25bp on September 18th.

Should You Buy the Asset or its Producer? Are you better off allocating to Gold or Gold Miners? Bitcoin or BTC Miners? SPX or Brokerage Firm? Generally, it is a win-win, however on the margin, and performance is measured in relative value, one is better off in the asset than the producer. Yes, I would rather own gold or BTC than their miners, despite strong performance by the miners, as the 3 charts below demonstrate. When you buy the physical your exposure is directly tied to its price, including ETF of physical. The miners add an additional layer of risk and are often not long significant quantities of the physical in deliverable form. While the miners’ stock is impacted by the price of the physical, it is also impacted by management of the company and its decisions, labor costs, CapEx, production costs, regulatory risks, its capital structure, and debt costs to finance its operation, and operating costs and profit margins. Net-net, the physical commodity usually has less risk because of the additional consideration of the company’s operations and its equity risk. Look no further than Lehman Brothers and Bear Steans, two proud companies that failed (2009) v. the performance of S&P 500. Likewise, many Bitcoin miners collapsed during the dark white crypto winter just 2+ years ago and many more would’ve if not for the pivot to AI compute, or the gold miners that must contend with strikes and geopolitical risks. When you own the commodity, there isn’t operational risk. When capital allocators consider their portfolio mix and real assets including commodities it’s an interesting conversation for your investment team to ponder. Long term wealth creation can be captured by buying the equity of the producer, however, in select cases the physical asset has performed better over the long run for assets such as gold, BTC and SPX. Oil, industrial metals, food commodities which have a seemingly endless supply and are produced in large quantities globally - the result is the opposite since the companies most often outperform the physical commodity given supply dynamics for the commodity. As a creditor, we are active in financing strong low-cost producers, yet we pay close attention in underwriting a commodity producer to the commodity bear case scenario to ensure the company can withstand trough prices. Commodities are inherently volatile, and while there are times to be constructive, as a creditor we always focus on protecting the downside. Huge CapEx to build a mine or plant can take years with cost over runs and uncertain sales projections, as well as transportation costs to deliver the commodity to its distributor. My preference is always to see it operational before providing financing. Project finance is too often mis-priced relative to risk. The price for Gold & BTC is up significantly in the past 2+ years. Meanwhile the miners are relatively flat, as is the Commodity Index (CRB), including metals, food, lumber, and the oil/gas/energy complex.

The Larger They Are, The _______ Larger LBO transactions - two key considerations, 1) deal flow has slowed materially, 2) BSL is fighting back as banks arrange financing terms that are highly competitive for syndication which then has the knock-on effect for private credit to compete in Upper Middle Markets and large deals to provide tighter spreads, looser documents, and cov-lite loans. However, the Middle Markets and Lower Middle Markets still carry wider spreads, tight documentation, and strong covenant protection. Bottom line for investors: Money-center banks are punching back at large Private Credit lenders, and spreads have gapped in for larger loan deals as terms converge with BSL. Moral of this story is to maintain investment discipline and stick with Middle Market Lending -> better returns, more consistent credit outcomes. Marathon Asset Management sees this with our own deal flow stemming from our robust origination platform. The chart below shows the dominant share of Middle Market M&A and thus the opportunity for Middle Market Direct Lending whereby non-bank lenders (private credit funds and BDCs) provide financing for sponsor and non-sponsor backed transactions.

Insurance Costs Soar Like an Eagle, but You Can’t Live/Drive Without It: Great CPI print yesterday that gives the Fed flexibility to lower rates in September. What is not good is the soaring costs for insurance. Adults are getting pummeled by surging auto insurance, healthcare insurance, and home insurance. Auto insurance rose +18.6% y-o-y as reported by BLS in yesterday’s CPI report; insurers are increasing premiums in response to auto repair costs. Home insurance rising sharply as home replacement increases with higher incurrence from damage from wind/fire/water damage results in insurance losses in 18/50 states Healthcare costs rose ~+7% y-o-y as medical care wages, pharma prices, doctor office visits and hospital costs have risen faster than CPI; healthcare insurance rose +50% over 10 years, with family coverage national average of ~$25,000 currently. Who benefits? The insurance industry of course. IAK, the ETF of domestic insurers up +33% y-o-y. Leading insurers included in the ETF: Progressive, Chubb, Travelers, AIG, Aflac, Allstate, Met Life, Hartford. Unfortunately, we can’t drive or live without it. Below is the IAK price chart; plus the AM Best Report on Home Insurance/states that insurance companies claim to lose money.